Market Monetarism – Part 2

By Julius Probst

In my previous blog post, I explained some of the core tenets of market monetarism, and also described the NGDP gap from the Mercatus Center, which we just added in Macrobond. In what follows, I will show some alternative data, including prediction markets, that market monetarists use and that we also have in Macrobond.

The speed with which the Corona shock hit the global economy has been totally unprecedented. Before more conventional macro indicators were giving warning signs, PredictIT started to price in a US recession and lower GDP growth from late February onwards.

While prediction markets are obviously not always reliable, economic research has shown that they efficiently aggregate disperse information and typically do outperform most moderately sophisticated benchmarks. And as the name market monetarism suggests, market-generated forecasts are generally our friends, since they tend to be better than expert opinion.

In 2015, for example, I doubted that the Fed would ever be able to raise their policy rate to 4% in the long run, which was their own forecast at the time. I turned out to be right, not because I have a more advanced DSGE model than those Fed economists (for the record, I certainly do not :D), but simply because I looked at Fed funds futures and other market forecasts at the time.

Market forecasts back then suggested that it was quite unlikely that the US economy could decouple from the current low-interest rate regime that is global in nature. Furthermore, global economic factors have more influence on the Fed policy rate than what the common narrative suggests. Even the Fed cannot stem the forces of secular stagnation.

While it is puzzling that financial markets discounted  the risk of a global pandemic until the month of February, it reflected common sentiment at the beginning of the year. However, during the month of March a clear repricing of risk and asset prices happened at an unprecedented speed, leading to my first post on our blog in which I argued that the negative demand effect of a global pandemic would outweigh the negative supply disruptions.

Since then, market signals have confirmed my view that we are facing a substantial deflationary shock and that the inflation risks that some people are worried about will not materialize any time soon.

The chart below shows the one-year ahead inflation expectation based on the Michigan survey and the 5-year ahead market forecast implied by TIPS spread. Consumer expectations are always somewhat higher than actual inflation, which has averaged below 2% since the Great Recession.

Market forecasts of future inflation completely collapsed in February until the Fed started to intervene massively in the economy. As the Fed’s balance sheet basically doubled to now more than 7 trillion USD, market expectations have recovered. However, they are still too low, which brings me to another core proposition of market monetarism. It is not the action that counts, but only the outcome.

Of course, there is a clear conflict between two economic policies right now. The Fed has a full employment mandate while at the same time local governments have been shutting down the economy to prevent the virus from spreading further.

I don’t think that anybody can expect a stable level of nominal GDP in the short-run. However, once the economic shutdown is over and the economy opens up again, there would be a need for a higher level of nominal spending than before in order to make up for the current shortfall.

And here is where I see a big problem in the future. Markets currently do not at all expect that such a Ketchup effect will happen. On the contrary, the inflation expectations curve based on a model by the Cleveland Fed suggests that inflation will remain low for years to come.   

Macrobond Moment: I have created the inflation expectations curve using our yield curve tool.

Financial markets currently price in 1% inflation or lower for the next few years. One can argue that monetary policy currently remains way too tight despite the Fed’s unprecedented easing policies. There is no reason why nominal spending should remain subdued for so many years. It could be a complete policy failure.

Moreover, Fed funds futures suggest that the policy rate will still be stuck at the ZLB in January 2022. This is a huge problem. First, it is now abundantly clear that pre-crisis neo-keynesian models completely underestimated the enormous risk of getting stuck in a zero-interest rate environment.

After enjoying barely three years of positive interest rates, the US economy got catapulted back towards zero while most other advanced economies never had the chance to lift off their policy rates in the first place.

Based on the futures market, the liquidity trap will remain with us for years, a clear sign that we will face significant demand shortfalls and that inflation will not be an issue any time soon.

While the current expansion of the monetary base is certainly impressive, market forecasts clearly suggest that Central Banks are still not doing enough to keep future aggregate spending on track.

The Fed‘s balance sheet is approaching 33% of GDP and the ECB’s balance sheet is heading towards 50%. Combined, the big 4 have injected more than 4 trillion dollars in liquidity over the last few months. However, one should keep in mind that Central Banks in Czech Republic and Japan have literally taken the balance sheet expansion to another level, since they are close to 100% of GDP.

Macrobond Moment: I have created the chart below in graph layout using stacked bars.

Market monetarists would argue that the current money expansion is not inflationary in a liquidity trap environment where base money velocity (and velocity of broader monetary aggregates) has completely collapsed and will remain low. The Fed’s job is only done when market forecasts of future inflation are back on track again in accordance with the Fed’s 2% price stability goal.

Central Banks obviously can create unlimited amounts of base money out of thin air in a fiat currency regime. Now could be the time to use this power!

To conclude, in my opinion, the only way to prevent another decade of economic stagnation is if Central Banks follow Krugman’s suggestion and credibly “promise to be irresponsible”. This means that they should continue with the current balance sheet expansion as long as necessary, and more importantly, make it contingent on future economic outcomes. If you commit to a level target (for inflation or better nominal GDP) and buy as many financial assets as needed, including equities, nominal spending will pick up again.

This will be the only way to prevent another decade of demand-side stagnation like we have faced in the aftermath of 2008 with excessive levels of unemployment and low inflation. Central Banks therefore better step up. A for effort for the actions taken so far, but ultimately it is only the outcome that counts!

Central Banks can only stop expanding their balance sheet once inflation picks up and not a second sooner, otherwise the current easing policies will turn out to be futile and we are setting ourselves up for another decade of secular stagnation.    

Disclaimer: We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of the author. While we think our writers are very smart, Macrobond Financial does not expressly endorse the views presented here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have Macrobond, you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have Macrobond, now you have a great reason to get it.

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