Almost exactly eight years ago, the S&P 500 index hit a low of 666. This is a number to which some numerologists – especially those at the wackier end of the spectrum – and apparently FT journalists too – attach a great deal of significance. However, for those of us with less esoteric leanings, the significant of the number is that it marked the bottom of the last major bear market in equities and signalled the beginning of the end of the Great Recession (spooky – just kidding!). Indeed, just a week or so later (March 15th, 2009, to be exact) in a televised interview Bernanke – then Fed Chairman – publicly stated:
“And I think as those green shoots begin to appear in different markets — and as some confidence begins to come back — that will begin the positive dynamic that brings our economy back.”
At the time one was sceptical of his assessment given the still dreadful tone of US economic data releases, which pointed to ongoing contraction albeit at a slightly reduced pace. With the benefit of hindsight, one should have known better.
The Two Main Ingredients
As any gardener will tell you, in addition to sunlight – which is invariably delivered every single day – for green shoots to appear two additional things are required: “liquidity” and “BS”. Via its orthodox and unorthodox monetary policy tools the Fed had already delivered the former, and with this comment, Bernanke provided the final – until then missing – ingredient.
Even though Bernanke’s comment was largely subjective (the polite term for BS), by virtue of his position they were influential. Moreover, in challenging the prevailing view of the crowd at the time, which was uniformly and profoundly bearish – the global economic growth heatmap below closely resembled an oil slick – it laid the foundations for the equity bull market that is still ongoing. It was a great example of crowd fail – possibly the greatest since the bursting of the dot-com bubble.
Exhibit 1: Economic Growth Sentiment – Global Heat Map (March 2009)
Despite the strong rise in asset markets over the past eight years (the S&P 500 is up more than 250% since the March 2009 low), one enduring mystery of the post-Great Recession period – one that continues to perplex the economics profession – is the interconnected triad of lacklustre economic growth, the sustained disinflationary undercurrent and, as a consequence, the continued reliance on very accommodative policy settings (most visibly monetary policy).
Is the Fed About to Make a Mistake?
In a recent interview, Olivier Blanchard – co-author of one of the leading post-grad economics textbooks, former IMF Chief economist and now senior fellow at the Peterson Institute – posits that the tepid nature of the post-Great Recession recovery is attributable to persistent weakness in private sector animal spirits. In essence, he proposes a self-fulfilling prophecy where people, worried that the future will be worse, spend less, reducing domestic demand and crimping present economic growth, further damping animal spirits.
Such sentiments – no pun intended – sound plausible. They are also very much in keeping with Keynes’s original analysis of the Great Depression, where he concluded that depressed animal spirits were one impediment to the economy recovering back towards the full-employment equilibrium, a process that was previously considered to be the natural course of events.
To validate his theory, Blanchard examined the relationship between revisions in forecasts of long-run potential economic growth rates – his proxy for animal spirits – and unexpected decreases in consumption or investment. He found a positive correlation between negative consumption and investment “surprises” and the persistent decline in potential economic growth rates estimates; an outcome consistent with his theory.
Even though this might sound a rather dry and academic exercise, it is manifestly not. It should be of considerable interest to investors because if Blanchard’s theory is correct, it implies the Fed is about to make a (potentially grave) policy error.
More Support Needed
As part of its more transparent approach, concomitant with its quarterly press conference the Fed publishes aggregated macroeconomic projections of the individual FOMC members. Because of the way the forecasting exercise is structured, their long-run economic growth forecasts correspond to their estimates of the US economy’s potential growth rate.
As shown in the chart below, US central bankers have been consistently lowering their estimates of the US economy’s potential growth rate, which as of December stood at just 1.8% – its lowest level in the post-Great Recession period. Under Blanchard’s framework, such a persistent decline constitutes prima facie evidence of a growth-impinging fall in US animal spirits, one that would seem therefore to warrant more not less monetary policy support.
Exhibit 2: FOMC – Long-run Potential Economic Growth Projections
Yet, over the past couple of weeks, the Fed has signalled its intention to go in the opposite direction. In fact, given the rather heavy-handed hints by leading members of the FOMC, including Chair Yellen, that it intends to accelerate the pace by which monetary policy accommodation is removed US interest rate futures markets have aggressively raised the implied odds of a 25bp hike at the March 15 policy meeting.
That said, there are solid reasons for doubting the validity of Blanchard’s theory. The use of long-run potential economic growth forecasts to proxy animal spirits is certainly a neat workaround, but like all workarounds, it is imperfect.
