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Economy in Brief

Money Illusion Stalks Financial Metrics
by Robert Brusca  December 29, 2021

In economics, 'money illusion' is a term to describe when 'real' and 'nominal' measures cast off different signals- as they are doing now. For the EMU, nominal money supply data in the top panel of the table show a steady drumbeat if firm-to-strong M2 money growth at annualized rates ranging from 6.5% over three months to 6.8% over six months and 7.1% over 12 months. These are all quite solid growth rates for money and in fact under some circumstances growth rates that are too strong to persist.

Step down to the lower panel and look at money growth in the EMU for 'real balances.' Suddenly, the picture is much different. Growth is 2.1% over 12 months and 0.9% over six months, but over three months the pace has flipped to show monetary shrinkage (-1.3%).

A tale of two growth rates
Obviously, real and nominal data are telling two different stories here. And since we have not been paying much attention to money supply for a while, it would not be surprising for you to ask the pointed question, “So what?”

Central banks have been steering policy for some time by focusing more on interest rates with an eye to real interest rates aware that that they had pushed rates down to the limit or beyond (as the EMU and Japan have tolerated negative yields for some rates). Since growth has been floundering in the wake of the Great Recession, central banks found themselves restricted by the 'zero bound' and have sought other ways to stimulated economic growth such as though large-scale asset purchases and related efforts. Fiscal policy was also thrown into the mix especially after Covid struck. Now, with the supply side of the global economy adversely impacted and various policies in effect to boost growth and spending, we are beginning to see economics at work again as too much money is changing too-few goods creating the classical results know as inflation.

Of course, central banks have been in denial of this process and have tried to ignore spiking inflation under the allegation that such inflation is only 'temporary.' However, as central bankers have hummed loudly to distract themselves and looked down at their shoes, all that neglect did nothing to reduce inflation which instead has grown worse and become more intense. In Europe, the ECB is pondering its next steps. In the U.S., the central bank stuck its pinky toe in the water and declared that it would begin to remove its asset purchases but very slowly and then after a month of watching inflation stay rooted, in horror, the central bank decided to advance the pace at which it would withdraw stimulus trumping its own freshly made policy. The Bank of England has already raised rates. Various Federal Reserve members make it clear that one reason to withdraw stimulus sooner is so the bank can raise rates earlier than it had planned if inflation stays high. The Fed's former position that 'tapering' and tightening are two wholly different acts with different triggers has melted away as it is now quite clear that the minute the tapering is done the central bank will be prepared to hike rates.

Forward guidance as a fairy tale or horror story
In recent years as rates have hovered low and growth has been weak, central bankers have tried to 'cook up' different schemes to sell as 'stimulus.' Among some of the snake oil that this has produced is the contention that central bank communication is a separate tool and that the central bank can use something called 'forward guidance' as another policy lever. How have these things worked out? Not well.
Communication- In the first place, communication is not a tool. It is simply a way to express to the public what is being done. To call it a tool- at least to me- implies that it will be used for a purpose other than to express facts and perhaps even be used to try to manipulate people and their perceptions. Once communication is used for any purpose other than to express truthfully what is being done, it ceases to be useful as communication. Not surprisingly, the Fed winds up having to reset its communication policy every few years. I'll let you ponder what that may mean…
Forward guidance- Forward guidance is an aspect of communication policy meant to help guide markets and investors about what the central bank plans to do next. There are two problems with this: (1) the central bank does not see the future perfectly and (2) because of (1) it has no idea what it will really do in the future. The idea behind forward guidance is that if the central bank expresses that it will leave interest rates very low for a very long time that verbiage will affect the actions of market participants who will believe the central bank and act on all that expected future stimulus, creating near-term stimulus out of thin air. Unfortunately, forward guidance as policy has been way oversold and overused. In its early stages, forward guidance was used to nudge or tweak markets in a direction. But in its last iteration - in the U.S. at least - the Fed went all gonzo with a pledge to not hike rates until inflation had run above its objective for some time and even then, not unless the economy was at full employment. Some central bankers even went out of their way to point out how such a pledge in the past would have been impossible or seemed fool-hardy (yes- as it in fact turned out to be: fool-hardy). Another limitation of forward guidance is that a central bank can tell you today based on what it sees and thinks today how it will act in the future under certain circumstances. In economic parlance, we call this the central bank 'reaction function.' However, central bankers will be making policy in the future not based on what they think today but upon the actual circumstances of the future. And in the future the forward guidance being given today may simply not work anymore. This, in fact, is where the Fed finds itself today. Its last policy recalibration has gotten it in hot water and many Fed officials are now looking for multiple rate hikes for the period ahead. The BOE has hiked rates already. The ECB is looking at a chronic inflation overshoot. 2022 is certainly going to see a very different take on global monetary policy than what it saw in 2021.

