September 10, 2012 8:14 pm
For true stimulus, Fed should drop QE3

Unsatisfied by the pace of the US recovery, the Federal Reserve seems set to launch a new round of quantitative easing. Well, the Fed can print all the money it wants – but it cannot dictate where it will go.

The first two rounds of quantitative easing fuelled a commodity bubble, increased income inequality and set a bad example for the rest of the world. During the 16 months of round one, up to March 2010, the CRB commodity price index rose 36 per cent, while food prices rose 20 per cent and oil prices surged 59 per cent. During round two, in the eight months up to June last year, the CRB rose 10 per cent, with food up 15 per cent, while oil prices rose a further 30 per cent.

It used to be the case that easy money reliably drove up the price of stocks, but not of commodities. However, since the Fed started to ease monetary policy aggressively in late 2007, hundreds of billions of dollars have flowed into new financial products (such as exchange traded funds) that allow investors to trade commodities the way they trade stocks. Now, there is a tight link between stocks and commodities, with prices rising and falling in lockstep.

This link neuters monetary policy makers, because rising commodity prices negate the stimulative impact of looser credit. When the price of oil hits $120 a barrel, consumer spending on energy reaches 6 per cent of total worldwide income and starts to cut into spending on other goods. Oil prices breached $120 a barrel in mid-2008, mid-2010 and mid-2011, and the global economy lost momentum each time. In effect, oil prices act as interest rates used to, discouraging consumption even when the Fed is trying to encourage spending. Estimates suggest that in the US, every $10 increase in the price of oil shaves 0.3 per cent from gross domestic product and instead adds 0.3 per cent to inflation. The Fed is keen to avoid deflation and to keep inflation at 2 per cent, but if it reaches that goal by means of commodity price inflation it will be something of a pyrrhic victory.

Worse, the Fed’s campaign is increasing inequality. The hope is that quantitative easing will drive up stock prices, making consumers feel richer and spend more. But this glow is felt mainly by families in the top 10 per cent of incomes, because they own 75 per cent of all stocks. Meanwhile, the poor are hit hardest by rising commodity prices: families in the bottom 20 per cent of incomes spend 8 per cent of their income on petrol and 30 per cent on food, while the top 20 per cent spend just 2 per cent on petrol and 5 per cent on food. This link between monetary easing and inequality is a byproduct of the new liquidity link between stock prices and oil prices.

As the Fed started to hint at QE3 a few weeks ago, oil and food prices started to rally again. Fed officials used to cite strong demand in the developing world to explain commodity price inflation, but with growth slowing in emerging markets, supply-and-demand dynamics cannot explain this rally. Trading fuelled by easy money can, however: actively traded commodities such as gold, copper and coal are selling at prices 20-65 per cent higher than the marginal cost of production. Prices of less actively traded commodities, such as steel and iron ore, are falling.

The Fed is trying to defy the course of history. As the International Monetary Fund has shown, output typically declines by 10 per cent relative to trend in the seven years following a major financial crisis and the US economy is so far following that path. The Fed wants a quicker recovery but so far it has merely produced a rise in commodity prices that hurts the US and major emerging markets, where food and energy constitute a larger share of consumer spending.

Following the Fed’s lead, China aggressively eased monetary policy after the crisis in 2008, creating a housing bubble. In the past five years, China’s ratio of bank credit to GDP rose 65 per cent, a bigger rise than in other major credit booms, including those of the US in 2007 and Japan in 1990. Beijing is backing away from more stimulus, fearful that it will further fuel inflation.

Meanwhile, the US is pushing a third round of quantitative easing, which could be more counterproductive than the first two, since oil and food prices are now dangerously close to levels that have acted as a tipping point for the global economy in the past. Some economists trace oil and food prices to non-monetary factors such as geopolitical tensions in the Middle East and drought conditions. Maybe. But at this point, abandoning QE3 would do more good than pushing it, because dropping it would lead to a fall in oil and food prices. That would be equivalent to a significant tax cut for the middle class and would act as a true stimulus for the global economy.

The writer is head of emerging markets and global macro at Morgan Stanley Investment Management and author of ‘Breakout Nations: In Pursuit of the Next Economic Miracles’ (Allen Lane 2012)

Copyright The Financial Times Limited 2012.

September 9, 2012 8:16 pm
Global economy: Not so different this time
By Robin Harding and Chris Giles
With policies failing to boost demand, central banks may have to heed calls for radical measures
Chairman of the US Federal Reserve Ben Bernanke©AFP

These are uneasy times in central banking. The big beasts of the profession who met this month in Jackson Hole, Wyoming, were once the ultimate masters of the universe. Now they are nagged by self-doubt.

