Janet Yellen, Fed chair  © Getty Images

As the Federal Reserve’s open markets committee meets for its crucial two-day session in Washington, Janet Yellen faces her first real policy test since assuming the chair in February 2014. Amazingly, she is already almost halfway through her first term. But, so far she has had the relatively easy task of piloting the exit from quantitative easing. The exit plan had already been mapped out by Ben Bernanke, and it was not particularly contentious inside the committee.

The decision on whether to raise interest rates this week is, however, proving more divisive. Among her key lieutenants, vice-chair Stanley Fischer seems somewhat hawkish, while William Dudley has stated the case for the doves. John Williams, her successor at the helm of the San Francisco Fed, and a key ally, also seems inclined to a more dovish view than he championed earlier in the summer.

Mr Williams recently told the Wall Street Journal that he would “honestly, honestly, honestly” want to hear the opinions of his colleagues at this week’s meeting before making up his mind. Does he protest too much, I wonder? Perhaps the decision has already been taken, but the Yellen camp wants to allow the hawks a full and fair hearing before announcing that rates would remain unchanged. Read more

Global investors have been in thrall to the central banks ever since quantitative easing (QE) started in 2009 and, of course, all eyes are on the Federal Reserve this week. The Fed has now frozen its QE programme, and may raise rates sometime this year, though perhaps not as early as next Thursday. Nevertheless, global investors have been comforted by the extremely large increases in balance sheets proposed by the Bank of Japan (BoJ) and the ECB, and the overall scale of worldwide QE has seemed likely to remain sizeable for the foreseeable future.

However, in recent months, an ominous new factor has arisen. Capital outflows from the emerging market economies (EMs) have surged, and have resulted in large declines in foreign exchange reserves as EM central banks have intervened to support their exchange rates.

Since these reserves are typically held in government bonds in the developed market economies (DMs), this process has resulted in bond sales by EM central banks. In August, this new factor has more than offset the entire QE undertaken by the ECB and the BoJ, leaving global QE substantially in negative territory.

Some commentators have become concerned that this new form of “quantitative tightening” will result in a significant reversal of total central bank support for global asset prices, especially if the EM crisis gets worse. This blog examines the quantities involved, and discusses the analytical debate about whether any of this matters at all for asset prices. 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

Yellen Discusses Monetary Policy At Federal Reserve Bank In San Francisco

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Now that the Federal Reserve has announced that its policy stance after June will be entirely “data determined”, the markets are watching the flow of information on US economic activity even more carefully than usual. Since 2010, there has been a recurring pattern in US GDP projections. They start optimistically, but are then progressively downgraded as the economic data come in.

Entering 2015, I was fairly confident that this depressing pattern would finally be overcome, but not so far. In the last few weeks, there has been a sharp downward adjustment to GDP growth estimates for the first quarter, and this has added to the market’s scepticism about whether the Fed will be ready to announce lift off for interest rates this summer. Read more

The Federal Reserve Begins Last Meeting Of 2008

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When the Brazilian finance minister Guido Mantega complained that the Federal Reserve was waging a currency war against his country in September 2010, his comments led to a wave of sympathy and concern. The Fed’s aggressive monetary easing was causing a capital flight from the US into the apparently unstoppable emerging markets.

Uncompetitive exchange rates and domestic credit booms in the EMs were the result of US quantitative easing. American monetary policy makers showed little sympathy, arguing that the US had its own domestic inflation and unemployment mandates to worry about. If the dollar fell in the process, so be it.

That episode proved short lived. The Brazilian real is now a chronically weak currency. Yet the term “currency wars” has stuck. It is now alleged that almost all the major central banks are engaged in weakening their currencies, if not against each other then certainly relative to commodities, goods and services. 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

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 [1]. 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” [2]. Read more

Janet Yellen has been nominated to take over as Fed chairman when Ben Bernanke steps down. Gavyn discusses with John Authers what a Fed led by Ms Yellen would mean for tapering and interest rate policy

In the past decade, the world’s central banks – first in the emerging and then in the developed world – have embarked on a Great Expansion in their balance sheets which is unprecedented in modern times. This blog sketches the anatomy of the Great Expansion and attempts to project what will happen as the US Federal Reserve tapers its asset purchases in the next 18 months.

The latest episode in the saga has, of course, involved the Fed’s attempt to distinguish between “tapering” and “tightening”, a distinction which the markets have been reluctant to recognise [1]. The US forward interest rate curve shows the first rate increase occurring very close to the time when the Fed is planning to stop buying assets in mid-2014. Whether it intended to do so or not, the Fed has de facto tightened US monetary policy conditions and will have to work hard to reverse this. Read more

The month just ended was the fourth worst month for government bond returns in the past two decades. This abrupt response to Ben Bernanke’s warning that the Fed might think about tapering QE at some point in the next few meetings has naturally raised fears that the great bull market in fixed income, which started in 1982, might now be threatened by a sharp reversal.

Some analysts regard this as the inevitable bursting of a bubble which has been created by the actions of the central banks (see this earlier blog). Others, like Jim O’Neill, regard the rise in bond yields as the start of a return to economic normality, and argue that would be a very good thing as long as it occurs in an environment of recovering economic confidence. Paul Krugman also points out that the pattern of behaviour in the major markets – bonds down, dollar up and equities up – is consistent with greater optimism about the US economy, rather than worries about the Fed or the onset of a debt crisis. Read more

The wobble in risk assets in the past week has followed the Fed’s shift towards hawkishness, weaker US jobs data and the budget announcement in Spain. The fact that eurozone equities have once again underperformed US equities suggests that the Spanish budget was probably the dominant factor.

As the first graph shows, Spain’s sovereign bond yields and bank CDS spreads have recently widened to near their worst readings since the crisis started in 2010. What is even more worrying is the consistent upward trend which is apparent in the data. The eurozone rescue operation, mounted by the ECB and heads of government last December, reversed this deterioration only temporarily, and markets now seem to have resumed their earlier adverse trends. Everyone is asking whether this will trigger a new, and larger, eurozone crisis in 2012. Read more

In the second half of 2011, the US economy appeared to buck the impact of the eurozone crisis, with American economic data surprising on the strong side in the final quarter of the year. But, as the new year begins, it seems improbable that economic activity in the US and the eurozone can remain so divergent for much longer.

Will the weakness in the eurozone eventually bring the US economy to its knees? Or will the greater resilience of the US win the day? The answer to these questions will determine whether the global economy will experience a double-dip recession in 2012.

The data released over the holiday period seem to be pointing in a more optimistic direction than markets have recognised. A year of above-trend growth certainly looks like a stretch in the present environment of fiscal tightening and global deleveraging. But the risks of a global double-dip recession appear to be receding, at least for now. Read more

The Fed decision was fairly close to what was anticipated in this earlier blog – all “twist” and no “shout”. However, on balance, the statement was slightly more dovish than I expected. Concerns about downside risks to economic activity were at least as great as in last month’s FOMC statement, with new downside risks from financial strains being specifically mentioned, and this has swayed the majority of the committee to introduce a slightly more aggressive operation “twist” than expected. Inflation concerns, while marginally greater than in the August FOMC statement, are clearly insufficient to impress the committee, which remains biased towards further easing even after today’s announcement.

 Read more