With the Scottish referendum still in the balance, this blog comments on the key macro economic issues in the campaign, hopefully with as little bias as possible [1].

The currency question, fiscal policy and the risk of a deposit flight from the banks have been much debated, but in the end they are all linked to the age old question of taxation, with and without representation. Is Scotland really willing to risk paying higher taxes as the price of political independence? We will know the answer on Friday morning. Read more

Next week will see the sixth anniversary of the collapse of Lehman Brothers. No single financial event in the post-war period has cast such a long shadow. Until now, the scars of the financial crash have dominated the economic landscape. The utilisation of labour and capital resources in the economy has remained far below normal, the growth rate of GDP has been unable to sustain any respectable recovery by past standards, and the overhang of debt has continued to erode household confidence.

Optimistic forecasts about the recovery have been repeatedly thwarted. But the US growth rate may finally be able to sustain a normal, healthy recovery, albeit with the level of GDP still tracking far below previous long term trends.

A genuine improvement in American economic conditions seems to have taken hold in the past 12 months. This was interrupted by the extreme weather conditions last winter, but “nowcasts” suggest that the last two quarters have seen a return to robust, above trend growth rates in the US, in sharp contrast to the depressed state of the economy in the euro area. Latest activity data show the US expansion touching 4 per cent, despite the disappointing jobs data released on Friday.

The key question is whether this apparently healthy recovery in growth rates can be maintained this time. This needs to be tackled from both the demand and supply sides of the economy. Read more

The Governing Council of the ECB has announced an important package of new measures, including cuts of around 0.1 per cent in policy rates, and an asset purchase programme of unknown size, confined to private sector assets, with no sovereign bond purchases. The immediate question that investors are asking is whether this is, at last, a programme of quantitative easing by the most reluctant of all quantitative easers, the ECB.

My instant answer is yes, this is indeed QE, and in significant scale. But its effects on expectations may be dampened by the fact that Mr Draghi was obviously so reluctant to admit as much. Read more

Mario Draghi (DANIEL ROLAND/AFP/Getty Images)

  © Daniel Roland/AFP/Getty

Mario Draghi’s remarkable speech at Jackson Hole has raised expectations that ECB purchases of sovereign debt will be soon announced by the governing council, if not this Thursday, then perhaps by the end of the year. In all the excitement about QE, the importance of Mr Draghi’s remarks about fiscal policy have gained less attention in the markets.

Mr Draghi’s speech broke new ground for an ECB president, and this could herald a significant change in the stance of fiscal policy in the entire euro area. Unusually, fiscal policy could be as interesting for markets as monetary policy in the months ahead.

Traditionally, ECB presidents have always argued in favour of fiscal austerity, and have of course refused to countenance any form of monetisation of budget deficits. The stance on monetisation changed a few months ago, and now even the Bundesbank accepts that QE is within the terms of the treaties.

But the Germanic approach to the fiscal stance (ie the level of budget deficits, as opposed to how they are financed), is only now being seriously questioned by the ECB for the first time. Not surprisingly, this is reported to have triggered consternation in Germany, and approval in France.

Mr Draghi’s new views on fiscal policy stem from a change in his underlying analysis of the economic problem facing the euro area. This has led the ECB president to throw his weight behind a fiscal plan which is slowly emerging from the European Commission, in conjunction with France and Italy. Now that the ECB has gone public on this, the pressure on Germany to give ground has increased markedly. The debate on this subject within Germany itself is clearly becoming crucial. Read more

“Pent up wage deflation” is an unfamiliar and somewhat abstruse term dropped into the economic lexicon last week by Janet Yellen at the annual Jackson Hole conference. Originally coined by researchers at the Federal Reserve Bank of San Francisco, the term is destined to be widely discussed because it is clearly influencing the US Federal Reserve chair’s thinking. If it exists, it would explain why wage inflation seems abnormally low, given the recent rapid drop in unemployment, and that could eliminate one important reason for keeping US interest rates at zero per cent for the “considerable period” promised by the central bank.

Ms Yellen is right to be aware of the concept, and to keep it under review, but in my view the Fed is unlikely to shift in a hawkish direction solely because of it. This blog explains the theoretical and empirical reason why this is the case.

