Of Central Bankers, Monkeys, and John Law

John Mauldin

Back in April, my good friend Charles Gave, Chairman of Gavekal, penned a short but brilliant piece in which he likened central bankers to a bunch of monkeys in a cage. In the unforgettable “Of Central Bankers, Monkeys and John Law,” he proceeded to run down the parallels between France’s 18th-century “Mississippi Bubble” and the situation in the Eurozone today.

Now Charles has given us a follow-up, titled “The Apex of Market Stupidity,” in which he regales us with a sardonic but spot-on recap of the sundry ways in which market participants and analysts have been witless over the years. And just last week, he says, we scrambled, clawed, and algoed our way to the very summit of market stupidity, when European markets were routed by the failure of ECB Chairman Mario Draghi to be sufficiently dovish.

Thus, Charles concludes, we now find ourselves in a world where “value in the financial markets is no longer a function of the discounted cash flow of future income, but instead is determined by the amount of money the central bank is printing, and especially by how much it intends to print in the coming months.”

This distortion of the basic tenets of investing is leaving otherwise rational market participants feeling like they are living in an alternate universe. Of course, reality will eventually reassert itself; but as Keynes famously said, “The markets can stay irrational longer than you can stay solvent.”

For today’s Outside the Box I bring you both of these pieces, which not only make for fun reading, as Charles is such a great writer, but will also help you understand a bit more about the psychology of the marketplace.

I want to offer a comment on Donald Trump’s latest contretemps – that we should not allow Muslims into this country for a period of time. That may be simply the most boneheaded, ill-conceived idea I have heard from a politician in my life, which is saying a lot, given Bernie Sanders’ recent suggestions for cutting carbon emissions by 80% by 2050, which is merely impossible without creating a multi-decade depression in the United States.

Aside from the Constitutional, ethical, and practical problems, closing the border to arbitrary groups, even temporarily, would cause enormous economic damage. Muslim-majority countries would certainly retaliate by barring Americans and/or Christians. The result could be a trade war at least as bad as that brought on by the old Smoot-Hawley tariffs, with people as the weapons and no resulting benefit to national security.

My associate Patrick Watson offered a very succinct thought on Twitter that is in the process of going viral (he is @PatrickW). Here’s a cut-and-paste of it:

Trump simply offers to ISIS and other Islamic terrorists a further rationale for their hatred of the West: “See, it’s just like we said. The West doesn’t just want to go after us; it wants to destroy all of Islam. They hate us, which is why we must fight back. Everything we do in our jihad is justified because of their actions.”

Whether or not their point of view makes sense to us is beside the point. They will take Trump’s words and talk about how well he is doing in the polls and say this is how most Americans feel. Forget the fact that this may be the most unconstitutional idea I have ever heard from a major candidate (has he read the First Amendment?), his proposal is simply offensive on so many levels. To characterize an entire major world religion as comprising nothing but extremists is just not right.

The United States was first settled by religious refugees, and more than a few of your and my ancestors came as refugees from religious persecution, poverty, or oppression by brutal governments. They were seeking freedom and opportunity.

We are a land of immigrants and we have an immigration process, and we have never had a religious requirement as part of that process. That would be unconstitutional and decidedly un-American. And yes, I get that many Muslim states are not taking in refugees, and all the rest. That isn’t any excuse for America to be anything less than the beacon on the hill that we are supposed to be.

Okay, let me just say it right here (even though this is going to anger more than a few of you): Donald Trump is the only man in America who could get me to vote for Hillary Clinton. You have to understand that my distaste for the policies that Mrs. Clinton would institute is monumental. I can’t tell you how bad a continuation of the current political climate would be for this country. But to have a loose cannon like Donald Trump in the White House – a man who could say and do just about anything at any time, with no control of his ego – would be too much.

Think about it for a moment. He is president, and basically, no one gets to tell the president no if he really decides he’s right. Sometimes that has worked well for the country, and at other times it has been a disaster. Donald Trump looks like a walking, talking, shoot-from-the-mouth-with-my-latest-greatest-idea disaster to me.

Trump continually spouts so-called solutions, and when asked how he would accomplish them, he just says, in essence, “I’m Donald Trump. I’m a world-class negotiator. I can just go to the bargaining table and get what I want.” When he says that ISIS would cease to exist under his administration but then offers no realistic plan as to how he would accomplish that, he reveals himself for the egotistical fool that he is. He really has no notion of history or military context or the impact of geopolitical decisions.

And now that I have offended a substantial number of my readers and probably even lost a few, I had better hit the send button before I get into even deeper trouble. Have a great week, and take comfort in the fact that 80% of Republicans haven’t decided who they will vote for, so that means Donald Trump is getting 25% of the 20% who have a favorite. I have to admit that I’m firmly undecided but would be happy with any one of five or six of them. They are probably not the same five or six you would choose, but I bet there would be some overlap.

Your trying to figure out what’s driving both politics and markets analyst,

John Mauldin, Editor
Outside the Box

Of Central Bankers, Monkeys, and John Law

By Charles Gave
April 17, 2015

A revealing experiment involved monkeys being placed in a cage with a pile of nuts stashed on an upper level. Their efforts to snaffle the food caused them to be doused in water, blasted with a siren and startled by an electric shock. After a number of attempts the monkeys gave up. Later, a second group of monkeys were introduced—the new entrants made a beeline for the goodies, but were quickly beaten back by the chastened first group of monkeys. Finally, this first group were removed from the cage and replaced by a fresh contingent. The new monkeys immediately made a dash for the nuts, but were beaten back by the second group; i.e., those who had never experienced the cold water, siren or shocks.

It does not take a wild imagination to see a parallel between our monkeys and central bankers. For generations central bankers were cowed by their inflation-scarred colleagues and accepted that the top of the cage was off limits. But then a rebel monkey, erh central banker, emerged in the shape of Alan Greenspan. As the gorilla in the pack he persuaded the rest that the fruits at the top of the cage may not be forbidden. The result of this “bravery” in economic policymaking has been two huge financial crises.

The funny thing is that the general public remains grateful to the central bankers since their “new-fangled” actions to “save” the world economy appear to be working. For the most part our monetary guardians have escaped responsibility for the crashes, with popular ire focusing instead on “nasty” commercial bankers. The concern must be that few experiments (certainly in economics) are “new”, except for those which ignore history. And, of course, to quote philosopher George Santayana “Those who cannot remember the past are condemned to repeat it”.

History has thrown up multiple attempts to create wealth by printing money from the Song Dynasty in China to renaissance era Italian bankers, through revolutionaries in France and their Assignat notes, to the more recent case of Zimbabwe. However, one of the most revealing cases took place in the early 18th century when France was ruled by the boy king Louis XV and power was exercised by his uncle, the Regent.

