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Where’s all this fear coming from?

By October 26, 2018 March 16th, 2020 No Comments

As I discussed in my last market outlook, economists are fearful of, slow productivity growth. Such fear is not unreasonable given the importance of productivity to our standard of living over the long term.

However, some economic policymakers today are displaying a fear that is unwarranted – the fear that the strength of today’s labor market, as evidenced by a historically low unemployment rate, will lead to a high rate of inflation.

Consider the economic theories on which such concerns are based.

The idea that a government-controlled central bank can adequately control inflation through its policies on the amount of money in circulation or on deposit at banks began in earnest with the theories of John Maynard Keynes during the Great Depression.[1]

In his 1936 treatise, The General Theory of Employment, Interest and Money, Keynes explained how the fiscal and monetary policies of the government could possibly smooth out short-run fluctuations in the economy. When the economy slows, the government should step in and increase overall demand. When the economy is growing the government should do the opposite.

That is, government should buy when everyone is selling and sell when everyone is buying.

While Keynes’s theory was widely accepted, it was never fully implemented or tested.  That is, Keynesian economics is incomplete.

For example, Keynes proposed that governments run budget surpluses throughout periods of positive economic growth. Before 1930, the U.S. government had a budget surplus in two out of every three years. In the subsequent 82 years we have seen only twelve. Currently, government spending is rising faster than tax receipts; the exact opposite of what the theory calls for.

Monetary policy is any action undertaken by a central bank to influence the availability and cost of money and credit.  Through a myriad of different actions in our banking system the U.S. Federal Reserve can push interest rates higher so as to influence banks’ ability to provide credit.  If the banks respond to such incentives they may reduce lending, thereby reducing the likelihood that prices will rise.

But just as with fiscal policy, government policymakers have rarely followed Keynes’s monetary advice. In the early 1980s members of the Federal Reserve’s policymaking committee followed the lead of Chairman Paul Volcker and dramatically raised interested rates to counteract the inflationary policies of the day.

For these reasons and more there has yet to be a full test of the Keynes’s theory, and thus a complete understanding of how fiscal or monetary policy affects the real economy. In the eighteenth century, economist David Hume argued that monetary policy has no real effect on the economy.  This idea of monetary neutrality means that over time changes in the supply of money and credit affects only nominal variables, such as interest rates and exchange rates. Such changes have no effect, however, on real variables like income and consumption.

Some economists claim that the Fed’s actions do nothing but increase financial repression. Financial repression occurs when such actions channel funds from one area of the economy to another, often the government’s own debt. Under this theory, the low interest rate policy from the Fed these ten years has simply distorted the value of stocks and other financial assets while increasing the level of uncertainty in the overall economy.[2]

Regardless of all these academic debates, policymakers continue to follow a Keynesian model known as the Phillips Curve.[3]

Economist A. W. Phillips published a report many years ago that suggested a negative correlation between inflation rates and unemployment. According to the theoretical model behind this supposed relationship, when the Fed keeps interest rates too low the money supply expands too fast. The economy moves along the Phillips curve to a point of lower unemployment but at the cost of higher inflation.

So it is fear of inflation that is keeping policymakers up at night.

According to the minutes from their most recent meeting, Fed policy makers expressed the view that “the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” From this observation they concluded “that further gradual increases in [interest rates] will be consistent with sustained expansion of economic activity…”[4] However, as noted above there is no certainty as to what effect such interest rate increases will have on the real economy.

So what is an investor to do if Keynes’s theory is incomplete and such policy concerns are unwarranted?  Keep your eye on the long-run goal! Don’t let the fears of some economists and some policymakers distract you.

We invest so as to secure a better future for ourselves and our families. We invest to provide a stable level of income in retirement or protect against health or other risks.

Over the long term, the current fiscal and monetary policies are likely to have little or no effect on the performance of my investments. As long as these policies don’t substantially deter businesses from investing in their operations and new products or services the US economy will continue to grow, even after adjusting for inflation. Historically, the only consistent hedge against inflation is stocks. The return on bonds tends to only match inflation.[5]

Fear in the financial markets is mostly unwarranted. Stick to your long-run investing plan.


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