2015 Article IV Consultation with the United States of America Concluding Statement of the IMF Mission

May 28, 2015


A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

The 2015 U.S. Article IV Consultation was focused on the prospects for higher policy rates and the outlook for, and policy response to, financial stability risks. In this, the work of the mission integrated the findings of the IMF’s latest Financial Sector Assessment Program for the U.S. The main policy messages were:
  • The underpinnings for continued growth and job creation remain in place. However, momentum was sapped in recent months by a series of negative shocks.

  • The FOMC should remain data dependent and defer its first increase in policy rates until there are greater signs of wage or price inflation than are currently evident. Based on the mission’s macroeconomic forecast, and barring upside surprises to growth and inflation, this would put lift-off into the first half of 2016.

  • Pockets of financial stability risks are emerging, putting a premium on improving the resilience of the financial system. Regulatory reforms remain incomplete and the structure of oversight has scope to be strengthened along a number of dimensions.

  • A range of challenges linked to poverty, productivity and the fiscal health of the U.S. economy remain largely unaddressed.

The Macro Outlook

1. Growth prospects. The U.S. economy’s momentum in the first quarter was derailed by unfavorable weather, a sharp contraction in oil sector investment, the West Coast port strike, and the effects of the stronger dollar. These developments represent a temporary drag but not a long-lasting brake on growth. A solid labor market, accommodative financial conditions, and cheaper oil should support a more dynamic path for the remainder of the year.

Despite this, the weaker outturn in the first few months will unavoidably pull down 2015 growth, which is now projected at 2.5 percent.

2. Jobs and inflation. Labor markets have steadily repaired over the past year and several indicators suggest a jobs outlook that is returning to pre-crisis norms. However, long-term unemployment, subdued participation, and high levels of part-time work point to remaining employment slack. Wage indicators on the whole have shown only tepid growth.

When combined with dollar appreciation, falling global prices of tradable goods, and cheaper energy costs, core PCE inflation is expected to fall in the coming months, to 1.2 percent by end-September. Inflation should start rising later in the year but reach the Federal Reserve’s 2 percent medium-term objective only by mid 2017.

3. A stronger dollar. The U.S. dollar has risen 13 percent in real effective terms over the past 12 months. This move has been rapid and a product of cyclical growth divergences, different trajectories for monetary policies among the systemic economies and a portfolio shift toward U.S. dollar assets.

4. A moderately overvalued currency. At current levels of the real exchange rate, the U.S. dollar is assessed to be moderately overvalued. As a result, the current account deficit is expected to move further away from medium-term fundamentals, to more than 3 percent of GDP over the medium-term. So far, the global adjustment of exchange rates has represented a warranted shift of demand to those parts of the world economy that were being most threatened by deflation and stagnation. Nonetheless, the stronger dollar is impacting U.S. growth and job creation, as well as weighing on inflation. There is a risk that a further marked appreciation of the dollar—particularly one that takes place in an environment where policies to address growth deficiencies languish both in the U.S. and abroad—would be harmful.

Monetary Policy

5. An uncertain backdrop. The U.S. economy remains below potential, wage and price pressures are expected to remain low, and inflation expectations appear well-anchored. There are, however, significant uncertainties as to the future resilience of economic growth, the remaining distance to maximum employment, and the current level and future path of the “neutral” fed funds rate that is consistent with full employment and price stability.

6. Possibility of a less-than-smooth liftoff. The Fed’s first rate increase in almost 9 years has been carefully prepared and telegraphed. Nevertheless, regardless of timing, higher U.S. policy rates could still result in a significant and abrupt rebalancing of international portfolios with market volatility and financial stability consequences that go well beyond U.S. borders. Alternatively, even without policy changes, higher inflation numbers unaccompanied by better activity data could lead to a sudden upward shift in the yield curve or risk spreads. In either case, asset price volatility could last more than just a few days and have larger-than-anticipated negative effects on financial conditions, growth, labor markets, and inflation outcomes. Spillovers to economies with close trade and financial linkages could be substantial.

7. Complex policy trade-offs. Weighing the net benefits between raising interest rates earlier or later involves an evaluation of difficult and uncertain tradeoffs.
  • Raising rates too soon could trigger a greater-than-expected tightening of financial conditions or a bout of financial instability, causing the economy to stall. This would likely force the Fed to reverse direction, moving rates back down toward zero with potential costs to credibility.

  • Raising rates too late could cause an acceleration of inflation above the Fed’s 2 percent medium-term objective with monetary policy left having to play catch-up. This could require a more rapid path upward for policy rates with unforeseen consequences, including for financial stability.
8. The case for a later liftoff. Given the balance in the likelihood and severity of these risks, as well as the significant uncertainty around inflation prospects, the degree of slack and the neutral policy rate, there is a strong case for waiting to raise rates until there are more tangible signs of wage or price inflation than are currently evident. Inflation inertia, firmly anchored expectations, Fed credibility, and a relatively flat relationship between inflation and slack suggest that a sudden acceleration in wages or prices is unlikely. Global disinflationary trends and the pass-through from the strengthening dollar are also likely to act as important dampening forces to inflation. A later lift-off could imply a faster pace of rate increases following lift-off and may create a modest overshooting of inflation above the Fed’s medium-term goal (perhaps up toward 2½ percent). However, deferring rate increases would provide valuable insurance against the risk of disinflation, policy reversal, and ending back at zero policy rates. If data evolves in line with the mission’s macroeconomic forecasts, and barring upside surprises to growth or inflation, such a policy would imply keeping the fed funds rate at 0-0.25 percent into the first half of 2016.

9. Effective Fed communication. As lift-off approaches, both public and market attention will shift to the pace of rate increases ahead. In this context, there remains merit in scheduling press conferences after each FOMC meeting and in publishing a quarterly monetary report that details baseline economic projections that are endorsed by the FOMC, accompanied by a snapshot of the range of FOMC views around that baseline.

10. Monetary policy and financial stability. At this stage, policy rates should not be used in an effort to reduce leverage and dampen financial stability risks. Efforts should instead be targeted toward strengthening the macroprudential framework, developing regulatory tools, and addressing gaps in regulation and supervision. There is clearly, though, an active debate on the role of monetary policy in addressing financial stability risks in both academic and policy circles. The authorities should give priority to understanding how this would apply in the context of the complex U.S. financial system, accelerating research on the theoretical and empirical nexus between interest rate changes and financial vulnerabilities and working to identify appropriate measures of the financial cycle.

Mitigating Financial Vulnerabilities

11. The state of financial stability. Much has been done over the past several years to strengthen the U.S. financial system and it will be important to ensure that this progress—including the legislative advances in the Dodd Frank Act—is not rolled back.

However, there has been a search for yield during the prolonged period of low interest rates, assets in the nonbank sector have grown rapidly, and there are signs of stretched valuations across a range of U.S. asset markets. At this point, the data points more toward a system that has pockets of vulnerabilities rather than one with broad-based excesses. Nevertheless, there are potentially serious, macro-relevant sources of financial instability that include:
  • The migration of intermediation to the nonbanks where there is less visibility on the size and nature of the embedded risks and fewer regulatory and supervisory levers to manage those risks;

  • The potential for insufficient liquidity in a range of fixed income markets which could lead to abrupt moves in market pricing, particularly during times when there is a large rebalancing of asset allocations.