Heroes and villains

This story has two protagonists: the first being a classic villain in the shape of John Law, a Scottish professional gambler, who can been thought of as a proto Mario Draghi. Our hero was Richard Cantillon, an Irishman, whose actions shared similarities with Georges Soros, the investment manager who in 1992 forced the pound to leave the European exchange rate mechanism. Back in the early 18th century France was almost bankrupt because of the wars that accompanied the end of Louis XIV’s reign. As a result, the French “rente”, the equivalent of today’s OAT, was selling at a huge discount to its face value.

Enter John Law who presented the Regent with a simple solution to the kingdom’s straitened financial situation: the government would grant a client company “La Compagnie des Indes Orientales” (CIO) a monopoly to conduct international trade between France and French colonies in the new world. Later CIO would become Banque Royale as its notes were to be guaranteed by the crown. Law would arrange for shares in CIO to be sold to the public, allowing payment to be made using the discounted French rente at full value, rather than its discounted market price. The price of the shares, and also that of the rente, went through the roof, which we have come to recognize as the usual response to a quantitative easing program. Since the run lasted quite a while, it led to a remarkable boom, centered on the Palais Royal in Paris and the luxury industries.

At this point, Cantillon joins the story. He was an astute financial operator who, sensing an opportunity, decided to move to Paris. He quickly had three key insights:

  • No new wealth was being created in France; rather there was just a massive increase in the monetary value ascribed to older assets. In fact France was getting less, rather than more competitive. He went short the French currency and long the British pound, a trade which eventually made him a ton of money.
  • The main beneficiaries of the artificial wealth being created were those cronies closest to the Banque Royale which had been granted the trade monopoly. This phenomenon was later called the “Cantillon effect”.
  • The system could work only as long as nobody asked to be repaid in real money, at that time gold.

When Cantillon started to see great French aristocrats (those close to the Banque Royal such as Prince de Conti) selling their shares against gold he opened up a large short position, and made out like an (Irish) bandit. When the system imploded, he was sued for both shorting the French currency and also being short the shares of the colonial monopolist. He won, as at that time the courts in France were genuinely independent.

Fortunately, he committed his analysis to paper in the book “Traite sur la nature du commerce” which is a must-read for anyone interested in financial speculation. Schumpeter spoke highly of Cantillon, who was probably the first economist to clearly distinguish wealth from money. He recognized the distinction between asset prices rising due to an economy becoming more productive rather than as a result of a massive expansion of the supply of credit. In the second case, the value of money is going down versus the price of assets, which is a form of inflation.

This audacious attempt to monetize asset prices by printing money resulted in ruin for the French middle class, which had sold its weak but solvent French rente against worthless shares. What followed was a collapse in the credit sphere followed by a great deflation. The lesson is that a huge inflation in asset prices is seldom followed by inflation in retail prices; rather once asset prices start deflating what usually follows is a deflation in retail prices (see “The Debt Deflation Theory Of Great Depressions” by Irving Fisher).

The stability of the system was predicated on the guarantee that French government bonds could, if asked, be repaid in gold, and the same for the shares in CIO. At the peak of the “Mississippi Bubble” the Banque Royale had 4mn francs in its vault and outstanding notes totaling more than 100mn francs. So when the consummate insider, Prince de Conti, started to convert his positions for gold, the system began to collapse. Within a year the CIO share price had fallen by more than 80%. From start to finish, the episode lasted a little more than three years.

Why I am recounting this old story? Because we are at it again. Simply replace the French rente with current Italian or Spanish Bonds; the Regent with Francois Hollande; John Law with Mario Draghi and it is clear that very little has changed. My hope is that most of our clients will end up following Cantillon rather than face the predicament of France’s ruined middle class at such time that latter day Prince de Contis cash out.

In the current system, gold is being replaced by the willingness of Germans to keep accumulating financial assets issued by the rest of Europe, which will never be repaid. The ratio that exorcised Cantillon was the value of the gold stock / the value of engagements; the modern equivalent may be the net external balance of Germany vs the rest of Europe with Angela Merkel or the Bundestag playing the Prince de Conti.

And what has Mario Draghi, in the role of John Law, done to prolong the agony? He has manipulated the cost of money by increasing the quantity of money, or, at least, promised to do so in the hope that speculators front run the ECB. They have, of course, duly obliged. And what happened during the Mississipi Bubble is now unfolding in our time. The increase in the quantity of money in itself cannot lead to an increase in wealth. For confirmation, consider the case of Italy as shown in the chart below.

The blue line is the ratio between the Italian and the German industrial production indices. From 1960 to 2000, Italian industrial output grew faster than its German equivalent by 48%. However, since 2002, the Italian measure has declined 40% versus that in Germany. As a result, the Italian stock market, which outperformed the German market between 1970 and 2002 by a robust 250% (in common currency terms) has, since 2002, underperformed by 60% (red line, right scale). I have few doubts that a modern day Cantillon would have been short the Italian stock market versus the German one at least since 2002.

Indeed, it is clear that wealth creation in Italy has effectively stopped, as shown by the fact that since 2000 the economy has spent three quarters of its time in recession. Indeed, measured in absolute terms, industrial production today is 25% below where it was in 2000.

Of course, the only sensible approach for a heavily indebted country which has seen growth disappear would be to devalue its currency. Since that option was off the table due to the strictures of the euro system, the bond markets, from 2008 onwards started to play the default game. By 2012, spreads had opened to such an extent that it should have been obvious that the euro was doomed (see bottom pane of the chart above).

At this point “Derivative Draghi” did his worst and promised to do “whatever it takes”. The bond markets understood this as a promise that the ECB would buy Italian, Spanish and Portuguese government bonds. As a result, yields promptly collapsed. But, and this is a big but, the Italian economy kept shrinking and the German economy kept expanding. If the policy had succeeded, one would have expected the expression of the relative return-on-investment in the two economies (namely the ratio between the two stock markets indices) to change direction.

Nothing of the sort has happened. In fact, the Italian government can now borrow at 1.5% or so, while the average growth rate of the Italian economy has been -1% for the last two years. Italy was and remains solidly in a debt trap; debt as a share of GDP will keep rising as long as the 10-year yield is above -1%. The problem is that negative rates destroy a country’s savings industry and thus its long term growth rate. The same is true for France or Spain, not so much because interest rates are too high but because both countries have massive primary déficits.

So what should the savvy investor do? Remember Richard Cantillon and do not trust John Law. Stay short the Italian stock market versus the German one (equivalent to CIO stock in 1717). Remain short the German bond market versus the US (equivalent to being short the French currency vs. the British one in 1717).

The Apex Of Market Stupidity

By Charles Gave
December 8, 2015

In some 40 years of watching financial markets, my dominant emotion has been a mixture of curiosity, amusement and despair. It seems the stock market must have been invented to make the maximum number of people miserable for the greatest possible amount of time. The bond market, meanwhile, has just one goal in life: to make economists’ forecasts for interest rates look even more silly than their other predictions.

