Market Thinking

making sense of the narrative

Inflation is about Balance sheets.

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The following is based on an article submitted to the Australian Financial Review, hence the bias towards Australia and UK in the commentary. Their site is behind paywall and the following is also unedited (by them).

We have long used the framework of Balance sheets as a way to analyse the economy. Essentially there are four Sectors; Household, Corporate, Financial and Government. Flows between these balance sheets determine economic activity, while expansion and contraction of these balance sheets drive inflation, and by extension appropriate monetary policy.

The discussions about whether the RBA should be buying long dated bonds might seem a little technical, but actually goes to the heart of the issues surrounding the effectiveness and indeed the wisdom of current central bank behaviour. Traditionally, the guiding principle of central banking was in maintaining credit in the economy at a level that was consistent with economic growth and a modest level of inflation. Mainly through using the policy levers of short term interest rates, central banks such as the RBA sought to keep a ‘Goldilocks’ level of credit expansion and economic activity. 

Logically the effectiveness of monetary policy would then depend on which sector is expanding or contracting their balance sheet. In some countries it is the business sector, but in countries with a large level of home ownership and a mortgage system structured around short term interest rates – such as Australia or the UK – it is traditionally the consumer sector. While the theory held it was about stimulating or curbing ‘investment’, the reality was that monetary policy acted as a form of fiscal policy, as mortgage payments behave like a tax on disposable income. However, this paradigm started to unravel around 20 years ago as the biggest user of the banking system became the financial sector itself. The real concern is that most economists and central bankers have not recognised this, meaning policy measures have become not only increasingly inappropriate, but have driven some serious unintended consequences. 

Whoever is expanding their balance sheet is going to cause inflation in the things they are buying. Now it’s government’s turn.

Paradigm Shift

The paradigm shift began in the wake of the dot com crash in 2000, when sharp cuts in rates by the US Federal Reserve triggered a housing boom in the US and a sharp increase in economic sensitivity to interest rates as US households switched from fixed to floating rate debt. Elsewhere, economies such as the UK and Australia also saw housing booms and significant boosts to household activity from lower financing costs and increased leverage. We saw household sector inflation where the ‘new money’ was being spent. What also happened however was that the financial sector itself began to rapidly expand its balance sheet as well, causing financial sector inflation and dramatically shifting the incidence of interest rates on the economy.

Thus as the fixed income markets began borrowing short and lending long – ie getting cheap money from the Fed and lending it to the government by buying bonds, bond prices boomed. This meant that long term interest rates fell sharply, helping equity markets as well but the unintended consequence was that it presented a problem for Pension funds and other long term investors. They could no longer use bonds as assets to match their liabilities. The biggest inflation had come in the cost of funding a pension.

Of course, the financial wizards invented new ways to repackage assets to meet the need for long term investment institutions to match their liabilities and with bond yields now too low and equities declared too ‘risky’, the derivative gurus took assets such as mortgage bonds and put them into illiquid and leveraged structures called Collateralised Debt Obligations CDOs, which ultimately led to the GFC in 2008. 

Post GFC Financial Sector Balance sheet expansion fuelled Financial Sector Inflation

The response to the GFC was, once again, to slash short term interest rates, but while this helped with lowering household funding costs, its impact on housing markets was modest, as the ability or willingness to expand household balance sheets further was no longer there. Hence growth, but no apparent household sector inflation. The Fed meanwhile, massively expanded its own balance sheet by buying in all the illiquid and over-leveraged derivative structures from the banks and undertook what we now know as Quantitative Easing, a temporary measure that is still in place over a decade later. This would be fine if the expansion of the Fed’s balance sheet had come in response to the necessary de-leveraging of the financial sector, but unfortunately it hasn’t. The financial sector has simply leveraged up again and it too has been buying fixed income. This new balance sheet expansion thus simply created inflation where both the Fed and the Financial Sector were spending their ‘new money’ ie in the financial markets, leaving us with another unintended consequence; big companies can now borrow at negative interest rates. So now they too have been leveraging up their balance sheets – buying their own shares, or other peoples and driving a credit and equity bull market on top of a bond bull market.

Pushing on a string

Meanwhile there is still no household sector inflation and Central banks are thus now in a bind; those like the RBA and the Bank of England, with heavily indebted household sectors on floating rate mortgages, can not raise interest rates without collapsing disposable income, but neither can they stimulate activity either as rates are already so low. There is a powerful image used in economics to describe policy impotence of ‘pushing on a string’ which is where we now are with the Household sector and monetary policy.  At the same time, those like the Fed who have allowed the financial sector to boom again by re-leveraging its balance sheets with a new range of leveraged financial products to be offered to insurance companies and Super funds – this time labelled ‘alternatives’ such as Private Equity, Private Credit, Leveraged loans and Real estate – have seen a huge distortion in savings markets and a dramatic increase in risk as measured by illiquidity and leverage. 

Which brings us to our last, and latest, balance sheet to be expanded, that of the Government. Governments everywhere are being seduced by the notion of Modern Monetary Theory, or MMT, which essentially means that they want the central banks to basically print money and buy government bonds directly – in effect giving governments a blank cheque. Initially this was presented as a need to ‘stimulate’ the economy, now in the wake of the economic collapse induced by the response to the Covid, it is being presented as a need to ‘save’ it. Thus we see government balance sheets are now also expanding rapidly and various central banks are justifying this by saying they need to ‘generate inflation’ in the economy, as if this is a good thing. Remember, they will only generate inflation where those expanding their balance sheets are spending the new credit and now it will be wherever government is spending its new found money – seemingly in the IT consultants and other government ‘services’ as well as state employee salaries and guaranteed minimum wages and most obviously the Green New Deal. Sooner or later this will trigger inflation, but it won’t be good, or controllable and a behavioural shift will be very hard to reverse. The opposite image to pushing on a string is one of trying to drag a brick on a piece of elastic over a rough surface; nothing happens for a while and then it breaks free and smacks you in the face.

Better be prepared to duck.

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