Living Life Near the ZLB

Doug Nolan

There must be members of the FOMC that feel they are about to be railroaded into a 50 bps cut a week from Wednesday. Chairman Powell essentially pre-committed to a reduction last week in testimony before Congress. For a Federal Reserve preaching “data dependent” for a while now, the less dovish contingent at the Fed must be asking, “But what about the data?”

It was interesting to see headlines Thursday afternoon from a speech by the President of the New York Fed, John Williams: “Williams: Lesson With Zero Rates is to Take Swift Action,” “Williams: Currently Estimates Neutral Rate in U.S. Around 0.5%.” Soon afterward, headlines from Fed vice chair Richard Clarida reinforced the point: “Fed’s Clarida: Central Bank Needs to Act Preemptively,” and “Clarida: You Don’t Necessarily Want to Wait Until Data Turns.” Things turned rather boisterous ahead of the Fed’s “quiet period.”

Markets were all ears. The implied yield on August Fed Funds futures dropped a quick nine basis points to 1.98%, a full 43 bps below the current rate. The Market’s Thursday afternoon pricing of a high probability of a 50 bps cut elicited an unusual backtrack: “Fed Says William’s Speech ‘Not About’ Potential Policy Actions.” (The President tweeted he liked Williams’ “first statement much better than his second.”) The implied rate on August Fed Funds futures closed the week at 2.10%, with market odds (60%) back to favoring a 25 bps cut. Ten-year Treasury yields dropped seven bps this week to 2.06%, with bund yields down 11 bps to negative 0.32%.

William’s speech, “Living Life Near the ZLB,” deserves of some attention: “My wife is a professor of nursing, and she says one of the best things you can do for your children is to get them vaccinated. It’s better to deal with the short-term pain of a shot than to take the risk that they’ll contract a disease later on. I think about monetary policy near the zero lower bound—or ZLB for short—in much the same way. It’s better to take preventative measures than to wait for disaster to unfold… Over the past quarter century, a great deal of research has gone into understanding the causes and consequences of the zero lower bound.”

[Note to PhD economics students: the clearest path to the upper echelon of the Federal Reserve System is to formulate some crackpot theory justifying aggressive monetary stimulus] How much “ZLB” Fed research has been conducted for environments characterized by record stock prices, strong Credit growth, booming corporate Credit markets, and a world with $13 TN of negative-yielding debt? Williams references a 2002 paper (co-authored with Dave Reifschneider) that evaluated “effects of the ZLB on the macro economy and examined alternative monetary policy strategies to mitigate the effects of the ZLB.”

“This work highlighted a number of conclusions based on model simulations. In particular, monetary policy can mitigate the effects of the ZLB in several ways: The first: don’t keep your powder dry—that is, move more quickly to add monetary stimulus than you otherwise might… When you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress. …My second conclusion, which is to keep interest rates lower for longer. The expectation of lower interest rates in the future lowers yields on bonds and thereby fosters more favorable financial conditions overall… Finally, policies that promise temporarily higher inflation following ZLB episodes can help generate a faster recovery and better sustain price stability over the longer run. In model simulations, these ‘make-up’ strategies can mitigate nearly all of the adverse effects of the ZLB.”

There would be outrage if the Fed was using similar “model simulations” to justify a policy course at odds with the markets. In a world of unprecedented complexity, model simulations are basically worthless. If the Fed cannot even effectively model consumer price inflation from actual policy measures, how are models simulating impacts on future economic and inflation outcomes (from untested experimental policy) supposed to be credible? Besides, how have the ZLB experiments been progressing in Europe and Japan?

Williams: “An added impetus to this research has been the growing evidence that the neutral rate of interest rate has fallen significantly. I... have devoted a significant chunk of my academic career to studying r-star, or the long-run neutral rate of interest, and its implications for monetary policy. Our current estimates of r-star in the United States are around half a percent.”

What happened to the traditional central bank focus on money and Credit? This “natural rate” framework is problematic – and particularly so in Bubble environments. What was the estimate of r-star last November with 10-year Treasury yields at 3.24% and December ’19 futures implying a 2.93% Fed Funds rate? R-star is defined as the “interest rate that supports the economy at full employment/maximum output while keeping inflation constant.” In a world where loose financial conditions and booming securities markets are required to sustain the global Bubble, one can indeed make the argument that r-star is quite low. R-star is today only relevant in the context of a policy objective of sustaining the Bubble.

I thought it was outrageous in 2013 when chairman Bernanke stated the Fed was ready to “push back against a tightening of financial conditions”. It was as if I was the only analyst that had an issue with Bernanke essentially signaling that the Fed would not tolerate risk aversion or market pullbacks. Now the Fed and global central banks are taking another giant leap – the latest iteration of New Age experimental central banking: The “insurance rate cut” – “an ounce of prevention is worth a pound of cure.”