Over the years I have often observed how most market participants are able to concentrate on only one set of information at a time. For example, in the 1970s, the only data release that mattered was the consumer price index. In the days leading up to the CPI’s publication, everybody dropped all other considerations to speculate feverishly about what the number might be. And then following the release, they would spend the next week or two commenting sagely on what the number actually had been. Eventually Milton Friedman convinced the Federal Reserve (and from there the markets) that there was some kind of relationship between the money supply and the CPI. So everyone stopped looking at the CPI, and instead started to focus on the publication every Thursday evening of M1 (or was it M2?). Inevitably each week would see an immediate rash of commentary on these arcane matters from the leading specialists at the time, Dr. Doom and Dr. Gloom.

This gave way to a period in which the US dollar went through the roof on the covering of short positions established during the era of the minister of silly walks in the 1970s. For a few years, the only thing that mattered was the spread between the three-month T-bill yield and the three-month rate on dollar deposits in London (an indication of the shortage of dollars outside the US). The beauty of this one was that the scribblers on Wall Street could comment on it twice a day or more, which of course had no discernible impact on reality, except for the destruction of the forests needed to print so much waffle.

That era came to an end in 1985 with the Plaza Accord. At that point the Fed, under the wise guidance of Paul Volcker—my favorite central banker of all time, probably because he was the only one without a PhD in economics, which may well explain his success—decided it was going to follow a type of Wicksellian rule-based policy under which short rates were kept closely in line with the rate of GDP growth. Of course, this meant the Fed paid little attention to the vagaries of the financial markets, so there was very little to comment on. The result of policymakers’ lack of interest in financial markets was that from 1985 to 2000 the US enjoyed a long period of rising economic growth, low inflation, low unemployment and high productivity; a period dubbed “the great moderation”. The trouble was that no one was able to make any money trading on inside information provided by the politicians and central bankers. As an advertisement for Sm ith Barney put it at the time: “We are making money the old way. We earn it.”

Naturally, that wouldn’t do at all. After nearly 20 years of economic success, the US budget was in surplus, the pension funds were over-funded, and the “consultants” in Washington were on the verge of bankruptcy, having nothing to say. Clearly something had to be done, and it was: policy shifted to accommodate Wall Street, with forward guidance, negative real rates, the privatization of money, and a lack of regulation. This allowed Wall Street to make money, but it created nightmares elsewhere through the ever-successful euthanasia of the dreadful rentier.

Still, the shift to an economy driven by the decisions of central bankers meant the market commentators were back in business in a big way. For the last 12 years, the only thing that has mattered has been to know whether or not the chairman of the Federal Reserve has had a good night’s sleep. Similarly in Europe, the dysfunctional euro, created by a bunch of incompetent politicians and Eurocrats, bred drama after drama. Since nobody wanted to admit it was a failure, the most important man in Europe became the president of the European Central Bank.  

In the last week, we have reached what is surely the apex of this stupidity. A bunch of algo traders programmed their computers expecting “Derivative Draghi” to be extremely dovish, as any proper Italian central banker should be. I am not sure I understand why, but some traders obviously decided that he had not been dovish enough. European stock markets plunged by -4%, while the euro went up by roughly the same amount in the space of a few minutes. What that means is simple: value in the financial markets is no longer a function of the discounted cash flow of future income, but instead is determined by the amount of money the central bank is printing, and especially by how much it intends to print in the coming months. So we are in a world where I can postulate the following economic and financial law: variations in the value of assets are a function of the expected changes in the quantity of money printed by the central bank. To put it in a format that today’s economists understand:

Δ (VA) = x * Δ (M), 

where VA is the value of assets and M is the monetary increase.

What we are seeing is in fact in one of the stupidest possible applications of the Cantillon effect, whereby those who are closest to the money-printing, i.e. the financial markets, are the biggest beneficiaries of that printing. This is exactly what happened in 1720 in France during the Mississippi Bubble inflated by John Law. The end results were not pretty (see “Of Central Bankers, Monkeys And John Law” [above]).

What I find most hilarious is that some serious commentators have been pontificating at considerable length about what the market’s participants think. These days, some 70% of market orders are generated by computers, and many of the rest by indexers. And computers do not think. They simply calculate at light speed, which allows them to react to short term movements in market prices as they were programmed to do. And since they are all programmed the same way, the result is some big short term market moves. In essence, these computers act as machines that allow market participants to stop thinking. As a result, I cannot remember a time when less thinking has ever been done in the financial markets, which is why I find today’s financial markets infinitely boring.

We are swimming in an ocean of ignorance, just like France in 1720. It seems all the painful economics lessons learned over the last 300 years have been forgotten.
I suppose that means we will just have to wait for another Adam Smith to appear.
La vie est un éternel recommencement...

Up and Down Wall Street

Commodity Rout: Only The End of the Beginning

Slashing dividends and expenses are just the first step to bring oil and metal supplies in line with demand.

By Randall W. Forsyth         

“This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Winston Churchill’s assessment of the Battle of El Alamein brings to mind the dramatic actions of a whole host of major commodity producers confronting the collapse of prices from petroleum to metals to agricultural goods. But rather than victory, their sharp cutbacks represent tactical retreats that are necessary in order to fight again another day.
This week alone has seen an onslaught of dividend cuts, most prominently by Kinder Morgan its payout.
And even with a 7% pop Wednesday after Wall Street analysts defended the stock, Bary writes the worst isn’t over for the Kinder Morgan shares.
That was followed by mega-miner Freeport-McMoRan’s suspension to its dividend to husband $240 million in cash while slashing capital spending. Meanwhile, BHP Billiton ( BHP ) yields nearly 10%--that is, if its current dividend is maintained, about which the market evinces some skepticism at these prices.
cat   Ore at Freeport McMoRan Inc.'s Grasberg copper and gold mining complex in Papua province, Indonesia. Photo: Bloomberg News            

Payout reductions or eliminations are relatively benign compared to the dramatic and traumatic actions seen at Anglo American, the U.K.-based mining giant that announced a major restructuring that will see about two-thirds of its workforce—some 85,000 jobs—eliminated, along with the suspension of its dividend. Following that news, Anglo American overtook Glencore, the Swiss-based mining giant, to be the year’s worst performer in London’s FTSE 100, the U.K. Telegraph observed, both having shed more than 70% in the mining rout this year.
Finally, American chemical giants Dow Chemical and DuPont were reported in serious talks to merge and then split up into three operating units, ostensibly to reap “synergies”—read headcount reductions—while satisfying antitrust concerns. Shares of both jumped about 10% Wednesday as the moves were seen as a response to the ongoing slump in commodities prices.

The old saying in the commodities pits is that the cure for high prices is high prices, and vice versa. Expensive goods result in demand destruction and then expanded supplies; think of hybrid and electric autos and fracking in reaction to oil prices rising past $100 a barrel starting back in 2008.

Now that prices for everything from oil to coal to iron ore to copper have collapsed, producers are being forced to cut back, slashing or eliminating dividends, payrolls and capital expenditures. And they’re pursuing mergers to writing out costs, with giants such as Dow and DuPont reportedly getting together to further those efforts, just as Exxon and Mobil did during the oil slump late in the 20th century to form ExxonMobil  to reassemble major parts of John D. Rockefeller’s Standard Oil.

Is this the end of the beginning? Based on some stock moves, some investors think so. The Materials Select Sector SPDR exchange-traded fund traded up 3% Wednesday while the Energy Select Sector SPDR gained 1.3%. That was on a day when the broad market represented by the SPDR S&P 500 ETF was off 0.8% and big tech tracked by the PowerShares QQQ Trust fell 1.5%.
The Battle of El Alemain took place in 1942. That year also saw the Battle of Midway, arguably the end of the beginning of the Pacific War, less than a year after the attack on Pearl Harbor.
But much fighting and many casualties still lay ahead before victory by the Allies.
In economic cycles, the central bankers are the generals, commanding forces as never before.

The so-called Commodities Super Cycle that lifted off in the past decade was fueled by the expansionary policies of the developed world that helped to fund the unprecedented boom in China. Unlike the classic inflation of “too much money chasing too few goods,” this cycle saw the expansion of supply in mining, metals and energy production, aided by new technologies such as fracking.
As China slows, there’s a surfeit of supply—of both commodities and the debt taken on to finance the expansion. On balance sheets, assets are being written down while the liabilities remain unchanged. On income statements, as revenues decline, companies are trying to slash expenses. The result is cash outflows, which puts real pressure on the firm to put their finances in order.
That’s the stage where these firms stand now. The problem is that there likely has to be more pain before a payoff.
Danielle DiMartino Booth, who offers her keen insights with our friends at the Liscio Report, observes in a recent trip to Dallas that some of the excesses pumped up in the oil boom are beginning to give way. But there’s more to come, she writes:
“Being familiar with the business of pulling black gold out of the ground, many Dallas private equity firms saw fit to lead the charge into the financing of the shale revolution. The damage will thus not be readily apparent until a good number of companies in the space run out of breathing room. One-in-five U.S. oil producers are hedged between $80 and $85 a barrel. The New Year will bring a crude reality to these companies whose lenders have been so badly burned they’re disinclined to extend a lifeline.”
The crash in West Texas crude to the mid-$30-a-barrel level thus just marks the end of the beginning of the campaign. As the hedges come off and credit lines get pulled, the real casualties will begin to rise. Only then will supply come into balance with demand, which still lies ahead.

What Would a Fed Interest Rate Hike Mean for Markets?
What Rate Hike? Markets Seen Shrugging Off Coming Fed Move 

The Federal Reserve’s plan to raise interest rates has had one of the longest drumrolls in history. At least, it seems that way. Speculation about when the hikes would begin, and how big they would be, has been going on for, well, years.

But this time, it seems, they really mean it. Comments made at the October meeting of the Federal Open Markets Committee all but guaranteed a 0.25% hike in its target for the fed funds rate at the mid-December meeting, raising it from near zero, where it’s been for seven years.

“I think global risks have receded,” says Wharton finance professor Jeremy Siegel, explaining why the Fed is likely to move now. Most importantly, he says, there is improvement in the U.S. job market. The Chinese markets and economy also appear to be stabilizing, he adds, reducing the danger of ripple effects from that big player. With the U.S. economy on more solid ground, the Fed can start a slow series of rate increases to head off any future inflation, Siegel says.  

But he expects the pace to indeed be slow, with the Fed perhaps foregoing increases at some meetings as it watches the economy’s reaction to each move.

The fed funds rate, which banks charge each other for overnight loans, was over 5% in early 2007, but has been kept near zero since late 2008 to encourage borrowing to stimulate the economy. The Fed has less control over long-term rates that guide things like mortgage rates, but an increase in short-term rates can nudge long-term rates up, unless the marketplace thinks conditions will sour.

Fed Chair Janet Yellen told Congress on Dec. 3 that she saw no reason to delay plans to start a slow-paced series of rate increases in December. Delaying too long, she said, could force more abrupt hikes later, which could be disruptive. On Dec. 4, a strong government employment report further strengthened the odds of a December rate increase. U.S. stocks rose, suggesting that good economic news trumps concerns about the negative effects from higher rates, such as steeper borrowing costs.

A Turning Point

A quarter-point rate increase is normally not such a big deal. But this one has an outsize importance because it will be the first increase in so long. It marks a turning point, with the Fed finally believing the U.S. economy is gathering steam.

But what does it mean, really?

“A 25 basis-point [hike] in itself … I don’t think people view that as, per se, something that should affect things that dramatically,” says Wharton finance professor Amir Yaron. “It’s more about what will happen going forward, and at what speed.”

Generally, the U.S. economic indicators for growth, employment and inflation are good, and Siegel says he expects meaningful improvements in worker productivity as well.

But there are a few clouds on the horizon. A late-November story in The New York Times, for instance, noted falling investor demand for various securities based on the risky types of debt, even though those securities offer higher yield than safer alternatives. About the same time, a Deutsche Bank Credit analyst noted ominously that poor performance in junk bonds compared to investment-grade bonds and stocks mimics a pattern seen in early 2000 and late 2007 — a pattern followed by market blow-ups. Performance of junk — or high-yield bonds — reflects views on companies deemed most at risk of running into trouble, offering an early warning of worsening conditions.

But these speculative markets tend to be jittery, as players often make short-term bets on modest changes in conditions. Over the longer term — a year or two or more — Wharton experts just don’t see major problems looming.

Ending Uncertainty

“The [FOMC] policy uncertainty is worse than the [likely effect of a] raise at this point,” Siegel said in late November, describing market jitters about change. “You have to see that the world will be left standing after the first raise…. We have to get the first raise out of the way.”

One of the Fed’s key priorities is to rein in inflation, and Yellen has said she expects inflation to rise over the next couple of years to the Fed’s target level of about 2%. The Consumer Price Index rose a mere 0.2% in the 12 months ended in October, but the core inflation rate, which excludes food and energy, was up 1.9%. By raising rates and making it more expensive to borrow, the Fed hopes to dampen spending a tad, making it harder for inflation to get a foothold.

But although the Fed is focusing on inflation, Siegel says there’s “no danger” that damaging levels of inflation will be here soon. Over the long term, inflation averages around 3% a year.

However, he says, the unemployment rate continues to go down so the Fed “must act preemptively,” which is why a small rate hike makes sense now.

Falling unemployment can force employers to raise wages to attract workers, sparking inflation. But Wharton finance professor Bulent Gultekin argues that cycles of wage-driven inflation are likely to be more modest in the future because of globalization. If wages in one country rise too fast, employers can move production to another.
“There is a lid on wage inflation in the United States and elsewhere, so I don’t anticipate that inflation will jump all of a sudden.”   –Bulent Gultekin
“The world economy is more interconnected,” Gultekin explains, adding that “as a result there is a lid on wage inflation in the United States and elsewhere, so I don’t anticipate that inflation will jump all of a sudden.”

