Central Banks

The global markets remained in reflationary mode for much of last week, a regime that has now persisted for many months. Led by the US, bond yields have been rising, mainly because inflation expectations are on the increase. Risk assets have been performing adequately, with the exception of the emerging markets.

This reflationary regime has been driven by much stronger global economic activity since mid-2016, and latterly by a belief that Donald Trump’s election victory will lead to US fiscal easing, along with the possibility of the “politicisation” of the Federal Reserve, implying overly accommodative monetary policy.

There are various ways in which this regime could end. The world economy could suddenly go back to sleep, as it has on many occasions since 2009. The US fiscal easing could become bogged down in the Washington “swamp”. Or the Fed could become unexpectedly hawkish, stamping on the first signs of inflationary growth in the American economy. This last risk is probably under-estimated, and is worth considering in detail. Read more

Hillary Clinton and Donald Trump

Hillary Clinton and Donald Trump  © Getty Images

Presidential elections have often marked major changes in American attitudes towards fiscal policy.

The arrival of President Kennedy in 1960 represented the beginning of Keynesian fiscal activism. President Nixon’s election in 1968 marked the high point of inflationary budgetary policy designed to finance the Vietnam War.

President Clinton in 1992 ushered in a period in which the reduction of public debt was paramount. The elections of President Reagan in 1980, and George W. Bush in 2000, marked eras in which tax cuts took precedence over budget balance, and counter-inflation policy was ceded to the Federal Reserve.

As the 2016 election approaches, investors are wondering whether another major change in the approach to fiscal policy is in the works. Is a lurch towards fiscal stimulus the “next big thing” in Washington? Possibly, but I am not convinced. Read more

The great global disinflation in the advanced economies started in 1982, flattened in the 1990s and 2000s, and then nosedived towards deflation as commodity prices collapsed in 2014-15. For much of that final period, deflation fears dominated global bond markets and, to a lesser extent, equities and other risk assets. But there have been signs during 2016 that markets have edged away from a regime of “deflation dominance”, and we have seen partial signs of reflation.

It would be a bold call to claim that the great disinflation of the last three decades is now beginning to reverse. I am certainly not making that call. However, headline inflation is now rising towards the rates recorded before the oil price crash. There are signs that the risk of outright deflation is falling and, in some parts of the developed world, core inflation has edged higher. Read more

James Carville won the Presidency for Bill Clinton in 1992 with a sign in the campaign’s headquarters saying “The economy, stupid”. Maybe there should be a sign in the Federal Reserve saying “Demography, stupid”.

Central bankers, like investors, have usually tended to ignore or underplay the influence of demographic factors over the short and medium term. The size and age distribution of the population changes very gradually, and in a fairly predictable manner, so sizable shocks to asset prices from demographic changes do not happen very often.

That does not mean that demography is unimportant. The cumulative effects can be very large over long periods of time. Apart from technology, there is a case for arguing that demography is the only thing that matters in the very long run. But demographic changes usually emerge very slowly, so they do not trigger sudden fluctuations in the determinants of asset prices, notably the economic cycle and monetary policy.

However, there are exceptions to this rule, and we may be living through an important exception at the present time. It seems that the Federal Reserve is starting to recognise that the decline in the equilibrium interest rate in the US (r*) has been driven not by temporary economic “headwinds” that will reverse quickly over the next few years, but instead has been caused by longer term factors, including demographic change.

Because these demographic forces are unlikely to reverse direction very rapidly, the conclusion is that equilibrium and actual interest rates will stay lower for longer than the Fed has previously recognised. Of course, the market has already reached this conclusion, but it is important that the Fed is no longer fighting the market to anything like the same extent as it did in 2014-15. This considerably reduces the risk of a sudden hawkish shift in Fed policy settings in coming years.

Furthermore, greater recognition of the permanent effects of demography on the equilibrium real interest rate has important implications for inflation targets, the fiscal stance and supply side economic policy. These considerations are now entering the centre of the debate about macro-economic policy. Read more

Maurice Obstfeld, the Research Director at the IMF, said last week at the IMF/World Bank Annual Meetings in Washington that global growth “remains weak”, but is “moving sideways”. That is an accurate description of the current situation compared to previous decades, according to the latest results from the Fulcrum nowcasts of global activity.

