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
President Xi Jinping (L) with Chinese Premier Li Keqiang © Getty Images
It would be easy to dismiss the recent extreme turbulence in global financial markets as a dramatic, but ultimately unimportant, manifestation of illiquid markets in the dog days of summer. But it would be complacent to do so. There is something much more important going on, involving doubts about the competence and credibility of Chinese economic policy and the appropriateness of the US Federal Reserve’s monetary strategy. These doubts will need to be resolved before markets will fully stabilise once more.
The August turbulence was triggered initially by a renewed collapse in commodity prices. For the most part, this was due to excessive supply in key energy and metals markets, and the sell-off only became extreme when there were panic sales of inventories, and a final unwinding of “commodity carry” trades. This inverse bubble was a commodity market event, not a reflection of weak global economic activity. In fact, taken in isolation, it would probably have been beneficial for world growth, albeit with very uncertain time lags.
However, that reckoned without the China factor. Activity growth in China had rebounded slightly following the piecemeal policy easing in April, but the data available so far for August suggest that the growth rate has subsided again to about 6 per cent, roughly 1 per cent below target. Although this is very far from a hard landing, it undermined confidence. Read more
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Last week, the Federal Reserve was forced to admit that it had mistakenly released the forecasts made by the board of governors’ economic staff for the June meeting of the Federal Open Market Committee. These forecasts are normally kept secret, until they are released with a five-year time lag.
This embarrassing error could not have come at a worse time for the board, since it is already under considerable pressure from Congress over the alleged misuse of public information in the recent past. Although there is no suggestion that this latest mistake involves any privileged access to secret information, it does mean that the Fed has accidentally made public much more information about its internal forecasts than it usually wishes to.
The rest of us therefore have more information than usual to work on. As this blog noted last weekend, the economic staff’s projections indicate a worryingly pessimistic view of the supply side of the US economy, with only a small output gap at present, and very low productivity growth in the future. If validated by future data, this pessimistic view will involve a much lower medium-term growth rate for the US economy than has generally been assumed by official and private economists, and eventually that might start to worry the equity markets. 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
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.
When the Federal Open Market Committee meets on March 17-18, it will be able to drop the word “patient” from its statement without shocking the markets. After some confusion, the Fed’s intentions on the date of lift off now seem fairly priced, with Fed funds rate contracts showing a probability of more than 50 per cent that the first move will come in June. The behaviour of the dollar, and of core inflation, are likely to determine whether June or September is eventually chosen for lift off.
Once that is out of the way, the markets will turn their attention to a much harder question: how rapidly will rates rise after lift off? The market currently expects a much more gradual path than the median shown in the FOMC’s “dot” chart, but there is huge uncertainty about this question on the committee. As the graph above shows, the interest rate forecasts for individual members of the FOMC, which will be updated on Wednesday, have a very wide range.
According to Fed vice-chairman Stanley Fischer, the rationale for rate rises is that the Fed wants to embark on a process of “normalisation”, and he is adamant that today’s rates are “far from normal”. That, of course, raises the question: how should we define normal? On this, the leadership group on the FOMC is not offering much guidance, but a common way of answering the question among macro economists is to consult the Taylor rule. 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
Opinion is sharply divided about what the Fed intended to signal in the statement issued on Tuesday. Some have seen the statement as very dovish, because it said that the Fed intended to leave short rates at “exceptionally low levels” until mid 2013 – the first time that a specific date of this sort has ever been set by the FOMC.
Others, however, concluded that the statement contained nothing really new, since the markets had already assumed that short rates would be close to zero for the next two years. Furthermore, the fact that there were three dissents from the majority decision has led some to deduce that the further large step to more quantitative easing (QE3) is still a long way off. On this view, nothing really changed. Read more
Ben Bernanke. Image by EPA.
The financial markets seem determined to interpret today’s statement by the Fed chairman in a dovish light, but a careful reading of his words does not support that point of view. True, Mr Bernanke outlined the possible ways in which monetary policy might be eased further if recent economic weakness should prove more persistent than expected. But he gave equal weight to the possibility that “the economy could evolve in a way that would warrant less-accommodative policy”.
There was no hint in the text about which of these outcomes he considered the more likely. We already knew from yesterday’s FOMC minutes for the June meeting that the committee is split about the likely evolution of policy, and we were waiting to see today whether the chairman would throw his weight behind either the doves or the hawks. He failed to do either. Read more
The ongoing discussions in Washington about the US public debt ceiling are raising some interesting ideas, some of which are highly unorthodox. One such idea is that the debt ceiling itself can simply be ignored because any attempt by Congress to restrict the ability of the United States to meet its debts appears, on the surface, to contravene section four of Amendment XIV of the Constitution.
This Amendment states that “The validity of the public debt…shall not be questioned.” I will leave this matter for debate among constitutional lawyers (see here and here), but as a simple economist I would question whether the US would retain its triple A status if the administration continued to make payments in contravention of an explicit act of Congress, which the President believed to be unconstitutional. What would happen to the “full faith and credit” of the United States if the Supreme Court subsequently ruled that the President was wrong? Read more
William Dudley, the President of the New York Fed, is an intellectual heavyweight with whom I was fortunate enough to work for a couple of decades. Long experience has taught me not to ignore his views on the economy. He made an important speech last Friday, spelling out the dovish view on monetary policy which is currently held by the most senior members of the FOMC, probably including Ben Bernanke.
Although the speech was careful to go no further than the statement which followed the last FOMC meeting in September, it explained in considerable detail why the Fed now believes that inflation is too low, and why he at least also believes that a further round of QE is the right response to the situation. Read more