Loose fitting

Global monetary policy is not tightening as expected

Quiescent inflation means low interest rates are still “the only game in town”
AT ITS outset, 2017 seemed likely to mark a turning-point for global monetary policy. The Federal Reserve had just raised its main interest rate by a quarter-point and was expected to add three such increases this year—or perhaps even more, if a new Republican Congress could agree on tax cuts with a new Republican president. In that case, low interest rates would no longer be the “only game in town” in terms of policy stimulus. The European Central Bank (ECB) would begin to wind down its programme of quantitative easing, or QE, probably by mid-year. The Bank of Japan would cut back on QE, too. In September it set a target yield for ten-year bonds, of 0.0%, which would probably require fewer asset purchases. Of the global giants, only China seemed likely to keep its policy settings as loose as in 2016.

In this context, the ECB’s meeting on June 7th and 8th was not long ago eyed as pivotal. The bank’s staff would produce new, upbeat economic forecasts. Many ECB-watchers (and maybe some of its governing council) reckoned it might signal the “tapering” of QE. That now looks unlikely. Figures this week showed that underlying inflation fell to 0.9% in April, well short of the ECB’s target of below-but-close-to 2%. On May 29th Mario Draghi, the ECB’s boss (pictured), told the European Parliament that the bank was “firmly convinced” that an “extraordinary amount” of monetary support was still needed.

Elsewhere, too, things are not going entirely to plan. The Fed raised interest rates in March and is widely expected to do so again in June. But thereafter markets have priced in little in the way of further increases. And few other central banks are following its lead. Indeed several have cut rates. Mr Draghi’s ECB is not alone in its taper caution. The pace of the Bank of Japan’s purchases has not fallen much. The balance-sheets of these three central banks, in aggregate, are still expanding. They are unlikely to start shrinking until 2019. A broad measure of rich-world monetary conditions compiled by Morgan Stanley, which incorporates short-term interest rates, bond yields, share prices and other variables, suggests that monetary policy is becoming looser, if anything (see chart). The wild card is still China—but in an unexpected way; banks’ borrowing has in fact been squeezed. But even there, the authorities are keen not to go too far.

Central banks are treading carefully in part because of low inflation. Headline rates of inflation have risen this year, but largely because of higher oil prices. Price indices that exclude volatile food and energy costs tell a different story. The underlying rate on the index preferred by the Fed fell to 1.5% in April, for instance. But monetary policy also reflects the specific risks to financial stability in America, Europe and China. The goals of stable inflation and steady finance are not always compatible. For instance, the ECB’s benchmark deposit rate is negative: ie, it charges commercial banks for holding deposits with it. The result is a check on banks’ profits. The ECB’s judgment has been that the positive effect of negative rates on the economy is worth the risks. The Bank of Japan also has a negative deposit rate, but is kinder to banks: its policy of “yield-curve control” ensures that long-term interest rates are higher than short-term ones, which helps banks make profits.

Yet the main risk highlighted in the ECB’s recent Financial Stability Review is a sudden rise in bond yields. A hasty withdrawal of QE could plausibly set off such a change, especially in countries such as Italy with large public-debt burdens. That is one more reason for the ECB to go slow. In contrast, China, where debt has risen from 150% of GDP in 2007 to 280% in 2016, faces a dicier trade-off. It is trying to tackle dangers in the financial system without slowing down the economy unduly. The People’s Bank of China, the central bank, has not raised its benchmark one-year lending rate, currently 4.35%—the way it has tightened monetary policy in the past. Instead, it has been stingier in supplying short-term liquidity to banks. Seven-day interest rates in the volatile interbank market have gone up by about half a percentage point since February, to around 3%. The goal is to restrict funding from China’s big, state-owned banks to so-called “shadow banks” that use the interbank market to finance risky lending.

China’s bank regulator has added to the squeeze. It has clamped down on irregular or complex transactions in the interbank market, and on ruses used by banks to increase leverage. The authorities have tried to limit the potential damage to the economy: by giving banks liquidity for medium-term loans; and through state-directed finance for infrastructure by “policy banks”, such as the China Development Bank. But a broad measure of credit growth has slipped, from around 16% in 2016 to 14.5%, according to Morgan Stanley. It might decline further, to 13%, by the end of the year. GDP growth will also slow.