Nor is there much chance inflation will be stoked overseas, he continues. “I think the world economy is moving into a slow-growth stage,” he says, citing China and Europe. “The U.S. is the only economy that seems to be moving forward … and it’s not sufficient to be the engine of growth for the rest of the world at this point.”

“There is probably a new normal which will keep interest rates below long-term averages for quite some time now,” adds Wharton finance professor Itay Goldstein. “There are several contributing factors to it including lower rates worldwide and lower growth due to changes in the labor market and due to changes in productivity.”

How will a measured pace of rate hikes affect stocks and bonds?

Some have worried that low rates on bonds have driven money to the stock market, pushing prices higher than they should be as investors chased higher returns. A Fed rate hike would boost the allure of new bonds but also make borrowing more expensive for companies and consumers — slowing down growth and reining in stock prices.

“An increase in rates will put a downward pressure on bond prices and stock prices and, if not handled correctly, could lead to a rush of investors out of funds and markets, which could aggravate the effect on prices,” Goldstein says. But, he adds: “This concern will further contribute to the tendency to increase rates much more slowly and to a lower level than in the past.”

But then again, this hike might not hamper stocks.
“To me it’s still about, do we find healthy growth and with it employment [growth]? Those will be the signs that we are back on the trajectory the economy needs to be on. I don’t think we are there yet.”    –Amir Yaron
There have been only four series of rate hikes over the past 30 years, and effects were mixed.

“Conventional theory of rising rates suggests that stock markets dip as the cost of capital increases for firms,” says former Federal Reserve analyst Jonathan Hill, director of investments for Gibraltar Private Bank & Trust. “I would suggest this is a negligible problem this time around with rates at all-time historic lows.”

Boon for Stocks?

Siegel says, “My feeling is [a rate hike] will clear the air and we could see a good [stock] market rally after the announcement.” He said he would not be surprised to see U.S. stocks gain 10% to 12% over the next year.

Though higher rates on new bonds can make older, stingier bonds less attractive, driving their prices down, Siegel does not think a small rate hike will affect existing bonds that much because an increase has been expected for so long that its effects are already reflected in bond prices. Nor does he expect much impact on the dollar.

That means a small Fed move is also unlikely to cause a spike in mortgage rates or other consumer loan rates, he adds.

Liz Ann Sonders, chief investment strategist at Charles Schwab, says yields on two-year Treasury notes are the highest in five years at over 0.9%, reflecting the market’s expectation of a Fed hike. But yields on 10-year Treasuries have not gone up as fast, sitting at about 2.2%.

“This suggests the Treasury market is still in the early stages of responding to an initial rate hike,” she says. “The market is likely expressing skepticism about the economy’s growth trajectory and/or the likelihood of inflation accelerating much from current levels.”

Going forward, Yaron thinks bond yields and lending rates will remain low by historical standards, and he does not expect the Fed to resort to more dramatic moves anytime soon.

“To me it’s still about, do we find healthy growth and with it employment [growth]?” he says.

 “Those will be the signs that we are back on the trajectory the economy needs to be on. I don’t think we are there yet.”

Chinese devaluation is a bigger danger than Fed rate rises

The yuan has fallen to the lowest in five years against the dollar. If China devalues in earnest, it will be an earthquake

By Ambrose Evans-Pritchard

Chinese Premier Li Keqiang has vowed to avoid devaluation, but he is not fully in control

Chinese Premier Li Keqiang has vowed to avoid devaluation, but he is not fully in control Photo: AP
The world has had a year to brace for monetary lift-off by the US Federal Reserve. A near certain rate rise next week will come almost as a relief.

Emerging markets have already endured a dollar shock. The currency has risen 20pc since July 2014 in expectation of this moment, based on the Fed's trade-weighted "broad" dollar index.
The tightening of dollar liquidity is what caused a global manufacturing recession and an emerging market crash earlier this year, made worse by China's fiscal cliff in January and its erratic, stop-start, efforts to wind down a $26 trillion credit boom. The shake-out has been painful: hopefully the dollar effect is largely behind us.
The central bank governors of India and Mexico, among others, have been urging the Fed to stop dithering and get on with it. Presumably they have thought long and hard about the consequences for their own economies.

It is a safe bet that Fed chief Janet Yellen will give a "dovish steer". She has already floated the idea that rates can safely be kept far below zero in real terms for a long time to come, even as unemployment starts to fall beneath the 5pc and test "NAIRU" levels where it turns into inflation.

Her apologia draws on a contentious study by Fed staff in Washington that there is more slack in the economy than meets the eye. She argues that after seven years of drought and "supply-side damage" it may make sense to run the economy hotter than would normally be healthy in order to draw discouraged workers back into the labour market and to ignite a long-delayed revival of investment.

There are faint echoes of the early 1970s in this line of thinking. Rightly or wrongly, she chose to overlook a competing paper by the Kansas Fed arguing the opposite.

Such a bias towards easy money may contain the seeds of its own destruction if it forces the Fed to slam on the brakes later. But that is a drama for another day.

The greater risk for the world over coming months is that China stops trying to hold the line against devaluation, and sends a wave of corrosive deflation through the global economy.

Fear that China may join the world's currency wars is what haunts the elite banks and funds in London. It is why there has been such a neuralgic response to the move this week to let the yuan slip to a five-year low of 6.4260 against the dollar.

Bank of America expects the yuan to reach 6.90 next year, setting off a complex chain reaction and a further downward spiral for oil and commodities. Daiwa fears a 20pc slide. My own view is that a fall of this magnitude would set off currency wars across Asia and beyond, replicating the 1998 crisis on a more dangerous scale.

Lest we forget, China's fixed capital investment has reached $5 trillion a year, as much as in North America and Europe combined. The excess capacity is cosmic.

Pressures on China are clearly building up. Capital outflows reached a record $113bn in November. Capital Economics says the central bank (PBOC) probably burned through $57bn of foreign reserves that month defending the yuan peg.

A study by the Reserve Bank of Australia calculates that capital outflows reached $300bn in the third quarter, an annual pace of 10pc of GDP. The PBOC had to liquidate $200bn of foreign assets.

Defending the currency on this scale is costly. Reserve depletion entails monetary tightening, neutralizing the stimulus from cuts in the reserve requirement ratio (RRR). It makes a "soft landing" that much harder to pull off.

The RBA said Chinese exporters are trying to keep their foreign earnings in dollars and large discrepancies are building up under "errors and omissions". There has been a "reduction in the willingness of China’s foreign suppliers to receive payment in RMB (yuan)," it said.

It also revealed - as long suspected - that the vast holdings of US bonds registered to investors in Belgium are actually PBOC assets held in Euroclear. These have halved.

