Macroeconomics

US monetary policy has now clearly embarked on an important new phase. For a long while, the markets have been extremely reluctant to recognise that the Federal Reserve might actually mean what it says about increasing short term interest rates by 0.25 per cent on three separate occasions this year. Remembering repeated episodes in which the Fed has failed to deliver its threatened tightening in policy since 2013, investors have concluded that dovish surprises from the Fed are endemic.

Last week, however, they woke up to the fact that FOMC really is serious about raising rates in March, and that this may be the first of three or even four rate hikes this year. After a series of hawkish speeches by several FOMC heavyweights, the coup de grâce came on Friday, when Janet Yellen warned that a rate rise in March “would be appropriate” unless economic data surprised in the meantime. She added rather ominously that policy accommodation would be removed more rapidly this year than in 2015 and 2016.

The great unknown is whether this will come as a major shock to the financial markets. It will certainly mean that investors will need to build in a faster path for rate hikes in the near term than anything that has previously been contemplated in this cycle. But the good news is that the final destination for rates does not seem to be changing, at least in the view of the FOMC. The Committee is increasing the speed of travel towards its destination, but is not changing the destination itself.

So what has justified the shift toward more hawkish thinking on the FOMC? And will this upset the equity market, which is still ignoring the prospect of higher rates? Read more

A year ago, Lawrence Summers’ perceptive warnings about the possibility of secular stagnation in the world economy were dominating global markets. China, Japan and the Eurozone were in deflation, and the US was being dragged into the mess by the rising dollar. Global recession risks were elevated, and commodity prices continued to fall. Fixed investment had slumped. Productivity growth and demographic growth looked to be increasingly anemic everywhere.

Estimates of the equilibrium real interest rate in many economies were being marked down. It seemed possible that the world economy would fall into a “Japanese trap”, in which nominal interest rates would be permanently stuck at the zero lower bound, and would therefore not be able to fall enough to stimulate economic activity.

Just when the sky seemed to be at its darkest, the outlook suddenly began to improve. Global reflation replaced secular stagnation as the theme that dominated investor psychology, especially after Donald Trump’s election in November. Why has secular stagnation lost its mass appeal, and has it disappeared forever? Was it all a case of crying wolf? Read more

President Trump has an almost unprecedented opportunity to reshape the key personnel and legal basis of the Federal Reserve in the next 12 months, essentially rebuilding the most important economic organisation in the world in his own image, if he so chooses.

The President may be able to appoint five or even six members to the seven-person Board of Governors within 12 months, including the Chair, Vice Chair for monetary policy, and a new Vice Chair for banking supervision. He may also be able to sign into law a bill that alters aspects of the Fed’s operating procedures and accountability to Congress, based on a bill passed in 2015 by the House of Representatives.

Not surprisingly, investors are beginning to eye these changes with some trepidation.

Some observers fear that the President will fill the Fed with his cronies, ready to monetise the budget deficit if that should prove politically convenient. Others fear the opposite, believing that the new appointments will result in monetary policy being handed over to a policy rule (like the Taylor Rule) that will lead to much higher interest rates in the relatively near future. Still others think that the most important outcome will be a deregulation of the banking system that results in much easier credit availability, with increased dangers of asset bubbles and economic overheating.

It is not difficult to see how this process could work out very badly indeed. But, at present, I am optimistic that a modicum of sense will prevail. Read more

It has been clear for a while that the most important political risk to global financial markets in 2017 will be the possible election of a President Marine Le Pen in the second round of the French elections on 7 May. Last week, this risk came into sharper focus when a small change in the odds of her winning the Presidency caused a sudden widening in Eurozone bond spreads, with the France-Germany spread reaching about half of the average levels seen during the euro crisis of 2011 (see graph).

Investors have now become accustomed to political shocks driven by swings towards populism, notably in the UK and the US last year. These experiences have led some investors to conclude that a third “populism” surprise is quite likely in France because “no-one can believe the polls any more”. But they have also tended to add that “Brexit and Trump did not disrupt the markets, so Le Pen would not do so either”.

Both of these inferences are wrong. The risk of a President Le Pen is far lower than the ex ante risk of Brexit or President Trump was last year, but the consequence of her winning would be far worse. This time, the “experts” are not exaggerating how bad it could be for markets. Read more

In mid 2016, the global economy embarked on a regime of reflation that has been dominating market behaviour ever since then. This has constituted a simultaneous rise in real output growth, along with a rebound in inflation as commodity prices have recovered from their 2014-15 slump.

The result has been a sharp increase in nominal GDP growth in most of the major economies. As the secular stagnation theme has lost its potency for investors, a decline in the perceived risk of outright deflation has triggered a rise in breakeven inflation expectations in bond markets everywhere.

