Updated: Aug 3, 2022
The combination of central bank weakness and fiscal policy error is a toxic one
In a recent post I looked at the public policy twins - fiscal and monetary - over the last 100 years in relation to the US. In the mid 60s we had very loose fiscal policy that triggered high inflation for the next 15 years. However, unlike today, the Fed back then was lean and fit, though it could be argued it did not put these strengths to good use in reining in high inflation, at least not until the early 80s.
Despite Wednesday's 75bp hike in the Fed Funds Rate, monetary policy today is still ultra loose, as evidenced by a balance sheet that is still bloated. The same can be said for the ECB, BOJ and BOE. Indeed, monetary policy has been ultra loose since the deflation shock of 2008/9 and has been getting looser since. The Fed tried to start losing weight, as it were, in 2015 but then growth slowed towards the bank end of 2019, followed by covid, so the taps were turned on full again. Despite a 10% or so reduction in the US monetary base since November last year, it is still around 40 per cent higher than it was at its peak in 2015.
When their balance sheets are bloated as they are today, central banks' monetary policy becomes a less effective tool. The fragilities in economies appear so great today that any tightening of monetary conditions, rather than reining in inflation, will tend to send growth into a tailspin. This happened in 1937 when the Fed's balance sheet was similarly bloated - a faily small shrinkage of the balance sheet caused growth to plummet and the stock market to halve. At the same time, loose fiscal policy over the last two years boosted growth but only temporarily. Its main effect has been to put significant upward pressure on inflation.
Another important point to make about the effectiveness of monetary policy is the lack of a direct transmission mechanism with respect to the Fed Funds Rate.
The Fed Funds Rate is the rate at which financial institutions lend/borrow reserves to/from each other. Because of QE, financial institutions are awash with reserves (actual reserves are several multiples of what is required) so do not need to borrow them. If nobody is borrowing reserves, nobody is paying/receiving interest at the Fed Funds Rate. It is therefore an ineffective policy tool for the Fed, other than in communicating a message that it would like the price of money to rise. It is also disappointing that Fed chairman Jerome Powell never gets questioned by the press about this issue of massive excess reserves and the impotence of the Fed Funds Rate.
In the 70s we had weak growth with high inflation i.e. stagflation. Central banks however were in good shape. I fear that as a result of the current state of central banks and the error with respect to fiscal policy, what we might have to look forward to is a sustained period of very weak growth with very high inflation. Stagflation on steroids.
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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