Expect more from the Fed — and soon

Mohamed El-Erian

November 15, 2012


The minutes of the US Federal Reserve released on Wednesday are an essential read for those interested in a real time snapshot of the complexity of modern day central banking. They are also a cautionary note for all who believe that, acting on their own, today’s hyper-active central banks can engineer good economic outcomes.

While the Fed is already deep in experimental mode, the minutes confirm that officials there are already considering additional measures. There are two reasons for this. First, their baseline economic expectations remain subdued as more positive housing and consumption indicators are offset by slower business activity. Second, they recognise the “significant downside risk” to the baseline forecast due to the global economy’s synchronised slowdown and the possibility of further financial shocks, such as the US falling off the fiscal cliff.

The minutes also reveal considerable confusion as to what exactly the Fed should do next. With interest rates at zero and forward interest rate guidance already extended to mid-2015, policy is faced with a shrinking set of options. This includes evolving further its communication role by moving to “quantitative thresholds” (i.e., specific targets for the unemployment rate and inflation or,
alternatively, for a broader concept such as nominal GDP); and/or expanding the programme to purchase securities on the open market (or “QE3”) in order to change the private sector’s behaviour.

While many Fed officials appear to favor additional policy activism, the minutes cite the need “to resolve a number of practical issues” before taking another major step. That is not surprising. What the Fed is now considering is fraught with even greater operational complexity. And this applies to both components.

As regards communication, the challenges go well beyond the tricky specification of the quantitative thresholds. Should the Fed target actual or forecasted levels? Should its policy reaction function involve a glide path or a step function? How conditional should its commitment be?

The Fed is also running against practical concerns when it comes to the possibility of more QE. Already, its large purchases has turned this traditional referee into a non-commercial player with influential ownership of many individual market issues. The Fed has imposed a sizable footprint on the markets for US Treasuries and mortgages. In doing so, it has altered not only valuations but also the efficient functioning of markets. As such, it is also far from straightforward to expand the institution’s securities program without creating significant damage.

As real as these problems are, they pale in comparison to what is really at issue: the worrisome signal that – with other policymakers essentially missing in action and politicians again playing Russian Roulette with the economyinfluential members at the Fed feel that they have no choice but to do more using imperfect, untested, partial and, potentially, risky tools.

This policy dilemma is amplified by the fact that, until now, the Fed’s unusual policy activism has failed to deliver the growth and employment results that its policymakers expected. At best, Fed officials have provided more time for the system to heal, but at the risk of growing collateral damage and unintended adverse consequences.

Judging from the minutes, some Fed officials are worried, questioning “the effectiveness of current purchases.” Yet this will not stop the institution from implementing additional highly experimental policies – and not because it wants to but, rather, because it feels it has no choice but to do so. And it could happen as early as the December or January Fed policy meetings.

Expect the Fed to move to quantitative thresholds, announce additional outright purchases of securities, and re-introduce Treasuries to their list of targeted instruments. But unless (and until) politicians and other policy making entities step up to their responsibilities, this unusual policy activism will fail to deliver the economic outcomes that the country needs and deserves.

Up and Down Wall Street


Is the Fed Losing the Fight Against Deflation?


QE3 fails to boost stocks and commodities as money printing is unable to offset the drag of debt.


Prior to the financial markets' obsession over the looming fiscal cliff, their single-minded focus was on monetary policy. Now, two months after the Federal Reserve announced its so-called QE3, its third round of quantitative easing, it appears the fuss was much ado about very little.

Ben Bernanke seems to be losing his battle with deflation, observes Walter J. Zimmerman, chief technical analyst for United-ICAP. So far, the Fed's scheme announced in September to buy $40 billion of mortgage-backed securities for however long it takes to lower unemployment has little to show for it. Quite to the contrary, market prices show the U.S. central bank has shown itself impotent in its fight against the undertow of deflation.

Global stocks and commodities are down significantly from their peaks reached in mid-September while the dollar has strengthened, he points out. That is contrary to the record of QE1 in 2009, QE2 in 2010 and so-called Operation Twist (the Fed's purchase of long-term Treasuries and offsetting sales of shorter-dated maturities) beginning in 2011. While the first two iterations of QE boosted stock and commodity prices and lowered the dollar significantly from their outset, the markets have done the opposite under QE3.

