Long before the Fed’s first – and according to the “reincarnated”, now uber-dovish James Bullard, last – rate hike last December, we warned that with the Fed’s attempt to tighten so late in the business cycle, there is an all too real risk of the Fed repeating the mistake of 1936/37 and waking the “Ghost of 1937” when- during a period of massive Fed balance sheet expansion which rose from 5% to 20% of GDP – it tightened monetary policy in a series of three steps, when it doubled reserve requirements and pushed 3 Month rates from 0.1% in December 1936 to 0.7% by April 1937.
What happened next was not only a 49% plunge in the Dow Jones, but also led to the start of the acute recession of 1938 which ultimately culminated with the start of World War II.
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Over the weekend Morgan Stanley’s Chetan Ahya, co-head of economics and chief Asia economist, appears to have noticed the same pattern and in the bank’s weekly “what’s next in global macro” note asked if we are about to experience a “1937-1938 Redux?“
Here is his full note:
1937-38 Redux?
2016 will likely mark the fifth consecutive year of global growth below its 30-year average. Inflation expectations in various key economies have decelerated towards fresh lows, underlying trends in inflation data are subdued, private capex growth is slipping and productivity growth is weak. The risk of a global recession remains elevated. We think headwinds from the 3D challenge of debt, demographics and disinflation are key to why the global economy has remained weak.
The experiences of the 1930s are particularly relevant today as a number of major economies faced the 3D challenge then. The unproductive build-up of debt caused the Great Depression of the 1930s and the Great Recession of 2008. Weaker demographic trends in a number of economies during both periods weighed on potential growth. The drop in private demand because of the subsequent debt deleveraging process created intense disinflationary pressures.
The critical similarity between the two cycles is that the financial shock and high debt changed private sector risk attitudes and led private companies to repair their balance sheets. The concurrent deleveraging of financial intermediaries exacerbated and prolonged the adjustment cycle. Meanwhile, the tighter macro-prudential policies and regulatory environment were constraints, making the deleveraging process more complicated and leading to persistent deflationary pressure. Hence, private demand will likely stay weak for longer and inflation expectations should also remain subdued.
To address the demand deficiency and lowflation risks, monetary and fiscal policy should work in tandem. During the 1930s, the initial tight monetary policy stance prolonged the recession between 1929 and 1933. However, strong monetary expansion and expansionary fiscal policy over 1933-36 led to a return to positive growth and inflation from 1934. As the financial crisis broke in 2008, it seemed policy-makers had heeded the lessons from the 1930s as they eased monetary policy to address the sharp fall in output. Rapid interest rate cuts and successive rounds of quantitative easing meant that the Fed was able to keep real interest rates negative, helping to smooth deleveraging. Fiscal policy was deployed in the immediate aftermath of the global financial crisis, and the boost to public demand helped to offset weak private demand.
However, premature tightening of macro policies means risks of a relapse. In 1936, the Fed doubled the reserve requirements for banks and the Treasury began to sterilise gold inflows, slowing the growth of high-powered money. Fiscal policy was tightened, with the fiscal deficit narrowing significantly from 5.1% of GDP in 1936 to 0.1% in 1938. The premature and sharp pace of tightening of policies led to a double-dip in the economy, resulting in a relapse into recession and deflation in 1938.
Similarly, in the current cycle, as growth recovered, policy-makers began to worry about high public debt restraining longer-term economic growth prospects, and so tightened fiscal policy, which has contributed to a slowdown in growth in recent quarters.
Now, the effective solution to prevent a relapse into recession would be to reactivate policy stimulus. Although there remains some space for monetary policy, we are approaching the limits, and the effectiveness of monetary easing is waning. Fiscal policy can be employed to boost demand, but policy-makers are hesitant or constrained by the political cycle to fully employ it as a counter-cyclical tool.
Activating fiscal policy, particularly when the monetary policy stance is still accommodative, could lead to a virtuous cycle in which the corporate sector takes up private investment, and sustains job creation and income growth.
Structural reforms that boost productivity growth have an important role to play, but we think activating fiscal policy will be critical to crowd in private investment.
We think that policy support will have to remain in place until inflation expectations have stabilised, and we see signs that the private sector has shifted to risk-seeking again. For now, the evidence indicates a risk-averse private sector, which means the key factor determining the macro outlook is an effective policy response. Our base case is that the policy response remains somewhat hesitant and global growth remains below trend.
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In other words, Morgan Stanley is in Bank of America’s camp, which as we reported last week summarized sentiment as follows: “Wanted: Policy Panic” – Why The Biggest Investors Are Praying For A Market Crash. What this means is that in order to spur the next big move higher in risk assets, now that the credibility of central banks to do it on their own has been all but exhausted, politicians will need to see a significant drop in asset prices to be shocked out of their “Get to work Mr. Chairman” stupor and launch fiscal policy, either sterilized or in the form of helicopter money. We are confident we have a hint which one Morgan Stanley, and all of Wall Street, would rather see…
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