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
China was promoted to the largest economy in the world last week, at least according to the implications of a new data set released by the World Bank. The new figures, which were not warmly welcomed by the Chinese authorities, involved a downward revision to the prices of non traded goods and services in China, therefore increasing the real value of GDP measured at purchasing power parity exchange rates. In 2014, China will overtake the US on this definition.
While the absolute size of the Chinese economy is clearly of interest (see Martin Wolf’s lucid analysis here), it was inevitable that China would overtake the US on the basis of PPP measures within a few years, so the latest revelation was not exactly a shock. Furthermore, PPP-based comparisons have many drawbacks, as Michael Pettis explains here.
The new price data are, however, important in another respect. This concerns the valuation of the yuan, and has direct implications for Chinese exchange rate policy, which could be on the verge of a profound change. In fact, Beijing’s attitude towards its currency could turn out to be the most important change in global macro economic policy so far in 2014. Read more
The FOMC meeting this week is not likely to see any policy fireworks, but it will mark the departure of Governor Jeremy Stein, who returns to academic life at Harvard at the end of May. He has only been on the Board for two years, but he has made an intellectual mark in a critical area where leading members of the FOMC have been largely silent – how to set monetary policy when the need to maintain financial stability is conflicting with the near term outlook for inflation and employment.
The issue can be simply stated: should the Fed tighten policy solely because they are worried about the emergence of bubbles in asset prices?
After the financial crash of 2008, this should be a subject close to the heart of the new Chair Janet Yellen and her senior colleagues. Up to a point, it is. An enormous amount of attention has been given to the new financial architecture that has followed the crash, and Chair Yellen has already spoken specifically about the importance of too-big-to-fail, and the reform of the wholesale money markets.
Yet the vast majority of the Fed’s recent communication has been on the familiar topics of estimating slack in the labour market, and the consequences of this for inflation. In its statements and minutes, the FOMC has generally given very little attention to the difficult question of how to maintain financial stability and thus avoid the next “Minsky moment”. Read more
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