Janet Yellen, in an unusually ebullient mood, suggested last month that there may not be a repeat of the Global Financial Crash (GFC) “in our lifetimes”. Given the extreme severity of the GFC, that is perhaps a fairly easy hurdle for the central bankers to clear. As a result of the co-ordinated efforts of Basel III and the Financial Stability Board under Mark Carney, the fault lines in the pre-2008 financial architecture have been largely repaired.

A more difficult question is whether the current phase of rising markets, which began in 2009, will end because financial asset prices implode under their own weight. There may not be a complete collapse of the entire financial system this time, but there could still be a very unpleasant bear market for investors to endure.

It is clear from the latest Fed minutes that “a few” members of the FOMC are more worried about the risk of financial instability than Chair Yellen, but even they seem reluctant to tighten monetary or prudential policy unless the Fed’s dual mandate, aimed at low inflation and maximum employment, is under threat.

While this is probably good news for asset prices in the near term, it is notable that the central banks are choosing to allow the remarkable build up in market risk, as evidenced in stretched asset valuations, to continue.

Recent central bank speeches and reports on financial stability [1] suggest that this can be tolerated because it is occurring without much associated growth in bank credit in the advanced economies, and because any setback to markets will not trigger an amplifying shock among banks and other financial institutions this time. Let’s hope they are right. Read more

The US CPI report for June, published on Friday, was the fourth successive monthly print that surprised on the low side. Initially, these inflation misses were dismissed by the Federal Reserve as idiosyncratic and temporary, but they are now becoming too persistent to ignore. If they are not reversed fairly soon, the FOMC will need to give greater weight to the possibility that inflation may not return to target over the next couple of years.

Janet Yellen appeared to open the door to this possibility for the first time in her evidence to Congress last week. In a distinct change of tone, she specifically mentioned uncertainties about “when and how much inflation will respond to tightening resource utilisation”, thus acknowledging the possibility of alterations in the Phillips Curve.

She also emphasised that monetary policy is not on a preset course, adding that the FOMC will be carefully monitoring whether the recent decline in inflation is reversed in the months ahead. Normally, her guidance on data is more even handed, without specifically highlighting downside inflation risks.

My colleagues at Fulcrum (especially Juan Antolin-Diaz and Alberto Donofrio) have recently estimated some new econometric models [1] to track the course of inflation in the US, and these models identified the importance of the latest inflation surprises fairly early in the process. After the latest CPI data, the models suggest that there is a high and increasing chance that US inflation will fail to return to target within the next 2 years. Read more

In this month’s regular temperature check on global economic activity, the Fulcrum nowcasts identify a continuing strong and co-ordinated global expansion, with no significant signs of any meaningful reversion to trend, especially in the advanced economies. We reported a couple of months ago that the very robust rates of growth in the US and China had come off the boil, but these economies have since rebounded again, and the Eurozone has continued to record stellar rates of expansion by its own subdued standards.

Rather belatedly, the consensus growth projections published by mainstream economic forecasters have begun to reflect these strong activity reports, despite the aberrantly weak GDP data in the US in 2017 Q1. These upgrades to global growth projections break the dismal pattern of repeated downgrades that has been experienced ever since 2012.

It is unclear whether these improvements represent merely a short term cyclical recovery based on expansionary demand policy. The absence of any rise in core inflation suggests that, at the very least, supply has so far been able to match any increase in demand, though it is far too early to conclude that this will prove sustainable.

John Williams, President of the San Francisco Fed, strongly expressed the mainstream, pessimistic view about supply side growth in a good speech last month. Nevertheless, it is worth at least considering the possibility that a very modest supply side improvement may finally be underway, while recognising that the case will be unproven for a very long time to come.

The Fulcrum monthly nowcasts are attached hereRead more

Markets are becoming concerned about the central banks’ response – or rather their lack of response – to a series of inflation releases that have surprised economists on the low side recently. A few months ago, with the oil price shock of 2014-16 fading into history, it seemed that the Federal Reserve and the ECB were on a relatively smooth path towards attaining their inflation targets of around 2 per cent over the next three years. Now, that seems much less certain.

In the US, there have been three successive monthly inflation reports that have been much lower than forecast. In the eurozone, the monthly path has been bumpier, but the upshot is that core inflation has been stuck at 1.0 per cent, showing no sign of any progress towards target.

