US economy


The turbulence in the global financial markets in the past few weeks has been widely attributed to a “China shock” that has increased the risks of a major downturn in global activity. Last month, this blog concluded that our regular “nowcasts” for global activity had not yet corroborated this narrative.

This month, we have identified the first clear evidence that the global economy has slowed down since mid year, with emerging markets and advanced economies both now growing more slowly. A new factor is a clear slowdown in the US economy, though much of this appears to be due to the temporary effects of an inventory shake-out.

The Chinese economy has not shown any further signs of slowdown in September. The dominant contractionary force in the global economy is a commodity shock, which of course is somewhat connected to events in China (as it rebalances its economy away from commodity-consuming sectors), but it is not exactly the same thing.

The commodity shock is redistributing activity away from commodity producers and towards commodity consumers, both within and between countries. Eventually, the commodity shock should be net beneficial to the global economy, but so far global activity growth has dropped to only 2.6 per cent, which is 0.4 per cent below the rate in mid year, and 0.8 percentage points below trend. This means that global spare capacity is currently rising at a worrying rate.

Because the emerging markets are much more exposed to commodity producers than developed markets, they have been hard hit by the commodity shock. They are now growing at 3.5 per cent, or 1.5 percentage points below trend. It is unclear whether this growth rate is still dropping.

In the advanced economies, the growth rate in activity is about 1.7 per cent, which is roughly at trend. The slowdown identified in the US in September has been offset to some extent by signs of firmer activity in the eurozone.

An important and worrying feature of global growth in 2015 has been the large drop in global industrial production relative to services in the second quarter. This was driven mainly by weakness in industrial production in the US energy sector – not in China – and it has since been reversed. Read more


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

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


> on March 5, 2015 in Beijing, China.

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

Global Growth Report Card, June 2015

According to Fulcrum’s “nowcast” factor models, global economic activity has improved significantly in the past month, with data from China and Japan recording stronger growth than has been seen for some time.

The eurozone remains fairly robust (if only by its own rather unimpressive standards), but the US has failed so far to bounce back from a sluggish first quarter, even after the strong jobs report last Friday. There have been further downward revisions to forecasts for US GDP growth in the 2015 calendar year, including notably by the International Monetary Fund. This will be yet another year in which US growth has failed to match the optimistic expectations built into consensus economic forecasts at the start of the year.

Despite some lingering doubts about the US, the improvement in global growth this month has significantly reduced the tail risk that the world might be heading towards a more serious slowdown. The reduced risk of a more severe global slowdown, along with signs of a bottoming in headline inflation in most economies, has probably been a factor behind the sell-off in bond markets in recent weeks, as the perception of global deflation risks has faded.

The regular proxy for global activity that we derive from our “nowcast” factor models (covering the main advanced economies plus China, see graph on the right) shows that activity growth is now running at 3.5 per cent, which means that the slight dip in the growth rate that we identified around March/April has now been eliminated. Although the “recovery” in growth is only around 0.7 per cent from the low point, it is nevertheless significant because it suggests that the risk that a hard landing in China could drag the world economy into a more severe downturn has diminished, at least for now. 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

Yellen Discusses Monetary Policy At Federal Reserve Bank In San Francisco

Getty Images

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.

 Read more

Yellen Discusses Monetary Policy At Federal Reserve Bank In San Francisco

  © Getty Images

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

  © Getty Images

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

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

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

The Federal Reserve told us in December last year that it would maintain its asset purchases until the outlook for the US labour market had improved substantially. Does Tuesday’s rather anaemic jobs data release meet this criterion any more than it did last month, when the Fed decided not to taper its asset purchases? Not really.

The underlying pace of job gains is certainly not rising, and may even have fallen slightly. But the unemployment rate dropped to 7.2 per cent, and the pace of decline suggests that the 6.5 per cent threshold for considering interest rate rises could be reached in mid-2014, ie before the balance sheet tapering has ended! This gives Janet Yellen, the incoming Fed chairman, an early problem: she will surely have to reduce that 6.5 per cent threshold soon.

In this blog, we use some statistical tools which have been developed by the regional districts of the Fed to frame a judgment about the underlying state of the labour market, updated to include this week’s new information [1]. Read more

The US official statisticians have today issued revised statistics for GDP dating all the way back to 1929. It may be alarming for investors and policy makers to hear that our understanding of economic “truth” needs to be amended for the last 84 years, but the changes have not in fact made much fundamental difference to the debates which matter for the economy today.

In particular, there has been very little change in the Fed’s likely view of the amount of slack which remains in the economy, though the latest version of growth in the last few quarters, including the publication of data for 2013 Q2 for the first time, may persuade them that economic momentum is a little firmer than previously believed.

The most dramatic-sounding news in today’s release is that the level of nominal GDP has been revised up by 3.4 per cent in 2013 Q4. This follows a number of methodological changes, the most important of which is to treat R&D spending as a positive contributor to investment and GDP, rather than as an input to the production process. But since this change impacts GDP levels for decades in the past, it does not make much difference to our understanding of the economy’s capacity to grow in the immediate future. It simply involves viewing the same objective truth through a different coloured lens. For most practical purposes, this change can be ignored.

