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. Read more
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. Read more
The Ukraine crisis has been widely described as the most dangerous confrontation between Russia and the west since the end of the Cold War. Today’s talks between US Secretary of State John Kerry and Russian Foreign Minister Sergei Lavrov offer hope that the crisis might be defused, with the US suggesting what seems like a joint US/Russian demilitarised “protectorate” in the Ukraine, in exchange for Russian withdrawal from the Crimea.
We shall see whether that satisfies President Putin, whose recent rhetoric about Russia being “cornered for centuries” suggests that he might have much wider plans.
So far, the global financial markets, outside Russia, have been almost completely unaffected by events in the Ukraine. Initially, there was some decline in the stock markets of European economies with significant trading and banking links with Russia, including Germany, but recently these losses have been reversed.
The low probability of direct military confrontation between Russia and the west in the Ukraine is obviously key to this. Perhaps the markets also believe that the crisis will blow over without a major outbreak of tit-for-tat sanctions, beyond the limited restrictions on individuals which have been announced so far. Or perhaps they have concluded that, while the west can greatly damage the Russian economy, the same cannot happen in reverse.
What has become obvious is that the Russian economy itself is very vulnerable indeed to a worsening in the crisis. The burgeoning capital outflow since the start of 2014 has, in effect, imposed a form of economic “sanctions” on the Russian economy, without the need for western governments to take much action of their own. Western leaders clearly believe that this could turn out to be President Putin’s Achilles heel, though this reckons without the possibility that he will opt for riskier foreign adventures in an attempt to distract attention from economic weakness at home. Read more
When Janet Yellen was nominated to be Fed Chair in October 2013, the markets viewed her as the most dovish candidate the President could possibly have selected. Based on her decades of published economic research, that judgment seemed amply justified. At around the same time, the FOMC appeared to duck an obvious opportunity to taper its asset purchases in September. The Fed’s extreme dovishness appeared to be baked in.
However, in retrospect, last autumn turned out to be the high point for the dovish camp. Asset purchases were tapered in December; Ms Yellen quickly adopted language very close to the mid point of the FOMC, not the dovish end; and the statement after her first FOMC meeting last Wednesday led to an immediate jump of almost 15 basis points in the 5 year treasury yield.
Many commentators, including the normally well-informed Robin Harding and Jon Hilsenrath, argued that Ms Yellen had not intended to give such a hawkish signal. Viewed narrowly, that is probably right: Ms Yellen herself claimed there had been no change in policy last week.
But in a wider sense there has been an unmistakable shift in the FOMC’s centre of gravity in the past few months. The key to this shift is that the mainstream doves who have dominated policy decisions in the past few years have now essentially stopped arguing against either the tapering of the balance sheet or the start of rate hikes within about a year from now. Only the isolated Narayana Kocherlakota remains in the aggressive dovish corner.
The markets still seem entirely untroubled by this impending headwind for asset prices, but it is the new reality, unless the economy slows sharply. Read more
Financial turbulence continues to surround the emerging markets, raising the question whether this now morphing into a genuine EM crisis, of the type seen in previous eras of Fed tightening, including the early 1980s, and 1994-98. If so, how will it progress?
I have asked three distinguished international economists to debate this with me. They are Maurice Obstfeld (University of California, Berkeley), Alan M. Taylor (UC, Davis) and Dominic Wilson (Co-Head of Global Economics, Goldman Sachs). Each has produced leading edge research on this topic in recent years.
The entire debate is attached here, and I would encourage everyone interested in the subject to read it in full. However, since the text turned out to be fairly lengthy, I would like to offer here a summary of the main points which emerged.
Please contribute to any aspect of the debate in the comments section below. Read more
A few weeks ago, this blog advanced the theory that the behaviour of the major central banks, which had dominated market attention for so long, would not be the decisive element for asset prices in 2014. With the Fed, the Bank of England and the ECB all increasingly doubtful about the effectiveness of further growth in their balance sheets, the central banks had become much more circumspect about how much more monetary policy could achieve. Supply side pessimism was gaining ground.
So far, so good for this theory. The Fed has embarked upon “tapering by auto pilot”, and seems increasingly satisfied with its handiwork. A moderate recovery in GDP growth, along with much diminished risks of financial market disruption, is sufficient. They are in no hurry whatsoever to reduce the size of their balance sheet, and that could yet cause trouble; but nor do they show much urgency to return the US economy to its long term output trend.
Emergency policy interventions like QE3 in 2012 have been replaced by an atmosphere of calm. Following the example of the medical profession, they seem to have decided: “first, do no harm”. Read more
American optimism is irrepressible and an enormous comparative advantage for the nation. Yet the actual economic experience of the median American has been rather disappointing in the past four decades, and there is pronounced pessimism among some economists about the medium term future.
For example, Robert Gordon of Northwestern University, a very distinguished academic, specialising in long term economic growth, predicts that the real living standards of all but the top 1 per cent in the income distribution will barely grow at all in the decades ahead. In other words, the economic performance of America may not be reflected in the experience of most Americans.
Such a gloomy forecast may seem startlingly improbable to most people, but the historic experience of the vast bulk of the population has been no better than that since 1973. Over the whole of that period, median real household income has actually risen by only 0.1 per cent per annum.
There are three main reasons for this – the profits share in the economy has risen at the expense of labour income; the distribution of labour income has become much more skewed in favour of the top 1 per cent, so the median (mid point) of the income scale has grown far more slowly than the average; and the rate of growth of productivity has fallen sharply for most of the period, despite the growth of information technology.
These factors are now well known and have been much debated. But Robert Gordon’s latest work goes even further, predicting almost no improvement into the indefinite future for the vast bulk of the population. Read more
There has been a significant weakening in China’s exchange rate in recent days. Although the spot rate against the dollar has moved by only about 1.3 per cent, this is actually a large move by the standards of this managed exchange rate. Furthermore, the move is in the opposite direction to the strengthening trend seen in the exchange rate over the past three years.
This has triggered some pain among investors holding long renminbi “carry” trades, along with much debate in the foreign exchange market about what the Chinese authorities are planning to do next. Since China does not explain its internal or external monetary policy in a transparent manner that is intelligible to outsiders, there is much scope for misunderstanding its true intentions. The key question is whether the Chinese authorities are changing their commitment to a strong exchange rate and, if so, why? Read more
The G20 Summit in Sydney ended on Sunday with a call to boost global growth by 0.5 per cent per annum from 2014-18, thus raising world output by over 2 per cent ($2.25 trillion) in the final year of the period. Australia, the host country, had been pushing for the adoption of a global growth target, and US treasury secretary Jack Lew said after the meeting that this target marked a profound change of tone for the G20, compared with the focus on budgetary austerity in previous years.
Others, like the ECB and the German Finance Minister, were much more sceptical, and in fact no new measures have yet been adopted to help attain the growth targets. The real test will come at the Brisbane G20 Summit in November, when concrete measures are intended to be unveiled.
Policymakers may pay lip service to the need for reforms, but in practice they seem increasingly satisfied with the rather weak economic recovery which is now underway in the developed economies. The good news is that the underlying recovery in GDP does not seem to have been significantly dented, despite the slowdown in the manufacturing sector, in recent months. Read more