THE DAY AFTER PLAN
How the World Is Messing With Investors and the Fed
Policy makers and investors might need to get new playbooks
By Justin Lahart
The world is messing with the Federal Reserve’s plans. Investors should be able to relate.
Fed Chairwoman Janet Yellen in a speech late Thursday said the central bank aims to raise rates later this year. In doing so, she made the case that despite last week’s decision to keep rates on hold, trouble overseas wasn’t likely to have a significant effect on future policy decisions. The crux of her argument rested on a view that reduced unemployment will push wages higher, leading inflation back toward the 2% that the Fed has targeted.
One risk to that view is that overseas economies’ ability to influence U.S. prices may have risen to the point where the inflation the Fed expects to see in the years ahead won’t come.
That has implications for investment allocation decisions. Traditional moves into or out of, say, stocks and bonds might not make as much sense this time around.
To understand why, consider the relationship between a falling unemployment rate and rising wages.
This is named the Phillips curve after one of the economists to first identify it and forms the backbone of economic models used by Ms. Yellen and her staff. But the Phillips curve relationship has been spotty lately.
As a result, lower import prices that have come about as a result of the dollar’s rise and weakness in China and other developing economies matters more than in the past. And they may continue to weigh on inflation well into next year. Indeed, according to Johns Hopkins economist Jonathan Wright, futures-market implied inflation expectations suggest that the Labor Department’s consumer price index will be up by just 0.35% on the year next June. That points to an inflation environment where the Fed, if it does raise rates this year, will have a hard time raising them thereafter.
It isn’t just the Fed that’s in a muddle. Investors have long based allocation decisions on where they think the U.S. is in the business cycle. This is first characterized by strong growth with low inflation (buy bonds) and then strong growth with rising inflation (buy stocks).
As the Fed clamps down, there is weakening growth and too-high inflation (buy commodities), followed by weakening growth with falling inflation (retreat to cash).
A more global investing environment—U.S.-based companies have more substantial overseas operation than before, for example, while the role of the U.S. economy in setting commodities prices has been diminished—makes a hash of that. Uncertainty about the Fed only makes the picture more complicated.
Both Fed policy makers and investors might need to get new playbooks.
After the hold, be bold
It will take more than patience to free rich economies from the zero-interest-rate world
SOMETIMES doing nothing really is better than doing something. On September 17th the Federal Reserve made the right decision to leave its benchmark interest rate, unchanged since 2008, near zero. With inflation sitting well below the Fed’s 2% target and doubts about China’s economy prevalent, a rise would have been an unnecessary risk.
Yet Janet Yellen, chair of the Fed, will face a similarly tough choice in October—and possibly for many months thereafter. And whenever “lift-off” occurs, financial markets expect rates to stay historically low for years to come. The era of unconventional monetary conditions shows no sign of ending. If the rich world’s central banks are to get back to the normality they crave, their standard toolkit may not suffice. It is time to think more boldly, especially about the idea of inflation targeting.
That is because the usual relationship between inflation and unemployment appears to have broken down. In the short run, economists think these two variables ought to move in opposite directions. High joblessness should weigh on prices; low unemployment ought to push inflation up, by raising wages.
Unfortunately, in many rich countries this standard inflation thermostat is on the blink. In 2008 economic growth collapsed and unemployment soared, but inflation only gradually sank below target. Now, by contrast, unemployment has fallen to remarkably low levels, but inflation remains anaemic. This has wrong-footed central banks. Assuming that rising prices would follow hard on the heels of a jobs boom, both the Fed and the Bank of England ended stimulative bond-buying programmes and prepped markets for looming rate rises. Their recoveries have instead proved nearly inflation-free. Worse, with interest rates close to 0%, central bankers have less room to respond if they misread inflation risks and tighten too soon.
Given this double bind, it makes sense to look beyond inflation—and to consider targeting nominal GDP (NGDP) instead.
Critics fret that NGDP is hard to measure, subject to revision, and mind-bogglingly unfamiliar to the public. Yet if NGDP sounds off-putting, growth in income does not. And although inflation can be measured easily enough, central banks now rely nearly as much on estimates of labour-market “slack”, an impossibly hazy number.
