The Quandary on Inflation

In recent congressional testimony, Chair Janet Yellen expressed dismay that inflation has remained persistently below the Fed’s target of 2% despite years of monetary stimulus and a decline in joblessness to its lowest level in more than 40 years. Granted, all data have anomalies and measurement issues, yet the recent shortfall in US inflation (see Figure 1) seems strikingly ‘abnormal’ relative to that of recent years, especially in the context of a tighter domestic labour market and comes at an awkward time as the Fed has set course for an historic unwinding of its extraordinary policies of the past eight years. Will low inflation derail the Fed’s exit strategy? If not, where are they headed?

Notwithstanding the fascination of market observers with quandary presented by the latest undershooting, the Fed is not likely to give up on the notion that inflation will begin to rise now that the economy has reached its potential – at least not yet. One of the most enduring relationships in macroeconomics has been the link between the so-called output gap and inflation depicted in Figure 2 on the next page. Note, however, the delayed response of core inflation even after real GDP exceeds its inflation-stable potential (i.e., the output gap measured on the left-hand scale crosses its target of zero.) This seemingly perverse lag can be seen during the late 1990s and again in 2003 when inflation actually declined after output had already surpassed potential. On average, the delayed reactions can last for one year, so this latest undershoot is not yet cause for FOMC members to lose faith in this relationship.

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Rules versus discretion - Lessons from recent history

Critics of central banks have long recommended various operational rules for setting monetary policy instead of allowing the governing boards free reign in making those decisions. Milton Freidman, for example, after an exhaustive study of the Fed’s policy actions during the Great Depression, came to the conclusion that policymakers should adopt a simple rule of steady growth in the monetary base and let interest rates go where they might.1 More recently, central banks have targeted some combination of price stability and full employment, however defined. Those two goals were set out in the Full Employment and Balanced Growth Act of 1978 (informally known as the Humphrey-Hawkins Act) and have become the underlying rationale for most, but not all, Fed policy decisions ever since. Indeed, the Fed only deviated from its dual mandate during four periods over the past forty years - during the early 1990s, briefly in 1998-99, in the early 2000s and after the onset of the Global Financial Crisis in 2008. These episodes provide a glimpse into how the Fed assesses potential risks associated with financial instability, ranging from banking crises and dysfunctional financial markets that disrupt financing to contagion from some other non-financial disturbance. Whatever the source of financial instability, the Fed on those occasions felt free to use discretion in setting policy, for better or worse.

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SSC - Capping QE

After next week’s FOMC meeting, we are likely to hear a lot more about the central bank’s plans to unwind their experiment with asset purchases of public and private debt securities as a therapy whatever ails the economy during periods of financial stress. Indeed, Fed officials already have made clear that they intend to begin to shrink their balance sheet later this year through some process of attrition. For those observers who have a long view on monetary issues and the efficacy of financial markets, this news should come as a welcome relief because central banks in general should not make a habit of such large-scale interventions lest they cause permanent distortions and collateral damage to financial markets. Others with shorter horizons will fret about the dangers that any exit strategy has the potential to create volatility, reminiscent of the ‘taper tantrum’ of 2013, and to tighten monetary conditions enough to undermine the economy’s slow-moving recovery. Of course, Fed officials must take the long view and hence tend to believe they can engineer a graceful exit. Their plan is somewhat akin to ‘cap and trade’ schemes for weaning the world of pollutants. Unlike those supposedly market-based plans, which can be more complicated and less effectual than advertised, the Fed’s exit strategy seems to have considerable flexibility including the option to change course if need be.

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Decoding the latest Fedspeak

Central bankers tend to speak in jargon that financial markets can understand or at least can interpret with a modicum of guidance. Clarity has its rewards whereas hyperbole and words in quotation marks are strictly off limits. When new words are introduced into the policy discussion, financial analysts parse the words with unending zeal until their implication for monetary policy is better understood. So when the latest policy directive from the Federal Reserve was released in March, much attention was directed at the reference to the Fed’s “symmetric inflation goal”, which seemed to imply a tolerance for running the economy hot or more precisely above its inflation-stable potential.

The inevitability of tighter monetary conditions

The Inevitability of Tighter Monetary Conditions

This year begins under a fog of uncertainty that rivals any other in my long association with financial markets. No one knows where politics of populism will take us. The comfortable status quo of globalisation and unfettered capital flows has lifted asset prices to new heights over the past several decades but in doing so also has worsened the gap between rich and poor. For whatever reasons, widening inequality seems to foster a reversion to populist politics and protectionist policies even though history indicates that neither of these frameworks augments the wealth of nations and, if sustained over time, tend to sap a country’s strength and vigour. We now seem to be in the initial throes of optimism about a change in policies, as often occurs in the wake of a US presidential election. Markets are dismissing what they do not know about the future in the hopes that whatever transpires will remedy the shortcomings of past policies. I often refer to this phase of the business cycle as “la la land” for politicians and investors who think fiscal stimulus is a free lunch and asset prices have no upper bound when in reality we are setting the stage for an inevitable tightening in monetary conditions. The only questions are how soon, how much and with what consequences. The Federal Reserve will provide some answers in the months ahead.

FOMC: On a Fast Track to Normalisation

The FOMC decided to raise the fed funds rate to 0.75% on December 14th, and have pencilled in an extra rate hike in 2017. The media would have us believe that the faster pace of normalising the policy rate to its long term norm now estimated at about 3% reflects both a stronger US economy and expectations of outsized fiscal stimulus under a Trump presidency. Neither of these conjectures is correct...

On a Trump Presidency

Donald Trump’s election victory is bringing forth a lot of speculation on the next administration’s possible economic policies and their consequences. These exercises are fraught with uncertainty in part because Trump as a candidate spoke so little about what his policies would be. A few themes are likely to remain intact now that election posturing is finished and so some thoughts are worth considering. Some of the main items on the agenda supposedly will include: renegotiating trade agreements including NAFTA, curbing immigration, health care reform (again), deregulation (notably for small businesses), repeal of Dodd-Frank, tax cuts and most significantly fiscal stimulus presumably in the context of infrastructure spending. Some of this agenda, however modified, is likely to move forward in 2016 because America has voted for ‘change’. Recall that each of the previous 8-year US presidents (Reagan, Clinton, Bush and Obama) was replaced with someone who was diametrically different in some sense from their predecessor, so the populous expects and Congress must deliver something new.

The illusion of policy divergence

The illusion of policy divergence

By far the most consensual view today is that monetary policies, at least among major central banks, are headed in opposite directions. The Federal Reserve is tightening while both the ECB and BOJ are trying to double-down on quantitative easing (QE).  Even the PBOC is perceived in some circles as a potential candidate for the dubious honour of embracing unconventional policies... 

Whats the Fed got to do with it?

It has become almost a mantra for the media. Every news article on currencies contains a seemingly obligatory phrase associating strength in the US dollar, either past or prospective, with the Fed’s long-awaited normalisation of short-term interest rates. If you hear it enough times, like political banter, you are supposed to believe it. Resist that intuitive leap of faith and rely on analytical thinking. A more plausible thesis is that US Treasuries and dollar-denominated assets in general have been perceived as safe havens in a global economy that is flirting with deflation.