The data don't lie...they simply 'are'
For some reason at least in the U.S. the Federal reserve opted for a course of policy that could only be called 'data free.' You know, it's like your credit card company that keeps sending you requests to go paper free! In December 2015, the Fed decided it would ignore actual data and instead make policy based on its forecasts for inflation. That turned out badly as the Fed ignored persistent inflation undershooting. As a result, the Fed then had to change policy and promise never to do that again. Instead, it promised to not hike rates until inflation overshot its target and until full employment was achieved. Now while this latter pledge does require looking at data, it also requires judgement about what full employment is and then there is the fact that the Fed switched to targeting and an unspecified inflation average instead of just 2%. Put together all these changes and they have had profound impact on inflation and on the conduct of policy.

Globally covid struck and nations took steps to prop up demand, but supply was impacted. Yet, the Fed and other central banks assumed that it was the same world as 2015-2018 when it could not get inflation jumpstarted come Hell or high water. Of course, this judgment was dead wrong. So with rates at the zero bound and large scale asset purchases cooking and rounds of fiscal stimulus in play, how surprising is it that we finally created inflation? I'd say…not very.

That is where we stand. Inflation is excessive, pretty much everywhere (Japan excepted). The virus is still a factor just to make things a bit more complicated- let's not forget about the new and highly transmissible Covid strain known as Omicron. And with the inflation rate cooking and central bankers realizing that they have a problem on their hands, there is now the delicate job of pulling the fat out of the fire without getting burned.

And the data say...
The tabular data make it clear that nominal money supply is strong but real money and real credit growth in the EMU are weak (those terms refer to money and credit growth after the effects of inflation are removed). Money has overshot its bounds; and like a river that overflows its banks, it is soaking the countryside and making everything wet until nature can dry it up. The Fed will try to speed up this process of 'drying out.' Policy can take a new tack but it must also be careful not to tip the economy over to recession since with the virus circulating and all the disruption the global economy has been through this would be a really bad time to cause a recession with monetary policy.

So, there we are.

As the saying goes, wherever you go, there you are. And here we are in a circumstance of our own making. We got here by following the GPS known as denial. We got here by making one policy mistake followed by another and pressed ahead with policies implemented uncritically- this has been especially true in the U.S. But now even the politics have shifted. In the U.S., President Joe Biden realizes that inflation is hurting him, and he has gotten religion when it comes to controlling inflation – but not when it comes to the role of fiscal policy.

Looking ahead
As we look to 2022, what will happen is anyone's guess. We do get regular new 'guesses' about the future from the Fed in a process known as the SEPS (summary of economic projections). Recently, the Fed Chair has been going out of this way to wave his arms and let us know that the SEPS are not a coordinated Fed policy and are not official but represent the individual views of each FOMC member. So does that make them irrelevant? I don't think so. Suddenly, Fed officials are looking for three rate hikes in 2022. The world as seen by the SEPS has shifted sharply. Of course, inflation has also risen sharply and the unemployment rate in the U.S. has fallen faster than expected even if the rate of employment has not been rising in step.

I surely look for rate hikes in the year ahead. I do not know how fast the Fed will act. I am completely confused about fiscal policy where the weight of the world seems to fall on the shoulders of one or two key voters in the Senate. The ECB has been facing its pressure, too to hike rates. The BOE has seen that ship sail. Will central bankers be able to make up for past mistakes without making devastating future mistakes? The lessons of from 2015 and beyond are not encouraging. The divided state of politics globally is hardly the stuff of what a new moderate consensus for policy will emerge from. But maybe it will surprise us.

The one constant in life is that whatever happens stock prices rise (and so do house prices!). Can that possibly continue? My crystal ball is very cloudy since it lacks any underpinning at all. I do not know about fiscal policy. Monetary policy has embraced so much denial I no longer have a framework by which to evaluate it. Politics are fractured beyond belief and on a global scale.

And then there is Omicron… On that front, Israel, the most vaccinated country in the world, has been pondering a fourth shot. So much for his being a three-shot vaccine. And remember this shot is a 'therapy;' it does not give anyone any immunity. Once 'vaccinated' you can still get the disease and still pass it on. And a boost shot lasts only four months. In many ways we are no closer to herd immunity that were back in March 2020 when Covid first struck.

When operating a simple GPS device even if it has all the maps of the world in it, you cannot use it for directions unless you can answer the simple question, 'where are we now?' Right now, we have no idea where we are politically, economically, in the business cycle, in the covid cycle or in any other way. We can't be sure of the policy goal or resolve of our leadership and so we look ahead to 2022 like a ship sailing into a thick deep fog. Maybe it will get better and maybe it won't…

Commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

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