Most important, an NGDP target would free central banks from the confusion caused by the broken inflation gauge. To set policy today central banks must work out how they think inflation will respond to falling unemployment, and markets must guess at their thinking. An NGDP target would not require the distinction between forecasts for growth (and hence employment) and forecasts for inflation.
What might an NGDP target mean in practice? Most economies have fallen well short of their pre-recession trend in nominal-income growth. Before the financial crisis, nominal GDP growth of 5% was considered normal in America. Yet the economy is 16% below the income threshold it would have reached had it grown at that pace since 2006. In Britain, too, NGDP is 15% short of where it could have been. The euro zone and Japan are even worse. Such shortfalls are too great to make up quickly; doing so would imply dangerously high inflation rates. Yet even relative to recent trends, rich economies are coming up short; American NGDP is 5% below what you might have anticipated in 2010. Faster NGDP growth could come from better productivity, more hiring or faster inflation; all of which rich economies could use a bit more of.
Setting a different target does not mean central banks will automatically reach it. And their unconventional toolkit looks depleted. Quantitative easing, which is still in use in Europe and Japan, is falling out of favour because of worries about asset prices. Interest rates cannot be cut far below zero without radical changes in the nature of money (the Bank of England’s chief economist recently suggested eliminating cash). But getting the target right is an important start. Patiently waiting for inflation to turn up is no longer good enough.
France signals EU treaty change to avert Brexit, warns on euro survival
'We mustn’t close the door to the British if what they are demanding from other member states is acceptable,' said French economic tsar Emmanuel Macron
By Ambrose Evans-Pritchard
France has opened the door to full-blown treaty changes in a bid to keep Britain in the EU, warning that it would be grave mistake to disregard the legitimate demands of London.
Photo: Bloomberg Finance
The comments came a day after French president Francois Hollande met David Cameron for a brain-storming session at Chequers. There appears to be a coordinated move by Paris to defuse an unnecessary clash with Britain.
Mr Macron said changes to the UK’s membership terms could be lumped together with euro reform in a broader EU accord, giving Mr Cameron the coveted imprimatur of full treaty change.
“The first step is for the British government to clarify its requirements. The question is: ‘What exactly do you want?’” he said.
France seems determined to keep Britain in the EU, not least because the two countries are working tightly together in foreign policy and defence. Nobody wants an avoidable fight with the UK when eastern Europe is rebelling over migrants and the EU itself faces an existential crisis.
Yet there are limits to French appeasement. “An a la carte Europe is not feasible. It would progressively kill the European idea,” he said.
Mr Macron had even tougher words for Germany, warning that the eurozone will disintegrate in a storm of populist revolt unless Berlin drops its vehement opposition to fiscal union and large transfers to the poorer regions.
The former Rothschild banker said the currency bloc is fundamentally unworkable without a joint budget to back it up and will leave debt-stricken countries on the periphery in permanent trouble.
“If we don’t move forward, we are deciding the dismantling of the eurozone. We have to choose: is it a fixed exchange system or a monetary union?” he said.
He called the struggle over the euro a new Thirty Years war in Europe between Calvinists and Catholics. "The Calvinists want to make others pay until the end of their life. They want reforms or no contributions toward any solidarity. On the other side are the Catholics, largely on the periphery,” he said.
"At every eurozone summit, at every Eurogroup, we have this same dilemma between member states. We have to exit this religious war," he said.
Mr Macron has repeatedly argued that Germany's one-sided approach to the aftermath of the euro crisis is what has pushed the region into a deflationary vortex. Vulnerable countries are being forced to go through harsh reforms and budget cuts with little economic solidarity in return.
It is a gift to “demagogues”, able to capitalize on seething resentment against Brussels - a clear allusion to the Front National’s Marine Le Pen, currently leading French opinion polls at 29pc with vows to restore the French franc.
Mr Macron said the design flaws of EMU have led to a situation where the eurozone’s inner core is sucking the lifeblood out of the rest of the currency zone. “The periphery will never converge without fiscal transfers,” he said.
He called for an EMU treasury and investment arm with powers to raise taxes in order to cope with asymmetric shocks hitting any one area, perhaps through the tithing of VAT payments.
Unemployment costs should be “mutualised” through some sort of joint insurance scheme. The whole structure could be built on the current bail-out fund (ESM), under the executive control of an EU super-commissioner, answering to a eurozone parliament.
