Modern Monetary Theory
Modern monetary theory is quite the interesting approach to macroeconomics and monetary policy. It is with both strong proponents and critics. Both sides of the isle seem to think that the other side doesn’t really understand their arguments.
We would like to avoid over-complications here and focus on the core of MMT and its arguments. Essentially, MMT argues that as long as debt is denominated in one’s own currency, government deficits are much less important than neoclassical economics implies.
This is because the government must first spend currency before it can tax it!
Nevertheless, the fundamental constraint on government spending, according to MMT, is the generation of inflation, which results from excessive demand in the economy. However, MMT suggests that central banks should not focus on inflation and should instead let fiscal policy take the lead on controlling inflation.
In this sense, MMT is more prescriptive than predictive. In other words, MMT suggests that governments should spend more during a recession, deficits are less important than initially thought, and inflation should be controlled by Congress, not the Fed.
As such, many have criticized MMT for not factoring in that inflation expectations are controlled by the Fed for a reason and limit the sustainability of long term government deficits.
Supply and Demand, War and Covid
In addition to monetary policy considerations such as the supply of money in circulation, the level of interest rates, bond purchases, and the like, there are considerations related to aggregate supply and demand.
Holding everything constant, if an economy experiences a negative supply shock, then average prices will rise. Additionally, if an economy experiences a boost in demand, say from increased government spending, then all things being equal, prices will rise.
Currently, we are in the midst of the perfect storm for inflation. In addition to accommodative policies by the Fed and increased government spending, Covid was a massive (negative) supply shock that distorted prices. While it did cause average prices to rise, this effect was highly asymmetric and unequal.
Moreover, after Russia invaded Ukraine, food and energy supplies were disrupted worldwide, certain to lead to continued inflation in the coming months. Interestingly, China’s recent Covid-related lockdown is having a negative impact on aggregate demand, which in theory should reduce prices.
So, while the Fed is raising rates to combat inflation, the supply side shocks from Covid and the war in Ukraine are partially countered by decreased aggregate demand from an extended lockdown in China. No one said being an investor was easy!
Inflation is a macro phenomenon, so here we focus on the big picture, not on individual stocks. While it is clear that the probability of a recession in the next 12 months is higher than it was 12 months ago, it is important to not invest as if the end of the world is coming tomorrow.
There will always be another recession, and at their peak stocks certainly seemed overvalued compared to historic norms, but to beat the market, an investor has to know when to sell while everyone else is getting greedy and buy when everyone is getting fearful.
After over 6 weeks of negative returns in the S&P 500 and Nasdaq, equities are looking more attractive than at the beginning of the year. Nevertheless, it is clear that we are in the middle of a tightening cycle, where the Fed is raising interest rates and decreasing liquidity in the market.
As such, it’s unclear as to whether or not the market has temporarily bottomed, but timing a market bottom is a fool’s errand for most. Instead, you should continue dollar cost averaging into markets. As markets dip, you find buying opportunities.
In terms of investing around inflation, in general, during periods of high inflation, commodities do well, but there are always confounding variables. If the Fed raises interest rates too quickly, then the market narrative will be one of recession.
Inflation is elevated, but dropping, interest rates are rising, but subject to change, and equities are approaching bear territories, but eager for a turn around. Until there is more clarity on medium term interest rates and the short term probability of recession, expect choppy trading ahead.