Macroeconomics

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

The crisis in the emerging markets’ “fragile 8″ , which threatened to sweep all before it a few weeks back, seems to have settled down almost as quickly as it erupted onto the scene. Investors are already asking whether it is now safe to enter the undoubted attractive valuations in the emerging world.

After the latest rally, emerging assets have performed almost in line with developed equities since the beginning of the year, and there has been little sign of the sudden jump in correlations between countries with good and bad fundamentals that is the hallmark of a genuine crisis in the emerging world. After all the hype, surely that cannot be the end of it, can it? Read more

The governing council of the European Central Bank meets on Thursday amid rising expectations in the market that it will signal another easing in monetary policy, either in February or March. Most ECB watchers now expect the council to cut the refinance rate by around 15 basis points before quarter end (from 0.25 per cent to 0.10 per cent), and some expect the deposit rate to be reduced into negative territory for the first time. This action would be in response to recent volatility in money market rates, and an unexpectedly low inflation rate of 0.7 per cent for the euro area in January.

If the ECB was to follow this course of action in the next couple of months, it would represent another relatively minor adjustment in its policy stance in response to surprisingly low inflation data. It is still thinking in terms of incremental changes in policy, rather than anything more dramatic. This, of course, follows from the fact that the ECB has a pessimistic view of the growth in potential output since 2008, implying that the output gap is fairly small, and that inflation in the medium term will gradually return to the target of “below but close to” 2 per cent.

This view is, however, being increasingly challenged by the data. Some forecasters now see the 12-month inflation rate falling to only 0.5 per cent in the spring, depending on the behaviour of oil prices. More importantly, core inflation also continues to drop. After the next round of interest rate cuts, the central bank will genuinely be at the zero lower bound for the first time ever. The ECB will therefore face a major problem if the inflation data confound again, and head towards zero. Read more

The start of 2014 has seen the global markets decisively in risk-off mode, with global equities falling, government bonds rallying and many emerging market currencies collapsing. Yet few investors currently believe that the risk-off pattern will continue in the developed markets (DM’s) for the year as a whole. The bullish consensus for developed equities remains firmly intact, for now.

Economic fundamentals in the DM’s have not really changed. There have been some mildly disappointing data releases in the US, but these have been mostly due to an excessive build-up in manufacturing inventories since mid 2013, and the prospects for final demand seem firm.

Furthermore, the Fed’s tapering of asset purchases has now been clearly separated from its intentions on short rates, which remain extremely dovish. So far, the decline in developed market equities has been very minor compared with the rises seen last year, and do not even constitute a normal pull-back in a bull market.

In the emerging markets (EM’s), however, there is much greater cause for concern. As the graph above shows, the EM crises in the late 1990s did not, in the end, prove fatal for equities in the US and Europe, but they did cause occasional air pockets, notably in 1998. This is why investors are focused on whether the current EM crises will deteriorate further, and whether they will eventually take the DM’s down with them. Read more

The generally optimistic tone at Davos last week was rudely interrupted by a melt-down in emerging markets, triggered by concerns that the major central banks in the developed economies are contemplating an exit from easy money sooner than previously expected.

The Fed will probably take its second step towards tapering next Wednesday and now seems to be on auto-pilot for the rest of the year. More surprisingly, the Bank of Japan sounded some cautious notes about the likelihood of further quantitative easing when fiscal policy tightens in April. Finally, the UK authorities, in the shape of “aides of the Chancellor”, hinted that a rise in short rates may be no bad thing this year.

A significant shift towards tighter monetary policy in the developed world as a whole still seems extremely unlikely, given the deflation risks highlighted by the IMF last week.

But the British case is now very intriguing and, after contradictory messages at Davos, also somewhat confused.

Because of low productivity, the level of UK GDP continues to lag well behind the recovery from the Great Recession achieved in many other economies. But the remarkable recent surge in UK growth rates, along with a sharp fall in unemployment, means that the Bank of England now has to reconsider its entire monetary stance. With forward guidance now in murky waters, the markets will want greater clarity in the next Inflation Report in February. Read more