Accommodation is the New Neutral

June 2019 will mark the tenth year of the economic expansion that rose from the ashes of the financial crisis. As expansions go, the US is set to break all records for longevity, previously set by the expansion of 2001 at 41 quarters. Notwithstanding its stamina, our current expansion represents the shallowest in modern history.

 

Mired in a global financial crisis set off by the bursting of the US housing bubble, the global banking system froze. Thanks to a coordinated effort led by Ben Bernanke’s Federal Reserve, the world’s central banks slashed overnight lending rates to zero and amassed $14-plus trillion of bonds. The financial system subsequently recovered and risk taking ensued.

Despite an impressive bull market that has propelled the S&P 500 upward by over 350 per cent since that time, the financial system remains fragile. How else could one explain why the economy and markets responded so poorly in the face of monetary normalization? Nearly $9 trillion of bonds still sport negative yields. That’s down from over $12 trillion in 2016, but negative interest rates were unheard of prior to the financial crisis.

Below-market interest rates had benefits. Since the cost of production is a zero-sum-game of commodities, labor and capital, cheap capital and weak commodity prices helped enable the cost of labor (wages) to grow. Real median household income in the US has expanded by up to 4 per cent annually over the 5 years though 2017, according to the US Census Bureau.

On the flip side, artificially low interest rates have enabled debt accumulation to escalate. Non-financial corporate debt has ballooned to nearly $10 trillion, representing nearly 53 per cent of GDP, while government debt has skyrocketed to $17.7 trillion, or 95 per cent of GDP.

A global economy that’s still limping along despite this massive monetary support is akin to the Wizard of Oz’s Scarecrow, but in this case its biggest threat is inflation, not matches. In such a case, central bankers would be forced to normalize rates to douse the flames.