When Monetary Policy Fails
Raising nominal GDP growth (inflation plus real growth) remains the primary goal of most central banks around the world. According to Eisenbeis, adding real growth plus inflation creates a decent proxy for what the fed funds rate should be, though it isn’t the formula the central bank uses. If it were, fed funds would be paying between 3.5% and 4.0%, a far cry from the current 0.1%.

Little wonder then that achieving their nominal GDP objectives remains remarkably elusive. For many overleveraged nations, a small amount of inflation could make their debt loads more manageable.

“It’s disturbing that we could have QE all around the world with negative interest rates and we can’t get inflation going,” says J. Michael Martin, chief investment officer of Financial Advantage Inc. in Columbia, Md. “Many people think real inflation isn’t even 1.5%.”

Indeed, the inability of central banks to spark any meaningful nominal GDP raises questions about the efficacy of the instruments in their arsenal. “The real economy is OK, but the nominal economy is where the problems are,” says Richard Bernstein, a former chief market strategist at Merrill Lynch who now runs his own asset management firm. “You can lead a horse to water, but you can’t make it drink.”

It’s no mystery what’s wrong in Bernstein’s view. “Monetary policy should be impotent when you are dealing with deleveraging from a debt bubble,” he says. “In the absence of the credit market functioning properly, you need fiscal policy to take charge. What you got was fiscal policy working in reverse.”

Since 2010, the U.S. private sector has been growing at about 3.0% a year, decent in a recovery from a financial crisis but hardly spectacular. “For the first time since the 1950s, government spending actually went down for several years [since 2010],” Bernstein says. Contrary to popular mythology, the 1950s were hardly the happy boom times some Americans vaguely recall. The economy experienced three recessions and grew at the same anemic 2% rate as it deleveraged from World War II.

America was only one of many developed nations to embrace austerity in the post-financial crisis world. In the European Union, budget guidelines theoretically placed a limit on any stimulus program a nation could initiate domestically. The European Central Bank (ECB) failed to launch a quantitative easing program until 2012, a year after Mario Draghi replaced Jean-Claude Trichet as head of the ECB.

Many share the view that comatose fiscal policy was a major cause of the weak global recovery. But skeptics pointed to the experience of Japan, where numerous stimulus programs and variants of zero interest rate policy have been implemented repeatedly for two decades with negligible results.

Even though the U.S. has a reserve currency and none of the restraints that EU nations face, the world is too interconnected to operate in a void. Even though the U.S. domestic economy has displayed sufficient strength for several years to withstand a small hike in interest rates, the problem, as minutes of Fed meetings reveal, is the rest of the world. “The Fed has a domestic mandate and international problems,” Fuss says.

Crisis Part Three: Emerging Markets
No less an authority than IMF managing director Christine Lagarde has led a chorus of voices urging the Fed to maintain the ZIRP in recent months. There is no question that many emerging market nations are facing severe headwinds, including China, Brazil and Russia.

In late September, Goldman Sachs told clients the global financial crisis that began in 2008 was entering its third phase—the first being the U.S. housing crisis and the second being the European sovereign debt crisis. Ground Zero for this third wave, Goldman says, is located in commodity-producing nations and emerging markets.

It is apparent, however, that the individual problems confronting these countries would be only tangentially exacerbated by a 25- or 50-basis point increase in the fed funds rate. China reacted to the Great Recession by launching a massive infrastructure program, building cities bigger than Houston on a quarterly basis that have very few occupants. But its transformation from an economy where investment has accounted for 50% of GDP to one led by services and consumption will take years.

Brazil was an immediate beneficiary of China’s stimulus but now finds itself grappling with spiraling inflation and corruption scandals. Russia, Nigeria and Venezuela are among the many petro-states experiencing severe recessions.

If any consensus surfaced at Financial Advisor’s showcase, it was a visceral aversion to emerging markets. Conditions in China, always hard to read, are likely to get worse before they get better.

“Yum Brands [a giant U.S. operator of restaurants in China] said things were fine in China in August,” notes Joshua Jones, portfolio manager of the Boston Partners Global Long-Short Equity Fund. By early October, Yum was blaming disappointing earnings on guess where.

The last time there was a financial crisis centered in the emerging markets was in the late 1990s, when these nations represented 15% of global GDP. Almost two decades later, their contribution has soared to 40% of the world’s output, as China’s GDP has quintupled since 1990.