Monthly Archives: September 2013

One of the main motors behind the growth of the world economy in recent decades, the expansion of world trade, seems to have entirely lost its mojo. In the next few weeks, there will be vital multilateral negotiations ahead of the WTO’s Ninth Ministerial Conference in Bali on 3-6 December, which will attempt to salvage something from the Doha Round. And there will be further negotiations towards the US-inspired Trans Pacific Partnership, which is still supposed to be completed this year. With protectionism now on the rise, it is crucial that something is salvaged from these talks.

World trade volume has been virtually stagnant in the 12 months ended mid 2013. Zero growth in world trade is normally a sign of impending global recession, not of a sluggish expansion. Furthermore, there are extremely strong reasons for believing that growth in trade is one of the principal contributors to supply-side gains in global GDP, so a slow-down in underlying trade growth involves permanent losses in welfare. What has gone wrong, and what does it mean for the future? 

The Fed’s actions last Wednesday created more outrage than usual from investors, some of whom clearly felt that they had been misled, inadvertently or not, by the FOMC’s botched attempts at forward guidance during the summer months.

Challenged at his press conference, Mr Bernanke said that he makes monetary policy for the good of the economy, not to ratify the expectations of investors. In this, he is fully justified. The fact that a minority of investors might have lost money as a result of the so-called “broken contract” should not concern the Fed one jot. Caveat emptor!  

The financial markets, after many months of forward guidance and supposedly “transparent” communication from the Fed, were very surprised by the FOMC’s latest decision to delay the start of tapering its asset purchases. This can be seen most clearly in the immediate 0.15 per cent drop in the yield on ten year treasuries, which reflects the extent of the lurch towards dovishness shown by the committee.

Prior to the announcements, the market thought that it knew two things with a high degree of confidence. First, the Fed chairman had said explicitly that the start of tapering was likely “in the next few meetings” and then clarified that this meant “before the end of the year”. Second, he had given explicit guidance that the end of tapering would occur around the middle of 2014, by which time the unemployment rate was expected to be below 7.0 per cent.

Given that the starting and ending dates for tapering were well pinned down, only the pace in between seemed to be up for debate. This left little room for manoeuvre on the final total for the Fed balance sheet, which was thought to be around $4.1 trillion (or 24 per cent of GDP).

All of this has now been thrown into considerable uncertainty following the chairman’s latest press conference. It is no longer as likely that the start of tapering will come this year, though December now seems to be the best single bet. Not can it be assumed that the 7 per cent unemployment rate is a good guide about the end point. Although the FOMC’s economic projections still show unemployment dropping below this rate somewhere around mid-2014, the chairman seemed to pour cold water on the importance of the 7 per cent figure, a consideration he himself had voluntarily introduced in the June press conference. 

“Not until after the German elections” became a very familiar refrain during the darkest hours of the euro crisis in 2012. Sometimes it meant that Greece could not be expelled from the single currency until then. More frequently, it implied that Germany would not be ready to make larger fiscal transfers to the deficit economies until Angela Merkel was safely installed in the Chancellery for four more years. There is still some optimism in eurozone political circles, and even in the financial markets, that the reform process, painfully slow even when the single currency looked like breaking up, will now accelerate.

In a week’s time, the polls will be closed, and Mrs Merkel will probably be embarking on her third and likely final term as Europe’s de facto leader. Like a second term American President, she might become hamstrung by her lame duck status. Alternatively, freed from the shackles of electoral politics, she might strike out in a bolder direction, driving banking union, fiscal union and structural reform towards the finishing line. 

The Fed has said that it will taper its asset purchases next week if it judges that the labour market outlook has improved “substantially”, and will consider interest rate rises when the unemployment rate falls below 6.5 per cent. Jan Hatzius of Goldman Sachs says that the Fed is suffering from “buyer’s remorse” over the 6.5 per cent threshold, and may reduce it next week. But are they right to use the unemployment rate as their key indicator of labour market conditions? The evidence on this is becoming increasingly murky.

