Nailing down the nominals
by Peter Warburton - 28 September 2016
The painfully slow growth of nominal (current value) incomes and expenditures is a source of great consternation in policy circles. In the most recent data release, the value of US GDP rose by only 2.4% from a year earlier, tumbling from 4.9% growth in the third quarter of 2014. At various times, Larry Summers and Charles Evans (Chicago Fed) among others have proposed that a growth target for nominal GDP should replace the current framework of inflation targeting in the US. Why the crescendo of interest in nominal GDP targeting?
It’s the debt, stupid! Quite simply, all the advanced economies need faster nominal growth in order to turn back the still-rising tide of indebtedness of households, companies, and governments. While the expansion of private sector debt in response to record-low interest rates has been less than overwhelming, it has exceeded the recent pace of nominal GDP. Hence, leverage is rising in most advanced economies.
The paradox for policymakers is that the revival of nominal GDP rests on a reversal of the prevailing policy stance in the realms of monetary policy, fiscal policy and financial regulation. Let’s think in terms of the Cambridge equation: Money stock (M) multiplied by the income velocity of money (V) = price level (P) multiplied by transactions volume (T). The facilitators of the growth of nominal income (P.T) are monetary growth and quickening velocity.
The framing of fiscal policy and the management of government debt is geared to neutralise the impact of government borrowing on the money supply. Central bank purchases of government debt make an exception to this principle and, indeed, when the Fed was engaged in new asset purchases (until late-2013), these contributed to monetary expansion. Since then, fiscal outturns have been deliberately neutral in monetary terms.
Encroaching international financial regulation, following the global crisis in 2007-09, has severely limited the expansion of commercial bank balance sheets and has steered banks towards the purchase of Treasury and agency securities rather than the increase of their loans to businesses and individuals. Regulatory constraints, consistent with Basel 3 and Dodd-Frank, have stymied the banks in their role as intermediators of cheap credit.
The force of monetary policy actions over the past 7 years has been to lower short-term interest rates to near-zero, crush the term premium and compress credit quality spreads for corporate debt. These actions have necessarily weakened the velocity of money, inviting private sector savers to retreat to the ‘safety’ of government and corporate bonds.
The chart shows intervals of close correspondence between M2 money velocity and 10-year Treasury bond yields, but other periods of divergence. Essentially the divergence between the early 1990s and 2007 is explained by de-regulation of the US financial system and the associated expansion of shadow banking. The financial crisis triggered the demise of shadow banking and since then, the path of velocity has reassumed its association with the ‘opportunity cost of money’.
Nominal income growth has been weak because US economic policy has nailed down its facilitators: growth of the money stock and quickening velocity. In order for the US to achieve materially faster nominal GDP growth, it must relax some combination of its domestic financial regulations (repealing Dodd-Frank), permit the under-funding of the budget deficit and withdraw from the policies of financial repression that have contributed to an over-priced and distorted bond market.
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