Monday, February 20, 2017

Why is the current easy-monetary policy ineffective?

Ben Inker, head of GMO's Asset Allocation team had a great article this quarter.


It has been the extended period of time in which extremely low interest rates, quantitative easing, and other expansionary monetary policies have failed to either push real economic activity materially higher or cause in ation to rise. The establishment macroeconomic theory says one or the other or both should have happened by now. It seems to us that there are two basic possibilities for why the theory was wrong. 
The first is a secular stagnation explanation of the type proposed by Larry Summers and others. 
The second possibility for why extraordinarily easy monetary policy has not had the expected effects on the economy and prices is an even simpler one: Monetary policy simply isn’t that powerful. is line of argument (which Jeremy Grantham has written about a fair bit over the years) suggests that the reason why monetary policy hasn’t had the expected impact on the real economy is that monetary policy’s connection to the real economy is fairly tenuous.

In this context, there are some important aspects.

First, monetary policy and economy are connected to each other by feedback loops. By now, every market participant knows that if there is any inflation up-tick the monetary policy will be tightened. This information prods the participants in asset classes where the inflation impact will be low. A look at inflation basket will tell us which are these sectors where price runs will not affect inflation. Exotic assets are in fashion for this reason. Art, diamonds, high-end real estate (trophy), luxury items etc all form part of this group.

Second, why does the low-cost debt not push investment for improving productivity for general items that form part of the inflation basket? The answer is there is no demand. When the market concludes that there is a substantial demand to justify the investment then the investments will come. There is no demand because there is excess capacity, predominantly in China for manufactured goods. This is the reason monetary policy is not effective. 

Monetary policy is effective when there is underlying demand is strong. Without demand monetary policy is just an enabling environment for nothing in particular.  That the monetary policy is not working is itself a data point. It is telling us that the masses do not have the purchasing power to fuel a demand pick-up. There are two reasons.

Most of these masses derive their incomes from the products that make up the inflation basket. If inflation remains subdued, their incomes remain subdued. The low-interest rate has reduced the cost of capital meaning it is cheaper to deploy robots instead of people. So in fact machines are replacing some jobs. These two factors currently suppress the purchasing power. To compensate, people want to build higher threshold of income-level before they start consuming normally. So, the general population is busy buttressing their purchasing power. 

The second reason is that the pre-crisis demand was inflated by debt. The low-cost debt created a hyper-demand which may never return. At the same time, the debts from the past consumption binge have come due. So the indebted families are busy working their debts off. If all the debts of the bottom 50% of the population were simply forgiven, it would have been cheaper than QE. But it would have immediately buttressed the purchasing power of the masses. 

It is a complicated explanation, but it cannot be simplified any more. When feedback systems are interacting, you will get complexity.