As the markets anticipated an end to quantitative easing, the consensus expectation was that the pace of U.S. economic growth would pick up and inflation would remain quiescent. Things did not work out as planned.
In recent months the small improvement in employment signaled a lack of forward momentum in the economy. This was confirmed by the release of disappointing second-quarter 2011 Gross Domestic Product compounded by a jump in the annualized rise in the core personal consumption deflator above the perceived two percent Federal Reserve target rate. Meanwhile, the debt ceiling compromise appeared to fall short of expectations and was followed by Standard & Poor’s downgrading of U.S. debt. For investors and traders, the environment has become uncomfortable at best, highly risky at worst.
Upsetting the policy framework
Since the mid-1970s, the actions of the Federal Reserve were framed within a traditional monetary policy framework that appeared to work quite successfully until the Great Recession. Fed actions would start with a change in its benchmark short-term interest rate, the federal funds rate, which would alter market interest rates and lead to changes in economic activity.
Since 2008, however, the Federal Reserve first lowered the federal funds rate down to 25 basis points or so and then the Fed turned to quantitative easing that effectively increased the size of its balance sheet. This was intended to provide the private banks with additional reserves whereby these institutions would be able to increase their lending to private firms.
Easier monetary policy, which tends to lower market interest rates in the short run, thereby reduces the cost of capital for many possible investments that would have an expected rate of return above that now lower interest rate and thereby these investments would now appear to be profitable.
Unfortunately, two major problems showed up along the way, affecting both the demand and supply of credit. On the demand side, credit demand did not respond to the lower interest rates as much as was expected. The recession had lowered the expected pace of growth in the economy and particularly in what were considered interest rate sensitive sectors such as consumer durable goods and housing.
The lower expected rate of growth of the economy meant a lower expected pace of top-line sales for any company, and with business confidence low, especially in the small business sector, the expected rate of return on any investment fell. Therefore, despite the lower level of interest rates in general, the lower expected returns on investment reduced the demand for credit and thereby the ability of policy generated lower interest rates to generate economic growth. The recent lower GDP growth rate and its revisions have altered the expected future growth rates and interest rate patterns in the United States.
On the supply side for credit, lenders had just experienced a period of rapidly rising delinquencies on creditor payments and were also facing the same economic uncertainties as borrowers. Therefore, when presented with new reserves from the Fed’s easier monetary policy, lenders held a much larger than usual portion of those reserves as excess reserves — higher reserves than needed to support the current level of lending.
So why would lenders retain excess reserves/liquidity and not lend to the maximum? Pervasive uncertainty is the answer. There is uncertainty with respect to the quality of past lending due to losses on the loan portfolio as well as high levels of delinquencies across the board. There is also uncertainty about the returns on future lending given the disappointing pace of expected future economic growth. Lower economic expectations mean a lower expected rate of return on any loans from the viewpoint of the lender.
Meanwhile, the experience of recent years has led to a heightened level of financial regulation in the United States after the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. While the details of the regulation remain to be defined by the regulators, the direction is expected to be toward higher, more restrictive regulation. This domestic shift toward higher regulation is reinforced by the pursuit of higher capital standards as well as other moves to increase regulatory oversight under Basel II and eventually Basel III as well. This higher level of regulatory oversight at the global level leads into our next major issue.
Globalization alters the financial marketplace in unforeseen ways
Over the last 30 years, the coincident emergence of increasing cross-border financial flows and greater imbalances in those flows between major countries have raised the prospect that small changes to market expectations would lead to larger changes in market pricing of credit, financial assets and economic growth expectations for any given shock in the global market system.
Two aspects of the globalization have altered the traditional paths from policy actions to economic results. First, the role of forward-looking expectations became paramount. Exchange rate markets have become unhinged from the Bretton Woods system and aware of the inflation history of the 1970s adopted a more forward looking view of policy implications. Second, without a fixed exchange rate regime, growth, inflation and interest rates each had its own influence on the exchange rate for each country. As market trading became a 24-hour phenomenon, the implications of changes in the perception of Chinese/Japanese growth rates, inflation in South America and changes in interest rates across Australia, India and the Euro community all had significant implications for financial markets. So too have policy actions, as any given change in fiscal and monetary policy would have a very different impact in an open economy than a more closed one.
Yet, the U.S. dollar reaction to relative interest rates and the growth of financial movements has also grown over the years. In recent months, we have seen a surprise, to some, appreciation of emerging market currencies, such as the Brazilian real, versus the U.S. dollar, while the Chinese yuan has also moved upward under the managed exchange rate system adopted there. Risk is very prevalent in the financial sector. The United States has become a significant capital importer today relative to an earlier age, and those imports come from a very small group of lenders, primarily Japan and China. As a result, there is a growing perception that the United States is dependent on capital flows from abroad. That dependency creates a heightened sensitivity to changes in expectations around growth and interest rates abroad, as well as to political risk.
In markets, uncertainty on the flow of credit creates volatility in prices for such assets as gold, farm land, currencies and strategic commodities. In the last six months this dependency and its implications have been escalated given the problems on the real side of the economy. Uncertainty is reflected in both the amount and direction of financial flows and thereby the sharp changes in asset prices.
Moreover, with the integrated currency and credit markets, changes in monetary/fiscal policy in national markets are not generating the growth/credit easing that had been expected. Instead, additional monetary liquidity has flowed to commodities and higher inflation in emerging markets, notably China, at a rate faster than some policymakers feel is comfortable.
Pervasive impacts across all financial markets
Surprises in the impact of additional global liquidity reinforce the impression that any actions by the public or private sectors will have pervasive impacts in areas of the global economy that we do not associate with any given action. For example, the downgrade of U.S. Treasury debt was not enough to get investors to shy away from Treasuries. Instead, investors sold equities and, for risk-weighted fixed-income portfolios, investors shied away from lower-rate, investment-grade credits so that the average rating of the portfolio would remain the same.
Integration of the capital markets has reinforced the need for investors and traders to be aware of the hidden, implicit, assumptions we all make when we put in place our investment strategies. In some ways, this is reminiscent of the assumptions of liquidity and marketability that were made prior to the 2008 recession. On the usual path, the reaction of equity prices to lower economic growth expectations following the release of the revised GDP data was not surprising. Lower growth would suggest lower corporate profits/earnings and thereby less willingness to pay up for equity ownership. Yet, beyond that, the uncertainty on the quality of credit in the Eurozone is also having an impact on U.S. equity prices in a way that would not have been expected years ago.
This impact reinforces our need as investors and decision makers to revise our framework for examining markets. Too often the tendency is still to think in linear terms — i.e., increased federal spending leads to increased growth — without taking into consideration the negative feedback effect that higher spending might suggest larger future debt burdens that an increasingly skeptical global investor is likely not to accept that higher debt without the price of higher interest rates and/or a weaker U.S dollar. The pervasiveness of impacts of any change in one set of actions in one country upon a host of other countries is one of the distinguishing factors in our 21st century economic system.
John Silvia is a managing director and chief economist for Wells Fargo. Prior to his current position, Silvia was chief economist for the U.S. Senate Banking, Housing and Urban Affairs Committee. In 2010, Silvia was recognized by the Federal Reserve Bank of Chicago for the best inflation forecast, the best overall forecast and the best personal consumption expenditures forecast.
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