Interesting times, these we are currently living in. In order to avoid general deflation in the aftermath of 2008’s global economic meltdown, a humongous amount of cash has been deployed in the global financial system.
This unprecedented effort has been coordinated by the main Central Banks around the world. Yes, the very institutions created to defend the value of their respective currencies.
Throughout these wacky years, not only the target nominal rates dropped to zero, in some of the main economic regions, they incredibly crossed the zero threshold into the negative side and are simply locked in there, because the expected outcome – namely, Inflation – simply doesn’t appear… Or does it? In order to answer this question, we have first to work on a semantic problem: What is the meaning of the word inflation, whatsoever? Oxford Dictionary defines it as "general increase in prices and fall in the purchasing value of money.“
Is it the same Inflation Central Bankers are looking for? Well, this is a tricky one! Modern Central Banks adhered to the so called „Inflation Targeting Models“ - pioneered by New Zealand, Canada and UK in the early 90’s. They work on the assumption that consumer activity may be fine-tuned by the aggregated cost of capital.
And here comes another dangerous assumption: That the Basic Target Rate defined by the monetary authorities is a good proxy for the cost of capital of economic agents within a Country‘s economy. Is it? And if it is (was) the case, should we assume that its mechanisms of transmission are static or dynamic, varying through the time due to current Economic/Institutional/technological realities?
I am of the opinion that we have enough empirical evidence to conclude that there are serious flaws in this and other assumptions underneath the model. Serious enough to call for a revision of the role of Central Banks and their current tools. And its side-effects are dangerous. The most screaming one is the fact that we are being punished to save money for the future. I will allow myself to work a little on that:
Most Central Banks under Inflation Targeting Regime currently assume the so-called Consumer Price Indexes (CPI‘s) as Inflation. Trying to put it simple, the CPI is a large basket of goods & services supposedly consumed on average by a country‘s population. It is periodically adjusted in order to reflect changes in the consumption patterns. It may be practical, but should we assume it is a good proxy? I believe we shouldn‘t, given that in times of 4th Industrial Revolution, the prices of many goods and services tend to zero either because their supply grows abundantly (e.g. information processing and storing) and/or because the very nature of the aggregated demand is changing abruptly (e.g. from possession to subscription).
Technology is one of those subjects mainstream Economists always had trouble with. And they also have this bad habit of pretending a variable doesn‘t exists if they don‘t know how to model it.
It happens that in the early years of inflation targeting (90’s), when technology evolution pace was far slower than today, consumption patterns were stable enough to grant that CPIs were reasonable inflation proxies. It may not be the case now.
Demographics also plays a big role at this stage. We are getting older, that’s a fact. Thanks to the gigantic leap forward in Life Sciences knowledge, we’ll probably live more than we previously thought. That’s good news, indeed! But it comes with important economic consequences. This seems to be deflationary by itself, since it forces us to rethink priorities and to focus more in saving for the future instead of spending now.
Elder people have to make sure they are going to have enough income and it usually comes from their lifetime savings. We may say that as we get older, our focus changes from increasing our income (e.g. a better job) to protecting our accumulated net worth in order to: (a) live decently, and; (b) let something to our loved ones. So, instead of a new car, we may desire to build a sound portfolio of income generating assets with the help of good Wealth Management (my apologies, I couldn’t avoid a little advertising here).
Cost of Capital
Inflation Targeting models also ignore the fact that Economies are opened, not closed systems. Economic cycles are not synchronous among countries and consequently, monetary policies naturally differ, and so do the level of basic rates. In their hunt for high profit/ low cost, economic agents around the planet may borrow cheap cash anywhere and swap it into more attractive currencies/assets. As per consequence, the interest rate elasticity of a single country is lower in a globalized economy because the effects of each Country’s monetary policies may be canceled away. Simply put, the target rate may no longer be a good proxy for the aggregated cost of capital.
If we give it a thought, we may conclude that by ignoring the above-mentioned flaws, Inflation Targeting regimes can backfire big time! Simply put, negative carry almost certainly will lead us to financial distress in the future, a very undesirable situation. So, instead of increasing current expenditures, we may feel forced to increase savings in a desperate search for yield. History tells us that in such situations, not rarely, investors lowered the quality of their risk assessments, setting the course to bubbles and crashes.
What strikes me most is that instead of revisiting their models and assumptions, this weird breed, the Central Bankers, simply ignore the screaming evidences that their actions are creating important distortions in the system. Curiously, the main one should be called INFLATION.
