The extraordinary volatility in all financial asset classes in the past week can only be described as ominous. On Wednesday, the US ten year treasury, perhaps the most liquid financial instrument in the world, traded at yields of 2.21 per cent and 1.86 per cent within a matter of hours. This type of volatility in the ultimate “risk free” asset has previously been seen only in 2008 and other extreme meltdowns, so it clearly cannot be swept under the carpet.
A few weeks ago, investors had widely expected a strengthening US economy to lead to a rising dollar and a tighter Federal Reserve, with an amazing 100 per cent of economists saying they were bearish about bonds in a Bloomberg survey in April. Instead the markets have started to act as if the world is about to topple into recession, and an abrupt reversal of speculative positions has probably led to exaggerated market moves, in both directions.
Now that excessively large positions have been washed out, what is the underlying message from the past month of market action? Read more
Financial markets caught a nasty chill last week, when extremely weak activity data from Germany coincided with fears that the ECB could not overcome Bundesbank opposition to more aggressive quantitative easing. Then the IMF reported that there is a 40 per cent probability of a recession in the euro area within 12 months, along with a 30 per cent chance of outright deflation. Markets fear that policy makers in the euro area are once again losing control over their weakening economy.
Since markets often sniff out impending trouble before economists do, there is, as Martin Wolf warns, no room whatever for complacency. But, so far, the blip in global risk assets hardly registers on the Richter scale. Nor is there much evidence from published data of a major slowdown in global GDP growth up to now.
US domestic demand is strengthening, and the 20 per cent fall in oil prices since June will boost the oil importing economies markedly in coming months. Unless euro area policy is spectacularly dysfunctional, which I do not expect, the slide in the euro area should not be powerful enough to offset these expansionary forces. Read more
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Last week’s press conference by ECB President Mario Draghi left the markets disappointed and somewhat perplexed about the shift towards quantitative easing that had just been sanctioned by the governing council (GC). Because this was focused on private sector assets, in the form of asset backed securities and covered bonds, there were doubts about whether the new policy could be implemented in sufficient size to deal with the deflationary threat in the euro area.
Mr Draghi was noticeably hesitant about giving any firm indication about the likely scale of the programme. Although private sector quantitative easing (QE) is likely to suit the needs of the euro area rather well, as I argued here, the absence of any firm guidance on scale certainly undermined the beneficial announcement effects of the policy change.
The ECB president addressed this issue on Thursday in an appearance at Brookings in Washington. This time, freed from the need to speak for the entire GC, he clearly changed his tune on the scale of the programme. But this highlighted the extent of the gap between his view and that of Bundesbank President Jens Weidmann, who presented his position in a revealing interview with the Wall Street Journal on Monday. It is far from obvious how this disagreement will be bridged. Read more
Tuesday’s extremely weak German industrial production figures published for August have come an awkward time for the German government. An informal “employment conference” including some EU leaders has been called by Italian Prime Minister Renzi, and it is scheduled to take place, amid little advance publicity, in Milan on Wednesday. This will presumably set the stage for the next European Council meeting on October23. In between will be the International Monetary Fund/World Bank annual meetings in Washington, when the German approach to economic policy in the euro area will be heavily scrutinised.
The official German line heading into these meetings is that the recovery is proceeding well, both in Germany and in the euro area as a whole, implying that the recent marked weakening in both gross domestic product and inflation data are just a temporary aberration. There is no sign that the Merkel administration is ready to change its longstanding formula for economic success in the eurozone: member states should stick to the fiscal targets in the Stability and Growth Pact, and should accelerate structural reforms, so that the expansionary monetary stance provided by the European Central Bank can bear fruit. Read more
The annual meetings of the IMF and World Bank will take place in Washington next week, with Christine Lagarde warning that the global economic recovery is “brittle, uneven and beset by risks”. Nowhere is this more true than in the euro area, where forecasts for GDP growth and inflation have both been revised progressively downwards, and where medium term inflation expectations are no longer consistent with the ECB’s inflation target.
ECB President Draghi’s remarkable speech at Jackson Hole in August seemed to offer a bold way forward, incorporating structural reform, fiscal easing and monetary expansion. Unfortunately, there have been few signs that political leaders are eager to co-operate with Mr Draghi on the first two of these three pillars, and even the third seems to have run into familiar obstacles on the ECB governing council. Read more
Much of the attention at the last policy meeting at the Federal Reserve was focused on the FOMC’s indication that interest rates would stay unchanged for a “considerable time”. But a more fundamental issue concerns another key phrase in the statement, which is the FOMC’s assertion that “there remains significant under-utilisation of labour resources” in the US. We are likely to find out more about this on Friday, when the US jobs data for September will tell us whether last month’s weak release was an aberration.
If there is still a large margin of slack in the labour market, despite tumbling unemployment figures, the Fed is unlikely to tighten monetary conditions very much in the next couple of years. Slack will also keep the wages share in national income low, thus boosting the profits share further. The utilisation of labour resources in America is thus critical not only for monetary policy, but also for the outlook for US equities.
The academic discipline of labour economics, which has not really been centre stage since the wage-push inflation of the 1970s, is therefore very much back in vogue. Empirical labour economists are needed to determine whether the decline in the official unemployment rate is providing the correct read on labour market slack and, if not, how to handle the problem.
This was the subject of a very timely conference at the Peterson Institute last week, which brought together many leading labour market academics, as well as key officials from the policy establishment in Washington and the wider Fed. The debate is available on the web, and is worth watching in full.
The overall message, which almost certainly reflects what the FOMC is being told by the academic and official economics community, was more dovish than I had expected.
Despite the fact that the official unemployment rate has fallen close to the Fed’s estimates of its “natural” or equilibrium rate, few empirical labour economists seem to believe, at least with any certainty, that labour resources are near full utilisation at present. Read more
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China’s economic rebalancing has been the main downside risk to global economic activity in 2014, and will probably remain so for the foreseeable future. The industrial production figures for August were the weakest seen since the 2008-09 recession, and they were followed by a statement from finance minister Lou Jiwei to the effect that there would be no change in economic policy “in response to one indicator”.
This echoed Premier Li Keqiang’s recent speech at the summer Davos meetings, which indicated broad satisfaction with the overall thrust of policy. “Just like an arrow shot, there will be no turning back”, he promised.
The possibility of a clash between a slowing economy and a Chinese administration that appears implacably set on a pre-determined course was not what the markets wanted to hear. Many western investors have long been predicting a hard landing for China, and do not need much persuasion to believe that it is finally at hand. But recent data do not suggest that it is happening yet. Read more
As the market awaits the Federal Reserve’s statements on Wednesday, the focus is on whether the FOMC will choose to signal a significant shift in a hawkish direction since its last meeting in July. Many investors believe that the key litmus test for this will be whether it chooses to drop two words from its July statement.
These words are “considerable time”. If that phrase disappears, then the market will need to absorb the fact that the Fed has deliberately chosen to force an upward adjustment in forward interest rate expectations, for the first time in this economic cycle. Read more
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 .
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
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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 . 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” . 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 .
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 . 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