This is not about prevention, and William’s vaccine analogy is misguided. The world is suffering from chronic (debt) illness. An individual with diabetes, heart disease or cancer will find a cure in a vaccine. Over the years, activist monetary policies have been likened to giving an alcoholic another shot of whiskey or a drug addict another hit of heroin. While these have obvious merits, to counter Williams analogy I’ll instead use antibiotics. Global central bankers have been fighting the world’s chronic debt and economic maladjustment disease with steady doses of antibiotics. Not surprisingly, these pathogens have built up strong resistance to medication.

More stimulus at this point in the cycle is not for prevention – but instead a narcotic for sustaining unsound financial and economic booms (i.e. “extend the expansion”). The Fed and central bankers are again crossing a dangerous red line – compelled to aggressively administer antibiotics hoping to prevent a plague that has evolved to the point of thriving on antibiotics.

It wasn’t that long ago that Fed policy stimulus operated through a mechanism of adding reserves directly into the banking system, with additional reserves working to reduce rates while encouraging borrowing and lending. Policy would act to provide a subtle change in lending conditions that over time would reverberate throughout the economy. The Federal Reserve under Alan Greenspan increasingly shifted to using the markets as the mechanism to loosen financial conditions and stimulate the economy. The 2008 crisis unleashed the policy of direct market intervention, with Bernanke later doubling-down with his “push back” comment.

The U.S.’s coupling of market-based finance with market-directed monetary stimulus created a powerful – seemingly miraculous - combination. Others wanted in on the action. It was pro-Bubble for the U.S., but nonetheless took the world by storm. It became Pro-Global Bubble, and the world today is engulfed in historic market and financial Bubbles.

What is the “r-star” for economic equilibrium today in China? Chinese Bubble finance evolved to become the marginal source of finance globally and the Chinese economy the marginal source of global demand. With Aggregate Finance expanding almost $2.0 TN during the first half, Chinese Credit is again leading a global Credit upsurge.

July 16 – Bloomberg: “China’s efforts to shore up sagging economic growth are leading to a resurgence in indebtedness, underlining the challenge President Xi Jinping’s government faces in curbing financial risk. The nation’s total stock of corporate, household and government debt now exceeds 303% of gross domestic product and makes up about 15% of all global debt, according to a report published by the Institute of International Finance. That’s up from just under 297% in the first quarter of 2018.”

July 15 – Bloomberg (Alexandre Tanzi): “Global debt levels jumped in the first quarter of 2019, outpacing the world economy and closing in on last year’s record, the Institute of International Finance said. Debt rose by $3 trillion in the period to $246.5 trillion, almost 320% of global economic output, the Washington-based IIF said… That’s the second-highest dollar number on record after the first three months of 2018, though debt was higher in 2016 and 2017 as a share of world GDP. New borrowing by the U.S. federal government and by global non-financial business led the increase.”

July 15 – Financial Times (Jonathan Wheatley): “Debt in the developing world has risen to an all-time high, adding to strains on a global economy flagging under the weight of rising trade protectionism and shifting supply chains. Emerging economies had the highest-ever level of debt at the end of the first quarter, both in dollar terms and as a share of their gross domestic product, according to… the Institute of International Finance. The figures include the debts of companies and households. The IIF said that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. In recent months the US Federal Reserve has changed its policy outlook and a string of emerging market central banks have cut interest rates… ‘It’s almost Pavlovian,’ said Sonja Gibbs, the IIF’s managing director for global policy initiatives. ‘Rates go down and borrowing goes up. Once they are built up, debts are hard to pay down without diverting funds from other goals, whether that’s productive investment by companies or government spending.’”

Only “almost Pavlovian”? I’ve been closely monitoring Bubbles going back to Japan’s late-eighties experience. It’s always the same: Everyone is happy to ignore bubbles when they’re inflating. Bubble analysis, by its nature, will appear foolish for a while. But bubbles inevitably burst. There is no doubt that China’s historic bubble will burst, and I expect this will prove the catalyst for faltering bubbles across the globe – including here in the U.S.

The obvious transmission mechanism will be through the securities markets. Global markets have become highly synchronized – across asset classes and across countries and regions. Market-focused monetary stimulus has become highly synchronized, essentially creating a singular comprehensive global bubble.

