Is the belief of investors that central banks can achieve a robust V-shaped economic recovery with expansive monetary policy only an illusion? What can be learned from trade flows and what does the new inflation target mean?

 

In the following, we will examine what central banks can achieve with an expansive monetary policy. We take a brief look at the latest report of the World Trade Organization. Unfortunately, as far as international trade in goods is concerned, no indicators of a V-shaped economic recovery can be seen so far. What can the FED’s new “inflation target policy” achieve?

The World Trade Organization (WTO) writes: “Additional indicators point to partial upticks in world trade and output in the third quarter, but the strength of any such recovery remains highly uncertain: An L-shaped, rather than V-shaped, the trajectory cannot be ruled out.”

The goods barometer of the WTO records the growth of world trade in real time. In June 2020, the barometer fell to its lowest level since the surveys began.

Graph 1: Development of the WTO Barometer of Goods

Development of the WTO Barometer of Goods
Source: WTO

 

Largest drop in index since data acquisition

The WTO further writes: “This reading – the lowest on record in data going back to 2007, and on par with the nadir of the 2008-09 financial crisis – is broadly consistent with WTO statistics issued in June, which estimated an 18.5% decline in merchandise trade in the second quarter of 2020 as compared to the same period last year.”

The WTO expects a 13% decline in global merchandise trade in 2020. In contrast to many national purchasing managers’ indices, global trade is unfortunately not (yet?) showing a V-shaped recovery. The slump in the aviation industry (cargo flights) remains particularly dramatic. In particular, international air traffic has not even reached 50% of the pre-COVID-19 level. This is illustrated by the following chart.

Graph 2: Index number of commercial flights, 1 January 2020 – 31 July 2020, 1 January =100

Index number of commercial flights, 1 January 2020 - 31 July 2020, 1 January =100
Source: OpenSky Network and WTO Secretariat calculations.

 

Central banks cannot force a V-shaped economic recovery

What can central banks do? Looking at the “big picture”, they can do a lot to prevent worse, but almost nothing to ensure a V-shaped economic recovery. Ask yourself the following questions:

  1. Would you book a flight if the central bank cut interest rates by another 25 basis points?
  2. If the central banks bought up more government bonds, would that encourage you to book a cruise or eat out more often?
  3. If the central bank bought up bonds from Facebook, Apple, Netflix and Google, would you buy a new car because of that?
  4. Can necessary isolation measures be countered by an expansive central bank policy?

The good news is that a certain easing of the pandemic has been observed. Not in terms of the number of cases, but in terms of deaths and hospital stays.

 

 

What the central banks can do

Central banks, as “lender of last resort,” can temporarily delay corporate bankruptcies, but if there is no structural profitability, they cannot ultimately prevent this. Unless the central bank becomes the owner and subsidizes the unprofitable business to infinity, as the GDR did with the state-owned enterprises.

By financing the rampant new debt of states through direct lending, central banks can help prevent an excessive rise in interest rates.

The governments’ additional packages of measures have so far made it possible to subsidize consumption and to prevent an excessive slump in consumption through generous unemployment benefits. This is the path that the USA has chosen. The Europeans have chosen a different path. They have tried to prevent companies from having to make mass redundancies by subsidizing jobs through credit financing.

Another point is the influence of the central banks on the asset situation. The excess liquidity created flowed into stocks, bonds and real estate and drove all prices up, so that investors “felt richer”, which in turn was to support consumption. Central banks can also help prevent worse by generating a positive wealth effect. Nevertheless, critically modify the above questions, e.g. question 1: If the central bank drove the stock market up by 10%, would you book an international flight because of this?

 

The new inflation target: What is the use of proclaiming targets?

The FED adjusted its target inflation policy in early September 2020. It is now aiming for an average inflation target of 2%. It has clearly communicated that in future it will tolerate a moderate overshooting of inflation if inflation has previously been clearly too low for a long time, even if the unemployment rate is below the “natural unemployment rate”.

The FED has been trying in vain for years to achieve the inflation target of 2%. The problem is therefore not the goal in itself, but the lack of resources to achieve this goal. By changing the target, more powerful weapons are not suddenly available to achieve the goal.

Regarding to the achievement of a given consumer price inflation, however, things look different. The central banks have created a world in which debtors are systematically subsidized and creditors are systematically cheated. This policy has systematically incentivized and rewarded excessive debt to finance consumption, government consumption (= politicians’ gifts), etc. Through these incentives to become irresponsibly overindebted, masses of zombie companies and zombie countries were created. As is well known, a zombie feeds on the living, is itself half-dead and infects the healthy. A zombie company can only stay alive by taking on more and more debt to secure the interest and repayment of the loans. Thus, with the zombification of the economy, the growth rate of the debt rises above the growth rate of the real economy, which leads to an increase in the gross debt in relation to the economic output. Since assets are needed to collateralize the collateral values, asset price deflation would bring the entire system down as the loans would no longer be sufficiently collateralized.

A sharp decline in asset prices would quickly lead to a recession. Currently, the newly created money (the expansion of the money supply) flows primarily into the stock or bond market as well as real estate etc. and not into consumption. However, an increase in consumer demand above production capacity is a necessary condition for inflation. In this sense, asset price inflation is a substitute for consumer price inflation. The central banks have extensive control over “near-cash money”. They can, however, control higher, more non-cash money to a lesser extent and are relatively powerless to influence the speed of money circulation. More aggressive inflation targets do little to change this.

 

More powerful than proclaiming ambitious targets is the proclamation of new means

In order to bring about a rise in inflation, the central banks must present credible means. Perhaps you, dear readers, can help the central banks? In any case, the markets are waiting to see whether the change in the FED’s objective (to target periods with inflation above 2% to compensate for previous periods with too low inflation) will have immediate monetary policy consequences.

 

 

This post was automatically translated


Thomas Härter
Chief Investment Officer Aquila