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Summary of Thoughts: Policy Dissonance

The post-crisis economic policy mix has focused on achieving a handful of crucial outcomes:

  • Force the financial sector and bond markets to take credit losses from the crisis early and quickly.
  • Stress test financial sector balance sheets, and turbo-charge conservative recapitalization plans with public money.
  • Provide publicly-funded aggregate demand while privately funded aggregate demand is contracting.
  • Use central bank balance sheet policy first to normalize systemically important financial risk premia, and thereafter to stabilize medium- to long- term inflation expectations close to the 2% objective regardless of realized cyclical undershooting.
  • Set and leave short-term nominal “risk-free” interest rates well below the level of expected inflation in the medium- to long- term for an extended period to facilitate financial asset reflation, ultimately leading to a faster recovery in private sector balance sheet health.
  • Monitor financial market prices for destabilizing overshoots, and act as appropriate to prevent them.

Thus far, the U.S. business cycle has progressed largely as expected:

  • Expansionary fiscal policy provided a significant cushion to declining aggregate demand in 2009.
  • Private sector de-stocking in 2009 turned to private sector re-stocking in 2010 on the back of publicly-funded aggregate demand growth.
  • Private sector final demand began to expand in 2011, led by short leverage life consumer durables consumption, which tends to be most responsive to easing financial conditions.
  • Long average life housing investment joined the private sector final demand recovery in 2012, as the financial sector became fully recapitalized and U.S. real estate prices became cheap from a valuation perspective.
  • Services consumption and aggregate labor market demand accelerated in 2013.
  • Capacity utilization increased in 2014 due to a lack of capital expenditures, giving rise to better generalized priced power for corporations.

Looking forward, there are the likely natural next steps in the U.S. business cycle:

  • Improved pricing power, less slack in labor markets and productive capacity, combined with still easy financial conditions in 2014, lead to an increase in expected ex ante returns on newly invested capital, sparking capital expenditures acceleration in 2015.
  • Accelerating capital expenditures in 2015 reinvigorate the flagging operating profits’ recovery in 2016, thereby creating the necessary conditions for a self-sustaining private sector positive feedback loop and an eventual exit for the Federal Reserve from extraordinary monetary policy.
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