Bond markets have adjusted their inflation “breakevens” downwards. Although this has been in part driven by a widening in negative inflation risk premia, it seems to imply a loss of confidence that the global reflationary forces are gaining momentum.

When inflation surprised on the downside after the oil price collapse in 2014, the major central banks eventually responded by aggressively adding to monetary stimulus (in the case of the ECB), or by postponing the intended tightening (the Fed). This time, the central banks have completely refused to alter their planned monetary stance, and several of them – notably including the ECB – have been making more hawkish noises.

Although the drop in inflation has been very modest compared to 2014-15, some commentators have started to worry about a “Sintra pact” among global central bankers to normalise interest rates.

So what is going on, and does this new policy response spell danger for risk assets? Read more

In January 2012, the FOMC started to publish its “dot plots” showing the committee’s median expectation for the fed funds rate several quarters ahead. Ever since then, it has become customary to compare the Fed’s dots with the market’s forward pricing for the funds rate over the relevant horizon. Frequently, the dots have been much higher than the market pricing, and this has usually been taken as a signal that the market expects a more dovish stance for monetary policy than implied by the FOMC.

Lawrence Summers recently took this argument a step further, arguing that the gap between the dots and the market’s path for rates suggests not only that the Fed will not, but should not, raise rates. He believes that the dot plot comparisons show that investors do not see sufficient justification for a monetary tightening in the near future. In supporting evidence for this, Professor Summers points to the forward path for inflation built into the inflation-linked bond market, which is also much lower than the inflation path predicted by the FOMC.

It does not normally pay to disagree with Larry Summers, and he may well be right about the immediate future for Fed policy. Inflation is clearly coming in lower than expected.

Nevertheless, it is worth examining the Summers argument in greater detail, since the existence of risk (or term) premia in the market’s forward pricing for interest rates and the inflation rate can scramble the message that investors should take from these readings. Read more

Chancellor Philip Hammond

Chancellor Philip Hammond  © Getty Images

The UK chancellor, Philip Hammond, is due to deliver his postponed Mansion House speech on Tuesday, following a general election result that has caused, to put it mildly, great uncertainty about the medium-term outlook for the economy and the government finances. If the Conservatives had won the election with a sizeable majority, the government would have been mandated to proceed with its hard Brexit strategy, combined with further “austerity” budgets. As an aside, Mr Hammond would also have lost his job.

The hung parliament has thrown this into confusion. The 2016 referendum result no longer reigns quite so supreme in British politics. It is more difficult to see how a hard Brexit, and its associated large-scale legislation, can be piloted through the new parliament, either in the Commons or particularly in the Lords. Read more

In this month’s regular update on global activity data, the Fulcrum nowcasts have continued to report that the world economy is expanding at slightly above trend rates. As we noted last month, there have been some signs of a modest slowdown in the US, but the Eurozone, Japan and the UK have remained fairly robust. China had shown a few signs of slowing in the spring, but the most recent growth estimates have rebounded to the 7 per cent average that has been intact for several previous quarters.

There now seems to be less chance that the global economy will achieve a clear upside break in its growth rate this year, but there are no signs of a significant or broadly-based slowdown either.

As we have noted on many occasions, the global financial markets have been in a regime that has come to be known as “global reflation” since March, 2016. However, some of the elements of that regime, including rising inflation expectations in the bond markets and a firm US dollar, have clearly frayed at the edges, following a decline in the market’s confidence that a sizeable fiscal reflation package will be introduced by the Republican administration in Washington, and the publication of weak inflation reports in the US and the Eurozone.

The current market regime is probably better described as one of “global expansion” rather than “global reflation”. In retrospect, that would have been a more accurate description of the entire market regime that started last year, since this period has always been about rising real output growth, rather than rising core inflation.

The latest monthly nowcasts are presented in detail here. Read more

It was widely reported at the weekend that the Trump administration is seriously considering the nomination of Marvin Goodfriend, a professor of economics at Carnegie-Mellon University, to one of the vacant positions on the board of governors of the Federal Reserve. As a former Fed official, a much cited academic author on monetary economics, and an impeccable conservative, he could be even a candidate to replace Janet Yellen next year.

