Market Update - The effect of fiscal and monetary policy on markets
The effect of fiscal and monetary policy on markets
Many consider that the response to the Great Financial Crisis of 2008/9 was a watershed moment when it came to loosening monetary policy. Indeed, it was extraordinary to see the coordinated response from central bankers as they slashed interest rates to zero, or, as in the case of Japan and Switzerland, less than zero, or negative to use the technical term.
Despite some early interventions when the US Treasury devised several schemes to rescue the investment banking, mortgage, and insurance sectors from absolute annihilation, it was monetary policy which carried the burden of rescuing the global economy. Central bankers then had to get creative with monetary policy as governments blanched at the idea of spending further taxpayer money on further bailing out a greedy and callous financial sector. This saw the implementation of quantitative, and indeed qualitative, easing programmes. The former involved regular purchases of government bonds. This expanded to mortgage-backed securities and corporate debt. The Bank of Japan, quite the trailblazer in this regard, even added equity EFTs into the mix. Essentially, central banks were printing money to boost the stock prices and bonds of favoured companies. Who would have believed it could come to this, especially with prime brokers able to front-run these purchases for risk-free profits.
Cheap debt zombies
This extraordinary loosening of monetary policy was meant to be temporary. The idea was to boost the balance sheets of commercial banks and they in turn would lend that money out so that it would trickle down to the wider economy. Instead, it got stuck in the system. Large corporations were able to borrow as much as they wanted, and this they did. But most of the loans went into stock buybacks and dividend pay outs, rather than investing directly into companies to fund organic growth. The opportunity to update outdated machinery and IT, train new staff and take measures to improve corporate productivity was largely squandered. The inference was any company that genuinely needed money to survive through this period wasn’t worth lending to. But larger corporations stayed in business, funded by cheap debt. Many remain zombies that refuse to die and make room for fresh, innovative businesses.
Some central bankers seemed slightly embarrassed by the situation. In July 2012, during the European sovereign debt crisis, the European Central Bank President Mario Draghi had famously promised to do ‘whatever it takes’ to save the euro. But at the same time, he was insisting that central banks couldn’t do everything on their own, and he repeatedly called for greater fiscal union and fiscal stimulus. For various reasons, not least the complications that came from being in the European Union, that help was not forthcoming. The reluctance of the US and UK governments to provide fiscal help was also political. They understood that the public wouldn’t stomach more taxpayer funds spent on a problem largely caused by the banking sector.
Now all this central bank largesse was supposed to be temporary. But it wasn’t until eight years after the financial crisis that the US Federal Reserve attempted to reduce its balance sheet to something more akin to pre-crisis levels. Bear in mind, its balance sheet had risen from around $800 billion to over $4.5 trillion during the crisis, while interest rates were effectively zero – a situation previously unknown in banking history. The Fed began quantitative tightening (selling, rather than buying bonds) in October 2017. But as this continued, investors became increasingly nervous and started to unwind their holdings of stocks in September 2018. By the end of December, the S&P 500 had fallen over 20% and the following month Fed chair Jerome Powell indicated that monetary tightening was coming to an end. By August 2019 it had managed to reduce its balance sheet to $3.8 billion from $4.5 billion. The following month it restarted its bond purchase programme.
In all that time, inflation, as measured by traditional measures such as CPI and Core PCE, remained tepid. But it was showing up in equity prices, bonds, property and artworks. Then came the coronavirus pandemic. This time not only did central banks rush to loosen monetary policy (the Fed’s balance sheet is currently around the $8 trillion mark) but governments quickly mobilised to offset the most damaging effects of locking down the global economy. In the US, the Biden administration is looking to push through a total of $6 trillion-worth of fiscal spending, around half of which has already been approved by Congress. Some of this is directly related to the pandemic, but much isn’t. If passed, this would see the US hit its highest level of sustained federal spending since the Second World War. The big question now, particularly as a successful vaccination programme is helping to open the economy, is whether the combination of monetary and fiscal stimulus will finally bring about the advent of a new inflationary era.
Can it be contained?
Some insist it won’t. They point out that both the financial crisis of 2008/9 and the Covid pandemic were massively deflationary events and actions taken now will simply get us back to where we started. They point out that the recent pick-up in inflation is due to comparing the rapid reopening after lockdown to the deflationary panic this time last year as economic activity ground to a halt. Most central bankers insist that any rise in inflation will be transitory, and that investors shouldn’t worry about interest rates suddenly spiking higher to counter rapidly rising prices. But others point to the month-on-month data as evidence that inflation is on the increase and may turn out to be persistent. If so, it could prove impossible to contain without drastic action. Certainly, this is the first time in many years where we have extraordinarily loose monetary policies, together with governments which show few restraints when it comes to fiscal spending. In addition, there is little chance that this fiscal stimulus can be paid for by taxing corporations and the wealthy. Instead, most of it will be deficit funded, with the Treasury issuing bonds and the central bank buying them up. While inflation is very good at getting rid of debt, too much inflation is an incredibly dangerous thing. With higher interest rates the main weapon in the central bank arsenal to curb inflation, we better hope that it doesn’t get out of hand.