On Jan. 25, 2016, the Financial Times published an article by Ray Dalio, chairman and chief investment officer (CIO) at Bridgewater Associates. Dalio warns the U.S. Federal Reserve and other central banks to stop tightening monetary policies. This is a second public note from Dalio after he issued his first letter through LinkedIn on Aug. 25, 2015, urging central banks to stop raising the interest rate. The key takeaway points from Dalio's January 2016 op-ed are that the global economy is at the end of its debt supercycle, the risk of deflationary contraction is higher relative to the risk of inflation, and that the Fed and other central banks should stop tightening their monetary policies.
End of Long-Term Debt Cycle
Dalio contends that there are two types of cycles to follow: the business cycle with an eight- to 10-year span, and the debt supercycle, or the long-term debt cycle, with a 50- to 75-year span. While the Fed has been more focused recently on the short-term debt cycle and began raising interest rates, it should not ignore what he thinks is the end of the debt supercycle. The U.S. public debt as a percent of gross domestic product (GDP) is at a record level, and U.S. household debt as a multiple of real median household income is at a historic high.
Dalio speculates that when a government hits the limit of spurring growth financed by a mix of debt and money, an economy is reaching the peak of its debt supercycle. Dalio contends that the end of the long-term debt cycle is the main reason behind witnessed global weakness and increasing risk of deflation around the world. With this in mind, Dalio thinks that monetary authorities around the world, including the Fed, will have limited options other than quantitative easing (QE) in spurring growth with rock-bottom interest rates.
Central banks around the world, including the U.S. Fed and the European Central Bank (ECB), have used QE as an unconventional monetary policy to stimulate economies when other monetary tools such as interest rates become ineffective. During QE, a central bank buys financial assets from the private sector, which pushes asset prices higher, lowers yields, increases money supply, and stimulates credit and spending.
For QE to be effective, Dalio states that interest rates should not be at their absolute minimum and there should be sufficient risk premia. However, the expected returns on bonds are currently very low compared to the expected return of holding cash, which is typically very low or negative in the developed world. In this scenario, Dalio thinks that QE becomes much less effective at pushing asset prices up and stimulating the economy.
Dalio contends that with record debt levels in relation to income, increasing debt further may result in higher debt costs, a reduction in consumer spending and curtailing demand. With the end of the debt supercycle, significant deflationary pressures and low risk premia, Dalio thinks that the Fed should stop tightening its monetary policy, and that it should wait and see how things play out before making more commitments to raising interest rates.
Dalio's January 2016 op-ed mirrors his August 2015 comments. He thinks that the Fed placed too much weight on the short-term debt cycle and is committing itself too much to a tightening path. This can lead to inconsistent monetary policy signals if the Fed reverses its course of action and resorts to QE again. Dalio contends that the tightening to be observed going forward will be very minimal, as history shows what happens when a long-term debt cycle approaches its end.