Transcript of World Economic Outlook Update Press Conference

Christine Lagarde, Managing Director, International Monetary Fund

Maury Obstfeld, IMF Economic Counsellor and Director of Research

Gian Maria Milesi Ferretti, Deputy Director, Research Department

Gerry Rice, Director, Communications Department

MS. LAGARDE: This is the first time that the IMF presents its midterm outlook on the occasion of the World Economic Forum. I want to thank Klaus Schwab for hosting us this year.

It also gives us the pleasure of seeing all of you which would not be the case of we were in Washington. I will be very happy to introduce in a minute Maury Obstfeld and his team but first I want to give a few words of introduction, just to give you the landscape as we see it at the moment. Global growth has been accelerating since 2016, and all signs point to a continuous strengthening of that growth this year, 2018, and next year, 2019. This is very welcome news. Being here, and having arrived to the media center in the middle of the snow, we might be tempted to think of the words of the poet William Blake: “In winter, enjoy.” But we believe that this would be a mistake and that complacency is one of the risks that we should guard against.

We certainly should feel encouraged by the strengthened growth, but we should not feel satisfied. Why? First of all, there are still far too many people left out from the recovery. In fact, about one fifth of emerging markets and developing countries saw their per capita incomes decline in 2017. Second, this is clearly mostly a cyclical recovery. Absent continuous reforms, the fundamental forces that had us so much worried about the “new mediocre” that we feared – in other words, the scars from the crisis, the low productivity, the aging population, and on and on -- – and future potential growth -- all of this will continue to weigh on medium-term prospects. Third reason: there are uncertainties in the year ahead. The long period of low interest rates has led to a buildup of potentially serious financial sector vulnerabilities. We are seeing a troubling increase in debt across many countries and we need to remain watchful. You will say this is the responsibility of the IMF to constantly see the potential downside risks even down the road if not in the immediate short terms. And yes, it is our responsibility. Doesn’t change the fact that we are quite upbeat for the immediate future. But what we are seeing for the more medium term gives us ground for worry.

I did say at the October Annual Meetings, quoting John Fitzgerald Kennedy, that the time to repair the roof is when the sun is shining. I will not venture there today. But it is clearly when the snow stops that here they clear the roads. The same analogy works. It is a perfect opportunity for the world leaders to repair their roofs. This year’s theme of the WEF annual meeting ‘Creating a shared future in a fractured world’ clearly demonstrates that. Let me outline three areas where the sharing has a meaning:

Shared Growth . We think that policymakers should use this moment to make the difficult structural and fiscal reforms that might not happen otherwise and that are too difficult in time of hardship. This means taking steps to boost long-term growth, paying down debt in places where it is too high, and in other places, investing back into the economy through infrastructure and effective social spending. Why is it shared? Because sharing begins by mending your own turf.

Shared Opportunity. Growth in our views needs to be more inclusive, not only across countries – which has occurred over the last few decades -- but also within them. Some areas of focus in our view require training for workers displaced or at risk of being displaced by technology and globalization. We need those new opportunities for workers at risk, for young people, and for women as well, and them being included safely in the workplace.

Shared Global Responsibility. We need robust international cooperation if we are going to tackle shared problems – including fighting corruption, improving the international trading system, tackling tax evasion, addressing climate change issues, and on and on.

While we should certainly appreciate this season and the good news, we should focus on the measure that are needed today for long lasting solutions in order to have that better-shared future.

With that, I am very honored to turn the floor to Maury who will present the Update. I will sit attentively to what he has to say and then I will disappear.

MR. OBSTFELD: Thank you Managing Director, the honor is hours to have you introduce the Update, which is very exceptional. My remarks will echo a number of things that the Managing Director just said.

