Markets’ dependence on central bank largesse has also revealed the limits of unconventional ultra-accommodative policy. The end of the debt Supercycle poses secular headwinds for growth because the level of debt suppresses central banks’ ability to rekindle a credit cycle. Contrary to fears of QE creating uncontrollable inflation, it turns out that high debt levels are deflationary, and deleveraging is difficult to effect when income is growing so slowly. Monetary policy has lost potency in terms of its ability to stimulate growth by rekindling demand for credit. This is because the credit creation process, the primary channel through which monetary policy typically impacts the economy, is impaired.
Easier monetary policy has generated asset price reflation, however, which has spawned a wealth effect that has supported spending, in the absence of income growth. Equities have risen mostly thanks to multiple expansion, courtesy of the portfolio balance effect forcing holders of low yielding safe assets into higher risk securities. This asset allocation shift powered shares from 2012 through 2014, while earnings were growing, but since earnings have stopped growing, multiples and share prices have been moving sideways. The portfolio balance effect reflated financial assets when valuations were cheap, but seems to have run out of steam now that they’re not.
While the effects of quantitative and credit easing on asset prices are a positive sum game, easing financial conditions ubiquitously, the third transmission mechanism for monetary easing, currency depreciation, is a zero sum. Real interest rate differentials drive currency values. In the last two years, outside the US, every G10 central bank but the UK has eased policy; the divergence of this trend with the Fed’s tightening bias has driven the dollar higher, even as expectations for the future path of US short rates have declined. This highlights the fact that no central bank operates in a vacuum, particularly in a growth-starved world.
Japan’s strategy to engineer an incremental easing in financial conditions via negative rates has backfired. Bank shares have sold off, prompting markets to pare expectations of central banks’ ability to cut rates any further for fear of short-circuiting banks’ ability to function.
Japanese government debt and household net worth have grown at roughly the same pace over the past two decades, so the deterioration in public finances has coincided with an equal and opposite improvement in household balance sheets. Public sector spending has filled the short fall in aggregate demand created by the drawn out private sector deleveraging cycle. The country has one of the lowest tax revenue to GDP ratios in the developed world and a vast store of taxable household wealth, 250% of GDP, upon which taxes could be levied retroactively via estate taxation. This means that what are now regarded as radical policies – debt monetization, or helicopter money – the practice of permanently increasing the money base through overt central bank financing of the fiscal deficit – can work in Japan. The country can issue debt in its own currency and has scope to tighten fiscal policy when inflation targets are reached without worrying that the unemployment rate will soar.
It is the exercise price of that proverbial ‘policy put’ option for markets, not its existence that is open to debate. The strike price for such a put is likely a long way down from current asset price levels. This suggests that the path to political endorsement for such stimulus is more economic and financial market pain.
Just because the practical limits of NIRP have been exposed does not mean that monetary policy divergence has peaked. US money markets priced only 59 basis points of rate hikes over the next 24 months, coming into the April Fed meeting, but short rates are not expected to rise until 2019 in the UK and 2021 in Europe and Japan. The need for low to negative rates outside the US ensures that any tightening in US policy will cause the dollar to appreciate, such that the normalization of monetary US policy will occur more through currency adjustment than interest rate hikes.