Rethinking Price Stability

Central banks are not equipped to tackle the structural forces that underlie the deflationary bias of today’s global economy. The big issues are income inequality in both the developing and emerging economies, excess saving especially in East Asia, persistent trade imbalances, the human cost of rapid technological advances, and climate change . All these factors weigh on growth prospects and have undermined the effectiveness of monetary policy in achieving full employment. In short, ultra-generous monetary policies and negative real interest rates have had limited success in overcoming these structural obstacles to growth, and conversely quantitative tightening has done little to impede growth, contrary to claims by the Trump Administration. Notwithstanding those limitations to policy effectiveness, the Federal Reserve is contemplating whether to change its framework for targeting inflation from a simple guideline of 2% per annum to something more aggressive. Unfortunately, no monetary elixir will fix what ails global growth.

The Origins of the 2% Target

The Federal Reserve’s current policy framework evolved from the Full Employment and Balanced Growth (aka ‘Humphrey-Hawkins’) Act that the US Congress passed in 1978 amidst both rising unemployment and growing inflation. Among other things, the Act mandated the Board of Governors to establish a monetary policy whose goals were to promote full employment and price stability and to sustain long-term growth. In addition to these general goals, the Act set specific targets for unemployment and inflation. Namely, economic policies were supposed to reduce unemployment to 4% for the working-age population and inflation to 0% by 1988. The latter target was inappropriate for several reasons including its proximity to destructive deflation and the tendency of most measures of inflation to have an upward bias, especially those measures using fixed expenditure weights such as the Consumer Price Index.

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Should Financial Markets Celebrate Powell's Pivot?

At his press conference following the FOMC meeting of January 29-30, Fed Chairman Powell expressed the Board’s decision to be ‘patient’ in implementing future adjustments to its policy rate. The media immediately dubbed his statement as a ‘pivot’ away from the forced march toward policy normalisation over the past two years that steadily had raised the funds rate and had begun to shrink the Fed’s bloated balance sheet. Financial markets rejoiced with significant rallies in equities, long-dated bonds and risk assets in general. To be sure, the Fed is taking its foot off the brakes and is willing to wait and see on how the economy fares in the months ahead. The question that comes to mind, of course, is why has the Fed set a new course? Do they know something we do not?

The Asynchronous US Economy. To be fair, there have been many red flags in recent months that signal economic and financial stresses around the globe. Credit spreads have widened appreciably toward the end of 2018; global trade flows have been disrupted by US tariffs and smouldering trade wars; and Brexit negotiations have created uncertainty in Europe. Emerging economies in general, and China in particular, have reported slower growth. Commodity prices have declined, and financial markets have been volatile. Yet none of these developments deterred the Fed from a rate hike in December, in large part because the US economy was still ‘strong’, and inflation was stable at the Fed’s long-term target of 2%.1 The other shoe seemed destined to drop on America, yet US employers continued to hire prolifically in January.

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Why Do Economic Expansions End?

With the normalisation of US monetary policy and evidence of an economic slowdown emanating from China, attention is turning to whether the United States can escape a recession. Indeed, the flattening of the Treasury yield curve often is cited as a potentially ominous sign. Over the past four decades, recessions invariably ensued whenever short-term interest rates rose above long-term rates. Figure 1 shows the often-cited recession metric - the yield differential between 10-year Treasury bonds and 2-year notes along with shading for recessions. Even a small inversion in this measure, such as the one that occurred in 2007, proved to be a precursor to the Global Financial Crisis. Granted, the lead time between inversion and the onset of recession has varied from about six months to one and a half years, but the consistent pattern begs the question of why this indicator has worked so well and whether investors should worry about a further flattening of the curve. Correlations, however, do not necessarily indicate causation, so it is worth asking why this relationship exists and as well as the broader question of why do economic expansions end.

