Federal Reserve

It was widely reported at the weekend that the Trump administration is seriously considering the nomination of Marvin Goodfriend, a professor of economics at Carnegie-Mellon University, to one of the vacant positions on the board of governors of the Federal Reserve. As a former Fed official, a much cited academic author on monetary economics, and an impeccable conservative, he could be even a candidate to replace Janet Yellen next year.

Although I do not know Prof Goodfriend personally, I have admired his writings for several decades. He is both a monetary historian and a mainstream macroeconomist. In his most cited academic paper, in 1997 he outlined a “New Neoclassical” model, including rational expectations, sticky prices and a real business cycle underpinning. This is similar to today’s “New Keynesian” models routinely used by all the major central banks. Read more

The Federal Reserve is actively considering a profound change in US monetary policy, in effect the reversal of quantitative easing (QE). In its March meeting, the FOMC discussed its strategy for the future run down of its balance sheet, and said that further debate would take place in upcoming meetings.

The FOMC has already concluded that “a change in the Committee’s reinvestment policy would likely be appropriate later this year” and that this would need to be flagged “well in advance”. The minutes to the May meeting (to be published on 24 May) will probably provide some further indication about their thinking on this important topic.

Investors are therefore beginning to focus on the possible consequences of the reversal of QE on interest rates and the shape of the yield curve.

In a previous column, I outlined the likely path for the US central bank balance sheet under the new policy, and predicted that this would cause global QE to turn negative in 2019, after being consistently positive by about 2 percentage points of global GDP in every year since 2011. The great unknown is whether this reversal of central bank support will remove the underpinnings from the bond market, risk assets and the global economic upswing.

I take the optimistic side of this debate, but investor opinion is sharply divided on the matter. Read more

In this month’s regular update on global economic activity, the Fulcrum nowcasts have once again identified extremely strong growth rates, especially in the advanced economies. These results continue to suggest that the global economy is expanding at the fastest rate seen since 2010, with the implication that the expansion may be reaching escape velocity, where it is no longer in need of emergency support from the central banks or fiscal authorities.

However, our models have been greatly affected in recent months by the remarkable strength in business and consumer surveys. Hard economic data have also improved, but have done so by less than the surveys. This has led to doubts about the reliability of the nowcasts, especially in the US, where the official real GDP growth rate in 2017 Q1 seems likely to be well below 2 per cent for the second successive quarter.

The sluggishness of US growth based on the official GDP data is clearly influencing the Federal Reserve, which has made no upward revision to its growth forecasts in the past few months, despite the surge in the nowcasts. Furthermore, it may also have influenced the financial markets, which are starting to have doubts about the “reflation trade” in global markets.

Given the extremely large difference between surveys and hard data at present, it is important to consider which of these sources of evidence is likely to be giving the correct signal on the current pace of the global expansion. Based on past evidence, we continue to give considerable weight to the buoyant surveys, even when they conflict with the relative weakness of hard data.

A second question is whether the extremely buoyant growth rates identified by the nowcasts can be maintained into the future. The models expect these elevated growth rates to decline somewhat over the rest of 2017, but growth seems likely to remain well above trend in the AEs, with plenty of scope for upward revisions to consensus GDP forecasts.

My colleagues Juan Antolin-Diaz, Thomas Drechsel and Ivan Petrella have released a technical paper about the use of hard and soft data in nowcasting – see the latest draft attached here. The latest monthly set of Fulcrum nowcasts is attached hereRead more

The global economic recovery that started amid the gloom of the financial crash in March 2009 is about to celebrate its 8th birthday. In the advanced economies (AEs), the GDP growth rate during this recovery has averaged only 1.8 per cent, well below normal, but unemployment has dropped from 8.1 per cent to a still fairly high 6.1 per cent. According to JP Morgan, the volatility of GDP growth has fallen to the lowest levels for four decades since 2014.

This slow but extremely steady period of expansion has of course been accompanied by much lower interest rates, which have proven terrific for asset prices. The index of total equity returns in the AEs has tripled since the bear market ended.

Janet Yellen and other officials at the Federal Reserve have said on many occasions that “recoveries don’t just die of old age”. Unless something goes wrong, the upswing in the cycle will be prone to continue. At present, econometric models that attempt to assess recession risks suggest that these risks are exceptionally low over the next 12 months.

Furthermore, the growth rate in the US and other AEs seems, if anything, to be breaking upwards. This may be because the headwinds that have held growth down for so long – excessive debt, a malfunctioning banking system, extreme risk aversion, low capital investment etc. – may finally be fading away. Perhaps the world economy is at last attaining escape velocity.

However, good times cannot last forever. It is common for euphoria to set in just when the economic and financial cycle is nearing a peak. As in 2001 and 2008, the end could come much sooner than anyone predicts [1]Read more

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

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

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

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

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

This month’s regular update from the Fulcrum nowcast models shows that global economic activity is growing fractionally below its trend rate, and is little changed from last month’s report. Global recession risks have therefore fallen recently to more normal levels, compared to the elevated risks seen in February. However, neither the advanced economies nor the emerging markets appear to be sustaining a break-out to above trend growth.

