Wednesday, February 18, 2015

Who's Buying?

For all the not-so-good economic news that is streaming out of most developed, and some developing economies, the news out of the US is interestingly upbeat. The same economy that just lead the world into and out of a Global Financial Crisis, is now the measure of growth amoung its peers. Inflation is below the Fed’s long-term target, and the unemployment rate is within range of what is considered full employment. In addition, the Federal government can borrow for long periods at relatively low rates, and stock market indexes are at record highs. But looking closer, there appears to be several details of this rosey picture that do not align with the overall sentiment.  


Retail Sales is an interesting starting  point. Since 2011, the year-over rate of growth in Retail Sales [in both the broad and adjusted sence] has been slowing. This trend represents a period of restraint on the part of the US consumer, typically seen leading up to a recession as illustrated by U.S. Census Bureau data. The outcome of this slowdown in retail sales growth may not necessarily be an outright recession because most measures of consumer sentiment are at levels not seen since the run-up to the 2008 – 2009 recession. What this slowdown, in retail sales, may be signaling is an overshoot from the momentum of the recovery to a level above the a new [lower] equilibrium, and its inevitable correction. All the same, a lower equilibrium level for retail sales growth would ultimately mean  subdued demand behind consumer spending. However, this does not lineup with the strong growth picture being painted by the labor market and other measures of economic progress.

Sunday, February 1, 2015

The QE Effect: US vs EU

Whether faced with deflation, or economic malaise, or recession, central banks around the world are turning to Quantitative Easing (QE) to solve issues to which normal monetary policy would otherwise be the solution. The most recent to embark on the journey down the rabbit hole is the European Central Bank (ECB). However, due to structural differences in how the financial system intertwines with households and corporations in the US vis-a-vis the EU, the outcomes of similar monetary policy approaches will be inherently different.

In the US, corporations tend to tap the financial markets directly for funding via debt and equity issuances, which allow them more direct access to and benefit from new money created by the Federal Reserve. In the European Union (EU), on the other hand, corporations tend to tap the banking system for funding, which in-turn taps the financial markets. That additional step lets the banks in the EU play an even greater role in transmitting monetary policy into the real economy. In the US, the inflationary effects of QE were nullified by the banks, as the new money created by the Fed never left the Fed. The banks simply held the new money from the Fed on deposit at the Fed, and continue to collect the interest on it. Capital that wasn't held as reserves was invested in short-term market securities and equities. The Federal Open Market Committee (FOMC) is not agile enough to calm jittery financial markets and deal with run-away inflation simultaneously, so it worked out in their favor that the only price increases were in the financial markets, which are the beneficiaries of lowered funding costs.

If the banks in the EU do what banks around the developed world have done when new money is created and made available by their central banks, they will simply pad their balance sheets with cash and securities. This is fine if the issue is with the quality of assets held by the banks; but, when the issue is a lack of credit creation through loans, this is counterproductive.

European QE will amount to the ECB refinancing sovereign debt across the continent via the commercial banks, since banks can post government debt as collateral for cheap money from the central bank. Because of almost no opportunity cost due to a lack of inflation and current nominal interest rate levels, banks can invest in market securities whose prices will be supported by the ECB's QE policy. At this point consumer and business loans are not very appealing to the banks, as the viability of those loans is tied to underlying macro-economic performance, which has been lackluster of late. Instead, based on the design of the EU monetary transmission mechanism, this type of monetary policy could lead to a lowering of borrowing costs for banks and sovereigns and as a by-product, rising equity markets. The one thing that might be conspicuously absent is inflation; with QE from most other central banks, monetary policy at the zero lower-bound is very inefficient at generating inflation as wages remain outside of the sphere of influence.