Commentary on monetary policy in the spirit of R. G. Hawtrey
The S&P 500 fell today by more than 1 percent, continuing the downward trend began last month when the euro crisis, thought by some commentators to have been surmounted last November thanks to the consummate statesmanship of Mrs. Merkel, resurfaced once again, even more acute than in previous episodes. The S&P 500, having reached a post-crisis high of 1419.04 on April 2, a 10% increase since the end of 2011, closed today at 1338.35, almost 8% below its April 2nd peak.
What accounts for the drop in the stock market since April 2? Well, as I have explained previously on this blog (here, here, here) and in my paper “The Fisher Effect under Deflationary Expectations,” when expected yield on holding cash is greater or even close to the expected yield on real capital, there is insufficient incentive for business to invest in real capital and for households to purchase consumer durables. Real interest rates have been consistently negative since early 2008, except in periods of acute financial distress (e.g., October 2008 to March 2009) when real interest rates, reflecting not the yield on capital, but a dearth of liquidity, were abnormally high. Thus, unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital. That is why ever since 2008, movements in stock prices have been positively correlated with expected inflation, a correlation neither implied by conventional models of stock-market valuation nor evident in the data under normal conditions.
As the euro crisis has worsened, the dollar has been appreciating relative to the euro, dampening expectations for US inflation, which have anyway been receding after last year’s temporary supply-driven uptick, and after the ambiguous signals about monetary policy emanating from Chairman Bernanke and the FOMC. The correspondence between inflation expectations, as reflected in the breakeven spread between the 10-year fixed maturity Treasury note and 10-year fixed maturity TIPS, and the S&P 500 is strikingly evident in the chart below showing the relative movements in inflation expectations and the S&P 500 (both normalized to 1.0 at the start of 2012.
With the euro crisis showing no signs of movement toward a satisfactory resolution, with news from China also indicating a deteriorating economy and possible deflation, the Fed’s current ineffectual monetary policy will not prevent a further slowing of inflation and a further perpetuation of our national agony. If inflation and expected inflation keep falling, the hopeful signs of recovery that we saw during the winter and early spring will, once again, turn out to have been nothing more than a mirage
“Consumate statemanship” indeed! Don´t know if you´ve seen this from the NY Fed, but it appears these guys are all in for technical showmanship and blind to the underlying substance: http://thefaintofheart.wordpress.com/2012/05/14/please-less-technique-and-more-substance/
China doesn’t have deflationary expectations necessarily – imports crashed. In India, there’s the problem of not being able to control inflation.
Both India and China could do with higher exchange rates followed by rate reductions at home. Both US & Europe could do with lower exchange rates. Some kind of global monetary coordination is definitely in order – national interests will almost never be as well aligned as they are now.
China will find a way to combat a slowing economy. They simply have too. Huge numbers of unemployment is the real threat to China. This is what they are trying to stop. Honestly that is what Spain, and Greece should do as well. The US is not much better off. For to long this has been a case for kicking the cane down the road. As longest the system keeps together while I’m in Office nothing will change. That has been the attitude of the past Presidents. I’m hoping for the elites to change there mind.
David: “…when expected yield on holding cash is greater or even close to the expected yield on real capital, there is insufficient incentive for business to invest in real capital and for households to purchase consumer durables. ….Thus, unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital. ”
Curious where you think gold fits in here. Presumably if holding zero-yielding money becomes more attractive than investing in real capital, then holding some durable asset that also yields zero (and requires minimal storage costs) becomes more attractive than investing in real capital?
Gold is an industrial metal. Gold is attractive to hold when the price of gold is less than the full cycle cost of extracting gold. It’s unattractive to hold when it exceeds the cost of extraction.
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David Glasner Washington, DC
I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.
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