  • The fact that insurers have taken on greater market risk and, under severe but plausible scenarios, stress tests show that a large part of the industry—particularly life insurers—could be faced with negative shareholder equity if firms were forced into fire sales.
12. Further investments in resilience. Following the passage of the Dodd-Frank Act a panoply of measures were put in place to lessen the potential for financial sector vulnerabilities. These include enhanced capital and liquidity buffers, strengthened underwriting standards in the housing sector, and greater transparency to mitigate counterparty risks. To keep pace with a continuously changing financial risks profile, the deployment of additional regulatory and supervisory tools is necessary. There are five prominent near-term priorities:

The Financial Stability Oversight Committee. Given the complexity of the U.S. regulatory system—including the number of agencies involved—the effectiveness of the FSOC in proactively identifying and addressing risks in a timely and assertive manner is critical.
  • To underscore this goal, all the individual FSOC member agencies should have an explicit financial stability mandate. Each material threat identified in the FSOC Annual Reports should be accompanied by a list of specific follow-up actions with regular reporting of progress in tackling these risks.

  • For newly designated entities, oversight by the Federal Reserve should be put in place on an expedited timetable and delays in the implementation of enhanced regulatory measures to safeguard against risks should be minimized.

  • While coordination between agencies has clearly improved, there is a need for greater clarity on the roles and responsibilities for system-wide crisis preparedness and management, under the FSOC umbrella.

Data blind spots. Despite progress made by the work of the Office of Financial Research, the Fed, and other FSOC member agencies, the comprehensive information needed to fully assess and understand financial stability risks—particularly the channels for interconnections between different parts of the system—is not available. Data is compartmentalized with some agencies seeing part of the puzzle but none having a full picture. Evidently, such data collection and analysis will always be a work-in-progress. However, greater efforts are needed to overcome the legal, technological and other obstacles to providing the FSOC and the Office of Financial Research with the data it needs to have a comprehensive view and analysis of systemic risks. Continued and more expansive cross-agency collaboration to better understand specific vulnerabilities will also prove valuable.

Insurance. The absence of national standards or consolidated supervision makes any assessment of risks in the insurance industry necessarily tentative and incomplete. There is significant scope to improve the institutional framework. Specifically, there is a need for:
  • A coordinated, nationally consistent approach to regulation (particularly for valuation and solvency requirements), supervision and stress testing. This would bring about a convergence in standards and supervisory practices and eliminate regulatory arbitrage as, for instance, through captive insurers.

  • Assigning regulatory responsibilities for insurance to an independent agency that is adequately resourced, with a nation-wide mandate, operational independence, appropriate powers, and accountability. In their current configuration, neither the Federal Insurance Office nor the National Association of Insurance Commissioners is equipped to take on this role (although their expertise would be indispensable to a new nation-wide body).
Asset Management. The U.S. system of regulatory oversight has not kept pace with the shift in the locus of systemic concerns toward nonbanks. The increase in assets held by high-yield debt funds and the liquidity transformation undertaken by some asset managers creates a potential channel to amplify shocks through asset liquidation and funding channels.
  • Such vulnerabilities call for explicit requirements on risk management and internal control in the sector (particularly linked to liquidity and derivative use) as well as more frequent and intensive examination of asset managers.

  • There should be a structured effort to stress test the industry for a range of downside shocks (including illiquidity and counterparty risks). The results should be published so as to help build a better data landscape of the industry and to facilitate a more complete understanding of embedded risks. Over time, such an effort could be combined with a strengthened Dodd-Frank Act stress testing process that explores interconnections and bank-nonbank feedback chains.
Money markets. Despite reforms, vulnerabilities (including the reliance on two clearing banks) in the triparty repo market remain large.
  • Potential next steps could include the use of central counterparty clearing houses for repo transactions. This, in turn, would require implementing adequate risk management requirements for central counterparty clearing houses including cyber resilience, standardized stress testing, and recovery and resolution regimes.
  • The requirement that some money market funds move to a floating net asset value by 2016 is a positive step. However, a significant share of funds will be able to maintain stable net asset values, allowing institutional and retail investors to treat their investment as deposit-like. Shifting all money market funds to floating net asset values should be reconsidered.
13. Improving the understanding of interlinkages. Given the complexity of the system, the extensive use of derivatives to shift and hedge risks, and the significant role of nonbank entities, there is a clear need for a coordinated effort to better trace the interconnections and channels of contagion across the system. The regular Fed stress tests could be expanded to incorporate a deeper analysis and assessment of propagation effects via inter-institutional links.

14. Simplifying the institutional structure. Over time, the regulatory system should be made simpler, with fewer agencies, so as to lessen gaps and overlaps and reduce the potential for regulatory arbitrage. This would also make the FSOC’s coordination role easier.

15. Cross-jurisdiction resolution. The five largest banks in the U.S. account for 45 percent of banking system assets, twice the share of 10 years ago. As such, effective resolution and recovery plans for large banks are important to underpin a stable financial system. Existing plans should continue to be thoroughly assessed against severe contingencies that have a salient cross-border component. While cooperation agreements with relevant overseas authorities have recently been signed to manage the resolution of institutions that have a significant international presence, attention will need to be devoted to their implementation. Moreover, legislative changes would likely be needed to avoid undue ring-fencing and the subordination of foreign claimants.

Fiscal Policy

16. The current fiscal policy dysfunction. The inability of the Congress and the Executive Branch to collectively pass a budget and corresponding appropriations bills creates a level of fiscal uncertainty that is damaging to the U.S. economy. The potential for disruption from either a government shutdown or a stand-off linked to the federal debt ceiling represent important (and avoidable) downside risks to growth and job creation which could move to the forefront, once again, later in 2015.

17. Medium-term adjustment. Public finances in the U.S. remain on an unsustainable path. The federal debt and deficit are expected to decline during the next few years but under the current constellation of policies this downward trajectory will not last. By 2019, the federal debt will begin rising again as aging-related spending pressures assert themselves and interest rates move to more normal levels.

As a consequence, the federal debt is forecast to rise to 78 percent of GDP by 2025. Addressing these medium-term imbalances will require actions on multiple fronts:

  • Tax reform. A reform of the U.S. tax code is long overdue. Complexity and loopholes have increased over the years, undermining revenues and damaging productivity. The IMF’s longstanding advice has been that changes should focus on simplifying the system by capping or eliminating personal income tax deductions; removing tax preferences exclusions and deductions from the business tax; and changing the tax treatment for multinationals to limit base erosion and profit shifting. In addition to improving the structure of the system, it is also worth reiterating previous recommendations that revenues should be raised through a broad-based carbon tax, a higher federal gas tax, and introducing a federal-level VAT.

  • Pension reform. The prospective depletion of the social security trust fund needs to be countered through a gradual increase in the retirement age, greater progressivity of benefits, raising the maximum taxable earnings for social security contributions, and indexing benefits and contributions provisions to chained CPI.