The Fed faces no such conflict. It is raising interest rates for standard reasons: to head off excessive inflation. Financial risks are quite low down its list of worries. In a speech on May 30th, Lael Brainard, a member of the Fed’s board of governors, noted mild concern about the car-loan market and corporate debt. But in general, finance was stable, she said. House prices are aligned with rents, in contrast to the mid-2000s; stockmarkets are dear but less so than in the late 1990s. Her main concern was not that equity prices are frothy but that weak inflation might persist. She noted that the underlying rate is falling and wage growth is not picking up, despite lower unemployment.

Though most market participants expect the Fed to increase the target range on its main interest rate on June 16th by another quarter-point to 1-1.25%, the markets are pricing in very little beyond that.

Investors are betting that the federal-funds rate will be just 1.5% at the end of 2018. If the Fed lives up to the median forecast of its rate-setting committee, the rate by then should be 2.25%.

But sluggish inflation may well force a rethink. In any event, the Fed has prepared the ground for a reduction in its balance-sheet, to begin soon. As things stand, the Fed reinvests the proceeds of maturing bonds, but the plan is to allow a fixed amount of those to run off. Initially the cap would be set at a low level (as little as $12bn a month on one reckoning) and would gradually increase every quarter. Economists at JPMorgan Chase reckon that shrinking the Fed’s balance-sheet by $1.5trn would eventually push up ten-year yields by 0.25%. But the Fed is likely to move so slowly that the effect will be barely perceptible. Since the plans were outlined, the yield on ten-year Treasuries continued to fall, reaching 2.2%, down from a recent peak of 2.6% in March.

In large part, falling bond yields reflect a growing conviction that short-term interest rates are unlikely to rise quickly or soon. Central banks are fearful of cutting short the synchronised global economic upswing and, with inflation quiescent, see no real need to take the risk. They are buying lots of assets: the ECB and Bank of Japan are acquiring more; the Fed is still reinvesting. In short, little is afoot to upset the bull-market mood: “They’ve still got your back”, is the message that investors are taking from central banks, says David Riley, of BlueBay Asset Management. Global stockmarkets are buoyant. The cost of short- and long-term borrowing remains low by any standards.

The dollar has retreated. In the broadest terms, financial conditions are easy. The global upswing is still receiving plenty of support from central banks. An extraordinary amount, in fact.

‘Secular Stagnation’ Even Truer Today, Larry Summers Says

The Harvard economist tells David Wessel he has been vindicated by slow economic growth, low inflation and low interest rates

Former Treasury Secretary Lawrence Summers in 2013 at the economic forum where he introduced his “secular stagnation” hypothesis. Photo: Chip Somodevilla/Getty Images

Larry Summers is doubling down on his secular-stagnation hypothesis.

The Harvard economist and former Treasury secretary first offered the bleak diagnosis in November 2013 at an International Monetary Fund conference. The U.S. and much of the rest of the world, he suggested, was suffering from a chronic shortage of demand and profitable investment opportunities, he argued. There wasn’t any interest rate that would produce healthy growth (given that rates can’t go much below zero).

At a recent academic conference at the Federal Reserve Bank of San Francisco, I asked Mr. Summers how his secular stagnation hypothesis looks today, three and half years after he inserted a Depression-era phrase into today’s debate about the economic outlook. Many economists have had their doubts about his gloomy hypothesis, and not all has gone wrong with the U.S. economy. Unemployment, for example, has fallen to 4.4% from 7.2% in 2013, leading to a rise in wages.

But Mr. Summers says he has been vindicated by slow economic growth, low inflation and low interest rates, which many forecasters now expect to persist. Today, he is more convinced than ever that secular stagnation is the defining economic problem of our time—one that won’t be easily defeated as long as fiscal authorities are overly preoccupied with debt and central bankers are overly focused on keeping inflation at low levels.

Here are edited excerpts of Mr. Summers’s observations from our exchange.

With hindsight, his gloomy 2013 view looks better than the consensus 2013 view.

“When I made my comments in 2013 at the IMF they were couched with very substantial doubts. Today I would have fewer. The essence of my argument then was that because of a variety of structural factors the neutral rate of interest was much lower than it had been and, therefore, getting to an adequately low rate was going to be more difficult. And that was going to act as a constraint on aggregate demand much more of the time than people thought.

Relative to the prevailing forecasts at the time that I spoke, interest rates have been very substantially lower. Growth has been very substantially lower. Inflation has been very substantially lower for the industrialized world. Fiscal policy has been more expansionary. So the broad argument that I was making at that time seems more true today.”

