The U.S. is on pace to run a record fiscal deficit in dollar terms and as a percentage of overall gross domestic product (GDP), partially from an increase in spending and partially from a decline in overall GDP. At the same time, the Federal Reserve has a record high balance sheet value in dollar amount and as a percentage of GDP.
The reasoning behind these large numbers is that they are supposed to lend support to the overall economy and help increase overall economic growth and inflation. The Japanese and European governments and central banks have been doing similar things for many years. We can look at some of the results in those regions of the world to determine what impact they have had.
One of the policies that Jerome Powell, the Chairman of the Federal Reserve, has recently announced is the idea of inflation targeting. The Federal Reserve has a dual mandate of price stability and full employment. In order to achieve their price stability objective, they are now going to allow inflation to average at 2% over time. The Bank of Japan announced something similar in the beginning of 2012. They decided the goal would be a target of 1% within their overall range of 0-2%. Later that year, they also announced increased fiscal policy support through what became known as Abenomics, named after the prime minister, and further enhanced central bank purchases dubbed QQE. As a result of these increased activities, they raised the inflation target to 2% by the end of 2012. Excluding a few months in 2014 surrounding the implementation of a value-add tax (VAT), the 2% target has never been reached and 1% has not been reached since October 2018.
Source: FRED.
Over that same period, Japan was barely able to generate a year of annual GDP growth above 2%, and from Q3 2013 until Q3 2019 (no VAT, pre-COVID), GDP growth was 7% total and averaged 1% annually.
Source: Alhambra Investments.
Source: FRED.
Europe has also focused on increasing inflation and GDP growth by holding interest rates low and expanding the type of assets that the central bank can purchase. Over the last five years, Harmonized CPI in the Eurozone has only been above 2% for four months, all in the middle of 2018.
Source: FRED.
2017 was the only year Eurozone GDP growth was above 2% since 2010. Prior to 2008, that was a regular occurrence.
Source: FRED.
Despite increasing the size of their government debt to GDP ratio and their central bank balance sheets as a percent of total GDP, Europe and Japan have not been able to generate meaningful levels of economic growth or inflation.
One of the reasons the rise in the fiscal spending/government debt levels was unable to help increase growth and inflation is that productivity levels did not increase. The money that was borrowed was not spent on areas that have a long-term return or enhance economic output.
One of the reasons the increase in central bank balance sheets has not lead to higher growth and inflation is that global bank balance sheets have been declining and financial debt as a percent of GDP has been declining (excluding Japan but their banks have more of a direct mandate to provide capital to local companies).
Source: Alhambra Investments.
Source: Alhambra Investments.
Source: Alhambra Investments.
Source: Alhambra Investments.
One of the main regulatory focuses after 2008 was decreasing the riskiness of bank balance sheets and increasing their durability. While this may be a sound strategy, it created a problem for the global monetary system. Those assets and liabilities on bank balance sheets represented transactions they were undertaking to grow the supply of capital/liquidity in the system. As banks have been pulling back, there has not been a similar size force that has come in to replace them. Central bank policy is currently designed to work through banks/dealers, and if they are unable or unwilling to provide capital/liquidity into the marketplace, then central bank policy will likely not have much of an impact.
Looking at the U.S. situation, it is unlikely that the increase in fiscal and monetary policy efforts will create a different outcome than the one experienced by Japan and Europe unless they are implemented in a different way. Currently, productivity in the U.S. is running below prior trends and has not experienced much of an increase while government debt has been increasing.
U.S. banks have also been scaling back their balance sheets and financial debt as the percentage of GDP has been declining. If this dynamic continues, it will likely prevent monetary policy from having much of an impact on economic growth and inflation, much the same way it has in Europe and Japan.
Source: Alhambra Investments.
Source: Alhambra Investments.
Global developed market central banks have been trying to use fiscal and monetary policy to get economic growth and inflation back to levels reached prior to 2008. There appears to be structural impediments to achieving this, brought on by non-productive growth in government debt and a global banking system that is not performing the same functions as pre-2008. Until these dynamics change, economic growth and inflation are likely to continue to be below the targets policy makers are seeking.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC
