The Federal Reserve treads a fine line on monetary tightening
Inflation will determine how bumpy the ride will be
by Martin Wolf
© James Ferguson
Is a surge in inflation a significant threat to sustained recovery? The likely answer is: no. But the proposition is no longer absurd, as it was when Kevin Warsh, then a governor of the Federal Reserve and now a candidate for chairman, stated in March 2010 that “I don’t think we should be complacent about inflation risk”. That misjudgment should rule out his candidacy.
Yet times have changed. This explains the Fed’s commitment to gradual monetary tightening.
The European Central Bank is planning to withdraw stimulus. The question is whether this tightening cycle will be smooth or bumpy. Inflation would make the difference.
Even a broken clock will be right twice a day. Austrian economists and goldbugs have warned of an imminent upsurge in inflation for years. Maybe they will be right, at last. The consequences would be highly disruptive. If inflation rose really rapidly, monetary policy would have to tighten significantly. That would trigger fears of a recession. Moreover, even if long-term real interest rates did not rise, risk premia on inflation, expected future short-term interest rates and the uncertainty surrounding those expected future rates would all jump, raising yields on conventional bonds substantially.
All this would undermine elevated asset markets and might trigger worries over debt sustainability. In a still fragile world economy, the results might be ugly. One might even see a return to the stagflation of the 1970s, with far lower inflation, but also far higher indebtedness.
The focus of attention is on the Fed. The US is still the world’s most important economy and the Fed the most important central bank. The US is also far more advanced in its return to normal economic conditions than other large, high-income economies. In a lucid recent speech, Janet Yellen laid out the issues. She also demonstrated why she is, of known candidates for next chairman, the outstanding one. Donald Trump would only choose one of the others if he were as determined to destroy the Fed as he is to ruin the state department and other agencies.
The starting point is a puzzle: why is inflation so low when the rate of unemployment is already a little below the level the Fed (and most economists) consider to be “full employment” (the rate at which inflation should start to accelerate upwards). The Fed’s analysis suggests that labour market slack is no longer an important downward factor, while a series of temporary downward shocks are also now in the past. So, the Fed believes, inflation will soon move back towards its target. (See charts.)
Why might this view be wrong? One possibility is that more labour market slack still exists than the unemployment rate suggests. The ratio of employment to population for those aged 25 to 54 is still well below previous cyclical peaks. The rate of part-time employment is also somewhat elevated. A thorough study by the International Monetary Fund in its latest World Economic Outlook notes, more broadly, that “while involuntary part-time employment may have helped support labour force participation and facilitated stronger engagement with the workplace than the alternative of unemployment, it also appears to have weakened wage growth”. Yet most other measures of labour market pressure are back to pre-recession levels. So even if US wage growth is well contained, this might not last.
Another factor is inflation expectations. This cuts two ways. At the moment those expectations are well anchored, the only big worry being a decline in market expectations of inflation (or inflation risk) more than five years hence. Such expectations might feed into behaviour, generating a self-fulfilling prophecy of low inflation. This would counteract the symptoms of the labour market pressure. At some point, however, the latter could boil over into rapidly rising wages, probably at rates well above those consistent with stable inflation. We have seen that before.
At present, however, the risks do not seem that great. But, as always, this is a matter of risk management. We can have little doubt that a substantial rise in inflation above target would create significant danger. Raising the target in such a situation would certainly destroy confidence in the Fed. Yet trying to hit the target could, for reasons indicated above, be destructive, possibly tipping the US back into a recession from which it would be hard to exit. This would be particularly true if the damage to asset price effects were large and much bad debt re-emerged. Yet, under this scenario, short-term interest rates would at least have to rise substantially, giving the Fed more room to cut than it has now.
If a big jump in inflation would be destructive, so would premature, or excessive, tightening. That could further lower inflation, destabilising expectations further. It might weaken the economy so much that, given still limited room to cut interest rates, without going into negative territory, it would be difficult to restore demand, without going into negative territory. Above all, after the huge and politically destabilising shock of the Great Recession, a lengthy period of strong labour markets would be hugely desirable, even healing.
The Fed has to balance between tightening too fast and too slowly. Nobody can be sure it is now wrong. My best guess is that an explosive rise in inflation is highly unlikely. The Fed can afford to take its time, while testing the capacity of the US economy to expand supply. But risks are real on both sides. The Fed has probably been right to tighten a little. But it must be careful not to go too far. It has earned much credibility over inflation. Sometimes what one has earned should be spent. This is just such a time.
THE FEDERAL RESERVE TREADS A FINE LINE ON MONETARY TIGHTENING / THE FINANCIAL TIMES COMMENT & ANALYSIS
BOND MARKETS NEED TO WAKE UP TO GLOBAL UPSWING / THE FINANCIAL TIMES MARKETS INSIGHT
Bond markets need to wake up to global upswing
Investors are mistaken if they think yields will be able to stay low for much longer
by Michael Heise
Markets predict no interest rate rises in the foreseeable future from the ECB © Reuters
Since the financial crisis in 2008, the global economy has been characterised by slow growth, low inflation and extremely expansionary monetary policies. Markets seem to expect a continuation of this so-called “new normal”. They predict no interest rate rises in the foreseeable future from either the ECB or the Bank of Japan, and they expect the Fed funds rate to stay lower than indicated by the Fed`s governors.
After years of sluggish growth, many people seem to be stuck in a “great recession” or secular stagnation mindset. There are, however, clear signs of a cyclical recovery and it is accelerating.
First, global trade is staging a comeback — notwithstanding the protectionist rhetoric of some political leaders. After two dismal years in 2015 and 2016, the trade recovery is fuelled by a recovery in the Chinese economy and the turn of commodity markets. The interlinkages of trade are reinforcing global growth.
Second, globally, a new expansionary credit cycle is supporting growth. In emerging Asia, credit growth remains strong, despite policy efforts to limit financial stability risk, especially in China. In the US, the credit cycle turned about three years ago, with first the corporate sector and then households assuming more debt. The debt-to-GDP ratio in the private non-financial sector, which had declined massively in the years following the financial crisis, has been rising again since 2014. In the eurozone, the new credit cycle is in its infancy, but here, too, loans to the private sector are rising again. The time of deleveraging and consolidation of private debt is over.
Finally, capacity utilisation in most developed markets is back to normal or even above normal.
Current estimates of output gaps indicate there is hardly any slack in the world`s big economies. That is true even in the eurozone, where capacity utilisation in manufacturing is reported to be above average. While it is true that prices and wages and prices in today’s globalised and digitised economy don’t react to capacity utilisation as strongly as they used to in former decades, it seems unrealistic to expect no reaction at all. Improving business confidence, little idle capacity and tightening labour markets will at least gradually increase wage demands and output prices.
What does the economic upswing imply for bond yields and stock markets? Usually, we would expect bond yields to be roughly in line with nominal GDP, both on the basis of economic logic and historical experience. But while nominal GDP growth has averaged 2.7 per cent in the eurozone and 3.5 per cent in Germany in the last three years, bond yields have remained much lower, in many countries close to zero.
One reason for this discrepancy is, of course, monetary policy. Our own estimates, as well as statements by ECB officials, suggest that the central bank’s asset purchase programme has pushed down the German 10-year Bund yield by about 0.8 percentage points. A normalisation of monetary policies, notably an end to QE, would drive up bond yields. By how much is an open question, as the phasing out of QE will to some extent have been priced into yields already. An exit, if done carefully and gradually, should therefore not unsettle markets. It would leave eurozone bond yields much below nominal growth rates.
Bond yields could react more forcefully, if and when market participants upgrade their expectations concerning future growth and inflation. Once investors wake up to the return of the economic cycle, their expectations about interest rates and the course of monetary policy will also change. The ECB is cautioning against overly optimistic expectations and remains expansionary in its forward guidance. But as the cyclical expansion gains force, central banks might have to take tougher action to correct an excessively expansionary path. Further delaying the exit from QE therefore harbours risks.