However, compared to the more recent past, a better assessment would be “solid at the trend growth rate”. Although that trend growth rate is disappointingly low, it is no longer falling (according to the models), and the actual growth rate is no longer below trend, so the global margin of spare resources in no longer increasing. Read more

Fiscal policy activism is firmly back on the agenda. After several years of deliberate fiscal austerity, designed to bring down budget deficits and stabilise public debt ratios, the fiscal stance in the developed economies became broadly neutral in 2015. There are now signs that it is turning slightly expansionary, with several major governments apparently heeding the calls from Keynesian economists to boost infrastructure expenditure.

This seems an obvious path at a time when governments can finance public investment programmes at less than zero real rates of interest. Even those who believe that government programmes tend to be inefficient and wasteful would have a hard time arguing that the real returns on public transport, housing, health and education are actually negative [1].

With monetary policy apparently reaching its limits in some countries, and deflationary threats still not defeated in Japan and the Eurozone, we are beginning to see the emergence of packages of fiscal stimulus with supply side characteristics, notably in Japan and China.

Investors are asking whether this pivot towards fiscal activism is a reason to become more bullish about equities and more bearish about bonds, on the grounds that the new policy mix will be better for global GDP growth. This is directionally right, but it is important not to exaggerate the extent of the pivot. Read more

Since mid-February, the financial markets have become much less concerned about a hard landing in global economic activity, or at least about a potential clash between slowing economic activity and inappropriately tight macroeconomic policy from China and the US Federal Reserve. Financial conditions indicators have eased in the big economies, and this has been accompanied by a partial recovery in business surveys in many parts of the world.

In the last edition of our monthly report card on Fulcrum’s global nowcasts, we commented that economic activity had turned a corner in the US and China, but this was offset by continued weakness in several key economies, including Japan and the UK. A similar pattern is apparent in this month’s nowcasts. Global recession risks, which seemed elevated in January and February, have now receded, but the world economy is far from robust.

We therefore leave the overall verdict unchanged from last month: global activity growth is somewhat better, especially in the emerging economies, but it is still a long way from being satisfactory. (Full details of the latest nowcasts are shown here.)

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Foreign exchange traders are buzzing with talk of a new “Plaza Accord”, following the marked change in the behaviour of the major currencies after the Shanghai G20 meetings in late February.

Since then, the dollar has weakened, just as it did after the Plaza meetings on 22 September 1985. The Chinese renminbi has been falling against its basket, in direct contrast with the “stable basket” exchange rate policy that was publicly emphasised by PBOC Governor Zhou just before Shanghai. The euro and, especially, the yen have strengthened, in defiance of monetary policy easing by the ECB and the Bank of Japan.

Following Shanghai, the markets have become loathe to push the dollar higher, believing that the G20 may now have come to a co-ordinated agreement, as they did at the Plaza, to reverse the direction of the US currency. Does this comparison make any economic sense?

The Shanghai communique did place increased emphasis on an agreement among the major economies to avoid “competitive devaluations”. The main suspects here were Japan, the Eurozone and (sometimes) China, all of whom have good reasons to push their currencies down. The fact that the communique eschewed this course of action is therefore a reason to believe that the dollar might be subjected to less upward pressure. But that does not make it a new Plaza. Read more

Financial asset prices have been on a roller coaster in 2016. In mid-February, gloom was pervasive and global equities were down about 10 per cent year to date. Then came a sudden rally, wiping out all of the losses in the US equity market, but not in the eurozone market, and especially not in the Japanese market, which fell further.

What happened to generate this abrupt change of direction in February, and what does this tell us about the future? Read more

As Paul Krugman pointed out a year ago, a sharp difference of views about US monetary policy has developed between two camps of Keynesians who normally agree about almost everything.

What makes this interesting is that, in this division of opinion, the fault line often seems to be determined by the professional location of the economists concerned. Those outside the Federal Reserve (eg Lawrence Summers, Paul Krugman, Brad DeLong) tend to adopt a strongly dovish view, while those inside the central bank (eg Janet Yellen, Stanley Fischer, William Dudley, John Williams) have lately taken a more hawkish line about the need to “normalise” the level of interest rates [1].

