Secular stagnation is a policy choice
In my most recent posts, I have been saying that bond markets are pricing in secular stagnation scenarios based on how shallow the yield curve is. And that will force the Fed to pause its policy normalization path.
But secular stagnation is a policy choice. And that is something I thought I should highlight in view of UK Prime Minister Theresa May’s change of heart in pursuing austerity. Some comments below
Now, if you look at the US government bond yield curve, the short end of the curve is selling off, with the 2-year Treasury ending last week near a March 2017 peak of 1.40%, which was the highest since November 2008 at the depths of the last recession and financial crisis. And that makes sense because interest rate futures are pricing in a virtual 100% probability that the Federal Reserve will raise the federal funds rate 25 bps to the 1.00%-1.25% range at the Federal Open Market Committee meeting that ends on Wednesday. The futures market is also expecting at least one more interest rate hike in 2017, with the market-implied probability of another hike by year-end at 55%.
At the same time as the bond market is sending this signal, the curve is flattening. We go from 1.33% on two year bonds to 2.20% for 10-year and 2.86% for 30-year paper based on figures at the end of last week. That’s less than 100 basis points for the 2-10 spread, a marker for weak expected nominal growth.
And so, as I put it last week, “[a]t some point, either the yield curve flattening will stop or the Fed will stop. During the energy capex bust, the Fed already showed us it is responsive to data. And so to the degree the yield curve continued to flatten, I believe it would show up as poor economic data and the Fed would be forced to yield. Alternatively the flattening could end due to a re-acceleration of growth, ending the whole speculation about secular stagnation, at least temporarily.”
My bet is on the Fed’s pausing. Why? Policy choices.
See, monetary policy is the only game in town. It has been for as long as most of us can remember. This is an outgrowth of stagflation in the 1970s when activist fiscal policy was seen as a primary cause of inflation. And we are still fighting that battle from the 1970s, with the Fed hiking rates now even as it has undershot its target inflation rate for what Fed Governor Lael Brainard recently acknowledged is 58 straight months. And the Fed will soon add double-barrelled tightening to boot, when it starts shrinking its balance sheet.
But monetary policy and fiscal policy are different beasts. Fiscal policy is about the government spending money and collecting taxes. If the government spends more without raising taxes or cuts taxes without cutting spending, this deficit spending is a direct transfer of assets to the private sector. And, of course, government can target fiscal policy by spending in specific arenas or cutting specific taxes. The bonds that are issued as a result of this spending are the visible sign of the accounting entries that have created private sector assets.
Monetary policy doesn’t add directly to private sector assets the way deficit spending does. Instead, it redistributes wealth between debtors and creditors by changing interest rates. And ostensibly that feeds through the economy by giving relief to debtors or making it more difficult for them to borrow. Some say monetary policy also affects the economy by altering debt-financed consumption and investment. But the jury is out on whether it actually does enhance investment (see here).
The orthodoxy today says that monetary policy is the right way to go to ‘steer’ the economy. This thinking says fiscal policy is to be used as a cyclical boost only in extremis, as it was in 2009 when there were fears of another Great Depression. Now that those depression fears are no longer with us, we would be hard pressed to break orthodoxy and see fiscal policy coming to the fore. Moreover, with Donald Trump’s policy agenda sidetracked, this is even less likely now. Instead, the Republican Congress is trying to figure out how to boost the economy in a revenue-neutral way – that is, without deficit spending that transfers assets to the private sector.
But remember, this is a policy choice. We see this now in the UK with Theresa May admitting to her MPs that her adherence to austerity cost them seats. She made a policy choice on cutting public services for police, schools, hospitals and childcare and got a shellacking at the polls for it. Now she is easing this stance.
My conclusion on the US is that the bond markets have got this mostly right. They are betting that secular stagnation is going to continue in the US. And that’s because we’ve made policy choices that limit wage growth and increase inequality. And judging from the policy priorities in the Trump Administration and in Congress we will continue to do so.