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More fiscal and monetary stimulus means more slo-flation



The Law of Unintended Consequences, coupled with a contrarian mindset, is often the best way to understand the impact of government policies on the economy: whatever the government is trying hardest to do, expect the opposite. At the very least, remain very skeptical.

Today the FOMC reminded us that they are trying really, really hard to stimulate the economy by keeping short-term interest rates very, very low, "at least through late 2014." Notably missing in today's FOMC statement was boilerplate which promises that the FOMC will keep its eye on the evolution of inflation and inflation expectations. The Fed is trying to be bold, but even they realize that "a highly accommodative stance for monetary policy" is only likely to foster more inflation rather than more growth. Rising inflation expectations sap some of the economy's vitality by steering resources to speculative activities (e.g., buying gold and stockpiling commodities, buying other currencies), rather than taking on real risk by investing in new plant and equipment and creating new jobs.

Last night, in his SOTU speech, Obama reminded us that he is willing to do just about anything to help the economy grow—except to give the private sector more room to work its growth magic. That would expose the fatal conceit of those, like him, who believe that nothing good can come if it does not originate in Washington. It's not enough to just lower the corporate tax rate to a more competitive level and eliminate loopholes and tax subsidies. He'd rather punish corporations that "export" jobs overseas, and reward those who bring them back, as if the federal government or mere politicians knew better how to manage a business like Apple than Tim Cook. Unfortunately, the more changes to the tax code designed to create politically-favored outcomes, the more distortions this introduces to the economy and the less growth we are likely to get.

Today's market reaction to the SOTU speech and today's FOMC news was consistent with this interpretation: thanks to myopic fiscal and monetary policies, we're likely to see somewhat more inflation, and only modest real growth. Call it slo-flation, rather than stagflation.


The 10-30 Treasury spread is the only part of the yield curve that is more or less immune to Fed ministrations. By pledging to keep short-term rates very low for years, the Fed can dominate interest rates out to the 10-yr maturity area. But they have very little control over interest rates beyond 10 years. The 10-30 spread has been widening since last October, in line with the rise in forward-looking inflation expectations, as shown in the above chart. Both jumped today because the bond market is getting nervous about the prospects for inflation.


Gold shot up by $43 in the wake of the FOMC announcement. This makes perfect sense, since extremely low borrowing costs locked in for a long time make it easier and safer for speculators to bet on rising gold prices, and extremely accommodative monetary policy promised for as far as the eye can see only undermines the outlook for the dollar's purchasing power, thus boosting the demand for tangible assets.

The S&P 500 inched higher, up only 0.5% as of this writing. The trailing PE ratio of the S&P 500 is still less than 14, substantially lower than its long-term average of 16.6, and Apple's trailing PE of 12.75 and expected PE of 11.21 is hardly what one would expect to see for a rapidly-growing company. Low PE ratios—especially in today's environment of super-low interest rates—can only mean that the market is highly skeptical about the prospects for future growth.

Equity and high-yield debt prices are rising—reluctantly—mainly because the risk of deflation is disappearing, and rising inflation means faster nominal growth and that is good for corporate cash flows. But PE ratios remain depressed, since the promise of true growth remains elusive.

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