Next month’s election is the first since the Federal Reserve ended Quantitative Easing (QE) efforts. But it’s clear that monetary policy and the Fed has taken the spotlight away from the candidates’ fiscal policies and plans for economic growth. This is the direct result of two major trends over eight years.
First, Congress’ failure to find common ground with President Barack Obama has produced a tremendous amount of gridlock on even non-partisan issues. Traders largely anticipate that gridlock in Washington will produce an ongoing business climate that fails to address the worst economic recovery since World War II.
As a result, Federal Reserve Chair Janet Yellen, and Ben Bernanke before her, have been at the center of financial coverage as the Fed’s easing policies and rate-hike speculation have become, rightly or wrongly, the primary influence of market performance during the Obama Presidency.
Based on expectations, neither Rupublican candidate Donald Trump nor Democratic candidate Hillary Clinton will be the most important figure in Washington during the next two years. That title belongs to Yellen, whose fraught face on our cover highlights our realization that markets will look to the central bank for further guidance on the U.S. economy.
Each day, pundits speculate on the Fed’s next move. Headlines pin daily gains and losses on rate-hike probability fluctuations from the CME Group’s FedWatch Tool. CNBC has become the Fed network leading up to each FOMC meeting.
“There is a hyper-obsession that is almost deranged,” says Steve Moore, distinguished visiting fellow at the Heritage Foundation, about this coverage.
Yes, the problem has been exacerbated by Trump’s statement reversals on Yellen. He was in favor of low interest rates until he was against them. He has cheered Yellen’s tenure, and later accused her of politicizing the Fed. But this is just a series of headlines.
The real trouble is the Fed’s influence — real or perceived — on the markets.
Brian Barnier, principal at ValueBridge Advisors and founder of FedDashBoard.com, argues that the Fed’s stimulative policies fueled more than 93% of all S&P 500 movements between 2008 and 2014.
“Central bankers wanted a quantitative easing ‘wealth effect’ where stock price increases would pump-up consumer spending and thus business production,” Barnier wrote in April. “Their hope was that stock prices and business production would raise together — a balance that would avoid stock market bubbles. Instead, central bankers got what they feared — bubbles as stock prices rose faster than the tangible economy.”
Barnier argues the best measure of a stock market bubble is based on how much a stock market rises in comparison to the fundamental of “ringing cash registers.”
Barnier’s research dates back to World War II. Future GDP estimates fueled 90% of market performance through the 1970s. A dramatic expansion in household debt explained 95% of market moves into the first Clinton presidency.
As the tech bubble began to inflate, Barnier shows that 97% of that market bubble came from the increase in commercial paper. Next, the housing bubble helped explain 94% of market moves into 2008.
Since then, it has been the Federal Reserve’s show, while Washington has failed to establish a pro-business climate. Barnier has called the Fed’s efforts a monetary shell game. “The Fed set out to create a wealth effect, but it didn’t work. It has done nothing but produce a big bubble.”
Monetary policy is not a long-term solution (just ask Japan), but a short-term focus on the Fed’s next move has been the driving media narrative for eight years. At best, some CNBC and print pundits fail to understand the limitations of monetary policy. At worst, they provide cover for a flawed idea that we can do the same thing over and over again, and anticipate different results.
That coverage has also helped produce an “illusion of control” — a concept advanced by hedge fund manager Mark Spitznagel of Universa Investments.
“Central banks are so small relative to the global financial markets, and we greatly overestimate their ability to set prices,” says Spitznagel. “They are the tail wagging the dog. The end game of this enormous bubble will be the eventual abandonment of this illusion. This can come from an unwind of central bank balance sheets, so I doubt that will happen.
It can also come from the collective psychology shifting, from its own dynamics — this is what ultimately drives markets. While the illusion of control has, of course, been a virtuous circle driving markets up for all these years, it will similarly be a vicious circle driving them back down.”
The long-term health of the U.S. markets relies on more than just Fed intervention, lest we dissolve into the quagmire fueled by the Bank of Japan.
“The general driver of economic growth is always productive capital investment. Problem is, that’s just happening less and less. This is an unintended consequence of artificially low rates, which induce a mad, levered scramble for short-term yield rather than patient long-term investment,” says Spitznagel. “Keynesians can’t seem to wrap their heads around that. When we are starved for yield, all that matters is that next cash flow.”
A Fiscal Fix
The Fed’s increased significance has been influenced by gridlock in Washington. Congress has failed to step up and provide a better solution to America’s troubled business environment, leaving more pressure on the central bank.
The debate – and the pressure – needs to shift to ways to improve capital investment and inspire growth. U.S. GDP has not ticked above 3% during the last eight years. It is the first time that a President has been in office for eight years but failed to top that figure.
“Our problems are largely fiscal,” Moore says. “And you can’t print jobs by printing money.”
Addressing fiscal policy must be the priority of 2017 in Washington. Moore argues this would help promote a real economy that drives stock prices.
One would have hoped that this election would have inspired fresh approaches to address the weakest economic recovery since World War II.
Hyper-partisanship has produced #NeverTrump and #AnyoneButHillary movements. These hashtags foreshadow another four years of Washington gridlock, even though traders and investors are truly begging for “anything but the status quo.”
We contend our economy is, as well.
On the fiscal policy side, both candidates offer 20th century policy solutions to an evolving 21st century economy. It is also frustrating to take either candidate on their word about plans to create a better environment for business in America.
Trump’s economic plan does promote more growth, but America’s problems require a long-term, streamlined policy commitment, not a four-year compromise constantly under the bombardment of critics. More troubling is Trump’s throwback idea to 1930s-style tariffs, which rightly scares investors.
But Clinton’s plan is more of the same. A commitment to raising taxes on the wealthy and feeding the expansion of more bureaucracy through reckless command economy efforts. It was Congresswoman Nancy Pelosi (D-CA) who argued that welfare payments were the best way to stimulate an economy. That’s the Keynesian flaw: Borrow and spend yourself into prosperity. And when it doesn’t work, double down on calls for more spending and replace all the shovels with spoons.
Expectations for fiscal reform are low because of one obvious problem, tax policy. Economists recognize the economic drag caused by tax code distortions. Politicians view taxation as “revenue.”
In August, Northwestern University economist Robert Gordon wrote that capital formation has plunged back to levels not seen since the 1980s. A primary problem: The tax code.
“The American tax code exerts a downward pressure on capital formation and therefore on economic growth,” writes Gordon. “It is now 30 years since the passage of comprehensive U.S. Federal tax reform. In the intervening years, nearly every developed country has reformed its tax codes to make them more competitive. Meanwhile, the United States has allowed its tax code to atrophy.”
Both Gordon and Moore advocate for tax reform to bring jobs and capital back to the United States and improve competition.
“When we start thinking about tax reform, we should start with the principle of revenue neutrality, the idea that all corporate income should be treated in the same way, no matter how it is earned,” Gordon writes. “The goal should be to eliminate all special provisions and to reduce the corporate tax rate to a level competitive with our international partners.”
Real tax reform in the first year would help help ensure that businesses reallocate capital and set a long-term focus on economic growth in development in a nation desperate for real growth.
Tax reform is not a left or right issue. It is an up or down matter that requires Washington’s attention right now. We will be paying close attention to the rhetoric heading toward Nov. 8. We also offer support to any current or future candidate who offers the most convincing case for a commitment to real tax reform.
Pro-business tax reform would also send a signal to the markets: We’re focused on long-term solutions, not the latest sugar high from cheap money.