Although I do not know Prof Goodfriend personally, I have admired his writings for several decades. He is both a monetary historian and a mainstream macroeconomist. In his most cited academic paper, in 1997 he outlined a “New Neoclassical” model, including rational expectations, sticky prices and a real business cycle underpinning. This is similar to today’s “New Keynesian” models routinely used by all the major central banks. Read more

A few months ago, the Federal Reserve seemed determined, at long last, to normalise monetary policy in the US. In fact, it still seems to be set on that course. The FOMC has indicated that it intends to raise rates in June by a further 0.25 per cent, and they also seem ready to announce a plan to shrink the central bank balance sheet in September.

But there is now a fly in the Fed’s ointment. The last two monthly releases for consumer price inflation have been much weaker than anyone expected. Although the FOMC was fairly dismissive of the first of these announcements – saying in the minutes of its May meeting that it was probably caused by temporary or idiosynchratic factors – it is not yet known whether they have continued to ignore the second set of weak CPI data in April. The two months together have left core CPI inflation 0.4 percentage points lower than expected.

When the PCE deflator is released next Tuesday, it will probably show the 12-month core inflation rate at 1.5 per cent in April, the lowest figure since the end of 2015. The FOMC’s reaction to this incoming news will depend on their reading of the underlying causes of low inflation, which are highly uncertain. But the markets have already decided that they will take the evidence seriously enough to abort their programme of rate rises after the planned June increase. Read more

The Federal Reserve is actively considering a profound change in US monetary policy, in effect the reversal of quantitative easing (QE). In its March meeting, the FOMC discussed its strategy for the future run down of its balance sheet, and said that further debate would take place in upcoming meetings.

The FOMC has already concluded that “a change in the Committee’s reinvestment policy would likely be appropriate later this year” and that this would need to be flagged “well in advance”. The minutes to the May meeting (to be published on 24 May) will probably provide some further indication about their thinking on this important topic.

Investors are therefore beginning to focus on the possible consequences of the reversal of QE on interest rates and the shape of the yield curve.

In a previous column, I outlined the likely path for the US central bank balance sheet under the new policy, and predicted that this would cause global QE to turn negative in 2019, after being consistently positive by about 2 percentage points of global GDP in every year since 2011. The great unknown is whether this reversal of central bank support will remove the underpinnings from the bond market, risk assets and the global economic upswing.

I take the optimistic side of this debate, but investor opinion is sharply divided on the matter. Read more

The global economy has continued to expand at well above its trend growth rate since the beginning of 2017, but there have been some early signs of a slackening in recent weeks. According to the latest monthly results from the Fulcrum nowcasts (attached here), global growth is now running at 4.1 per cent (at PPP exchange rates), which is about half a percentage point lower than a month ago.

This “slowdown”, which has been driven by the US and China, is well within the normal range of monthly fluctuations in the global nowcast, and it may be nothing more than a temporary blip. There are some legitimate reasons for concern about the slowdown in China, which seems to be connected to tighter credit polices. Fortunately, however, the Chinese economy seems in better shape to absorb this tightening than it was in 2013-15. Read more

The dire performance of labour productivity growth in the global economic recovery – the so-called “productivity puzzle” – is by far the most depressing feature of recent economic performance in the big economies.

Growth in total-factor productivity in the advanced economies (i.e. the efficiency of labour and the capital stock combined) has fallen to zero in recent years, compared with a little below 1.0 per cent a year in the decades immediately before the Great Financial Crash. Growth in labour productivity (i.e. output an hour worked) has fallen even more. This collapse in TFP and labour productivity has been by far the main cause of the disappointing growth in GDP in the advanced economies since 2008.

Actually, the productivity “puzzle” is not so much of a puzzle, as a new study by IMF economists clearly demonstrates. In the long run, structural forces have been reducing productivity growth since the 1960s. These include slower rates of technological advance, the ageing of the population and slower advances in education. It is also possible that there has been some increased mismeasurement of inflation that has in turn resulted in underestimates of real output and productivity.

The effects of these forces were in evidence well before the GFC, and they are still inexorably getting worse. There is no good reason to expect any improvement in these structural trends in the near future.

However, there are also many reasons why productivity growth may have been temporarily affected by changes in economic behaviour since the GFC. Strained corporate sector balance sheets and a dysfunctional banking sector have weakened capital investment and led to slower implementation of technical advances and a misallocation of capital to zombie companies. Read more

The global reflation regime that has been dominant in the financial markets for much of the past 12 months has paused in recent weeks. Many commentators, including James Macintosh at the Wall Street Journal and the FT’s Gillian Tett, have suggested that this pause in the markets is giving ominous signals about the health of global economic activity. Concerns have been expressed about the strength of official US GDP data in 2017 Q1, and there have been unexpectedly low readings for core inflation in several economies.