Policy Blunders and Currencies

In December 2015, I wrote a commentary entitled “The Illusion of Policy Divergence” which expressed my skepticism on the longevity of the so-called ‘reflation trade’ that was in fashion at the time.  The consensus of opinion was that US monetary and fiscal policies were poised to diverge from those of the rest of the world because the Federal Reserve had embarked on a pre-programmed exodus from quantitative easing and zero interest rates, while President Trump was promising to undertake a major fiscal stimulus with a massive infrastructure program. That policy mix – tighter monetary conditions and loose fiscal policy – tends to be a classic prescription for currency appreciation, at least as long as it generates a domestic economic cycle that is asynchronous with what is happening elsewhere. Therein lay the illusion: the large parts of the world, notably Europe and China, already were recovering from the lull of 2013 without the need of fiscal assistance. Moreover, other members of the QE Club were destined to follow in the Fed’s footsteps in unwinding their unsustainable asset purchases and negative real interest rates. That scenario meant the global economy as well as national economic policies were gravitating toward convergence rather than divergence, thereby undermining the flimsy rationale for the US dollar rally.



Regime Change: Inflation

With the nomination of Jerome Powell for Chair of the Federal Reserve Board, we hear much speculation about whether a change in Board members will alter the course and conduct of US monetary policy.  Strong Chairs, including Paul Volcker and Ms. Yellen, have managed to guide policy in times of dramatic change in the economic landscape. Mr. Volcker reshaped America’s future by breaking the wage-price nexus of the 1970s. Ms. Yellen will be remembered as the architect of extricating the Fed from the extraordinary policies undertaken in the aftermath of the Global Financial Crisis. Mr. Powell faces a much less tangible challenge that he and the Board are in danger of missing altogether. Namely, the world has changed dramatically over the past three decades, and the analytical tools underpinning monetary policy have not evolved in tandem. Economists often refer to such transformations as “regime changes”, and the challenge will be to develop new tools that fit the new world order.  In short, central bankers are flying blind and are in need of upgrading their radar systems. For that matter, so are other policymakers, planners and anyone else who must use projections as a basis for their judgments and decisions.

At the top of the list of the causes of regime change are globalisation and technology, which tend to be catch phrases that subsume many possible causes but nonetheless are over-arching phenomenon that have changed the way the world works. Other sea changes including the saving patterns of aging populations, China’s meteoric industrialisation, Asia’s saving glut and a widening gulf in wealth inequality also have contributed to the breakdown of old economic norms. To be sure, many of these forces are interrelated and mutually reinforcing. What matters to investors are whether these changes are long-lasting and hence might somehow justify current lofty valuations.

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Is the Fed behind the curve?

I have addressed many of the issues concerning the question of whether or not the Fed is behind the curve in two recent commentaries1. There are two dimensions to being 'ahead' or 'behind' the curve. The first dimension is the traditional perspective on the federal funds rate. The second is the bloated state of the Fed’s balance sheet that imparts monetary stimulus via its effect on long term interest rates.

Many observers are focused on the real Fed funds rate and conclude that the Fed is behind the curve because a central bank supposedly should not persist with a negative real policy rate at full employment. That is correct, but the question remains as to 'how much?" The answer to that question depends critically on what the neutral policy rate is and the prospective risks to financial stability. My fed funds model, which includes a proxy for systemic risk to address the Fed's foremost priority of safety and soundness of the financial system as well as measures of the Fed’s other two objectives of price stability and full employment, gives a new perspective on how much the Fed might be behind the curve. Figure 3 from my paper entitled "Policy Rules Versus Discretion: Lessons from History", is reproduced below. Over the past year, the Fed has closed the gap behind the funds rate and its estimated value in this model to about 35 basis points. Granted, the model expects the funds rate to rise further now that the economy is at full employment and inflation is inching up to its target of 2%. But the ultimate nominal neutral rate in this model is 2% to 2-1/2% - far lower than most observers perceive it to be yet a target consistent with staff and IMF studies on the new neutral rate. In this context, the Fed would be judged to be a little behind the curve, albeit not as much as they often are at full employment.

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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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Policy 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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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.

On the surface, this leap of logic makes some sense. After all, FOMC participants repeatedly have said that the US economy is operating close to full employment. Indeed, unemployment fell to 4.5% of the labour force in March, which is one of the lowest levels in the standard (so-called U3) measure of joblessness since the 1960s. We can debate why other aspects of the job market have changed, including the rise in part-time work and the decline in labour force participation especially among young persons. The bottom line, though, is that employers are struggling to find workers with the requisite skills to fill vacancies. The clear implication would seem to be that a strong economy – abetted by the Fed’s still-accommodative monetary stance – will put pressure on costs and prices. In those circumstances, highlighting the inflation goal as symmetric would seem to imply some tolerance for letting inflation drift higher in lieu of applying the monetary brakes more aggressively.