Health care. Cost pressures have declined but more efforts are needed. Legislation could usefully focus on ensuring a better coordination of services to patients with chronic conditions, steps to contain overuse of expensive procedures and technologies including through a higher degree of cost sharing with beneficiaries, and eliminating tax breaks for more generous employer-sponsored health plans.

18. Near-term fiscal priorities. Tackling the longer-term fiscal challenges would provide scope to modestly expand the near-term budget envelope to finance supply-side measures that support future growth, job creation, and productivity. This would include front-loading infrastructure spending, raising labor force participation (e.g., through policies such as subsidized childcare assistance), incentivizing private innovation, strengthening education spending (including through apprenticeships and vocational training), and improving job search assistance programs. Creating a stable funding solution for the Highway Trust Fund that will prevent the need for continued stop-gap patches is an immediate priority.

Poverty, productivity and growth

19. The U.S. economy faces substantial fundamental challenges from demographic changes and an unfinished policy agenda. In tackling these, the advice from past Article IV consultations—summarized in Box 1—bears repeating.

Box 1. Longstanding IMF Policy Advice
Confronting poverty

• Combine an expansion of the earned income tax credit (to workers without dependents, low-income youth, and older workers not yet eligible for social security) with an increase in the federal minimum wage.

• Make permanent the tax provisions that are due to expire in 2017, including the extension of the earned income tax credit to larger families, the mitigation of the marriage penalty, and increase in the child tax credit.

Raising productivity

• Invest in infrastructure, particularly in surface transportation. Find a permanent solution to the funding of the Highway Trust Fund and expand sources for infrastructure financing.

• Reinstate and make permanent the Research and Experimentation tax credit.

• Support states in improving training programs and build partnerships with industry and higher education institutions for vocational training. Raise educational outcomes through better spending on early childhood education and support for science, technology, engineering and math programs.

Increasing labor force participation

Improve family benefits, including childcare assistance for working families and modify the federal disability insurance to provide incentives for beneficiaries to work part-time.

Immigration reform

Institute a comprehensive, skills-based immigration reform. Such a program would have a significant positive impact on growth and fiscal finances by increasing the labor supply (and thus future economic growth rates), strengthening productivity, and reducing the dependency ratio.

Trade policy

Promote plurilateral and bilateral trade agreements with renewed efforts to advance the multilateral trade agenda.

Housing finance reform

Lessen the government’s footprint and foster a greater role for the private sector by expanding the use of market transactions to transfer first-loss risks to private investors; establishing a single securitization platform; making GSE guarantee fees more risk-based; subjecting GSEs to similar regulatory requirements as other systemically important financial institutions; and lowering the ceilings for the size of mortgages that can be securitized by the GSEs.


Europe’s Last Act?

Joseph E. Stiglitz

JUN 5, 2015

greece hourglass

NEW YORK – European Union leaders continue to play a game of brinkmanship with the Greek government. Greece has met its creditors’ demands far more than halfway. Yet Germany and Greece’s other creditors continue to demand that the country sign on to a program that has proven to be a failure, and that few economists ever thought could, would, or should be implemented.
The swing in Greece’s fiscal position from a large primary deficit to a surplus was almost unprecedented, but the demand that the country achieve a primary surplus of 4.5% of GDP was unconscionable. Unfortunately, at the time that the “troika” – the European Commission, the European Central Bank, and the International Monetary Fund – first included this irresponsible demand in the international financial program for Greece, the country’s authorities had no choice but to accede to it.
The folly of continuing to pursue this program is particularly acute now, given the 25% decline in GDP that Greece has endured since the beginning of the crisis. The troika badly misjudged the macroeconomic effects of the program that they imposed. According to their published forecasts, they believed that, by cutting wages and accepting other austerity measures, Greek exports would increase and the economy would quickly return to growth. They also believed that the first debt restructuring would lead to debt sustainability.
The troika’s forecasts have been wrong, and repeatedly so. And not by a little, but by an enormous amount. Greece’s voters were right to demand a change in course, and their government is right to refuse to sign on to a deeply flawed program.
Having said that, there is room for a deal: Greece has made clear its willingness to engage in continued reforms, and has welcomed Europe’s help in implementing some of them. A dose of reality on the part of Greece’s creditors – about what is achievable, and about the macroeconomic consequences of different fiscal and structural reforms – could provide the basis of an agreement that would be good not only for Greece, but for all of Europe.
Some in Europe, especially in Germany, seem nonchalant about a Greek exit from the eurozone. The market has, they claim, already “priced in” such a rupture. Some even suggest that it would be good for the monetary union.
I believe that such views significantly underestimate both the current and future risks involved.

A similar degree of complacency was evident in the United States before the collapse of Lehman Brothers in September 2008. The fragility of America’s banks had been known for a long time – at least since the bankruptcy of Bear Stearns the previous March. Yet, given the lack of transparency (owing in part to weak regulation), both markets and policymakers did not fully appreciate the linkages among financial institutions.
Indeed, the world’s financial system is still feeling the aftershocks of the Lehman collapse. And banks remain non-transparent, and thus at risk. We still don’t know the full extent of linkages among financial institutions, including those arising from non-transparent derivatives and credit default swaps.
In Europe, we can already see some of the consequences of inadequate regulation and the flawed design of the eurozone itself. We know that the structure of the eurozone encourages divergence, not convergence: as capital and talented people leave crisis-hit economies, these countries become less able to repay their debts. As markets grasp that a vicious downward spiral is structurally embedded in the euro, the consequences for the next crisis become profound. And another crisis in inevitable: it is in the very nature of capitalism.
ECB President Mario Draghi’s confidence trick, in the form of his declaration in 2012 that the monetary authorities would do “whatever it takes” to preserve the euro, has worked so far. But the knowledge that the euro is not a binding commitment among its members will make it far less likely to work the next time. Bond yields could spike, and no amount of reassurance by the ECB and Europe’s leaders would suffice to bring them down from stratospheric levels, because the world now knows that they will not do “whatever it takes.” As the example of Greece has shown, they will do only what short-sighted electoral politics demands.
The most important consequence, I fear, is the weakening of European solidarity. The euro was supposed to strengthen it. Instead, it has had the opposite effect.
It is not in the interest of Europe – or the world – to have a country on Europe’s periphery alienated from its neighbors, especially now, when geopolitical instability is already so evident.
The neighboring Middle East is in turmoil; the West is attempting to contain a newly aggressive Russia; and China, already the world’s largest source of savings, the largest trading country, and the largest overall economy (in terms of purchasing power parity), is confronting the West with new economic and strategic realities. This is no time for European disunion.
Europe’s leaders viewed themselves as visionaries when they created the euro. They thought they were looking beyond the short-term demands that usually preoccupy political leaders.
Unfortunately, their understanding of economics fell short of their ambition; and the politics of the moment did not permit the creation of the institutional framework that might have enabled the euro to work as intended. Although the single currency was supposed to bring unprecedented prosperity, it is difficult to detect a significant positive effect for the eurozone as a whole in the period before the crisis. In the period since, the adverse effects have been enormous.
The future of Europe and the euro now depends on whether the eurozone’s political leaders can combine a modicum of economic understanding with a visionary sense of, and concern for, European solidarity. We are likely to begin finding out the answer to that existential question in the next few weeks.