This shift in mood is probably too pessimistic. The change in market behaviour has so far been small, relative to the large rise in equities and the decline in bond prices seen since world activity bottomed in February 2016. Furthermore, while there has been a modest slowdown in US activity indicators since March, the growth rate remains well above trend, and the official GDP numbers are likely to be much stronger in 2017 Q2 and Q3.

However, there are legitimate concerns about the ability of the Trump administration to deliver the large fiscal stimulus that had been expected. These concerns need to be addressed in the announcements on tax policy that are expected imminently. Read more

President Trump’s remarks last week about the dollar and US monetary policy offer more evidence that America’s strong dollar policy, launched in 1995 by Treasury Secretary Robert Rubin when the dollar was near post-war lows, is now changing.

The President said that a strong dollar “sounds good”, but added that “our dollar is getting too strong…it is very, very hard to compete when you have a strong dollar and other countries are devaluing their currency”. He also said that he “likes a low interest rate policy” and that Janet Yellen is “not toast”.

Separately, Mr Trump dropped his campaign promise to label China as a currency manipulator, suggesting that the US is willing to make concessions on trade policy in exchange for a strategic deal on North Korea with Xi Jinping.

The US Treasury followed this yesterday with its semi annual official report on the foreign exchange policies of US trading partners. Several countries, including China, South Korea, Taiwan, Germany, Switzerland and Japan, were warned that they are on a “monitoring list”, but concrete action against them has been postponed, perhaps indefinitely. The Administration seems to have decided that the threat of future trade protection will induce some of these countries to allow their currencies to rise against the dollar.

It seems that the President has recognised that it is pointless to pursue protectionist measures if their effect on US manufacturing is offset by a rising currency. Instead, he wants the dollar down. But, as Roger Blitz suggests, is doubtful whether his jawboning will, on its own, do much to influence the trend of the American currency. In order to change the direction of the dollar in a meaningful way, other economic policies will need to change. Read more

Marine Le Pen

Marine Le Pen  © Getty Images

The European Central Bank has been one of the two main providers of global monetary easing since 2015, and that seems likely to persist throughout 2017. Despite its continuing importance to the setting of global monetary conditions, the bank’s policy deliberations have made only little waves in the markets since deflation risks abated last year.

The eurozone economy seems to be in an increasingly healthy state, at least from a cyclical point of view, and monetary conditions appear to be normalising across the entire region. The latest rounds of asset purchases have proved more successful than previous doses, primarily because they have reduced sovereign and other credit spreads in the troubled economies, thus bringing monetary assistance to countries that needed it most. Read more

In this month’s regular update on global economic activity, the Fulcrum nowcasts have once again identified extremely strong growth rates, especially in the advanced economies. These results continue to suggest that the global economy is expanding at the fastest rate seen since 2010, with the implication that the expansion may be reaching escape velocity, where it is no longer in need of emergency support from the central banks or fiscal authorities.

However, our models have been greatly affected in recent months by the remarkable strength in business and consumer surveys. Hard economic data have also improved, but have done so by less than the surveys. This has led to doubts about the reliability of the nowcasts, especially in the US, where the official real GDP growth rate in 2017 Q1 seems likely to be well below 2 per cent for the second successive quarter.

The sluggishness of US growth based on the official GDP data is clearly influencing the Federal Reserve, which has made no upward revision to its growth forecasts in the past few months, despite the surge in the nowcasts. Furthermore, it may also have influenced the financial markets, which are starting to have doubts about the “reflation trade” in global markets.

Given the extremely large difference between surveys and hard data at present, it is important to consider which of these sources of evidence is likely to be giving the correct signal on the current pace of the global expansion. Based on past evidence, we continue to give considerable weight to the buoyant surveys, even when they conflict with the relative weakness of hard data.

A second question is whether the extremely buoyant growth rates identified by the nowcasts can be maintained into the future. The models expect these elevated growth rates to decline somewhat over the rest of 2017, but growth seems likely to remain well above trend in the AEs, with plenty of scope for upward revisions to consensus GDP forecasts.

