There is perhaps no more vociferous debate in the always exciting world of macroeconomics than that associated with the marriage of fiscal and monetary policy in the wake of the pandemic.
By now, even casual observers (armchair economists, as it were) are acutely aware that central banks are enabling fiscal stimulus, in some cases on an almost dollar-for-dollar basis.
In essence, the pandemic necessitated and brought forward the real-world application of Modern Monetary Theory, although the presence of primary dealers in the equation still provides all parties with plausible deniability when it comes to charges of overt debt monetization.
These fiscal-monetary “partnerships”, along with the advent of average inflation targeting in the US, have stoked inflation worries, contributing to 2020’s record-setting run-up in gold.
In addition, some fear that once the near-term deflationary side effects of the pandemic are behind us, the longer-run inflationary consequences of the COVID shock (e.g., supply chain disruptions, re-shoring, increased protectionism, and reinvigorated de-globalization in the name of public health) will overwhelm the lingering demand shock, pushing up prices just as the proverbial chickens come home to roost vis-à-vis ostensibly perilous deficit and debt dynamics.
Responses to Bank of America’s “Global Fund Manager Survey” over the summer reflected those concerns.
That’s the backdrop for a new interview with my good friend and reader favorite Kevin Muir, formerly head of equity derivatives at RBC and best known for his exploits as The Macro Tourist.
Happily, the interview is conducted by Rob Koyfman, all around nice guy and, more germane, founder and CEO of financial data analytics platform Koyfin. Rob and Kevin discuss MMT, how to invest in higher inflation through a steeper yield curve, TIPS, breakevens, the euro, gold and European equities.
You can watch the full interview below. The discussion is well worth your time, and, just to give Rob and Kevin a laugh, I’ll add that they probably enjoyed this measured, level-headed, and even-keeled exchange with each other far more than they’ve enjoyed some of their conversations with me over the years.
As a bonus, you can find Kevin’s latest on inflation, republished here with permission from his daily letter, below the interview.
Inflation Prep with Kevin Muir, hosted by Rob Koyfman
Excerpted from the second installment of The Macro Tourist’s Inflation Series.
In the first installment of my INFLATION SERIES posts, I outlined why Quantitative Easing on its own was not sufficient to cause inflation. I hopefully showed why “printing money” through Fed Balance sheet expansion results in nothing more than increased bank reserves sitting on commercial banks’ balance sheets.
Although optimistic that I convinced all but the hard-money Austrians who somehow haven’t yet cancelled their subscriptions, the question remains why this was even up for debate in the first place. Why do some many people believe that QE causes inflation? All too often, Fed balance sheet announcements conjure up comparisons to Wiemar Germany, with warnings that “it won’t be long before hyperinflation sets in”.
You would think two decades of predicting this outcome in Japan would give the skeptics reason to pause and re-evaluate how the economy works, but it doesn’t seem to sink in. Now, I realize that I have just offended the “Japan is doomed” crowd. I apologize, but I am more interested in figuring out how markets/economy work than sticking to a dogma that has been wrong for two decades.
Now, you may believe that all these policies will end badly and that the skeptics will eventually prove correct. Could be. I am not here to ordain the best way for society to assemble the economy. I am only interested in figuring out which way it is headed, and what that means for markets.
Why have so many believed (including me at one time) that QE would cause runaway inflation? And before you condemn me for my transgression, remember that in 2010 some really smart folk believed that QE would cause inflation enough to take out a full page ad in the Wall Street Journal to warn Fed Chair, Ben Bernanke:
The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
We disagree with the view that inflation needs to be pushed higher and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.
(To be fair, QE programs do indeed “distort financial markets”, but that’s a story for another day.)
On its own, QE does not cause inflation, so why do so many believe it does?
Monetary Policy effectiveness
I am far from a full blown heterodox economic disciple, and although I keep an open mind to their new way of looking at things, one of my main complaints is that too often, they throw out too many of the conventional economic parts that actually work.
Understanding why most people believe QE causes inflation is important. By breaking this down, we can better incorporate the different parts of both schools of thought into our analysis, and hopefully make more accurate market and economic forecasts.
Here is the main reason most people believe QE causes inflation; for the past four decades, monetary policy has been the primary tool to stimulate and dampen economic activity. What happened when the Dotcom bubble burst and suddenly unemployment spiked? The Fed cut rates aggressively. How about when the housing market heated up and inflation poked its nose above the target rate? The Fed raised rates until they arrested the speculation.
Until the Great Financial Crisis, monetary policy was the sole tool in speeding up or slowing down the economy. No wonder Quantitative Easing scared people. Until then, most stimulus was in the form of lower interest rates, but the GFC brought about a frightening new development of the Federal Reserve aggressively buying bonds. That certainly sounds irresponsible and given the contrast to the previous methods of stimulating (lowering interest rates), it seemed draconian.
Most importantly, up until that point, monetary stimulus worked. Sure, it took more and more of it, but to say that monetary policy is completely ineffective is where I part ways with many new-era-economists. It’s only at the zero bound that monetary policy stops working completely.