Secular Stagnation Then and Now

Nov. 2013 Expectat           Now 
10-Year Interest Rate2.8%2.2%
10-Year Real Rate0.6%0.4%
Fed Neutral Rate4.0%2.9%
Inflation Five-Year/Five-Year Expectations2.5%1.9%
Market Terminal Rate (OIS)4.1%2.1%
PCE Core Inflation*1.9%1.7%

Nov. 2013 Expectations
PCE Core Inflation*1.9%1.7%
Market Terminal Rate (OIS)4.1%2.1%
Inflation Five-Year/Five-Year Expectations2.5%1.9%
Fed Neutral Rate4.0%2.9%
10-Year Real Rate0.6%0.4%
10-Year Interest Rate2.8%2.2%

The decline in the U.S. unemployment rate doesn’t disprove his hypothesis.

“Nobody ever said that the economy was always going to be permanently in a state of deflation.

If you go back to the Alvin Hansen [who coined the secular stagnation phrase in 1939 ], he talked about weak recovery. So here we are. We’ve managed to get to 2% growth, not much inflation pressure, 4% unemployment and in order to be there, we’ve got a fed-funds rate eight years into a recovery of 1%. I read that as, on net, something substantial has happened relative to what anybody expected rather than nothing important happened.”

Economists are no longer arguing about whether the neutral rate of interest has fallen, but instead are wondering why.

“We now have a kind of embarrassing overabundance of explanations for the decline in the neutral rate [the interest rate that will prevail when the economy is at full employment and price stability].

You got smart thoughtful people who think that demography is 75% or 80%. You’ve got smart thoughtful people who think increased risk aversion and a shortage of safe assets is 75% or 80% of it.

You’ve got smart people who think widening inequality and a higher propensity to save is half of it.

You’ve got smart people quantifying sludged-up financial intermediation as explaining a significant part of it. You’ve got careful thinking about declining capital-goods prices explaining a significant part of it. You’ve got people thinking about corporate savings and rising profitability as explaining a significant part of it. And nobody has come forward with strong a priori arguments for why the real rate should have increased.”
This trend has its roots in developments that preceded the Great Recession.

“One thing you should pay attention to is the yield on 10-year TIPS [Treasury Inflation-Protected Securities] because I think the interesting part is not the short-run dynamics but averaging over the cycle. If you look at the real interest rate decade by decade, it’s been going down for five decades.”

All this strengthens the case for more public investment.

“I would be trying to raise R-star [another term for the neutral rate] so I would be wanting to operate with a different fiscal-monetary mix. Even though some of the things the Trump administration is doing are giving it a bad name, the basic impulse that increased business confidence that raises the propensity to invest is a good thing. So, first, more public investment I think is a good thing.”

When pressed, Mr. Summers acknowledges a few vulnerabilities in the secular-stagnation view.

“I always try to phrase this carefully with words like ‘the foreseeable future,’ because I know that if you’d asked me in 2003 was liquidity-trap economics going to be central to understanding the American economy in the rest of my professional lifetime, I would have said overwhelmingly likely no, and I would have been wrong. So could a whole different configuration with a whole different set of issues prove to be important 10 years from now? Yeah, that could certainly happen.

“I don’t think we’re as straight as we’d like to be on the global aspects of this. One of the arguments that I’ve made is that we had the mother of all housing bubbles, we had a vast erosion of credit standards, we had really easy money, we had the Bush tax cuts plus the Iraq war, and all that got us in the precrisis period was adequate growth. Doesn’t that show that there’s some kind of secular stagnation that you needed all that extraordinary stuff to get to adequate plus growth? That’s an argument I’ve made. It’s made a little more awkward by the very large current-account deficit we had in much of that period, which suggests that maybe there was stronger demand, and it was just falling outside the United States. I’m comfortable with my overall view, because I think this is best framed as an issue of the industrial world, but I think that this is a weakness of the line of argument that I’ve taken.

“Some people would say it’s really all the supply side, and you’re all about the demand side. We’ve had a big productivity slowdown and isn’t that the right thing for you to think about, and I think there’s obviously something to that. The point I’d make about that is that, in general, we have a way of telling the difference between supply shocks and demand shocks, which is that supply shocks raise prices and demand shocks lower prices. The general tendency to low inflation coincident with low quantity guides you a little more towards the demand-shock view therefore then the supply-shock view.

“There is some evidence related to hysteresis for what I called a Reverse Says Law—lack of demand creates its own lack of supply down the road in terms of productivity growth. But if one was attempting to synthesize everything rather than to push a very important aspect of a phenomenon that had received too little attention, I think integrating exogenous developments on the supply side would be worthwhile.”

The U.S. Economy Is About to Face Its Biggest Test in Years

By Justin Spittler, editor, Casey Daily Dispatch

Investors beware: the U.S. economy is in for a huge shock.