July 18 – Bloomberg: “A cash crunch at one of China’s best known conglomerates is getting worse as the company said it will not be able to pay its upcoming dollar notes. China Minsheng Investment Group Corp.’s offshore unit said in a filing that it won’t be able to repay the principal, as well as the interest on the 3.8% $500 million bond due August, after considering its liquidity and performance. On Thursday, the property-to-financial conglomerate announced it only managed to repay part of the principal on a 6.5% 1.46 billion yuan note. The development underscores the liquidity crisis that has been pressuring the… company that aspired to become China’s answer to JPMorgan... It will be the first time that the firm’s dollar bond creditors will miss out on repayment.”

“Repo Rate on China’s Govt Bonds Briefly Hits 1,000% in Shanghai,” read an eye-catching early-Friday Bloomberg headline (picked up by ZeroHedge). Repo rates were back to normal by the end of the session, yet it sure makes one wonder… Aggressive PBOC liquidity injections have for the past several weeks calmed the Chinese money market after post Baoshang Bank government takeover (with “haircuts”) instability. The implicit Beijing guarantee of virtually the entire Chinese Credit system is now being questioned. This greatly increases the risk of Chinese money market instability – with ominous ramifications for China and the world.

With this in mind, there’s a particular circumstance that could catch global markets and policymakers by surprise: A dislocation in China’s “repo” securities lending market that reverberates throughout repo and derivatives markets in Asia, Europe and the U.S. This latent risk, in itself, could help explain this year’s global yield collapse and market expectations for aggressive concerted monetary stimulus. When Chairman Powell repeats “global risks” in his talks these days, I think first to global “repo” markets, global securities finance and global derivatives.

Markets are these days are luxuriating in impending Fed rate cuts and global rate reductions that have commenced in earnest. Liquidity abundance as far as eyes can see… What could go wrong? It’s already started going wrong. The flow of Chinese finance to the world is slowing.

July 18 – CNBC (Diana Olick): “Challenging conditions in the U.S. housing market, along with tighter currency controls by the Chinese government, caused a stunning drop in foreign demand for American homes. The dollar volume of homes purchased by foreign buyers from April 2018 through March 2019 dropped 36% from the previous year, according to the National Association of Realtors. The decline was due to a drop in the number and average price of purchases. Foreigners bought 183,100 properties with a total value of about $77.9 billion, down from 266,800 valued at $121 billion in the previous period. They paid a median price of $280,600, which is higher than the median for all existing homebuyers ($259,600), but it was down from $290,400 the previous year. ‘A confluence of many factors — slower economic growth abroad, tighter capital controls in China, a stronger U.S. dollar and a low inventory of homes for sale — contributed to the pullback of foreign buyers,’ said Lawrence Yun, NAR’s chief economist. ‘However, the magnitude of the decline is quite striking, implying less confidence in owning a property in the U.S.’”

Trade War Casualty: Why the Days of Cheap Chinese Goods Are Over

Flexport’s Phil Levy and Mary E. Lovely from Syracuse discuss what’s ahead in the U.S.-China trade dispute.

As President Trump and his Chinese counterpart, Xi Jinping, are set to meet at the G20 summit in Osaka, Japan, on June 28-29, expectations are low for a meaningful truce on the trade war that has defined their relationship over the last three years. More than 640 U.S. businesses and trade groups — including giant retailers like Walmart and Target — sent a letter to President Trump on June 13 asking him to cancel his threat to increase tariffs on some $300 billion worth of imports from China. That is on top of tariff increases the U.S. imposed in May on $200 billion worth of Chinese imports, after several attempts to forge a trade deal.

The U.S. has had several sticking points in its negotiations with China, such as Chinese government subsidies to local enterprises, controls on U.S. businesses operating in that country, and China’s laws on intellectual property rights. China has attempted to placate the U.S. on some fronts. In March, it announced a new foreign investment law where it promises a level playing field for foreign investors.

The businesses that wrote to Trump — organized under a group called Tariffs Hurt the Heartland — warned of disruptions to supply chains, higher consumer prices and erosion of U.S. competitiveness in global markets if the Trump administration goes ahead with its threat to extend tariffs.

If the Trump administration proceeds with higher tariffs on the remaining $300 billion worth of imports from China, the damage to businesses and consumers would be greater than in earlier rounds of such tariff increases, said Phil Levy, chief economist at logistics firm Flexport.

“When the Trump administration was putting its tariffs on China, it went first with the products that were supposed to be least painful and easiest to handle,” Levy pointed out. “That means the stuff that is left is harder and more painful. That is what these companies are describing as serious interruptions to supply chains, which will really hit consumers in the pocketbook.”

Numerous companies are set to give their testimonies before the U.S. Trade Representative beginning Monday to protest the proposed tariff extensions. Those testimonies are important because they explain “how they’re using these complementary inputs and how difficult it is to find alternative supplies,” said Mary E. Lovely, economics professor at Syracuse University’s Maxwell School of Citizenship and Public Affairs; she is also a nonresident senior fellow at the Peterson Institute for International Economics.