As the year 2018 begins, the world economy is gathering speed. Our new World Economic Outlook Update revises our forecast for the world economy’s growth in both 2018 and 2019 to 3.9 percent. For both years, that is 0.2 percentage point higher than last October’s forecast, and 0also .2 percentage point higher than our current estimate of 2017 global growth. This is good news. But – and the IMF always has a but -- political leaders and policymakers must stay mindful that the present economic momentum reflects a confluence of factors that is unlikely to last for long. The global financial crisis may seem firmly behind us, but without prompt action to address structural growth impediments, enhance the inclusiveness of growth, and build policy buffers and resilience, the next downturn will come sooner and be harder to fight. Every government should be asking itself three questions today. First, how can we raise economic efficiency and output levels over the long term? Second, how can we support resilience and inclusiveness while reducing the likelihood that the current upswing ends in an abrupt slowdown or even in a new crisis? Third, how can we be sure to have the policy tools we will need to counter the next downturn?

Looking first at where we are now, we at the Fund see the world economy as follows: The primary sources of GDP acceleration so far have been in Europe and Asia, with improved performance also in the United States, Canada, and some large emerging markets, notably Brazil and Russia, both of which shrank in 2016, and Turkey. Much of this momentum will carry through into the near term. The recent U.S. tax legislation will contribute noticeably to U.S. growth over the next few years, largely because of the temporary exceptional investment incentives that it offers. This short-term growth boost will have positive, albeit short-lived, output spillovers for U.S. trade partners, but will also likely widen the U.S. current account deficit, strengthen the dollar somewhat, and affect international investment flows. Trade is again growing faster than global income, driven in part by higher global investment, and commodity prices have moved up, benefiting those countries that depend on commodity exports. Even as economies return to full employment, inflation pressures remain contained and nominal wage growth remains subdued. Financial conditions are quite easy, with booming equity markets, low long-term government yields and borrowing costs, compressed corporate spreads, and attractive borrowing terms for emerging market and developing economies.

How do we explain the current upturn? It did not arise by chance. It began to take hold in mid-2016, roughly, and owes much to accommodative macroeconomic policies, which supported market sentiment and hastened natural healing processes. Monetary policy has long been and remains accommodative in the largest countries, underpinning the current easy global financial conditions. Even though the United States Federal Reserve continues to raise interest rates gradually, it has been cautious, having wisely responded to the turbulence of early 2016 by postponing previously expected rate hikes. The European Central Bank has started to taper its large-scale asset purchases, which have played a critical role in reviving euro area growth, but has also signaled that interest-rate increases are a more distant prospect.

Moreover, fiscal policy in advanced economies has, on balance, shifted from contractionary to roughly neutral over the past few years, while China has provided considerable fiscal support since its growth slowed at mid-decade, with important positive spillovers to its trade partners. In the U.S., of course, fiscal policy is now poised to take a markedly expansionary turn, with complex effects on the world economy.

Our view is that the current upturn, however welcome, is unlikely to become a “new normal” and faces medium-term downside hazards that likely will grow over time. We see several reasons—to some extent reflected in our medium-term growth projections—to doubt the durability of the current momentum:

First of all, advanced economies are leading the upswing, but once their output gaps close, they will return to longer-term growth rates that we still expect to be well below pre-crisis rates.

While we project advanced-economy growth of 2.3 percent in 2018, our assessment of the group’s longer-term potential growth is only about two-thirds as high. Demographic change and lower productivity growth pose obvious challenges that call for major investments in people and research. Fuel exporters face especially bleak prospects and must find ways to diversify their economies. A second reason we think this is not a ‘new normal’ is that the two biggest national economies driving current and near-term future growth are predictably headed for slower growth. China will both cut back the fiscal stimulus of the last couple of years and, in line with the stated intentions of its authorities, rein in credit growth to strengthen its overextended financial system. Consistent with these plans, the country’s ongoing and necessary rebalancing process implies lower future growth. As for the other big driver, the United States, whatever output impact its tax cut will have on an economy so close to full employment will be paid back partially later in the form of lower growth, as temporary spending incentives (notably for investment) expire and as increasing federal debt takes a toll over time. Thirdly, as important as they have been to the recovery, easy financial conditions and fiscal support have also left a legacy of debt – government, and in some cases, corporate and household – in advanced and emerging economies alike. Inflation and interest rates remain low for now, but a sudden rise from current levels, perhaps due to procyclical policy developments, would tighten financial conditions globally and prompt markets to re-evaluate debt sustainability in some cases. Elevated equity prices would also be vulnerable, raising the risk of disruptive price adjustments.

