Increasingly, central banks face a dilemma. Typically, when an economy is in the grip of recession, key interest rates are lowered until economic growth picks up. Subsequently, rates need to be hiked as monetary policy is tightened. The idea is that growth will drop to the level of potential growth exactly as the economy reaches full capacity utilisation.

Potential growth is defined as the sum total of the increase in productivity and the increase in the working population. It points to the growth rate that can be achieved – in theory – when the economy is running at full capacity without higher inflation. In reality, this never happens. Instead, an overshoot tends to occur. Next, interest rates need to go up and monetary tightening is required to restore the balance. Often, this leads to a new recession.

Following the credit crisis, the big problem was that even an ultra-loose fiscal policy and minimal interest rates were not enough to kick-start the economy. As a result, central banks started to create more money than the real economy could absorb.

This money had to go somewhere. To a certain degree, it remained stuck in the banking system but a lot ended up in the financial markets, where it put upward pressure on the prices of stocks, bonds, and houses. As the balance sheets of consumers and businesses improved, deleveraging decreased until, at a certain moment, people started to borrow more and they saved less. Easing credit started to boost growth and job creation. Wage income picked up and confidence improved. This will likely result in rising consumption and investments, leading to an upward economic spiral.

The other side of the coin is that expanding credit will cause the money multiplier and money velocity to rise. If this happens in a situation of massive money creation, hyperinflation will loom. The only way to stop this is to rapidly remove the surplus liquidity from the economy. There is a chance that prices will plunge just as fast if the extra money is removed. If this scenario unfolds, growth will nosedive.

*Unemployment and all marginally attached and part time workers as a percentage of the labour force
Source: Thomson Reuters Datastream/ECR

On the other hand, there is a possibility that an improving economy will offset shrinking money supply. In that case, asset prices will stay reasonably high. The IMF is not optimistic in this respect; at least, in connection with the West. The reason is that, compared with before, investment has been poor for years. As a result, the increase in productivity has dropped while the increase in the working population is declining owing to the ageing population. And as a consequence of this, potential growth has decreased in Europe and the US. As a result, rising interest rates and tighter monetary policy can send asset prices tumbling.

This brings us to the central banks’ dilemma. Seven years since the credit crisis broke out, low interest rates and ultra-loose monetary policy are still paving the way towards full capacity utilisation. Growth will have to be driven down once full capacity utilisation has been reached. A likely implication is that stock markets will collapse. The situation demands very loose monetary policy. However, the sobering fact is that this will result in bubbles that will burst, eventually.

Bank of England changes tack

Remarkably, last month the Bank of England stated that interest rates could be raised sooner than the markets are discounting. Evidently, a conclusion has been reached that to keep the base rate on hold for a long period of time will increase the risk of bubbles, which are bound to burst once interest rates rise sharply. The question on everyone’s lips is: does the same apply to the Fed?

Deflation or inflation?

The US central bank faces a complicated situation. Most of all, because of huge uncertainty about the real state of the economy. Various important data has led to doubt. First and foremost, data linked to the job market. Wage increases are still low. At the same time, leading indicators point to gradual upward pressure. The rate at which wages rise depends on the tightness of the US labour market. In the past few years unemployment has dropped faster than expected. It is now close to the rate considered ‘full employment’ (5%-5.5%).

Quite a few economists think that from now on, the jobless rate will not drop as quickly. Other economists disagree. Their argument is that if all existing vacancies were to be filled, unemployment would be around 4%. This is highly unlikely; businesses complain that many jobseekers lack the required skills and/or training. The conclusion is that ‘full employment’ may be realised when the jobless rate is 6%-6.5% instead of 5%-5.5% because many people feel they are unemployable and will no longer be looking for work.

Source: Thomson Reuters Datastream/ECR

Growth is another contentious factor. In Q1, the US economy likely saw a contraction of nearly 3%. This calls into question the underlying strength of the US economy. Remarkably, employment has increased substantially in the first quarter of this year, at a rate that would be compatible with growth rates near 3%. This suggests that either the payroll data or the growth data is out of kilter. Experience shows that the growth data is the most likely ‘culprit’. If so, it would indicate the underlying vigour of the US economy. Of course, this will have implications for interest rate policy.

Monetary policy based on trial and error

Our conclusion is that these uncertainties make it very hard to pinpoint the ‘correct’ monetary policy. A method of trial and error will have to be employed to find out how to prevent plummeting asset prices and deflation, while at the same time limiting the risk of high inflation and (additional) bubbles. At the present juncture, most central banks seemingly prefer an overly loose monetary policy to premature tightening.

This does not offer a favourable outlook for bonds and stock in the United States. What the Fed wants is no secret. First, the US economy should achieve full employment; rapidly or at leisure. Then wages should increase. One thing is clear: consumption cannot be fuelled by easing credit forever. In short, higher disposable incomes are the solution. This could be done by raising wages at the expense of profits. This should be possible, since wages have lagged profits for decades.

How can you achieve this shift from higher profits to rising wage increases? Once wages soar, inflation will rise and can only be contained if interest rates are raised. If this results in plunging asset prices, growth will decelerate and as the slack returns to the labour market, wages will stop rising. A way out would be to allow slowly rising inflation. This could happen as follows: as the job market tightens, wages go up. Subsequently, the central bank raises the short-term interest rate albeit cautiously, so asset prices do not fall sharply and the economy continues to grow at a reasonable pace.

Source: Thomson Reuters Datastream/ECR

The latter will drive up inflation but as soon as investors become aware of this, long-term interest rates will rise. Although the central bank will need to raise the fund rate, it can stay behind the curve and the rate hikes will not be severe enough to seriously dampen economic growth. Or inflation, for that matter. Not a particularly favourable climate for bonds or equities because nominal interest rates would be rising and wages will rise at the expense of profits.