In earlier rounds of the trade dispute, the administration’s belief that firms would be able to find alternative suppliers was not entirely accurate, which is why it attempted “to reduce the pain” with some rollbacks, Lovely said. “One can very glibly say, ‘Well you can just get it someplace else,’ and that just seems to be completely ignorant of the reality that there aren’t alternative suppliers.”
The U.S. was comfortable with China in earlier years as long as it produced low-cost goods for U.S. consumers, said Wharton emeritus management professor Marshall W. Meyer, who is also a longtime expert on China, in a separate interview. “However, once China announced that it would compete at the high end of the value chain and directly with us, U.S. policy shifted sharply and the Trump administration took actions aimed at thwarting Chinese aspirations.”

The current tariff war and U.S. actions like declaring that Chinese firms like Huawei are agents of the Chinese government are manifestations of that shift, he explained.

Erosion of Business Confidence

If the proposed new tariffs take effect, the biggest impact would be on U.S. “business confidence and business expectations,” said Lovely. In the initial stages of the tariff moves against China, U.S. businesses viewed them as “preliminary and temporary,” she recalled. “The administration has always promised us a big win and a reset of the relationship [with China] that would open up new opportunities for American businesses. As it gradually becomes clearer that that’s not where this is going to end up, businesses start to rethink investments and they see their costs going up.”

As businesses pull back on their investments, U.S. economic growth could also slow down and have ripple effects elsewhere in the world, she warned. Some of that may also have been deliberate, Lovely suggested. “Making the Chinese economy grow more slowly may be part of a ‘make them-hurt-until-they-give’ strategy,” she said. “But it’s also bad for the global economy. We have to remember that the U.S. is the second-largest exporter in the world. So what happens outside of U.S. borders still remains important to U.S. businesses.”

Levy explained why businesses are also complaining that the new tariffs will hurt their competitiveness. “The secret to how many American businesses have managed to be competitive is that they do parts of the production process in the U.S. using those skills we have and the capital we have. But they complement that with work that occurs in other countries. You put it together and have a competitive product. If you cut the second part out of that, you don’t have a competitive product and you’re in serious trouble.”

Hastening China’s Slowdown

An escalating dispute with the U.S. would of course hurt China as well. However, China’s economy would hit headwinds even without a trade war, said Meyer. “The trade war makes the nearly inevitable slowdown in China a little more inevitable,” he added. The slowdown is inevitable because “China’s episode of high growth, above 6%, has been unusually long. Sooner or later, the law of regression to the mean operates and growth decelerates dramatically.”
Secondly, China’s GDP growth has been driven “as much or more by investment than by consumption,” said Meyer. He noted that investment as a percentage of GDP has remained above 40% since 2004 or 2005; a stimulus program now underway may increase that share. By contrast, private consumption as a percentage of GDP has dropped steadily since the 1970s and has remained below 40% since 2007, he added. “Excessive investment leads to declining returns on investment and declining productivity.”

According to Meyer, China’s growth has been at the expense of productivity in most sectors. Barring select industries such as information and communication technology, productivity has declined across industrial sectors, he said. “Sustainable economic growth isn’t possible without productivity growth. You can juice up GDP by injecting a lot of capital into the economy.” As returns on capital and productivity start to erode, China’s debt will increase, he warned.

Threat of Chinese Tech Leadership

That setting explains why the Chinese government is pushing investments in advanced technologies like AI, 5G, genomics and green energy, where there are opportunities for productivity improvement, he explained. “This shift, called Made in China 2025, is the source of the trade war,” he said. Through that program, China aspires for technological leadership, using tools like subsidies and acquisition of intellectual property rights

“If China becomes a global leader in advanced technologies, this will go hand in hand with developing sophisticated capabilities in the likely tools of 21st century warfare,” Wharton Dean Geoffrey Garrett wrote in Knowledge@Wharton last December when Huawei’s CFO Meng Wanzhou was arrested in Canada at the request of U.S. authorities. “This is why Huawei is so central to U.S. concerns. Huawei is poised to be a world leader, if not the world leader, in the rollout of 5G digital networks in the next few years — not American companies like AT&T and Verizon.” The U.S. has charged Wanzhou with multiple offenses including bank fraud and wire fraud; she faces extradition hearings in Canada beginning January 2020.

Do Business Protests Work?