Despite rising growth in Europe, Asia, and North America, there is less good news in the Middle East and Sub-Saharan Africa, the last area weighed down by the weakness of its larger economies. Low growth, driven in part by adverse weather events and sometimes combined with civil strife, has sparked significant outward migrations. Improvements in some large Latin American economies are notable but aggregate growth in the region will be weighed down this year by continuing economic collapse in Venezuela.

Even though the recovery has lifted employment and aggregate income from crisis lows, voters in many advanced economies have soured on political establishments, doubting their ability to deliver broadly shared growth in the face of tepid real wage gains, reduced labor shares in national income, and rising job polarization. A turn to more nationalistic or authoritarian governance models, however, could result in stalled economic reforms at home and a withdrawal from cross-border economic integration. Both developments would harm longer-term growth prospects, to the detriment of those who have already fallen behind over the past few decades. Levels of inequality are high in emerging market and low-income economies, and carry the seeds of eventual future disruptions unless growth can be made more inclusive.

The situation creates challenges for policy makers. Perhaps the over-arching risk is complacency. While the current conjuncture might appear to be a sweet spot for the global economy, prudent policymakers must look beyond the near term.

No matter how tempting it is to sit back and enjoy the sunshine, policy can and should move to strengthen this recovery. Now is the time to build policy buffers, reinforce defenses against financial instability, and invest in structural reforms, productive infrastructure, and people.

The next recession may be closer than we think, and the ammunition with which to combat it is much more limited than a decade ago, notably because public debts are so much higher.

An upswing so broad also furnishes an ideal moment to act on a range of multilateral challenges. These include countering global financial stability threats, including cyber-threats; strengthening the multilateral trading system; cooperation on international tax policy, including the fight against money laundering; and promoting sustainable development in low-income countries. Of especially urgent importance is to fight irreversible environmental damage, notably from climate change.

MR. RICE: Thank you very much Maury, thank you Mme Lagarde’s. We have a large audience in the room and online. Please identify yourselves and your affiliation.

QUESTION: You mentioned that overarching risk is complacency. You mention we might be closer to a recession than we think.

MR. OBSTFELD: It's hard to, you know, identify one risk as the biggest because I think all are quite worrisome, and they also interact. I think policy makers really need to think broadly, comprehensively, and for the long term, not just over the next political cycle which is sometimes hard for them. As an example, I flagged that the lower long-term growth rates -- these are part and parcel of the sort of political dissatisfaction I think we've been seeing in many economies. Particularly as, you know, the fruits of growth have been quite unequally distributed, and in some countries increasingly so. Financial stability, how we regulate the financial sector is also not disconnected with concerns about inequality. I think pushing on one priority would probably do a disservice to the challenge that policy makers face. They really need a broad approach, one that is very comprehensive.

QUESTION: You mention specifically Spain in the report, and you reduced the prospective for this year because of political uncertainty, but you raise it for next year. So must I assume that you believe that political uncertainty will finish, or that we will have any other stimulus of any kind? Thank you.

MR. OBSTFELD: Well, we are certainly hopeful that the political situation and the uncertainty that it causes will diminish, and that, while this is an internal matter for Spain, that within the laws of the country some way to move forward will be reached. For the current year's forecast we did do a downgrade. This reflects some uncertainty from the Catalonia situation coupled with some optimism because there is growth in the Eurozone and this will benefit Spain. And we expect that momentum to carry over into 2019. Spain is now benefiting. I mean, the growth has been above 3 percent for several years now. It is benefiting from past reforms. We think that pace is not quite sustainable, but, you know, we do see healthy growth for the next couple of years. I don't know if Gian Maria wants to add to that or?