This week's tweak to the "yuan fix" comes after trade data showed that Chinese exports stalled in November following a tentative rebound over recent months. Shipments fell 6.8pc year-on-year, but what is most ominous is that the export tally included re-exports sales of refined oil products and a 22pc rise in steel sales.

It comes just as Beijing sends a terrible trade signal by cutting the export tariff on steel billets and pig iron. "Put simply, China is exporting its excess output onto a saturated global market, and there is certainly far more where that came from," said Neil Mellor from BNY Mellon.

Whether China has an over-valued currency is a hotly debated question. It also has a current account surplus that may soon reach $800bn, a sign of calamitous imbalances.

What is clear is that China has suffered a major currency shock. The yuan has been strapped to the rocketing dollar through its peg at a time when it needed a weaker exchange rate, and this has been made worse by Japan's devaluation game next door and by crumbling currencies in Russia and East Asia.

China's real effective exchange rate has risen by 30pc since mid 2012. Wages have been rising at near double-digit rates as the country crosses the "Lewis Point" and runs out of cheap labour from the villages.

The twin-effect is a relentless squeeze on Chinese corporate margins. Profits have fallen for the past five months, dropping by 4.6pc in October. The carnage in the shipbuilding industry is gruesome.

East Heavy Industry and Mingde Heavy Industry have gone bust. Rongsheng Heavy Industries Group has stopped production. Fujian Crown Ocean has stopped paying its workers.

It is the same story in the Chinese steel industry, now responsible for half the world's production, and sitting on 300m tonnes of excess capacity. The state giant Sinosteel has already defaulted - to state banks.

Premier Li Keqiang has so far resisted devaluation, knowing that this would draw out the agony, would lead to Japanese-style "zombie" companies on life-support, and would play into the hands of vested interests and party dinosaurs he aims to defeat. As he has repeatedly warned, China is heading straight into the middle income trap unless it can reinvent itself in time.

A beggar-thy-neighbour policy would be hard to square with China's ambition to be a stabilizing pillar of the world's economic order, newly annointed as a member of the International Monetary Fund's currency basket (SDR).

Mr Li has vowed to keep the yuan "basically stable". Chinese officials say the PBOC is targeting a trade-weighted index. So far this has stayed level. There has been no devaluation yet.
China bulls argue - and on this I agree - that the "new economy" is doing fine as the country ditches its obsolete development model and shifts up the technology and service ladder. The trade share of GDP has dropped to 41.5pc from 64.5pc in 2006.
The flip side of this is that services have jumped from 44pc of GDP to 51pc over the past four years. Healthcare is booming now that hospitals have been opened up to market forces.

Bears rely on the Li Keqiang index to discern economic collapse - usually from a safe distance, without straying into Chinese territory. It is based on Mr Li's Wikileaks comment in 2007 where he admitted relying on electricity use, rail freight and credit growth for the truth on GDP.

That was seven years ago, The index fails to capture the deliberate switch away from heavy industry, or the galloping gains in energy efficiency. It dwells on a 16pc fall in rail freight, ignoring a 6.5pc growth in road freight, which is 10 times larger. It relies on an old measure of credit that does not include bond issuance by local governments. It is useless.

Craig Botham from Schroders said acidly in a "postcard from Beijing" that if China is really collapsing, "the country is hiding it well". The best estimates are that China's growth has slowed to around 5pc, but the labour market is still tight and employers are crying out for workers.
Yet there are winners and losers in this traumatic shift from one economic model to another, and the old guard of the Communist Party still controls much of the Central Committee. The patronage system of the party bosses depends on keeping the giant state companies (SOEs) alive.

President Xi Jinping is chiefly concerned with harnessing "reforms" to smash rivals, centralize all power in his own hands, and restore the hegemony of the party - and party control is ultimately incompatible with the free market.

His military and strategic expansion in the South China Sea show that he would not have slightest hesitation in dumping yet more of China's excess capacity on everybody else if he thought it to be in his political interest.

Li Keqiang commands the economy on sufferance only. Rumours constantly surface that he has been isolated in the Standing Committee.

The real danger for the world is that he is simply shoved aside. The stability of the yuan and the world currency system rests on thin political ice.

Schengen and European Security

Daniel Gros


BRUSSELS – Another key European project is under threat. Some two decades after border controls were first abolished under the Schengen Agreement – which now includes 26 countries, including four non-members of the European Union – Germany has reinstated controls at its border with Austria, and France at its border with Belgium. The controls are meant to be temporary, and the vast majority of other borders remain open. But more openness does not seem to be the direction in which Europe is headed – and that is a serious problem.
The shift away from a “Europe without borders,” instigated by images of refugees walking across internal frontiers, was fortified by the news that most of those who carried out last month’s Paris attacks came from Belgium, and that some may have entered the EU via the Balkans, posing as refugees. The underlying assumption – reinforced by many European politicians, especially interior ministers – is that there is a tradeoff between security and openness. This is far from accurate.
In fact, the reinstatement of border controls seems to be an example of “security theater” – a policy intended to make the public feel like something is being done. But, far from making Europeans safer, rolling back Schengen would actually hinder the fight against terrorism, because countries would be forced to devote valuable resources – thousands of police officers, if the agreement were to be abolished altogether – to checking documents at borders. Those resources would no longer contribute directly to investigations into terrorist activities.
And those investigations need all the help they can get. After all, the objective – to identify a few terrorists hiding among millions of law-abiding citizens, before they commit a violent act – is the equivalent of finding a needle in a haystack. The recognition of the flawed logic behind reinstating border controls is probably why police officials have remained guarded in discussing the issue.
It should be remembered that when five countries – Belgium, France, Germany, Luxembourg, and the Netherlands – agreed in 1985 (in the village of Schengen, Luxembourg) to abolish border controls, they did not do so on a whim or because some politicians had a lofty vision.

