Current Unconventional Monetary Policy & What Comes Next

I have struggled to answer some basic contradictions in our economy. On the one hand, we have printed, spent, and borrowed unprecedented amounts of money at unprecedented rates. Yet, inflation has been nowhere to be found. The traditional relationship between employment and inflation has been broken (known as the Phillips curve).

These are important questions for portfolio managers because they (a) are key to understanding what is happening in companies and markets more broadly, and (b) how we “exit” this economic moment may define how we invest today. That is, if hyper-inflation will become a worry all of a sudden, we need to prepare for that today. Or, if something else “breaks” because of these policies, I’d like to get ahead of it.

So, I recently embarked on a research project in an attempt to find answers to these questions. Based on that research, here is what I think is going on and how we position ourselves as investors.

THE LIQUIDITY TRAP
My Eureka moment came while reading Dr Yi Wen (VP at the St. Louis Federal Reserve). In his paper (technical version | readable version) he models the liquidity trap.

There are two relevant components of our particular liquidity trap: (1) low interest rates, and (2) excessive liquidity (cash) fueled by quantitative easing (QE).

As interest rates approach 0%, there is no opportunity cost to owning cash instead of debt. Since cash allows investors to be more flexible in the future, cash becomes the preferred investment, and all subsequent money printed is hoarded by investors and companies. In this way, low interest rates makes quantitative easing exponentially less effective.

As you can see in the graphic below, as interest rates fall (y axis), the demand for money (blue curve) becomes equal across all forms of money (x axis). This is the interest rate component of the liquidity trap.

When coupled with the QE component of our liquidity trap, we can fully explain the absence of inflation! If newly minted money is not spent, but is instead hoarded, then this new money only serves to dampen inflation, rather than increase it! A counterintuitive result!

In the plot below, Dr. Wen illustrates how excessive money injections “break” our inflation expectations as this new liquidity becomes trapped. Once liquidity moves beyond a certain percentage of GDP (x axis), the demand for money begins to grow exponentially (y axis). This massive surge in demand means that new cash is simply absorbed rather than spent. This lack of spending means new cash does not contribute to inflation, and may, shockingly, yield deflation if demand grows faster than supply.

What is interesting is that Dr. Wen’s work also explains other phenomena we observe in our current economic environment:

• In a liquidity trap, less productive companies begin to own a larger share of equity and debt markets as projects which would otherwise be unprofitable become viable. Though more lending is done, the productivity of each loan is lowered. In the aggregate we would expect to see a less productive economy (lower, rather than higher, economic growth)
  
  • We see this today with the massive rise in zombie companies. In addition, we currently see lowered economy-wide productivity (TFP growth), and lower average economic growth.
    
• In a liquidity trap, investment dynamics coalesce into a “winner take all” environment as the most productive companies become disproportionately flooded with cash.
  
  • We see this today with the top handful of companies gaining ever-more market cap relative to the bottom 95% of companies.
    
• Companies and households attempt to offset lowered investment returns by “reaching for yield”—taking more risk. This creates crowded trades and further reduces risk-adjusted investment returns.
  
  • We have seen the crowding into risky trades—especially risk parity strategies and high yield bond buying. As a general asset class, high yield bonds do not yield enough to offset the probability of default, much less offer attractive risk-adjusted returns.
    
• Low interest rates force savers to increase savings rates because lower investment returns mean you have to save more today to achieve the same future outcome. Counter-intuitively, this encourages less spending today because labor income remains stagnant and households have budget constraints. Less spending further reduces inflation expectations.
  
  • We currently observe above-average savings rates and lowered spending rates than we have seen historically.

WHAT’S NEXT (1)—THE FED’S PATHS TO EXIT
Dr. Wen also analyzes optimal exit strategies for QE and interest rate normalization. As he observes, there are short-term benefits for massive amounts of QE and lowered interest rates. A liquidity trap can be used to offset credit shocks and/or productivity shocks (like a pandemic that forces everyone to stay home). However, these benefits come with long-term costs, like the lowered efficacy of investment, and the very real threat of deflation.

The Fed, then, must balance these short-term benefits with their long-term costs.

Dr. Wen finds that the optimal exit strategy is an unanticipated, one-time exit. This would be quick, sudden, and normalizes policy very quickly—mitigating the long-term effects.

The second-best strategy is is an anticipated and gradual exit. While less optimal in the short-term, it serves to normalize policy longer-term.

In the plot below, Wen illustrates the effects on output of the various exit strategies. Note the orange line (unanticipated, sudden exit) and the lavender line (anticipated, gradual exit).

WHAT’S NEXT (2)—INVESTMENT STRATEGY
Now that I better understand what the hell is going on in our economy, I can better understand how we should position ourselves. I genuinely have no idea if the higher ups at the Fed have read and/or “believe in” Dr. Wen’s work—perhaps Victor Xing is better qualified to answer these types of questions.

It would be well outside the Fed’s demonstrated character to withdraw QE and normalize interest rates without advising market participants ahead of time. So, while it may be the optimal path, I see the Fed taking the anticipated and gradual path in an attempt to balance financial market interests with economic interests.

In any case, the path to normalization likely pretty far away. Wen would advise first observing a “fix” to the economic shock to which the Fed is responding. In our current case, that shock is productivity and labor.

Here are my takeaways (these are general—you have to pay me to give you specifics):

1. So long as Fed policy is what it is, the liquidity trap presents no threat of inflation. Generally advise to avoid inflation hedges as they would be a waste.
   
2. Expect real interest rates (i.e. inflation-adjusted rates) to remain negative (or go further negative) so long as the liquidity trap exists. Counterintuitively, this means preference for longer, not shorter, duration.
   
3. Real rates will only increase when policy normalization begins. When it does begin, rates may move very quickly at first, then gradually normalize the rest of the way.
   
4. In all cases, risk assets lose value initially, and it takes some time before the long-term effects of normalization deliver their benefit. Hedges make sense in the face of this choppy environment.

Of course, all of this assumes the Fed does shepherd the economy out of a liquidity trap. It may very well be that the Fed would prefer to support asset prices instead, or be too afraid of the economic shocks that may come with policy normalization.

Even so, I at least now feel like I am flying with my eyes open.

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None of this is investment advice. Do your own research.