Four years on from the worst moment in the financial crisis, unemployment remains high across the developed world and the global economy is losing momentum. Risks from the eurozone and US fiscal policy loom large.

After the European Central Bank’s decision to counter speculation of a euro break-up by proposing to buy short-dated government bonds in peripheral European countries, the US Federal Reserve must this week decide how best to help an economy its chairman described as “far from satisfactory”.

Yet the deeper central bankers delve to solve the developed economies’ woes, the more some in the profession fret.

“I am a littlemaybe more than a little bitworried about the future of central banking,” said James Bullard, president of the Federal Reserve Bank of St Louis, in a Financial Times interview at Jackson Hole. “We’ve constantly felt that there would be light at the end of the tunnel and there’d be an opportunity to normalise but it’s not really happening so far.”

“What I’m worried about is this creeping politicisation,” said Mr Bullard. Pressure from politicians is often for central bankers to do more.

The biggest worry on display at Jackson Hole was whether these bureaucrats, sitting at the heart of every mature economy, still have the power to influence demand now that interest rates cannot fall much further. Lurking behind many debates was this question: if central bank policies are so effective, why is the global economy not growing faster?

For an answer, many reach for the insights of Carmen Reinhart and Kenneth Rogoff, who described how recoveries after a financial crisis tend to be painful and slow in their book This Time is Different.

Yet all of the central banking activism of the past four years is based on the belief that while this crisis may be similar to those of the past, there must be a cocktail of policies that will make the recovery different this time.

That faith is coming into question, however.

“I’ll confess that when that book came out I was a little sceptical about whether this was going to happen in the United States but they were right and I was wrong,” said Alan Blinder, a Princeton economics professor and former vice-chair of the Fed, from the platform at Jackson Hole. “We haven’t deviated that much from the pattern of a Reinhart-Rogoff recession.”

There are a few possible reasons why repeated rounds of central bank communication and quantitative easing, as the policy of buying long-dated assets in an effort to drive down long-term interest rates is known, have not brought about a strong recovery.

One is that something structural has changed to hold back growth. Speaking from the floor in Wyoming, Donald Kohn, another former Fed vice-chair now at the Brookings Institution, raised the possibility of “something deeper going on”, perhaps related to savings behaviour or the changed distribution of income between labour and capital.

Another is that the tools work, even if current conditions blunt their effect. If there are new headwinds, then the answer is to use them more aggressively. That is the mainstream view among central bankers.

“A balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks,” said Ben Bernanke, the Fed chairman, in his remarks at Jackson Hole.

A third possibility is perhaps the most alarming for central bankers such as Mr Bernanke, who have staked their reputations on successive rounds of quantitative easing: that it simply does not work.

In his presentation at Jackson Hole, Columbia University professor Michael Woodford presented evidence that, to the extent asset purchases have lowered long-term interest rates in the US, their effect was indirect. People saw the purchases as a signal that short-term interest rates will stay lower for longer, he argued.

That paper gave the assembled central bankers some food for thought, but will have little bearing on their immediate policy choices.

After August payroll growth came in at 96,000 jobsbelow estimates and scarcely enough to allay Mr Bernanke’sgrave concern” about the stagnation of the labour market – the Fed has three options to consider when it holds its two-day meeting this week.

It could buy more assets in another round of QE. It could extend its forecast of low interest rates beyond the current date of late-2014. Or it could cut the 25 basis points of interest that it pays to banks on their excess reserves.

Mr Bernanke spent most of his speech on the pros and cons of more asset purchases, and QE3 remains the Fed’s main option for a substantial stimulus. One idea that has gained a lot of ground on the rate-setting Federal Open Market Committee is open-ended action: buying a certain amount a month or meeting with no fixed target.

The difficulty is how to define a goal. More hawkish members of the FOMC want discretion to stop buying assets at any meeting.

Doves want a pledge to keep buying until a condition for improvement in the economy has been met. They would want that condition, most likely in words and not numbers, to imply a substantial QE3 unless the economy picks up.

A similar issue applies to the alternative of extending the Fed’s forecast of low interest rates into 2015. Doves would not want it interpreted simply as a prediction that the economy will stay weak. Instead, they would want to signal a change in the Fed’s behaviour, and that it plans to keep rates low even as the economy picks up.

What the Fed does will depend on whether the committee can agree on such a condition for improvement in the economy. If it cannot, then a straightforward chunk of asset purchases is more probable.

The last option, of cutting interest on reserves, has become somewhat more likely since the ECB cut its overnight deposit rate to zero without causing an apocalypse in the financial system. Few Fed officials think it would make much difference, however, and some continue to see modest risks. Certainly, it is unlikely except in conjunction with other actions.

