Policy Failure, Ammo Shortages And The ‘Who Pays For It?’ Problem

A simple read on falling inflation expectations and persistent undershoots relative to target, is that central banks have failed to deliver on their mandates.

That makes for nice headlines. “Here’s proof that central banks have lost credibility”, Etc. You’ve seen the like.

Of course, there’s some truth to that. But the flipside is that in a world where central banks have been forced to double down on the dovishness amid a deterioration in the outlook for the global economy and the above-mentioned ineptitude when it comes to pushing inflation sustainably to target, is that policy “failure” is bullish for risk assets.

We’ve been chasing the elusive target for years and it’s never been clear anybody actually wants to catch it. Remember, “Goldilocks” isn’t defined by still-subdued inflation and scorching hot economic growth. Rather, “Goldilocks” is subdued inflation and synchronous growth that’s solid, but not so good that it forces central banks to tighten policy. So, when it comes to risk assets in the post-crisis monetary policy regime, there are worse things in the world than lackluster inflation and a downswing in the global economy.

“Markets are questioning the efficacy of policy makers’ actions, and their perceived lack of ammunition [but] credit markets are viewing things in a much simpler and overwhelmingly bullish way”, BofA’s Barnaby Martin writes, in the latest edition of his popular European credit investor survey. “Policy ‘failure’ — and the ensuing rally in government bonds — has propelled the stock of global negative yielding assets to a high of $10.8 trillion surpassing the previous Q3 ’16 peak of $10.5 trillion.”

(BofA)

Obviously, that underpins risk assets like stocks and credit.

“We view the negative yielding backdrop as akin to a tax on safe assets across the globe, and we believe it will ‘rubber stamp’ the ongoing thirst for yield across markets”, Martin goes on to say, adding that this is clearly a tailwind for corporate bonds and, eventually, quality dividend stocks in Europe.

This is the quandary right now – plunging DM bond yields suggests all is not well in the global economy, but it’s also a reflection of dovish central banks which are themselves reacting to the perception of economic weakness. You can concede that central banks have generally “failed” to generate a robust recovery and still remain bullish on risk – as long as you believe policymakers’ efforts to double down on accommodation will avert a catastrophic outcome.

One issue that’s come up again and again in 2019 is the idea that monetary policy is simply out of bullets. Indeed, 14% of European IG investors surveyed by BofA identified “quantitative failure” as their top concern, up from just 5% in April.

(BofA)

“Investors don’t doubt policy makers desire to restore inflation, yet they question whether policy makers still have the tools to achieve it quickly”, BofA writes.

(BofA)

What happens when central banks run out of ammo? Well, that’s when fiscal policy is expected to take the baton, and, indeed, the semi-global populist uprising has served to make calls for fiscal stimulus that much louder. Matteo Salvini has, for instance, repeatedly cited Donald Trump’s fiscal policy in the US as an example of what Italy should be doing.

Read more: Trump-O-Nomics, Italian Style

But it’s not just right-wing populists calling for a fiscal jolt. The sudden fascination with modern monetary theory by progressives in the US is perhaps the most poignant example of how, when central banks can do nothing more to help, folks will turn to more “creative” options designed to  side-step the kind of policy prescriptions that exacerbate inequality (e.g., tax cuts for corporations and the wealthy).

Read more in the MMT archive

The problem, though, is that spending has to be financed. MMT has an answer for that, and to say not everyone agrees with that answer would be to grossly understate the case.

BofA’s Martin raises the issue in the color that accompanies the survey detailed above.

“Commensurate with the growing doubts around monetary policy efficacy, credit investors believe that the most supportive development for risk appetite in Europe would be signs of more fiscal spending and a more lenient EC”, he writes.

And while that would likely be a positive development in the short term, Martin frets that “adding more debt to an already big debt supercycle simply raises the question of who pays it back in the long-term?”

If you can’t inflate it away, there is no good answer to that question. As Martin concludes, “In the absence of a return of inflation, debt levels are an increasing vulnerability for the global economy.”