profiting from monetary policy

© THOMSON REUTERS 2011 32ND QUARTER 2011

PROFITING FROM MONETARY POLICY By Thomas Aubrey, Managing Director, Fitch Solutions

“Low interest rates, widely available capital, and international investors seeking to put their money in real estate assets in the United States were prerequisites for the creation of a credit bubble. Those conditions created increased risks, which should have been recognized by market participants, policy makers, and regulators.” Financial Crisis Inquiry Commission, January 2011

The Financial Crisis Inquiry Commission’s attack on the failings of monetary policy has challenged not only the very foundation upon which monetary policy is built, but also some of the fundamental tenets employed by parts of the investment community. In hindsight, it is clear that interest rates were not set at optimum levels to maintain economic stability. The excess liquidity created by loose monetary policy contributed to a significant asset boom from which the global economy has yet to recover fully. Hence, relying on the current level of interest rates as an indicator of future expectations of inflation and growth may lead to poor asset allocation decisions and higher-than-expected losses from asset price falls.

However, there are alternative monetary theories that can provide insight into such macroeconomic imbalances potentially leading to enhanced asset allocation decisions. One such approach is the analytical framework developed by the controversial Swedish economist Knut Wicksell (1851-1926) – who was notably jailed by the Swedish authorities for his opinions. According to Wicksell’s theory of interest, current monetary policy in the UK and US is generating excess liquidity, leading to rising inflation and equity prices.

Monetary theory todayMonetary theory has seen few dramatic changes since the inflation of the 1970s was conquered. In general, the rate of interest has been set to control the rate of inflation which in turn is a function of the output gap: the difference between actual and potential GDP. This approach appears to have been largely successful in bringing inflation down but, as previous crises have shown, it has also led to asset price inflation and economic imbalances. This unintended consequence has in turn made the asset allocation process more complex for investors. So how can monetary policy be used as a guide to make better-informed asset allocation decisions?

In Inflation, Sluggish Growth, Disco and Flares (Infostream Q1 2010) a Wicksellian framework was used to correctly predict that the United States was far more likely to see inflation expectations rising rather than enter a period of Japanese-style deflation. However, this Wicksellian framework can also be used as a tool for investors to understand what is driving the imbalances, allowing investors to make their own asset allocation decisions independent of what the Central Bank believes the future trajectory of inflation and growth might be.

FEATURE


A Swedish felonThe Wicksellian approach to monetary theory looks at the relationship between the money rate of interest (cost of capital) and the natural rate of interest (return on capital). One of the main benefits of this approach is that it doesn’t require an analysis of whether an economy has deviated from its “potential” rate of growth. Estimates of the output gap are notoriously difficult to discern, and hindsight demonstrates they were clearly wrong for much of the last two decades. Wicksell argued that the money and natural rates of interest should be in balance to ensure a stable economic output.

However, generating robust datasets to implement a Wicksellian analytical approach remains challenging. Firstly, a proxy needs to be derived for the average real return on capital for an economy: the return on capital is reported in company accounts. Secondly, an estimation of the average cost of funding also needs to be benchmarked, which in turn requires an assumption on which maturity to use. In the following examples, major equity index constituents have been used to generate the real return on capital as a proxy (S&P 500, FTSE 100, Nikkei 225). No correction for selection bias has been made, which will most likely slightly overestimate returns. The five-year real government benchmark rate has been used as a proxy for the cost of capital. For shorter or longer projects the rate will clearly differ, and given the dynamic nature of the yield curve can vary significantly.

Excess liquidity has to flow somewhereBy plotting these datasets over the last 30 years against inflation and equity prices, the impact of the Wicksellian differential – the difference between the demand price for credit and the supply price for credit – can be observed. The differential thus becomes a critical indicator in pointing to the level of liquidity within an economy, which in turn may create asset bubbles, inflation or economic depressions. The generation of excess liquidity equates to too much money chasing too few assets or goods driving up asset prices and/or inflation. Conversely the lack of liquidity will lead to a depressing effect on the economy and deflation.

Before proceeding to interpret the charts, it is worth noting that the impact of the differential does depend to an extent on the amount of leverage in an economy. As the price of credit falls relative to the return on credit, the economy booms and consumers leverage up to consume more. In an economic downturn, consumers deleverage, which often means that any attempt to boost the economy by lowering the cost of credit has limited impact. This notion was central to the arguments of Hayek and Von Mises, both disciples of Wicksell.

Chart 1 shows that during the 1980s the natural rate in Japan was above the money rate, driving the Nikkei 225 up to nearly 40,000 due to excess liquidity. However, between 1989 and 1995, monetary policy was, according to the Wicksellian approach, too tight with the natural rate in Japan being consistently below the money rate, which in turn drove the depression. From 2003, the natural rate shows significant growth above the money rate, reflating the economy only to be halted by the credit crisis.


Chart 1: Japan: Natural vs Money Rate of Interest, Inflation

and Equity Prices

Chart 2: Debt-to-Income Ratio:

Japan, US and UK

Source: Thomson Reuters Datastream.