The overall picture is therefore one of steady but disappointing growth, with little indication of a major cyclical acceleration at present. In particular, growth in the US remains subdued, and seems to be running at or below the 2 per cent threshold apparently required by the Federal Reserve to justify a June/July increase in interest rates. Although the jury is out on this point, Friday’s weak employment data have given extra weight to the subdued nature of our recent US nowcasts.

We also report for the first time forecasts for global GDP growth over the next 12 months derived from the dynamic factor models that are used to produce the nowcasts. These forecasts are a natural extension of the nowcast models. They should be used in conjunction with other forecasting methods to assess the statistical likelihood of activity “surprises” relative to consensus forecasts in the months ahead.

The latest results suggest that US GDP growth in the period ahead may well come in below the latest consensus forecasts.

The full set of the latest global nowcasts is available hereRead more

Since mid-February, the financial markets have become much less concerned about a hard landing in global economic activity, or at least about a potential clash between slowing economic activity and inappropriately tight macroeconomic policy from China and the US Federal Reserve. Financial conditions indicators have eased in the big economies, and this has been accompanied by a partial recovery in business surveys in many parts of the world.

In the last edition of our monthly report card on Fulcrum’s global nowcasts, we commented that economic activity had turned a corner in the US and China, but this was offset by continued weakness in several key economies, including Japan and the UK. A similar pattern is apparent in this month’s nowcasts. Global recession risks, which seemed elevated in January and February, have now receded, but the world economy is far from robust.

We therefore leave the overall verdict unchanged from last month: global activity growth is somewhat better, especially in the emerging economies, but it is still a long way from being satisfactory. (Full details of the latest nowcasts are shown here.)

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Foreign exchange traders are buzzing with talk of a new “Plaza Accord”, following the marked change in the behaviour of the major currencies after the Shanghai G20 meetings in late February.

Since then, the dollar has weakened, just as it did after the Plaza meetings on 22 September 1985. The Chinese renminbi has been falling against its basket, in direct contrast with the “stable basket” exchange rate policy that was publicly emphasised by PBOC Governor Zhou just before Shanghai. The euro and, especially, the yen have strengthened, in defiance of monetary policy easing by the ECB and the Bank of Japan.

Following Shanghai, the markets have become loathe to push the dollar higher, believing that the G20 may now have come to a co-ordinated agreement, as they did at the Plaza, to reverse the direction of the US currency. Does this comparison make any economic sense?

The Shanghai communique did place increased emphasis on an agreement among the major economies to avoid “competitive devaluations”. The main suspects here were Japan, the Eurozone and (sometimes) China, all of whom have good reasons to push their currencies down. The fact that the communique eschewed this course of action is therefore a reason to believe that the dollar might be subjected to less upward pressure. But that does not make it a new Plaza. Read more

Financial asset prices have been on a roller coaster in 2016. In mid-February, gloom was pervasive and global equities were down about 10 per cent year to date. Then came a sudden rally, wiping out all of the losses in the US equity market, but not in the eurozone market, and especially not in the Japanese market, which fell further.

What happened to generate this abrupt change of direction in February, and what does this tell us about the future? Read more

As Paul Krugman pointed out a year ago, a sharp difference of views about US monetary policy has developed between two camps of Keynesians who normally agree about almost everything.

What makes this interesting is that, in this division of opinion, the fault line often seems to be determined by the professional location of the economists concerned. Those outside the Federal Reserve (eg Lawrence Summers, Paul Krugman, Brad DeLong) tend to adopt a strongly dovish view, while those inside the central bank (eg Janet Yellen, Stanley Fischer, William Dudley, John Williams) have lately taken a more hawkish line about the need to “normalise” the level of interest rates [1].

My colleague David Blake suggested that this blog should carry a Galilean “Dialogue” between representatives of the two camps. Galileo is unavailable this week, but here goes. Read more

Janet Yellen

Janet Yellen, Fed chair  © Getty Images

This week has seen speculation about a mutiny from two members of the Federal Reserve’s board of governors against the leadership of Janet Yellen and Stanley Fischer, both of whom continue to say that they “expect” US rates to rise before the end of the year. Although “mutiny” is a strong term to describe differences of opinion in the contemplative corridors of the Fed, there is little doubt that the institution is now seriously split on the direction of monetary policy.

Furthermore, these splits could extend well beyond the date of the first rate hike to the entire path for rates in the next few years. Ms Yellen faces an unenviable task in finding a compromise path that both sides of the Federal Open Market Committee can support. Read more

In the aftermath of the supposedly “weak” US employment data published last week, investors seem to have shifted their assessment of the likelihood of the US Federal Reserve tightening interest rates by December — and also of the extent of tightening in the next two years.

Since the data were published, several investment banks’ economics teams have ruled out a December rise. Furthermore, equities have been strong; and the bond market’s implied probability of a 25 basis points rise in the federal funds rate by December has fallen from 76 per cent in mid-September to only about 40 per cent.

Nor is this seen as a minor postponement in the first rate rise. The expected federal funds rate at the end of 2016 implies only two Fed rate hikes in total over that entire period. Clearly, investors increasingly believe that the US economy is now slowing enough to throw the Fed off course.