Now you are probably thinking I am totally bananas. Please, allow me to say a few words in my defense: Yes, it is happening. The monetary expansion is indeed creating inflation. Just not the one forecasted by the inflation targeting framework, given that the products & services affected are not in the CPI’s basket. Actually, those are under strong deflationary pressure due to the points above mentioned.
The inflation (huge, by the way) is mostly located in financial assets. The price formation process for entire asset classes was impaired by this long experiment of monetary expansion. Don’t ask me why, but it happens that this neglected inflationary process is hidden under another name: „BUBBLE“.
Garbage in, Garbage out… My current worries
I believe that while our monetary luminaires are locked in their liquidity traps expectations on yield curve trends remain intact and asset prices will keep going up. But I’d like to point some issues that are currently worrying me and may trigger a reversion in the expectations and as per consequence, stronger correction in the market prices:
The ETF industry flourished in the after crisis and reached alarming size. When you buy a Passive ETF, you buy good and bad assets. You care neither about fundamentals nor intrinsic values of its components. You also don’t care about the liquidity of its component assets. In other words, this industry seems to be working against the mechanism of market price formation.
My worries are more related to those ETFs that must acquire illiquid assets traded on OTC markets with decaying liquidity and high modified duration (e.g. HY EM Bonds) - which are hard to replicate and should be limited in size. The problem with size is that a whole sub-class of structured products and derivatives with ample use of those ETFs as underlying assets have a multiplying effect on the exposure.
Overregulation also plays a big role in breaking the process of market price formation. Endowments, Pension funds, insurance companies all are enforced to follow strict rules to supposedly manage risk (another semantic problem here). And they have to adhere to minimum allocation requirements in all asset classes, depending on the investors‘ risk profile. ETF's marketing argument that these vehicles are cheaper and efficient on market risk diversification. I have my doubts.
The ample use of algorithms to drive asset allocation decisions may increase heard behavior in good and bad times. My worries, once again, lay on oversimplified models, shallow associations and neglected variables that may trigger herd behavior. The huge amount of free cash in the system also distorted important references. The most relevant being the concept of volatility, a key variable that is wrongly put as a synonym for risk and that is core in the pricing of many derivatives.
The currently super low volatility is nothing more than a side effect of the excessive liquidity in the system. Hence, this misleading association favors the general perception that the current market risk is too low. A perfect environment for the flourishing of Low Volatility / High Yield combos of derivatives and their underlying assets (a.k.a. Structured Products). Abrupt changes in variables or in the relation between those variables may trigger shockwaves in the global markets.
Not just because of what we see – which also worries me – but because of what we don’t. How leveraged is the banking system? How can we verify the quality of their reported assets? What about the SOEs? Can we trust official data? How to attract intellectual capital to a place with lower freedom? China has been going through a formidable transformation since the end of 1978, when Deng Xiaoping took over the country. But it still functions as a dictatorship with top-down control. And in the last couple of years, President Xi Jiping‘s has been reverting expectations of a more democratic and opened regime.
I deeply believe that prosperity and sustainable wealth creation are consequence of freedom and inclusive institutions (Douglas North, Daron Acemoglu). Trying to plan and control Complex Systems (e.g. Economic Systems) top-down is just non-sense.
An eventual impeachment process bumping into the election process may be a great source of volatility. It drains energy and focus from the Country‘s leaders, which is not desirable. But I don‘t believe that the outcome will benefit radicals from both sides. That said, I see more volatility spikes coming from US politics than any reversal in the economic trends.
USA x China
True, they are both economic giants. But the former is in fact stronger than the latter in institutional and in economic terms. A rupture in any of them would certainly lead to a systemic crisis. The point is that fragilities may be exposed and reach a point of rupture, big enough to shake the world.
In a world with either zero or negative nominal rates, many banking platforms may be economically unsustainable. Along with non-sense overregulation that drives costs to the sky and new inter-sectorial competition from digital platforms, traditional banking business model is being challenged and has to adapt quickly.
Endemic populism and low average education among voters make the task of dealing with entrenched corruption nearly impossible. Bullish cycles have been based more on wishful thinking than on sustainable productivity gains. When we look further, low education standards may not only cap sustainable growth - they may widen the wealth gap between the region and the leading economies. Just take a look in the current sector composition of the main equity indexes in the region. You will hardly find economic sectors/companies that are in the businesses of monetizing intellectual capital, which by the way, have been the main vectors of wealth creation in the world in the last 50 years, at least.
Borrowing the summary of a great (and wise) friend, who by the way, do not attribute relevant probability to some of my worries above mentioned, in the end of the day, any major correction is related to an abrupt reversion of monetary policy expectations. I agree. Time will tell…