America’s economy

Blip or blight?

Economists debate the meaning of a contraction in the first quarter

Jun 6th 2015

FOR the world’s largest economy, 2015 has been a series of disappointments. In March builders began construction on just 944,000 new homes, well short of the million or more that had been expected. In April the number of people out of work and claiming benefits exceeded economists’ predictions. And on May 29th official data, which had previously suggested the economy had grown by 0.2% at an annualised rate in the first quarter, were revised to show a contraction of 0.7%. Consumption slowed, investment slid 2.8% and exports dropped by 7.6%.

America still accounts for 23% of the world’s output, so a sustained slowdown would have global impact. Happily, most economists offer a comforting explanation: this is all temporary.

Start with America’s dreadful weather. Though this year escaped the “polar vortex” (the weather system that dragged down temperatures and output in 2014), it was bitterly cold.

Thermometers showed record lows in many eastern cities in February. With streets so icy and air so cold it is no wonder consumption expanded at just 1.8% at an annualised rate, much lower than the 4.4% of the previous quarter.

A simple analysis by Aneta Markowska of Société Générale, a French bank, tracks the correlation between anomalous temperatures and GDP. It suggests that the freeze lowered first-quarter growth by around 1.9 percentage points. The good news, she argues, is that the trend should reverse with improving weather.

Oil markets, boiling last summer, have cooled too. In the second half of 2014, the price of America’s benchmark crude, WTI, dropped from $106 a barrel to below $60. With the reward for finding oil falling sharply, the amount spent searching for it and extracting it has tumbled too. According to data from Baker Hughes, a firm that provides services to oil companies, the number of rigs drilling for oil fell from 1,866 a year ago to 875 on May 29th.

With time, cheap oil should help the economy, by leaving consumers with more to spend on other things. At the start of June petrol (gasoline) prices were $2.67 a gallon, nearly a dollar cheaper than a year ago. Some shoppers, fearful that they would soon rise again, may initially have saved this windfall. But inflation has now disappeared for goods like food, which cost a lot to transport and so are affected by energy prices. As the benefit of cheaper oil feeds through the supply chain, the increase in income may seem more permanent, and so spur spending.

America’s anaemic exports may gain strength too. Millions of tonnes of petroleum products and chemicals are shipped out through the ports of Los Angeles and Long Beach each year. A strike sapped activity at both by more than 3% in the first quarter. With the dispute resolved, they are now exporting record amounts. The exchange rate may help. The dollar rose by almost 9% in trade-weighted terms in the second half of 2014, as the American economy strengthened, making exports more expensive for foreigners to buy. That run-up has since reversed, with the greenback down 2% since March.

Those who believe that the economy’s contraction is a blip also advance an even simpler argument. Whatever the reason, since the onset of the subprime crisis in 2007, the first quarter has consistently been a bit of a dud. The average outcome has been a contraction; even in the best first quarter of late (that of 2013), the economy grew by only 2.7% on an annualised basis (see chart).

That logic, and the host of temporary factors hitting consumption, investment and exports, suggests much more can be expected from the second quarter. If it too is a disappointment, optimists will find the news much harder to shrug off.

The Falling Velocity of Money!

By: David Chapman

Thursday, June 4, 2015

Larger Image - Source: www.stlouisfed.org

I'd thought I would show another chart of the velocity of money but from a somewhat different perspective. I last showed a chart on the velocity of M1 in a Chart of the Week - The End of Cash? - April, 30, 2015. This is a chart of the velocity of MZM money stock and prior to 1960 money stock.

Money stock is the total amount of monetary assets available in an economy at any specific time. MZM money stock is defined as money with zero maturity. It includes notes & coins, travelers cheques & demand deposits, savings accounts and money market funds. MZM is not M1 or M2 but a hybrid of the two plus money market funds. The two time series don't line up exactly but the MZM money stock effectively takes over from money stock prior to 1960.

What is interesting about the chart is that it shows that the velocity of money stock has fallen to Great Depression levels. The velocity of money peaked around 1980 a period when interest rates hit 20%. It has been declining ever since. While the US experienced growth rates in the 1980s and the 1990s those growth rates were never what they were back in the 1950s through the 1970s.

Since the velocity of money refers to the relationship between GDP growth and money supply it is not surprising that the velocity of money has been sliding since the 1980s largely because the growth of real GDP has been growing more slowly than money supply (Velocity = GDP/Money Supply). It is another way of saying that it has taken more and more money to buy an additional dollar of GDP.

Since much of the monetary growth has been attributable to debt growth, it could be rephrased to say that it has taken increasing amounts of debt to purchase an additional dollar of GDP.

The chart below shows how GDP growth has slowed substantially since 1980 vs. the levels attained in the 1950s through the 1970s.

Larger Image - Source: www.stlouisfed.org

What is noticeable is the decline in the velocity of money got underway in the 1980s, accelerated in the 1990's and began to freefall after 1999. There was a brief respite for a few years following the high tech/internet crash of 2000-2002. What is significant about 1999 is that was the year the Clinton administration repealed Glass Steagall. Glass Steagall had existed since the 1930's to separate commercial banking and securities firms. The end of Glass Steagall signaled a shift from relationship banking to transactional banking.

The rise of transactional banking actually got underway in the 1990s with the introduction of numerous products often backed with derivatives. While transactional banking can vary from firm to firm its rise coincided with the rise of the large behemoth banks that dominate banking today.

Banking today is all about products largely created in capital markets. The products may be for retail or institutions. Trading became a big part of the banks and trading often dominates the banks.

The financial collapse of 2008 can be traced to the rise of transactional banking with products such as the sub-prime mortgages that dominated at the time. While the securitization of mortgages is not as predominate securitization has spread to auto loans, credit cards and student loans. These three types of loans have been the fastest growing segments of consumer loans since the 2008 financial crash. Mortgage loans in the US have actually declined since the financial crash of 2008.

Larger Image - Source: www.stlouisfed.org

Some believe that student loans could become the next sub-prime mortgage collapse as millennials struggle to find good paying jobs. The struggle of the millennials is just one part of a broader equation that has helped contribute to the fall in the velocity of money. Society is aging and the large baby boomer cohort is shifting from spending to planning for retirement. The majority of jobs created since 2000 are part-time jobs or low wage jobs bringing a high degree of uncertainty into the job market.

Additionally many companies have faced restructuring and waves of middle aged employees have found themselves unemployed as they were moving into their best earning years. Wages have been stagnant since the 1990's and that has added to the uncertainty. According to studies, most Americans and Canadians are not prepared for retirement and as a result are potentially facing a decline in their standard of living. Income has grown unequally with the upper 20% of seeing increases to their income while the majority stagnate or regress. A lengthy period of low interest rates has added to the uncertainty forcing people to either accept no or little growth for their savings or force them into the more speculative stock market seeking higher returns at higher risk.

Governments have played a role adding to the uncertainty. Despite six years of low or zero interest rates, and three rounds of QE the GDP growth levels have failed to reach previous levels coming out of a recession. The constant beat of the so called "war on terror" has also added to the uncertainty.