One of the most important questions for 2017 is whether this bout of reflation will continue. My answer, based partly on the latest results from the Fulcrum nowcast and inflation models (see first graph), is that it will continue, at least compared to the sluggish rates of increase in nominal GDP since the Great Financial Crash.

However, the nature of the reflation theme is changing. The term “reflation” does not necessarily imply that global inflation, or inflation expectations, will continue to rise very much from here.

A likely pattern in 2017 is that there will be upgrades in consensus forecasts for real output growth, but inflation will stabilise, and will not threaten to break above central bank targets in most advanced economies.

Equities and other risk assets would probably view this as a healthy mix of output and inflation components of national income, while bond markets would probably exhibit a stabilisation in breakeven inflation expectations, with real yields rising a bit. Read more

Investors are an emotional crowd, especially when US equities, measured by either the Dow Jones Industrial Average or the more accurate S&P 500 index, have just hit all-time highs. I am not sure who first remarked that market behaviour is motivated by two competing emotions, fear and greed. But I do know that Albert Einstein claimed that “Three great forces rule the world: stupidity, fear and greed”.

Some of the macroeconomists that I have learned not to ignore, like Lawrence Summers and Martin Wolf believe that the outlook for the US economy under President Trump is at best uncertain, and that the recent equity market highs are a “sugar rush”. I recognise that some of these critics have major political differences with the new Administration. But many others, like the perceptive and apolitical John Authers, are also very concerned about equity over-valuation.

So, are investors being “stupid”?

One of the advantages of using economic models to analyse the equity market is that the models should be good at avoiding all three of Einstein’s great forces.

That does not make the models the only source of wisdom about future asset returns. Far from it. They are good at avoiding some of the behavioural mistakes that investors are known to commit, such as a tendency to dislike losses about twice as much as they like gains. But human beings may be better at recognising when the investment climate is about to change because of policy upheavals.

In this article, I will try to eliminate emotion by reporting some recent results from the suite of economic and financial models built by Juan Antolin Diaz and his team at Fulcrum. The results are somewhat encouraging: recession risks in the US are low and the over-valuation of equities is less clear cut (on some measures) than is sometimes supposed.

In the short term, however, there are signs that the most active short term traders in the market may be heavily exposed to equities at the present time. This could make the market vulnerable in the short term to policy shocks that cannot be incorporated into the models, such as a major outbreak of trade protectionism. Read more

The sharp drop in sterling that has followed the Brexit referendum has imparted a major shock to anyone doing business, or owning assets, across the UK border [1].

In last week’s strategic speech, the prime minister apparently opted for a hard or so-called “clean” Brexit. This could result in Britain leaving the EU single market and possibly the customs union, and then relying on World Trade Organisation rules to govern trade with the EU. Britain would like to improve on that deal by negotiating a free trade area in some industries and services, but a “clean” Brexit may not include such deals at the outset.

Many of those affected by the devaluation appear to think that it is “obvious” that the pound will decline further under Mrs May’s new scenario. But nothing in the currency market is that obvious. This column discusses the large uncertainties that inevitably surround forecasts of sterling’s behaviour in the period around Brexit. Read more

The financial markets have begun to wake up to the fact that the Republican reforms to US corporate taxation will probably include important new “border adjustments” to the definitions of company revenues and costs. The basic idea is that US should shift to a “territorial” system, with corporations being taxed only on revenues and costs incurred within the US itself, and not on their worldwide aggregates, which is the principle behind the present system. [1]

A border tax was not explicitly part of the Trump platform before the Presidential Election. It was, however, included in the tax plan published last year by Paul Ryan in the House of Representatives, and Mr Trump has recently tweeted that companies that do not “make in USA” can expect to “pay big border tax”. That might be compatible with the Ryan plan, though it also might not be.

Although most other countries already operate “territorial” systems, the Republican plan includes other features that would make the new tax regime operate like a tariff on imports into the US, combined with a subsidy on many exports from the US, a combination that would have profound international economic consequences.

This is not just an obscure change to the details of America’s corporate tax code. It would be seen by trading partners as a protectionist measure that could disrupt world trade.

The direct effects of a border tax adjustment to the US corporate tax regime would be likely to raise American inflation, cut imports, boost exports and raise tax revenue, possibly by over $1.2 trillion over a decade. However, it would also raise the dollar’s exchange rate, which could offset or cancel out some of these other effects.

The impact on real GDP and employment would depend on how these effects panned out, and how the Federal Reserve reacted to the increase in inflation. It cannot be assumed that the effects would be beneficial. Recent estimates by Michael Gapen and Rob Martin at Barclays Capital suggest that the first year effects would be to raise US inflation by about 0.5-1 per cent, and to reduce real GDP by 1.0-1.5 per cent.