(Warning some of these arguments are quite intricate – skip to the end if you want to avoid the economic debate and just want the policy implication.) Read more

For macro investors, the end of summer is usually signalled by the Kansas City Fed’s annual conference at Jackson Hole. On occasions, former Fed chairman Ben Bernanke used this gathering to indicate major changes in monetary policy, going far beyond the minor, incremental adjustments that central bankers undertake in their regular policy meetings. Two years ago, he described high unemployment as a “grave concern” and presented the case for an open-ended increase in the Fed’s balance sheet, which came to be known as QE3.

With US quantitative easing ending in October, the focus this year was on whether Fed chairwoman Janet Yellen would provide any fireworks. She did not. But Mario Draghi did, raising expectations in the markets that the European Central Bank might be ready to follow in the footsteps of Bernanke two years ago. This may be going a bit far, but the ECB President certainly stole the show this year. After Jackson Hole 2014, the world’s two major central banks are clearly headed in very different directions. Read more

There have been a few false alarms about a possible upsurge in inflation in the US in the past few years, even as core inflation on most measures has remained extremely subdued. There is an entrenched belief among some observers that the huge rise in central bank balance sheets must eventually leak into consumer prices, and they have not been deterred by the lack of evidence in their favour so far.

Another such scare has been brewing recently. Core CPI inflation is running at 1.9% on a year ago, even after today’s reassuring data for June. James Bullard, the President of the St Louis Fed, is warning that an upside inflation surprise is feasible in the near future, if indeed it is not already happening. Although Mr Bullard describes himself as the “north pole of inflation hawks”, he has not previously been a doom monger about immediate prospects for inflation, so his views deserve to be taken seriously. Read more

The Federal Reserve broke new ground last week when its Monetary Policy Report to Congress specifically warned that the valuations of smaller firms, especially in the biotech and social media sectors of the US equity market, seem “substantially stretched”. Although there was no sign that the Fed planned to take any action to bring down valuations in these sectors, this remark naturally led to a sharp sell-off in shares.

The Fed’s overall message on asset prices last week was a little more bearish than previously. They once again said that overall equity market valuations are “generally in line with historical norms“, but they warned that extremely low implied volatility in the options market possibly reflected “reach for yield” behaviour among some investors. Read more

One of the most notable aspects of the response of western democracies to the cataclysmic economic events of the past decade has been the absence of any attempt to restrict the powers of the central banks. Far from it. With little political controversy, they have been allowed to increase their balance sheets by over 20 per cent of GDP, enormously widen their regulatory role, and profoundly alter the distribution of wealth in our societies.

Cynics will say that it is easy for politicians to approve of central banks when they choose voluntarily to pursue unprecedentedly easy monetary policy. It is when this is reversed that political problems would normally be expected to arise. But, in the US, we are now seeing signs that some members of Congress are seeking to shackle the Fed, not because policy has been too tight, but because they think it has been too accommodative. Read more

Paul Krugman has written two interesting comments (here and here) on my recent “Keynesian Yellen versus Wicksellian BIS” blog. Paul says that the Bank for International Settlements should not be labelled “Wicksellian”, and then asks a typically insightful question: what constitutes “artificially” high asset prices? Some of the discussion below on this point may seem a bit arcane, but in fact it could prove highly relevant for investors.

The crux of the matter is Knut Wicksell’s definition of the (unobservable) natural rate of interest, and its difference from the actual interest rate, as set by the central banks [1]. Krugman says that the Wicksellian or natural interest rate is that which would produce equilibrium between savings and capital investment in the real economy (“full employment”), and therefore leads to stable inflation. If the central banks set the actual rate below the natural rate, inflation will rise, and vice versa.

Since US inflation has generally been stable or falling for years, Krugman infers that the Federal Reserve must have been setting the actual interest rate at about the right level, or even too high (because of the zero lower bound). The further implication is that if current low interest rates are justified, so too are the high asset prices that they have triggered. In that sense, they are not “artificial” [2]. Read more

The Bank for International Settlements (BIS) caused a splash last weekend with an annual report that spelled out in detail why it disagrees with central elements of the strategy currently being adopted by its members, the major national central banks. On Wednesday, Fed Chair Janet Yellen mounted a strident defence of that strategy in her speech on “Monetary Policy and Financial Stability”. She could have been speaking for any of the major four central banks, all of which are adopting basically the same approach [1].

