Linearity, Fed Policy and Equity Markets
by George Hatjoullis
The consensus view at the moment seems to be that equity markets have some scope to squeeze for technical reasons but that the economic headwinds are so severe that further declines in equity markets seem inevitable. Moreover, the economic headwinds are such that neither the Federal Reserve nor the Bank of England has a case for raising interest rates. They will not, and should not, raise interest rates until the economic headwinds abate. Other central banks will, in the meantime, ease policy further (whatever this means).
The view on equities seems correct. One need only compare a monthly chart with a daily chart (any market) to see the contrast. The squeeze potential however does not look that great and the downside is material.
The economic headwinds are unmistakable. The thrust of the economic series of blogs has been that we are experiencing a global deflation for several overlapping reason. The inflation optimism of the central banks has thus been puzzling and somewhat frustrating (for me). In terms of conventional money policy tools there is not any case for tightening. However, conventional monetary policy is evidently no longer effective. It is now irrelevant. The only way the global economy is going to escape this deflation is if sovereign debt is monetized. Unfortunately monetization is taboo (and illegal in many contexts) so this is not going to happen any time soon. So what now?
Further easing by central banks is not going to make a great deal of difference. After 6 years of ultra easy monetary policy (arguably much longer in Japan), inflation is noticeable by its absence. The persistence of inflation expectations (by central banks and households alike) is a conditioned response (see Pavlov’s dogs) that was learned over 40 years, and this will take longer than six years to unlearn. In the meantime, the real disease, deflation, will not be addressed.
The deflationary context has some important structural elements which have been given a huge boost in the last few weeks. The move away from fossil fuels and material consumption has been evident for some time. The VW scandal has accelerated this trend. The VW scandal is a gigantic case of pollution fraud. It may end VW in its present form (see Enron). The impact on consumers is hard to predict but it is conceivable that it will accelerate the trend away from fossil fuel consumption. The structural impact of an accelerated trend away form fossil fuels and the related car industry is potentially huge. It is analogous to the decline in coal, steel and shipbuilding in the UK except on a global scale. New industries will emerge but with so much of output, especially in certain countries, related to these industries a great depression (in output an employment) could join and exacerbate the great deflation. It looks bad.
Anyone that believes that conventional monetary policy can offset these headwinds is delusional. Monetization of sovereign debt is the only remaining policy tool that can have any effect. The debate nevertheless continues in terms of the Fed raising rates and going back to QE. The Fed rather shot itself in the foot when it re-introduced the equilibrium real interest rate into the policy debate (I notice that many commentators that made a big song and dance about this then have gone quiet on the subject). The Fed has not mentioned this recently but then it seemed pretty damned convinced that this provided a justification for raising rates irrespective of short-term conditions. Apparently Yellen has changed her mind. It is daft concept of no practical value and should never have been resurrected so I will not miss it. However, it has muddied the policy debate somewhat.
Interestingly the Fed, and the markets, are now trapped in linear thinking. Rate cuts help the economy and rate hikes hurt. However, if rate cuts make no difference (in the present context) why should rate hikes hurt (in the present context)? Could rate hikes actually help? If it is not linear (and in my experience reality, as opposed to econometric models, rarely is) rate hikes may actually be the correct move. Indeed, I would argue that debt monetization and rate hikes is the optimal policy mix here. Too complicated and controversial for unimaginative central bankers but worth a thought.
A rate hike by the Fed now removes some uncertainty and sets a policy road; rising rates. They do not have to rise very fast or very far. The removal of uncertainty generally helps markets and economies. It does make credit more expensive. However, it also makes lending more lucrative and will encourage banks to expand their balance sheets. The economy needs active and enthusiastic banks if it is to lubricate the transition form declining industries to emerging industries. More easily available credit may, at this point, be better than cheap credit.