Analgesics are addictive. The US Federal Reserve has cut rates to address every downturn but sows the seeds of subsequent downturns so it can never quite normalize rates before the next crisis occurs.

Analgesics are very addictive. Before 2008, the Fed used interest rates to manage the speed of the economy. It has now discovered the wonders of QE. Expect bond buying to be deployed the next time there is a crisis.

Cutting rates and QE haven’t had the desired effect on real output and inflation. Asset markets, however, have done well. The result is that asset owners, especially leveraged ones, have done well while workers and people whose source of wealth and income is employment as opposed to dividends and coupons, have done poorly.

Interest rates and inflation. It is not clear that cutting rates incites inflation. Low interest rates can make capital cheaper encouraging over-investment and over-capacity leading to disinflationary pressure.

Interest rates and inflation. Low interest rates also makes it cheaper to finance the buying of factors of production relative to renting these factors. Labour is rented, fixed capital is bought. Low interest rates can therefore lead to underemployment of labour and overemployment of capital.

In a knowledge economy, labour’s share of income should fall over time. Entities and companies can accumulate intellectual property without bound. A single individual, however, intelligent, can accumulate only a lifetime’s intellectual property and has their intellectual capital bounded.

Unequal distribution of wealth and income complicates policy. Monetary policy faces a range of velocities of money corresponding to richer households which have a lower marginal propensity to consume (and a higher savings rate), and poorer households with a higher marginal propensity to consumer. In a highly unequal economy where the distribution is skewed, that is there are a very small number of ultra-rich, and a substantial majority of less rich, the velocity of money is lower than expected and monetary policy is blunted.

Interest rate policy impact depends on the prevailing level of interest rates. Raising rates when rates are low is not the same as raising them when they are high. When rates are low, interest rate hikes raise debt service costs significantly more than when rates are high. This can complicate central bank policy as they begin to retreat from accommodative policy.

As a reminder of the sometimes ignominious history of central banking. the world’s first central bank, Riksbank, was a failed commercial bank whose founder Johan Palmstruch was condemned to death for the collapse of the bank. The world’s second oldest central bank, the Bank of England, was created to monetize 1.2 million pounds of the British national debt which was raised to rebuild the navy.

In late June at the ECB Forum in Sintra, the ECB Chairman Mario Draghi remarked that “all the signs now point to a strengthening and broadening recovery in the euro area.” The market took this as a sign of the impending end to QE and the EUR began a rally from 112 to 119 and change. The ECB was quick to moderate the message soon after Draghi’s remarks. More recently the ECB has expressed concerns about the strength of the EUR, and at Jackson Hole this week, Draghi was careful not to telegraph any intentions as to the future trajectory of QE or interest rates.

On Sep 7 next week, the ECB will meet to decide on monetary policy. It is clear that the Eurozone economy has stabilized and is in the middle of a cyclical upturn, led mostly by Germany. However, growth rates are not equal, nor are labour markets. The variation of unemployment in the Eurozone ranges from 3.8% in Germany to 21.7% in Greece with Italy at 11.1% and the Euro area average at 9.5%. Greece and Ireland have negative rates of inflation with the region average at 1.4% while economic powerhouse Germany manages only 1.67%.

Given the ECB’s mandate of 2% target inflation, it is clear that policy has not achieved its aims. Not only that, it exposes the fact that policy is unable to address the varying growth, unemployment and inflation rates of the member countries. The single currency may have brought about convergence in interest rates up until 2008 but it has if anything exacerbated divergences in factor prices in the Eurozone, as conventional economics predicts it should if member countries have different factor productivity, which they do.

Not only has policy not achieved its aims but the current QE will run into technical difficulties. By buying bonds pro rata to the capital key, the ECB’s accommodation is strongest in Germany and weakest in the periphery. The limitations on how much of each issue the ECB (and by extension the national central banks) can buy and the issuance of bunds means that the ECB will not be able to maintain its volume of bund purchases much longer. Since it has to buy according to the capital key, this limits how much it can buy of peripheral bonds. The ECB may have to taper its asset purchases simply because it runs out of bunds to buy.

