Monthly Archives: April 2014

The FOMC meeting this week is not likely to see any policy fireworks, but it will mark the departure of Governor Jeremy Stein, who returns to academic life at Harvard at the end of May. He has only been on the Board for two years, but he has made an intellectual mark in a critical area where leading members of the FOMC have been largely silent – how to set monetary policy when the need to maintain financial stability is conflicting with the near term outlook for inflation and employment.

The issue can be simply stated: should the Fed tighten policy solely because they are worried about the emergence of bubbles in asset prices?

After the financial crash of 2008, this should be a subject close to the heart of the new Chair Janet Yellen and her senior colleagues. Up to a point, it is. An enormous amount of attention has been given to the new financial architecture that has followed the crash, and Chair Yellen has already spoken specifically about the importance of too-big-to-fail, and the reform of the wholesale money markets.

Yet the vast majority of the Fed’s recent communication has been on the familiar topics of estimating slack in the labour market, and the consequences of this for inflation. In its statements and minutes, the FOMC has generally given very little attention to the difficult question of how to maintain financial stability and thus avoid the next “Minsky moment”. 

Before the financial crash in 2008, it was frequently claimed that the developed economies had permanently ended the cyclicality of prior eras. In fact, a name – the “Great Moderation” – was invented to describe the stable period from 1984-2008, when the variability of real GDP growth and inflation both fell markedly. Recessions did occur during these years, but they represented short and fairly shallow punctuations between extended periods of moderate expansion.

That was before the Great Recession of 2008-09, by far the deepest since the 1930s. The financial crash made the term “Great Moderation” seem hubristic, if not absurd, and for a while it was banished from the lexicon. But now it is back.

Economists like John Normand at J.P. Morgan (from whom I have stolen the title to this blog), and Dominic Wilson’s team at Goldman Sachs, have recently argued that the developed economies might have embarked on the Great Moderation, Version 2.0 (GM 2.0). Jason Furman, Chairman of President Obama’s Council of Economic Advisers, suggested something similar last week, though he also argued strongly that this was not a sufficient condition for a healthy economy to exist.

GM 2.0, if it persists, is likely to share some similarities with 1.0, but there are also major differences. These comparisons may be instructive for policy makers and investors in the period ahead. 

The OECD pointed out last week that the ratio of public debt/GDP will reach all time historic highs in 2014, at about 120 per cent. Taken in isolation, this could certainly viewed as a worrying fact, with bad implications for the future of real interest rates and possibly inflation. A couple of days later, however, the IMF published a fascinating chapter in its latest World Economic Outlook (WEO) on global real interest rates, showing that the global real rate has fallen from about 6 per cent in the early 1980s to about zero today.

Both of these facts are of course very well known, but placed side-by-side, they still represent a stark contrast:

They also present a conundrum for policy makers and investors. Why has the surge in public debt not resulted in a large rise in real borrowing costs for the government, and for the wider economy? And what does this tell us about the future of the risk free real rate in the global economy?

The risk free rate is the bedrock of asset valuation, and is often presented as one of the great “constants” in economic models. But in the past few decades, it has been anything but constant.

 

Although the European Central Bank took no concrete action on Thursday in the face of a decline in consumer price inflation to only 0.5 per cent in March, president Mario Draghi’s statement contained new language which has moved the goalposts for future action by the bank. By stating that the governing council is now unanimously willing to adopt quantitative easing in order to cope with prolonged low inflation, the statement substantially alleviates the risk of secular “lowflation” that has been worrying investors for some time.

To recognise the importance of this change of stance, consider what the ECB has said about QE in the past. A few years ago it tended to dismiss the option on the grounds that it was too close to direct financing of government budget deficits, and was therefore against the terms of the euro treaties. More recently, while becoming gradually less dismissive of QE on constitutional grounds, it has been unwilling to concede that unconventional monetary easing was necessary, saying that conventional measures were still available, and would be used first.