by Niels Clemens Jensen, CIO, Absolute Return Partners
My only question is, who is our bigger enemy, Jay Powell or Chairman Xi?
– Donald Trump
The End of Magic Money?
“If the Fed loses its independence, the age of magic money could end in catastrophe”. That is pretty much how Sebastian Mallaby starts his article in the July 2022 edition of Foreign Affairs – called The End of Magic Money, which you can find here. As Mallaby points out, although the Federal Reserve Bank has not lost its independence (yet), it has fumbled enough in recent months that one is entitled to question its credibility.
By not taking the inflation ghost seriously enough for too long, it has ended up in the unenviable position of having to make compromises on its twin objectives – price stability and full employment. Although Mallaby doesn’t discuss the performance of any other central banks, on a personal note, I would add that the Fed is far from the only central bank spending time in the sin bin at the moment. Take for example the BoE, which is governed by a highly intelligent but rather inept Andrew Bailey, when it comes to understanding the finer details of financial markets. He clearly demonstrated his lack of finesse during the recent UK pension fund crisis, which was instigated by an even more inept Liz Truss.
Behind the recent fiascos is a monetary policy discipline introduced in the wake of the Great Financial Crisis in 2008 called MMT – Modern Monetary Theory to be precise, but often referred to as the Magic Money Tree by critics of the discipline. However, before you start arguing that the concept of Magic Money Trees has never worked and never will work, I should point out that, for the first 36 quarters, following the introduction of the first Magic Money Tree in 2009 – perhaps better known as QE – US inflation averaged only 1.5% and never exceeded the stated target rate of 2%.
Likewise, when Covid-19 struck in the spring of 2020, the Fed decided to harvest another Magic Money Tree and, again, the early results were impressive. US GDP dropped 32% year-on-year in 2Q20, the worst post-WW II quarter on record but, instead of going into a deep and long-lasting recession, the Fed’s swift response brought the US economy back on its feet very quickly.
Not only did the economy recover but, in the second half of 2020 and the first quarter of 2021, the stimulus plan had no visible impact on inflation. As recently as 1Q21, core consumer prices rose just 1.7% year-on-year. In other words, at least under the right conditions, Magic Money Trees can do wonders but, from the spring of 2021, things started to go wrong. It is therefore only fair to ask, what is it that went wrong? In short, there are four answers to that question:
#1: Presidential bullying:
In the second half of 2020, when the first inflation clouds started to gather in the US, Donald Trump – still President of the USA at the time – bullied the Fed Chairman, Jerome Powell, and, by doing that, probably caused the Fed to hold back on raising interest rates, whether consciously or subconsciously. Although Biden has taken an altogether different approach, one could argue that the damage had already been done by the time he moved into the White House.
#2: Miscalibration of the balance between supply and demand:
When the American Rescue Plan was passed in Congress in March 2021, it was on top of the $1.9Tn of fiscal stimulus that had already been passed in the spring of 2020 and the $900Bn passed in December 2020. Even before the $1.9Tn was approved in Congress, the U.S. economy was expected to grow by 4% between 4Q20 and 4Q21. In other words, too much, too quickly.
#3: Hesitating to admit a grave policy error:
As the rate of inflation in the US began to accelerate in 2021, the Fed sat on its hands for too long, labelling the bout of inflation “transitory”. And, when the first rate hike came in March 2022, it was a paltry 25 basis points. Russia had already invaded Ukraine, putting serious price pressure on many commodity prices, and core inflation in the US was already over 5% at the time. In other words, too little, too late.
#4: Ignoring the financial bubble of 2021:
Ever since Alan Greenspan characterised the bubble in 1996 as “irrational exuberance”, Fed officials have been reluctant to comment on financial markets, but they should have learned a lesson or two from that experience. In today’s highly financialised global economy, asset prices are way too important to ignore.
The most important lessons learned
Although the Fed has the twin objectives referred to earlier, the inflation objective must take priority over full employment. In practical terms, this means that we are not likely to see more Magic Money anytime soon. For the foreseeable future, it is about getting inflation under control. My concern is that most investors, whether private or institutional, are too young to have lived through the debacle of the late 1970s and early 1980s, when long-term interest rates peaked around 20%, although the peak varied from country to country.
Almost all young people I speak to maintain that this will never happen again. I am not so sure. The simple fact that a whole generation of investors deem it unthinkable, is a good reason why it may actually happen again. Until recently, inflation was primarily a dinner table topic for us ‘old farts.’ “Do you remember when …?” sort of discussions after the second bottle of red wine had been emptied. I wonder if the younger generations take the inflation problem seriously enough. I am not convinced.
Globalisation has definitely contributed to low rates of inflation in recent years. At least partially because of globalisation, supply grew faster than demand for many years and, when that happens, inflation turns into disinflation and possibly even deflation. Now, globalisation is stalling. How will that affect inflation? We recently added Globalisation 2.0 to the list of megatrends we have identified. If you subscribe to ARP+ and haven’t read the paper yet, I recommend you do so. You can find it here. The bottom line is that the nature of globalisation is changing, and that the disinflationary impact of it has largely vanished.
Another factor not to be ignored is ageing, and the implications this has on inflation. Back in 2015, the Bank for International Settlements (BIS – the central bank of central banks) argued in a research paper, which you can find here, that ageing is actually modestly inflationary. They claimed that ageing affects the supply side of the economy more so than it affects the demand side (Exhibit 1). In simple terms, when people retire, they no longer produce anything, but they still consume something. You may not recall, but we actually covered the topic in an Absolute Return Letter back in September 2019. You can find that letter here.
The jury is still out on this matter. As many argued when the BIS paper came out, if correct, why is inflation in Japan virtually non-existent? After all, Japan is at the front of the curve, ageing-wise. Another argument presented by the dissenters was the introduction of advanced robotics. Robots have exactly the opposite effect, they argued. They produce a great deal, but they consume virtually nothing, apart from a few spare parts and some electricity.
It is only fair to say that this issue has not been resolved yet. Having said that, let’s assume the researchers at BIS are correct. If they are, central banks all over the world may find it much harder to bring inflation back to the levels we have enjoyed in recent years than we all think.
When talking about bringing inflation back to the levels we enjoyed not so long ago, I ought to remind you that inflation destroys debt. Given the colossal mountain of debt we have established in most countries, a bit of debt destruction may be quite handy. Debt can only be destroyed in two ways, either through inflation or through default, and there can be no doubt that debt destruction through inflation is most central bankers’ preferred choice of medicine. Therefore, I am convinced that central banks are no longer committed to bringing inflation back to 2% at all costs, although you will probably never come across a central banker who will admit to that. If I am correct, aggressive QT, as some predict, will almost certainly not happen, and another bout of QE cannot be entirely dismissed.
Final few words
I can condense the lessons that I have learnt with respect to MMT as follows:
- Magic Money only works when conditions are extreme.
- Asset inflation eventually leads to inflation on goods and services, even if the early signs suggest otherwise.
- Low inflation in the 1990s, 2000s and 2010s was not because of sublime monetary policy but because of globalisation.
- A different set of policies may be required when inflation is supply-driven rather than demand-driven.
Whether our central bankers have learnt these same lessons is an altogether different story. Only time will tell.
Niels C. Jensen
1 November 2022
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