Monetary orthodoxy would have central bankers heed Bagehot’s rule to act as lender of last resort:
“Lend without limit, to solvent firms, against good collateral, at ‘high rates.’”
But for 35 years, Greenspan and his successors have departed from that maxim leading us to today. Breaking the pricing mechanism is like throwing sand in an engine. Performance deteriorates and can eventually fail altogether.
And now very little seems to be working right for the Federal Reserve. As a result, Fed officials conducted a review of recent policy, and Fed Chair Powell has provided a synopsis of its purported new look.
Reality Check: The Fed’s Monetary Review
At the virtual Jackson Hole symposium, the Fed Chair espoused a continuation of the Greenspan school’s heterodox formula in "New Economic Challenges and the Fed's Monetary Review." He cited four factors motivating the Fed review:
- Fed: Assessments for potential, or longer-run, growth rates of the economy are lower.
Reality check: There is no doubt growth has disappointed for decades. Demographics or population growth slowed as economic policies became extremely unfriendly to family formation. Also, trade and regulatory policies severely limited manufacturing, which has a much higher propensity to drive productivity gains than service activities in the ascendant healthcare and educations sectors.
- Fed: The general level of interest rates has fallen in the U.S. and worldwide.
Reality check: Yes. Rates are all being anchored near the zero-bound.
- Fed: Record expansion resulted in best labor market in some time.
- Fed: That strong labor market did not trigger significant inflation.
Reality check (3&4): Not entirely accurate. Labor markets have never been allowed to strengthen sufficiently to generate healthy inflation—real wage growth. We doubt demographics can fully explain that the civilian labor force grew at an extremely low rate over the last 12 years. This had the effect of understating actual unemployment in the economy.
We estimate that unemployment bottomed closer to 6% in January 2020, much higher than tight labor markets that the U.S. experienced in the early periods of low unemployment. For example, 1950’s saw the unemployment rate bottom around 2.5% and in the late 1960’s that rate was 3.3%.
Again, manufacturing likely plays some role in the explanation. China entered the WTO at the turn of the century and an exodus of jobs moved to Asia as an estimated 60,000 or more factories shuttered. Less manufacturing translates into less demand for higher skill, higher paying jobs. Lack of core industrial capacity also diminishes demand for support and services jobs around those activities.
New Look Results: Average Inflation Targeting
To wit, the Fed is now as Powell says, “prepared to use our full range of tools to support the economy” as they execute monetary policy around statutory guideposts of full employment and price stability.
- Employment: Fed decisions will now be informed by shortfalls of employment by its maximum level as opposed to deviations.
- Price Stability / Inflation: With respect to price-stability the Fed is looking at a 2% average inflation rate, “a flexible form of inflation targeting.”
Summary: Come hell or high water the Fed will get inflation.
Asset and Total Factor Inflation Has Been Reality
In the classic sense, the Fed has been highly successful at creating inflation. Remember inflation is always and everywhere a monetary phenomenon.
Jerome Powell is certainly increasing the money supply. There is abundant inflation in Fed assets and M2, a measure of money supply. The Fed balance sheet has increased over 600% since 2008. If you say QE is only an asset swap and has no effect on broad asset prices, you are kidding yourself.
There is inflation in equities as valuations are at or near all-time highs across multiple metrics that have been reliable in explaining long term variation in returns. These valuations are occurring while we are in the largest economic contraction in nearly 100 years.
Beyond stocks, real estate has steadily inflated given its tax favorability and penchant to be easily leveraged, since it is the banks’ preferred asset to lend against.
Total factor inflation can be seen in those areas of the economy that are highly inelastic, most notably healthcare and education have seen dramatic rises over the last several decades.
The U.S. pays the highest per capita price for healthcare in the world without achieving universal care, longer life expectancy or superior outcomes. There is a hidden factor inflation as resources are directed away from infrastructure causing increased maintenance and replacement costs due to wear and tear on equipment and systems.
Where Is Good Inflation or Shall We Say Deflation?
Good inflation ought to be found in wages and should be tied to productivity. Though there have been nominal gains, real wages have not kept up with productivity gains. If productivity gains do not translate to wages and goods prices are increasing, then inequality results.
Inflation and Equity Market Valuations
What does all this mean for equity markets? A good part of the variation in market multiples is tied to growth and the path of interest rates. The Phillips Curve, a belief in the trade-off between inflation and unemployment, seems to historically have had some effect on these. Among many factors, inflation, payroll growth, credit impulses and earnings trends all help to partially explain multiple levels.
Now that the Fed has placed inflation and employment growth front and center, we need to consider the impacts of these prospective policies.