This big change in market opinion is, frankly, surprising. The rise of 142,000 in non-farm payrolls in September was not all that weak, given the normal random fluctuations in the monthly data. And as John Williams, president of the San Francisco Fed, has pointed out, a slowdown to a monthly rate of increase of under 200,000 was long overdue anyway. Rightly or wrongly, there is little indication so far that important Federal Open Market Committee members share the market’s increased post-jobs-data dovishness.

The crucial question is how much growth in the US has slowed since the middle of the year, and whether this will continue. This is the kind of question that economic “nowcasts” are best suited to answer, so let us examine the recent evidence. Read more

When Janet Yellen announced last week that the Federal Open Market Committee had considered, but decided against, a rate rise in September, many commentators concluded that the Fed had taken a decisive shift towards dovishness. Yet the markets, so far, have not really shared this interpretation. Since Thursday’s press conference by the chair of the US Federal Reserve, the interest rate path expected by the bond markets has dropped very slightly; but the dollar has risen and equities have remained weak.

There is little sign that investors’ assessment of the Fed’s underlying policy stance has been altered by what is increasingly seen as nothing more than a “postponement” of the almost inevitable rate hike later this year. Whatever it intended to do, the Fed has not cleared the air. Read more

The extreme turbulence of the financial markets in August resulted in a temporary rise in the Vix measure of US equity market volatility to levels that have been exceeded on only a few occasions since 2008. Markets have now settled down somewhat, but it is far from clear whether the episode is over. In order to reach a judgment on this, we need to form a view on what caused the crisis in the first place.

The obvious answer is “China”. The response of the Chinese authorities to the stock market bubble, and the manner in which the devaluation of the renminbi was handled, raised questions about policy credibility that added to ongoing concerns about hard landing risk in the economy. The conclusion that a China demand shock was the main driving force behind the global financial turbulence was given added credence by the simultaneous collapse in commodity prices, and in exports from many emerging economies linked to China.

It would be absurd to deny that China had an important role in the crisis of August 2015. But was it the only factor involved? After all, China’s growth rate does not seem to have slowed very much. Furthermore, standard econometric simulations of the impact of a China demand shock on the major developed economies suggest that the effects should not be very large, and certainly not large enough to explain the scale of the decline in global equity prices, or in the “break-even” inflation rates built into US and European bond markets.

It is conceivable that bad news from China triggered a sudden rise in risk aversion among global investors that exacerbated the shock itself. It also possible that markets were responding to the fact that the Federal Reserve apparently remained determined to raise US interest rates before year end, regardless of the new deflationary forces that were being triggered by events in China.

New econometric work published today by my colleagues at Fulcrum suggest that the perception of an adverse monetary policy shock may have been important in explaining the financial turbulence, in which case the Fed needs to tread extremely carefully as it approaches lift-off for US rates. Read more

Ever since the crash in 2008, the central banks in the advanced economies have had but one obsession — how to set monetary policy to ensure the maximum growth rate in aggregate demand. Interest rates at the zero lower bound, followed by a massive increase in their balance sheets, was the answer they conjured up.

Now, those central banks contemplating an exit from these policies, primarily the US Federal Reserve and the Bank of England, are turning their attention to the supply side of their economies. When, they are asking, will output reach the ceiling imposed by the supply potential of the economy?

The Bank of England has been in the lead here, with the Monetary Policy Committee recently conducting a special study of the supply side in the UK. Its conclusion was that gross domestic product is now only 0.5 per cent below potential, which implies that tighter monetary policy will soon be needed if GDP growth remains above potential for much longer.

In the US, the Fed has been much less specific than that, but the unemployment rate has now fallen very close to its estimate of the natural rate (5.0-5.2 per cent). Sven Jari Stehn of Goldman Sachs has used the Fed staffers’ supply side models to calculate that their implied estimate of the US output gap may be only 0.6 per cent, not far from the UK figure.

If the UK and US central banks were to act on these calculations, the implication would be that they no longer hold out much hope that they can ever regain the loss in potential output that has occurred in the past decade, relative to previous trends. That would be a massive admission, with an enormous implied sacrifice in future output levels if they are wrong. It would also be very worrying for financial assets, since it would draw the market’s attention to a downgrade in the Fed’s estimation of the long-run path for GDP. Read more

Yellen Discusses Monetary Policy At Federal Reserve Bank In San Francisco

Getty Images

The financial markets listened to Janet Yellen’s speech on “normalising” monetary policy last Friday, shrugged, and moved on largely unaffected. It was, indeed, a dovish speech, of the type that had been foreshadowed at her press conference after the FOMC meeting in March (see Tim Duy for a full analysis). But it also spelled out her analytical approach to monetary policy more clearly than at any time since she has assumed the leadership of the Federal Reserve.

In the speech, the Fed chairwoman used the term “equilibrium real interest rates” no less than 25 times. This concept is very much in vogue at the Fed. The Yellen speech uses it to explain what she and Stanley Fischer mean by “normalising” interest rates. It was also at the centre of Ben Bernanke’s first forays into economic blog writing this week, which reminds us that it has some pedigree at the central bank.

 Read more