Fed

The US CPI report for June, published on Friday, was the fourth successive monthly print that surprised on the low side. Initially, these inflation misses were dismissed by the Federal Reserve as idiosyncratic and temporary, but they are now becoming too persistent to ignore. If they are not reversed fairly soon, the FOMC will need to give greater weight to the possibility that inflation may not return to target over the next couple of years.

Janet Yellen appeared to open the door to this possibility for the first time in her evidence to Congress last week. In a distinct change of tone, she specifically mentioned uncertainties about “when and how much inflation will respond to tightening resource utilisation”, thus acknowledging the possibility of alterations in the Phillips Curve.

She also emphasised that monetary policy is not on a preset course, adding that the FOMC will be carefully monitoring whether the recent decline in inflation is reversed in the months ahead. Normally, her guidance on data is more even handed, without specifically highlighting downside inflation risks.

My colleagues at Fulcrum (especially Juan Antolin-Diaz and Alberto Donofrio) have recently estimated some new econometric models [1] to track the course of inflation in the US, and these models identified the importance of the latest inflation surprises fairly early in the process. After the latest CPI data, the models suggest that there is a high and increasing chance that US inflation will fail to return to target within the next 2 years. 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

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

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

Professor Christopher Sims

Professor Christopher Sims  © Getty Images

The most far reaching speech at the Federal Reserve’s Jackson Hole meeting last week was not the opening address by chairman Janet Yellen, interesting though it was, but the contribution on the fiscal theory of the price level (FTPL) by Professor Christopher Sims of Princeton University.

The FTPL is normally wrapped in impenetrable mathematical models, and it has therefore remained obscure, both to policy makers and to investors. But the subject is now moving centre stage, as Prof Sims’ lucid explanation makes very apparent. It has important implications for the conduct of macro-economic policy, especially in Japan and the eurozone member states.

In these countries, Prof Sims is challenging the claim that further quantitative easing can achieve the 2 per cent inflation target, without explicit co-operation with the government budget. In the US, he is disputing Ms Yellen’s assertion last week that the Fed has further unconventional monetary weapons in reserve if the economy is hit by negative shocks in the future. Read more

Ever since the crash of 2008, the global financial markets have been subject to prolonged periods in which their behaviour has been dominated by a single, over-arching economic regime, often determined by the stance monetary policy. When these regimes have changed, the behaviour of the main asset classes (equities, bonds, commodities and currencies) has been drastically affected, and individual asset prices within each class have also had to fit into the overall macro pattern. For asset managers of all types, it is therefore important to understand the nature of the regime that applies at any given time.

This is not easy to do, even in retrospect. There will always be inconsistencies in asset performance which cause confusion and require interpretation. Nevertheless, it is an exercise which is worth undertaking, because it can bring a semblance of order to the apparent chaos of asset markets.

Two main regimes have been in place in the asset markets of developed economies since 2012. (The emerging markets also fit the pattern, with some slight differences.)

These regimes are, first, the period in which quantitative easing was the dominant factor, from 2012 to mid 2015; and, second, the period in which deflation risk has been the dominant factor, from mid 2015 to now.

It is possible that the markets are now exiting the period of deflation dominance, and they may even be entering a new regime of reflation dominance, though this is still far from certain. Secular stagnation is a powerful force that will be hard to shake off. But if that did happen, the pattern of asset price performance would change substantially compared to the recent past. Read more

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The influence of the global economy on the decisions of the US Federal Reserve has become a topic of frontline importance in recent months.

Since the start of 2016, events in foreign economies have conspired to delay the FOMC’s intended “normalisation” of domestic interest rates, which had apparently been set on a firmly determined path last December.

This delay has taken the heat out of the dollar. But the key question now is whether weak foreign activity will continue to trump domestic strength in the US.

To judge from last week’s surprisingly hawkish FOMC minutes, which I had not expected, the Fed seems to be reverting to type (see Tim Duy). Many committee members have downplayed foreign risks and have returned to their earlier focus on the strength of the domestic US labour market, which in their view is already at full employment. Read more

Janet Yellen in December announcing the Fed's first rate rise since 2008

Janet Yellen in December announcing the Fed's first rate rise since 2008  © Getty Images

This blog has barely commented on the Federal Reserve’s thinking in the past few weeks, which is unusual. It probably indicates that the Fed has temporarily disappeared from the centre of the markets’ focus, as the probability of a June rate hike has receded. Even the earlier hawks among the analyst community have been sharply reducing the number of rate hikes to be expected this year.

