May 25, 2021

Unprecedented stimulus fuels
market distortion

Guest: Todd Thompson, CFA, Managing Director and Portfolio Co-Manager
at Reams Asset Management

In this episode of Markets in Focus

An experiment that started in the wake of the Global Financial Crisis is now entering its second decade, as fiscal and monetary stimulus pours liquidity into the markets. Todd Thompson, CFA, Managing Director and Portfolio Co-Manager at Reams Asset Management, wonders whether policymakers will ever be able to pull away the punchbowl. Todd joins Steve Masarik, CFA and Portfolio Specialist, to discuss how stimulus is distorting markets now and what may happen when the bill comes due.

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Steve Masarik:
The song Crossroad Blues by legendary bluesman Robert Johnson has been interpreted by many of his fans as an allegory of Johnson selling his soul to the devil in exchange for his otherworldly musical talents. This particular tale resides more in the realm of mythology, but what is real is the Faustian bargain that our monetary and fiscal authorities seem to have struck. Under the guise of providing emergency stimulus to help the economy avoid a significant and prolonged recession as a result of the pandemic, the twin barrels of ultra-loose monetary policy and unprecedented fiscal spending have gone into overdrive and there is no end in sight. The immediate results have been mostly predictable and mostly positive. The economy is indeed recovering and risk assets are levitating once again, but there are negative side effects to consider and a final bill that must eventually come due.

This is Markets in Focus from Carillon Tower Advisers. I'm your host today, Steve Masarik. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Be sure to subscribe for new episodes and visit us at for additional insights. Joining me now is Todd Thompson, CFA, managing director and portfolio manager at Reams Asset Management. Todd, welcome.

Todd Thompson:
Thank you, Steve. Glad to be here.

Steve Masarik:
We have talked and written quite a lot about monetary policy in the post-2008 period, but perhaps it would be good to start with a bit of historical context. We are currently stuck at the lower bound in terms of the Fed funds policy rate. The Fed is hoovering up 80 billion of treasuries and another 40 billion of agency mortgage-backed securities per month and the Fed's balance sheet has exploded higher towards the $8 trillion level. Todd, maybe you can kick things off today by answering the simple question: How did we get here?

Todd Thompson:
Great question, Steve. You have to look back and realize this started as an experiment a long time ago, what it seems like, in the wake of the 2008 financial crisis. At that time, you had a residential real-estate-induced recession, crashing of markets, and the Fed stepped in to engineer monetary policy lowered interest rates, but ran into a lower bound at that time as well, what was at the time unprecedented conditions, and had to deal with not just the markets, but the fallout of the correction in real estate and both commercial and residential that was affecting virtually every part of society, which is not just an asset like stock and bonds that are owned by certain segments of the society, but real estate is really affecting everyone, so at that time, they stepped in and used their unprecedented monetary policy at that time and engaged what is now known as "quantitative easing." It started back then.

What that process does is with the Fed using their balance sheet to purchase bonds in the market, it has a tremendous amount of financial liquidity to the system. By them buying assets, the money effectively goes into the banking system, adding liquidity, which is a major domino effect for virtually all financial assets. It's almost like a crowding-out effect. The Fed is purchasing assets for their own balance sheet and that is effectively crowding out the space that other investors could be doing for their own purchases in the open market. In effect, quantitative easing lifts valuations of everything as the demand exceeds the available supply of those financial instruments. Some people have asked, "Is this arguably a form of manipulation of financial asset prices?" Arguably, one could say, yes, it is definitely a distortion of those prices in the market, but manipulation, I guess that's for debate.

Without a doubt, this is all an experiment that started back in 2008 and 2009 and has gone on for much longer than what people have expected. It's simply just one more tool in the toolbox that monetary authorities have at their disposal. The goal was to exit this, which they started to do a few years back when we had economic growth that was strong. They thought that was their window to be able to exit this experiment, but the pandemic changed everything. I don't think they realized they'd be back at this in such short order, but that's how we're here today.

Steve Masarik:
It seems as though there are several potential goals for monetary stimulus. One obvious one is to help avert some sort of immediate disaster, a collapse in capital markets and the follow-through effects on the economy. Another effect of all this QE and monetary stimulus has been a prop-up asset process. As you look up the unprecedented policy response, again, starting back in 2008, it has extended and hasn't really gone away. Has this long-term campaign of monetary stimulus achieved its main goals, and if it hasn't achieved the intended goal of promoting higher growth and stabilizing the economy, why not?