This shock won’t start with auto loans…student loans…or even U.S. corporate debt.

It will begin north of the 49th parallel.

That’s right. Canada will soon put the U.S. economy to the test.

Regular readers know where I’m headed with this.

In short, Canada has a gigantic housing bubble on its hands. And it looks like that bubble is finally about to burst.

When it does, Canada will have serious problems. It could even have a recession or a full-fledged banking crisis.

• And yet, you’re probably not too worried about this…

That’s because, if you’re like most Dispatch readers, you live in the United States…not Canada.

This makes it easy to assume that Canada’s housing crisis isn’t your problem. But that’s a very dangerous assumption.
You see, financial crises almost never stay in one place. Instead, they move from country to country like a plague of locusts.

Investors learned this the hard way in 2007 when a U.S. housing crisis turned into a global financial crisis almost overnight. By the time the dust settled, investors from Tokyo to London were sitting on huge losses.

I’m reminding you of this because Canada's housing crisis could trigger the next global economic meltdown.

I'll show you why in a minute. But let’s start by looking at why Canada’s economy could unravel soon.

• Housing is the heart of Canada’s economy…

Real estate and related financial services industries account for almost a quarter of Canada’s economic output. That’s the highest level since at least the 1960s.

In British Columbia, real estate, construction, and related industries make up 40% of the economy.

But housing isn’t just a key pillar of Canada’s economy. It’s also about the only thing holding up Canada’s economy right now.

According to Bloomberg Markets, Canada’s economy would have actually shrunk in February were it not for the country’s red-hot housing market.

• Canada’s housing boom has also lifted other parts of the economy…

According to the Toronto-Dominion Bank, the housing “wealth effect” has driven one-fifth of Canada’s consumer spending since 2001.

In other words, rising housing prices have made Canadians feel richer. And that’s led them to spend more money on other things.

That may seem like a good thing. But you have to understand something about the wealth effect. It slices both ways.

This means Canadians are going to feel less rich when housing prices inevitably crash. They’re going to eat out less…visit the mall less often…and take fewer vacations.

• In short, a housing crisis would drag down Canada’s entire economy…

But don’t take my word for it. Mark Chandler, who runs the fixed-income desk at RBC Capital Markets in Toronto, recently had this to say:

You don’t need a collapse in house prices, you don’t need housing starts to be cut in half for weaker real estate sector to have a significant effect on GDP [Gross Domestic Product] and incomes.

According to RBC, it would only take a 10% drop in housing prices to shave a full percentage point off of Canada’s economic growth rate.

Unfortunately, Canada’s housing market isn’t on the verge of a 10% correction. It’s headed for a major crash.

David Rosenberg, one of Canada’s leading economists, thinks Toronto housing prices could fall 40% or more.

• That kind of crash would send Canada’s economy into a tailspin…

It could even trigger a full-fledged banking crisis.

Most Canadians haven’t considered this possibility. That’s because Canadian banks are supposedly safer than U.S. banks. Because of this, Canadians can’t imagine having the kind of financial crisis that the States had a decade ago.

Now, there’s some truth to this. For instance, Canadian banks have issued fewer subprime mortgages than U.S. banks did a decade ago. They’ve also bundled fewer mortgages into “toxic” securities.

But let’s be clear about something…

• Canadian banks wouldn’t be immune to a nationwide housing crisis…

That’s because real estate holds Canada’s entire banking system together.

In fact, residential mortgages now make up about 52% of Canada’s chartered bank loans.

Real estate companies also account for 14% of all private business loans. That’s the most since 1981.

At this point, Canadian banks also now lend more money to real estate companies than they do to manufacturing and oil companies combined.

In other words, Canadian banks are far more exposed to real estate than most investors think.

• So, avoid Canadian bank stocks if you can…

You might also want to consider shorting (betting against) Canadian bank stocks.

Just understand that shorting is highly speculative. So, only bet with money you can afford to lose.

I also encourage U.S. investors to take a good look at their portfolios.

That’s because Canada is America’s most important trading partner. Every year, we send them $267 billion worth of goods and services. That’s more than we export to China, Japan, and the United Kingdom combined.

In other words, the fate of the U.S. and Canada are highly intertwined.

More importantly, the U.S. economy sits on a mountain of cheap money, just like Canada.

We have more auto loan, student loan, credit card, and corporate debt than we’ve ever had. Plus, the federal debt is at $20 trillion and counting. And that “official” figure doesn’t include Social Security, Medicare, or Medicaid.

