Between a Rock and a Hard Place
John Mauldin's Outside the Box

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There is the strong possibility that policy makers in the US and UK will not time the transition from the current quantitative easing to a more tightened monetary policy. That is not because they are no competent. It is because the task is very tricky and there is no play book outlining the steps. This is not Tom Landry (former Dallas Cowboy coach) pacing the field with a play for every situation already planned and practiced well in advance.

The odds favor they will either be too late or too early. Getting it "just right." The Goldilocks play, would be more than fortunate. In fact, there may be no right play to call. They may be forced to choose between a slower economy and/or inflation/deflation. And as this week's Outside the Box authors note, there is also the possibility of yet another asset bubble, making the choices even more risky.

Those who are absolutely positive about which of a variety of outcomes will emerge have a level of clairvoyance with which I am not familiar. It makes risk asset (like stocks) investing particularly tricky right now. This is a time to be nimble and avoid creating opportunities for large losses if you are wrong.

We will start this week's OTB with a few paragraphs from the Bank Credit Analyst about the Great Depression and then move on to a piece from the London office of Morgan Stanley on the problems facing central bankers.

And on a less ominous but more important note, the Muscular Dystrophy Association (MDA) has issued a warrant for my arrest which goes into effect on August 26th! I will be held at the PM Lounge in the Joule Hotel from 3-6. My bail is set at $2,400, which will benefit local families living with neuromuscular disease. No one person can set me free. It will take a little help from all of my friends, family, colleagues and enemies! Please use the link below to visit my Bail Page and help me post my bond by contributing in any way that you can. Thank you for having a big heart! And come see me in jail!


And now, the thoughts from BCA.

John Mauldin, Editor
Outside the Box

"Prematurely exiting from an accommodative policy setting, derailed the recovery in the late 1930s and led to another leg of the depression.

"By mid-1936, the Federal Reserve lifted bank reserve requirements, in an attempt to soak up liquidity and prevent speculation from returning to Wall Street. However, the banking system was still too fragile and in need of capital. Consequently, both narrow and broad money growth plunged from a healthy clip back into negative territory. To make conditions worse, by 1937 fiscal stimulus programs ended and social security taxes were collected for the first time. The federal deficit shrank rapidly from -5.4% to -1.2% of GDP, creating significant contractionary forces.

"Obviously the economic relapse in the 1930s is an extreme example. Nonetheless, it does highlight the risks of authorities exiting prematurely before the economy and banking system are ready (even after an extended period of healthy growth). Currently, U.S. and U.K. money multipliers are still impaired, although aggressive easing has allowed some liquidity to flow through to the real economy. A decline in U.S. M2 growth would be a major warning sign. U.K. broad money growth has plunged in recent months, presenting a significant threat to the economy.

"Bottom line: Policymakers will need to continue to curb investor expectations for an early exit in order to allow a sustainable recovery to materialize. It will likely be at least until the end of next year before growth conditions in the U.S. and U.K. are robust enough to withstand a reduction in stimulus." (

Between a Rock and a Hard Place

By Manoj Pradhan & Spyros Andreopoulos | Morgan Stanley, London

Monetary policy usually finds traction in the real economy through different ‘channels of monetary transmission', working through falling interest rates, increasing asset prices and increased lending by banks. These translate into more consumer and business spending, which boosts economic growth. During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery. Turning away from the inflation-targeting (IT) regime that is now conventional wisdom to perhaps a price level-targeting (PT) regime or even explicitly accounting for asset prices may give central banks much-needed flexibility.

The Sequence of Events in Economic Recovery

In a garden-variety recession, policy rate cuts lead to declines in lending rates and slow traction in the form of a better outlook for consumer and business spending. Risky assets usually rally a quarter or two before the recession ends, whereas credit growth usually picks up only after recovery sets in (see "Credit Confusion", The Global Monetary Analyst, February 4, 2009). The Great Recession has not scrambled this sequence of events but it has changed the timing and response of some. Because of the freezing of credit markets, the interest rates that matter for borrowers fell much later than they would have during a more typical episode. Also, given the massive task of repairing balance sheets that confronts commercial banks and households in particular, spending and borrowing are likely to remain subdued. The risk is that credit growth could lag the end of the recession by more than usual. However, risky assets seem to have stuck to the script and rallied ahead of the bottom in economic growth by a familiar lead time.

Interest Rate Channel Less Effective So Far

When central banks cut policy rates, other interest rates respond quickest to the policy move. By providing cheaper borrowing rates to households and businesses, central banks aim to encourage spending and spur production. This is the ‘interest rate' channel for monetary transmission. This channel typically carries the bulk of the burden of resuscitating the economy. Untraditionally, during this current cycle, interest rates that matter to borrowers have fallen very slowly and much later than the cuts in policy rates. Even as they have fallen, however, they have met households who are reluctant to exploit these low rates, given the desire to save in the US and the UK and the conservative habits of German and Japanese households.

Credit Channel Likely to Be Subdued as Well

During a recession, credit flows to the private sector usually fall. Banks are less willing to lend and households and firms are less willing to borrow. Policy rate cuts normally provide commercial banks ‘carry' via a steeper yield curve, allowing them to borrow money at low rates and lend it at higher rates. In this cycle, central banks have had to resort to unconventional measures in addition to rate cuts to ensure that banks had the benefits of a steeper yield curve and an abundance of liquid funds to lend if they so desired. Surveys suggest that banks are becoming more receptive to lending but credit will likely grow with a lag (again see Credit Confusion) and quite slowly thanks to banks and households slowly rebuilding their balance sheets.