Todd Thompson:
Another great question, Steve. I would say when you take a step back and look at what are the intended byproducts of quantitative easing or this extreme version of alternative monetary policy, it's really to step in and support financial markets. That's the primary. It's basically intermediation. When there is a crisis, there is disintermediation. There's capital that leaves or liquidity to leave some market. The Fed is basically trying to step in and support and provide a bridge of intermediation in the financial markets, almost grease to wheels or grease to a machine to make it operate smoothly.

A secondary byproduct is a wealth effect. If you step in and engage in the first function that normally lifts those prices, it's the crowding out, it's the adding liquidity, the financial liquidity lifts all prices. Well, that creates a wealth effect. The wealth effect then spills over into consumers. Their financial well-being is better as a result and therefore that has a sum of a spillover, a factor associated with it and affects their spending down the line and so those are the main byproducts.

This is only supposed to be a bridge or a temporary solution during times of duress. The goal is provide a bridge and have a handoff until normal consumption in the economy, whether it's commercial or consumer is filling that void and given time, and then authorities can then retrench or pull back that bridge and go back to more of a neutral stance. That is the goal of this and that was the intent back in 2008, 2009 when it was started. Was it effective at that time? Arguably, yes. But one of the main challenges is: How do you effectively withdraw that bridge?

When you look back to, let's say, the 2008-2009 experience, let's judge the efficacy of this program. Was the financial markets supported and recovered? Absolutely. You saw the sharp rebound in stocks and rebound in credit instruments. Without those being recovered, capital formation would be very difficult. That would have a spill-over to business in the economy. From the forefront, you saw capital markets supported, and secondarily, the epicenter of that crisis was commercial and consumer residential real estate. Those markets, in turn, because of the liquidity poured into the system at the time, which would look unprecedented, those markets were supported and found their footing and allowed the clearing process of excess misplaced real estate, misallocated real estate, I should say, to be cleaned up and provide that necessary healing process of that credit cycle. The effectiveness was definitely there. The issue was how to withdraw that bridge once the demand on a global level resumed.

I will point out one thing, although it was effective at creating that near-term bridge, it did have its own set of unintended consequences, or maybe it was intended, but just tolerated consequences. Number one: Prices of financial assets, because of this overwhelming by-program, were arguably distorted. When you have a large purchase program going out there, particularly in the bond world, prices don't reach what might academics would say would be an equilibrium of natural supply and demand, so prices are distorted.

The second point I mentioned, too, is: How do you get away from this? A lot of people have viewed a nice analogy to describe alternative monetary policy is tantamount to a patient in a hospital who is ill and is using a drug to tide them over until their body has a natural healing concept. That's a great way to look at this. Well, quantitative easing works the same way. Similar to that patient, you have to wean them off that drug and get off. Well, we've never effectively seen both sides of that work here in the United States, and globally, quite frankly. We started to wean the patient off that and we've never really saw a full successful off-ramp before we had the pandemic ensue and caused to go right back on that drug again, but we still have yet to see a full circle of weaning the patient off that drug.

Steve Masarik:
Yes, indeed. Going back to your earlier analogy, if it was meant to be a temporary bridge, it sure feels like it's become the foundation. To your point, how do you effectively remove that stimulus without causing a lot of volatility and adjustment in the prices of risk assets? What is your best guess for how the Fed extracts itself from the zero interest rate policy and quantitative easing? We've been in emergency measures mode for 12 years running now. How do we exit?

Todd Thompson:
Before I answer that, one more point that's very integral to this is not just were prices distorted, but one observation of the last 10 years of watching this play out, an unintended consequence is the financial liquidity. Some people have asked, "Does it move the needle in regard to inflation?" That's a great question because even for the last 10 years, monetary authorities have aspired for higher goods and services inflation because it was running uncomfortably too low for the last 10 years and some have wondered whether there's structural reasons for that. Arguably, there has, there's the China effect or information technology. There's a lot of reasons, demographics, that could argue for why inflation is almost stubbornly too low, below the Fed's comfort level.

