After the crash in 2008, policy makers created an expansive monetary policy cocktail combining low interest rates, unlimited QE programs and outrageous government spending funded by unprecedented levels of debt. This has been the status quo for over a decade and it’s time to accept that this cocktail didn’t keep the party going for long. More than a decade later, here we are, on the edge of a new crisis with central banks lacking fire power and failing to keep the economy growing. The failure of these policies has not only left the economy in liquidity trap, but it has changed the way economies and consumers work. Credit is so cheap that today consumption is not driven by wealth, but by credit cards and inflation. Central bank mandates have now shifted from controlling inflationary pressures to driving economic growth and development using inflation as a pretext.
Many would argue that these programs worked, when we look at Equity Indexes. Before the crash in 2008, S&P had a historic high of 1,560 which was reached again in February 2013 and it has been hitting new record highs to the point of doubling to 3,000. But what does this really mean? When the 2007 levels were hit again in 2013, unemployment in the US was 8% and inflation 1.8% pushed by 0% interest rates in the US. If we compare these figures with the 2007, unemployment registered at 4% while inflation was 3.5% dragged by interest rates around 6%, there was internal demand back in 2007. The only word that comes into mind now is overvaluation. In 2013 , the market was hitting record highs despite unemployment at 7.7% , pushing consumers to look for resources into cheap credit sponsored by the Fed.
Graph 1. S&P vs US Inflation vs US unemployment
The graph below (graph 2) shows that low interest rates pushed consumers towards increased borrowing which in turn drove up demand. After 2011 borrowing increased in linear fashion from USD 2.6 trillion to USD 4 trillion. In 2016 after the first Fed hike, Consumer Credit retraced as expected but from this point on no matter how many increases we saw, consumer credit kept increasing at the same pace it did with 0% interest rates and here it became apparent that consumer patterns had changed. Consumers now rely on credit for consumption instead of using their own resources. This is a key idea to understand that increases in retail sales are nothing but a policy maker placebo effect that does not reflect a healthy economy, but an injection that is fuelled by cheap credit instead of the actual engine which is the consumer.
Graph 2 – Consumer Credit VS Fed rates
Central banks mandates are not homogenous, but most would agree that the primary mandate of any central bank is to control inflation. It seems to be the case that after 2008 we have seen that the primary concern of central banks is stimulating economic growth, while inflation now seems to be a pretext rather than a priority. Equity markets rally based on central bankers policies instead of macroeconomic results. QE programmes and interest rate cuts are now the main source of growth instead of government policies and private sector initiatives to add value into GDP. We have seen different indicators showing a US recovery and I would tend to agree that is true to a certain extent. Looking at GDP per capita from its peak in 2007 using constant prices, the US economy has grown 8%, but at the expense of growing inequality.
The market has not only changed, but also the geopolitical environment is very tense. The US government has declared a trade war with China and markets are feeling the pressure. The extension of these policies has also brought challenges to NAFTA and Europe. In the old continent we see Brexit turmoil weighing on sterling and uncertainty is affecting foreign direct investment. These tensions all relate to a lack of cooperation across economies that will only increase the prospect of risk and pressure over the stock market, but the Fed can always print more bills if that is the case.
The concern is that nothing seems to change. Geopolitical tensions keep growing every day, further interest rate cuts and QE programs are in the pipeline and Stock markets will feed from central banks’ ultra loose monetary policy. The consumer will top up their credit and all these elements together seem to be creating the perfect storm when central banks run out of paper. We have seen in times of crisis that USD, CHF and JPY tend gain value. USD itself has made steady gains during the course of this year and in case of an economic downturn we could see further appreciation of the greenback.