In short, the U.S. economy is sitting on a tinderbox of debt. And a Canadian housing crisis could very well be the spark that sets the U.S. economy on fire.

The good news is that you can protect yourself with a few simple moves. Here are three ways to get started:

-  Close out your weakest positions. Start by selling your most expensive stocks. You should also get out of companies that need a booming economy to make money.

- Hold more cash than usual. Setting aside cash now will help you avoid big losses should the market pull back. A cash reserve will also give you “dry powder” to buy stocks when they get cheaper.

- Own physical gold. Gold is the ultimate chaos hedge. Its value should soar when the next financial crisis takes hold.

These moves will shield you from huge losses should Canada’s financial crisis spill over into the United States.

Jobs in the Age of Artificial Intelligence

Simon Johnson, Jonathan Ruane
. Servers


WASHINGTON, DC – The world has no shortage of pressing issues. There are 1.6 billion people living in acute poverty; an estimated 780 million adults are illiterate. Serious problems are not confined to the developing world: “deaths of despair,” for example, are raising mortality among white males in the United States. Even when advanced economies grow, they are not lifting all boats.
Higher-income groups thrive while lower-income households and minority groups are consistently left behind.
And now some analysts suggest that new forms of computer programming will compound these developments, as algorithms, robots, and self-driving cars destroy middle-class jobs and worsen inequality. Even the summary term for this technology, Artificial Intelligence, sounds ominous.

The human brain may be the “most complex object in the known universe,” but, as a species, we are not always collectively very smart. Best-selling science fiction writers have long predicted that we will one day invent the machines that destroy us.
The technology needed to create this dystopian future is not even on the horizon. But recent breakthroughs in AI-related technologies do offer enormous potential for positive advances in a range of applications from transportation to education and drug discovery. Used wisely, this boost in our computational abilities can help the planet and some of its most vulnerable citizens.
We can now find new patterns that are not readily evident to the human observer – and this already suggests ways to lower energy consumption and carbon dioxide emissions. We can increase productivity in our factories and reduce food waste. More broadly, we can improve prediction far beyond the ability of conventional computers. Think of the myriad activities in which a one-second warning would be useful or even lifesaving.
And yet the fear remains: Won’t these same improvements entail giving up all of our jobs – or most of our good jobs? In fact, there are three reasons why the jobs apocalypse is on hold.
First, Moravec’s paradox applies. Hans Moravec and other computer scientists pointed out in the 1980s that what is simple for us is hard for even the most sophisticated AI; conversely, AI often can do easily what we regard as difficult. Most humans can walk, manipulate objects, and understand complex language from an early age, never paying much attention to the amount of computation and energy needed to perform these tasks. Smart machines can perform mathematical calculations far exceeding a human’s capabilities, but they cannot easily climb stairs, open a door, and turn a valve.
Or kick a soccer ball.
Second, today’s algorithms are becoming very good at pattern recognition when they are provided with large data sets – finding objects in YouTube videos or detecting credit card fraud – but they are much less effective with unusual circumstances that do not fit the usual pattern, or simply when the data are scarce or a bit “noisy.” To handle such cases, you need a skilled person, with his or her experience, intuition, and social awareness.
Third, the latest systems cannot explain what they have done or why they are recommending a particular course of action. In these “black boxes,” you cannot simply read the code to analyze what is happening or to check if there is a hidden bias. When interpretability is important – for example, in many medical applications – you need a trained human in the decision-making loop.
Of course, this is just the state of technology today – and high rates of investment may quickly change what is possible. But the nature of work will also change. Jobs today look very different from jobs 50 or even 20 years ago.
And new computer algorithms will take time to penetrate the economy fully. Data-rich sectors such as digital media and e-commerce have just begun to unleash the capabilities AI has created. The multitude of narrow AI applications that could affect jobs in sectors such as health care, education, and construction will take much longer to spread. In fact, this may come just in time – an aging population in developed economies implies a smaller workforce – and greater need for personal care services – in the coming decades.
Public policy decisions will shape the AI era. We need opportunity and competition, not the growth of powerful monopolies, in order to promote technological progress in a way that does not leave a large number of people behind. This requires improving access to all forms of education – and at low or zero cost.
With developed economies’ competitors, including China, investing heavily in AI, policymakers should be increasing support for basic research and ensuring that their countries have the physical and human resources they need to invent and manufacture everything connected with this major new general purpose technology.
We should not underestimate humans’ abilities to inflict damage on their community, their environment, and even the entire planet. Apocalyptic fiction writers may one day be proved correct.
But, for now, we have a powerful new tool for enabling all people to live better lives. We should use it wisely.