Over the last year and a half, global markets were shaken by a series of seismic volatility shocks that raised enough “dust” to obscure both investors’ and politicians’ views of the evolving economy.
Rather than being derailed by the recent tremors, the U.S. economy came bursting out of the dust with a full head of steam, already traveling at a 3.2% annualised growth rate in the third quarter, according to the U.S. Bureau of Economic Analysis (BEA). By November, the unemployment rate had fallen to 4.6%1, so low that there is a question about whether the U.S. economy can absorb many more jobs.
In the words of Myron Scholes, “The risk for investors has swung dramatically in recent weeks from protecting against the ‘bear’ to the possibility of missing riding the ‘bull.’” 2
Over the near term, this leaves investors with plenty of reasons to cheer. Over the longer term, however, if the president-elect follows through on his campaign promises of significant new fiscal stimulus, it could easily lead to wage inflation as opposed to real growth. A year from now we may start to face the inflationary consequences of stimulating an economy that’s already near capacity.
A key restraint on an overly stimulated, inflationary economy is an alert central bank, ready to tighten monetary policy to put a brake on excessive growth. One of the problems central banks face, however, is that the most astute time to raise rates is when nobody thinks it’s time to raise rates, to act before it’s obvious they need to act.
But even if the Fed is ready to act decisively when the economy is overstimulated, the braking mechanism now available is new and untested. In view of the enormous size of excess reserves in the banking system generated by the Fed’s quantitative easing (“QE”) programmes—to the tune of $2 trillion as of November 2016 (about 11% of nominal GDP)3 compared to around $1.5 billion prior to 2008—it is unrealistic to expect the Fed to be able to drain them from the banking system in the way it used to do.
An alternative braking mechanism is to pay an Interest Rate on Excess Reserves (IOER) sufficiently above the rate the banks can earn by lending the money to businesses that the excess reserves will stay at the Fed. Because this is analogous to paying bankers not to lend out money and may “increase” the U.S. budget deficit, the IOER approach is likely to face political headwinds.
If these brakes fail, there may be one other mechanism to slow an overstimulated U.S. economy. This is rising interest rates in the longer end of the U.S. Treasury market, which is controlled more by market forces than by the Fed. Because interest rates are global, with arbitrage between different markets for yield, however, foreign economies that still have active QE programmes may try to offset a rise in rates in these regions. Active QE bond-buying by central banks in Europe and Japan, trying to keep yields down, will likely restrain the degree to which U.S. rates can climb. This creates the risk that U.S. rates will be unable to rise sufficiently to adequately slow an overstimulated U.S. economy.
Thus, if the new administration comes in and seriously stimulates the economy with a lot more infrastructure spending, tax cuts, defense spending and so on, we may find that U.S. interest rates simply cannot go up enough to stop the excess growth. With Europe and Japan also driving it forward, we may find that the runaway train’s brakes no longer work properly.
1 29 November 2016 National Income and Product Accounts Gross Domestic Product: Third Quarter 2016 (Second Estimate) Corporate Profits: Third Quarter 2016 (Preliminary Estimate)
2 Myron Scholes and Ash Alankar, 28 November, 2016.
3 2016 November Aggregate Reserves of Depository Institutions and the Monetary Base - H.3
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CRC: 1677931 Exp: 1/9/2018