Rising bond yields in an economic expansion are nothing unusual and should not cause a fundamental repricing of stocks. After all, even bond yields of 2 or 3 per cent imply price earnings ratios for bonds that are way above stock market valuations. The transition from a “new normal” with a rather bleak outlook to a more cyclically driven expansion will inevitably generate volatility. Keeping it low as low as possible is a challenge for the ECB. A timely, but gradual correction of monetary policy is the best option.
Michael Heise is chief economist at Allianz
WHY FINANCIAL MARKETS UNDERESTIMAT RISK / PROJECT SYNDICATE
Why Financial Markets Underestimate Risk
Jeffrey Frankel
CAMBRIDGE – During most of 2017, the Chicago Board Options Exchange Volatility Index (VIX) has been at the lowest levels of the last decade. Recently, the VIX dipped below nine, even lower than in March 2007, just before the subprime mortgage crisis nearly blew up the global financial system. Investors, it seems, are once again failing to appreciate just how risky the world is.
.
CHINA, WHERE REFORM IS CARRIED BY AN IRON FIST / GEOPOLITICAL FUTURES
China, Where Reform Is Carried by an Iron Fist
Summary
THE EUROPEAN BANKING LANDSCAPE HAS NEW POWERHOUSES: FRENCH LENDERS / THE WALL STREET JOURNAL
The European Banking Landscape Has New Powerhouses: French Lenders
Société Générale and BNP Paribas have emerged as two of continent’s strongest banks after the debt crisis and years of economic stagnation
By Noemie Bisserbe
PARIS—France’s biggest banks have rediscovered their mojo by becoming boring.
When Pascal Augé, an investment banker at Société Générale SA, SCGLY -2.05%▲ was transferred to the French lender’s cash-management unit—which helps companies manage their cash flow—he was surprised: “For years, cash management wasn’t considered as a very sexy business,” said Mr. Augé, who now heads Société Générale’s global transaction and payment-services unit. “But we rediscovered the virtues of that business with the crisis.”
Now, a few years later, the decidedly unfashionable business generates nearly as much revenue for the bank as securities trading.
Société Générale and crosstown rival BNP Paribas SA BNPQY -2.39%▲ have emerged from the financial crisis, the eurozone debt crisis and long years of European economic stagnation as two of the continent’s strongest banks—and two of the few able to withstand the invasion from U.S. investment banks in Europe.
Société Générale had a return on equity of 9.5% in the first half of the year and BNP Paribas 10.6%, making them among the most profitable banks in Europe.
STANDING OUT
French Banks Societe Generale and BNP are gaining market share*
Net Revenues from fixed income, currencies and commodities
*Total Revenues for the top seven euopean Banks
Source: Goldman Sachs Global Investment Research
Part of their success has come from using dull but important service businesses, such as handling cash and securities, to attract clients they can upsell to investment banking and trading. The French lenders also have benefited from having long had a focus on corporate banking. France’s big corporate sector has remained comparatively strong through years of economic stagnation on the continent.
While European powerhouses such as Deutsche Bank AG , Credit Suisse Group AG and Royal Bank of Scotland Group PLC remain steeped in restructuring, Société Générale is expanding its lead in equities trading and BNP Paribas is growing its fixed-income business.
Société Générale saw its market share in equities in Europe rise to 16.4% in 2017 from 14.2% in 2013, while BNP Paribas’s market share in fixed income rose to 14.6% from 13.4% in the same period, according to a recent study by Goldman Sachs Group Inc. based on the revenue of the top seven European investment banks.
Meanwhile, Credit Suisse’s equities market share fell to 15.4% from 22.3% in Europe, and Barclays PLC’s fixed-income market share dropped to 12.9% from 16.7%.