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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.

The Current Setting for US Monetary Policy

Here is the Fed’s predicament in a nutshell. With the recent spurt in activity, the US economy now is operating on the cusp of its inflation-stable potential. That does not mean that the economy could not produce more output if companies invested more and idle workers accepted new jobs or worked longer hours. Rather, at this threshold the Fed now faces an inevitable trade-off between more growth and more inflation. In the jargon of FOMC members, the Fed has reached its operational targets of 2% inflation and full employment, at which point it must reconsider the wisdom of further monetary stimulus. As long as FOMC members believe the current favourable conditions are sustainable, then they have little choice but to shift policy to a ‘neutral’ stance. Granted, the Fed’s view of what constitutes ‘neutral’ has changed dramatically in recent years. Staff research shows that demographic trends have lowered the equilibrium real interest rate 125 basis points since 1980.1 That implies the new neutral for the fed funds rate now is no more than 50 to 100 basis points, which translates into a nominal funds rate of 2.5% to 3%. The spectre of the Fed being forced to hike short-term interest rates multiple times in the coming years raises key questions for financial markets ranging from what happens to long term interest rates, equity valuations and the viability of the current economic expansion that already is the longest in history.

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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. Indeed, it appears that the staff forecast, which heavily influences the views of most FOMC participants, is essentially unchanged from the September version. In my opinion, incoming data including the upward revision to Q3 GDP along with the strength of employment, earnings and household spending in Q4 can explain virtually all the small upward revisions to economic activity in both 2016 and 2017. Only the tiny revision to GDP growth in 2019 might be interpreted as a nod in the direction of incorporating more government spending or tax cuts under Trump, but I doubt that as well. The staff does not deal in speculating about future fiscal policies. Rather, its public sector forecasts are based on actual outlays and receipts coupled with data on congressional appropriations, none of which has occurred yet.

The staff forecast process begins with revisions to the current level of GDP based on data revisions and incoming data. In this case, many of the latest numbers have surprised forecasters to the upside, as has the sharp decline in the unemployment rate to 5.6% in November. Data on the labour market, especially the payroll survey, carry a heavy weight in the current quarter estimates at least until other flow data becomes available. Not only is employment the most up-to-date data, it also is tell-tale because of the simple notion that employers do not hire workers unless business is good. An upward revision to Q4 GDP also tends to have some carry-forward into the Q1 level of GDP in the staff’s forecast exercise, thereby explaining the small 2017 revision. That leaves the tiny revision to 2019, which is hardly worth mentioning. At 1.9% that forecast remains at or below the US long term potential growth of about 2%, which in itself is at the high end of the staff’s latest estimate of 1.5% to 2%.

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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 Trump agenda is a mixed bag of supposedly pro-growth policies for the short run that unfortunately could have very negative consequences for the economy’s long term potential, so let’s divide the discussion into two phases – the short view and the long view.

The Short View

Not surprisingly, much of the market’s initial reaction seems to focus on the short view, especially the prospects for infrastructure spending. Markets have responded by raising inflation premiums on long term bonds. Although a growing consensus of economists now believes infrastructure spending is a viable anecdote for secular stagnation, some caveats are noteworthy. 

  • When an economy is operating close to its potential, as is the case with the US economy today, an outsized initiative on infrastructure is ill-advised. The projects rarely provide jobs for the long-term unemployed or those who lack the requisite skills for such work. Moreover, the extra stimulus is likely to cause some inflation with a lag of about one year if it pushes the economy above potential. In a world where deflation still lingers, the risk is not so much a reversion to high inflation but rather the persistence of inflation from operating the economy ‘too hot’.
  • Congress will likely set restrictions on what projects would qualify, typically limiting the ventures to so-called ‘shovel-ready’ initiatives under the guise that the spending would not be a permanent feature of the government’s budget. The flip side of ‘shovel-ready’ however is that little thought is given to the long-term payback from projects or to what would be high priorities in raising the nation’s potential output. Only a small portion of the ARRA funding in 2009 was devoted to ‘greenfield’ projects which were next to impossible to accomplish within the two-year window of the stimulus package. The result often that most of the money is spent on pet projects, local road projects and transfers to local governments. This approach would be antithetical to the notion of remedying secular stagnation.
  • Waste is the Achilles’ heel of congressional legislation and infrastructure is no exception. Consider Japan’s ambitious building program of the 1990s that did nothing to augment potential growth but did implode the government deficit that remains today.

