Rising house prices, records in the stock markets, extremely expensive bond markets and a new high for bitcoin have caused the total assets of American households to rise by an unprecedented 20 percent in one year. That is more than the total GDP of the United States, expected to reach $21.5 trillion this year.
Consumer spending makes up 80 per cent of that GDP, so even if the American consumer spends only a fraction of the increase in wealth, it has a major positive effect on US economic growth.
Now the US economy is almost a quarter of the world economy, so the contribution of US consumer spending to the world economy is close to 20 per cent. If American consumers decide to spend a quarter of the wealth they have accumulated next year, that alone would be enough to grow the world economy by 6 per cent.
They are not just rich, they feel rich
Consumer spending is affected by several things. Many consumers spend what comes in. Americans, in particular, are not known for being big savers. Larger investments such as a new house or a new car require more. Such investments are often related to the bigger steps in a person’s life, such as marriage or having children. Increased prosperity means that more and more Americans can and dare take such a big step.
They are not only rich, but they also feel rich. Moreover, nowadays there are more vacancies than jobs, which ensures a high level of job security. That combination guarantees strong growth in consumer spending and, since that is 80 per cent of the economy, it will determine economic growth next year.
The problem is supply
That extra demand has to be met by extra supply. That is a problem. The Federal Reserve may point to the coronavirus crisis as the major cause of the supply-side problems of the economy, but those problems would not exist if demand had not been so strongly stimulated by the actions of the government and that same Federal Reserve.
Hardly any investments were made in new factories during the pandemic. Hardly any new staff were hired either; there are still millions fewer people at work compared to the pre-corona period. The oil industry is having a rough time of it: in the United States, only a third of the drilling rigs are still working compared to the pre-Corona period when the price of oil was at a similar level.
It is not surprising that demand is outstripping supply and prices are rising as a result. Normally, central banks respond to rising prices by raising interest rates. In the past, it was important for a central banker to stay ahead of the market in order to quell the slightest threat of inflation. By raising interest rates faster than the market expected, the central bank was ahead of the curve. That curve in this case is literally the interest rate curve. That curve incorporates expectations about the future.
If you want to know what the five-year interest rate will be in five years’ time, you subtract the five-year interest rate from the ten-year interest rate. In the past, this curve was an excellent indicator of future inflation expectations. After all, inflation is the biggest enemy of bonds. If the central bank raised interest rates enough, the interest rate at the long end of the curve would fall because of the confidence that economic growth and thus inflation would be reduced. Since the Great Financial Crisis, this has changed.
The Fed manipulates the yield curve
The central bank started to interfere with the yield curve and largely side-lined the market. Now central bankers are by far the biggest buyers in the bond market. Even if central bankers were to stop buying now, they would still be the biggest buyers, because the existing portfolio regularly releases loans that need to be reinvested.
So the yield curve is now much less a reflection of inflation expectations and much more a reflection of central bank policy. If they say interest rates will stay low for longer, there is no need for them to rise, no matter how high inflation is. What the central bank should do is cut liquidity, raise interest rates and thereby curb excessive consumption by reducing the prices of financial assets. However, this is no longer possible.
Indeed, since the Great Financial Crisis, central bankers have been striving for financial stability. This instability is caused by high levels of debt. When assets fall in value, the debts that finance them become a problem. The risk then arises that falling prices will increase the nominal debt problem. Hence the remarkable fear of deflation.
Deflation worse than inflation
Central bankers now believe deflation is a much greater risk than inflation. The many decades since Paul Volcker led the Fed have given them the illusion that they can handle inflation. Moreover, inflation is an excellent tool for addressing the debt problem. Reflation, or financial repression, has shown in the past that it works.
Prior to the Great Financial Crisis, most of the high debt was in the private sector (banks and consumers), but today it is in the government. A lot of debt was added during the corona crisis. So much so, that interest rates have to be kept low, otherwise the debts will grow much faster than the economy.
So these days, financial stability is no longer about the stability of the financial system, but about the stability of the country. Then the central bank has no choice. When it comes down to it, the central bank has no choice but to finance the government. The Federal Reserve, too, has no choice but to run behind the curve, resulting in much higher inflation than many had thought possible in recent decades. This seems an untenable situation, but it is not.
The ultimate outlet for this monetary experiment is the value of the currency. It is ultimately the child of the bill. The US government will always be able to pay off its debt to the last dollar; the only question is what can then be bought with those dollars. However, as long as the Fed stays behind the curve, 2022 will be another good year for the stock market.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear on Fondsnieuws in Dutch on Tuesdays and Thursdays and from time to time in English on Investment Officer Luxembourg.