Federal Reserve

One of the most dramatic monetary interventions in recent years has been the unprecedented surge in global central bank balance sheets. This form of “money printing” has not had the inflationary effect predicted by pessimists, but there is still deep unease among some central bankers about whether these bloated balance sheets should be accepted as part of the “new normal”. There are concerns that ultra large balance sheets carry with them long term risks of inflation, and financial market distortions.

In recent weeks, there have been debates within the FOMC and the ECB Governing Council about balance sheet strategy, and it is likely that there will be important new announcements from both these central banks before the end of 2017. Meanwhile, the PBOC balance sheet has been drifting downwards because of the large scale currency intervention that has been needed to prevent a rapid devaluation in the renminbi. Only the Bank of Japan seems likely to persist with policies that will extend the balance sheet markedly further after 2017.

Globally, the persistent increase in the scale of quantitative easing is therefore likely to come to an end in 2017, and it is probable that central bank balance sheets will shrink thereafter, assuming the world economy continues to behave satisfactorily.

Investors have become accustomed to the benefits of “QE infinity” on asset prices, and are cynical about the ability and desire of central bankers ever to return their balance sheets to “normal”. They will have to adjust to a new reality fairly soon. Read 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

The robust US employment data last Friday have left almost no room for doubt that the Federal Open Market Committee will raise short term rates by 25 basis points on 15 March, and will probably warn of two or three more hikes to come this year.

Analysts seem confident that this accelerated phase of Fed tightening will involve a further rise in bond yields and the dollar, and many active fund managers are positioned for both these events to occur in coming months. Other analysts believe that the more hawkish Fed will puncture the “euphoria” in the US equity market before too long. 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

A year ago, Lawrence Summers’ perceptive warnings about the possibility of secular stagnation in the world economy were dominating global markets. China, Japan and the Eurozone were in deflation, and the US was being dragged into the mess by the rising dollar. Global recession risks were elevated, and commodity prices continued to fall. Fixed investment had slumped. Productivity growth and demographic growth looked to be increasingly anemic everywhere.

Estimates of the equilibrium real interest rate in many economies were being marked down. It seemed possible that the world economy would fall into a “Japanese trap”, in which nominal interest rates would be permanently stuck at the zero lower bound, and would therefore not be able to fall enough to stimulate economic activity.

Just when the sky seemed to be at its darkest, the outlook suddenly began to improve. Global reflation replaced secular stagnation as the theme that dominated investor psychology, especially after Donald Trump’s election in November. Why has secular stagnation lost its mass appeal, and has it disappeared forever? Was it all a case of crying wolf? 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

As the global economy enters 2017, economic growth is running at stronger rates than at any time since 2010, according to Fulcrum’s nowcast models. The latest monthly estimates (attached here) show that growth has recovered markedly from the low points reached in March 2016, when fears of global recession were mounting.

Not only were these fears too pessimistic, they were entirely misplaced. Growth rates have recently been running above long-term trend rates, especially in the advanced economies, which have seen a synchronised surge in activity in the final months of 2016. 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

The response of the financial markets to the US election result has been almost as contradictory as the rabble rousing campaign of the President-elect himself. Unmitigated gloom in the hours after the Trump victory was swiftly followed by a euphoric atmosphere in US markets.

Investors are apparently assuming that the new administration will usher in a mix of fiscal reflation, prudent monetary policy, deregulation and tax cuts that will prove very good for the American economy. Trade controls are seen as damaging the emerging economies, but not the US. A steeper yield curve is seen as reflecting a “better” mix between fiscal and monetary policy.

With one very graceful acceptance speech, Donald Trump has suddenly morphed into Ronald Reagan in the markets’ consciousness. 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

The new UK chancellor Philip Hammond

The new UK chancellor Philip Hammond  © Getty Images

Until recently, the rate of expansion in global central bank balance sheets seemed likely to remain extremely high into the indefinite future. Although the US Federal Reserve had frozen its balance sheet, both the European Central Bank and the Bank of Japan were pursuing open-ended programmes of asset purchases, and the Bank of England actually increased its intended stock of assets by £50bn in August. Global central bank balance sheets were rising by about 2 percentage points of GDP per annum – a similar rate to that seen since 2012.

Some commentators argued that the central banks would never step aside from their programmes of balance-sheet expansion. After QE1, 2 and 3, we would get “QE infinity”. Others argued that unlimited quantitative easing would result in disaster, either through rapidly rising inflation, or bubbles in asset markets.

Neither of these dark outcomes has occurred. Instead, it seems that policy makers are moving away from QE because it is no longer effective and no longer necessary. “QE infinity” is coming to an end, not with a bang but with a whimper. Read more

As investors anxiously await the key monetary policy decisions from the Federal Reserve and the Bank of Japan next week, there have been signs that the powerful rally in bond markets, unleashed last year by the threat of global deflation, may be starting to reverse. There has been talk of a major bond tantrum, similar to the one that followed Ben Bernanke’s tapering of bond purchases in 2013.

This time, however, the Fed seems unlikely to be at the centre of the tantrum. Even if the FOMC surprises the market by raising US interest rates by 25 basis points next week, this will probably be tempered by another reduction in its expected path for rates in the medium term.

Instead, the Bank of Japan has become the centre of global market attention. The results of its comprehensive review of monetary policy, to be announced next week, are shrouded in uncertainty. So far this year, both the content and the communication of the monetary announcements by BoJ governor Haruhiko Kuroda have been less than impressive, and the market’s response has been repeatedly in the opposite direction to that intended by the central bank.

As a result, the inflation credibility of the BoJ has sunk to a new low, and the policy board badly needs to restore confidence in the 2 per cent inflation target. But the board is reported to be split, and the direction of policy is unclear. With the JGB market now having a major impact on yields in the US, that could be the recipe for an accident in the global bond market. 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

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

  © Getty Images

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

The latest and, so far, the most severe scare about global deflation started with the oil price collapse in mid 2014, and reached its peak with the sharp drop in global industrial production in mid 2015, swiftly followed by the Chinese devaluation episode in August. Fears of an imminent slide towards a global industrial recession haunted the markets, and both expected inflation and bond yields in the advanced economies approached all-time lows.

But, just when everything seemed so bleak, the flow of economic information changed direction. Global industrial production rallied, and China stabilised its currency. On Friday, the US jobs and wages data were much stronger than expected. Inflation data in the advanced economies have passed their low points for this cycle, and the rise in headline 12-month inflation in the next three months could surprise the markets.

This certainly does not mean that the repeated warnings of the inflationistas will suddenly be proved right. It may not even mean that long-run deflationary pressures in the global economy have been fully overcome: global growth rates are still below trend, and spare capacity is rising in the emerging world. But the peak of the latest, commodity-induced deflation scare is in the past. Read more