A credit-based financial economy (as opposed to pure cash) depends on an ever-expanding outstanding level of credit for its survival. Without additional credit, interest on previously issued liabilities cannot be paid absent the sale of existing assets, which in turn would lead to a vicious cycle of debt deflation, recession and ultimately depression. It is this expansion of private and public market credit which the Fed and the BOE have successfully engineered over the past five years, while their contemporaries (the ECB and BOJ) have until now failed, at least in terms of stimulating economic growth.
The unmodelled (for lack of historical example) experiment that all major central banks are now engaged in is to ask and then answer: what growth rate of credit is enough to pay prior bills, and what policy rate/amount of quantitative easing (QE) is necessary to generate that growth rate? Assuming that the interest rate on outstanding debt in the US is approximately 4.5% (admittedly, a slight stab in the dark because of shadow debt obligations), a Fed governor using this template would want credit to expand by at least 4.5% per year in order to prevent the necessary sale of existing assets (debt and equity) to cover annual interest costs. That is close to saying they would want nominal GDP to expand at 4.5%, but that’s another story/investment outlook.
Credit growth has been far from impressive in recent years
How are they doing? The chart, Dismal rate shows outstanding credit growth for recent quarters and all quarters since January 2004. The chart’s definition of credit includes the standard Fed definition of private non-financial credit (corporations, households, mortgages), public liabilities (government debt), as well as financial credit.
The current outstanding total is approximately $58 trillion and has been expanding at an average annual rate of 2% for the past five years, and 3.5% for the most recent 12 months.
Put simply, if credit needs to expand at 4.5% per year, then the private and public sectors in combination must create approximately $2.5 trillion of additional debt per year to pay for outstanding interest.
They are underachieving that target in the US, which is the reason why GDP growth struggles at 2% real or lower and nominal GDP growth seems capped at 4.5% or lower. Credit creation is essential for economic growth in a finance-based economy such as ours. Without it, growth stagnates or withers. Its velocity/turnover is critical as well.
The velocity/turnover of credit mentioned above, in turn, is a function of price or the yield of credit. No central banker knows what that appropriate yield/price is and so Yellen/Carney/Draghi/Kuroda walk up forward interest rates carefully, so as not to cause a credit collapse. As a general rule, the projected return on financial assets (relative to their risk) must be sufficiently higher than the return on today’s or forward curve levels of cash (overnight repo), otherwise holders of assets sell longer-term maturities and hold dollar bills in a mattress — lowering velocity and creating a recession/debt delevering.
The slack is slowing
There's no revival in investments despite fiscal policy changes
We are dangerously close to the crossing of the lines between long-term asset returns and forward levels of cash yields, which currently rest at 2.5%+ in 2017 and beyond. If the forward levels are not validated, however, the danger is lessened.
Today’s levels of interest rates and stock prices offer a historically unacceptable level of risk relative to return, unless the policy rate is kept low — right now and in the time to come. That is the basis for the New Neutral, which is Pimco’s assumption that the Federal funds rate peaks at 2% or less in 2017 versus others’ assumptions (either Taylor, Fisher, Lacker or the market) that it goes much higher. BOE’s Carney, by the way, believes that his country’s New Neutral is 2.5%, a level consistent with Pimco’s 2% in the US. If so, existing asset prices in the Unites States (while artificially high) and bond yields (while artificially low) may continue to be so, unless the Fed oversteps its interest rate line.
This global monetary experiment may in the short/intermediate term calm markets, support asset prices and promote economic growth, although at lower than historical levels. Over the long term, however, economic growth depends on investment and a rejuvenation of capitalistic animal spirits — a condition that currently does not exist.
Central bankers are hopeful that fiscal policy (which includes deficit spending and/or tax reform) may ultimately lead to higher investment, but to date there has been little progress, as seen in the chart, The slack is slowing. The US and global economy ultimately cannot be safely delevered with artificially low interest rates, unless they lead to higher levels of productive investment.
Reproduced from Pimco’s investment outlook for September 2014. Bill Gross has since quit Pimco to join Janus Capital