What the ECB needs to do is to find a way of buying or enabling the buying of, Eurozone bonds according to the needs of each economy, and not according to the capital key. Given how the rules are drawn up, and the opposition it faces from the Bundesbank, it will not be able to directly buy bonds. It will likely have to resort to a mechanism it first engaged in late 2011, the unconditional LTRO.

Why the original LTRO worked:

The national private commercial banks bought bonds which the ECB could not. As long as the bonds they bought were eligible collateral, and had a yield above zero, private commercial banks would have an incentive to buy them, since they could be financed effectively at 0% in the LTRO.

The original LTROs were not conditional on the size of banks’ loan books. Banks could buy as much of sovereign bonds as they liked with LTRO money. Under the later TLTROs, the size of their LTRO utilization was conditional on their loan books. If the banks could not or would not increase their loan books, they could not increase their LTRO participation. This is one reason why TLTRO take up (some 400 billion EUR) was much smaller than LTRO take up (which topped a trillion EUR).

The LTRO is ideal in encouraging private commercial banks to perform proxy-QE for the ECB, and would circumvent the capital key. Assuming that the single currency did not break up, banks would be incentivised to buy bonds of Italy, Spain and Portugal, where yields were highest, and not bonds of France and Germany where yields were tightest, and up to 10 year, negative. Assuming that there was some default risk and break up risk, at least the national private commercial banks of Italy, Spain and Portugal would buy their own respective national debt. If nothing else this would push also their current accounts further into surplus and narrow the spreads to French and German bonds.

If we believe that the ECB intends this route, then we also know that they are unlikely to raise interest rates since the LTROs require super cheap funding to work.

The September 7 ECB meeting is very much up in the air. The last 3 months have seen conflicting signals and some clumsy communications by the ECB. I believe that in the current environment, the ECB will do the following:

1. Hold interest rates at -0.4%.

2. Announce a tapering of bond purchases in the public and private markets.

3. Announce a resumption of unconditional LTRO up to a size of 1 trillion EUR over the next 12 months.

The consequences of this, based on lessons and parallels drawn from Dec 2011, could be:

1. Exert downward pressure on the EUR.

2. Bring convergence between peripheral rates and bunds.

3. Trigger a rally in EUR high yield.

4. Impact on equities not so certain.

For central banks the world over, inflation is too low, apparently. Continued efforts to reflate economies have led to some growth and employment but have not had much impact on inflation. As asset markets make new highs and valuations get more stretched, labour markets become tighter and growth stabilizes, central banks are at a loss as to why their policies have not created more inflation. Despite highly accommodative policies we continue to see weak consumer price inflation and weak wage growth.

One distinction that perhaps blunts measurement is that there are various strata of society and each has their own consumption patterns and thus price baskets. From 1982 – 2016, the Forbes Cost of Living Extremely Well Index (CLEWI), has risen at 5% per annum compared with the CPI which rose at 3% per annum. A 2% gap over 35 years adds up. Manhattan luxury housing has risen at a pace of over 6% p.a. over the last 10 years compared with 0% for the Case Shiller 20 City Composite Index. Coutts Luxury Price Index rose 6% YOY compared with a UK CPI of 2% and in China, the Hurun Luxury Price Index rose at 3.6% July YOY compared with a CPI of 1.4%.

Aggregate CPI numbers are blunted by acute inequality. The CPI basket is weighted towards goods which for the rich are at saturation and for the poor are facing low demand. The economy relevant to the rich is vibrant, healthy and inflationary. For the poor, stagnant wages and a shrinking share output and income cap demand.

Central bank efforts have not targeted the right areas, which are employment and real output. By focusing on asset solutions and funding costs, regulators have enriched those with outsized access to credit and high exposure to investments in assets. By suppressing the USD yield curve, the Fed supports higher valuations for equities and credit which are generally owned by higher income and more wealthy people. This section of society, being wealthier, save a greater proportion of incremental wealth so that the wealth creation fails to trickle down and the velocity of money falls, limiting the transmission towards higher inflation.

