Did Monetary Policy Cause the Recovery- Hussman

Prof. Hussman discusses the relationship between the economy and monetary policy in regards to his opinion what caused the rebounding economy. Hint" it was not QE.

We can quite reliably estimate the long-term returns that stocks are likely to deliver over a 7-10 year horizon. Still, valuations often have less direct effect over shorter portions of the market cycle. The present situation is complicated by the fact that while valuations are extreme from a historical standpoint, investors are tied to a narrative that assumes a cause-and-effect link between monetary policy and market direction. The “follow the Fed” narrative certainly did not prevent the market from losing half of its value during the 2000-2002 and 2007-2009 plunges, despite aggressive monetary easing in both instances, but what matters in the short-run is not the truth of that narrative, but the perception that it is true. 

Since about 2010, normal economic relationships have taken a back seat to ever larger monetary policy interventions. The correlation between reliable leading measures of economic activity and subsequent job growth and GDP has dropped not just to zero but to negative levels (see When Economic Data is Worse Than Useless). Similarly, extreme overvalued, overbought, overbullish syndromes, which throughout history have been closely followed by severe losses, have instead been followed by further speculative gains. The question is whether this reflects a permanent change in economic dynamics, or a temporary overconfidence about the effectiveness of monetary policy.

To address this question, a proper understanding of the credit crisis is essential. Much of the present faith in monetary policy derives from the belief that it was the central factor in ending the banking crisis during what is often called the Great Recession. On careful analysis, however, the clearest and most immediate event that ended the banking crisis was not monetary policy, but the abandonment of mark-to-market accounting by the Financial Accounting Standards Board on March 16, 2009, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The change to the accounting rule FAS 157 removed the risk of widespread bank insolvency by eliminating the need for banks to make their losses transparent. No mark-to-market losses, no need for added capital, no need for regulatory intervention, recievership, or even bailouts. Misattributing the recovery to monetary policy has contributed to a faith in its effectiveness that cannot even withstand scrutiny of the 2000-2002 and 2007-2009 recessions, and the accompanying market plunges. This faith is already wavering, but the loss of this faith will be one of the most painful aspects of the completion of the present market cycle. 

The simple fact is that the belief in direct, reliable links between monetary policy and the economy - and even with the stock market - is contrary to the lessons from a century of history. Among the many things that are demonstrably not true - and can be demonstrated to be untrue even with simple scatterplots - are the notions that inflation and unemployment are negatively related over time (the actual correlation is close to zero and slightly positive), that higher inflation results in lower subsequent unemployment (the actual correlation is positive), that higher monetary growth results in subsequent employment gains (the correlation is almost exactly zero), and a wide range of similarly popular variants. Even "expectations augmented" variants turn out to be useless. Examining historical evidence would be a useful exercise for Econ 101 students, who gain an unrealistic sense of cause and effect as the result of studying diagrams instead of data. 

In regard to what is demonstrably true, it can easily be shown that unemployment has a significant inverse relationship with real, after-inflation wage growth. This is the true Phillips Curve, but reflects a simple scarcity relationship between available labor and its real price, but this relationship can't be manipulated to create jobs (see Will the Real Phillips Curve Please Stand Up). It's also true that changes in stock prices are mildly correlated with subsequent reductions in the unemployment rate and higher GDP growth. But the effect sizes are strikingly weak. A 1% increase in stock prices correlates with a transitory increase of only 0.03-0.05% in subsequent GDP, and a decline of only about 0.02% in the unemployment rate. So to use the stock market as a policy instrument, the Fed would have to move the stock market about 70% above fair value just to get 2.8% in transitory GDP growth, and a 1.4% decline in the unemployment rate. Guess what? The Fed has done exactly that. The scale of present financial disortion is enormous, and further distortions rely on the permanent belief that there is actually a mechanistic link between monetary policy and stock prices. 

We know very well the mechanisms and actual historical relationships between monetary policy and financial markets, and doubt that any amount of quantitative easing will prevent a market slaughter in any environment where investors find short-term liquidity desirable (QE only “works” to the extent that zero-interest liquidity is treated as an undesirable “hot potato”). Still, the novelty of quantitative easing, and the misattributed belief that monetary policy ended the banking crisis, has created financial distortions where perception-is-reality, at least for now. We believe that the modifier “for now” will prove no more durable than it was during the tech bubble or the housing bubble.