MR. MILESI-FERRETTI: I would just mention that the external environment is clearly helpful because we are forecasting a strong recovery in the Euro Area, including for 2019. So that supports Spanish exports.

QUESTIONER: Two questions. First of all, China actually has been the growth engine during the 2008 financial crisis. Right now it has been ten years from there and you just mention China goes through it rebalancing process. So what role China plays right now comparing to ten years ago? And the second one is, let's say if that will raise rates the same pace as last year.

Do you worry it's going to have more pressure on the emerging market? MR. OBSTFELD: China, of course, carried out a very large fiscal stimulus at the time of the crisis. This was a strong support not only for Chinese growth, but for global growth, and even though China's growth rate has come down, given its size in the world economy, given its relatively high growth rate it is still a major source of growth. You know, there are certainly challenges which the leadership has recognized in terms of strengthening further financial regulations, strengthening further hard budget constraints on state-owned enterprises, strengthening the relationship between local and federal budgets. So, there are challenges there, but, you know, we see China as a strong driver of global growth going forward. You know, as far as the Fed is concerned we will expect them to look at the situation in the U.S. and make data-dependent decisions to attain their mandate which is full employment, stable prices. I think the communication over the last couple of years has been particularly good. The adjustment has been gradual. This has not overly stressed the emerging the markets, and our baseline would be for that to continue.

QUESTION: Quite a lot of the last little while has to do with geopolitics. We have seen Southern Africa some dramatic changes in the political situation there. Are you reading, like Goldman-Sacs does, which on the weekend said that South Africa is a top emerging market for 2018? Have you worked any of that into your calculations?

MR. OBSTFELD: Yes. I mean, basically these update numbers pre-date the -- you know, what has been going on in South Africa, these very recent developments, and so we will have more of that in our spring numbers when we issue the World Economic Outlook. But we have not, you know, fully incorporated those very recent developments.

QUESTION: (off mic)

MR. OBSTFELD: I think we have to wait and see how this works out.

QUESTION: You mentioned the tax policies in the U.S. will have impact on growth globally.

Attributing that upgrade to the tax policies. Do you expect the same to happen after 2022? Is the U.S. growth going to become a drag on the global growth because of the tax policies and the slow down? Do you expect that?

MR. OBSTFELD: I should preface this by saying that the tax bill and its impact is quite complex and there's a lot of uncertainty around our estimates. Given that some of the features of the tax bill are explicitly temporary we do expect there to be some pay back. For example, temporary expensing of investment should give a surge of investment in the near term. But when that stops there will be some pay back of that. On the other hand, some of the features, the cutting corporate tax, the move to a territorial system are not temporary. We also incorporate in our forecast the pay/go provisions which would require cuts in government expenditure going forward as the deficit grows. Hard to say whether those will be adhered to or relaxed. So, there's certainly some potential for the pay back in U.S. growth to result in slower import growth in the U.S. which would affect trading partners. That's somewhat symmetric with what's happening in the current years, but how big those affects would be, you know, how the overall picture would look is very hard to predict.

QUESTION: When you talk about repairing the roof are you also suggesting that the Eurozone nations should enact structural reforms to increase risk sharing such as deposit insurance and common fiscal policy among them? And a quick second one is do you see any risk, systemic risk in Bitcoin and crypto currencies?

MR. OBSTFELD: In Europe, a number of European countries over the last few years have enacted important structural reforms. I mentioned Spain, a few years back. The Jobs Act in Italy. President Macron's plans for France are quite ambitious. But it would be fair to say that a much broader push incorporating even more nations would benefit the Eurozone countries and the E.U. generally. Now, that's not an architectural issue. That's something every country has to do on its own. As far as the architectural issues are concerned we certainly promote a completion of the banking union, the structures that have been created, the single supervisory mechanism, the single resolution mechanism are great steps forward, but more can be done, for example, in the area of deposit insurance. We also, you know, would like to see more in the way of a central fiscal capacity. So, part of the project of fixing the roof is certainly to enhance and approve the architecture of the Eurozone.