Lovely said that in the first rounds of tariff increases, protests by U.S. businesses did result in some “very small adjustments” to placate them, but other than that, their complaints have been “largely ignored.” Trump has often looked at stock market sentiments as endorsement of his policies. He may feel emboldened this time around, too, as the markets have stayed “fairly steady” while businesses oppose the tariff moves, she added.

At the same time, as business testimonies are heard on Capitol Hill, members of Congress sometimes are moved to intervene, Lovely noted. She pointed to the recent threat by the Trump administration to impose 5% tariffs on all imports from Mexico unless it complied with U.S. demands on curbing illegal immigration. That prompted opposition from members of Congress, especially behind-the-scenes moves by Republicans to speak directly to Trump, and he eventually “found an alternative route,” she added.

Nine days after it made the threat to impose those tariffs on Mexican products, the Trump administration dropped the plan, and Trump claimed a victory in securing an immigration agreement. As Levy saw it, the probability of Congress acting similarly on the proposed China tariffs is “significantly higher than six months ago.”

All the same, it is unlikely that Trump would fundamentally changes his views on tariffs, Levy said. “When he speaks out about this, he says our best solution is to bring in many billions of tariffs revenue from abroad. Never mind that that’s not quite how it works.”

What the Talks Could Produce

Meyer saw two likely outcomes of the current trade dispute – one later this month and another over the long term. At the upcoming meeting in Osaka, “Trump and Xi may announce a face-saving trade ‘deal’ but it’s likely to be little more than a temporary truce since the larger strategic issues won’t be addressed,” he said. He also foresaw longer-term price impacts for businesses and consumers. “Business people will grasp that the days of China as synonymous with cheap are over, and supply chains and prices will adjust accordingly.”

Lovely also did not expect the issues to be meaningfully resolved in the Trump-Xi meeting. “We see these high level meetings creating a lot of heat but very little light in it,” she said. She noted that “very little” has come out of other high profile meetings Trump has had with world leaders in the past. “You cannot negotiate a trade agreement or fundamental changes on very difficult issues like the role of state-owned enterprises in international trade with simply a meeting between the two heads of state.”

Lovely is not optimistic about a breakthrough deal also because she did not see the right atmosphere for backroom negotiations. “What has transpired over the last six months has had a chilling effect on relations between the two countries,” she pointed out.

Typically, government officials do much of the spadework before such meetings between heads of state. “You have a lot of staff working for a long time setting everything up and then the leaders come together and they remove a few brackets and they close the deal,” said Levy. He added that it is not clear that such activity has occurred or is occurring now ahead of the Trump-Xi meeting. 
The stakes have also risen as the trade dispute has gathered momentum. Last month, it appeared that China might strike a deal by promising “some new market access, some purchases of liquid natural gas and stuff like that, but basically just accept something and call it a win,” said Levy. There was no sight of a solution that would address “deeper, structural issues,” he added.

Meanwhile, the dispute has gained other layers that make it more “compounded,” such as nationalism, animosity and national security risks, Levy noted. The U.S. had made the first move by voicing its concerns over security issues such as cyber espionage using Chinese telecom equipment, for example, and China responded that it would not be pushed around by U.S. aggression, he said. “Those [issues] are hard to peel back quickly,” he added.

Levy pointed out that no easy answers exist for issues like how China treats foreign investors, its plan to deal with cyber attacks or the acceptable level of government subsidies. For instance, with government subsidies, ”there is no chance that we’re going to snap to a right answer in six months even if we had one,” he said.

Previous U.S. administrations have attempted to achieve “slow and steady progress” to resolve those issues, but “with mixed success,” Levy said. “The Trump administration has been noted for a different approach [with China] which is, ‘We’ll hold the big stick and we’ll hit you with it if you don’t agree to the right answer.’” Lovely added: “Unfortunately, the big stick doesn’t work with big countries and particularly not with China.” According to her, that strategy is “doomed to failure.” She expected the Trump-Xi meeting to produce “a little bit of window dressing if there’s even any sign of a victory.”

Other countries are unlikely to support the U.S. strategy on China, nor are U.S. businesses, said Lovely. “It’s almost absurd on its face to think that the rest of the world will not want to be part of the growth of the Chinese economy,” she added. Along with China, businesses also have to take note of India, which is set to grow rapidly. “Businesses have to be looking at where they’re going to get their global sales and profit growth. American companies want to have better conditions for their businesses inside China. Unfortunately, they’re going to be sadly disappointed by what comes out of this in the end.”

Fresh Approaches

According to Levy, the correct approach would probably be a series of steps, such as “patient commercial diplomacy,” even if such tactics do not necessarily achieve dramatic results overnight. Here, he noted that the U.S. might have had better negotiating power with China had it stayed within the Trans-Pacific Partnership. The Trump administration pulled the U.S. out of the TPP in January 2017, shortly after Trump assumed office.