Rarely will followers of macro-economics have a better opportunity to compare and contrast the two distinct intellectual strands in the subject, as explained in real time by active policy makers. Faced with exactly the same set of evidence, the difference in interpretation is stark, as is the chasm between them on monetary and fiscal policy.

Martin Wolf has already done a superb job in dissecting the BIS report. To a large extent, the dispute can be viewed as old wine in new bottles: the “Wicksellian” BIS versus the “Keynesian” Yellen [2]. But the Great Financial Crash has provided the two schools with plenty of new evidence to deploy. Read more

The revised data for US real GDP that were published last week would ordinarily have caused a major shock in global markets. The latest estimate shows an annualised decline of -2.9 per cent in Q1, down from a previous estimate of -1.0 per cent. If confirmed in future releases, this would be the weakest quarter for US real GDP outside a recession since the Second World War.

The markets largely ignored this piece of news because investors still seem convinced that the first quarter was hit by a series of temporary shocks to GDP. The extreme weather was clearly the main such shock, but there was also an outsized downward revision to the official estimate of consumers’ expenditure on health services. This alone knocked 1.2 percentage points off the GDP growth outcome for the quarter.

It is a mystery why this has occurred, given that the launch of the Affordable Care Act (Obamacare) in January was expected to boost health expenditure considerably. There is chance that the official data have been severely under-recorded in this area, but nobody knows quite why.

Another reason why the markets are ignoring any recession risk in the US is that the GDP data are at odds with many other sources of information on the underlying growth rate in the American economy, including the improving employment data, buoyant business surveys, and robust manufacturing and durable goods reports. Read more

The markets were little moved by Fed Chair Yellen’s press conference last week, though there was a slight sigh of relief that the Fed did not follow the example of the Bank of England in shifting towards hawkishness. The FOMC’s neutral stance, for the moment, was no great surprise.

More interesting is the fact that the FOMC’s “dot plot” showed that there is still a wide disparity of opinion among committee members about the appropriate level of interest rates in 2015 and 2016.

This disparity is much greater than the difference in the individuals’ economic forecasts would appear to justify, so it suggests that the policy reaction functions between the hawks and the doves remain very far apart. This argument has been shelved during the period of tapering, when the Fed is on autopilot. But the debate is very much alive beneath the surface. And Ms Yellen still seems to be firmly in the dovish camp.

(Note: some of this debate is slightly technical. Readers not interested in the technicalities should jump to the final section on Yellen’s “balanced approach”.) Read more

Mark Carney delivered a substantial hawkish surprise to the markets in his Mansion House speech on Thursday. After appearing to be a convinced dove ever since he became BoE Governor in July 2013, he now says that the first UK interest rate rise could come “sooner than expected”, with the decision on the timing of the first rise “becoming more balanced”. Market expectations of forward short rates in 2015 immediately jumped by 20 basis points.

Although the Governor is still talking about a very gradual rise in UK rates, he appeared to have changed the dovish tone of the forward guidance given by the BoE last year. This has made investors nervous, with many asking whether Fed Chair Janet Yellen may do the same in her press conference on Wednesday.

This seems unlikely, because the US economic recovery is still lagging that in the UK. Nevertheless, the parameters within which investors view forward guidance, including the Fed’s “dots” showing the future path for interest rates, may have been somewhat shaken. Read more

The US employment report on Friday was notable because it showed that the number of jobs in the American economy now exceeds the high point reached in January 2008 for the first time since the Great Recession. Another important signal that the economy is returning to normal, it might be claimed.

But a period of more than six years with zero growth in jobs in the American economy is anything but normal. According to the Economic Policy Institute in Washington, the US would need to create an extra 6.9 million jobs before the labour market could really be said to be back to normal, in the sense that all those who want employment would be fully satisfied.

The same point can be made about the path for real GDP in almost every developed economy since 2007. While several economies have now returned to their previous peak levels of output, very few have approached the previous long term trendlines which had been established for decades before that. For the developed economies as a whole, output remains about 12 per cent below these trendlines.

