US capital spending and a lesson in the monetary transmission mechanism

This is from

Companies in the U.S. are beginning to empty their deep pockets and boost capital spending as they look past the specter of sequestration and global growth risks.

Orders for capital goods excluding aircraft and military equipment — an indicator of future business investment — increased 1.5 percent in May, a third consecutive advance and the longest streak since October 2011. Chief executive officers are more optimistic about the economy, based on the Business Roundtable’s quarterly outlook index, which rose to 84.3 in the second quarter, the highest in a year.

Spending on information technology is up 4 percent this year compared with 2 percent last year, according to the median in asurvey of 203 businesses by Computer Economics, a research company in Irvine, California.

…Such increases are set to bolster the U.S. expansion between now and year-end as companies unleash cash from their record-high balance sheets amid a brighter economic outlook. Job gains that beat expectations in June have helped firm market projections of a September start for the Federal Reserve to begin reducing its unprecedented $85 billion in monthly asset purchases, indicating confidence that growth is sustainable without record levels of monetary stimulus.

This is exactly what Market Monetarists said would happen if the Federal Reserve eased monetary policy within a rule based framework. This in my view is a pretty clear demonstration of how the monetary transmission mechanism works.

This is how I in 2011 explained it would work:

Lets assume that the economy is in “bad equilibrium”. For some reason money velocity has collapsed, which continues to put downward pressures on inflation and growth and therefore on NGDP. Then enters a new credible central bank governor and he announces the following:

“I will ensure that a “good equilibrium” is re-established. That means that I will ‘print’ whatever amount of money is needed so to make up for the drop in velocity we have seen. I will not stop the expansion of the money base before market participants again forecasts nominal GDP to have returned to it’s old trend path. Thereafter I will conduct monetary policy in such a fashion so NGDP is maintained on a 5% growth path.”

Lets assume that this new central bank governor is credible and market participants believe him. Lets call him Ben Volcker.

By issuing this statement the credible Ben Volcker will likely set in motion the following process:

1) Consumers who have been hoarding cash because they where expecting no and very slow growth in the nominal income will immediately reduce there holding of cash and increase private consumption.
2) Companies that have been hoarding cash will start investing – there is no reason to hoard cash when the economy will be growing again.
3) Banks will realise that there is no reason to continue aggressive deleveraging and they will expect much better returns on lending out money to companies and households. It certainly no longer will be paying off to put money into reserves with the central bank. Lending growth will accelerate as the “money multiplier” increases sharply.
4) Investors in the stock market knows that in the long run stock prices track nominal GDP so a promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% path growth rule for NGDP investors will expect a much less volatile earnings and dividend flow from companies. That will reduce the “risk premium” on equities, which further will push up stock prices. With higher stock prices companies will invest more and consumers will consume more.

I think that is exactly what is now happening in the US economy. The fed’s de facto announcement back in September last year of the Bernanke-Evans rule is moving the US economy from a “bad equilibrium” to a “good equilibrium”.

Hence, it is not only in the increase in the money base, which is lifting the US economy out of the crisis, but also a marked shift in expectations among US investors and consumers. It is the Chuck Norris effect. At least that is what the survey mentioned above indicates.

Furthermore, this is a clear demonstration of the Sumner Critique – the fiscal multiplier will be zero if the fed follows a clear nominal target. Hence, any fiscal tightening will be offset by monetary easing and/or expected monetary easing. So while fiscal policy contracts investments and private consumption is expanding.

I am still puzzled that it took the fed four years to figure this out and I should say that the Chuck Norris effect could have been much more powerful had the Federal Reserve been a lot more clear about its objectives. Now investors and consumers are still to a large extent guessing what the fed is targeting. Had the fed announced an NGDP level target then I am sure we would have seen an even stronger recovery in US capital spending.

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