Importantly, it is not a clean measure of economic “animal spirits” because potential growth rates are impacted by changes in capital and labour inputs as well as shifts in productivity. Moreover, because potential growth rates are unobservable, they have to be estimated and hence are therefore subject to error.
US Growth Estimates vs. Sentiment
One useful crosscheck is to compare the persistent downward revision in US potential economic growth estimates with the crowd-sourced US economic growth sentiment indicator derived from the analysis of millions of mainstream and social media posts published online every day.
The chart below shows the evolution of this sentiment indicator in the years preceding the Great Recession to the present day. One can clearly see the extreme negativity eight years ago, indicative of very low private-sector animal spirits that turned our global heatmap into a veritable oil slick.
Exhibit 3: Crowd-sourced Economic Growth Sentiment – US
Subsequent to the aforementioned “green shoots incident,” US economic growth sentiment rebounded fairly robustly. Although this improvement was somewhat uneven at first, by 2013 and 2014 public perceptions towards US growth were consistently positive, matching levels seen prior to the Great Recession.
If Blanchard’s hypothesis that subdued animal spirits were acting as a significant drag on economic growth is correct, this should have marked a key turning point because, to borrow former PIMCO CIO Mohamed El-Erian’s phrasebook, the US economic recovery should have achieved “escape velocity”. Growth rates thereafter could have been more robust and – importantly – self-sustaining, providing global policymakers with scope to dial back on demand-side stimulus because the vicious circle of low animal spirits and weak economic growth would have been broken.
Shoulda, Coulda, Woulda
Yet, this virtuous circle never materialised. The improvement in animal spirits proved transitory and central banks were forced, once more, to step in and provide fresh monetary support. For the Fed, which, envisaging a more durable recovery had slowed then ceased altogether its asset purchase programme in 2013/14, this meant delaying the start of its long-anticipated tightening cycle.
This failure means either Blanchard’s potential GDP growth estimate is a better proxy for capturing animal spirits than our crowd-sourced sentiment indicators or his theory for the “new normal” is incorrect. Unfortunately for him, but fortunately for us, of the two the most plausible is that it is his theory and not our sentiment indicators that are faulty.
After all, consider what has happened in the past few months following Trump’s election victory. Anticipating the incoming administration would inject more fiscal stimulus, as Trump pledged during the campaign, our crowd-sourced US economic growth sentiment indicator rebounded.
This move is entirely consistent with the sharp rally seen on Wall Street and the subsequent publication of better US so-called soft “survey” data. All three trends point to a clear improvement in animal spirits, something that is completely at odds with the US potential GDP growth estimate (recalling chart 2 above) staying at post-Great Recession lows.
That said, even though Blanchard’s animal spirits proxy may be flawed, and his theory incorrect, the implied view on the Fed making a policy error may not be. To see why one needs to consider a different explanation for the tepid post-Great Recession recovery.
Growing Debt vs Animal Spirits
For market participants, the most obvious candidate for the unexpectedly soft economic growth performance since 2009 is elevated global indebtedness. Despite all of the focus on deleveraging and consolidation over the past eight years, total debt – that is public and private – have increased in almost every major economy.
Given debt represents the intertemporal substitution of consumption (the single largest expenditure component of GDP) it is hardly surprising that at elevated levels debt serves as a disinflationary growth-impinging drag, one that can also account for the steady decline in potential economic growth rates for reasons unconnected with animal spirits. This is something that most mainstream economists, like Blanchard, fail to appreciate or recognise fully.
Moreover, elevated debt also explains why the global economy did not achieve “escape velocity” in 2014 when private sector animal spirits were at least as high as in the pre-Great Recession period. Improving animal spirits can provide a temporary fillip to an economy (or financial asset price), but they cannot do so indefinitely absent a fundamental improvement.
The best analogy is the interaction of the elastic rope and gravity during a bungee jump. The elastic may be able to overcome the force of gravity briefly, but it is gravity that wins in the end.
Trump’s promised fiscal policies may well be able to achieve this outcome over time, but it remains unclear to what extent these get enacted. With the debt ceiling suspension due to end on March 15th (the same day as the FOMC meeting), it should not be long before investors get some sense of the degree of opposition to Trump’s fiscal plans from the GOP – a crucial element given they control both the House and the Senate.
Until there is greater clarity on this front, the wiser course of action for the Fed would be to refrain from accelerating the speed by which monetary accommodation is removed. Hence, even though for entirely different reasons than Blanchard, one also suspects that a Fed hike next week would constitute a policy error, but one they seem intent on making.