The upcoming U.S.-China talks could also cover issues such as China’s requirement that U.S. firms that desire to operate in the country must form joint ventures with local entities, instead of creating wholly owned subsidiaries. Lovely said the ability for U.S. companies to form wholly owned subsidiaries would also help address issues relating to intellectual property protection.

The U.S., on its part, must also refresh its thinking on some issues, such as government subsidies, said Lovely. “We need to have a clear view of what we think is fair trade,” she added. “Saying that all goods will be produced by private companies that have no subsidies from the government is on its face a nonstarter.” She pointed out that the U.S. might find fingers pointing at itself, where defense contracts to a company like Boeing might be characterized as a form of subsidies.

Sputnik Moment?

Meyer saw an opening for the U.S. to reclaim the narrative with China. “Why can’t the U.S. recognize that this is another Sputnik moment — that China is challenging the core of our economy, and that the U.S. will need to respond competitively rather than coercively?” The answer to that lies in the country’s leadership, he added.

According to Meyer, the immediate issues the U.S. and China are trying to resolve are merely the early signs of a larger contest. Describing them as a trade squabble is “our mis-framing of the problem,” he said. “It is a race for leadership in what are likely to be the critical technologies of the 21st century and beyond.”

Are Central Banks Losing Their Big Bet?

Following the 2008 global financial crisis, central banks bet that greater activism on the part of other policymakers would be their salvation, helping them to normalize their operations. But that activism never came, and central bankers are now facing a lose-lose proposition.

Mohamed A. El-Erian


ZURICH – In recent years, central banks have made a large policy wager. They bet that the protracted use of unconventional and experimental measures would provide an effective bridge to more comprehensive measures that would generate high inclusive growth and minimize the risk of financial instability. But central banks have repeatedly had to double down, in the process becoming increasingly aware of the growing risks to their credibility, effectiveness, and political autonomy. Ironically, central bankers may now get a response from other policymaking entities, which, instead of helping to normalize their operations, would make their task a lot tougher.
Let’s start with the US Federal Reserve, the world’s most powerful central bank, whose actions strongly influence other central banks. Having succeeded after 2008 in stabilizing a dysfunctional financial system that had threatened to tip the world into a multiyear depression, the Fed was hoping to begin normalizing its policy stance as early as the summer of 2010. But an increasingly polarized Congress, exemplified by the rise of the Tea Party, precluded the necessary handoff to fiscal policy and structural reforms.

Instead, the Fed pivoted to using experimental measures to buy time for the US economy until the political environment became more constructive for pro-growth policies. Interest rates were floored at zero, and the Fed expanded its non-commercial involvement in financial markets, buying a record amount of bonds through its quantitative-easing (QE) programs.

This policy pivot was, in the eyes of most central bankers, born of necessity, not choice. And it was far from perfect.

The Fed knew it had no power to promote genuine economic recovery directly via fiscal policy, ease structural impediments to inclusive growth, or directly enhance productivity. This was the preserve of other policy actors, which, lacking the Fed’s political autonomy, were sidelined by the inability of a deeply divided Congress to approve such expansionary measures. (These disagreements subsequently led to three US government shutdowns.)

Faced with this unfortunate reality, the Fed tried to support growth in indirect, experimental ways. By injecting liquidity using multiple means, it raised financial asset prices well above what the economy’s fundamentals warranted. The Fed hoped that this would make certain segments of the population (asset holders) feel richer, enticing them to spend more and encouraging companies to invest more.

But such “wealth effects” and “animal spirits” proved quite feeble. So the Fed felt compelled to do more of the same, which led to a host of unintended consequences and risks of collateral damage that I discussed in some detail in my book The Only Game in Town.

The European Central Bank – second only in systemic importance to the Fed – has followed a similar path, though with even more unconventional monetary policies, including negative interest rates (that is, charging savers rather than borrowers). Again, the impact on growth has been rather subdued, and the costs and risks of such measures are mounting.

Both central banks – and especially the ECB under outgoing President Mario Draghi – have stressed the importance of a timely policy handoff to more comprehensive pro-growth measures. Yet their pleas have fallen on deaf ears. Today, neither the Fed nor the ECB is anticipating that other policymakers will take over any time soon. Instead, both are busy designing another round of stimulus that will involve even more political and policy risks.

Other risks are already giving central bankers headaches. The protracted Brexit process is hampering the Bank of England’s longer-term policy strategy, while the short-term impact on global growth of governments’ weaponization of trade tariffs is complicating the task of both the Fed and the ECB.