My colleague David Blake suggested that this blog should carry a Galilean “Dialogue” between representatives of the two camps. Galileo is unavailable this week, but here goes. Read more

Janet Yellen

Janet Yellen, Fed chair  © Getty Images

This week has seen speculation about a mutiny from two members of the Federal Reserve’s board of governors against the leadership of Janet Yellen and Stanley Fischer, both of whom continue to say that they “expect” US rates to rise before the end of the year. Although “mutiny” is a strong term to describe differences of opinion in the contemplative corridors of the Fed, there is little doubt that the institution is now seriously split on the direction of monetary policy.

Furthermore, these splits could extend well beyond the date of the first rate hike to the entire path for rates in the next few years. Ms Yellen faces an unenviable task in finding a compromise path that both sides of the Federal Open Market Committee can support. Read more

In the aftermath of the supposedly “weak” US employment data published last week, investors seem to have shifted their assessment of the likelihood of the US Federal Reserve tightening interest rates by December — and also of the extent of tightening in the next two years.

Since the data were published, several investment banks’ economics teams have ruled out a December rise. Furthermore, equities have been strong; and the bond market’s implied probability of a 25 basis points rise in the federal funds rate by December has fallen from 76 per cent in mid-September to only about 40 per cent.

Nor is this seen as a minor postponement in the first rate rise. The expected federal funds rate at the end of 2016 implies only two Fed rate hikes in total over that entire period. Clearly, investors increasingly believe that the US economy is now slowing enough to throw the Fed off course.

This big change in market opinion is, frankly, surprising. The rise of 142,000 in non-farm payrolls in September was not all that weak, given the normal random fluctuations in the monthly data. And as John Williams, president of the San Francisco Fed, has pointed out, a slowdown to a monthly rate of increase of under 200,000 was long overdue anyway. Rightly or wrongly, there is little indication so far that important Federal Open Market Committee members share the market’s increased post-jobs-data dovishness.

The crucial question is how much growth in the US has slowed since the middle of the year, and whether this will continue. This is the kind of question that economic “nowcasts” are best suited to answer, so let us examine the recent evidence. Read more

The deleveraging of the Chinese economy has always seemed likely to be a long and troublesome saga, lasting many years or even decades if it is to prove successful. The latest episode involves a sudden collapse in domestic “A” shares, which have dropped by 19 per cent in less than a fortnight, and have triggered what has been widely described as an “emergency” easing in monetary policy this weekend. Read more

Lord Jim O’Neill, formerly my colleague and chief economist at Goldman Sachs, has just delivered his maiden speech as the new commercial secretary at the UK Treasury. He said that one of the government’s “primary objectives is to deliver a step change in the nation’s productivity”. Even for him, this represents a tough challenge. After featuring barely at all in the recent election campaign, low productivity growth has rightly become public enemy No 1.

Falling productivity growth has been an increasingly serious problem for most advanced economies since the early 2000s, when the boost from IT seems to have run out of steam. But the problem has been particularly severe since the 2008 financial crash, and the collapse in the UK since then has been much greater than in other advanced economies.

Overall, UK productivity had fallen about 16 percentage points below its previous trends by 2014, about a quarter of which might be due to faulty measurement in the official data. If the UK government is to make any inroads into the problem, it first needs to solve the “puzzle” of why the rest of this huge shortfall has occurred. Read more

Ever since the crash in 2008, the central banks in the advanced economies have had but one obsession — how to set monetary policy to ensure the maximum growth rate in aggregate demand. Interest rates at the zero lower bound, followed by a massive increase in their balance sheets, was the answer they conjured up.

Now, those central banks contemplating an exit from these policies, primarily the US Federal Reserve and the Bank of England, are turning their attention to the supply side of their economies. When, they are asking, will output reach the ceiling imposed by the supply potential of the economy?

The Bank of England has been in the lead here, with the Monetary Policy Committee recently conducting a special study of the supply side in the UK. Its conclusion was that gross domestic product is now only 0.5 per cent below potential, which implies that tighter monetary policy will soon be needed if GDP growth remains above potential for much longer.

In the US, the Fed has been much less specific than that, but the unemployment rate has now fallen very close to its estimate of the natural rate (5.0-5.2 per cent). Sven Jari Stehn of Goldman Sachs has used the Fed staffers’ supply side models to calculate that their implied estimate of the US output gap may be only 0.6 per cent, not far from the UK figure.