Some people have asked why they've used this tool. I mean, that's the main tool that's been used for the last 10 years. The other one is fiscal policy before the pandemic, that was really more fiscal neutrality or fiscal restraint, if anything, and budgetary prudence has really been the rule of the last decade, both here and in Europe. But one could argue that the only thing quantitative easing has done, it hasn't done anything with goods and services inflation, but rather has had rather large impact on financial asset inflation. You have to separate the two, financial asset inflation and goods and services inflation. That's alarming. Their goal is to move the needle on goods and services inflation, but we bypass that completely and affected all the financial assets. I think that's something they have to reckon with is that's what we know now to be: When you use financial instruments as the medium or avenue by which to affect this policy, you've now created and pushed inflate inflation over to financial assets and missed your mark completely.

To your question about how to get away from this and how to extricate yourself or to get the patient off the drug, it remains to be seen. It's an open question because again, it requires that legitimate consumption in health of the economy and its natural progression to be able to wean that off. Perhaps we might be there at this point. We were beginning to go down that route in 2015, 2016 when they architect a course to do that and designed a course, but now that all got thrown aside with the pandemic. But now maybe this time, the hope is with a resumption post-pandemic and with the help of fiscal stimulus, there might be some scope for doing that. We could talk about some of the impediments to that, but at least there is some belief that's your best chance of doing that to be able to finally unwind this extraordinary monetary policy.

Steve Masarik:
In terms of timing, though, the Fed has consistently said that they're going to maintain zero interest rates through 2023. This hard-line stance seems rather odd with an economy that is now growing rapidly and signs that inflation is picking up. Is there a breaking point? In your view, is there some data that the Fed may be waiting for, some signal that will finally get them to move away from the super accommodative policy stance?

Todd Thompson:
I think right now the Fed is playing a little bit of posturing, a little bit of a game face in regard to managing expectations in the market. They keep using terms like "transitory" or "temporary" in regard to these near-term threats of inflation and trying to manage expectations that they will be here for the long term, they'll be here to continue the stimulus and not have to disturb the markets with rising interest rates too soon.

However, this is an experiment of unprecedented monetary stimulus and unprecedented fiscal stimulus, almost a double-barreled approach of stimulus all coming at the same time. Although they had expectations for a liftoff and a resumption of employment and economic growth, several things that could go wrong in regard to inflation, in regard to ability to absorb those unemployed people back in the workforce, that anything that could create a discomfort with those numbers of the Fed, they may be forced to take action to remove financial combination sooner rather than what they've led on to believe with this posturing. If it becomes something that's a fear that it's becoming more runaway or more sustained at a level above their comfort zone, they will end up acting much quicker than what they have articulated up to this point. That's really the issue.

Now, that has one vexing issue to this is the labor situation. My guess is as of today there still between eight and 8.5 million jobs still displaced from the pandemic according to economists. Those are not coming down as fast as expected. Now, if the economy were to absorb those jobs rapidly in conjunction with inflation going up, my guess is it would create a little bit of a concern at the Fed and hasten this decision, but what we're seeing now, which is a new challenge to the market, is it's going to be tough to absorb those jobs.

A lot of that, in my opinion, has to do with the stimulus and the benefits that are being offered to people. It's basically saying the government is competing with low-wage employers to compete for those people and now it's created a conundrum at that low-wage point of trying to pay enough to draw those people in off the sidelines. It's trouble. Most of these businesses that are struggling to get employees are at food establishments or retail establishments and some hourly laborers for just general manufacturing jobs in the economy. That now becomes a constraint and a supply shortage, so to speak, and so that is now maybe an impediment to the Fed getting their goals of employment down. But going back to your original question, I think if inflation becomes back to a higher sustained level than what they're comfortable with, it would pull their horizon into unwinding this much quicker than what they've articulated up to this point.

Steve Masarik:
Okay, let's turn to fiscal policy now. Since 2019, Fed Chairman Jay Powell has repeatedly said that monetary stimulus would not be enough in response to crises like the US-China trade war, and later, the pandemic. That fiscal stimulus would also be needed. We certainly have that now. The level of deficit spending is unprecedented going all the way back to World War II. We also have a couple of additional fiscal packages on the table. What are your expectations for the rest of this year and into 2022? Do you expect the fiscal stimulus spigot to remain wide open for the foreseeable future?

Todd Thompson:
This is an incredibly challenging topic because it's gone full circle from where it has been for quite some time. As I said before, fiscal for the last 10 years has been almost restraint or belt-tightening globally. As you know, the mantra has been, "Balanced budgets, balanced budgets," and now there's a new paradigm, it seems. I think what broke this was the pandemic.

