A brief mental model for thinking about monetary policy and resource misallocation
With two recent Fed governors – Tarullo and Brainard – expressing a need for caution with normalizing Fed policy, I wanted to break down how I tend to think about monetary policy and its affect on resource allocation and private portfolio preferences. While I give the doves credit in that the US economy would suffer due to the portfolio preference and resource allocation shifts after a rate hike, I also believe that the Fed’s move to a zero rate policy is an artifact of excessive reliance on monetary policy to do the heavy lifting of cyclical policy adjustment. And the necessary consequence is resource misallocation that will make the next cyclical downturn more pronounced.
Let me say at the outset here that I would consider my economic thinking at this point to be part standard economic theory and part heterodox, with heavy influence from both Post-Keynesian and Austrian schools as well as some influence from monetarists. It’s a bit of a hodge podge in that sense. And so the mental models I construct to think about macro phenomena reflect several strains of economic influence. What I am going to go through with you today is very much in that vein, with the central element of private sector credit-based demand growth largely an outgrowth of post-Keynesian influence. On the other hand, the stuff on resource misallocation is strictly Austrian in nature.
Let’s look at this in narrative form to make the points more clear, rather than using charts and graphs.
I want to start with the understanding that there is an inter-temporal mechanism that credit creates for economic output. The reason credit growth has a high degree of correlation with change in GDP is because GDP is not just derived from income but also from credit, that allows additional production in the present using funds to be earned later. Credit is created out of thin air, meaning that when a financial institution makes a loan, it creates a deposit – it creates money. And that money is used to increase output and add to GDP growth. This is why private credit growth is so important in understanding how well the economy is doing.
Monetary policy comes to bear here by affecting the price of credit, the interest rate that creates the inter-temporal transformation of future income into present credit and income. In conducting monetary policy, the Fed is mostly concerned with medium-term sustainability of domestic demand growth as manifested by inflation and employment levels. And it uses the interest rate level to affect these variables. However, after the most recent crisis, it has turned to other unconventional policy measures as rates have gone to zero.
Could it be that Fed is pushing on a string, that monetary policy is much less effective? I say, yes. This is true particularly when private debt levels are high, and resource slack – as measured by capacity utilization and labour market slack – is high. In times like these the capacity and/or desire to take on or allocate more credit is weak. No matter how much easing the Fed does, it will not have the desired impact on the real economy in reaching full employment or getting inflation to the desired level.
The Fed never seems to acknowledge the potential ineffectiveness of monetary policy. Instead, Fed Chairs have talked about the additional firepower the Fed can bring to bear on the economy with unconventional policy, even with interest rates at zero. Moreover, they claim that just having rates at zero is stimulus enough that will have the desired impact on employment and inflation. But what about the financial economy – the high cyclically-adjusted market P/E ratio, the huge shale oil capital investment binge, and the gargantuan levels of student and auto debt now being taken on? Aren’t these indicators of the efficacy of Fed policy to shift resource allocation and private portfolio preferences? Yes, 100% yes.
I believe what we are seeing is a divergence between the interest rate and monetary stance consistent with real economy full employment and moderate inflation and the rate and stance consistent with small shifts in private portfolio preferences and low resource misallocation. Much of this divergence owes to the private debt overhang that still exists in the US. Banks have rebuilt balance sheets but credit growth to households remains weak because households are still recovering from the mortgage debt binge of the previous decade. As a result, the easing the Fed has done has been concentrated in other sectors like student and auto debt, and shale oil as well as in portfolio preference shifts between domestic and foreign assets.
Think back to the “currency war” that Brazilian Finance Minister Guido Mantega complained about as quantitative easing got underway. Yes, there was a “currency war” in that Fed policy induced a portfolio preference shift away from lower-yielding US-based assets because the Fed was signalling that policy easing would remain in place for some time to come. There was a massive flow of capital to emerging market mutual funds, to emerging market commodity plays and the higher-yielding emerging market bonds. EM currencies soared and those economies overheated as a result.
But once the Fed switched tack to tightening – And, yes, tapering IS tightening, announcing intentions to raise rates IS tightening – the flow went the other way and emerging market currencies were crushed as money flowed out. Now my good friend Warren Mosler points to the Saudis as the price setter and swing producer on why oil prices have declined. But we have seen a rise and then precipitous drop in all commodity prices and a huge rise and then fall in emerging market currencies. It is clear that these markets are all moving in tandem.
The Fed is the world’s central bank, not just America’s. These events make that clear. The Fed, by resisting the urge to hike rates in September, has recognized this. And now, the doves are coming out to urge the Fed hold even longer. Here’s what Lael Brainard had to say about the feedback from international developments:
There is a risk that the intensification of international cross currents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions. For these reasons, I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery–and argue against prematurely taking away the support that has been so critical to its vitality.
She’s saying in effect that the Fed is the world’s central banker. And the monetary tightening the Fed has already conducted has been felt full bore abroad and could boomerang back on the US if the Fed tightens any more. Dan Tarullo is saying the same thing.
So what’s the takeaway here?
First, permanent zero is back on the table as a potential policy outcome i.e. the Fed may be at zero indefinitely.
Second, to the degree the US economy weakens enough to precipitate recession domestically, permanent zero would create a Japanese scenario in which there is no room on the short side to go lower and the long end of the curve flattens, eroding net interest margins and restricting the ability of financial institutions to deal with credit losses via a steepening yield curve. The shift to permanent zero is toxic for banks and that means credit growth will be anemic to the degree we are still at zero when the next recovery begins – which, of course, makes the chances greater that zero rates remain in place for longer.
Third, we should expect long-term yields for safe and near-safe assets to stay low and the convergence to zero trade definitely make sense in that environment. That means safe assets in Australia, New Zealand, Canada first and in the US and the UK second.
Finally, I think all of this points out how a monetary-heavy policy response has reached its limits. The lack of further credit writedowns offset by fiscal policy in the form of tax cuts or countercyclical spending will limit the ability of the economy to recover sustainably as long as the private debt overhang is in place. Japan is the model here, especially for Europe where the demographics are less favourable.
I still hold out some hope for this cycle powering through due to an uptick in wage growth. However, the evidence is heavily tilted toward a less benign outcome given the decline in the rolling 12-month growth of non-farm payrolls and the existing misallocation in shale and autos and education. Let’s see what the data bring. My mental model says the misallocation has already occurred. And that will be hard to overcome once credit to those sectors stops flowing.