Intuitively, every 1% move up in inflation reduces the market multiple by approximately 2x. For example, if inflation moved from 1.5% to 5% the average market multiple might decline from 18x to under 11x P/E. Ironically, if payroll growth gets too strong, it has a negative effect on multiples as well. The scatter plot below shows there may be some correlation between multiples and inflation.
The theory for a causal link lies in an expectation of reduced corporate profitability and a higher path of future interest rates as cost inflation becomes entrenched.
Today, the S&P 500 is trading in the 97th percentile of monthly Price to Earnings multiples. Payroll growth is poor, while inflation has recently been at levels seen at the depths of the global financial crisis. You would have to go back to 2009 or the 1960’s to get other comparable low inflation prints.
New Look Scenarios for the Economy
If one wanted to reduce debt, some combination of these three methods can accomplish it. 1. Liquidation and write-offs; 2. Amortization or paying off the debt derived from the net cash flows of productive investment; or 3. Inflating the debt away.
Inflation through monetization of government spending seems to be the key result from the Fed’s new policy language. Potentially, the Fed may be called on to fund some version of universal basic income until employment and the economy return to a self-sustaining recovery.
We briefly consider a few scenarios.
Japanification: Deflationary Bailouts
Outside of the extreme monetary inflation and CARES Act money bleeding into markets, historically high multiples may be anticipating an expectation of sustained deflation, lower payroll growth and subsequent Federal Reserve interventions.
The absolute low levels of yields in sovereign and credit markets are consistent with this story: The Fed will only be successful entrenching inflation in assets and sectors of highly inelastic demand or monopolistic rents.
In this scenario the economy would continue to be hallowed out and growth weaker. Equities may be bid as other alternatives for yield disappear. Returns across all asset classes could be perpetually low on a nominal basis.
In High Cost of High Prices, Quicksand Economics, and Equity Markets Have Disconnected from the Real Economy, we discuss how past policies have resulted in a path toward ‘Japanification’--a condition characterized by low growth, stagnation with an active central bank monetizing debt.
To these we may add a caveat. If the Fed pursues direct monetization transfers to individuals without fundamental reforms, the U.S. could continue to get the worst types of inflation—those that unnecessarily increase total factor costs.
Monetary inflation could make the U.S. a less competitive economy and its citizens more dependent on the state. As small businesses continue to suffer from lockdown restrictions and reduced sales, the economy could be remade into something more sclerotic.
Then stock investors’ experience may look like this post-1989 chart.
Inflationary Boom / Bust
If the Fed is successful in obtaining its 2% average inflation target via generating sustained inflation above 3%, multiples will likely be under pressure.
High EPS Growth, High Inflation Scenario: If inflation is sustained above 5%, then single digit multiples could apply. Assume S&P 500 earnings increase 150% from today’s c. $128 or reach $320. The market could easily apply a 7x multiple assuming the Fed will eventually raise rates significantly to maintain U.S. Dollar reserve currency status. Applying 7 multiple to $320 EPS yields the S&P 500 trading near 2,240 or c. -34% decline from recent levels.
EPS Growth Mitigated by Cost Inflation: What if earnings ‘only’ grow to $200 as margins contract from cost inflation, then a similar scenario implies an S&P 500 conceivably trading at 1,400 or a near -60% decline from current levels.
Perhaps this inflationary path could lead to serious employment growth and reduced debt levels, but the interim impact on valuations could result in a serious bear market.
There is a path for positive economic results that could rebuild the U.S. as market clearing reallocates capital away from zombies and to its highest use.
- Reshoring supply chains to ensure industrial and technological self-sufficiency could add millions of jobs.
- Strategically reconstruct infrastructure to enable corporations to come home to a business and cost friendly operational environment.
- Change the tax and regulatory environment to favor small and medium enterprises.
- Using the monetary power of the Fed to fund productive investment.
- Lowering additional total factor costs of healthcare, education, etc.
- Finally, letting capital markets efficiently underwrite may be the best tonic for allocating capital and a return to lower debt levels and higher interest rates.
There would likely be a severe bear market and systemic cleansing of bad debts, but these could be offset through new and better fundamentals in the composition of the economy and jobs.
Few Scenarios Point to Market Upside
Markets can continue to rally. At some point, a continuing market divergence from fundamentals could signal a loss of monetary confidence where nearly all purchasing power could be lost, or the makings of an epic market collapse would be in place.
Whether the United States experiences deflation or inflation, market valuations have reached a level that presents deeply negative asymmetries. As we wait for the outcome, the Fed’s new look fails to hint at a return to practicing Bagehot’s maxim of sound central banking.