On Bitcoin, we don't like to comment on specific crypto currencies. From the sort of block chain technology in general we see possible advantages in terms of the efficiency of payment systems and inclusion. It's an interesting development. We also see that crypto currencies could offer risks, and it is going to be important for regulators to be watching very carefully to make sure that the risks don't materialize.

QUESTION: Is growth, in itself, not an outdated concept or measurement when we're seeing the benefits at the last cycle filter through to fewer and few people?

MR. OBSTFELD: I think there are two aspects of your question. One aspect is, is GDP the right way to look at welfare? And there I would argue, certainly no, but it's probably better than all the other ways that have been suggested. But it clearly leaves out a lot, and to the extent we can improve our measurement of what the economy produces, both positively and negatively. The economy also produces climate damage and that is not measured in GDP, although in principle we would do that, so that's sort of one issue.

The other issue is GDP is an aggregate. It is the aggregate of what a country produces, but it doesn't measure the distribution of the rewards from producing that. That is something one could do, but it would require a value judgement. You would have to weigh the, you know, the deservingness of the poor versus the rich, and economists have kind of struggle with this for centuries, actually, this is not something that's a new idea. How do you measure overall utility? But it would require a value judgement, and therefore, different people would disagree about how to do it. So, we think you have to keep GDP as an anchor, and where it doesn't get at all of the social or welfare issues that you want to discuss then you supplement it with other data. It's probably never going to be possible to produce one single number that, you know, somehow summaries the happiness of the totality of people in the world. But I think GDP is a key concept and we will keep looking at it.

QUESTIONER: Slight further moderation of China's economic outlook in 2018. I would like to know where China can continue to play a big role?

MR. OBSTFELD: China has, indeed, come to play a much bigger role in global governance and coordination. Tt's a member of the G-20. It's the IMF's third biggest shareholder. It has now entered the SDR, so, you know, there's no question that China is a major, major player.

As I mentioned, Chinese growth just quantitatively is incredibly important to world growth. It's going to be important for China to, you know, to play its role in supporting the multilateral system. Judging from President Xi's comments here in Davos last year it's very eager to do that. That will require I think further steps from China to also open its own economy to imports, and work on a range of issues. Everyone is going to have to contribute to make the multilateral system work better, and China's role is critical.

MR. RICE: Thank you very much, Maury. You'll have a chance to hear more from Maury over the next day or so here in Davos, and, of course, Madame Lagarde. I just want to thank him, thank Gian Maria, Madame Lagarde, and thanks to all of you.

IMF Communications Department

Central banks are not the culprit behind a weaker dollar

Falling reserve currency has loosened global financial conditions

John Plender

The Bundesbank recently declared it was proposing to move part of its reserve holdings into the renminbi © Bloomberg

Dollar weakness has been one of the hallmarks of Donald Trump’s chaotic administration, while bearish sentiment towards the greenback has been notably persistent since the turn of the year. In the short run the US government shutdown has clearly done nothing to help. At the same time the breakthrough in Germany’s coalition talks puts yet more pressure on the dollar against the euro.

What is striking about the longer-term trend is how little interest rate differentials have had to do with it. Since last summer widening interest differentials between the US and other advanced economies have failed to underpin the dollar. In effect, leading currencies have not been responding to the supposed laws of international finance. Hence growing speculation that a structural shift may be under way whereby Trump’s dollar is losing its status as the pre-eminent global reserve currency. The suggestion is that managers of official reserves are dumping it in favour of non-traditional reserve currencies including the renminbi.

There is some superficial evidence to support this hypothesis. According to David Sunner of the Reserve Bank of Australia, the share of total reserves allocated to non-traditional reserve currencies rose from 2 per cent in 2009 to almost 7 per cent in 2017. The Australian and Canadian dollar each account for about a quarter of that latest figure and are now included in two-thirds of all reserve portfolios.