Because this level of output has never actually been attained in the real world, there is little sense of tangible loss about this, notably in the political sphere. Nevertheless, the opportunity cost could still be enormous. Read more

The European Central Bank’s decision to reduce the interest rate on deposits at the central bank to minus 0.10 per cent went as far as even the most ardent doves could reasonably have expected. Rates can probably fall no further. As Mario Draghi, the ECB president, said: “For all practical purposes, we have reached the lower bound.”
For that reason, the more technical elements of the package announced on Thursday in Frankfurt are in some ways the most significant. There was a €400bn injection of liquidity, in what the ECB called a “targeted longer-term refinancing operation” – a near copy of the Bank of England’s Funding for Lending Scheme. There was a form of quantitative easing, in which the central bank will buy securities backed by private sector loans. And there was the cessation of a “sterilisation” exercise, which had previously damped the monetary effect of the ECB’s purchases of government bonds.
 Read more

Fears of a crash in the Chinese property market are widespread in the financial markets. That is nothing new. The domestic real estate sector has been growing at breakneck speed ever since private property ownership was first permitted in 1998, and on several occasions, most recently in 2012, there have been dire warnings from western investors that housing supply was far outstripping demand.

An easing in monetary policy headed off a hard landing two years ago, but this may only have delayed the inevitable. The renewed correction in the market in mid 2013, which now seems to be gathering momentum, is certainly the main downside risk in the global economy in 2014.

Following the devastating global impact of the US property crash of 2005-08, it is little wonder that investors are paranoid that China might be treading the same path. But there are many differences between the US then and China now. The US housing crash was transformed into something far more serious by excesses in the financial sector, and by adverse wealth effects on consumer spending.

Even though China has also built up severe credit excesses in its shadow banking sector, it is hard to make the macro arithmetic add up to a shock comparable in size to the 2008 US/global meltdown.

(Apologies for greater length than usual in this blog – skip to “GDP effects” for the bottom line.) Read more

There is much talk about how and when the central banks will exit from unconventional monetary accommodation, at least in the US and the UK. So far, it is all talk and not much action.

A few months ago, it all looked very different. The Fed’s “taper tantrums” from May 2013 onwards had demonstrated that markets could be very vulnerable to any hint of an end to monetary accommodation, and US monetary conditions had tightened as bond yields rose.

The People’s Bank of China had embarked on what seemed likely to be a prolonged squeeze of the shadow banking sector. The ECB was refusing to ease its stance, despite an apparent threat of outright deflation. The Bank of England was thought likely to act against the UK housing bubble by raising rates before the end of 2014. Only the Bank of Japan seemed likely to press ahead with unlimited quantitative easing.

The markets feared that Fed tapering would soon trigger a global monetary tightening. So what has happened since? Precisely the opposite. Global financial conditions, on the best indicators available, have actually eased again in the first half of this year, and now stand near to their easiest levels since the financial crisis began.

Whether or not this will prove to be a policy mistake (please do not shoot the messenger!), it is another reminder to investors that any genuine monetary tightening could still be a very long way off. Read more

The UK’s very British economic recovery, dominated by London housing in particular and the consumer more generally, continues to strengthen. The Bank of England argued in its latest Inflation Report last week that there was no case yet for higher interest rates, and repeated its previous guidance that rate rises, when they come, will be very gradual.

But Governor Mark Carney spelled out much more clearly than ever before that he is now concerned about the risks to financial stability posed by the housing sector, and he came very close to promising that the Financial Policy Committee will take regulatory steps to dampen the market at its meeting in June.

The UK housing market is therefore shaping up to be the first major test of the new macro prudential weapons that the central banks now have at their disposal. The need for these new arsenals is very apparent, but it is much less clear whether they will actually work. Read more

Macro prudential policy has been designed in the wake of the great financial crash to solve a dilemma which policy makers faced, and failed to resolve, in the late 1990s and the mid 2000s. In those periods, consumer price inflation was subdued, persuading the central banks to restrain the rise in policy interest rates. Yet the financial sector entered phases of excessive risk taking, and these eventually ended in the equity crash of 2000 and the implosion of subprime credit in 2008.

The Greenspan doctrine, that interest rates should be set to achieve macroeconomic objectives, while the effects of financial excesses could be mopped up later, was found to be badly mistaken. In its place, the monetary authorities have unveiled a new set of cyclical regulatory and prudential controls that can be tightened when financial excesses occur, while inflation remains below targets. There are increasing signs that some central bankers, notably in the Bank of England and the Federal Reserve, think that the time is coming to use these new weapons as an alternative to rate rises.

Is this view justified? And will the weapons work, if deployed? Read more