Meanwhile, some pro-growth policies currently being mooted could, if not well designed, increase the risk of disruptive financial instability and thus further complicate central bankers’ task. The notion of a “people’s QE” – that is, a more direct channeling of central-bank funding to the population – is getting more attention from both sides of the political spectrum. So is the related Modern Monetary Theory, which would explicitly subjugate central banks to finance ministries at a time when the concept of a universal basic income is also attracting growing interest and there is a need to reassess the wage determination process.

Furthermore, some on the political left are exploring the extent to which returning to greater state ownership of productive assets and control of economic activity could improve prospects for faster and more inclusive growth. And populists in European countries with more fragile debt dynamics, including in the Italian government, seem willing to retest the markets’ vigilance by running larger budget deficits without a concurrent focus on balancing pro-growth initiatives.

Such policy proposals are the tip of a political iceberg that has been enlarged by fears about the impact of technology on the workplace, climate change, and demographic trends, as well as concerns about excessive inequality, marginalization, and alienation. These developments highlight how newly salient political issues are impinging on policymaking, rendering economic prospects even more uncertain. And with central-bank activism intensifying, the gap between asset prices and underlying economic and corporate fundamentals is likely to widen further.

Central banks bet that greater activism on the part of other policymakers would be their salvation. But these days, they are facing an increasing probability of a lose-lose proposition: either a policy response materializes but turns out to be one that risks eroding central banks’ credibility, effectiveness, and political autonomy; or nothing materializes, leaving central banks shouldering a policy burden that is already too heavy and exceeds the remit of their tools. Like seasoned gamblers, central bankers may soon discover that not all bets pay off over the longer term.

Mohamed A. El-Erian, Chief Economic Adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-Chief Investment Officer, was Chairman of US President Barack Obama’s Global Development Council. He is President Elect of Queens’ College (Cambridge University), senior adviser at Gramercy, and Part-time Practice Professor at the Wharton School at the University of Pennsylvania. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund. He was named one of Foreign Policy’s Top 100 Global Thinkers four years running. He is the author, most recently, of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.

A long economic recovery is not necessarily a better one

Recessions are a natural part of capitalism, not something to be avoided at all costs

Rana Foroohar

At the beginning of July, the US’s current economic expansion will officially become its longest one since 1854, the year National Bureau of Economic Research data on business cycles started. Unemployment is at a 49-year low. Asset prices are near record highs. And the US Federal Reserve signalled yet again last week that it was leaning towards lowering rates due to “uncertainties” in the economic outlook and muted inflation.

That intuitively makes sense when you consider how rocky geopolitics are at the moment, and how bifurcated this recovery has been, mostly favouring large multinational companies and individuals with lots of assets.

But it is also rather stunning how quickly the Fed has gone from tightening monetary policy to preparing to ease it, and concerning that the central bank will be working from a historically low rate base as it attempts to navigate the next recession, whenever it comes.

Even more disturbing, this oddly long economic cycle is not singular. A Deutsche Bank research paper looked at 34 US economic expansions over the past 165 years and found that the past four business cycles have been longer than average. In fact they account for four of the six longest cycles. Since 1982, longer cycles have become the new normal.

Why is this? Optimists would say that less frequent recessions are a result of positive structural shifts and better policy choices that have made the US economy less prone to downturns. A January Goldman Sachs research paper points to better inventory and supply chain management (much of it the result of technological improvements) and the declining share of the US economy that is linked to more cyclical sectors, thanks partly to offshoring of manufacturing. At the same time, the growth of the US shale industry has reduced the risk and impact of oil price shocks, once a major recession trigger.

Other explanations of the lengthening economic cycle highlight the ways the world economy has evolved. Technological advances and globalisation, particularly China’s reintegration into the market system and higher levels of cross-border trade, have increased productivity and growth while dampening inflation.

Meanwhile, the end of the Bretton Woods exchange rate system gave US central bankers more freedom to extend economic cycles, because they no longer had to worry about maintaining a fixed relationship between gold and the dollar.

The result was fewer recessions but also a rise in both public and private debt, as governments worldwide were able to fund more deficit spending, and companies took advantage of low rates set by central bankers who could be less focused on price stability, once Paul Volcker tamed inflation in the 1980s.

Debt has papered over myriad problems in the US economy in recent years, from rising inequality to stagnant wages. It also helps mediate squabbles between various political interest groups. Both Republicans and Democrats have largely embraced a “markets know best” approach since the 1980s because it allowed them to avoid making unpopular choices about dividing up the national wealth pie.

Why choose between guns and butter when you could simply deregulate markets, unleash the financial sector, and hope rising asset prices would let you turn the other way?

