Inflation, investing, bond prices and monetary policy

Today’s commentary

Summary: Over the past few years, investors who have expected aggressive monetary policy to produce high levels of consumer price inflation and have invested accordingly have been disappointed. The right question goes to why consumer price inflation has remained subdued and whether it will continue to do so. Below are a few comments on this topic.

I am due to be at a Euromoney conference on inflation-linked products all day tomorrow. I believe my view here is reasonably clear but I thought today would be a good time to revisit the theme of investing in a world of low interest rates and aggressive monetary policy. The last time I addressed this question was in August when I laid out How the United States gets deflation and becomes the next Japan. My thesis was as follows:

1. We live in an endogenous money world. That means that demand for and supply of credit – not base money supply – largely determine broad money supply and credit growth aggregates. In our post-crisis world we are seeing this.
2. Increases in base money will not spur credit growth. The attempts to spur economic growth via credit growth are at heart based on the money multiplier fallacy that sees credit growth as dependent on base money growth. But in an endogenous money world this hasn’t worked and it won’t work.
3. The problem is private debt. You cannot get broader credit and money aggregates to grow in a world of restrained credit demand/supply no matter how much QE you do to add to the monetary base. The system is constrained by high levels of private sector debt and the attendant balance sheet issues at financial institutions servicing that debt.
4. So what happens in the next downturn? I have always believed this is the critical question. As I laid out this thesis mentally, I asked myself what happened when you have near-zero rates, extraordinary levels of monetary ease and liquidity, increasing public debt, and high private debt when recession begins? I think you get deflation, spiking non-performing loans, credit writedowns, insolvent financial institutions, massive private and public sector pension problems and renewed crisis. This is Japan.

Please read the full piece to get a more complete view of my argument. This thesis is largely framed from a deflationary angle i.e. from the viewpoint that slowing or contraction of private credit is the determining factor in consumer price inflation from a financial economy perspective. That is to say, I am looking at this in terms of financial economy constraints as opposed to real economy constraints. And because private debt is high and nominal interest rates are low, the constraint to high levels of private debt growth is large.

But what about the real economy? For example, we learned last night that Japan is now seeing the highest real growth and lowest deflation numbers since the global credit crisis began. Japan is the model for what awaits the U.S. and Europe. And the real economy is responding to the stimulus that Japan has enacted. Irrespective of the secular and political forces impinging on Japan, that has to have a medium-term effect on asset prices.

Two things here. First, we have to broaden the inflation discussion to include both consumer price inflation and asset price inflation. In an environment of excess capacity and elevated unemployment, it is unrealistic to expect consumer price inflation to become unanchored easily unless labor has some sort of collective bargaining power to force up wages. Absent some sort of market power, excess capacity translates into price cuts by sellers as opposed to price increases. On the other hand, while there is excess capacity in the real economy, in the financial economy there is a shortage of higher-yielding safe assets. The crisis has caused the real economy to turn south and capacity to overflow to excess but it has also caused monetary policy to loosen, making higher-yielding fixed-income financial assets more scarce. And because all contracts are in nominal terms, this creates a dilemma for those looking to match liabilities and assets in nominal terms. Either you increase risk by chasing higher yields to maintain your nominal yield targets or you increase risk by moving into non-fixed income asset classes in a bid to boost nominal returns or you accept the lower yield environment and use current income to make up the shortfall in your asset-liability mismatch. This is why low rates have caused investors to move into EM, junk bonds and elsewhere as they reach for yield.

The result of reaching for yield is asset price inflation. It drives up prices of fixed-income assets, it drives up the prices of alternative asset classes and it drives down discount rates which boosts the returns from distant cash flows. So while the real economy suffers from low inflation and deflation concerns, loose monetary policy as a response to the downtrend in the real economy creates asset price inflation.

Second, the cyclical forces that create forward momentum in a business cycle do not get repealed by a secular bear market or even by an economic depression. Eventually momentum shifts during business cycles and the economy turns up. We are seeing that in Japan, in China, in the U.S., and in Europe. The result is that the asset price inflation that is a natural outgrowth of easy money is aided by the cyclical upturn in the real economy. And that creates a dilemma for investors because missing a bull market is a dismissible offense whether that bull market is a cyclical or a secular one. I would even argue that the desire of investors to chase returns in order to meet the market performance has an amplifying impact both to the upside and to the downside.

The overall point here then is that we are in the sweet spot of the business cycle upswing within a broader deflationary environment. That means we are going to see yields tick up to a certain degree. We are also going to see shares tick up. That is normal. And if you are managing money, you have to be cognizant that these cycles can go on for quite a while, the U.S. cycle from 2001-2007 being a perfect example.

The bottom line here is that the real economy is doing fairly well in a number of developed markets. And it is improving in Europe, even in the periphery. That speaks to asset price inflation but I am still on the fence as to whether this can generate any consumer price inflation in the U.S. before the cycle turns down. We are a long way from full capacity and wage growth just isn’t there. Consumer price inflation quickly becomes demand destruction in such an environment. So for now, I think the bull can run even while it is vulnerable to a major correction in the near term. It is the cyclical downturn where the big problems will arise.

That’s my thinking here. I am looking forward to the investor conference to see what others are saying.