The "war on terror" has also been accompanied by acts such as the US Patriot Act and here in Canada Bill-C51 that have been according to many besides civil libertarians to be an attack on freedom and charter rights. The surveillance state of NSA in the US has added to that uncertainty. All of these and others in different ways have been contributing to uncertainty and the result is stagnating retail sales and the subsequent plunge in the velocity of money.

If zero interest rates were a panacea to encourage inflation and economic growth by that account Japan should be booming. But 25 years after the Japanese stock market topped in 1990 Japan has been plagued by a series of rolling recessions with at best anaemic growth. Europe has now moved to negative interest rates and the response has been for people to hoard money and withdraw their funds from the banking system. In Europe, the US and even in Canada the underground economy is large.

With governments seeking new sources of tax money to help pay for their huge debts that in many cases now exceeds 100% of GDP there has been calls in the EU in particular to ban cash. Ostensibly, it is to prevent hoarding but instead it might cause a backlash as the end of cash could spell the end of privacy.

The problem facing the western developed nations (EU, US, Canada, Japan) is not inflation but deflation. High levels of debt and the potential for debt default is deflationary not inflationary.

There has been asset inflation in high-end real estate, art and collectibles even as interest rates have collapsed. Some claim that asset inflation is also in the stock market but stock market growth has lagged the growth in the former. Surprisingly asset inflation has not yet hit gold that has in the past been a store of value. That could change later as the end of cash could see a larger shift into gold and other means in order to get around the restrictions of a cashless society.

There is also growing illiquidity in the bond market which has caused a shift from the long end of the yield curve to the short end of the yield curve. Short-term rates are stagnant but bond yields have been rising at the long end of the curve. Many financial institutions are now only transacting corporate bond trades on an agency basis rather than acting as market makers as they might have in the past. This has added to the uncertainty.

With interest rates at or near zero and following years of QE and other stimulus that has failed to push GDP growth to higher levels governments are running out of ways to further stimulate the economy. There has been speculation that the US could hike interest rates in the fall. But with no clear signs that the economy is growing hiking interest rates could cause a shock to the stock markets.

The other side of this is the US in particular has no room to lower rates further if the economy should slow. Rates are already at zero. Or they could join the EU with negative interest rates. That in turn could spark hoarding and withdrawals from the banking system something that has already been seen in the EU.

The collapse in the velocity of money is a warning sign that something is amiss in the economy.

That it has now fallen to Great Depression levels is not a positive sign. Recent OECD economic forecasts have downgraded growth potential for the western developed nations and China. The OECD is urging further stimulus methods. But given high debt levels the western nations have little room to manoeuvre. China will do its bit but China is beginning to experience debt defaults as their property boom slows. All of this is most likely going to add to the uncertainty and the velocity of money could fall further. And that is not necessarily a good thing.

Investing Ideas

8 Reasons to Take a New Shine to Gold

The formerly precious metal is in a slump, but could top $2000 over the next decade with Asia’s boom.

By Kopin Tan

June 5, 2015 2:40 a.m. ET


Gold should be ashamed of calling itself a precious metal these days. Since it peaked near $1,889 a troy ounce in August 2011, the price of gold has fallen almost 40% into a perennial bear market. This year alone, gold has underperformed stocks in China, Japan, Hong Kong, Taiwan, Korea, Australia, the U.S., Russia, Switzerland, Italy, Portugal, Ireland, Germany, Poland and Israel; government bonds of countries from China to Russia; the dollar, Swiss Francs, Picassos, Warhols, Rothkos, Manhattan real estate, cocoa, eggs, cotton, silver and – gasp – even lead! Like frankincense and myrrh, gold has been relegated to the heap of has-beens, overlooked by fast money chasing momentarily hotter assets.
So why is now the time to take a new shine to the old metal? Let us count the ways:
1) Once a hedge against market turmoil and inflation, gold has lost its calling in a world where stocks keep rising and inflation stays maddeningly meek. But Asia’s surging stock markets represent the last big reflation trade – where money managers snap up risky assets in anticipation of central bank easing, and which had paid off in markets including the U.S., Europe, Japan and China. But this popular playbook is now running out of pages, and if the volatility that has lately plagued currencies and bonds starts spilling over into stocks, then watch out.

2) Stocks have been a big – and logical - beneficiary of the trillions printed by global central banks, but valuations cannot climb indefinitely. How many indexes across the planet are already pushing record highs, even while economic growth remains middling? The MSCI World Index, for instance, already commands a price nearly 18.6 times what its components earned, while the Russell 2000 index of small U.S. stocks fetched 44 times.
3) While gold has gone nowhere over the past four years, the formerly precious metal seems to have found a floor near $1,200, with buyers stepping in each time prices slide below this threshold.

In addition, gold is a famously expensive metal to mine, and producers are unlikely to increase new supply until gold prices rally well above $1,200. All this helps limits the downside risk of adding gold at current levels, near $1,174.
4) Rising wages and purchasing power across Asia will improve the demand for gold, especially in tightly-regulated economies with under-developed financial systems where gold is still a store of wealth.
ANZ chief economist Warren Hogan and commodity strategist Victor Thianpiriya reckon that average gold demand amounts to just 0.70 grams per person among Asia’s emerging economies – half the per capita consumption of more developed countries. “Per capita gold demand in emerging economies of the Asia 10 has the potential to double as these countries become richer and more industrialized,” wrote Hogan and Thianpiriya, who expect gold demand among individuals and institutions to reach 5,000 tonnes per year by 2030, up from 2,500 tonnes recently. They see gold prices rising gradually and breaking through the $2,000 level within the next decade.

5) Central banks, especially those in emerging economies, will need to stockpile more gold to shore up confidence in their liberalized exchange rates. “If all central banks in the world were to hold at least 5% of their foreign exchange reserves as gold, this would require the purchase of almost 8,000 tonnes of gold,” argued Hogan and Thianpiriya. Emerging market central banks should remain net buyers of gold to bring their allocations more in line with developed countries’ – to the tune of about 75 tonnes a year, they added.
China, in particular, not only wants to establish the yuan as a global reserve currency, it wants to build Shanghai into a global hub for gold trading. Having supplanted South Africa as the biggest gold-producing nation, China is also the biggest importer of gold. Yet its share of global gold trading is still modest. Don’t be surprised if China’s central bank is buying up the country’s own domestic production, while also amassing gold from abroad.
6) Already, sentiment toward gold couldn’t get much worse. Once upon a time, gold bugs were as loud and as legion as Benedict Cumberbatch’s teenage fans. But Barron’s latest “Big Money Poll” showed a whopping 71% of money managers who said they’ve become bearish about gold, while the huddle of bulls shrank to just 29%.
Meanwhile, Newmont Mining, which mines the unloved and allegedly precious metal, quietly became the fourth best performing stock in the Standard & Poor’s 500, and has shimmied up 41% this year.
7) Of course, rising U.S. interest rates threatens to siphon money from assets including gold. But the prospect of rising real rates has become one of the longest drum rolls heard in the financial markets, and may already be amply factored into current prices.
Nearly 83% of the planet’s stock market cap recently is supported by zero interest rate policies, and more than half of all global government bonds still yield less than 1%, according to BofA Merrill Lynch. Even if U.S. rates were to climb spiritedly – a big “if” given the fragile state of global growth – rates from Europe to Japan won’t necessarily join the party.
8) Central bank largesse, quite arguably, has become the biggest driver of asset prices in recent years, but the bill for all this wanton money-printing will one day come due. Either central banks will eventually succeed in inflating prices, or the surplus liquidity and leverage will suck money from the economy’s productive sectors into its more speculative fads, and central banks will then have to wean us from the lavish stimuli. In either scenarios, gold benefits. And when that happens, some of what glitters just might be gold.