Up until that point, lower interest rates do indeed have stimulative effects on the economy. It’s important to understand how. Only then can we figure out when they will stop working and what are the ramifications to using this sort of stimulus.
Monetary policy and the private sector
In my previous piece I argued that when the Federal Reserve buys bonds from JP Morgan as part of a Quantitative Easing program, the private sector does not rush out and make loans with that new money. The demand for credit is not affected by the Fed’s balance sheet expansion. Given that banks are generally not reserve constrained, the money from the Fed’s bond purchase does not get loaned out and therefore ends up just sitting within the banking systems as excess reserves.
However, what about in 2000 when the Federal Reserve lowered interest rates from 6.50% down to 1.00% in a little less than three years? Was that monetary stimulation met with the same inert response?
No, with the massive reduction in interest rates, the private sector responded. In what way? The consumer went on an epic house buying spree that eventually sowed the seeds for the next crisis. There is no denying that the Fed’s monetary stimulus was effective at encouraging economic growth.
When modern monetary theory proponents argue that conventional economists have ignored the government’s role in creating money (the fiscal side of the equation), they are spot on correct. When these MMT folk gloss over the role that private sector plays in money creation (the monetary policy side), they are committing an equally ill-thought out error. Sure, at the zero bound Central Banks lose their ability to further stimulate the economy, but until that point, their role is quite pronounced.
Herein lies the rub. As the private sector becomes increasingly indebted, monetary policy needs to become more and more stimulative to achieve the same results.
I like to do a simple exercise of “follow the money” to understand how monetary policy works in the real world. Imagine you are a typical homeowner with a couple of kids and a mortgage. In an economic slowdown, the Federal Reserve slashes interest rates to stimulate the economy. You, as a homeowner, upgrade to a larger house given that the carrying cost has been dramatically reduced. So you take your debt-to-net worth from 50% to 80%, but with the lower interest rate, your payments are approximately the same. When you borrow money from the banks, they are “creating” it out of thin air. This is expansionary – just like the Federal Reserve hoped.
Then, in the next economic slowdown, rates are once again reduced, but this time, you already have plenty of debt, and you need an even lower rate to entice you to borrow more. The Federal Reserve cuts rates, but much to their surprise, the private sector does not respond as vigorously as they hoped, and it takes an even lower rate to pull the economy out of the slump.
The same works on the economic upturn. Faced with increasing levels of debt, the Central Bank needs to raise rates less and less to slow down the economy.
This is why five out of the last six economic cycles have seen lower rate peaks:
When we look at consumer credit, it’s readily apparent that a constant increase is needed to feed economic growth:
Look closely at the only two periods when consumer credit contracted – the 1993/4 period and the Great Financial Crisis. Both of those periods were difficult economically.
When an economy relies on monetary policy as the main form of stimulating and dampening economic activity, inevitably too much stimulation will be applied, and in doing so, the amount of debt will expand to a level where eventually no more debt can be piled on.
This is what happened in 2007 when the Great Financial Crisis hit. The private sector refused to respond to lower interest rates. There was simply too much debt in the system and even dropping rates to zero could not entice the private sector to take on more debt. This is known as the debt-trap, or a Balance Sheet Recession.
At this point, monetary policy has reached it limit.
The most egregious errors in modern financial history have been committed by monetarists who refused to accept this fact. Many mainstream economists will distort themselves into complicated knots of logic to make monetarism work below zero. Have you heard Ken Rogoff’s twisted beliefs regarding eliminating currency so that Central Banks can take interest rates to “deeply negative levels?”
I throw up a little bit in my mouth every time I read this. I’m sorry, but this is an abomination. To think even more negative rates are the solution to our problems is madness of the first order. Does he not understand that the private sector does not want to create any more credit, regardless of how much you penalize them for holding cash?
And not only that, let’s face it, using monetary policy as a tool for stimulating is already fraught with problems as access to credit is not equally distributed. Those individuals with more financial means traditionally have been better credits, therefore banks are more likely to lend to them.
I’m not here to judge the best way to stimulate the economy. Rather, I would like to simply acknowledge what works, what doesn’t, and the reasons for the different outcomes.
It’s important to understand that monetarists are incorrect when they warn that Quantitative Easing and other stimulative Central Bank monetary policies will cause runaway inflation. They won’t. (Let’s not get into what it does to financial asset prices).
However, let’s also acknowledge that fiscal policies can always be stimulative, but that this is not the only way to create money (as some MMT’ers seem to believe).
Private sector credit creation is real. It’s actually been the main tool for creating money during the past financial credit super cycle. To ignore this fact is just as foolish as those who think we can fix everything with ever lower interest rates.
The reality is that both forces of credit creation are always at work, and it’s only because we have reached an extreme where the private sector cannot provide enough credit creation due to the zero bound that we have being able to clearly separate the two different methods.
However, they both exist and to focus on one without acknowledging the other is like driving with half the windscreen blacked out.