As we said before, Chairman Powell mentioned for several years, even before rates were lowered after the China trade conflict, he basically said, "I can't do this alone. We need help at the Fed." I think what that was a tacit admission that monetary policy has limitations near the zero bound. I mean, he was basically saying, "There's only so much we can do. We need to rely on something different," which, of course, he was speaking of fiscal stimulus. Well, we knew that and he finally admitted it, but he basically said, "We need Washington to do some." Well, he got that, but I don't think he had ever envisioned it would be this much on this scale. We had our first installment March of 2020, it was 2.8 trillion all told. We had a second installment December. This was all appropriate at the time.

Let me stop there and say, "What do you mean? What's appropriate when you think of fiscal stimulus?" Well, when you have a sinkhole, that's the way I describe economic growth, that's the way I describe it, last year, a sinkhole of economic growth around the second quarter that has to be filled. That's demand that's lost. It was around 34% annualized in that second quarter because of the stoppage and shut-in in the economy. Well, that needs to be filled in, the sinkhole needs to be filled with artificial demand, or temporary demand. That's what they did. They issued over $2.8 trillion of stimulus. That was roughly 10, 12%, like most of the countries of demand. What that did was filled the hole of demand that was lost because of the shut-in. Academics would say, "Thumbs up, you did the right amount."

But what's surprising is that even though we're coming out of this pandemic, there is another launched program of 1.9 trillion in March of 2021, so we've gone beyond the sinkhole. Now, as you alluded to, Steve, there's two more, the American Jobs and the American Family Program. That is 3.8 trillion that's sitting on deck in addition to that, so it is as if the new administration got some success last year with a much-needed program, but it's almost like the thinking is, "Well, we're on a roll. Let's do some more while the party's still rolling and let's get in as much in as we can," and they're using that much-touted budget reconciliation tool to massage that and make it go through the Senate relatively easy.

This is obviously, again, back to the academics, this is much larger than what's needed, so one can say this has expanded beyond what is needed for the economy and is now moved into more of a political agenda for the administration. That's really what is going on, but that goes back to the issue of how is this going to be funded, and that's why we're talking now about tax increases on income, tax increases on capital gains, among other things to make all this tie together.

Steve Masarik:
I guess the question is: Does it need to be funded? This really dovetails with something that has entered the zeitgeists over the last couple of years, which is the concept of modern monetary theory with the caveat that it's not really modern, it's not monetary in nature, and we could also debate if it's actually a coherent theory, but nonetheless, MMT has certainly entered the picture and we have fiscal spending as far as the eye can see. Todd, can you give us a layman's explanation of what MMT is?

Todd Thompson:
Well, thanks, Steve, because I'm not an economist, but I'll take my best shot at doing this layman's term explanation. MMT, which stands for "modern monetary theory," states that for those countries that have a fiat currency and have the ability to print without limitation of that currency, print additional quantities of it, that you can always print what you need and spend and adjust, use that as a counterbalancing to adjust the economy. That is what it looks like on paper.

Are we doing this the United States as advertised? No, we are engaging in what I call a "pseudo" or "backdoor" way of making this happen. "How's that?" you might ask. Well, we're spending the money, that's definitely happening through the fiscal program, but we're not just printing money and giving that from the treasury to the government to spend on fiscal stimulus or giving it away directly. In our form of modern monetary theory, what we're doing is buying securities when the Fed is purchasing securities for their own account and printing money to make those purchases. The money is going into the banking system and creating liquidity, so it is a backdoor way of accomplishing this.

Or let me say it differently: We're issuing treasury bonds to fund all this fiscal largesse, so to speak. Then the Fed on the other side of the house is growing their balance sheet each month to purchase those same instruments that are being issued to fund the fiscal deficits, and so it is an indirect way and I think that's a way that no one actually has to admit that we're engaging in this process. But for all intents and purposes, it is modern monetary theory. That's how we get to this.

We've talked about two programs today, a monetary policy, Jay Powell and what the Fed is doing with the quantitative easing and fiscal policy with President Biden and the infrastructure spending, so-called, but they're not separate because of what you mentioned, Steve, they are indeed inextricably linked together because of this. What Biden is doing on the fiscal side is clearly related to what Jay Powell is doing because he is buying those same bonds issued by Biden in the treasury area, and so by that, they are inextricably linked. Back to your point, you made about Jay Powell, yes, he has asked for fiscal stimulus, but he got a lot more than what he had asked for, and potentially significantly more, but now has created somewhat of an issue because now he's almost beholden, one could argue, to Biden and the fiscal stimulus program that's out there right now, and which continues to grow with these additional programs that are in negotiation right now.