Meet the New Generation of Robots for Manufacturing

They are nimbler, lighter and work better with humans. They might even help bring manufacturing back to the U.S.

By James R. Hagerty

June 2, 2015 11:08 p.m. ET

 ABB and others have introduced robots designed to assemble small parts and detect whether products are being put together properly.
ABB and others have introduced robots designed to assemble small parts and detect whether products are being put together properly. Photo: ABB Robotics

A new generation of robots is on the way—smarter, more mobile, more collaborative and more adaptable. They promise to bring major changes to the factory floor, as well as potentially to the global competitive landscape.

Robots deployed in manufacturing today tend to be large, dangerous to anyone who strays too close to their whirling arms, and limited to one task, like welding, painting or hoisting heavy parts.

The latest models entering factories and being developed in labs are a different breed. They can work alongside humans without endangering them and help assemble all sorts of objects, as large as aircraft engines and as small and delicate as smartphones. Soon, some should be easy enough to program and deploy that they no longer will need expert overseers.

That will change not only the way an increasing number of products are made. It could also mean an upheaval in the competition between companies and nations. As robots become less costly and more accessible, they should help smaller manufacturers go toe to toe with giants. By reducing labor costs, they also may allow the U.S. and other high-wage countries to get back into some of the processes that have been ceded to China, Mexico and other countries with vast armies of lower-paid workers.

Some of the latest robots are designed specifically for the tricky job of assembling consumer-electronics items, now mostly done by hand in Asia. At least one company promises its robots eventually will be sewing garments in the U.S., taking over one of the ultimate sweatshop tasks.

To enlarge graph click here                         

“Robots are going to change the economic calculus for manufacturing,” says Hal Sirkin, a Chicago-based senior partner of Boston Consulting Group. “People will spend less time chasing low-cost labor.”
The changing face
Today, industrial robots are most common in auto plants—which have long been the biggest users of robot technology—and they do jobs that don’t take much delicacy: heavy lifting, welding, applying glue and painting. People still do most of the final assembly of cars, especially when it involves small parts or wiring that needs to be guided into place.

Now robots are taking on some jobs that require more agility. At a Renault SA RNO -0.79 % plant in Cleon, France, robots made by Universal Robots AS of Denmark drive screws into engines, especially those that go into places people find hard to get at. The robots employ a reach of more than 50 inches and six rotating joints to do the work. They also verify that parts are properly fastened and check to make sure the correct part is being used.

The Renault effort demonstrates a couple of trends that are drastically changing how robots are made. For one, they’re getting much lighter. The Renault units weigh only about 64 pounds, so “we can easily remove them and reinstall them in another place,” says Dominique Graille, a manager at Renault, which is using 15 robots from Universal now and plans to double that by year-end.

Researchers hope robots will become so easy to set up and move around that they can reduce the need for companies to make heavy investments in tools and structures that are bolted to the floor.

That would allow manufacturers to make shorter runs of niche or custom products without having to spend lots of time and money reconfiguring factories. “We’re getting away from the [structures and machinery] that can only be used for one thing on the factory floor and [instead] using robots that can be easily repurposed,” says Henrik Christensen, director of robotics at Georgia Institute of Technology.
Built to collaborate
Another big trend at work: The Renault robots are “collaborative,” designed to work in proximity to people. Older types of factory robots swing their steel arms with such force that they can bludgeon anyone who strays too close. Using sonar, cameras or other technologies, collaborative robots can sense where people are and slow down or stop to avoid hurting them.
At a Renault car plant, robots drive screws into engines—a sign of their progress in handling small parts.
At a Renault car plant, robots drive screws into engines—a sign of their progress in handling small parts. Photo: Renault

These types of innovations aren’t limited to the auto industry. ABB Ltd ABB -2.39 % of Switzerland, Boston-based Rethink Robotics Inc. and others have recently introduced robots designed to help assemble consumer-electronics items, among other products. These new robots are designed to work close to people and handle small parts, rather than doing heavy lifting or welding or painting.

Another aspect of doing more delicate work is the robots’ ability to sense whether parts are being assembled correctly, something that wasn’t possible with previous generations of clumsier robots. At a trade show in Germany in April, Kuka Roboter GmbH showed one of its robots installing a tube inside a dishwasher. Kuka’s robot uses “force torque” sensors to judge whether a part is in the right place. “The robot is able to wiggle it into place like a human would,” says Dominik Bösl, Kuka’s innovation manager.

This delicacy is allowing robotics to spread into a wider variety of industries. At a plant in Wichita, Kan., due to open in November, JCB Laboratories will use robots to pick up syringes, fill them with medications and snap on caps, among other tasks. The production line, designed by ESS Technologies Inc. of Blacksburg, Va., involves three robots from Japan’s Fanuc Corp. FANUY -0.31 % The robots will be five to six times faster than the people who now do the work, says Brian Williamson, president of JCB, owned by Fagron FAGR -3.47 % NV of Rotterdam.

Using robots also will reduce the risk of human error or contamination, he says: “They’re very precise, they don’t get tired, and they only do things they’re told to do.” The robots will eliminate two jobs, Mr. Williamson says, but the workers can be redeployed to other tasks.

Fender Musical Instruments Corp. uses Fanuc robots to apply polyester and urethane coatings to guitars at a plant in Corona, Calif. A spokeswoman says the robots apply coatings faster and more consistently than people could and allow people at the plant to “focus on areas that are more crucial to the overall look, feel and sound” of the instruments. Those tasks include designing, buffing and assembly.

Some in the robotics industry see machines moving into even more industries. Per Vegard Nerseth, ABB’s global robotics chief, expects increasing demand for robots from makers of watches, razors, toothbrushes and toys. He also thinks robots could help make muffins in local bakeries, slice vegetables and meat, and wash windows.

An Atlanta startup, SoftWear Automation Inc., which last year attracted $3 million of venture capital, has developed robots that the firm says can sew garments. The company hopes the robots will allow some clothing production to move back to the U.S. from low-wage nations.
Robots everywhere?
But some caveats are in order for this rosy picture.

Though the U.S., Europe and other high-wage areas should benefit from these trends, they won’t have the field to themselves. China also is investing heavily in robots as its wages soar and its population ages. For now, China has just 30 robots per 10,000 manufacturing employees, trailing South Korea (437), Japan (323), Germany (282) and the U.S. (152), according to the International Federation of Robotics, a trade group. But the federation projects that the total number of industrial robots being used in China will exceed that of North America next year. IHS Technology, a research firm, projects that robot sales in China will surge to about 211,000 units in 2019 from 55,000 last year.

