US stock prices have been unusually buoyant through the lazy-days of summer, and have jumped almost ten per cent since the end of May, to within just two per cent of the levels that prevailed immediately before the financial crisis entered its most dangerous phase during the summer of 2008.
The most recent turnaround in the stock market’s fortunes has been somewhat surprising, given that virtually all of the latest economic data points to nothing better than sub-trend growth, while ‘Corporate America’ has just completed its most disappointing quarterly-earnings season – at least, versus bottom-up expectations – since the current upturn in equity values began more than forty months ago.
The major market averages’ resilience against what would appear, on the surface, to be bad news, almost certainly reflects investors’ blind faith in the Federal Reserve’s ability – and willingness – to deliver infinite rounds of emergency stimulus in the face of sagging growth, that should, in the bulls’ eyes, not only prevent the realisation of unfavourable outcomes, but perhaps, even return the economy to a more robust growth trajectory.
The close to God-like status afforded to the inhabitants of the Marriner S. Eccles Federal Reserve Board Building in Washington D.C. is warranted, or at least the bulls argue, by the fact that the monetary authority delivered the ‘Great Moderation’ through the mid-1980s and beyond, and managed to prevent a repeat of the ‘Great Contraction’ of the 1930s, in the face of the largest systemic crisis in generations. It is clear that the ‘Greenspan Put’ has simply evolved into the ‘Bernanke Put’ – but, investors’ increasing dependence upon central bankers’ continued wizardry could well be nothing more than wishful thinking.
It is beyond dispute that the ‘Great Moderation’ was a very real phenomenon, whereby a broad-based decline in macroeconomic volatility began during Paul Volcker’s second term as Chairman of the Federal Reserve, and persisted throughout the Greenspan era. Indeed, the volatility of quarterly real GDP growth more than halved in the period from the final quarter of 1983 to the end of 2007, as compared with the previous quarter century. Further, the dramatic decline in macroeconomic uncertainty was not confined to quarterly output, and extended to a multitude of variables including inflation, employment, and exchange rates.
The ‘Great Moderation’ was well-known to investors for several years, but captured the public imagination in the spring of 2004, when Ben Bernanke delivered a speech given to the Eastern Economic Association, which concluded that, “improvements in monetary policy…have probably been an important source of the Great Moderation.” Various central bankers have put forward the same view, which has been dubbed ‘enlightened discretion,’ but numerous academic studies have poured scorn on this hypothesis.
Indeed, a paper by James Stock and Mark Watson finds that monetary policy had little to do with the substantial drop in output volatility, and everything to do with good luck. The authors attribute as much as ninety per cent of the economy’s improved stability to good luck – or the absence of large adverse shocks – rather than the economy’s dynamic response to these disturbances. The very same conclusion has been reached by various respected academics, which undermines central bankers’ current God-like status.
Those who remain unconvinced, and continue to believe that central bankers are miracle-workers and not ordinary mortals, should take a close look at the rhetoric emanating from the higher echelons of the Federal Reserve before the crisis struck. They championed the financial innovations that precipitated the crisis, and were blind to structured finance’s soft underbelly. Further, once the crisis struck, they consistently underestimated the potential size of the shock.
The Federal Reserve did prevent a repeat of the 1930s, but the monetary policymakers have been consistently surprised by the economy’s underwhelming response to unconventional stimulus. Indeed, the Fed wizards believed in the summer of 2010 that economic growth would be between 2.9 and 3.8 per cent for the full calendar year, and between 2.9 and 4.5 per cent in 2011. The actual outcomes were a disappointing 2.4 and 1.8 per cent respectively.
Investors need to appreciate that in spite of extraordinary monetary stimulus, the current economic upturn is the most uninspiring in post-war history. Indeed, output growth has averaged just 2.2 per cent over the twelve quarters since the recession’s nadir in the summer of 2009 – or less than half the average pace of growth registered during the three-year periods that immediately followed the previous ten post-1945 recessions – while the current unemployment rate is still above all but three of the prior recession peaks.
The economy’s good luck ran out when the financial crisis struck, and the Federal Reserve is not a miracle-worker, and simply does not have a silver bullet that will return the economy to a more robust growth trajectory. Meanwhile, the structural headwinds behind the lacklustre growth performance, exposes the economy to adverse shocks. Welcome to the ‘Great Stagnation.’
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