Anyone who has been following US fiscal policy over the past three years, which by implication means US monetary policy since Congress and the president have dumped everything in the lap of the Fed, which by implication means the Fed's guide to investing in the Russell 2000, knows too well that it can be summarized in two words: financial repression. Read the attempt to force everyone out of "riskless" assets such as Treasurys and mortgages and into risky assets such as Amazon and its 200+ P/E. All else equal, there has been one huge error with this policy which is akin to the Fed attempting to herd cats: instead of pushing investors into other asset classes, all the Fed has achieved is to get everyone to front run it in buying whatever bonds the Fed has not committed to monetizing just yet as we showed before [7]. The other problem is that all else is not equal, and as SocGen shows Financial Repression, even by construct assuming practice and theory were the same, will not be sufficient due to the following three reasons.
- Firstly, countries that currently benefit from financial repression still have primary deficits that are inconsistent with debt stabilisation.
- Secondly, the demographic time bomb means that a further deterioration of the primary surplus will appear in the future unless reform is undertaken.
- Thirdly, we believe there is a limit to how far central bank asset purchases can go. If this were not the case, the government could in extremis stop collecting taxes and just let the central bank buy all the bond issuance required to cover public spending! This is reminiscent of the story of German hyper-inflation under the Weimar Republic (albeit not the only historical episode of hyper-inflation).
And assuming we ever get across the chasm, there is the other side to consider: what happens when central bank balance sheets have to be unwound:
Managing exit strategies from asset purchase programmes will be a challenge and will in our opinion ultimately carry either a growth and/or an inflation price tag. Inflation expectations are key in this respect and for the present remain fairly well anchored.
[8]
The most immediate channel from QE to inflation is the currency channel. The credit channel is an additional factor; at some point economic agents may seek to lock in what is perceived to be exceptionally low interest rates – this can be helpful for the initial stages of recovery, but left untamed a new credit bubble could well prove inflationary not to mention destabilising for the economy. Ultimately, inflation expectations are a question of credibility and here government actions become important. Should economic agents lose confidence in the ability of governments to manage public finances, inflation expectations could soar.
In other words: damned if you do and damned if you don't. That's a great corner you have pegged yourselves into, dear central planners.