The Federal Reserve (Fed) has announced that it will start tapering soon. To some, this news is welcome, for they believe inflation may get out of hand. Others are worried given that growth numbers already seem to be easing. In either case, these worries are misplaced. The fact is that what the Fed does or does not do matters little for inflation nowadays.
- Do not fear the taper and stay invested.
- As for inflation, we continue to believe the current inflation episode is transitory and that ‘gravity’ still pulls us towards deflation.
The Fed has been incessantly ‘printing money’ for over a decade now. Yet, and despite numerous predictions, US inflation has struggled just to meet its 2% target up until very recently. Why is that? The short and simple answer is that monetary policy is unable to stimulate lending and credit as it did prior to the Great Financial Crisis.
Richard Koo, chief economist at Nomura Research Institute, came up with the concept of ‘balance sheet recession’ after studying the case of the Japanese economy following the bursting of its equity and real estate bubble at the beginning of the 1990s. The basic concept is quite simple, but it turns mainstream economics on its head. In a classic economic textbook model, as interest rates go down, the demand for credit increases. This postulate is true for both well-being-maximising households and profit-maximising firms and is at the base of the credit transmission mechanism. But Mr. Koo lays out a situation in which the private sector stops maximising its objectives because it has just suffered a huge, negative wealth shock. This was the case in Japan, and later in the US as a result of the financial crisis, and in the Eurozone, following its own debt crisis.
The resulting loss in asset values is compounded by the still important stock of debt (e.g. mortgages, consumer loans, corporate loans, etc.) that economic agents have to repay. As a result, households and corporate balance sheets ‘sink underwater’, leading them to rebuild their equity rather than take advantage of loose monetary conditions and indebt themselves further. In aggregate, this results in a sizeable private-sector savings surplus in the economy. Thus, no matter how low central bank rates get or how much funds they inject into the system, there are not enough private borrowers to absorb this liquidity. With no new borrowers, the credit channel is broken, and monetary policy loses its main influence on aggregate demand and inflation as a consequence.
To illustrate our point, we show the ratio of US commercial bank loans to deposits. It has been on a downtrend since the 2007/2008 financial crisis and has, most recently, taken a nosedive with the onset of the corona crisis. Indeed we can see that despite the large amount of stimulus, banks have not been able to lend as much as they did before.
This time is no different
The reopening of the global economy, following its unprecedented shutdown by governments to contain the Covid-19 pandemic, has given rise to growth and inflation statistics that we have not seen in decades. Starting from a very low point at the worst of the crisis, real GDP grew by 12.2% year-on-year in the second quarter of 2021 (a 70-year high), while core personal consumption expenditures (PCE) inflation skyrocketed to 3.6%, which is also the highest in 30 years. For many, the case of sustained inflation seems to be the strongest that it has been in a decade. So is inflation back in the game?
As suggested above, from a monetary policy perspective, this does not seem to be the case. Other measures of leverage that we regularly monitor also do not signal a return to the ‘old’ policy paradigm. In the US, total bank loan growth was still negative as of August 2021, and it shows no signs of coming back to pre-2008 levels, particularly for consumer loans and mortgages.
We believe there should be enough structural demand for US Treasury bonds so that rates do not significantly rise.
This is important, because it means that the focus on monetary policy and inflation is misguided. On one hand, the current inflation episode is driven by factors outside of policymakers’ hands, such as supply bottlenecks and energy prices. On the other hand, it is driven by a demand boost that is both a result of the extraordinary closing and reopening of economies and of fiscal, not monetary, stimulus. If anything has pushed consumers to go and spend more today it has been the stimulus checks, not low interest rates.
Don’t fear the taper
This brings us to the juncture at which we stand today. The Fed has announced that a tapering is coming, so how should investors react? The inflation issue excluded, should investors brace themselves for a market correction? We think not.
- First, we believe the Fed is right in signalling a tapering. The rise in asset prices following the latest recession was tremendous. It would be prudent for the Fed, based on its financial stability goal, not to be overly complacent. By gradually reducing the flow of liquidity, the central bank can prevent potential bubbles from forming in a controlled way – which should, in turn, limit any negative effects on the overall market.
Second, we believe there should be enough structural demand for US Treasury bonds so that rates do not significantly rise. The main reason for our conviction is that the other two major developed economies’ central banks, the European Central Bank and the Bank of Japan, are nowhere near the US when it comes to restricting their policy stance.
Third, exceptional corporate profitability should sustain equity valuations and help the market to weather a reduced liquidity environment. In 2021, S&P 500 corporate earnings are expected to rise to over USD 200 per share – an all-time high. Furthermore, stock buy-back announcements are above 2018 highs on the US market, which provides additional support for equity prices.
In short – do not fear the taper and stay invested. As for inflation, we continue to believe the current inflation episode is transitory and that ‘gravity’ still pulls us towards deflation.
What lies ahead in the economy and financial markets? Our Group Chief Investment Officer explains.