Low interest rates also alter the labour to capital mix by distorting prices. Low interest rates and easy access to credit encourages investment in fixed capital relative to labour. A firm can borrow to fund wages but it the cheaper credit becomes the cheaper it is to invest in fixed capital that can be depreciated aggressively increasing the returns on investment in future time periods. Put simply, a firm can own fixed capital but it can only rent labour. When rates are low, it makes sense to own your factors of production rather than rent them. Low rates skew the labour capital mix and suppress wages.

Another effect is that as QE was undertaken, inflation expectations were raised. Conventional economics indicates that rate cuts and monetary expansion lead to higher inflation. This did not happen. Instead inflation was low and assets rose. The inflation to money supply relationship is not precise and since there is a vector of goods and prices, it is not clear in which goods markets the inflation will take place in. If there is excess capacity in a particular market, even if demand manifests there, output may rise to compensate for any inflationary pressure and prices might even fall, theoretically. To complicate matters, for all practical intents and purposes, this vector of markets into which money could flow includes not only goods and services but assets as well. If inflation expectations were being driven up the response could have been to consume in the current period or to buy claims on future production, in other words, equities or high yielding credit.

Policy needs to look not only at aggregates but also at the structure of an economy. A country has to decide if its policy is there to serve the many or the few, the rich or the poor. And while the right answer is obvious so is the outcome. Even assuming away cynical behaviour, any policy that favours the poor against the rich, in relative or absolute terms, will likely encourage tax or regulatory arbitrage. An internationally coordinated solution is needed to ensure that if tax advantages are sought then they are the result of true immigration. This is difficult but adoption of Common Reporting Standards, for example, are a step in the right direction.

An internationally coordinated tax system would either require convergence of tax rates, or will encourage physical or true immigration, sometimes to the detriment of the source country. Tax convergence is unreasonable given the needs of individual countries. A tiered global, national, state tax system might be a solution but the coordination it would require to design let alone implement is still far away.

Tax funded transfers are only one way of addressing inequality, not just of wealth but of impact on the economy. A better understanding of how interest rates impact the economy at the micro level will also make for better central bank policy. Current efficacy of policy has been questioned not just by the public but by central banks themselves. To carry on a policy when its impact is not well understood is inadvisable.

The distortionary impact of interest rate policy on business planning could advise a tax code that applied a policy-externality-weighted expense system to calculate tax credits to compensate. To encourage a reduction in youth unemployment, a company hiring under 25’s could deduct more than 100% of their wage costs when calculating their taxable income, for example. Such a system of weighted expense tax deductibility could be used to fine tune behaviour to achieve policy goals.

Compensatory training and skills upgrading could be provided and tax-funded to lower wealth and income people to reduce the skills gap and narrow the potential wealth trajectory.

Real estate taxes can also narrow the wealth gap as real estate is a significant store of wealth. Real estate should be a resource or used for dwelling and not investment. Supernormal profits should be taxed and used to fund the less wealthy.

The purpose of these apparently socialist and redistributive policies is not to pursue a social agenda but to address a fundamental inadequacy of policy. Its aims are to increase development, growth and employment for the majority of the population and not an aggregate that is highly skewed because of acute inequality. It is hoped that by rethinking and redesigning policy, the interests of the many are served over the interests of the few.

Let us say that you have made 16% per annum for the past 2 years investing in the S&P500. As at this point, you have.

What is the return you would have to make over the next 2 years so that your 4 year average return was equal to the long term potential return of the S&P500?

The 63 year historical average return of the S&P500 is about 10%. I used data from 1954 to the present because that’s all I could get. Sorry. If you compounded at 16% for the past 2 years, you would have to make 4.3% p.a. for the next 2 years to bring you back to this average.

What if you thought that long term returns were 7% going forward? Then your next 2 years’ average returns would have to be -1.30% p.a.

Chart of S&P 500 and its Exponential Trend Line:

The best thing investors can do about the US debt ceiling issue is to talk about it and do nothing. In 2011, a Democrat White House and a Republican Congress had a similar debate about the debt ceiling. The Obama administration argued that failure to raise the debt ceiling would result in a sovereign default which would lead to an international financial crisis. On July 31, 2011, President Obama announced a bipartisan agreement on deficit reduction and some flexibility around the debt ceiling.