The US unemployment rate has fallen from a peak of 10.0 per cent of the labour force in October 2009 to only 7.3 per cent today, an impressive rate of decline. Yet the employment/population ratio has hardly changed at all over the same period, implying that the whole of the decline in unemployment has been due to a decline in the participation ratio, as disillusioned job seekers have quit the labour force.

On this basis, many Keynesians have argued that the labour market has not improved at all, let alone substantially. The corollary is that the unemployment statistics are giving a seriously misleading indication of the scope for further action to stimulate demand.

This issue has been rumbling along for at least a couple of years, but it came to the fore last week with an important speech by John Williams, President of the San Francisco Fed. He said explicitly that “the preponderance of evidence indicates that the unemployment rate remains the best overall summary statistic”, while “the employment-to-population ratio blurs structural and cyclical influences”.

Mr Williams pointed out that the unemployment rate has consistently been the best single measure of slack in the labour market for many decades, and that it remains very closely correlated with alternative measures of slack derived from other sources. This is supported by the data. The unemployment rate is now about 0.7 standard deviations above its long term mean. The first graph shows three other measures of labour market slack derived from entirely different sources, and all of them are in the region of 0.0-1.0 standard deviations from normal, which substantiates the broad message from the unemployment data. 

Harold Macmillan, the former British Prime Minister, famously described the main risks facing his government as “events, dear boy, events”. Investors no doubt feel the same way about the most crucial single element in their deliberations, the future actions of the Federal Reserve.

A week ago, the immediate path ahead for the Fed seemed to be well mapped out for the financial markets. There was a clear consensus that the FOMC would taper its asset purchases in its 17-18 September meeting, and would completely end its asset purchases in mid 2014. Furthermore, it seemed increasingly certain that Lawrence Summers would be nominated by the President to be the next Fed Chairman sometime in October, and that the ratification process would end in time for him to take office on 1 February. Now this timetable has been thrown into much greater doubt. 

Pessimism dies hard in the UK. Even so, the startling rise in sentiment in UK business surveys in recent months calls for a rethink of the downbeat view of the British economy which prevailed almost everywhere at the start of 2013. After several years of gloomy economic data, there was a strong consensus that the UK was permanently mired in a severe demand shortfall, and that none of the usual levers – monetary policy, fiscal policy or weaker sterling – were ready or able to remedy the problem.

The outlook appeared so bleak that the government imported Mark Carney from Canada to devise emergency ways of easing monetary conditions.

By the time that Mr Carney took office as governor of the Bank of England in July, however, the economy had already embarked on a completely unexpected recovery. According to Fulcrum Asset Management’s statistical system, which tracks all of the available data sources and combines them into a single composite indicator of activity, economic growth in the third quarter is running at an annualised rate of 4.5 per cent, the highest rate seen since the booms of the 2000s and the 1980s. 

Raghuram Rajan‘s arrival in the Governor’s office at the Reserve Bank of India on Wednesday coincides with the worst economic crisis his country has faced since the early 1990s (see this earlier blog). The rupee hit new lows in the foreign exchange markets last week, and there are signs that a gradual erosion of confidence in the currency is turning into a complete rout. The restoration of confidence in the currency is now the sine qua non for any recovery in the economy more generally.

Like 2013′s other new central bankers (Governor Kuroda in Japan, and Governor Carney in the UK), Mr Rajan now has the advantages of the new broom, providing him a brief opportunity to seize the initiative and change market perceptions about macro-economic discipline in India. But he does not, by any means, hold all of the cards in his own hand. The Fed’s likely tapering of its asset purchases in September has clearly been the catalyst for the acute phase of the crisis. And the seeds of today’s problems have been sown over many years in which an excessive budget deficit has been partly monetised by the RBI, feeding a credit bubble, and a burgeoning current account deficit.