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.