Chart 2 helps explain why the transmission mechanism of ultra-low interest rates generally has limited impact, which is largely due to excess leverage. Until the consumer has deleveraged, consumption is unlikely to increase significantly enough to lead to surging investment and employment. The debt-to-income ratio is used as a proxy for consumer leverage and is inversely correlated with the savings rate. In this instance, the Japanese consumer has been deleveraging ever since 2001.


Chart 3 shows the divergence between the money and natural rates in the United States taking place in 1985, which in turn drove inflation up towards 5% from 1987. Interest rates rose, causing the recession of the early 1990s. As part of an attempt to kickstart the economy, US real interest rates fell again, driving the Wicksellian differential up. However, it took time for consumers to start leveraging up again, hence it wasn’t until 1995 that equity prices began to rise, leading to their peak in 2000. Inflation of course remained subdued due to the integration of China and India into the global supply chain, which had a one-off deflationary impact on prices over the period. As a result, monetary policy has remained loose since the early 1990s, leading to the ever-increasing leverage of the US consumer and rising asset prices.

Wicksell’s theory highlights that the current attempt to re-invigorate the US economy through maintaining a loose monetary policy is unlikely to demonstrate significant economic growth until the consumer has deleveraged. Chart 2 shows that the US consumer has been deleveraging since 2007, although, given the excess liquidity that drove the economic growth of the last 20 years, it may take a significant rise in the savings rate before investment and employment begin to surge. However, the large Wicksellian differential will stimulate the equity market as well as inflation, particularly given that China and India are now exporting inflation rather than deflation.

Chart 4 shows the similarities between the UK and the US, with a mid-1980s expansionary story leading to rising inflation and a period of deleveraging before the Wicksellian differential increased during the 1990s and early 2000s, sending asset prices soaring. As in the US, according to Wicksellian theory, the transmission mechanism of low interest rates is unlikely to have much impact on increasing output significantly with the consumer still deleveraging, although it will stimulate equity prices and inflation.

Chart 3: US: Natural vs Money Rate of

Interest, Inflation and Equity Prices



Chart 4: UK: Natural vs Money Rate of

Interest, Inflation and Equity Prices


The investor’s conundrum – what to do with excess liquidity?The current datasets show the Wicksellian differential for Japan is just over 1% largely due to the lower real return on capital for Japanese companies. However, the differential for the US is approaching 11% and the UK just under 10% due to ultra-low real interest rates and high real returns on capital. The excess liquidity being generated by US and UK central bankers needs to flow somewhere and Wicksell’s theory shows this will drive both inflation and equity valuations, although there is likely to be a delayed effect on the equity market due to continued deleveraging as was shown in the early 1990s.

One challenge with the analysis is related to the fact that the datasets for the return on capital figure are generally annual and therefore a lagging indicator, making the asset allocation decision more challenging. However proxies can be found using the IBES aggregated earnings per share figures (EPS). This dataset provides robust indicators on a quarterly basis. Current EPS growth for the UK and US remains strong with Japan muted as set out in Chart 5, providing insight into the direction of the return on capital.


Chart 5: Aggregated EPS:

Japan, US and UK


Clearly one factor that would cause investors to pause from moving into equities, would be if central bankers decided to raise interest rates to levels which would bring the economy back into a Wicksellian balance. This would require rates to rise in the UK and the US several percentage points, which is highly unlikely given the impact this would have on highly leveraged consumers. Indeed, the leverage created by lax monetary policy over the last two decades may prevent the possibility of being able to bring the money and natural rates of interest back in line for many years to come.

One final issue with the Wicksellian framework is that it says little about the right time to exit a bubbling asset class. It would appear that the looser the monetary policy, the greater the trajectory of the rise in asset prices – and the larger the subsequent fall. Hence, according to Wicksell, equity valuations are likely to boom significantly due to the current excess liquidity. At a minimum, knowing that an asset class is being driven up due to excess liquidity is clearly useful information as opposed to assuming that asset prices are rising due to a “this time is different” argument.

ConclusionIn summary, Wicksell’s approach to monetary theory explains much of the criticism now being thrown at monetary policy, as highlighted by the Financial Crisis Inquiry Commission earlier this year. Moreover, it also can provide a useful framework to make improved asset allocation decisions in light of decisions being made by central bankers that, according to Wicksell’s approach, are generating excess liquidity.

The views expressed in this article are solely the opinions of the author. The contents of this article are not indicative of the opinions, commentaries or analyses of Fitch’s rating analysts, and are therefore separate and distinct from rating analyst activity, actions and opinions. Nothing in this commentary is a recommendation to buy, sell or hold any security.

Further readingAubrey – Inflation, Sluggish Growth, Disco and FlaresColeman – Inflation without a quantity of money: a simple Wicksellian model outlinedHayek – Monetary Theory and the Trade CycleVon Mises – Theory of Money and CreditWicksell – Interest and PricesWoodford – Interest and Prices

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