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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. The upshot of this supposed divergence is a disturbingly universal view, constantly repeated in the media, that the US dollar will strengthen further in 2016 taking dollar-denominated assets along for the ride. Unfortunately, the cozy comfort of this consensus thinking is an illusion that can lead to poor strategic thinking. A better framework would begin with the mix of policies, both monetary and fiscal settings, which are moving in the direction of convergence rather than divergence. Namely, central banks are gravitating toward a real policy rate of zero and most governments belatedly are shifting toward fiscal stimulus. This broad convergence in economic policies leads to some surprising macro implications, most notably less currency volatility and more economic growth. Even a weak US dollar is a possibility as is a minor recovery in Europe. In short, do not be distracted by conventional presumptions about the Fed’s tightening cycle and interest rates. The ultimate bogeyman of this investment cycle will be credit quality and the warning sign will be when banks tighten lending standards.

The Tenuous Link between the Fed and the Dollar

When central banks are out of sync, especially with the Federal Reserve, currencies do tend to revalue, usually in favour of the country offering higher real interest rates. The reason, of course, is that the differential in interest rates is an irresistible lure for the legions of carry traders, from banks to hedge funds, in the fluid world of globalised capital markets. There are caveats to this sacred tenet, however. First, the interest rate differential must be sufficiently large to offer out-sized returns. Small differentials do not have enough juice, even with the help of leverage. Second, asynchronous policies must be perceived as long-lasting. A short horizon doesn’t work. So whatever forces are believed to be causing the divergence in monetary policies must persist even as the favoured currency appreciates...

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What's 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. Similarly, the booms and busts of emerging currencies have more to do with China’s gluttonous demand for commodities and the US dollar’s role in funding for commodity currency trades than Fed policy. Zero interest rates and QE policies of western central banks have been classic breeding grounds for disruptive and potentially destabilising carry trades. The Fed should weigh these undesirable costs of unconventional monetary policies, including distortions to asset prices and increased use of cheap leverage, against their diminishing benefits in stimulating economic activity. Absent some compelling evidence to the contrary, the Fed should be thinking in terms of removing the proverbial punch bowl before the party gets out of hand.

Consensus Thinking on US Dollar’s Strength

On a trade-weighted basis, the US dollar has risen about 8% this year and almost 11% over the past 12 months. That move is significant. Even though the Fed’s dual mandate focuses on full employment and price stability, the Fed does and should care about large changes in the terms of trade. One often-cited concern is that lower import prices will make it more difficult for the Fed to reach its inflation target of 2%. Here is the empirical evidence. A 10% rise in the trade-weighted dollar lowers overall inflation about 3/4% spread over three years, or about 0.25% per year.1 That may not seem like much, but every little bit matters to central banks that believe deflation would be more destabilising than a bit more inflation. Underlying that calculation is the presumption that the currency remains elevated. Unfortunately, one of the main reasons multiyear currency forecasts are notoriously inaccurate is because circumstances do change.

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China's gordian policy knot

  • The renminbi will appreciate 2-3-% per year on average over the next five years. A stronger currency is the only way to limit the high cost of forex sterilization.
  • The PBOC will widen the currency bands whenever hot money flows reappear until they are +/- 5%.
  • The principal drivers of the currency will be China’s current account surplus and China’s status as one of the world’s largest creditors.
  • Greater renminbi flexibility will be accompanied by continued strides to develop local debt instruments.
  • In contrast with other interest rates, deposit rates will not be deregulated anytime soon.
  • The ongoing internationalization of the renminbi should be viewed as means for lowering the cost of trade transactions rather than a driver of the currency per se.
  • The final phase of China’s financial evolution will lead to substantial overvaluation by as much as 25% to 30%.
  • Complete convertibility including financial flows will be among the last of the financial reforms.

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