Steve Masarik:
What are some of the potential negative side effects and distortions with this implicit backdoor MMT? However you want to define it, whatever term we use, we have massive fiscal spending and huge federal budget deficits. Can we really have our cake and eat it, too, or will the chickens eventually come home to roost? Feel free to answer entirely in clichés if you want.

Todd Thompson:
I can't do the clichés as good as you can, Steve, but let me try to take a stab at it. I think we are reaching a very critical point because a lot of people have long thought the Fed to be independent in their positioning. But I wonder right now, with this current construct, how independent can they really be? They're almost forced right now to do the assistance of the administration in regard to the financing this largesse of a fiscal program. After all, they are one of the larger buyers of this large debt program that is funding the fiscal stimulus, and so one of the questions is not only are they independent now that they're being pulled in more and more, but can they even taper at all if they wanted to?

That's one of the things that people are on the lookout for is will the Fed taper. Well, can they? I'm not really sure at this point they even can because walking away and tapering means you have stepped away from that critical function of being one of the significant financiers or buyers of the debt of this large fiscal stimulus program. If they were to back away, that would have to be supplanted with something else, like higher interest rates to attract other buyers, particularly foreign buyers, or perhaps higher taxes in relatively short order to supplant on the revenue side. But either way, these two issues have come into question, number one, their independence, and number two, can they even taper as a weapon at all?

We already talked about before the goal by itself, the goal of quantitative easing is provide a bridge and you ultimately want to let go of that bridge or walk away from that. Well, I'm sure they felt the uncomfortableness of being there and they want to unwind what they're doing, but now, I wonder if they really can, because now, you're inextricably linked to the fiscal side and it's going to require a pretty draconian assistance on the other side to supplant you for you to be able to walk away in the first place.

I guess one of the worst scenarios to think about at the other side of this is: If you can't pull this off where you have a larger fiscal demand and now the Fed is doing your beck and call, one of the vulnerabilities, if you can't pull this off, is your currency. At the end of the day, that is one of the vulnerabilities you face is you are debasing your currency and if you lose support from that on the international community as a reserve currency, that becomes costly as well. That's the one thing to think about, this all works well with a stable currency, but continued printing of this and financing your deficits is, by definition, a cheapening of your currency situation and it must be factored in as well.

Steve Masarik:
When you think about global reserve currencies like the euro and yen, they're also pursuing some form of this as well. That currency debasement could be masked to a large extent because we're all racing towards the bottom here. I might offer that what we're seeing when you look at some of the things going on with cryptocurrencies, NFTs, just asset prices more broadly, everything that is priced in fiat currency is getting more and more expensive by the day. That's possibly how all of this is being priced in because normally you might've expected rates to move a lot higher based on all this deficit spending, not to mention the monetary stimulus as well. You might expect to see the US dollar weaken significantly, but if everyone is playing the same game at the same time, then you're not seeing that superficial effect.

Todd Thompson:
You brought up a great point, which has been in our mind as of late, which is, as I alluded to a few moments ago, one of the unintended consequences of alternative monetary stimulus is financial asset inflation. Well, people never really equated fiscal stimulus with financial asset inflation because that's normally they equate infrastructure with buying brick and mortar, cement, wood, and really pumping a demand side to the situation would be able to affect prices.

But I got to be honest with you, what we've seen in the last, last six months, now we wonder if, like monetary stimulus causing financial asset inflation, one can say fiscal stimulus has now done the exact same thing for the points you mentioned. You have to wonder if the run-up we have seen in the first part of this year and some of the alternative investments, if I can dare say that, items such as NFTs or cryptocurrencies or SPACs or the meme stocks, you have to wonder how much of that run-up was associated with the fiscal stimulus, which dare I remind you, deposited a lot of free money in people's checking accounts. It's not just monetary stimulus that has created financial asset inflation, it's now arguably the fiscal stimulus that has done so as well. This just happens to be yet another unintended consequence of this very large program that we've been experiencing the last 12 months.

Steve Masarik:
Well, I think that's a great place to leave things. This has been an excellent discussion, Todd. I really appreciate your time today. Thanks, everyone, for listening to Markets in Focus from Carillon Tower Advisers. Remember to subscribe to our podcasts on Apple Podcasts, Spotify, or wherever you listen to podcasts. You can also find additional market insights at Thank you for listening.


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