One
of the questions most commonly asked by investors is why the economy has been
so sluggish in recent years despite the Fed’s efforts at stimulating it?
This
question was recently asked of former Treasury Secretary Timothy Geithner by Time magazine. His answer was that Americans are still
“still living with the scars” of the credit crisis, implying that the reason
for the slow pace of recovery is more psychological than anything. His answer is unsatisfactory, however, since
it obscures the deeper reason behind the slow growth era of the last few years.
A
more academic attempt at answering this question was also made recently by
economist Ed Yardeni. Dr. Yardeni
asserts that the ultra-easy money policies of central banks may actually be
keeping a lid on inflation by boosting capacity. He cites China’s borrowing binge of recent
years, which “financed lots of excess capacity, as evidenced by its PPI, which
has been falling for the past 26 months.”
Yardeni also noted that conditions are especially easy among advanced
economies. “Rather than stimulating
demand and consumer price inflation,” he writes, “easy money has boosted asset
prices. It has also facilitated
financial engineering, especially stock buybacks.”
The answer as to why demand has remain muted
while inflation has remained in check these last few years can be easily
summarized in terms of the long-term cycle of inflation and deflation. The 60-year cycle, which bottoms in just a
few short months, has been in its “hard down” phase for the last several
years. The down phase of the cycle acts
as a major drag on inflationary pressure; more specifically, it actually
creates deflationary undercurrents and sometimes even leads to periodic
outbreaks of major deflationary pressure in the economy (as it did in
2008). This cycle explains why, despite
record amounts of money creation by the Fed since 2008, inflation hasn’t been a
problem for the U.S. economy.
The term “financial engineering” is one we’ve
heard a lot lately. It involves
companies repurchasing their own shares in order to reduce supply, thus
increasing earnings-per-share. This in
turn boosts stock prices, thus perpetuating a self-reinforcing feedback loop. Financial engineering has been spectacularly
successful since 2009 mainly due to the influence of the deflationary
cycle. Because the 60-year cycle is in
decline, it suppresses interest rates and thereby makes stock dividends attractive
by comparison. When a new long-term
inflationary cycle begins in 2015, however, this technique will eventually
become less effective. When inflationary
pressures become noticeable in the next few years, “financial engineering” will
lose most, if not all, of its impact in boosting stock prices.
Another
facet of the 60-year cycle is interest rates.
Interest rates have remained at or near multi-decade lows since 2009
with the deflationary cycle in its “hard down” phase. This has also made it much easier to
facilitate financial engineering. One of
the primary motives behind the Fed’s Quantitative Easing (QE) policies that
began in November 2008 was to keep interest rates artificially low in order to
decrease the cost of debt servicing and to help resuscitate the housing
market. The Fed has begun tapering the
scale of its asset purchases to the tune of $10 billion/month with plans to
completely end QE by the end of this year.
The Fed then plans to unwind its $4 trillion balance sheet and allow
interest rates to steadily increase.
Robert
Campbell of The Campbell Real Estate
Timing Letter believes this puts the Fed between the proverbial “rock and a
hard place” since the Fed may be tempted to keep rates artificially low, yet
doing so would create a potential catastrophe for pension plans and insurance
companies which need higher rates.
“Thus
the Fed may have to let interest rates rise to prevent the pension catastrophe
from becoming even worse,” he writes.
Indeed, rising interest rates are part and parcel of the inflationary
aspect of the 60-year cycle. We should
eventually expect to see a gradual rising trend in coming years as the new
inflationary cycle becomes established.
