Five Decades Of Systemic Shocks And Policy Responses
With the decision of the Federal Reserve to continue its policy of asset purchases (QE) as long as US employment remains depressed, we can say that inflation targeting as a tool of monetary policy, introduced in the early 80s under Paul Volcker, has finally been buried. Central banks are now moving towards a policy of targeting asset prices and other economic variables, primarily nominal GDP. The consequences of this monetarist revolution on asset price formation are difficult to assess. However, we cannot overemphasise the potential disruption to the correlation and volatility regimes to which investors have become accustomed. In such conditions, proven investment strategies may prove obsolete. More than ever, investors will need to be able to challenge and fight against preconceived ideas. Lastly, and fundamentally, it is to be hoped that the policy of quantitative easing (QE) does not last too long, because, ultimately, it could lead to a massive distortion in the allocation of capital. However, as the charts below illustrate, every decade has been characterised by a different economic, monetary/fiscal policy, and investing environment.
Forthcoming shifts in monetary/fiscal policy
Since the early 1980s, monetary policies throughout major developed nations had been focusing on inflation, evolving in the early 1990s into specific inflation targeting, but the sub-prime crisis in late 2008 prompted central banks to take pragmatic emergency steps. Inflation targeting gave way to quantitative easing.
This particular approach to monetary policy cannot be regarded as a transient phenomenon though: after all, its primary objective has, purely and simply, been to prevent the whole financial edifice from crumbling. We will see a shift away from quantitative easing over the coming years. But what will the new monetary policy look like? The answer to this question is self-evidently unclear. However, the persistence of below-potential economic growth, high unemployment and high debt levels simultaneously in the developed world do seem to point to two possible paths:
- firstly, a return to virtuous growth would help to mop up unemployment and provide a virtuous route to paying down all the accumulated debt;
- secondly, quickening inflation, ideally to a limited extent, would also help to lighten the debt burden. Taking those two factors into consideration, monetary-policy stances geared to nominal GDP targeting or nominal income targeting must be regarded as serious candidates. The implications for the major asset classes – i.e. accelerating growth and/or inflation to a limited degree, i.e. not exceeding 4%-5% p.a. – would be positive for equities, but very negative for sovereign bonds regarded as the safest of havens (Bunds and US Treasuries) and positive for peripheral eurozone government bonds (Spain, Portugal, etc.).
Since 2008, several, if not all, developed countries have been pursuing a Keynesian fiscal policy mix. This has betrayed its limitations. To start with, governments’ financing capabilities are close to being exhausted. Secondly, the spending spree by governments has failed to deliver virtuous economic growth, as stubbornly high jobless rates show. Worse still, once government spending is reined back, growth immediately slows and drops permanently below potential.