Given these economic effects, it is very doubtful whether this form of border tax, taken in isolation, would be good for the overall equity market, though other planned reforms to the corporate tax regime (including lower marginal tax rates, and full deduction of capital spending in the first year) certainly would be. Read more

Exactly a year ago this week, the mood in the financial markets started to darken markedly. As 2015 had drawn to a close, financial markets had seemed to have weathered the first increase in US interest rates since 2006 in reasonable shape. The Federal Open Market Committee had telegraphed its step to tighten policy in December 2015 with unparalleled clarity. Forewarned, it seemed, was forearmed for the markets.

Meanwhile, China had just issued some new guidance on its foreign exchange strategy, claiming that it would eschew devaluation and seek a period of stability in the RMB’s effective exchange rate index. This had calmed nerves, which had been elevated since the sudden RMB devaluation against the dollar in August 2015.

A few weeks later, however, this phoney period of calm had been completely shattered. By mid February, global equity markets were down 13 per cent year-to-date, and fears of a sudden devaluation of the RMB were rampant. It seemed that the Fed had tightened monetary policy in the face of a global oil shock that was sucking Europe and China into the same deflationary trap that had plagued Japan for decades. Secular stagnation was on everyone’s lips.

We now know that the state of the global economy was not as bad as it seemed in February, 2016. Nor was the Fed as determined as it seemed to tighten US monetary conditions in the face of global deflation. And China was not set upon a course of disruptive devaluation of the RMB. Following the combination of global monetary policy changes of February/March last year, recovery in the markets and the global economy was surprisingly swift.

A year later, the key question for global markets is whether the Fed and the Chinese currency will once again conspire to cause a collapse in investors’ confidence. There are certainly some similarities with the situation in January 2016. The Fed has, once again, tightened policy, and China is battling a depreciating currency. But there are also some major differences that should protect us this time. Read more

As the global economy enters 2017, economic growth is running at stronger rates than at any time since 2010, according to Fulcrum’s nowcast models. The latest monthly estimates (attached here) show that growth has recovered markedly from the low points reached in March 2016, when fears of global recession were mounting.

Not only were these fears too pessimistic, they were entirely misplaced. Growth rates have recently been running above long-term trend rates, especially in the advanced economies, which have seen a synchronised surge in activity in the final months of 2016. Read more

The rise in political “populism” in 2016 has forced macro-economists profoundly to re-assess their attitude towards the basic causes of the new politics, which are usually identified to be globalisation and technology. The consensus on the appropriate policy response to these major issues – particularly the former – seems to be changing dramatically and, as Gavin Kelly persuasively argues, probably not before time.

Unless economists can develop a rational response to these revolutionary changes, political impatience will take matters completely out of their hands, and the outcome could be catastrophic. Unfortunately, while the nature of the problem is coming into sharper focus, the nature of a solution that makes economic sense while also being politically feasible remains embryonic at best (see Danny Leipziger). Read more

A year ago, there was a pervasive mood of gloom among economists and investors about prospects for the global economy in 2016. China was in the doldrums, and fears of a sharp renminbi devaluation were rife. The oil shock had caused major reductions in capital spending in the energy sector, and consumers seemed reluctant to spend the large gains they were enjoying in real household incomes.

Deflation risks dominated the bond markets in Japan and the Eurozone. In the US, the Federal Reserve seemed determined to “normalise” interest rates, despite the rising dollar and the weakness in foreign economies.

At the turn of the year, there were forecasts of global recession in 2016. At the low point for activity and risk assets in 2016 Q1, the global growth rate (according to the Fulcrum “nowcasts”) had dipped to about 2 per cent, compared to a trend growth rate of 4 per cent. It was a bleak period. The dominant regime in financial markets was clearly one of rising risk of deflation.

Since then, however, there has been a marked rebound in global activity, and in recent weeks this has become surprisingly strong, at least by the modest standards seen hitherto in the post-shock economic recovery. According to the latest nowcasts, the growth rate in global activity is now estimated to be 4.4 per cent, compared to a low point of 2.2 per cent reached in March.

The latest growth estimate is the highest reported by the nowcast models since April, 2011 – before the euro crisis and the China slow-down hit global activity very hard. This relatively upbeat take on the current state is supported by alternative data sources. For example, the Goldman Sachs Global Leading Indicator has just reached its highest point since December, 2010.