Zimmerman writes the Standard & Poor's 500 rose some 63%, or 5.3% per month, following QE1. After QE2, the S&P 500's cumulative gain was 9.7% or 1.4% per month. Operation Twist produced a 30% gain, or 2.7% per month. In the two months since QE3, the S&P 500 was off 6.9% as of Friday.

True, the equity market has had to fight the tide of slowing corporate earnings and the political uncertainties of the elections and the looming fiscal cliff. But the decline since the implementation of QE3 also shows that money printing can't cure all economic ills.

Not even those at which the policy is aimed most directly. The Fed's purchase of mortgage-backed securities is explicitly designed to bring down home-loan interest rates and thus stimulate the residential-property market. That had always been the magic elixir for the economy in past cycles; Fed easing would lower mortgage yields, which would spur housing as well as refinancing activity that would put more cash into homeowners' pockets. The combination was always a potent cocktail that could be counted upon to get the economy hopping.

In this cycle, the effect of the Fed's shot of whiskey has been dulled by the hangover from the crash after the bubbles of the last decade. Even homebuilder stocks, which have soared on the prospect of a rise in residential construction -- albeit from deeply depressed levels and only to ones that marked the nadirs of previous cycles -- are beginning to roll over.

Monday, D.R. Horton (ticker: DHI) saw its stock fall nearly 6% despite strong quarterly earnings and revenues while Beazer Homes USA (BZH) plunged 17% on a bigger-than-expected quarterly loss even with revenues that exceeded analysts' forecasts. The limits of the Fed's ability to boost housing activity are becoming apparent.

Where the Fed can claim some measure of success is in bringing down corporate-bond yields. International Strategy & Investment points out medium-grade (Baa by Moody's) corporate yields fell to a record low of 4.22%, down 190 basis points (1.9 percentage points) from their peak last year. Similarly, comparable European corporate-bond yields are down a huge 430 basis points from their peak last year, to 3.72% -- a "big win" for the European central bank, ISI adds.

These victories accrue to large corporations that can tap the bond market for hundreds of millions or even billions at a pop. And just as bankers will only lend money to somebody who doesn't need it, the bond market is open to companies with tons of cash already on their balance sheet but want to take advantage of record-low interest rates to refinance old debt or to buy back stock, perhaps even pay out more in dividends. But the cheap financing is not spurring expansion of plant and equipment as capital spending rolls over amid excess capacity in many industries.

Governments are the other great beneficiaries of the bond market's beneficence -- for now. There has been no penalty for the U.S. hurtling toward the fiscal cliff -- and more potential downgrades of its remaining triple-A ratings from Moody's and Fitch after last year's cut by Standard & Poor's -- while the Treasury can borrow at record-low interest rates. The so-called bond vigilantes of yore -- who in the 1980s and 1990s sharply boosted interest rates at the first sign of inflation -- are overcome by the central bank's purchases of the securities that finance the budget deficit. So, Bernanke & Co. are enablers of the dysfunction in D.C.

But, the signs are building that even the Fed is failing in its main aim of QE3, the blunting of deflationary forces. Along with equities, Zimmerman points out that even the DJ-UBS Commodity Index is down 8.4% since the mid-September announcement -- a sharp contrast to the 42% total rise after QE1, the 23% pop after QE2 and the 8.6% gain after Operations Twist.

At the same time, the U.S. Dollar Index has rallied 3.2% since the start of QE3, also the reverse of the 8% drop under QE1, the 5.5% fall under QE2 and the 1.2% dip under Operation Twist. Zimmerman also points to the diminishing returns from each round of Fed easing apparent in these data.

Monetary expansion is a necessary, but not sufficient, ingredient for economic expansion. The classic Keynesian remedy for the so-called liquidity trap -- in which borrowers won't borrow and lenders are loath to lend even at rock-bottom interest rates -- has been for the government to run deficits to offset the surpluses in the private sector.

But, as Carmen Reinhart and Kenneth Rogoff showed in This Time is Different: Eight Centuries of Financial Folly, when government debt reaches about 90% of gross domestic product, it slows rather than boosts growth. A little debt is a stimulant; a lot is a depressant. At which point, central banks' ability to steer the economy diminishes.


Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

The ENDGAME for Western Governments and the NEW GAME of Income Investing


Missing Growth Multipliers

Ashoka Mody

14 November 2012


PRINCETONIn April 2010, when the global economy was beginning to recover from the shock of the 2008-2009 financial crisis, the International Monetary Fund’s World Economic Outlook predicted that global GDP growth would exceed 4% in 2010, with a steady annual growth rate of 4.5% maintained through 2015. But the forecast proved to be far too optimistic.

In fact, global growth has decelerated. In its most recent WEO, the IMF forecasts global GDP to grow by only 3.3% in 2012, and by 3.6% in 2013. Moreover, the downgrading of growth prospects is remarkably widespread.

The forecast errors have three potential sources: failure to recognize the time needed for economic recovery after a financial crisis; underestimation of the “fiscal multipliers” (the size of output loss owing to fiscal austerity); and neglect of the “world-trade multiplier” (the tendency for countries to drag each other down as their economies contract).

For the most part, the severity and implications of the financial crisis were judged well. Lessons from the October 2008 WEO, which analyzed recoveries after systemic financial stress, were incorporated into subsequent forecasts.

As a result, predictions for the United Stateswhere household deleveraging continues to constrain economic growth – have fallen short only modestly. The April 2010 report forecast a US growth rate of roughly 2.5% annually in 2012-2013; current projections put the rate a little higher than 2%.

By contrast, the fiscal multiplier was seriously underestimated – as the WEO has now recognized. Consequently, forecasts for the United Kingdom – where financial-sector stresses largely resembled those in the US – have been significantly less accurate.

The April 2010 WEO forecast a UK annual growth rate of nearly 3% in 2012-2013; instead, GDP is likely to contract this year and increase by roughly 1% next year. Much of this costly divergence from the earlier projections can be attributed to the benign view of fiscal consolidation that UK authorities and the IMF shared.

Likewise, the eurozone’s heavily indebted economies (Greece, Ireland, Italy, Portugal, and Spain) have performed considerably worse than projected, owing to significant spending cuts and tax hikes. For example, Portugal’s GDP was expected to grow by 1% this year; in fact, it will contract by a stunning 3%. The European Commission’s claim that this slowdown reflects high sovereign-default risk, rather than fiscal consolidation, is belied by the UK, where the sovereign risk is deemed by markets to be virtually nonexistent.

The world-trade multiplier, though less widely recognized, helps to explain why the growth deceleration has been so widespread and persistent. When a country’s economic growth slows, it imports less from other countries, thereby reducing those countries’ growth rates, and causing them, too, to reduce imports.

The eurozone has been at the epicenter of this contractionary force on global growth. Since eurozone countries trade extensively with each other and the rest of the world, their slowdowns have contributed significantly to a decrease in global trade, in turn undermining global growth. In particular, as European imports from East Asia have fallen, East Asian economies’ growth is down sharply from last year and the 2010 forecast – and, predictably, growth in their imports from the rest of the world has lost momentum.

Global trade has steadily weakened, with almost no increase in the last six months. The once-popular notion, built into growth forecasts, that exports would provide an escape route from the crisis was never credible. That notion has now been turned on its head: as economic growth has stalled, falling import demand from trade partners has caused economic woes to spread and deepen.

The impact of slowing global trade is most apparent for Germany, which was not burdened with excessive household or corporate debt, and enjoyed a favorable fiscal position. To escape the crisis, Germany used rapid export growth – especially to meet voracious Chinese demand. Although growth was expected to slow subsequently, it was forecast at roughly 2% in 2012-2013. But, as Chinese growth has deceleratedowing partly to decreased exports to Europe – the German GDP forecast has been halved. And, given that this year’s growth has largely already occurred, Germany’s economy has now plateaued – and could even be contracting.

In good times, the trade generated by a country’s growth bolsters global growth. But, in times of crisis, the trade spillovers have the opposite effect. As the global economy has become increasingly interconnected, these trade multipliers have increased.

Indeed, while less ominous and dramatic than financial contagion, trade spillovers profoundly influence global growth prospects. Failure to recognize their impact implies that export – and, in turn, growthprojections will continue to miss the mark. The projected increase in global growth next year will likely not happen. On the contrary, policy errors and delays in individual countries will seriously damage economies worldwide.

Ashoka Mody is a visiting professor of International Economic Policy at the Woodrow Wilson School of Public and International Affairs, Princeton University.

