- Market Commentary
- By Jack Ablin
- October 15, 2019
How QE Morphed from Cure into Chronic Condition
As we surpass the tenth year of global economic expansion, we pause to examine the ongoing trend among governments worldwide to intervene to an unprecedented degree with monetary and fiscal measures to boost their economies and garner a political edge over their rivals. Quantitative easing (QE), an extraordinary monetary measure prompted by the 2008-09 global financial crisis and which has expanded global central bank balance sheets by more than $15 trillion, does not appear to be reversing. In fact, the Federal Reserve just announced a plan to resume bond buying to keep the overnight lending market stable.
The US government has continued to expand its budget deficit despite a stable economic and employment backdrop. The current federal budget deficit of just over $1 trillion represents 4.4 per cent of GDP, its largest share of the economy since 2013. This is remarkable given that we’re in the tenth year of an economic expansion and the unemployment rate is at its lowest level in 50 years. Historically, running budget surpluses and deficits represented economic ballast: when times were tough the government would operate a deficit as tax collections fell and transfer payments, like unemployment, benefits rose. In good times, vice versa: the government would operate a surplus, absorbing economic excess.
Since 2001, the federal budget deficit and the US unemployment rate have been closely linked. Statistically, the changes in the unemployment rate explain nearly 85 per cent of the variation in the size of the federal budget deficit as a share of GDP. But for at least the last two years that relationship has broken down as the deficit has expanded in the face of increasingly lower unemployment. Based on their close historical relationship, a 3.5 per cent unemployment rate would suggest a budget deficit of 2 per cent, or about $450 billion, not $1 trillion where it is today.
The divergence may be occurring for several reasons but the most important one is inflation, or lack thereof. Historically, in an economy that’s out of spare labor or production capacity, inflation tends to heat up as prices for scarce goods rise and wages escalate. But that’s not happening this time. In fact, inflation continues to run below the Fed’s 2 per cent target. As a result, interest rates are not only low by historical standards, they’re falling. Shifting demographics is an important factor keeping inflation at bay. As of 2017, about 15.6 per cent of the US population was 65 years old or over; this figure is expected to reach 22.1 per cent by 2050. The share of retirees is even higher in the rest of the developed world. Retirees are savers, not borrowers, suggesting a greater supply of credit than demand for it. Retirees don’t spend as much as younger, working people who are starting families and buying homes. Lastly, inflation expectations are subdued. Since the Fed started targeting inflation in the 1980s, inflation rates have steadily declined. Nearly 80 per cent of America’s working-age households have never experienced accelerating inflation.
Low interest rates are fueling a misconception among policymakers that deficits don’t matter. Quantitative easing, once an experimental monetary policy, proved successful in digging the global economy out of a colossal financial funk. And because the treatment seemed to work without side effects, inflation remained tame and the dollar’s value appreciated, policymakers have kept the spigot open longer than necessary. Even today the world’s central banks are ready buyers of government bonds used to finance budget deficits. The Federal Reserve owns 17 per cent of US Treasuries outstanding, while the ECB owns 25 per cent of European sovereigns and the Bank of Japan owns more than 40 per cent of Japanese government debt. Just because inflation is absent doesn’t mean it won’t return, though. Governments, like homeowners leveraged up on teaser rates, would suffer a sobering scenario in the face of inflation-fueled rate hikes.
In the meantime, the table is set for risk takers. We expect this ineluctable policy trend to remain in place as long as inflation, interest rates and currencies remain tame. It was a globally coordinated policy that got us to this point and a coordinated effort will be needed to reverse it. The Fed ended its QE program in 2017, and to date has reduced its balance sheet by about $642 billion – but it just announced its plan to purchase $60 billion of Treasury bills in October and November to keep money markets running smoothly.
We expect commercial real estate, one of the biggest beneficiaries of low rates and strong growth, to continue to gain from monetary largess. Other income-oriented investments, like utilities and energy infrastructure, should continue to benefit as well. Given the unprecedented supply of non-financial corporate debt, funded in large part by floating rates, we recommend income investors shift toward consumer credit exposure.