Uncertainty String Theory
Financial markets are stirring nervously. Long term bond yields have risen sharply and central bankers don’t quite know how to react. Some of them say higher yields are a sign of greater confidence in the economic recovery – in other words higher yields should be welcome. Others say that central banks remain committed to buying bonds and keeping yields low – in other words higher yields should be avoided.
Inflation concerns have come back to the fore, with some analysts and market participants dusting off comparisons to the 1970s and even to the Weimar Republic’s hyperinflation. Even for this era of Twitter-friendly hyperboles this is a remarkable reference to bring up.
I don’t see hyperinflation on the horizon. But I do think we are facing an unprecedented and underestimated level of uncertainty. This will make policymakers’ job a lot harder – they might find themselves pushing on a string, with high uncertainty undermining their words and actions. To a large extent policymakers have themselves to blame, though others among economists and politicians have contributed.
In the run up to the Global Financial Crisis, policymakers facilitated a major debt bubble while claiming we had eradicated recessions and achieved the “Great Moderation”. After the GFC, many argued that economic science should be thrown out of the window and replaced with something better. Central banks got busy rebuilding massive leverage while claiming that inflation had gone extinct due to some form of economic climate change.
From there it was just a short step to argue that in this brave new world, debt-financed fiscal stimulus faces no limit. Treasury Secretary Janet Yellen and Fed Chairman Jay Powell never endorsed Modern Monetary Theory (which claims that a government with its own currency does not have a budget constraint), but the policy combination shaping up in the US is MMT in anything by name (“observationally equivalent”, as economists like to say).
To confuse matters further, central banks have also embraced a widening set of objectives, from climate change to equality in labor markets. Central bankers who persistently failed to boost inflation to their 2% target want us to believe that, once inflation does move above 2%, they will be able to control it with deftly calibrated interventions, all while safeguarding strong growth and employment, preserving financial stability, fighting climate change and reducing inequality.
The world economy is already getting more complex on its own, between the disruptive impact of innovation, the rise of China and the related shifting balance of power in global trade. With their unprecedented fiscal and monetary interventions, policymakers add a new layer of uncertainty – not just because of the staggering magnitude of these interventions, but because of the accompanying suggestion that we can throw caution to the wind, and that things have changed to such an extent that even the common sense rules of economics no longer apply.
Financial markets have reason to get nervous as they see new waves of policy stimulus hit an overleveraged global economy. Maybe inflation concerns are again misplaced; monetary policy was very loose after the GFC and inflation remained low. But by the same token, the previous round of massively increased leverage did end in tears. And now it is happening again. The chart below shows how total credit to the non-financial sector spiked in advanced economies just in the first half of last year (latest data available, from the BIS).
Financial markets have reason to get nervous. Central bankers might find it a lot harder to reassure them. If inflation expectations, interest rates expectations, business or consumer confidence take the wrong turn, policy makers might find it a lot harder to bring them back on track. New promises of easy monetary policy or fiscal spending will not cut it.
How worried should we be? Financial markets volatility could start to give investors a bumpy ride. Markets have become overly dependent on central banks’ commitment to ever easier monetary policy. Adjusting valuations to a more holistic assessment of growth prospects and financial risks would be healthy; with global growth set to improve, this can happen without excessive financial turmoil, though it will imply more differentiation based on asset quality, and will correspondingly inflict some pain on the lower-quality credits.
As far the growth outlook, the impact of higher rates will vary across countries. If interest rates rise because vaccines and fiscal stimulus herald stronger growth, they should not derail the economic recovery. But the timing and strength of the recovery are uneven. To the extent that the rise in global yields is driven by stronger prospects in Asia and the US, Europe will suffer, as it lags behind both in vaccinations (with the notable exception of the UK) and reopening of the economy.
Interesting times ahead – again.