November 14, 2012 6:45 pm
China’s rapid change and missed chances
In the decade since Hu Jintao became secretary-general of the Communist party, China’s economy has gone from a size of $1.5tn, the world’s sixth-largest, to $7.3tn, second only to the US. Since 2002 per capita income has more than tripled from $1,135 to $5,445, transforming China from a low-income country on a par with Cape Verde to a middle-income one more like Montenegro.

Back then, 38 per cent of people lived in cities as opposed to 50 per cent today. China had no high-speed rail. Now it has the longest (though certainly not the safest) network in the world. When Mr Hu came to power, just 45m Chinese used the internet. As he approaches the end of his term, almost 600m are hooked up. For a president who is sometimes said to have presided over a lost decade – or at least a decade of lost opportunityMr Hu’s record doesn’t seem all that bad.

So breakneck has China’s progress been that it is worth reminding ourselves just how far China has come. When Mr Hu took the helm, China had only just joined the World Trade Organisation. There followed an extraordinary period of export growth that saw the current account surplus widen to an unprecedented– and entirely unsustainable10 per cent of gross domestic product. Fortunately, it is now down to about 4 per cent.

The renminbi was unshackled, at least partially, from the dollar. It has since appreciated by more than 30 per cent. China redirected investment from the coastal to the inland provinces, scrapped agricultural taxes (improving the lot of farmers) and built the rudiments of a social security system. It hosted the Olympics, displaying its power in an opening ceremony that awed the world. It put a man in space. It survived the global financial crisis with the biggest stimulus package in history. It even launched its first aircraft carrier, albeit one made from an unfinished Ukrainian hull.

It is also worth reflecting on the fact that Mr Hu is handing over power at all. The process is opaque and entirely undemocratic. That almost raises the question of why it is worth doing at all. Mao Zedong never dreamt of giving up power. Only in 2002, with the withdrawal of Jiang Zemin and the ascendance of Mr Hu, has China institutionalised a generational transfer of authority.

These are huge achievements. Yet, Mr Hu is just as likely to be remembered for his failures. “In terms of wealth creation, the last 10 years have been very successful,” says Mao Yushi, an influential liberal economist. In terms of economic reform, he scores Mr Hu a zero. He scolds Mr Hu for talking about rebalancing the economy while allowing it to get further out of whack. Fixed capital investment has risen to an extraordinary 50 per cent of GDP and property prices have soared.Sooner or later there must be a crisis,” he predicts.

Whether or not Mr Hu has stored up dangers for his successor, critics say he has merely ridden the economic dragon unleashed by his predecessors. Much of the growth of the past 10 years stems from the reforms of the state sector and of a near-bankrupt banking system that Zhu Rongji championed as premier from 1998-2003. Mr Hu has not been bold. Perhaps hydraulic engineers rarely are. Shi Jiangtao, writing in the South China Morning Post, calls him a “diffident apparatchik” who exemplifies the “Communist regime’s mediocrity”.

Mr Hu’s talk of “building a harmonious society” was all very well. But society became less harmonious under his watch. Protests against environmental degradation, local corruption and illegal land grabs have reached such a level that the internal security budget now outstrips that allocated to national defence.

Opinion on the internet has become more or less uncontrollable. There have been protests and crackdowns in both Tibet and Xinjiang.

It is hard to guess how much might change under Xi Jinping. Mr Mao has greater hopes for Mr Xi, whom he says grew up in more open times. Many academics argue that real progress towards democracy will have to be made if social tensions are not to bubble over.

Economically, change is already afoot. The latest five-year plan talks about a slower growth rate of 7 per cent. Built into the calculation is a shift from investment to consumption. That has long been the mantra, but many economists think this must now happen, partly as changing demographics force an adaptation of the export-oriented model. Fewer young people in the workforce should mean a higher proportion of GDP goes to wages.

Under reasonable assumptions, China’s economy should double in size during Mr Xi’s tenure. That would make it bigger than the US in purchasing power parity terms.

If it avoids a crisis, the economy should also be on a more sustainable footing. McKinsey reckons that, by 2020, private consumption, at 45 per cent of GDP, will have surpassed investment, which should have fallen to 36 per cent. Mr Hu has more than quadrupled the size of the economy and is judged by some to have been a failure. Mr Xi must hope to double it and be judged a success.

Copyright The Financial Times Limited 2012