When is the stimulus too strong for the markets?

The writer is President of Queens’ College, Cambridge University, and Advisor to Allianz and Gramercy

For many years, the operational simplicity of positioning investment portfolios has contrasted sharply with the complexity of the national and global economic outlook.

By getting the right decision from the central bank and simply overweighting index products, investors have benefited greatly from investments in stocks and bonds. Meanwhile, economists have struggled to predict even basic economic variables such as growth and inflation.

This configuration may be changing, and not because the enormous liquidity injected by the US Federal Reserve is likely to end anytime soon. This will not be the case.

On the contrary, more fiscal policy is now expected to add to the Fed’s flooding of the system with liquidity. This raises interesting questions as to whether the beneficial outcome for the markets will get complicated or, conversely, involve volatile contradictions requiring careful active management.

Driven by a sufficient and predictable injection of liquidity, investors put aside many traditional economic and political influences as the Fed sucked up securities at non-commercial prices. The indirect effect turned out to be substantial, conditioning investors to buy every drop in the market, regardless of the cause, and to allocate more capital to ever more risky investments.

In his recent remarks, Fed Chairman Jay Powell made it clear that the central bank did not intend to change this policy approach, whether it be the large-scale purchase of securities (currently at $ 120 billion). dollars per month, or about 7% of gross domestic product on an annualized basis) or the lowest key rates.

This despite a brighter outlook due to the acceleration of the diffusion of vaccination, the success of the reduction of infections, ultra-flexible financial conditions and the multiplication of indices of excessive risk-taking. The latter includes the proliferation of speculative, special-purpose acquisition companies, the record pace of corporate debt issuance and a surge in transactions using borrowed funds.

But in extrapolating the impact on asset prices of the Fed’s continued liquidity injections, investors must now consider the impact “Go big” fiscally. The first part of this involves the Biden administration seeking congressional approval for a $ 1.9 billion (roughly 9% of GDP) stimulus package. A second package is planned to follow this infrastructure focused, bringing the total fiscal effort to around $ 3-4 billion (14-19% of GDP).

The initial reaction of investors was that the two massive injections were wonderfully additive to asset prices. Inventories hit several records in the first six weeks of the year. However, in recent days, as the market chatter remains exuberant, investors are slowly being forced to confront an already hotly debated issue among economists: When is so much stimulus too much stimulus?

The argument for ever is based on the idea that endless cash injections protect against most business failures. The counter-argument highlights two fears of liquidity. One is the destabilization of inflationary expectations which fuels an excessively steep steepening of the yield curve, disrupts investor conditioning and increases the likelihood of a market crash.

The second is that, with a Fed reluctant to cut its stimulus measures, it faces lose-lose policy options – let the risk of financial instability increase and threaten the real economy or intervene more in the functioning of markets, worsen wealth inequalities and risk further distortions that undermine the efficient allocation of financial and economic resources.

Given the size and speed of markets, what is good for more inclusive economic growth may not be good for investors in the short term. Moreover, aware of its “implicit contract” with the markets, the Fed is likely to react to too rapid a change in yields by further easing its policy, despite existing fears of financial overheating. This would only worsen an already unhealthy co-dependent relationship with the markets.

The answer is not to abandon fiscal stimulus. Rather, it is about improving the targeting of immediate relief and accelerating the impact on long-term growth. And the Fed needs to seriously think about how best to slowly take its foot off the monetary accelerator.

This much-needed transfer from money to taxation would be much smoother if prudential regulation caught up more quickly with the massive migration of risk from banks to non-banks, including “sand in the wheel” measures to moderate risk. excessive-taken. The longer this three-dimensional solution eludes us, the greater the risk of financial instability affecting economic well-being.

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