In early December Janet Yellen provided the above chart showing the Fed's estimates of the real natural rate. As shown, in the aftermath of the GFC the natural rate has been quite negative for a prolong period of time. Since the Fed was never willing or politically able to reduce their policy rate into negative territory, they justifiably resorted to balance sheet expansion and forward guidance in hopes of adequately easing monetary policy.
It's well understood by now that the Fed set off a portfolio rebalancing effect when they first instituted ZIRP before expanding the monetary base by buying safe treasury bonds from non-bank financial institutions*. Asset managers were incentivized to incrementally reach for yield by buying securities further out on the risk spectrum. Some of the favored securities were:
- High yield bonds/debt
- Emerging market bonds/debt
- Debt linked to commodity producers
As credit spreads narrowed, markets were effectively giving riskier entities the license to issue a greater quantity of dollar as well as locally denominated debt in order to fund more speculative projects. However without the following list of post-crisis narratives (among others not listed), it's highly doubtful that the Fed's monetary policy alone would have been enough to incite the financial flows and global credit creation we have witnessed.
- A Chinese investment led growth strategy after the GFC greatly promoted global economic activity. Profit opportunities were abound.
- As a result of this investment/infrastructure spending, China stimulated demand for commodities. Consequently, huge profit opportunities existed in commodity producing countries especially as commodity prices soared.
- The expectation was that the Chinese yuan would be a one way bet higher against the dollar.
- More generally the dollar was expected to decline against a range of currencies as slow US economic activity relative to fast growth in EM would ensure that the Fed would be on hold for longer. The dollar collapse/inflationary Armageddon story coupled with the perception that commodity bets were a savvy way of hedging against impending inflation gained traction. Moreover, negative real rates encouraged the build up of dark inventory.
- The US shale revolution allowed US corporations to participate as the price of oil rebounded to over $100 per barrel. Capital market funding enabled a greater use of leverage in this space.
- Oil producing countries used the inflow of petrodollars to increase domestic social spending and fund investment abroad. During periods of high oil prices and revenues, Petro states are able to import (claim) a great share of global output.
Problematically, foreign Central Banks were forced to make a choice in how to handle the torrent of financial inflows. They could either allow their currencies to appreciate, expand their monetary base by purchasing the inflowing dollars, or some combination of both. The first option risked hurting their export competitiveness. The second alternative risked creating a degree of credit expansion that threatened to disrupt their financial institutions if financial/bank regulations proved to be inadequate. That is of course unless regulators decided to restrict the movement of portfolio flows by using capital controls.
Eventually these stories ceased to be true as reality stop confirming prior expectations of what was going on during the post GFC recovery.
- Chinese and global investment created excess capacity. This adversely caused the rate of profit in these projects to slow if not outright decline. Until aggregate demand can match existing supply, greater spending on new investments is now perceived to be much riskier. As Michael Pettis has pointed out, Chinese companies suffering from falling profitability may not be able to service their financial obligations out of returns from their debt financed investments. Such firms may need to borrow in order to roll over old debt thereby creating a situation where rising debt levels coincide with slowing growth.
- Commodity producers around the world saw their biggest costumer reduce their demand which created excess capacity at home. This has adversely affected fiscal and corporate balance sheets especially firms/governments who issued a great deal of foreign denominated debt. It goes without saying that the commodity price collapse has made matters that much worse. This has generally led to an economic slowdown in these countries.
- The yuan is certainly no longer viewed as a one way bet as capital outflows persist. The slowdown in China has forced policymakers to respond by easing monetary policy. Moreover, the dollar FX rate peg caused the yuan to adversely rally against its major competitors. Thus, Chinese policymakers can either allow the market to take the FX rate where it will or they can continue to drain their foreign exchange reserves. If the PBOC allows the yuan to continue falling, what will this mean for the global system?
- After reaching a cyclical bottom in 2011, the dollar didn't collapse but staged a multi-year uptrend against most currency pairs. Although the US recovery has been weak by historical standards, the US has been one of the strongest performing economies since the financial crisis. As the US economy began to produce closer to full potential while EM/commodity producing countries started to slow, market participants began to expect that the Fed would engage in a period of tightening while their foreign counterparts would be forced to move in the opposite direction (policy divergence). Traders seeking to front run US monetary policy tightening took dollar long positions that reinforced the weakness in foreign FX. Given the dominance of the greenback in international credit markets, a rising dollar FX rate in effect had already passively tightened global financial conditions many months before the Fed's first rate hike.
- With the oil price collapse, US shale companies dependent on capital market funding have been forced to slow or curtail further investment in the energy sector. This in itself has adversely affected US growth (all else is obviously not equal) as capex slows. More generally, credit spreads especially in high yield have been widening since 2014. This also points to a passive tightening of financial conditions that began to occur prior to the Fed's December 2015 announcement.
- Petro states are now forced to adjust to a new economic reality where they will likely have to diversify their economies as long as oil prices remain depressed. During periods of low oil prices and revenues, oil producing countries can not rely on petrodollar flows to either subsidies domestic oil prices or import the desired quantity of foreign goods. This risks creating political and social instability in these regions.
Now consider Larry Summers' re-popularization of the theory of secular stagnation, the phenomena where the equilibrium level of savings or the desire to save (the drive to augment financial net worth by accumulating a larger portfolio of assets) is chronically in excess of planned investment as the natural rate of interest is persistently below real market rates. A natural rate of interest that is falling and persistently below real market rates discourages firms in aggregate from issuing enough bonds to satisfy the demand for them. A falling natural rate partially reflections the expectations that increased spending on large scale investments is too risky (high hurdle rates) relative to the potential rate of profit.