Such plans are anathema to Germany, where all major parties are opposed to any form of “transfer union”. They know from hard experience how much it has cost over the last quarter century to bail out the old East Germany within a currency union.
German experts say the cost of propping up half of Europe in this fashion would be greater than the reparations burden imposed on Germany at the Versailles Treaty in 1919. Such a move would destroy popular consent for the euro project.
Otmar Issing, the European Central Bank’s first chief economist and an iconic figure in Germany, warned earlier this month that any move towards an EMU treasury and budget would require a constitutional amendment in Germany backed by a two-thirds majority in both houses of parliament. "The chances of political union are close to zero," he said
He said it would be "dangerous" to transfer control over tax and spending to the EU federal level before full political union has been established on democratic foundations. Attempts to slip through such changes by the back door would be fatal.
Diplomats say the strategic trade-off is for France to give up some degree of sovereignty while Germany accepts some degree of fiscal burden-sharing, but a deal looks remote.
Mr Macron is currently launching a blitz of "Thatcherite" reforms in France, much to fury of the Left-wing of his own Socialist Party. His "Macron Law" is an assault on red tape and vested interests, applauded and reviled in equal measure as the first step in a root-and-branch reform of France’s archaic welfare model.
There have been attempts before to bring France kicking and screaming into the 21st century but this time the forces of the status quo are on the back foot. They cannot mobilize protests.
“The difference today is that we don’t have people out on the streets. People are perfectly aware of the situation we are in,” he said.
Asked about Volkswagen’s manipulation of emissions data, Mr Macron said it was outrageous conduct but so far appears confined to VW, and does not in itself change the strategic debate in Europe about clean diesel.
As for the instant market contagion to other car makers on European bourses, his answer was a wave of Gallic contempt. “It’s ridiculous,” he said.
Demographic change will have big economic impacts
THE population of the developed world is ageing. Everyone knows that it is happening but no one is sure what it will mean. A new paper from Morgan Stanley, part-written by Charles Goodhart, a former member of the Bank of England’s rate-setting committee, along with Manoj Pradhan and Pratyancha Pardeshi, suggests there may be dramatic economic impacts.
In particular, the paper suggests that the greying population may reverse three long-term trends: a decline in real (inflation-adjusted) interest rates, a squeeze on real wages and widening inequality. That is because those trends were driven by previous demographic shifts; first, the entry of the baby boomers into the workforce after 1970 and second, the more than doubling of the globally integrated workforce as China and eastern Europe joined the capitalist system.
This rise in the labour force produced downward pressure on real wages. It also led to slower improvements in productivity, particularly in Europe. As Mr Goodhart writes, “As labour cheapens, managers spend less effort and invest less capital in order to raise productivity.”
The falling cost of labour also produced downward pressure on the prices of manufactured goods, especially as companies relocated to Asia and eastern Europe. This created deflationary pressures, allowing central banks to ease monetary policy. China’s relatively closed financial system and lack of a social safety net created a savings glut that added to the downward pressure on real interest rates. In turn, lower real rates pushed up asset prices which, along with the pressure on wages, added to inequality since financial assets tend to be owned by the better-off.
But population growth in the rich world, which was 1% a year in the 1950s, has fallen to 0.5% and should drop to zero by 2040. Some countries will see declining populations before then.
Crucially, the share of the population formed by those of working age is already starting to fall.
Indeed, Mr Goodhart reckons that the ageing population will create additional demand for labour, as illnesses such as dementia will require more care workers. This will start to push real wages higher, raising labour’s share of national income and reducing inequality.
Real interest rates balance the desired level of savings with the desired level of investment. The elderly save less and spend more of their income than the middle-aged, as a natural part of the life cycle. But even the middle-aged will not save enough, Mr Goodhart says, either because they underestimate the amount they will need for a comfortable retirement or because they expect to depend on the state.
If that analysis shows that savings are bound to fall, what about investment? In a slow-growing economy, there will be fewer profitable investment opportunities. But Mr Goodhart argues that investment will not fall as fast as savings and thus real rates will rise.
What is his rationale? Most investment by households is in the form of housing. The old are usually reluctant to move out of the homes they bought when middle-aged, even though their children have moved out. This will make it more difficult for families to find the space they need; that means residential investment will not fall significantly. As for investment by firms, rising wages will encourage companies to substitute capital for labour. Corporate investment could rise.
