Good monetary policy it may or may not be, but a “high pressure economy” would bring significant risks for stocks and bonds.
Fomenting a “high-pressure economy”, as suggested on Friday by Federal Reserve Chair Janet Yellen, to help reverse the lingering effects of the great recession of 2008–2009 could offer both main assets classes some short term gains.
But unless Yellen can draw workers back into employment without allowing inflation to gather unwanted steam, the risks for both stocks and bonds are mostly to the downside.
Not only can inflation be self-perpetuating, it is toxic to the value of future streams of income from stocks and bonds.
And that’s even before we price in the higher volatility in asset prices implied by a bout of inflation followed by a rapid rise interest rates.
Arguing that unused labour demand, low productivity, and low levels of investment may be self-perpetuating, a concept known as hysteresis, Yellen raised the possibility of loosening the Fed’s reins on the economy even as it heats up.
“If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a ‘high-pressure economy’”, with robust aggregate demand and a tight labour market,” she said on Friday in a speech in Boston.
The idea certainly sounds good for business.
After all, Yellen’s “high-pressure” economy is one in which more workers would be hired, would spend more, and spur more investment by business.
As investors in the age of extraordinary monetary policy, though, we should be careful to distinguish between “good for the economy,” “good for top-line corporate revenue” and “good for asset prices.”
Yellen was careful to tiptoe around the possibility that allowing the economy to build up a head of steam would lead to high inflation.
Her argument is that old certainties about the relationship between employment and inflation appear to hold less water in this recovery than in those of the past.
That would be the gamble: allowing inflation to build in order to set right the damage of the last recession.
As policy, it has attractions. The economy clearly suffers from low levels of investment and worker participation. In addition, pursuing a course leading to a significant rise in interest rates over two or three years would put the Fed in an arguably better position to deal with any future recession. If a recession were to come soon, the tools now to hand would be poorly suited to the job.
Nice policy, pity about those multiples
For asset owners, this may be of little solace. Bonds will obviously dislike any policy which allows inflation to winnow away the already pitiful compensation they offer. Capital values will be hit badly. Bonds, though, are something close to a one-way bet these days, only likely to do “well” if the most extreme circumstances of low inflation and growth prevail.
Stocks, on the other hand, while not historically richly valued, have benefited from two of the circumstances that a “high-pressure economy” is expressly intended to combat.
Wage gains have been low and bottom line profits as a share of GDP are at historically elevated levels. Allowing a bit of “catch-up” to labour in the form of higher wages, without worrying too much about inflation, would inevitably hurt corporate bottom lines.
Stocks have also benefited from low inflation and extraordinary monetary policy, both of which entice money away from safer investments.
Even if the Fed gets a “hot” economy right, it would bring on a predictable interest rate hike cycle. All of this is likely to prompt a re-think of the appropriate multiple to pay for a possibly smaller dollar of earnings.
To be sure, Yellen’s speech is at this stage probably only a trial balloon. Speaking Monday in New York, Fed Vice Chair Stanley Fischer showed no appetite for any outright lifting of the Fed’s inflation target, arguing that the central bank is already doing reasonably well on its duel mandates.
“I’d be very reluctant to raise the inflation target,” Fischer said. “We’re not in deep trouble on monetary policy at the moment.”
Of course “high-pressure” and a higher inflation target are related, though different.
Either way, the debate is a reminder that one of the intended effects of monetary policy has been to abnormally inflate asset prices.
A return to normality, however that is achieved, almost certainly brings with it lower price-to-return multiples.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
