Main Street Never Wins

One of the defining features of the post-Lehman era was the glaring juxtaposition between massive inflation across financial assets and comparatively meager bang for monetary policymakers’ buck in the real world.

In simple terms, central banks underestimated the efficiency of the transmission channel from accommodative policy to financial asset prices and overestimated the effect of the same policies on the real economy.

The vaunted “wealth effect” worked — it just turned out to mean something different than economists thought it did. The simple figure (below) illustrates one side effect of that miscalculation.

If you don’t like that version of the chart, there are a hundred different ways to illustrate the same point. The bottom line is as simple as it is irrefutable: The wealth divide grew pretty much in lockstep with financial asset price inflation which, in turn, accelerated alongside ballooning central bank balance sheets, encouraged by various iterations of ZIRP and NIRP across the developed world.

You could argue that underestimating monetary policy’s capacity to create excesses in financial markets was an unforgivable lapse on the part of central banks. After all, there was plenty of historical precedent, if not for the sheer scope of the experiment in accommodation, then certainly for the Fed’s capacity to make or break markets. And even if there wasn’t any precedent, it doesn’t take a leap of logic to suggest that reducing the cost of money to zero and flooding the market with liquidity has the potential to create distortions.

But the original goal (i.e., Ben Bernanke’s goal) was to rescue the US economy from a second Great Depression. Only the most abrasive, incorrigible Fed critics still argue that Bernanke’s initial decisions were misguided. Rather, the debate centers primarily around when emergency policies should’ve been scaled back or terminated altogether.

In any event, a shift away from policies blamed for exacerbating inequality and towards a conjuncture more conducive to promoting broad-based prosperity was welcome — right up until it contributed to the highest real-world inflation in four decades. As ever, regular people find themselves in a no-win situation. The figure on the left (below, from Goldman) shows the juxtaposition mentioned above between asset price inflation post-GFC and virtually no “pass-through” to the real economy.

Again, what you see on the left contributed to an ever wider wealth gap for obvious reasons: The vast majority of financial assets are concentrated in the hands of the richest few. “The deflationary environment of the past cycle, together with the move to zero rates and QE, led to unusually high real returns across financial assets,” Goldman’s Peter Oppenheimer wrote, in a new note. By contrast, “inflation in the real economy was very low, while inflation of financial assets was unusually high both in nominal and real terms,” he added.

Regular people enjoyed low inflation, but wage growth was equally sluggish, as was economic activity more generally. The rich got richer and the poor got poorer, at least in relative terms.

The Fed’s tweaked mandate and the inauguration of fiscal-monetary partnerships to avert a deflationary spiral in the wake of the pandemic, were supposed to help the situation, but as I put it in January, we were dealt the wrong crisis. One could conjure any number of exogenous shocks that would’ve compelled the same policy rethink (i.e., the institution of fiscal-monetary partnerships) without the accompanying inflation. But the nature of the pandemic shock was incompatible with many key disinflationary forces (e.g., globalized supply chains), even as it magnified others (e.g., too much debt). Ultimately, inflation overshot materially, ruling out the pursuit of a “free lunch.”

Now, we have yet another inflationary crisis in Ukraine. The collision of the most acute spike in commodity prices in recent memory, monetary policymakers’ determination to push back against inflation with rate hikes and a fading fiscal impulse as governments attempt to “get their houses in order” means the odds of a stagflationary outcome have increased materially.

As Goldman’s Oppenheimer wrote in the same note mentioned above, “during the stagflationary period of the 1970s and early 1980s, the picture was almost the reverse” of that seen post-Lehman. “Inflation in the real economy was very high, most assets fell in real terms and the assets with the highest returns were gold and commodities,” he said, referencing the figure on the right (above).

Of course, for regular people, a stagflationary conjuncture has the potential to be considerably more painful than the macro backdrop that defined the post-GFC years. Average people aren’t exactly known for having large amounts of gold, and they generally consume commodities, not invest in them. Wage growth isn’t keeping up with inflation in the US except at the very low-end of the scale, and even there it’ll be difficult for workers to extract enough in the way of pay increases to keep up if raw materials prices continue along anything like the current trajectory.

If you’re an investor, Goldman helpfully noted that you can stay “overweight Basic Resources and Energy stocks” in order to keep ahead in a stagflationary environment. Both still trade at a near 40% discount to the broader market in both the US and Europe, the bank observed.

If you’re an everyday person, that’s likely to be irrelevant. Although your incremental dollars might well go to “basic resources” and “energy,” it won’t be because you’re buying stocks. Speaking to that, Oppenheimer wrote that “the relative performance of Consumer Discretionary to either the market overall or Energy stocks is linked to Energy CPI inflation,” while “sharply negative” real wage growth is “another factor correlated to Consumer Discretionary under-performance.”

Ultimately, it seems as though everyday people are staring down an “out the frying pan, into the fire” scenario. No, the Fed won’t be enabling as much financial asset inflation as it did previously. And yes, wage growth is scorching and nominal growth has been robust. All of that stands in stark contrast to the post-Lehman years, when monetary policy enabled inequality while the economy meandered along somewhat aimlessly.

But wage growth only matters if it outstrips inflation. And a consumption-driven economy can’t keep booming if everyday consumers are getting poorer in real terms. If real incomes shrink and the economy stagnates or falls into recession, it’ll be small comfort for average households if the rich are forced to live with negative real returns on portfolios that have quadrupled or quintupled since Main Street bailed out Wall Street more than a decade ago.