At the same time the renminbi has become an alternative reserve asset to the dollar since the International Monetary Fund decided in 2016 to include it in the basket of currencies that make up the Special Drawing Right. Last week the Bank of France revealed that it held an unspecified amount of its reserves in renminbi just after the Bundesbank declared it was proposing to move part of its reserve holdings into the Chinese currency. This came after the European Central Bank’s announcement last June that it had sold a small amount of its dollar reserves to reinvest in €500m worth of renminbi.

While this may be symbolic of a shift to a multipolar reserve currency system it is nonetheless peanuts in global market terms. The dollar still accounts for close to two-thirds of all official reserves, while the renminbi is little more than 1 per cent. And the shift to non-traditional reserve currencies is best seen not as a verdict on the dollar but as central bank herding in pursuit of yield. In today’s low interest rate world the return on their precautionary holdings of highly liquid sovereign IOUs is dismal. This has been felt most conspicuously in euro sovereign debt where since mid-2014 yields across much of the market have been negative. The euro has thus been dumped in favour of the dollar and other currencies. And there has been modest diversification into emerging market sovereign debt.

A growing number of central banks have also been increasing their exposure to equities and corporate bonds. This brings diversification at the cost of liquidity and credit risk. It can also make sense for emerging market central banks whose mercantilist interventions to keep their currencies undervalued have caused reserves to balloon. With reserves far in excess of what is required to guard against a currency collapse, it makes sense to maximise returns on the non-precautionary portion of those reserves.

The case for seeing the central banks as authors of the dollar’s decline sits a little uncomfortably with the behaviour of the world’s biggest holder of foreign exchange reserves.

After a big run down in 2016 China’s reserves rose $129.5bn to $3.1tn last year. It would be surprising if none of that went into the dollar. The broader capital flows picture is also suggestive. The Institute of International Finance estimates that capital outflows from China in 2017 will amount to about $60bn following a regulatory clampdown, compared with a spectacular $640bn in 2016.

The good news for investors about dollar weakness is that it loosens global financial conditions, so equity markets are exuberant. But to assume weakness will continue could be dangerous.

The yield even on short-term US Treasuries now exceeds the yield on US equities. Given the intensity of the hunt for yield not only by official reserve managers but by investors more generally, there is a distinct possibility that global capital could re-acquire an appetite for the dollar. This is treacherous territory.

The World’s Priciest Stock Market

Robert J. Shiller  

A trader wearing a 'Dow 25,000' hat

NEW HAVEN – The level of stock markets differs widely across countries. And right now, the United States is leading the world. What everyone wants to know is why – and whether its stock market’s current level is justified.

We can get a simple intuitive measure of the differences between countries by looking at price-earnings ratios. I have long advocated the cyclically adjusted price-earnings (CAPE) ratio that John Campbell (now at Harvard University) and I developed 30 years ago.

The CAPE ratio is the real (inflation-adjusted) price of a share divided by a ten-year average of real earnings per share. Barclays Bank in London compiles the CAPE ratios for 26 countries (I consult for Barclays on its products related to the CAPE ratio). As of December 29, the CAPE ratio is highest for the US.1

Let’s consider what these ratios mean. Ownership of stock represents a long-term claim on a company’s earnings, which the company can pay to the owners of shares as dividends or reinvest to provide the shareholders more dividends in the future. A share in a company is not just a claim on next year’s earnings, or on earnings the year after that. Successful companies last for decades, even centuries.

So, to arrive at a valuation for a country’s stock market, we need to forecast the growth rate of earnings and dividends for an interval considerably longer than a year. We really want to know what the earnings will do over the next ten or 20 years. But how can one be confident of long-term forecasts of earnings growth across countries?1

In pricing stock markets, people don’t seem to be relying on any good forecast of the next ten years’ earnings. They just seem to look at the past ten years, which are already done and gone, but also known and tangible.

