Does monetary policy still matter?
Economic data suggests that the transmission mechanism between monetary policy and the real economy is extremely loose, if not completely broken
Whether the Federal Reserve raises the overnight rate to 1% from 0.75% tomorrow rather than at its May meeting, as expected earlier, is a matter of compelling interest in the financial world. It shouldn’t be — not the way in which previous Fed tightening cycles held the undivided attention of the markets.
In 2007, the year before the great crash of 2008, total credit to the non-financial sector worldwide rose by a stunning 20% a year. By mid-2016, the rate of bank credit growth globally was close to zero, according to Bank for International Settlements data. That includes China, where credit growth is still close to 10%, as well as the eurozone, where credit growth is close to zero.
The Bank for International Settlements aggregates are quoted in US dollars, to be sure, and the dollar has risen against other currencies during the past couple of years, so the decline is probably exaggerated by a currency effect. The Federal Reserve influences dollar credit, though, so the volume of debt in dollar terms is the relevant measure when we consider the possible impact of Fed action.
If banks aren’t lending, central bank constraints don’t matter as much. An increase in short-term interest rates, to be sure, raises the cost of the existing volume of debt. But the object of monetary tightening is to discourage excess credit growth when the so-called output gap is close to zero, and prevent debt-financed economic expansion from generating inflation. No such thing was in evidence in the middle of 2016.
More recent lending data show that the deceleration in lending has continued. In China, total loans of financial institutions as calculated by Bloomberg turned negative year-over-year at the beginning of 2017. The recovery of wholesale prices in China accounts for part of the shrinkage in credit growth. Corporate profits fell sharply when factory gate prices declined during 2012 to early 2016, but recovered when prices improved. Lending growth peaked above 15% year-on-year in September 2015 when the Producer Price Index fell 6%, and turned negative as PPI rose above 6%. China’s monetary authorities have squeezed credit growth, but Chinese borrowers also have higher revenues and require less credit.
We observe something similar in the US, where loan growth jumped as oil prices crashed, and then fell from a peak of 13% in February 2014 to less than 6% today when oil prices recovered.
It appears that oil producers borrowed heavily when their revenues collapsed, and stopped borrowing when the oil price recovered.
Non-financial corporations are less dependent on bank lending because their free cash flow has risen dramatically since the early 2000s. Among the constituents of the S&P 500 Index, free cash flow has tripled since 2002. In the case of the broad European (Stoxx 600) and Japanese (Topix) indices, free cash flow has risen by 50% and 75% respectively. The MSCI Global Index shows a similar picture.
Free cash flow for the global market rose from US$34 billion in 2007 to US$112 billion in 2016. Free cash flow is high because revenues are up and capital investment is low, allowing companies to put cash earnings in the bank or return them to shareholders through dividends or stock buybacks.
Capex should pick up in the US in part because the horizontal drillers can make money with oil at US$50 a barrel, and because the new Trump administration’s pro-business policies will encourage it. If the administration’s corporate tax reform allows corporations to write down investments only after the law comes into effect rather than retroactively, corporations may postpone capital expenditures until the law is in effect, creating a temporary air pocket in capital investment. We don’t know the details of the administration’s plan, and neither do US corporations, so the capex outlook remains uncertain for the moment.
Whatever happens with the tax plan, it appears that US corporations have considerable internal resources with which to make investments, because they postponed or eschewed such investments during the Obama years. The high free cash flow yield in the S&P 500 is broadly based. Of the 500 members, 442 have a free cash flow yield above 5%, with 221 of those boasting yields of more than 10%.
The growth rate of credit to the non-financial sector has slowed, but high previous growth rates have left some parts of the world economy, notably emerging markets, with very high levels of debt relative to GDP.
China accounts for a disproportionate share of the increase, and can bear the burden as long as growth remains north of the 4%-5% mark. Still, the global increase in non-financial debt as a share of GDP is impressive. Between 2007 and 2016, emerging market non-financial debt rose to 170% of GDP from 120%.
That helps explain the underperformance of emerging market equities since 2009, as well as the sharp recovery of some of the most indebted emerging markets during the past year, notably Brazil, the best-performing major emerging stock market since January 2016.
As raw materials prices recovered the heavily leveraged commodity producers had an enormous relief rally.
The good news is that the reflation in raw materials prices appears to be a real event, rather than a monetary one. Investors aren’t buying industrial metals because they fear inflation, but because there is real demand, notably from China. We observe that the S&P/Goldman Sachs Industrial Metals Price Index tracks China’s purchasing managers’ index during the past six years.
All of this suggests that the world economy has little to fear from the sort of gradual rise in short-term rates that Fed Chair Janet Yellen has signaled in recent public statements. But it also suggests that the transmission mechanism between monetary policy and the real economy is extremely loose, if not completely broken.
The Fed feels compelled to tighten to some extent because its models state that economic activity and full employment should be pushing up prices — although none of this registers in recent data. On the contrary, economists have been flummoxed by the failure of US hourly wages to rise as employment increases. This probably is due to the extremely low labor force participation rate; there is a reserve of inactive workers who might come back to the market if work is available.
What the Fed should ask itself is whether the whole exercise is worth the trouble. If the transmission mechanism is broken, the brake and gas pedal will have little effect except to skid the tires and rev the engine. Rather than go through its usual exercise, the Fed might want to consider why its models have stopped working and think about devising better ones.