Competition among manufacturing nations isn’t only about robots, of course. Other factors that determine where things are made include taxes, regulation, availability of skilled workers and suppliers, energy costs and willingness to make long-term investments. At a minimum, though, investing in robots and using them effectively will be a price of staying in the global manufacturing game, says Mr. Sirkin of Boston Consulting Group. So even nations that rely on low-cost labor today will be forced to explore robotics or risk losing even more jobs.

Even if robots allow manufacturing to relocate, the impact on the workforce itself will be mixed. Greater use of robots means fewer people are needed on factory floors; those doing routine tasks requiring little education are most vulnerable. Yet even highly automated factories create or sustain jobs in design, engineering, machine maintenance and repair, marketing, logistics and other services.

What’s more, robots will have to make further strides in the years ahead to allow a major shift of electronics and other assembly work to migrate from Asia to the U.S. and Europe.
Speed restrictions
One problem is that today’s collaborative robots frequently have to slow down or stop whenever people veer into their paths, disrupting production. Take the case of Baxter, a friendly looking two-armed collaborative robot from Rethink.

The company introduced Baxter with huge fanfare three years ago. Yet Rethink has sold fewer than 1,000 of the robot, which is mainly used for such simple tasks as moving materials, picking up parts, and packing or unpacking boxes. In part, that’s because the robot’s speed is restricted by safety considerations.

Rodney Brooks, chairman of Rethink and a renowned robot developer, says Baxter has been a “tremendous learning experience” and has helped manufacturers and others see the potential of collaborative robots. In March, Rethink unveiled a new robot, Sawyer, which the company says will be up to twice as fast as Baxter, depending on the application.

Another hurdle is creating robots that can come closer to matching people’s fine motor skills in manipulating materials and small parts. For all the advances in recent years, robots have trouble dealing with soft or floppy things, such as cloth or bundles of electrical wire.

“Anywhere you manipulate flexible materials, that’s a very challenging task for robots,” says Julie Shah, an assistant professor at the Massachusetts Institute of Technology. People use “tactile feedback,” Dr. Shah says. If something doesn’t feel quite right, they adjust. Robotic science is only starting to deal with that challenge.

Mr. Hagerty is a news editor in The Wall Street Journal’s Pittsburgh bureau. 


Signs of a slowdown

A weaker yen poses problems elsewhere

Jun 6th 2015

THE efficacy of Abenomics, the reform programme of Japan’s prime minister, Shinzo Abe, is a matter of vigorous debate. There have been periods of decent economic growth and higher inflation since Mr Abe became prime minister in 2012, but they have not lasted. Japanese GDP is forecast to rise by only 0.8% this year and headline inflation is just 0.6% (the core rate is even lower, at 0.3%).

Where Abenomics has clearly made a difference is in the value of the yen. At the end of 2012 it was trading at ¥87 to the dollar; this week, it fell below ¥125, a decline of more than 30% in 30 months (see chart 1). That is down to the Bank of Japan’s massive programme of quantitative easing (QE), which involves creating new yen to buy assets; the Bank is printing ¥80 trillion ($644 billion) a year.

A weaker yen creates two challenges for the rest of the world. First, it makes Japanese exporters more competitive and thus weakens the position of rival exporting nations. That is happening at an especially inconvenient time. Over the past three months, all the main emerging markets bar China and Hong Kong have seen weaker exports than in the same period of 2014, according to UBS, a Swiss bank. Global exports fell slightly in May, the first decline in nearly two years.

Some of the recent sluggishness in global trade may be down to changes in the Chinese economy.

Chinese manufacturers used to import parts from the rest of Asia and then export finished goods to the rest of the world; now China may be making more of the parts itself. The result is a decline in intra-Asian exports.

That explanation, however, is of scant consolation to other Asian exporters. South Korea’s exports have fallen 11% in dollar terms (although less by volume); export growth in the Philippines has slowed to an annual rate of 1% from 13% in the last quarter of 2014. The purchasing managers’ indices in many emerging markets have fallen below 50, indicating a contraction in manufacturing (see chart 2).

The second challenge posed by the weaker yen is the potential deflationary effect. Cheaper Japanese goods will make it more difficult for competitors to raise prices. Lower commodity prices have led to falling headline inflation rates around the world. Central banks have been cutting interest rates in response. The latest example is India, which reduced rates for the third time this year on June 2nd.

A fall in commodity prices is a benign event for consuming nations, the equivalent of a tax cut that supports demand. Fears of a plunge into deflation in Europe have eased somewhat, with both headline and core inflation now positive. But falling prices for finished goods from Asia could yet have a bigger impact. A broad-based measure of Chinese inflation, the GDP deflator, is now showing falling prices. The prices of goods produced by Chinese factories have been falling for more than three years.

The continued willingness of both the Bank of Japan and the European Central Bank to pursue QE indicates continued concern about weak demand and deflation. In such an environment, central banks are happy to see their currencies weaken. The problem is that this exports deflation to the rest of the world.

For financial markets, however, QE means that central banks are absorbing an awful lot of new government debt. That has helped keep sovereign-bond yields low, despite a recent bout of volatility, which has encouraged investors to buy risky assets and allowed stockmarkets to shrug off weak economic data.

American GDP fell in the first quarter, and early indications for the second quarter are wan: the Atlanta Fed’s GDPNow model suggests annualised growth of just 1.1%. Britain also had a weak first quarter and the euro zone, although recovering, is hardly sprinting: its composite purchasing managers’ index (covering both services and manufacturing) fell in May.

Throw in the weak emerging-market data and it might seem as if the global economy is slowing significantly. But investors remain convinced this a blip. A survey of global fund managers by Bank of America Merrill Lynch in May found that 70% expected stronger economic growth this year, and only 11% thought it would weaken. If recent trends continue, investors may be in for a nasty shock.

Wall Street's Best Minds

What Stocks Really Do When the Fed Hikes Rates

Nuveen strategist Bob Doll thinks the hard historical facts should allay fears about an eventual rate move.

By Robert C. Doll       

June 4, 2015 12:17 p.m. ET

The current bull market is over six years old and has survived several calls for its demise. So far, it has weathered economic weakness, deflation fears, earnings slowdowns, an oil collapse, the surging dollar, geopolitical risks and valuation worries. The latest bugaboo is one that has often been associated with corrections or the onset of bear markets: the start of a Federal Reserve rate hike cycle and rising bond yields.
We believe such concerns are likely overwrought. We expect rates and yields to rise in the coming months. But while this will likely contribute to market volatility, it shouldn’t spell the end of the current bull market.
A Look at History: Fed Rate Cycles and Equity Markets
Many investors believe that when rates rise, the party is over for stock prices. Historically, however, this has not been the case.
Consider the past six rate hike cycles going back to the early 1980s. Using time periods of 250 trading days (roughly equivalent to one year), we found that while pockets of weakness surrounded rate hikes, equities generally weathered the storm. In most cases, equities performed well prior to Fed rate increases, then struggled or declined slightly after the onset of rate hikes, only to recover and outperform in the two years following the first rate increase.