But when Campbell and I studied earnings growth in the US with long historical data, we found that it has not been very amenable to extrapolation. Since 1881, the correlation of the past decade’s real earnings growth with the price-earnings ratio is a positive 0.32. But there is zero correlation between the CAPE ratio and the next ten years’ real earnings growth. And real earnings growth per share for the S&P Composite Stock Price Index over the previous ten years was negatively correlated (-17% since 1881) with real earnings growth over the subsequent ten years. That’s the opposite of momentum. It means that good news about earnings growth in the past decade is (slightly) bad news about earnings growth in the future.

Essentially the same sort of thing happens with US inflation and the bond market. One might think that long-term interest rates tend to be high when there is evidence that there will be higher inflation over the life of the bond, to compensate investors for the expected decline in the dollar’s purchasing power. Using data since 1913, when the consumer price index computed by the US Bureau of Labor Statistics starts, we find that the there is almost no correlation between long-term interest rates and ten-year inflation rates over succeeding decades. While positive, the correlation between one decade’s total inflation and the next decade’s total inflation is only 2%. 2

But bond markets act as if they think inflation can be extrapolated. Long-term interest rates tend to be high when the last decade’s inflation was high. US long-term bond yields, such as the ten-year Treasury yield, are highly positively correlated (70% since 1913) with the previous ten years’ inflation. But the correlation between the Treasury yield and the inflation rate over the next ten years is only 28%.

How can we square investors’ behavior with the famous assertion that it is hard to beat the market? Why haven’t growing reliance on data analytics and aggressive trading meant that, as markets become more efficient over time, all remaining opportunities to secure abnormal profits are competed away?

Economic theory, as exemplified by the work of Andrei Shleifer at Harvard and Robert Vishny of the University of Chicago, offers ample reason to expect that long-term investment opportunities will never be eliminated from markets, even when there are a lot of very smart people trading.

This brings us back to the mystery of what’s driving the US stock market higher than all others. It’s not the “Trump effect,” or the effect of the recent cut in the US corporate tax rate. After all, the US has pretty much had the world’s highest CAPE ratio ever since President Barack Obama’s second term began in 2013. Nor is extrapolation of rapid earnings growth a significant factor, given that the latest real earnings per share for the S&P index are only 6% above their peak about ten years earlier, before the 2008 financial crisis erupted.

Part of the reason for America’s world-beating CAPE ratio may be its higher rate of share repurchases, though share repurchases have become a global phenomenon. Higher CAPE ratios in the US may also reflect a stronger psychology of fear about the replacement of jobs by machines. The flip side of that fear, as I argued in the third edition of my book Irrational Exuberance, is a stronger desire to own capital in a free-market country with an association with computers.

The truth is that it is impossible to pin down the full cause of the high price of the US stock market. The lack of any clear justification for its high CAPE ratio should remind all investors of the importance of diversification, and that the overall US stock market should not be given too much weight in a portfolio.

Robert J. Shiller, a 2013 Nobel laureate in economics, is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance, the third edition of which was published in January 2015, and, most recently, Phishing for Phools: The Economics of Manipulation and Deception, co-authored with George Akerlof.

Inflation Tsunami Ahead

By: Michael Pento

Inflation is one of the most misunderstood, misused and lied about topics in economics. The Fed professes to know what causes it: an overly employed workforce. But, perhaps it is aware this is false and intentionally promulgates the ruse of growth as inflation’s progenitor because central banks want to deflect attention away from its money printing. Nevertheless, one thing is abundantly clear, we all have to agree that the Fed can’t readily control the exact rate of inflation; nor can it direct what the repositories will be for its quantitative counterfeiting misadventures.

Ever since the Great Recession, the Fed, along with all other major central banks, adopted a perplexing 2% inflation target. Their avowed purpose was that a 2% inflation rate is a necessary condition to maintain a healthy economy. However, the sad truth behind central banks’ inflation targets is that a constant rate of inflation is now sought in order to prevent asset prices from ever deflating as they did during the Great Recession.

Inflation, at least as measured by the Fed, has been below target for the past nine years.

Ironically, nine years of failure to reach its dollar-depreciation goal has not dissuaded the Fed to temporarily reverse course on its Quantitative Easing and Zero Interest Rate Policies.

