PIMCO bond manager Bill Gross says the Federal Reserve’s low policy rate is sufficient to provide a return on investment for stock and bond owners, but does not induce the sort of productive investment needed to generate long-term economic growth.
In his September investment outlook appropriately titled “For Wonks Only,” the fund manager offers his insights into the economic theory behind his oft-stated “New Neutral” thesis, which holds that a levered global economy severely limits how much the Fed can raise rates.
Two variables figure in the monetary straitjacket Gross describes: credit creation and credit velocity.
The former must constantly expand at a high enough rate to pay interest on previously issued liabilities so as not to trigger the need for the sale of existing assets.
If the current rate on outstanding debt in the U.S. is 4.5%, the Fed should target credit expansion of at least 4.5% per year. Nevertheless, credit expansion has averaged just 2% for the past 5 years and only 3.5% in the past year.
U.S. underachievement in credit creation is to blame for today’s economic stagnation, where the economy struggles to reach 2% real GDP growth.
A second variable of monetary policy is the velocity of money. Gross says no central banker knows how fast money should be changing hands in the economy and must therefore only dial the level up or down cautiously in order to avert a credit collapse.
But as a general rule, he writes, “the projected return on financial assets (relative to their risk) must be sufficiently higher than the return on today’s or forward curve levels of cash (overnight repo), otherwise holders of assets sell longer-term maturities and hold dollar bills in a mattress — lowering velocity and creating a recession/debt delevering.”
We may be “dangerously close” to that level where the mattress is more appealing than a Treasury bond, Gross warns.
Indeed, the portfolio manager says that were it not for the Fed’s low policy rate, which he has argued will peak at 2% in 2017, stock prices would be too risky relative to their return at today’s interest rates.
For now, Fed policy is supportive of continued asset price growth, but long-term economic growth will not be forthcoming absent productive investment in the economy.
Gross says that central bankers are looking hopefully to elected leaders to solve that problem of weak growth through deficit policies and tax reform that might revive “capitalistic animal spirits.”