Equities Survived Previous Fed Rate Hikes

S&P 500® Index Returns Before and After Rate Increases

Performance Before/After Initial Rate Hike
Date of Initial Hike 250 Days Before 250 Days After 500 Days After
Average 14.00% 2.60% 14.40%

While equities have generally performed well before and after Fed rate hikes, we have seen increased volatility. In particular, a period of consolidation often accompanied the start of rate increases. The table shows the average daily returns of the six time periods discussed above. In the 250 days before the rate increases and the 500 days after, stock prices trended higher but experienced a modest selloff. The numbers are different for each of the six time periods, but on average, equities have experienced a peak-to-trough decline of roughly 10%.
Improving Growth and Signs of Inflation Should Push Rates Higher

In some ways, the current economic and market backdrop is typical compared to previous periods of rising rates. In a normal economic cycle, the economy emerges from recession as the Fed cuts rates and tends to grow relatively quickly during a time of low inflation. At some point, the backdrop shifts and the Fed begins increasing rates, usually due to climbing inflation or improving growth. This Fed policy shift divides the first and second halves of economic expansions.
Today, we believe the United States has reached that inflection point: Economic growth has been slower than typical recoveries and expansions, but it is gradually accelerating. Despite a few blips, growth could be characterized as solid, and indicators such as the strengthening labor market suggest this growth will continue.
Inflation is more complicated. For years, inflation has been virtually nonexistent in the United States, but we believe that is changing. The sharp and dramatic collapse in oil prices since mid-2014 has put downward pressure on headline and core inflation. We are, however, seeing indications that some inflationary pressures are starting to emerge. We believe overall inflation is bottoming and will begin moving modestly higher.
Wage inflation is one critical signal for inflation. If and when wages start to climb, consumer spending should increase, which may increase demand for goods and services and start an inflation cycle.
Wages can be measured in several ways, but we believe the best measure is the quarterly Employment Cost Index (ECI). Since the end of the Great Recession, the ECI jumped early and leveled off for several years. That has recently begun changing. The first quarter of 2015 reading showed the ECI climbing at its fastest annual pace in six years.
As a result of improving growth and inflation pressures, we expect the Fed will begin increasing rates, and bonds yields should move erratically higher. The United States is hardly in a robust growth mode, and inflationary pressures are only beginning. Unlike previous cycles, the Fed is under no pressure to rein in unsustainable growth or curb mounting inflation. The important issue, however, is that the U.S. economy is strong enough to withstand higher rates.
The unprecedented lowering of the fed funds rate to zero happened as a result of an emergency—the worst financial crisis since the Great Depression. That emergency is long past, and we believe it is time (if not past time) for the Fed to act. Our best guess is that the Fed will begin to increase rates in September 2015. When the Fed moves, we believe it will do so slowly and carefully. At the same time, we think bond yields should rise unevenly. Both the start of the Fed rate cycle and improving growth trends should put upward pressure on yields.

The Starting Point Should Help Equities

There is a key difference between the current environment and previous rate increase cycles—the starting point is much lower. For the first time in history, the Fed will be raising rates from such a low level and bond yields are much lower than other rate increase cycles.
We see a couple of implications of this unique environment. The fed funds rate has room to move higher before it drags on economic growth. For example, if the Fed enacts four or five 25 basis point rate increases over the coming year (a reasonable expectation), the fed funds rate would increase to just 1.0% to 1.25%. This would hardly be punitive by any measure. During the previous six rate hike cycles, the fed funds rate started at an average of about 5%. Put another way, the current economy is probably still weak enough to need low rates—just not quite so low.
A second, and related, implication is that an environment of low and upward moving rates can be a good backdrop for equities. Not surprisingly, equities fared poorly when yields were high and moving higher. while they performed well when yields were decreasing from elevated levels. Interestingly, stock prices also tended to rise significantly when yields were low and starting to move higher.
Presently, the 10-year Treasury yield is around 2.25%. In the previous six time periods we discussed earlier, Treasury yields were much higher when rates started to rise. During those times, the 10-year yield ranged from 4.6% to as high as 10.3%, with an average starting point of 7.0%. This supports our argument that rising rates and yields won’t be enough to derail the current bull market.

Investment Implications: Performance Trends and Active Management

We see several implications for investors. The first is that equities will continue to outperform most other asset classes in the coming months and years. Equity valuations are higher now than a few years ago, but remain more attractive than cash and many areas of the bond market. A combination of improving growth, solid earnings and favorable valuations suggests that investors may want to overweight equities.
A look back at the historical time periods we have been considering suggests the same. Comparing different segments of equity markets with other asset classes,
We would caution not to make too much of these numbers, as they compare different asset classes over various time periods and diverse market environments. However, a few trends may repeat this time:
Equity markets generally outperformed Treasuries and corporate bonds.
Large cap equities outperformed small caps. Larger companies tend to have more stable earnings trends, and earnings become increasingly important in the second half of economic cycles.
Global equities outperformed U.S. equities. U.S. stock prices usually become more volatile and experience a downturn sometime during rate increase cycles. Since many regions of the world are still in a monetary policy easing mode, we expect some near-term outperformance by non-U.S. markets. However, we continue our favorable long-term view toward U.S. equities.
In addition to these broad asset class views, we also have some thoughts about specific sectors of the U.S. equity market. Sector returns tend to be volatile over time, but the 12-month average returns of the S&P 500 sectors following the last six rate hike cycles show consistent trends.
During periods of rising rates, valuations for equities tend not to expand, so earnings growth becomes the main driver of equity returns. Not surprisingly, sectors that tend to exhibit better growth prospects have generally outperformed during periods of rising rates. This gives us a positive view toward the technology and health care sectors, which we believe look quite attractive.
We believe a few historic trends will not reoccur in this cycle. Energy has historically performed well, but the recent collapse in oil prices combined with slowing growth in China will keep downward pressure on the energy sector for some time. Likewise, the utilities sector appears vulnerable, as valuations for this area appear stretched. We do not expect this part of the market to outperform.
Finally, we examine a historical connection between rising rates and active equity management. Over time, active managers have struggled when yields have fallen. Conversely, active managers have outperformed when yields are rising.
This connection exists for several reasons:
Rising interest rates tend to be associated with periods of market volatility. We believe more volatility means more opportunity for active managers to identify mispriced securities.
Rising rates typically signal accelerating economic growth. Stronger economic growth leads to more market breadth, and hence more performance dispersion. This can benefit active approaches.

Expect More Volatility, but Equities Should Still Advance

We understand why many investors view the prospect of higher rates with trepidation. The Fed’s highly accommodative monetary policy has been a main contributor to the extremely strong bull market we have enjoyed over the last several years. This policy shift will diminish what has been a strong tailwind.
Nevertheless, we believe equities have room to rise. The coming change in Fed policy is likely to bring additional volatility, and we believe the pace of equity gains will likely recede. But the balance of evidence suggests that stock prices are more likely than not to advance over the coming months and years.

Doll is chief equity strategist with Nuveen Asset Management, an affiliate of Nuveen Investments.