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.
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.
The markets were little moved by Fed Chair Yellen’s press conference last week, though there was a slight sigh of relief that the Fed did not follow the example of the Bank of England in shifting towards hawkishness. The FOMC’s neutral stance, for the moment, was no great surprise.
More interesting is the fact that the FOMC’s “dot plot” showed that there is still a wide disparity of opinion among committee members about the appropriate level of interest rates in 2015 and 2016.
This disparity is much greater than the difference in the individuals’ economic forecasts would appear to justify, so it suggests that the policy reaction functions between the hawks and the doves remain very far apart. This argument has been shelved during the period of tapering, when the Fed is on autopilot. But the debate is very much alive beneath the surface. And Ms Yellen still seems to be firmly in the dovish camp.
(Note: some of this debate is slightly technical. Readers not interested in the technicalities should jump to the final section on Yellen’s “balanced approach”.)
Mark Carney delivered a substantial hawkish surprise to the markets in his Mansion House speech on Thursday. After appearing to be a convinced dove ever since he became BoE Governor in July 2013, he now says that the first UK interest rate rise could come “sooner than expected”, with the decision on the timing of the first rise “becoming more balanced”. Market expectations of forward short rates in 2015 immediately jumped by 20 basis points.
Although the Governor is still talking about a very gradual rise in UK rates, he appeared to have changed the dovish tone of the forward guidance given by the BoE last year. This has made investors nervous, with many asking whether Fed Chair Janet Yellen may do the same in her press conference on Wednesday.
This seems unlikely, because the US economic recovery is still lagging that in the UK. Nevertheless, the parameters within which investors view forward guidance, including the Fed’s “dots” showing the future path for interest rates, may have been somewhat shaken.
The US employment report on Friday was notable because it showed that the number of jobs in the American economy now exceeds the high point reached in January 2008 for the first time since the Great Recession. Another important signal that the economy is returning to normal, it might be claimed.
But a period of more than six years with zero growth in jobs in the American economy is anything but normal. According to the Economic Policy Institute in Washington, the US would need to create an extra 6.9 million jobs before the labour market could really be said to be back to normal, in the sense that all those who want employment would be fully satisfied.
The same point can be made about the path for real GDP in almost every developed economy since 2007. While several economies have now returned to their previous peak levels of output, very few have approached the previous long term trendlines which had been established for decades before that. For the developed economies as a whole, output remains about 12 per cent below these trendlines.
Because this level of output has never actually been attained in the real world, there is little sense of tangible loss about this, notably in the political sphere. Nevertheless, the opportunity cost could still be enormous.
The European Central Bank’s decision to reduce the interest rate on deposits at the central bank to minus 0.10 per cent went as far as even the most ardent doves could reasonably have expected. Rates can probably fall no further. As Mario Draghi, the ECB president, said: “For all practical purposes, we have reached the lower bound.”
For that reason, the more technical elements of the package announced on Thursday in Frankfurt are in some ways the most significant. There was a €400bn injection of liquidity, in what the ECB called a “targeted longer-term refinancing operation” – a near copy of the Bank of England’s Funding for Lending Scheme. There was a form of quantitative easing, in which the central bank will buy securities backed by private sector loans. And there was the cessation of a “sterilisation” exercise, which had previously damped the monetary effect of the ECB’s purchases of government bonds.
Fears of a crash in the Chinese property market are widespread in the financial markets. That is nothing new. The domestic real estate sector has been growing at breakneck speed ever since private property ownership was first permitted in 1998, and on several occasions, most recently in 2012, there have been dire warnings from western investors that housing supply was far outstripping demand.
An easing in monetary policy headed off a hard landing two years ago, but this may only have delayed the inevitable. The renewed correction in the market in mid 2013, which now seems to be gathering momentum, is certainly the main downside risk in the global economy in 2014.
Following the devastating global impact of the US property crash of 2005-08, it is little wonder that investors are paranoid that China might be treading the same path. But there are many differences between the US then and China now. The US housing crash was transformed into something far more serious by excesses in the financial sector, and by adverse wealth effects on consumer spending.
Even though China has also built up severe credit excesses in its shadow banking sector, it is hard to make the macro arithmetic add up to a shock comparable in size to the 2008 US/global meltdown.
(Apologies for greater length than usual in this blog – skip to “GDP effects” for the bottom line.)
There is much talk about how and when the central banks will exit from unconventional monetary accommodation, at least in the US and the UK. So far, it is all talk and not much action.
A few months ago, it all looked very different. The Fed’s “taper tantrums” from May 2013 onwards had demonstrated that markets could be very vulnerable to any hint of an end to monetary accommodation, and US monetary conditions had tightened as bond yields rose.
The People’s Bank of China had embarked on what seemed likely to be a prolonged squeeze of the shadow banking sector. The ECB was refusing to ease its stance, despite an apparent threat of outright deflation. The Bank of England was thought likely to act against the UK housing bubble by raising rates before the end of 2014. Only the Bank of Japan seemed likely to press ahead with unlimited quantitative easing.
The markets feared that Fed tapering would soon trigger a global monetary tightening. So what has happened since? Precisely the opposite. Global financial conditions, on the best indicators available, have actually eased again in the first half of this year, and now stand near to their easiest levels since the financial crisis began.
Whether or not this will prove to be a policy mistake (please do not shoot the messenger!), it is another reminder to investors that any genuine monetary tightening could still be a very long way off.
The UK’s very British economic recovery, dominated by London housing in particular and the consumer more generally, continues to strengthen. The Bank of England argued in its latest Inflation Report last week that there was no case yet for higher interest rates, and repeated its previous guidance that rate rises, when they come, will be very gradual.
But Governor Mark Carney spelled out much more clearly than ever before that he is now concerned about the risks to financial stability posed by the housing sector, and he came very close to promising that the Financial Policy Committee will take regulatory steps to dampen the market at its meeting in June.
The UK housing market is therefore shaping up to be the first major test of the new macro prudential weapons that the central banks now have at their disposal. The need for these new arsenals is very apparent, but it is much less clear whether they will actually work.
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?