My colleagues Juan Antolin-Diaz, Thomas Drechsel and Ivan Petrella have released a technical paper about the use of hard and soft data in nowcasting – see the latest draft attached here. The latest monthly set of Fulcrum nowcasts is attached hereRead more

One of the most dramatic monetary interventions in recent years has been the unprecedented surge in global central bank balance sheets. This form of “money printing” has not had the inflationary effect predicted by pessimists, but there is still deep unease among some central bankers about whether these bloated balance sheets should be accepted as part of the “new normal”. There are concerns that ultra large balance sheets carry with them long term risks of inflation, and financial market distortions.

In recent weeks, there have been debates within the FOMC and the ECB Governing Council about balance sheet strategy, and it is likely that there will be important new announcements from both these central banks before the end of 2017. Meanwhile, the PBOC balance sheet has been drifting downwards because of the large scale currency intervention that has been needed to prevent a rapid devaluation in the renminbi. Only the Bank of Japan seems likely to persist with policies that will extend the balance sheet markedly further after 2017.

Globally, the persistent increase in the scale of quantitative easing is therefore likely to come to an end in 2017, and it is probable that central bank balance sheets will shrink thereafter, assuming the world economy continues to behave satisfactorily.

Investors have become accustomed to the benefits of “QE infinity” on asset prices, and are cynical about the ability and desire of central bankers ever to return their balance sheets to “normal”. They will have to adjust to a new reality fairly soon. Read more

The global economic recovery that started amid the gloom of the financial crash in March 2009 is about to celebrate its 8th birthday. In the advanced economies (AEs), the GDP growth rate during this recovery has averaged only 1.8 per cent, well below normal, but unemployment has dropped from 8.1 per cent to a still fairly high 6.1 per cent. According to JP Morgan, the volatility of GDP growth has fallen to the lowest levels for four decades since 2014.

This slow but extremely steady period of expansion has of course been accompanied by much lower interest rates, which have proven terrific for asset prices. The index of total equity returns in the AEs has tripled since the bear market ended.

Janet Yellen and other officials at the Federal Reserve have said on many occasions that “recoveries don’t just die of old age”. Unless something goes wrong, the upswing in the cycle will be prone to continue. At present, econometric models that attempt to assess recession risks suggest that these risks are exceptionally low over the next 12 months.

Furthermore, the growth rate in the US and other AEs seems, if anything, to be breaking upwards. This may be because the headwinds that have held growth down for so long – excessive debt, a malfunctioning banking system, extreme risk aversion, low capital investment etc. – may finally be fading away. Perhaps the world economy is at last attaining escape velocity.

However, good times cannot last forever. It is common for euphoria to set in just when the economic and financial cycle is nearing a peak. As in 2001 and 2008, the end could come much sooner than anyone predicts [1]Read more

The robust US employment data last Friday have left almost no room for doubt that the Federal Open Market Committee will raise short term rates by 25 basis points on 15 March, and will probably warn of two or three more hikes to come this year.

Analysts seem confident that this accelerated phase of Fed tightening will involve a further rise in bond yields and the dollar, and many active fund managers are positioned for both these events to occur in coming months. Other analysts believe that the more hawkish Fed will puncture the “euphoria” in the US equity market before too long. Read more

US monetary policy has now clearly embarked on an important new phase. For a long while, the markets have been extremely reluctant to recognise that the Federal Reserve might actually mean what it says about increasing short term interest rates by 0.25 per cent on three separate occasions this year. Remembering repeated episodes in which the Fed has failed to deliver its threatened tightening in policy since 2013, investors have concluded that dovish surprises from the Fed are endemic.

Last week, however, they woke up to the fact that FOMC really is serious about raising rates in March, and that this may be the first of three or even four rate hikes this year. After a series of hawkish speeches by several FOMC heavyweights, the coup de grâce came on Friday, when Janet Yellen warned that a rate rise in March “would be appropriate” unless economic data surprised in the meantime. She added rather ominously that policy accommodation would be removed more rapidly this year than in 2015 and 2016.

The great unknown is whether this will come as a major shock to the financial markets. It will certainly mean that investors will need to build in a faster path for rate hikes in the near term than anything that has previously been contemplated in this cycle. But the good news is that the final destination for rates does not seem to be changing, at least in the view of the FOMC. The Committee is increasing the speed of travel towards its destination, but is not changing the destination itself.

So what has justified the shift toward more hawkish thinking on the FOMC? And will this upset the equity market, which is still ignoring the prospect of higher rates? Read more