For those of you who missed the 1990’s, the movie Speed inexplicably became a box office hit. The villain, played by Dennis Hopper, attaches a bomb to a bus that will explode if it goes under 50 mph. What follows is a trail of destruction through Los Angeles as Keanu Reeves and Sandra Bullock keep the bus moving above that speed.
For a couple years I’ve followed Scott Sumner’s excellent blog theMoneyIllusion. In the past our monetary policy has targeted gold, stock prices, increasing levels of economic growth, inflation and, now, a mix inflation and employment (supposedly). In fact, the Fed has targeted under 2% inflation at the expense of employment, though has woken up to this problem in recent years. Professor Sumner’s solution would see the Fed target nominal GDP growth at 5%, year after year. If the economy slipped into recession, the Fed would allow inflation to rise. Conversely, if real economic growth was more robust than 5%, the Fed would allow falling prices.
Like the movie, the bus would have to maintain the same speed no matter what the consequences. In fact, the Fed seems to be following a similar policy, but the set speed is 2% inflation rather than 5% NGDP growth. Other mechanisms suggested are targeting the price of gold, or growth in the money stock. Like the bus, all these targets have consequences for the overall economic landscape. House prices, stock markets, wages, unemployment rates, oil prices: all of these will adjust to the metric the Fed uses. Janet Yellen is already playing the part of Dennis Hopper. She’s just chosen a different metric than the speed of the bus (maybe it’s more like RPM’s).
But the Fed has half-learned the lessons of 2008. Collapsing NGDP caused the financial crisis, and the Fed took strong actions to restore it. Bernanke, and then Yellen, pointed a gun at the economy (a combination of QE/forward guidance) and said NGDP must grow at a certain level. It cannot collapse.
With this quasi guarantee, how has the landscape shifted? Stock valuations are higher. With the prospect of guaranteed macro-economic stability, the “riskiness” of equities is less as earnings should stabilize (see Kevin Erdmann’s post). If the Fed can keep NGDP growth between 4-5% ad infinitum, P/E ratios should reflect decreased risk. Perhaps that will change. A constant speed could mean labor takes home a greater share of the constantly growing pie. Then stock markets would suffer as a new equilibrium was reached. But the speed would stay the same. As an aside, with the entry of millions of new workers into the global economy, I don’t see this happening anytime soon.
Housing prices have also recovered. I recently asked the question: can the same bubble happen twice? I don’t think it can. Again, reading Kevin Erdmann’s intriguing series on housing, it seems that house prices are simply poking through to their real value in light of the new macroeconomic reality.
Every monetary policy idea put forward is really a different version of the movie Speed. Targeting 0%-2% inflation had its consequences in the 2008 financial crisis and worries about the zero bound. Before that, the commitment to the international gold standard in the face of French deflationary policy had its consequences in the great depression (read this fascinating book Gold, France and the Great Depression, 1919 – 1932). As a target speed, it seems like the time of 5% NGDP growth has come, and may already be here. Investors need to be aware of the shift and realize that current P/E ratios may be the new normal in this entirely changed game.