There are, however, three areas where the revisions could be significant: Read more

The volatility in financial markets since Mr Bernanke gave evidence to Congress yesterday is a not-so-gentle reminder of what might happen when the Fed eventually begins to withdraw monetary accommodation. The Chairman’s warning that the FOMC might reduce the pace of its asset purchases “in the next few meetings” has clearly spooked the markets, especially those (like Japanese equities) where bullish positions had become very crowded.

The Fed’s main message at present is that it will “increase or reduce the pace of its asset purchases…as the outlook for the labor market or inflation changes”. This seems deliberately designed to inject some uncertainty into market psychology, and thereby prevent an excessive risk taking. Mr Bernanke said that he takes the risk to financial stability “very seriously”.

But the overall tone of the Chairman’s written evidence yesterday strongly suggested that the Fed is still a long way from contemplating any significant change in monetary policy. After all, tapering QE would only imply that the pace at which policy is being eased is being reduced. An outright tightening of policy still seems to be several years away. Read more

The FOMC will meet on Wednesday with the markets feeling confident that there will be no change in monetary policy. This means that the $85bn per month rate of balance sheet expansion will probably remain in place. But recently chairman Ben Bernanke has conceded, rather reluctantly, that the Fed’s exit strategy from quantitative easing will soon need to be reconsidered by the committee, and the debate could start at this month’s meeting. In any event, with economists now upgrading their forecasts for US GDP for the first time in quite a while, the markets are increasingly focused on whether the exit can be handled successfully.

The first question is whether the exit will be gradual or abrupt. The chairman’s personal preference is very well known: it should be gradual, and extremely well flagged in advance. But Mr Bernanke might not be in office after next January, and there are others on the FOMC who could have different ideas. Furthermore, economic and market circumstances could change. In 1994, GDP growth and inflation both rose markedly, and the Fed slammed on the brakes without any warning. The resulting 3 per cent rise in the Fed funds rate delivered a major shock to the financial system. Read more

The decline of 0.1 per cent in US real GDP in 2012 Q4 (at a seasonally adjusted annualised rate) is a definite negative surprise for financial market sentiment, which has become very complacent about the ability of the US economy to withstand the fiscal tightening due to hit the economy.

Fortunately, the underlying picture for final domestic demand is reassuring, which is why the markets have taken these figures in their stride. Today’s figures are unlikely to signal a serious downturn.

But the US economy almost never posts a negative quarter in the middle of a robust upswing, so the figures should give us some pause for thought. Furthermore, the weakness of exports, which is more than a one quarter phenomenon, shows that the global economy had become dangerously dependent on the strength of the US consumer towards the end of last year. Read more

The disappointing performance of UK GDP in the past couple of years has become a matter of international interest. Many economists, unsurprisingly, have concluded that the UK government has pursued totally the wrong economic strategy, especially with regard to the speed of fiscal consolidation. The adverse comparison of UK performance with the US, a country with similar exposure to housing, financial services and the bursting of the credit bubble, but with less fiscal tightening since 2010, has been widely emphasised. A consensus has developed that the fiscal multiplier has proven to be much higher than was expected in 2010, and many economists have concluded that fiscal consolidation in the developed economies should be reversed or slowed down. Read more

As Barack Obama is re-elected, he faces political wrangling over the US fiscal cliff. Image by Getty

The re-election of President Obama last Tuesday has triggered a fairly sharp fall in US equity prices, along with a decline in bond yields. Although I argued in this blog last weekend that bonds would prefer an Obama win, while equities would prefer a Romney victory, the extent of the decline in equities in mid week came as a surprise. To some extent, the market was reacting to prospective increases in capital gains taxes, and to tighter regulation of the financial sector, in the president’s second term. But undoubtedly the main factor was uncertainty about the fiscal cliff.

Most investors are assuming that Washington will agree to postpone most of the fiscal tightening which is implied by the “cliff”, but only after prolonged negotiations that could continue past the initial deadline at the year end, when the lame duck Congress departs from the Hill, and which might even be extended past the president’s inauguration on January 21. Read more

The two candidates in the American Presidential election are ideologically as far apart as any I can remember since Ronald Reagan and Jimmy Carter in 1980. In fact, it is hard to imagine the US political system throwing up a greater divide, unless the Republicans were to choose a Tea Party candidate. This gap is producing exceptionally strong personal sentiments from voters on both sides of the fence as the election approaches.

Yet the financial markets seem to be completely unfazed by the decision which the American electorate will make on Tuesday. Asset prices are acting as if they do not care very much who wins. Does this attitude make sense, and will it survive the election? Read more

The looming fiscal cliff in the US has now replaced the actions of the Fed and the ECB as the major macro talking point in the financial markets. Although most investors expect that the American political system will find a way out of the large fiscal tightening which is currently scheduled to take place in 2013, there is a great deal of uncertainty about how and when this will be accomplished. In the meantime, concerns about the fiscal cliff have now clearly started to damage capital goods orders in the business sector, which last week dropped in a manner which is normally seen only in recessions.

The US economy remains fragile, and a large downward shock to capital spending, which now seems inevitable in the final quarter of the year, is certainly not what the doctor ordered. It may well lead to a further slowdown in GDP growth in Q4, from the already anaemic 1.8-2.0 per cent rate which seems likely for Q3. However, unless policy makers in Washington prove unable to break free of political gridlock after the elections on 6 November, it still seems improbable that the economy will slide into recession early next year. Read more