All this begs the question of whether longer really is better when it comes to business cycles. Recessions are a natural and normal part of capitalism, not something to be avoided at all costs. Indeed, the Deutsche Bank economists argue that productivity would be higher and American entrepreneurial zeal stronger if the US business cycle had not been artificially prolonged by monetary policy.

But the longer the period of expansion, the harder it is to take away the punch bowl. I agree that policymakers did have to intervene after the 2008 collapse of Lehman Brothers to avoid a bigger downturn — the human costs were already too high. But I also do not believe, as some optimists do, that “this time is different”.

Long periods of expansion invariably result in too much leverage, followed by a correction, and usually a recession. Non-financial corporate debt, which tends to rise until a recession hits, has exceeded prior peaks and gone from 35 per cent of US gross domestic product in 1985 to 46 per cent today. Yet corporate bond default rates have been at very low levels for a decade and a half.

I worry about what will happen when investors and traders put those two facts together and start pricing in a rise in defaults. It makes me wish that perhaps US policymakers had opted for smaller, more frequent doses of pain rather than brewing up history’s longest expansion.

The White House wants to keep the music playing at least through the 2020 election. President Donald Trump this week blasted the European Central Bank head Mario Draghi on Twitter for “unfairly” promising “more stimulus” and then hinted he might demote Fed chair Jay Powell if he failed to do the same. Mr Trump’s tirades remind me of my kids when I’ve let them stay up too late and eat too much ice cream. Maybe a tech productivity surge will eventually come along and turn this market-driven recovery cycle into something that spreads prosperity more widely. More likely there will be hell to pay for leaving the lights on too long.

Why Gold and Gold Mining Stocks Are Appealing

By Andrew Bary 

Photograph by Michaela Handrek-Rehle/Bloomberg

Gold prices hit their highest level since 2013 this past week, an indication that investors increasingly view the often-maligned metal as a good alternative to paper money and government bonds at a time of accommodative monetary policies around the world.

Gold climbed to $1,446 an ounce before ending on Friday at $1,425. The metal is up about 1% on the week and 12% so far this year, but remains well below its peak of $1,900 an ounce in 2011.

With gold rallying, gold stocks got a lift. The VanEck Vectors Gold Miners exchange-traded fund (GDX) gained 7% for the week, to $27.98. It is up 32% this year, outperforming gold.

Mining stocks tend to be more volatile than gold because their earnings are sensitive to changes in the price of the metal. The largest two stocks in the Van- Eck ETF are Barrick Gold(GOLD) and Newmont Goldcorp(NEM).

Barron’s argued in a cover story last September that gold, then trading near a low for 2018 at around $1,200, looked appealing, as did depressed gold stocks.

Gold tends to do well when inflation-adjusted interest rates are low. That is the case now, with $13 trillion of government bonds (mostly in Europe) carrying negative interest rates and the benchmark 10-year Treasury note at just 2.06%. The Federal Reserve, meanwhile, appears certain to cut short rates later this month; the only question seems to be how much.

Ray Dalio, founder of the world’s biggest hedge fund, Bridgewater Associates, recently promoted gold as an investment that does well “when the value of money is being depreciated and domestic and international conflicts are significant.”

Gold is also the anti-dollar. President Donald Trump wants a weaker dollar to make U.S. exports more competitive. And gold looks cheap relative to Bitcoin, which has more than doubled this year, to around $10,000.

Historically, gold has been a store of value and a reasonably good inflation hedge. There are an estimated six billion ounces of gold in the world, worth more than $8 trillion. Gold newly minted each year represents less than 2% of the total supply. Many major producers are struggling to maintain output given a dearth of world-class projects and political and environmental obstacles. Central banks led by Russia had their highest first-quarter purchases of gold since 2013.

Gold stocks aren’t cheap, but they rarely are. Investors typically give them “option” value, as earnings tend to get a boost when gold prices rise. Barrick Gold, at $17, is up 27% this year and now trades for 39 times projected 2019 earnings of 44 cents a share, while Newmont, at $39, changes hands at 28 times estimated 2019 earnings of $1.39 a share.

Barrick could be the better bet. Both companies are benefiting from the combination of their large Nevada operations, which should produce $500 million in annual benefits, with Barrick getting more than 60%.

CIBC analyst Barron’s argued in a cover story last September that gold, then trading near a low for 2018 at around $1,200, looked appealing, as did depressed gold stocks.

Investors may want to get direct exposure to gold through ETFs like the SPDR Gold Shares(GLD). Then there are mining-stock ETFs like the GDX and the VanEck Vectors Junior Gold Miners ETF (GDXJ), as well as individual stocks.

Gold exposure of 5% to 10% in a portfolio might not be a bad idea now.