The thesis is vulnerable to other changes in the economy. The labour force could be boosted by greater participation by women and the elderly, or by immigration—although Mr Goodhart does not think these factors will be sufficient to compensate for the effect of ageing. The less educated, for example, find it harder to stay in the workforce beyond 65.
This last point also raises the question of whether inequality will fall as he predicts.
Demography has not been the only factor behind widening inequality: many economists point to “skill-biased” technological change as a driving force. Low-skilled workers who can be replaced by computers or robots will be more vulnerable in a world of rising real wages; the computer-literate will still command premium salaries.
The people who would most like Mr Goodhart to be right are probably mainstream politicians.
The sluggish performance of real wages in advanced economies, along with the signs of rising inequality, have caused them to lose votes to parties on their left and right. If these trends go into reverse, voters might be a bit more content. But the change might not occur fast enough to save some political careers.
Open Letter to John Mauldin
By: Bob Hoye
Thanks to today's incredible communications, I have had the opportunity to read your discussions about the financial markets. Mainly these seem to focus upon what policymakers are doing or should be doing. At times of acute financial setbacks, the tone can become, "OMG, please do something".
Regrettably, there have been times when markets do not respond to central bank policies.
Indeed, through the great bubbles since England's major banking reform of the 1840s, administered rate changes made by the senior central bank have been months behind the critical changes in market rates of interest.
Debating Fed policy now is likely to keep one behind market forces. Particularly, as margin clerks have always overwhelmed the abilities of central bankers to keep a bubble going. China's massive support during the initial panic in August updates the point.
Your letter of September 12th noted that Volker as Fed Chair had "stamped out" inflation in 1980 by raising rates. This note will review that no matter how popular the legend is, it is unsupportable. It will also place in perspective your call for an "inverse Volker".
Often the conclusions by the cottage industry that thrives upon discussing policy alternatives is that central banks will "muddle" through. At times, the orthodox regard for orthodox measures has little doubts. In the face of a decade or so financial violence the belief still remains that intervention is necessary and a future without intrusive central banking is unthinkable.
Sometimes specific policy measures are criticized, but the system of central banking, itself, is never criticized by the establishment.
Fortunately, interventionist economics provides its own critique. Involuntarily, but the establishment seems not to notice. Case studies are used in teaching law and MBAs.
Intervention assumes the efficient market theory and the random walk. There are no cases to study.
In the month that the economy peaked in December 2007, Harvard's Greg Mankiw boasted that nothing could go wrong. The reason was that the Fed had a "dream team" of economists.
Then, less than two years later the boast was that without massive ease the panic would have lasted much longer.
What was deemed impossible was then ended solely by those who had deemed it impossible.
The blunder has two aspects. The first was the assumption that the Fed in cutting the administered rate would keep the expansion going. Throughout business history market rates of interest have increased during a boom and decreased during the bust. In so many words, rising rates confirm the expansion and falling rates indicate the contraction. Fed aficionados could break from theory and look at the history of interest rates and recessions.
The other aspect is the assumption that financial booms need not clear excesses. The one that cleared in October 2007 had many of the features of a classic bubble. It was followed by a classic contraction, called the Great Recession.
As in 1932, liquidation of unsupportable positions ended and a business recovery accompanied by raging inflation in financial assets has been on since 2009.
Prior to Keynes, inflation was an inordinate expansion of credit. And therein lies the confusion.
John Maynard, himself, arbitrarily declared that inflation was rising consumer prices. Of course, this has nothing to do with central bank issuance. Soaring prices are solely due to an unfortunate outbreak of inflation expectations by the benighted consumer. It helps to have a degree in tautology.
However, the way that markets have worked over many centuries is that credit does expand inordinately against a speculative rise in prices. In one era it will be against tangible assets, such as in the 1970s and the 1910s. In another it will be against financial assets, such as in 2007 and in 1929.
It has been naïve to assume that markets are not self-correcting (up or down) and that unrelenting and arbitrary positive feedback from a government agency is necessary. In engineering, positive feedback mechanisms accelerate to destruction.
Lately, central bankers are extremely concerned about their notion of "inflation" falling below a rate of 2 percent but they seem unconcerned about highly-inflated financial assets.
