How can central banks "retrain"
participants while maintaining their extreme policies of stimulus?
Human habituate very easily to
new circumstances, even extreme ones. What we accept as "normal" now may have been
considered bizarre, extreme or unstable a few short years ago.
Three economic examples come to
mind:
1. Near-zero interest rates. If someone had
announced to a room of economists and financial journalists in 2006 that
interest rates would be near-zero for the foreseeable future, few would have
considered it possible or healthy. Yet now the Federal Reserve and other
central banks have kept interest rates/bond yields near-zero for almost nine
years.
The Fed has
raised rates a mere .75% in three cautious baby-steps, clearly fearful of
collapsing the "recovery."
What would
happen if mortgages returned to their previously "normal" level
around 7% from the current 4%? What would happen to auto sales if people with
average credit had to pay more than 0% or 1% for a auto loan?
Those in
charge of setting rates and yields are clearly fearful that
"normalized" interest rates would kill the recovery and the stock
bubble.
2. Massive money-creation
hasn't generated inflation. In classic economics, massive money-printing (injecting
trillions of dollars, yuan, yen and euros into the financial system) would be
expected to spark inflation.
As many of
us have observed, "official" inflation of less than 2% does not align
with "real-world" inflation in big-ticket items such as rent,
healthcare and college tuition/fees. A more realistic inflation rate is 7%-8%
annually, especially in the higher-cost regions of the US.
But setting
that aside, there is a puzzling asymmetry between low official inflation and
the unprecedented expansion of money supply, debt and monetary stimulus (credit
and liquidity). To date, most of this new money appears to be inflating assets
rather than the real world. But can this asymmetry continue for another 9
years?
3. Stock markets are soaring
but sales and profits are stagnant. Everyone knows central banks are still pumping billions of
dollars per month into the financial system, and this (coupled with central
bank purchases of stocks and bonds) has been pushing stocks sharply higher for
the past 9 years, with only a few hiccups along the way.
This is
pushing valuations out of alignment with traditional metrics of valuing assets
such as sales and profits--a process known as "price discovery." In
essence, traders and investors have habituated to central banks driving
private-sector markets higher, not because the assets are generating more value
or profits. but simply as a function of centralized money creation and asset
purchases.
All of these extremes generate
mal-investment, diminishing returns and perverse incentives for ramping up
unproductive and risky speculation, leverage and debt. Yet the central banks
have trapped themselves in this risky trajectory because they've pushed the
accelerator to the floorboard for 9 years. Any extreme held in place for 9
years has long slipped from "temporary" to permanent.
Participants
have now habituated fully to central banks extreme stimulus of financial
markets, and in a sense they've forgotten how to price assets based on
real-world private-sector measures.
How can
central banks "retrain" participants while maintaining their extreme
policies of stimulus? The only possible answer is: they can't.
This essay was drawn from
Musings Report 2018:1. The Musings Reports are emailed weekl to constributors,
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