The Federal Open Market Committee has not entirely given up on June, as these statements from Dennis Lockhart, the Atlanta Fed president, and John Williams of the San Francisco Fed indicate. But since the latest employment report, which was widely taken to have dovish implications, there has been no attempt among the inner circle surrounding Janet Yellen to prepare the market for a shock.

The most recent evidence for this is the important interview with Bill Dudley, head of the New York Fed, by Binyamin Appelbaum at the New York Times. Tim Duy, a professor at the University of Oregon and close Fed watcher, rightly says this is a “must read”, but it has created remarkably little interest in the markets. Since this is the first detailed piece of analysis from the heart of the FOMC for some time, it is worth taking careful note of the main points that Mr Dudley raises. Read more

A few months ago, this blog commented that a rise in inflation in the advanced economies early in 2016 was “almost certain”. Thank goodness for the word “almost”. Since then, oil prices have plumbed new depths, and the markets have remained obsessed with fears about deflation.

The case for higher inflation in 2016 rested on the fact that the impact of energy on headline consumer price inflation would change direction when oil prices stabilised. This “inevitable” arithmetic effect has been delayed by the slump in oil prices in January, but it should manifest itself in the near future.

The key question, though, is whether this automatic rise in headline inflation presages a more important turning point for underlying inflation in the advanced economies – a turning point that has been wrongly predicted for several years now.

The answer is that there are some tentative signs of a slow rise in underlying inflation in the US, where price increases have been higher than expected in recent months. In contrast, inflation rates in the Eurozone and Japan have surprised on the low side. There, fears of “secular stagnation”, leading to deflation, still seem all too real. Read more

Most investors have been able to muster only two cheers for the year that has just ended.

In 2015, the performance of the main asset classes just about managed to maintain the broad pattern that has been seen since the equity bull market started in March 2009 but there are now definite signs of market fatigue. And although some major trends were obvious in retrospect — weak oil prices, falling euro, rising dollar, tumbling emerging currencies – they recorded sharp reversals that many macro investors failed to navigate in real time.

Global equities returned about 2 per cent in local currency terms [1], less than in recent years. In dollar terms, returns were slightly negative and market peaks in May 2015 have not yet been re-attained. A top may be forming, but as yet there is little sign that a major bear market trend has started.

Government bonds returned about 1 per cent, defying widespread predictions of a trend reversal, and yields were almost exactly flat during the year. Commodity prices plummeted by 33 per cent, continuing the crash that started in mid 2014, and they eventually took credit markets down with them. US high yield securities, for example, returned -9 per cent in 2015. Emerging markets (with the perplexing exception of Chinese equities, the best performing of the major markets) were also hit by the commodity melt-down and generally continued to under-perform developed market assets, in equities, credit and currencies.

Overall, then, the magic mix of moderate gross domestic product growth combined with extremely easy monetary conditions has continued to work in the developed markets. However, overall global asset market returns (bonds plus equities in local currencies, equally weighted) were only about 1.5 per cent, suggesting that some of the magic is wearing thin.

Looking ahead, it seems likely that 2016 will, at best, see similarly low asset returns. That, anyway, is overwhelmingly the consensus central view among mainstream forecasters. But as the bull market matures, it seems inevitable that one year soon we will experience a major setback to asset prices. Will 2016 be that year? Read more

In this month’s regular report card on global activity growth rates, we conclude that the downward momentum identified by our “nowcasts” a month ago seems to have been arrested during October. The risk of a global recession has therefore declined recently, but growth in the emerging markets remains well below trend, and global spare capacity is continuing to rise.

Furthermore, the growth rate in activity in the US has dropped since mid year, and is now slightly below trend. Other advanced economies, especially the euro area, continue to record reasonably healthy, above trend growth rates, with some signs of a recent acceleration.

Overall, we therefore conclude that the risk of a global hard landing has diminished in the past month. However, while not in recession, the global economy does appear to be in the midst of a growth malaise, in which the “miracle” of the 2000s in the emerging world is unraveling, and productivity growth in the advanced economies has maintained its long term downtrend.

In this month’s report, we will examine the main sources of the global growth malaise in more detail. (Full results of all the latest global nowcasts are attached here. Last month’s report card, with explanations of the regular graphical layout, is attached here.) 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

US-ECONOMY-BANK-RATE

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