Asset Price Channel Leading the Charge...

Risky assets have outplayed the other channels by a margin over the last few months. This is an encouraging sign for central banks, who will undoubtedly welcome the economic traction that accompanies rising asset prices. A rise in equity prices should enhance the incentive to invest because the higher price of existing capital implied by higher share prices increases the relative attractiveness of investing in new capital (Tobin's q). Back in March, with the worst of the economic bad news likely already having been delivered and ultra-expansionary policy in place, risky assets rallied and rallied hard, which is a positive for investment. A possible bottoming in the housing market in the US and the UK would mean that Tobin's q could be applied to the housing sector as well. Households are more likely to buy new houses if house prices are rising, and this encourages homebuilding activity. Also, rising asset prices have supported the balance sheets of financial institutions.

...but Risky Asset Rallies Come at a Cost

One of the most important lessons from the Great Recession is the damage that asset bubbles can wreak. As the Fed and the ECB kept policy rates low for a very long time after the 2001 recession to ward off deflation concerns, they chose to allow an ultra-expansionary policy to inflate asset prices. Even though economic growth in the next couple of quarters could be very strong, the medium-term outlook for the major economies and therefore for global growth remains quite fragile. Policymakers therefore may end up having a repeat of the 2001-type dilemma on their hands.

Between a Rock and a Hard Place

If the imbalance between risky asset prices on one hand and interest rates and credit on the other persists for a significant period of time, the transition from über-expansionary policy to a neutral stance could be an extremely tricky balancing act for central banks. In the long run, asset prices cannot keep exceeding the growth potential of the economy. However, over shorter horizons, a loose policy regime with plentiful excess liquidity can lead to significant asset price inflation when markets see an improving economic outlook. If policymakers allow asset prices to surge because the other transmission channels have been weak, they risk inflating the type of bubble that got us here in the first place. If they decide to head off asset prices by tightening policy, they risk raising rates into a weak recovery! The transition to a neutral policy stance thus requires greater balance between the channels of monetary transmission - ideally from interest rates and credit growth gaining better traction in the economy as asset price inflation cools down. This balance is far from guaranteed. Worse, a revival in credit growth could further stoke asset price inflation. Not the best news for central banks.

Inflation Targeting Too Stringent

What could central banks do if they find themselves in such a situation? Using the interest rate tool to quell asset price inflation when the economy is yet to recover fully would risk sustained deviations from the inflation target on the downside. At the same time, it would expose central banks to criticism from politicians and the public since the policy might jeopardise the recovery. Central banks might try to counter the pressure by arguing that pricking asset price bubbles would foster price stability over a longer time horizon by preventing crises such as the current one. But this riposte would be problematic in the current policy framework. Deliberately using policy rates to pursue objectives other than inflation - especially in a way that is detrimental to achieving the inflation target - is incompatible with the inflation-targeting (IT) orthodoxy. More to the point, pursuing asset prices could deliver a fatal blow to the transparency of the monetary policy regime. If the public is unclear about what the objectives of monetary policy are, it could lose faith in the central banks' commitment to price stability and inflation expectations would become unanchored. One of the main advantages of IT - transparency - would then be rendered defunct.

A Way Out?

Assuming CBs want to ‘lean against the wind' of asset prices, is there a way for CBs to escape the strictures of orthodox IT without risking the loss of their holy grail, the credibility of monetary policy? Price level targeting (PT) may be the answer. Under PT, the central bank aims at a certain path for the price level, with the rate of increase in the price level given by the inflation target (see "From Inflation Targeting to Price Level Targeting", The Global Monetary Analyst, July 15). PT differs from IT in that past deviations from the inflation target have to be corrected. For example, with a price level target path consistent with 2% inflation, if inflation in one period is 1%, then it would have to be 3% in the next period. The undershoot in one period would have to be compensated for by an overshoot in the next period in order to return to the price level target path. In short, PT is essentially ‘average inflation' targeting.

How Would PT Help Central Banks?

By effectively increasing the time horizon over which the inflation target can be achieved, it would give monetary policy much-needed flexibility to, if necessary, pursue asset price inflation in the short term. At the same time, long-term inflation expectations would remain anchored since monetary policymakers would commit to achieving 2% inflation on average. Indeed, inflation expectations under PT would themselves have stabilising effects on the economy. While inflation undershoots the target temporarily in order to burst the bubble, the public would know that this would soon require a compensatory overshoot. Short-term inflation expectations would then rise, decreasing real interest rates. This would, in turn, increase spending and output.

In summary, the transition from ultra-expansionary policy to a neutral stance may be very tricky if the imbalance between different channels of monetary transmission persists. Central banks may find themselves hiking into a weak recovery to quell asset prices, or they might compensate for the weakness in the interest rate and credit channels and allow asset prices to rise but risk inflating another bubble. Central banks could gain some much-needed flexibility by thinking outside the IT box - but whether they will make a dramatic move and switch to a PT regime remains to be seen.


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 08-24-2009 2:06 PM by John Mauldin


Glenn Goya wrote re: Between a Rock and a Hard Place
on 09-03-2009 8:17 PM


What do you think about JPMorgan's recent forecast of a "V" shape recovery saying that they are banking on the Fed's not tolerating a 9 or 10% unemployment rate. Also, the Fed and Obama will keep liquidity high until clear signs recovery under way. They will tolerate some inflation for the sake of of faster recovery and reducing unemployment.