The uptick in global activity growth has, of course, been accompanied by a rise in headline inflation rates in almost all major economies. Recently, I argued that this jump in inflation was still “weak and patchy”, and almost entirely due to the partial recovery in oil prices, which has been taken further this week by the market reaction to the OPEC decision to reduce oil production.

However, the bond markets have taken the reflation trade increasingly seriously, in part because of the assumed shift towards fiscal easing after the election of Donald Trump in the US. Although the case for a rise in core inflation in 2017 (as opposed to headline inflation) is far from convincing, the recent rebound in global activity may well give the “reflation trade” a further leg upwards.

Morgan Stanley says that investors have stopped asking “is reflation happening?” and instead they are now asking “will it prove sustainable?” It is easy to be sceptical about this. We could be observing nothing more than another short term spike in activity. But, for the moment, the newsflow is clearly improving in a manner that has not hitherto been seen during the faltering “recovery” from the Great Financial Crash. (Full details of the monthly nowcasts can be found here.) Read more

Perhaps the most important among all the many uncertainties surrounding the economic policy of the Trump administration are those related to trade and protection. During the election campaign, the president-elect made blood-curdling promises in this area, and his official campaign documentation was no less strident. If he intends to implement a large part of this agenda in office, the chances of a global trade war would be high.

Last week, trade issues moved to centre stage in the transition. The president-elect released a video confirming that America would immediately withdraw from the Trans-Pacific Partnership, a trade deal that had been intended to be the culmination of President Barack Obama’s political and economic pivot towards Asia.

This was no surprise, since the political supporters of the deal ran for cover during the 2016 elections, but it does mean that any further liberalisation of US trade (including the Transatlantic Trade and Investment Partnership with the EU) is now dead in the water.

It also provides China with a clear opportunity to take the lead in forming an Asian trading bloc, and they have eagerly stepped up to the plate. None of this will have immediate adverse consequences for global markets. It is an opportunity missed rather than a step backwards.

The second big development is the rumoured appointment of Wilbur Ross as commerce secretary (see Gillian Tett). Mr Ross is a business person rather than an ideologue on trade. If anything, he seems to be from the supply side wing of the Republican party. The market would vastly prefer this appointment to a feasible alternative such as Peter Navarro, who is an outright hawk on trade relations with China (and, somewhat ironically, the only PhD economist in Trump’s advisory team).

Although Mr Ross clearly believes that the US should be far more assertive in its trade negotiations with other countries, he has played down the likelihood of dramatic initiatives such as Mr Trump’s threat of a 45 per cent tariff on all imports from China. He has also said clearly that “there will be no trade wars”.

If this turns out to be the dominant tone of the Trump administration, then the tide of globalisation may not be rolled back very far in the next few years, and the global markets will breathe a huge sigh of relief. Read more

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

The response of the financial markets to the US election result has been almost as contradictory as the rabble rousing campaign of the President-elect himself. Unmitigated gloom in the hours after the Trump victory was swiftly followed by a euphoric atmosphere in US markets.

Investors are apparently assuming that the new administration will usher in a mix of fiscal reflation, prudent monetary policy, deregulation and tax cuts that will prove very good for the American economy. Trade controls are seen as damaging the emerging economies, but not the US. A steeper yield curve is seen as reflecting a “better” mix between fiscal and monetary policy.

With one very graceful acceptance speech, Donald Trump has suddenly morphed into Ronald Reagan in the markets’ consciousness. 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

The sharp decline in sterling since the UK voted for Brexit has been widely viewed by economists as inevitable and, for the most part, desirable. Brexit will probably reduce UK productivity and competitiveness, so living standards will be lower than otherwise. The decline in sterling raises domestic inflation, which is the main route for the necessary decline in living standards to be imposed on the population. It also repairs the loss in the UK’s international competitiveness. The IMF has estimated that a drop of 5-15 per cent in sterling should be sufficient to do the job.

Sterling is now 16 per cent lower than it was on referendum night. What appeared to be an orderly decline in the exchange rate has shown signs of getting out of hand in the wake of the Prime Minister’s speech at Conservative Party conference, in which she appeared to favour a hard Brexit.

This could be a negotiating stance, or it could be a genuine political preference: we will not find out until mid 2019. But markets are saying that a hard Brexit will require a larger drop in sterling to restore equilibrium. This will result in higher inflation than previously contemplated.

Separately, the Governor of the Bank of England appears more willing than before to accept a “temporary” rise in inflation, while keeping domestic interest rates close to zero. The combination of hard Brexit with a super-easy central bank is not a recipe for a strong currency.

There has been some loose talk that this loss of confidence could develop into something really nasty – a sterling crisis. Although the UK has been a serial offender in this regard since leaving the Gold Standard in 1931, I doubt it will happen this time. 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