If the UK and US central banks were to act on these calculations, the implication would be that they no longer hold out much hope that they can ever regain the loss in potential output that has occurred in the past decade, relative to previous trends. That would be a massive admission, with an enormous implied sacrifice in future output levels if they are wrong. It would also be very worrying for financial assets, since it would draw the market’s attention to a downgrade in the Fed’s estimation of the long-run path for GDP. Read more

Downturn In Oil Prices Rattles Texas Oil Economy

  © Getty Images

Ever since the collapse in oil prices started last summer, the behaviour of the global economy and financial markets has been heavily affected by the consequences of lower energy prices. Now, however, there is gathering evidence that the primary effects of the oil shock have been absorbed into the system, and there are signs that other forces are beginning to take control. What are these forces, and how will they affect the global economy in the months ahead?

When the oil shock reached its maximum early in 2015, economists were largely agreed on its likely impact. Since it seemed to stem mainly from the supply side of the oil market, not the demand side (a fact corroborated by IMF research last week), it was thought likely to boost real global GDP growth this year by about 0.5-0.75 per cent, leading to a break-out in global growth to the upside. It also had a dark side, increasing the deflation threat in the eurozone and Japan, but this was likely to be offset by further aggressive monetary easing by their respective central banks. Read more

Yellen Discusses Monetary Policy At Federal Reserve Bank In San Francisco

  © Getty Images

Now that the Federal Reserve has announced that its policy stance after June will be entirely “data determined”, the markets are watching the flow of information on US economic activity even more carefully than usual. Since 2010, there has been a recurring pattern in US GDP projections. They start optimistically, but are then progressively downgraded as the economic data come in.

Entering 2015, I was fairly confident that this depressing pattern would finally be overcome, but not so far. In the last few weeks, there has been a sharp downward adjustment to GDP growth estimates for the first quarter, and this has added to the market’s scepticism about whether the Fed will be ready to announce lift off for interest rates this summer. Read more

When the Federal Open Market Committee meets on March 17-18, it will be able to drop the word “patient” from its statement without shocking the markets. After some confusion, the Fed’s intentions on the date of lift off now seem fairly priced, with Fed funds rate contracts showing a probability of more than 50 per cent that the first move will come in June. The behaviour of the dollar, and of core inflation, are likely to determine whether June or September is eventually chosen for lift off.

Once that is out of the way, the markets will turn their attention to a much harder question: how rapidly will rates rise after lift off? The market currently expects a much more gradual path than the median shown in the FOMC’s “dot” chart, but there is huge uncertainty about this question on the committee. As the graph above shows, the interest rate forecasts for individual members of the FOMC, which will be updated on Wednesday, have a very wide range.

According to Fed vice-chairman Stanley Fischer, the rationale for rate rises is that the Fed wants to embark on a process of “normalisation”, and he is adamant that today’s rates are “far from normal”. That, of course, raises the question: how should we define normal? On this, the leadership group on the FOMC is not offering much guidance, but a common way of answering the question among macro economists is to consult the Taylor rule. Read more

At the National People’s Congress in Beijing on Thursday, Premier Li set a target of about 7 per cent for GDP growth in 2015, and around 3 per cent for inflation. At present, both targets look hard to attain, especially on inflation. Economic reform remains paramount for the government, but China’s premier made clear that this could only succeed in the context of adequate growth. This will probably necessitate a progressive easing in fiscal, monetary and exchange rate policy – something that is already under way.

The Chinese renminbi’s exchange rate has weakened noticeably against the dollar in the past few weeks, raising concern that Beijing is joining the “currency wars” that are (allegedly) being waged by other major nations.

A big change in China’s exchange rate strategy would certainly be something to worry about. Not only would it mean that the deflationary forces evident in the country’s manufacturing sector would be exported to the rest of the world, it would also disrupt the uneasy truce on trade and exchange rate policy that has emerged between the US and China since mid-2014.

Fortunately, on the evidence available to date, it seems that China has changed its currency strategy in a relatively limited way, and in a manner that is difficult to criticise in view of exchange rate turbulence elsewhere in the world. Read more

When Federal Reserve chairwoman Janet Yellen gives evidence to the Senate Banking Committee on Tuesday, she has an opportunity to speak above the heads of the financial markets to Congress and the American people. There is pressure in the Senate to bring the Fed under Congressional “audit”, something that almost everyone in the central bank abhors. So Ms Yellen’s main message is likely to be about how well the Fed has done in recent years, focusing on the generally good out-turns for unemployment and inflation. Read more