3D Economics: Part 2. The avalanche awaits.

The current dilemma central banks are struggling with is how to move money away from the savings economy and into the current, consumption economy. Unfortunately, this will require them to undo much of what they have spent the last decade doing, buying financial assets.

Whether people chose to hold their wealth in the form of savings or consume their wealth is a question of relative values.  The Fed has through its repeated actions shown it will backstop the markets and hence reduced the risk of buying equities and bonds.  Behaviour breeds behaviour and there has been a cycle of the Fed reinforcing the market's view that the Fed "has your back".  Now the size of the savings markets compared to GDP is so large, see below, any shock to the markets will have a much larger impact on the real economy.

Not only does money need to move from savings into consumption but it needs to do this in a controlled way which does not cause either the markets to crash under their own weight but also not cause a tidal wave of demand which ignites hyperinflation. From the chart above, just 1% of stocks and Federal debt is equivalent to 13% of GDP. Releasing this amount of the money supply into the current economy could not be absorbed by an increase in supply in any short number of years.

The Fed's current plan

The objective of 2% average inflation over the long run is a stated aim of the Fed. They believe this will encourage current investment and consumption.  Unfortunately for the Fed, they are not able to target their increases in the money supply towards those who would rather consume than save. Hence their continued call for governments to do more.

However, what they do not seem to appreciate is that they do not need to add to the money supply since there is already too much value soaked up in savings. What they need to do is incentivise people to switch from savings to consumption.  Perhaps they believe implicitly that generating inflation will cause people to bring consumption forward for fear of rising prices.  However, I expect not since this incentive would only work if prices were rising relative returns on savings.

Relative value

Whilst interest rates are near zero there is an expectation for continued capital returns.  This is due to the belief that history, recent history, repeats and also likely due to an expectation that rates will continue to go lower even whilst they sit near zero.

It is therefore not so much that consumption is not attractive but that the relative value in consuming now versus saving is not positive.

Balancing act

The Fed therefore needs to create an expectation of no capital gains or even minor capital losses from savings in order to encourage people to release money from savings into the real economy.  Raising interest rates is a clear possibility but has the risk of causing the crash in markets which has been their focus in avoiding since 2008.  The snow now lies very deep on the cliff face.

The only way the Fed can achieve this balancing act is to allow the market to talk itself into understanding that this course of action is in its best interest. The market needs to believe that yields are more likely now to rise than fall but they will do so at a controlled rate.  However, the risk is that what starts as a light drift of snow turns into an avalanche.

Of course, what action the Fed should have done is now too late. Allowing or even causing small shocks is better than allowing snow to build to a dangerous level.  How can governments ensure people are protected when the inevitable occurs?  A downpour of inflation is the most likely outcome, however it may occur.

Did somebody say "run"

Panic has a very strange way of happening all at once.  Whilst now there seems little reason to doubt the Fed's put under the markets, if the market sniffs the put is not there and the Fed does nothing to convince the market otherwise, there could be one almighty run for the exits.

Last week, Powell noted rising yields but did not show concern.  If he does not indicate in clear terms the Fed still has the market's back, there will likely be a sell-off after next week's FOMC when the market will be looking for him to do just that.