“Unusual suspects continue to outshine” investment banks, Goldman Sachs analysts noted.
SLOWLY BUT SURELY
Net Revenues from equity trading*
* Market share of total revenues for the top seven European investment Banks
Source: Goldman Sachs Gobal Investment Research
France’s largest lenders were relatively sheltered from the 2007-2008 financial crisis, despite Société Générale’s embarrassing €4.9 billion ($5.85 billion) loss from rogue trader Jérôme Kerviel in 2008. Investment bank Natixis also ran into trouble in 2009 due to wrong bets on complex derivatives, eventually forcing the government to orchestrate a merger between its two parent companies.
Most French banks specialized in trading stocks, rather than the fixed-income products that were most hurt during the financial crisis. And more of their business came from traditional banking activities with corporate clients, not investment banking.
The sovereign-debt crisis of 2010-2012 hit them harder. French lenders were hurt especially by their dependence on short-term U.S. money markets, which became harder for some foreign banks to access during the crisis. Franco-Belgian lender Dexia SA ultimately had to be bailed out.
Crédit Agricole SA booked losses totaling more than €5 billion over five years before selling off its Greek banking arm Emporiki to domestic rival Alpha Bank for just one euro in 2013. BNP Paribas wrote down €900 million of goodwill related to its Italian unit BNL in the face of tougher regulation.
The sovereign-debt crisis forced France’s surviving banks to find new funding in capital markets and through corporate and institutional deposits, and to restructure their corporate and investment-banking business.
“French banks responded quickly to the crisis,” says Kinner Lakhani, head of pan-European bank research at Deutsche Bank. Because of the quality of their corporate loan book, French lenders were able to source new funding and rethink their business models, he adds.
BNP Paribas had a return on equity of 10.6% in the first half of the year. Photo: Christophe Morin/Bloomberg News
The liquidity crunch in the summer of 2011 acted as a trigger.
“We realized that we needed to completely change the way we did business,” says Yann Gérardin, the head of BNP Paribas corporate and institutional banking.
French banks developed their cash management and securities services to attract new customers for other investment-banking businesses like fixed-income and foreign exchange.
Royal Bank of Scotland’s departure in 2015 from the international cash-management business helped. The U.K. lender referred its clients to BNP Paribas as part of their agreement, and Société Générale hired some of RBS’s top staff in Europe.
French banks also benefited from Deutsche Bank’s financial trouble; many of the German lender’s clients sought to work with a second bank to manage their cash, French bankers say.
French banks’ focus on corporate clients, which have been far more active than institutional ones—such as mutual funds, pension funds and hedge funds—in recent quarters, has also given them an edge over many of their European rivals.
“French banks are well positioned to continue to gain market share across most corporate and investment banks products,” says George Kuznetsov, of the research firm Coalition.
Still, French investment banks are starting from a relatively low base.
Investment banking accounts for roughly one-third of French banks’ revenue, compared with more than half of revenue at Deutsche Bank or Credit Suisse. And French bankers are eager to preserve that balance.
“We believe in the strength of our diversified business model,” said BNP’s Mr. Gérardin.
French banks also remain largely focused on European markets.
“We don’t want to be a merger and acquisition bank in the U.S. and Asia, that’s not our core business,” said Didier Valet, Société Générale deputy chief executive officer.
Bienvenida
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.
Friedrich Nietzsche
Quien conoce su ignorancia revela la mas profunda sabiduría. Quien ignora su ignorancia vive en la mas profunda ilusión.
Lao Tse
“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.
Warren Buffett
No soy alguien que sabe, sino alguien que busca.
FOZ
Only Gold is money. Everything else is debt.
J.P. Morgan
Las grandes almas tienen voluntades; las débiles tan solo deseos.
Proverbio Chino
Quien no lo ha dado todo no ha dado nada.
Helenio Herrera
History repeats itself, first as tragedy, second as farce.
Karl Marx
If you know the other and know yourself, you need not fear the result of a hundred battles.
Sun Tzu
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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