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We Aren’t Even Close to the End of Accommodative Monetary Policy

Submitted by Taps Coogan on the 4th of December 2019 to The Sounding Line.

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A number of prominent economists and investors have proclaimed in recent months that the world is reaching the practical limits of accomodative monetary policy.

While that may be true in the sense that accomodative monetary policy has long surpassed the point of diminishing returns regarding its ability to provide stimulus to the real non-financial economy, that is largely beside the point for most investors.

The question for investors is simply whether central banks will attempt to do more stimulus, because, independent of its effects on the real economy, it works quite well at lifting financial markets higher.

Given central banks’ dogmatic belief that it is their job to ‘sustain the current expansion,’ there should be little doubt that they will want to provide stimulus during the next slowdown or market dive. In fact, central banks seem to interpret monetary policy’s weak effects in the real economy as evidence that they need to do more of it, not less, in order to to achieve a desired result. So, unless there is some physical limit that prevents more accomodative policy, more of it is coming during the next market scare, regardless of whether it actually works. To that end, whenever the economic or market outlook gets ‘scary’ again, the Federal Reserve is going to see itself as very far from such limits.

To illustrate that point, consider the Bank of Japan (BoJ). The BoJ first cut interest rates to zero in February 1999. In the two decades since, the BoJ’s balance sheet has grown from 80 trillion yen to 578.5 trillion yen ($5.3 trillion) or to a whopping 120% of Japan’s GDP. During the same time period, Japan’s national debt has swelled from about 100% of GDP to 225% ($9.7 trillion).

In other words, Japan has held interest rates at or below zero for 20 years, increased its national debt by more than 100% of GDP, and essentially printed every penny of that new debt. Did doing so produce side-effects that limit the policy’s continuation 20 years later? When Japan first cut rates to zero in February 1999, one US dollar would buy about 115 Japanese Yen. Today, it will only buy about 108. Since Japan embarked on its extreme negative interest rate, money-printing, debt binge, it’s currency has actually risen in value. Meanwhile, Japan’s official inflation rate is almost completely unchanged. While there is little economic growth to show for all the stimulus Japan has executed, there is also no obvious reason why Japan cannot go yet farther in its experiment with monetary stimulus.

The Eurozone’s ECB has been miserly with its stimulus compared to Japan. The ECB pushed interest rates negative only in June 2014, 15 years after Japan. The ECB’s balance sheet stands at 4.46 trillion euro ($4.95 trillion), ‘just’ 36% of the Eurozone GDP. The Eurozone’s combined national debts stand at roughly 10.7 trillion euro ($11.97 trillion) or ‘just’ 87% of GDP. The ECB has therefore ‘only’ monetized roughly 41% of the Eurozone’s national debts.

Now consider the US Federal Reserve. The Fed has been miserly, even compared to the ECB. The Fed’s current balance sheet amounts to $4 trillion, ‘only’ about 18.5% of US GDP and ‘just’ 17% of the outstanding national debt of $23 trillion (106% of GDP).

If the US wanted to print an equivalent amount of money as the ECB (36% of GDP) it would mean printing another $4.95 trillion, more than all the money it has printed since the Financial Crisis. If it wanted to print an equivalent amount of money as the BoJ (120% of GDP), it would mean printing a staggering $26 trillion, nearly twice the amount printed by every major central bank in the world since the Financial Crisis. While there aren’t even $26 trillion of treasuries for the Fed to buy today, nothing stops the government from running bigger deficits, and nothing stops the Fed from buying stocks, or corporate debt. The BoJ is already buying both.

It is doubtful that the US could get as far down the road as Japan before running into major side-effects, as we discussed at length here. However, whenever the economy slows, or markets dip, the Fed and other central could easily add several trillions of dollars more to their balance sheets. That may not do anything for the real economy, but it will do a lot for markets.

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