However symbolic the agreement may have been, symbolism wasn’t the point.
Participating countries’ security establishments had recognized that stopping people at the internal borders did not help them counter major threats, such as organized crime and drug smuggling. Truck drivers, who protested against long waits at customs stations, helped spur the effort. But it took another decade of hard-nosed, detailed negotiations, entailing efforts to strengthen the EU’s external borders, to reach the point, in 1995, where internal border controls could actually be lifted.
The subsequent decision by non-EU countries like Switzerland to join the Schengen Area highlights the massive benefits, including for security, of maintaining open borders. Rather than attempt to control the masses of tourists and business travelers entering the country from all sides – essentially an exercise in futility in Switzerland – the country decided to focus police resources specifically on security threats. By joining Schengen, the Swiss police also gained access to the Schengen Information System and other important European databases on criminal suspects, stolen cars, and more.
Of course, there are flaws in the Schengen system. Like the eurozone, the area began with only a small group of member countries, all of which had a similar outlook and capacity to implement common rules, but soon welcomed many others, some of which, it later became apparent, could not uphold agreed standards.
In the eurozone, imbalances in competitiveness and fiscal positions – which were not noted during the perfunctory check, based on formal criteria, that was conducted before approving new members – led to a protracted economic crisis. In the Schengen Area, some countries’ inability to protect external borders adequately – owing to a lack of administrative capacity (especially true in Greece, but also, to some extent, Italy), together with geographic challenges like long and fractured coast lines – have undermined confidence in the face of the refugee crisis.
The eurozone survived its crisis for two key reasons. First, a common institution, the European Central Bank, had the power to act. Second, member states relinquished some control over their banks, in order to boost the system’s overall stability.
If the Schengen Area is to endure, it needs to evolve in a similar direction, establishing a common institution responsible for securing external borders, while reinforcing the framework for internal security. As it stands, defense of Schengen’s external borders is up to individual member states, including one, Greece, that is already facing a devastating economic crisis. The only EU-wide operation aimed at helping police the external border, called Frontex, is severely limited in scope.
What the Schengen Area needs is a true European coast guard, with its own budget, ships, and personnel. The Mediterranean can be expected to remain the main security challenge for some time, owing both to illegal immigration and its proximity to terrorist training grounds. It thus makes sense for the new coast guard, backed by EU funds, to start there. Even a small fraction of the EU budget would far exceed the available resources of any individual country.
Moreover, a European coast guard would provide a flexible tool with which to allocate resources as effectively as possible at any given moment. After all, even if security threats remain concentrated in the same broad area, the most urgent challenges can shift considerably over time. Last year, the problem was Southern Italy. Today, it is the Aegean. Tomorrow it might be somewhere else. Europe needs to prepare for any eventuality.
It is not only possible to have both openness and security; the former can actually bolster the latter.
The Schengen Area’s members need to recognize that the security rationale for abolishing internal borders remains as compelling today as it was when they joined.

Fed's Rocket Ship Turns Hoverboard

By: Peter Schiff

Over the past year, while the U.S. economy has continually missed expectations, Federal Reserve Chairwoman Janet Yellen has assured all who could stay awake during her press conferences that it was strong enough to withstand tighter monetary policy. In delivering months of mildly tough talk (with nothing in the way of action), Yellen began stressing that WHEN the Fed would finally raise rates (for the first time in almost a decade) was not nearly as important as how fast and how high the increases would be once they started. Not only did this blunt the criticism of those who felt that the delays were unnecessary, and in fact dangerous, but it also began laying the groundwork for the Fed to do nothing over a much longer time period. To the delight of investors, the Fed has telegraphed that it will adopt a "low and slow" trajectory for the foreseeable future and move, in the words of Larry Kudlow, like "an injured snail."

I would suggest that Kudlow is a bit aggressive. I believe that if the Fed raises rates by 25 basis points next week, as everyone expects it will, that the move will likely represent the END of the tightening cycle, not the beginning. (As I explained in my last commentary, the current tightening cycle actually started more than two years ago when the Fed began shortening its forward guidance on Quantitative Easing). The expected rate hike this month has long been referred to as "liftoff" for the Fed, an image that suggests the very beginning of a process that eventually puts a spacecraft into orbit. But, in this case, liftoff will be far less dramatic. I believe the Fed's rocket to nowhere will hover above the launch pad for a considerable period of time before ultimately falling back down to Earth.

If we believe that the Fed will remain "data dependent", then we should not even expect an increase this month. The latest batch of data, including terrible retail sales figures, an ISM manufacturing number that indicates we may already be in a manufacturing recession, and a much weaker than expected ISM service sector number, show an economy that is rapidly decelerating. Even last week's supposedly good jobs report, that showed 211,000 jobs created in November, included a huge jump in the number of people (319,000) taking part-time jobs because they couldn't find full-time work.(Bureau of Labor Statistics, 12/7/15)

This current "recovery," engineered by the largest monetary experiment in history, that has left us with trillions of dollars of new debt that we will likely never be able to repay, is quickly running out of what little steam it had. On average, since the Second World War, the U.S. economy has experienced a recession every six years. Since it is approaching eight years since our last official recession began, time is not on our side. Interestingly, the Wall Street Journal reported this week on its front page that the "junk" bond market is poised to notch its first annual loss since the 2008-2009 financial crisis. Many economists consider distress in these high yield debt instruments as an early sign of a recession.

But rather than admit its rosy forecasts were too optimistic, and risk losing much of its remaining credibility, the Fed is apparently prepared to prove to the markets that it has the ability to deliver tough love with an actual rate hike. But that's the easy part. Although I believe that even 25 basis points may be too much of a headwind for this anemic economy to overcome, it's not something that should really spread fear in a marginally healthy economy. The dollar did not rally by 30% or more over the past year against many currencies based on the fear of a 25 basis point rate hike. What really moved markets and currencies was the prospect of a bona fide tightening cycle.

These fears moved into sharp focus in September when widespread fears of an imminent rate hike had caused the Dow to experience its first 10% correction in four years. That is when Yellen began stressing that it's not the first rate hike that is important, but what happens after. As a result, Wall Street now sees liftoff as a far less significant event, with far more attention being paid to the ultimate flight path.

As late as this summer many economists were predicting that Fed funds would be at least 2% by the end of 2017. The Fed's own forecasters still see rates at more than 2.5% by early 2018, according to its Summary of Economic Projections released 9/17/15. But over the last few months, those predictions have flattened out more than an open can of soda in the sun. The current Fed Funds futures contracts imply a 79% chance that the Fed raises rates in December (Reuters, 12/4/15). That figure is about as high as it has been for quite a few months. But the market also indicates that rates may only rise twice more by the end of 2016. (Reuters 12/4/15) This would put Fed Funds at 75 basis points by next December, presuming a 25 basis rise this month. That pace is less than half of the last rate tightening cycle of 2004-2006, when the Fed raised rates by 25 basis points for 17 consecutive meetings (Federal Reserve Bank of NY). (It's interesting to recall that then Fed Chairman Alan Greenspan was criticized for moving too slowly at that time, and even more so in the aftermath of the bursting of the housing bubble, as many correctly concluded that the Fed's measured pace had allowed the bubble to grow unnecessarily).

I believe that when it comes to gold, commodities and currencies, we may be headed into a "buy the rumor, sell the fact" market that might turn the tables on the trends of the past four years.

In this case, the "rumor" was a meaningful tightening cycle that would restore positive real rates, but the "fact" is likely to be a symbolic 25 basis point nudge. This "one and done/wait and see" scenario is gaining a surprising amount of support, especially among those Wall Street investment firms whose livelihood depends on perennially positive markets. How else could you explain the 4% rally in gold that had occurred from the lows on Thursday to the highs on Friday last week if not for the fact that markets are coming to expect much more tender loving care from the Fed?

I believe that the Fed understands the deteriorating economic data better than it cares to admit.