How long has inflation in tangible assets been occurring?
Since governments learned to nationalize and depreciate currency.
How long has inflation in financial assets been happening?
In London in the 1660s there were enough public companies and enough traders to call it a market.
The Bank of England was formed in 1697 to remedy a bankrupt government. The pitch was that with government sanction it would "infallibly" lower interest rates. Despite supernatural qualifications it defaulted a couple times.
An era of inflation in tangible assets blew out in 1711. The South Sea Company was a quasi-government company and the focus of the first huge mania in financial assets. Despite inspired attempts to keep the bubble going, it climaxed in June 1720. A lengthy credit contraction followed.
With the advent of modern financial markets and central banking, this became the "model".
The basic pattern has repeated, making 1929 the fifth example of an era of inflation in tangible assets setting up an era of inflation in financial assets. The mania ending in 2007 was number six in the series.
Now how about the legend that Paul Volker personally ended "inflation".
If the rampant speculation in commodities that completed in 1980 was the only one in history, it is possible for the establishment to conclude that Volker and the Fed ended it. However, it was a global phenomenon as was the example in 1920. That one was huge and the collapse was massive. Both shocked the establishment such that the Fed was very easy during the 1920s. The policy was to prevent wholesale and retail prices from falling. The Fed did not understand that it was time for another era of inflation in financial assets.
This completed in 1929 with the usual warnings from the credit markets. But hey, nothing could go wrong. The John Moody boasted that the old and bad Treasury System had been replaced by the modern and "scientific" Federal Reserve System.
In 1920, financial leaders had enough commonsense not to conclude that Fed Chairman Harding personally ended that remarkable surge in inflation in tangible assets.
Huge speculations in commodities have always been a global event. So have been the busts. The one that peaked in 1980 became exceptionally overbought and crashed, on Volker's watch.
Despite widespread acceptance, correlation is not causation. In taking a look at money supply figures through that bubble and crash, there was no setback. M2 continued to grow, largely because speculation was shifting to financial assets.
Market rates of interest increased with nominal long-dated Treasuries soaring to 15 percent.
Long rates adjusted for inflation (real rates) plunged to an exceptional low. By this measure, the Fed did not tighten.
By the M2 measure, the Fed did not materially tighten, but those speculating in tangible assets suddenly found the world had tightened funds to them. As with any crash in commodity prices, forced liquidation dominated until the market cleared. For the CRB it was in 2001.
The historical pattern replicated once again. A long advance in tangible asset prices blew out and was followed by another era of inflation in financial assets. On the latest burst of global enthusiasm, the highlight speculation was in Shanghai. The old history of great bubbles suggested this one would climax in May or June. Advanced technical research noted that the excesses displayed in June were matching those last seen in 2007 and in 1929.
In so many words. In one era the rage is to hoard tangible assets, which burns out. Then the rage is to hoard mainly financial assets, which burns out. Then the focus shifts to hoarding cash and/or near-cash instruments. The latter in the senior currency.
Volker's legend was confected by the Street, it is doubtful that it can conjure a reverse legend.
Who Caused the Refugee Crisis?
Contributing Op-Ed Writer
A Francis Effect for a Broken System
Les doy cordialmente la bienvenida a este Blog informativo con artículos, análisis y comentarios de publicaciones especializadas y especialmente seleccionadas, principalmente sobre temas económicos, financieros y políticos de actualidad, que esperamos y deseamos, sean de su máximo interés, utilidad y conveniencia.
Pensamos que solo comprendiendo cabalmente el presente, es que podemos proyectarnos acertadamente hacia el futuro.
Gonzalo Raffo de Lavalle
Las convicciones son mas peligrosos enemigos de la verdad que las mentiras.
Quien conoce su ignorancia revela la mas profunda sabiduría. Quien ignora su ignorancia vive en la mas profunda ilusión.
“There are decades when nothing happens and there are weeks when decades happen.”
Vladimir Ilyich Lenin
You only find out who is swimming naked when the tide goes out.
No soy alguien que sabe, sino alguien que busca.
Only Gold is money. Everything else is debt.
Las grandes almas tienen voluntades; las débiles tan solo deseos.
Quien no lo ha dado todo no ha dado nada.
History repeats itself, first as tragedy, second as farce.
We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.
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