. . .

But it is not just the Fed that is grappling with difficult policy issues. The ECB is faced with the threat of the disintegration of the single currency and a painfully slow international political process.

Its latest response has been to promise to buy bonds of European countries that have accepted potentially sweeping conditions of a programme of fiscal consolidation and economic reformpotentially in unlimited quantities. Buying only securities with short maturities, the ECB sees this as a monetary policy operation designed to bring short-term interest rates back into harmony across the eurozone. It wants to remove the devaluation risk premium in certain countries’ government bonds.

But the agreed operationoutright monetary transactions – is extremely controversial, with the Bundesbank, Germany’s ultraconservative central bank, viewing them “as being tantamount to financing governments by printing banknotes”. In addition, it sees the danger that if things go wrong, the potentially unlimited bond purchases “may ultimately redistribute considerable risks among various countries’ taxpayers” in the eurozone.

In Britain, too, the Bank of England, has moved away from buying government bonds in the hope of reducing long-term interest rates to seeking to intervene more directly to bring down the borrowing costs of households and companies.

Like the Fed, it insists QE is working. But the BoE is placing a lot of faith in the idea that by providing cheap funding for banks on the condition that they step up lending to the real economy, it will boost demand.

But there are other suggestions out there, some getting rather close to an arbitrary line across which central bankers fear to tread: the one that divides monetary from fiscal policy.

. . .

Some see value in pre-commitment to policy stimulus until it works. Mr Woodford argues for commitment to keeping interest rates low for a period that is linked to the performance of the economy. By holding rates down, even as inflation rises somewhat above a target such as the Fed’s 2 per cent, a central bank could make up for the period when the ideal interest rate would have been lower than zero.

And a rising number of voices, often those not so close to policy making circles but privately including some within the club, suggest central bankers could become more radical still. Central banks are being urged to buy assets other than government bonds, breaking a taboo that they should not accept credit risk on to their balance sheet.

While none of this is palatable, it is better than the really radical ideas that may gain traction if economic malaise lingers, such as the infamous helicopter drop”. A central bank could simply credit the bank accounts of the citizens in a country, directly boosting incomes for a period and encouraging them to spend.

A variant of this proposal is to finance the spending of government temporarily, allowing it to cut taxes for a period. This monetary financing of government is outlawed in Europe for the good reason that when it has previously been tried direct money-printing has ended in hyperinflation. An economy cannot provide sufficient goods and services to match all the newly minted cash at prevailing prices, and inflation takes hold.

Being conservative by nature, no central banker wants to consider ideas that have been off limits for decades. But there are rumblings afoot.

The textbook is not providing the answers. When that happens more radical options come to the surface.

GDP: The real story of nominal targeting

Central banks have worked hard to sell the idea of inflation targeting. Adopting a “target path for nominal gross domestic product” – an idea gaining momentum in academic circles – would be even harder to explain.

Even so, it may be the best possible solution to the problem that interest rates cannot go below zero.

Such a policy, advocated recently by Michael Woodford of Columbia University, would mean two changes for central banks.

First, the central bank would target the rise in total cash spending in the economynominal GDP includes real growth plus inflation – rather than just prices.

But second, and more important, it would target a constantly rising level of nominal GDP, rather than just the current rate of growth.

That is crucial, because it would link inflation in the future to conditions in the past. If nominal GDP growth was too low, the central bank would have to allow higher inflation to return it to the target path.

If a central bank, such as the US Federal Reserve, had been targeting a nominal GDP path in the past few years, markets would automatically assume interest rates of zero for years to come, as there is a big gap to make up. With the central bank promising to generate enough inflation to return eventually to the target path, people would have no reason to hold back on spending – and their expectations of the future get around the problem that rates cannot fall below zero today. Mr Woodford and economists such as Paul Krugman and Christina Romer advocate the policy for precisely this reason.

Central bankers worry about communication. A nominal GDP target all but guarantees they would sometimes have to target inflation higher than 2 per cent, and they fear there would be a cost to their credibility.

They also wonder how they will make good on the promise of higher inflation in times, such as today, when the only immediate policy tool is quantitative easing.

It may be particularly hard to introduce such a target now, when the economy is so far from its pre-crisis path, implying a lot of inflation to catch up. But the case for a switch is strong and growing stronger.

Successful academic ideas generally take time to gain acceptance by policy makers, so nominal GDP targeting is not about to be implemented. But watch the Scandinavian central banks. They are often first to latch on to new ideas.

Copyright The Financial Times Limited 2012