But candor is rarely high on a Fed Chairperson's agenda. (In an interview this week on the Freakonomics Podcast, former Fed Chairman Ben Bernanke blundered by accidentally telling the truth regarding his penchant for painting unjustifiably rosy economic pictures while in office, saying, "I was representing the administration. And you don't really want to go out and say, 'Run for the hills,' right?" In other words, one should expect the same partisan cheerleading from the supposedly independent Fed chairman as one gets from the blatantly partisan White House Press Secretary). This time around the Fed's rhetoric has now backed it into a corner, where its credibility with the markets is at stake. If they fail to deliver 25 basis points in December, as they have failed to do many times this year, then the markets may be shocked by the Fed's lack of confidence. As a result, they may reluctantly deliver a rate hike, even though the data they supposedly depend on would argue against it. But if all we get is a symbolic 25 basis point increase, then, I believe, any economic confidence that the Fed hoped would be implied by its actions will be lost anyway.

The real problem for the Fed will be how foolish it will look if it does raise by 25 basis points and is then forced by a slowing economy to lower rates back to zero soon after liftoff. At that point, the markets should finally understand that the Fed is powerless to get out of the stimulus trap it has created. But it looks like the Fed would rather look foolish later when it's forced to cut rates, than look foolish now by not raising them at all.

Given that we are going into an election year, look for the Fed to be hyper-vigilant in keeping the economy, and the financial markets, from contracting through the spring and summer.

History has shown that the incumbent presidential party fares very poorly in an election year when the economy is bad. Just ask George H.W. Bush, whose post-Gulf War popularity evaporated in the face of the 1992 recession, which turned out to be one of the mildest in memory. Can anyone really expect that the Fed's left-leaning leadership will sit still while a recession gains momentum and, in so doing, run the risk of easing Donald Trump into the White House?

In her testimony before Congress last week, Yellen indicated that if the economy unexpectedly slipped back into recession in 2016, and it turned out that the Fed had raised rates, it would simply reverse course and lower them. She also stated she would launch another round of Quantitative Easing (QE), because the program "worked so well in the past." But a recession that begins so soon after a 25 basis point rate increase, or even with rates still at zero, should prove to even the Fed's biggest boosters that its stimuli were complete and utter failures. But in government, nothing succeeds like failure. 

The challenges of central bank divergence

The US is years ahead of the EU in recovery and so at a different stage of the monetary policy cycle
James Ferguson Illustration©James Ferguson
The European Central Bank eased monetary policy last week, albeit not enough to please markets.
But the US Federal Reserve is widely expected to raise short-term rates next week. This divergence between the most important central banks is likely to prove significant. Does this make sense for each in view of their own mandates? And what complications might such a divergence create for the world?
At first glance, the answer to the first question is straightforward: yes. The Fed and the ECB ought to be following different policies because their economies are in such widely different places.
As Janet Yellen, Fed chair, pointed out last week, the US economy has enjoyed a sustained recovery since the Great Recession. The unemployment rate has declined from a post-crisis peak of 10 per cent to 5 per cent. The annual rate of core consumer price inflation — excluding food and energy — is also close to (though below) the target of 2 per cent. It seems reasonable, given all these facts, to argue that the US economy is both growing at well above potential rate and is close enough to full employment for tightening to begin.
The eurozone is in a very different place, as Mario Draghi, ECB president noted in another significant speech in New York last week. The eurozone has not enjoyed a strong recovery from the Great Recession and the subsequent eurozone recession. On the contrary, in the second quarter of this year, real domestic demand was still 3.5 per cent lower than pre-crisis. From its peak of 12.1 per cent in early 2013, the unemployment rate has fallen only to 10.8 per cent. As Mr Draghi stressed, the ECB is failing to achieve its mandate of price stability, as it defines it: a rate of CPI “be­low, but close to, 2 per cent”. In October, year-on-year core CPI was just 1.1 per cent and the headline rate just 0.1 per cent. Indeed, year-on-year core inflation in the eurozone has been below 2 per cent since March 2013.
To deliver on their mandates the central banks ought to be behaving differently. But this does not mean what they are about to do is right. This is partly be­cause their mandates are different.
It is also because both are too conservative.
Martin Wolf 1

First, the Fed. Here are four reasons why the case against raising rates is still strong. First, there is no sign of significant inflationary pressure; the strength of the dollar will also keep inflation in check.

Second, if the Fed were pursuing a symmetrical policy, inflation should be above 2 per cent as much as below. In fact, core inflation has been below 2 per cent most of the time since the end of 2008.

Third, there is a real risk that the tightening will have a bigger negative effect on the economy than expected, particularly if it is seen as the first of many moves (however gradual). Given this, there is a substantial risk that the interest rate will be brought back hard against the zero lower bound in the next (possibly quite imminent) recession.
Last and most important, while unemployment is low, so is the participation rate. There is a good chance that, if the economy is run “hot”, more workers will be pulled into the labour force. It is possible, too, this would accelerate investment and productivity growth, keeping inflation in check. So the risks of tightening exceed those of waiting.
Some will argue that delay risks further destabilising the financial system. This view is problematic. If the monetary policy that stabilises supply and demand in the real economy destabilises the financial system, the problem lies in the latter. It must be dealt with forcibly and directly.

The ECB, meanwhile, disappointed the markets. This is not of itself important; its job is not to please markets but to stabilise the eurozone economy. Still, it merely lowered the deposit rate 10 basis points, extending quantitative easing at an unchanged €60bn a month, by six months, to March 2017.

This simply does not qualify as decisive action.

In his New York speech, Mr Draghi seemed to recognise this. He made three fundamental points.

Today’s aggressive policies are working; the loosening last week was significant; and “There cannot be any limit to how far we are willing to deploy our instruments, within our mandate, and to achieve our mandate.” The points are reasonable. Even so, the ECB should have announced it will continue with QE until it hits its inflation goal. The unnecessary weakness of the eurozone economy has gone on too long.
Whatever the drawbacks of the decisions of the two central banks, the big picture is clear. The US is years ahead of the eurozone in its recovery and is, in consequence, at a different stage of the monetary policy cycle. It is likely the divergence will increase modestly in the next few years. The Fed is also likely to diverge increasingly from the Bank of Japan, which will remain ultra-loose, and the People’s Bank of China, which is loosening (albeit from a tighter starting point).

Martin Wolf 3

To return to the question of the potential complications of such a divergence, it is likely to reinforce the strength of the dollar, which in turn, would worsen the difficulties of dollar-denominated borrowers. Yet it would also be risky to extrapolate the divergence too confidently. The Fed may find the US economy is not as strong as it believes, particularly given the strength of the dollar. If so, the tightening might be small and brief.

While good reasons do exist for the divergence, experience reminds us of the danger of overconfidence. The BoJ has now had near-zero short-term rates for two decades. It also raised rates, modestly, in 2000 and in 2006 and 2007. It was forced to reverse. The Fed should note this sobering precedent.