As a result, investors, asset managers, firms, and households etc. are left to bid up existing financial and real assets. This introduces the potential for asset price "bubbles" which may drive economic activity temporarily but only to collapse later leaving behind a debt overhang and depressed economy in the aftermath. The alternative is to hoard "cash" money balances (short term bank deposits/debt or currency) to a greater degree (strong liquidity preference). Deficient investment spending coupled with the hoarding of bank deposit balances as if they are long term financial assets risks creating the conditions where spending on goods, services, capital inputs is persistently insufficient. Insufficient spending leads to an economy that cannot ensure full employment as it produces below full potential. Therefore, under these circumstances a country will either experience a series of booms and busts or a steady but depressed economy.**
Critics rightfully argue that in a globally integrated financial system, a country that is temporarily experiencing symptoms associated with stagnation, an output gap, high unemployment, and falling inflation will find that their interest rates will be lower than those found abroad. In this state of the world, market participants will come to expect close to zero domestic policy rates for longer especially relative to foreign policy rates. This will promote carry trades and capital flows that will put downward pressure on the domestic FX rate fostering an economic rebalancing. In other words, if weak domestic investment is leading to an insufficient amount of financial securities being produced at home, asset managers and financial institutions can take advantage of depressed rates to issue securities to either fund highly profitable foreign investments or the purchase of foreign financial securities. This process will augment the level of global aggregate demand which in turn will positively spillover into the domestic economy. In doing so, the symptoms associated with domestic stagnation are alleviated at least until developing countries reach developed status.
Well considering the global growth rate is still below its long term average as EM economies now struggle with how to deal with excess capacity as well as a legacy of debt, I can't help but wonder whether domestic stagnation has only been temporarily dealt with. It feels more likely that the sickness has been transmitted and spread. Despite a US economy that at best is still muddling through, foreign FX and interest rates are now the ones falling perspicaciously.
Is it only a matter of time before these developments emanating from abroad stop being dismissed as having only a transitory effect on US economic growth? If so, will market participants start to price in a more gradual path of Fed tightening (a lower terminal rate and potential reversal) than what is currently expected? Put differently, will this period of policy divergence give way to policy convergence? What would that scenario mean for the US yield curve and US dollar?
*There remains a great deal of skepticism as to how LSAP (QE) transmits to the rest of the economy. When the Fed buys a government security from a non-bank financial institution, excess reserves within the banking system and deposits held by the non-bank are simultaneously created. When thinking about the consolidated government balance sheet, interest paying excess reserves held by banks are the equivalent of overnight zero maturity T-bills. Mechanically, by purchasing higher yielding T-bonds for lower yield reserves, the Fed reduced the interest income earned by the non-government sector. This actually worked to bring down the fiscal deficit due to Fed remittance to the treasury. That aspect of QE is actually contractionary. Therefore if QE worked, it did so by signaling that policy rates would remain close to zero for longer.
**A more compelling argument can be made that an economy suffering a secular stagnation that arises from perpetually depressed private investment must rely on a greater use of fiscal policy. In such a state of the world, fiscal policy becomes imperative in generating enough aggregate investment and demand to ensure that all available resources, including labor, are put to productive use rather than wasteful sitting idle. This is particularly the case if existing monetary policy tools fail to gain traction in reducing slack in the economy. Unfortunately due to current political realities and ideologies, a more expansionary role for fiscal policy is often dismissed as a political non-starter. If these assumptions prove to be true, then the decision to accept secular stagnation is a political choice made within the confines of a broken political system.
***Ideally, tightening US Fed policy would coincide with a US economy that proved to be strong enough to considerably boost global economic activity. This would provide EM countries a new source of demand to compensate for slowing Chinese investment spending. In essence, US private investment and aggregate demand would begin carrying the global growth baton for the time being.
*There remains a great deal of skepticism as to how LSAP (QE) transmits to the rest of the economy. When the Fed buys a government security from a non-bank financial institution, excess reserves within the banking system and deposits held by the non-bank are simultaneously created. When thinking about the consolidated government balance sheet, interest paying excess reserves held by banks are the equivalent of overnight zero maturity T-bills. Mechanically, by purchasing higher yielding T-bonds for lower yield reserves, the Fed reduced the interest income earned by the non-government sector. This actually worked to bring down the fiscal deficit due to Fed remittance to the treasury. That aspect of QE is actually contractionary. Therefore if QE worked, it did so by signaling that policy rates would remain close to zero for longer.
**A more compelling argument can be made that an economy suffering a secular stagnation that arises from perpetually depressed private investment must rely on a greater use of fiscal policy. In such a state of the world, fiscal policy becomes imperative in generating enough aggregate investment and demand to ensure that all available resources, including labor, are put to productive use rather than wasteful sitting idle. This is particularly the case if existing monetary policy tools fail to gain traction in reducing slack in the economy. Unfortunately due to current political realities and ideologies, a more expansionary role for fiscal policy is often dismissed as a political non-starter. If these assumptions prove to be true, then the decision to accept secular stagnation is a political choice made within the confines of a broken political system.
***Ideally, tightening US Fed policy would coincide with a US economy that proved to be strong enough to considerably boost global economic activity. This would provide EM countries a new source of demand to compensate for slowing Chinese investment spending. In essence, US private investment and aggregate demand would begin carrying the global growth baton for the time being.
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