Perhaps this is because it is in a panic to refill the money printing presses with ink before the next recession is upon us.

However, the Fed will soon be back in the interest manipulation business like never before in its history. And its 2% inflation target will be something that only can be viewed far into the rearview mirror.

Here’s why. Given the record $21 trillion of U.S. National debt (105% of GDP) and our escalating solvency concerns, the current 2.6% benchmark Treasury yield should already be much higher than the historical average of around 7%. Then, we when you throw in the fact the Fed’s balance sheet reduction increases to $50 billion per month by October. And, when considering the ECB has already halved its QE program, and is predicted to be finished printing money by the end of this year; yields on sovereign debt will soon be rising sharply across the globe.

And now you have to also throw into this rising rate recipe the fact that the Bank of Japan just reduced its bond purchases; and China has issued a brand-new threat to stop buying Treasuries. According to Bloomberg, senior government officials in Beijing have recommended slowing or halting purchases of U.S. Treasuries. This is most likely in response to Trump’s threats of tariffs and sanctions against China. That’s the first step before outright sales. Since the Communist nation is the world’s largest holder of US debt, you can realize the precarious position of this bond bubble.

We also have soaring debt and deficits. The amount of red ink is projected to reach around $1.2 trillion per year by fiscal 2019, but that is just start of the bad news. The baseline projection is that there will be $12 trillion added to the $21 trillion National debt over the next ten years.

Then you add on to the debt Trump’s next fiscal gimmick, a massive infrastructure plan, which will add hundreds of billions to the total of red ink. And, since the next recession most likely isn’t more than just a few quarters away--and is already long overdue--deficits will jump again by a further trillion dollars per annum just like they did during the four years from 2009-2012. 

Plus, every 100 basis points higher in average interest costs on the outstanding debt piles on another $200 billion in debt service payments per year, which is expected to climb to $1 trillion of interest expenses by 2027—but that’s only if interest rates merely ascend slowly and end up rising to less than half their historical average. All this will be happening as the Fed is dumping $600 billion per year of MBS and Treasuries on to the balance sheet of taxpayers!

The upcoming surge in bond yields should lead to a stock market and economic collapse that will bring central banks around the world to their knees.

Which brings me back to explaining what inflation is and why it could soon grow intractable.

The Keynesian economists that run the Fed and dominate Wall Street believe dogmatically that inflation is a function of too many people working. To the contrary, prosperity has nothing at all to do with inflation. Inflation is all about the market losing faith in a fiat currency’s purchasing power. This most often occurs when there is a rapid increase in money supply; not just base money but broad money supply growth. It can also be the result of an existential threat to a country that would result in the current currency in use becoming extinct.

So here’s how the next super spike of inflation will play out. The next recession is long overdue and on its way very soon. The most probable cause will be a global spike in long-term interest rates. This next recession will cause asset prices to plummet and bring about a truncated period of rapid deflation, an inverted yield curve and economic chaos. The Fed will be in a panic to reflate the massive equity and bond bubbles, but the limitations of only being able to lower the Fed Funds Rate by a relatively small number of basis points and going back to QE isn’t going to work well enough or fast enough to retard the tide of selling. This is because nearly all of the Fed’s new credit will once again accumulate as excess reserves in the banking system and will not quickly save the public and private pension plans from getting destroyed.

The government is going to need to get both the supply and velocity of broad money to increase quickly. Look for ideas such as; Universal Basic Income, Helicopter Money and Negative Interest Rate Policies (which will require the banning of physical cash) as part of the extraordinary measures that could be undertaken this time around.

Those measures will surely be enough to shake faith in the dollar’s purchasing power and cause inflation to rise dramatically. Much more than the Fed’s phony and worthless 2% target.

Indeed, inflation could even go hyper.

The bottom line is that government will soon lose control of markets and the swings between inflation and deflation will become much more intense and violent. Therefore, investors will need a dynamic strategy to hedge against both conditions in order to have any hope of getting a real return on their savings.