Stock markets stalled after a yearlong rally but US treasuries which were at risk of a downgrade rallied through the 1st half of 2011 while fraught negotiations were ongoing. It is difficult to attribute factors for the volatility in equities and credit given that Europe was undergoing its own sovereign debt issues.

On Aug 3, a day after the debt ceiling deadline, the national debt surged almost a quarter of a trillion USD, to over 100% of GDP for the first time since WWII, and a few days later, S&P downgraded the US from AAA to AA+. US treasuries rallied with 10 year yields falling from 2.5% to 1.75%, and stock markets across the world sold off and credit spreads widened. It all made perfect sense. The sovereign issuer had been downgraded, the national debt had ballooned, and demand for US treasuries rose. Meanwhile, demand for private assets, fell.

Yesterday, 23 Aug 2017, Donald Trump brought up again the subject of the debt ceiling and the potential shuttering of the US government. Congress needs to approve a budget as well as raise the debt ceiling by 30 Sep. Trump has signalled that he wants his Mexican Wall to be included in the budget, that same wall that the Mexican’s were supposed to pay for. And if he doesn’t get what he wants, Trump has threatened to veto the bill. “One way or another, we are going to get that wall”, vowed Trump. Yet earlier this year, Trump was still insisting that Mexico pay for their own wall, if indirectly through import tariffs, a somewhat self-defeating strategy. Now it appears that Trump is looking for alternative finance for the wall, and that is the US taxpayer, less indirectly. Perhaps some of the investment bankers on his residual team could come up with creative conduits so that the American money paid to Mexico could be channelled somehow into the budget to fund the wall. If tariffs can raise sufficient revenue and be earmarked especially for the wall, it might all work.

In the meantime, Paul Ryan has said that Congress would rather not shutdown the government. And with Trump’s receding approval ratings, and Senate and House elections in just a little over a year (Nov 2018), the Republicans will be careful not to come across as obstructive, especially since they control the House, Senate, and to the extent that anyone has any control, the White House.

6 years ago Democrats and Republicans came together to craft a deal, imperfect, but a deal. It resulted in a sovereign downgrade and some market volatility, although ironically, the downgraded instrument rallied hard. We therefore have somewhat of a guide as to what could happen if there was a Mexican stand-off; between Republicans in the White House, Republicans in the House and Republicans in the Senate.

How concerned should investors be about the current situation? Probably not very. The debt ceiling is academic. The budget determines the debt issuance, not the ceiling. A default by the US government would have sufficiently serious consequences that it would not be allowed to happen, especially since it is a technicality. Imagine if the most widely used collateral in secured lending markets defaulted. The implications would go well beyond American borders. Technical solutions would be found to avert a default, some of which were tabled in 2011 which would not require endorsement of the executive.

US treasuries would probably rise, as they did in 2011 before and after the deadline. This may seem irrational but the value of a security is what everyone agrees it is. There is little intrinsic value to all the paper claims that comprise the liquid markets.

The equity and credit markets might fall given lofty valuations, but mitigating this could be that this is not a new experience. The S&P500 fell 18% during the 2011 standoff, but this was the confluence of the novelty of the debt ceiling negotiations as well as economic troubles in Europe. Lower bond yields would relieve some of the relative over-valuation of equities which might provide some support. They would have the effect of a de facto rate cut. In the extreme case, the Fed may even cut rates or belay balance sheet normalization, resuming liquidity operations to support asset markets.

On the downside, the S&P trades at 21X today versus 16X in 2011, suggesting a 24% downside if multiples revert to those levels, more if they overshoot. This calculation should be discounted as equity markets are hardly scientific or rational in the short term, and the analysis is somewhat crude anyway. If confidence prevails, equities might dip and resume their climb. If confidence fails, even if the Republicans tame their President and find an amicable budget solution, equities could fall more than 24%.

In 2011, a Democrat in the White House faced off against a Republican Congress, but one had the sense that both sides would be strenuously resolute, but responsible and rational. Today we have Republicans in each pillar of government but an erratic President who has no qualms about alienating his partners in the House and Senate. So far, faced with stern resistance from his Congress Trump has always backed down or been thwarted but there may be limits to how much disappointment and ignominy he can endure.