‘The Ultimate Conundrum’ At The Limits Of Stimulus

On Thursday, in what amounted to a kind of sequel/followup to the “Mike Tyson” post from late last month, we brought you some excerpts from the latest note by Nedbank’s Mehul Daya, whose analysis raises further questions about the limits of monetary stimulus and diminishing returns on credit creation.

This is an especially critical debate at the current juncture. Global growth is decelerating and central banks, having barely gotten started down the long road to normalization after a decade of extraordinary accommodation, are left to confront the burgeoning slowdown with little in the way of “ammo”, where that means rates are, at best, just off the zero bound and, at worst, still mired in NIRP. Balance sheets, meanwhile, are still bloated.

But even you believe that policymakers will be willing to reimagine what’s possible when it comes to pushing the boundaries of accommodation, there are signs of diminishing returns in a world awash with debt and defined by structural factors that have frustrated efforts to bring about a sustainable rise in inflation.

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No Escape ‘Velocity’.

Well, on Friday, following a week that brought still more evidence to support the slowdown narrative and saw the ECB pivot back towards accommodation in the face of mounting headwinds to the outlook for the euro-area, BofAML’s Barnaby Martin is out with a new note that touches on all of these issues.

“There are natural limits to the effectiveness of monetary stimulus if the end result [is] more debt”, he writes, introducing the latest update from the BIS on global debt, which shows that “there has barely been any progress in reducing global debt/GDP levels, and likely this number will rise for Q4 ’18 given the slowdown in world growth.”

(BofAML)

The good news is that the global debt-to-GDP ratio has in fact declined by nearly 14pp from its peak in the third quarter of 2017. The bad news is, that deleveraging was the product of the synchronous global growth story which, for lack of a better way to say it, died last year. Meanwhile, global debt rose by $3.3 trillion and as Martin cautions, “decelerating global growth and [a] surging supply of fixed income securities suggest this deleveraging trend is only short-lived.” Global leverage, he warns, is likely to “rise again in coming quarters.”

After rehashing the recent history of leverage (i.e., that corporate debt has led the charge in terms of explaining 42% of global debt growth since 2000 versus 35% for governments and 23% for households), Martin asks the following question:

How do you solve a debt problem without inflation?

“Tangible inflation remains the antidote to high global debt levels given that default and restructurings are not palatable options, but tangible inflation remains elusive globally”, he goes on to pseudo-lament, citing the usual suspects to account for the disinflationary impulse:

1. aging populations,
2. lack of animal spirits,
3. the trend to temporary employment,
4. tech disruption

For Martin, this raises “the ultimate conundrum” vis-à-vis calls for fiscal policy to take the reins when it comes to reflating the global economy and staving off another downturn. To wit:

And so we are left with somewhat of a conundrum. With both Mr Draghi and the OECD now calling for “smart” fiscal stimulus to boost European (and world) growth, this will simply add to an already high backdrop of global debt. And the results may end up being self-defeating. We highlight an excellent chart from our EM equity strategist Ajay Kapur.

He argues that countries with higher debt/GDP ratio are usually associated with lower monetary velocity. In other words, money supply growth has a less powerful effect on GDP growth. We show that this situation has become more extreme over the last 20yrs as debt/GDP ratios have risen globally. Why might this be? Ultimately, if banks are required to hold more of their domestic government debt, then they have less flexibility to lend funds to the real economy. [Thursday’s] less than emphatic market reaction to more Draghi dovishness may be highlighting exactly this: that we are starting to get to the limits to central bank stimulus…

It would be difficult to add anything to those passages that would make them more effective than they already are, so we’ll spare you any further editorializing.

But we would encourage you to read the two posts liked here at the outset, as they provide additional color and context on what is likely to be one of the most critical debates of all going forward.