Pension Storm Warning

John Mauldin

This time is different are the four most dangerous words any economist or money manager can utter. We learn new things and invent new technologies. Players come and go. But in the big picture, this time is usually not fundamentally different, because fallible humans are still in charge. (Ken Rogoff and Carmen Reinhart wrote an important book called This Time Is Different on the 260-odd times that governments have defaulted on their debts; and on each occasion, up until the moment of collapse, investors kept telling themselves “This time is different.” It never was.)

Nevertheless, I uttered those four words in last week’s letter. I stand by them, too. In the next 20 years, we’re going to see changes that humanity has never seen before, and in some cases never even imagined, and we’re going to have to change. I truly believe this. We have unleashed economic and technological forces we can observe but not entirely control.

I will defend this bold claim at greater length in my forthcoming book, The Age of Transformation.

Today we will zero in on one of those forces, which last week I called “the bubble in government promises,” which I think is arguably the biggest bubble in human history. Elected officials at all levels have promised workers they will receive pension benefits without taking the hard steps necessary to deliver on those promises. This situation will end badly and hurt many people. Unfortunately, massive snafus like this rarely hurt the politicians who made those overly optimistic promises, often years ago.

Earlier this year I called the pension mess “The Crisis We Can’t Muddle Through.” Reflecting since then, I think I was too optimistic. Simply waiting for the floodwaters to drop down to muddle-through depth won’t be enough. We face an entire new ocean, deeper and wider than we can ever cross unaided.

Storms from Nowhere?

This year marks the first time on record that two Category 4 hurricanes have struck the US mainland in the same year. Worse, Harvey and Irma landed directly on some of our most valuable and vulnerable coastal areas. So now, in addition to all the problems that existed a month ago, the US economy has to absorb cleanup and rebuilding costs for large parts of Texas and Florida, as well as our Puerto Rico and US Virgin Islands territories.

Now then, people who live in coastal areas know full well that hurricanes happen – they know the risk, just not which hurricane season might launch a devastating storm in their direction. In a note to me about Harvey, fellow Rice University graduate Gary Haubold (1980) noted just how flawed the city’s assumptions actually were regarding what constitutes adequate preparedness. He cited this excerpt from a recent Los Angeles Times article:

The storm was unprecedented, but the city has been deceiving itself for decades about its vulnerability to flooding, said Robert Bea, a member of the National Academy of Engineering and UC Berkeley emeritus civil engineering professor who has studied hurricane risks along the Gulf Coast.

The city’s flood system is supposed to protect the public from a 100-year storm, but Bea calls that “a 100-year lie” because it is based on a rainfall total of 13 inches in 24 hours.

“That has happened more than eight times in the last 27 years,” Bea said. “It is wrong on two counts. It isn’t accurate about the past risk and it doesn’t reflect what will happen in the next 100 years.” (Source)

Anybody who lives in Houston can tell you that 13 inches in 24 hours is not all that unusual. But how do Robert Bea’s points apply to today’s topic, public pensions? Both pension plan shortfalls and hurricanes are known risks for which state and local governments must prepare. And in both instances, too much optimism and too little preparation ultimately have devastating results.

Admittedly, public pension liabilities don’t come out of nowhere the way hurricanes seem to – we know exactly where they will strike. In many cases, we know approximately when they’ll strike, too. Yet we still let our elected officials make impossible-to-fulfill promises on our behalf. The rest of us are not so different from those who built beach homes and didn’t buy hurricane or storm surge insurance. We just face a different kind of storm.

Worse, we let our government officials use predictions about future returns that are every bit as unrealistic as calling a 13-inch rain in Houston a 100-year event. And while some of us have called pension officials out, they just keep telling lies – and probably will until we reach the breaking point.

Puerto Rico is a good example. The Commonwealth was already in deep debt before Irma blew in – $123 billion worth of it. There’s simply no way the island can repay such a massive debt. Creditors can fight in the courts, but in the end you can’t squeeze money out of plantains or pineapples. Not enough money, anyway. Now add Irma damages, and the creditors have even less hope of recovering their principal, let alone interest.

Puerto Rico is presently in a new form of bankruptcy that Congress authorized last year. Court proceedings will probably drag on for years, but the final outcome isn’t in doubt. Creditors will get some scraps – at best perhaps $0.30 on the dollar, my sources say – and then move on. We’re going to find out how strong those credit insurance guarantees really are.

“That’s just Puerto Rico,” you may say if you’re a US citizen in one of the 50 states. Be very careful. Your state is probably not so much better off. In 10 years, your state may well be in the same place where Puerto Rico is now. I’d say the odds are better than even.

Are your elected leaders doing anything about this huge issue, or even talking about it? Probably not.

As it stands now, states can’t declare bankruptcy in federal courts. Letting them do so would raises thorny constitutional issues. So maybe we’ll have to call it something else, but it’s going to end the same way. Your state’s public-sector retirees will not get what they were promised, and they won’t take the outcome kindly.

Blood from Turnips

Public sector bankruptcy, up to and including state-level bankruptcy, is fundamentally different from corporate bankruptcy in ways that many people haven’t considered. The pension crisis will likely expose those differences as deadly to creditors and retirees.

Say a corporation goes bankrupt. A court will take all its assets and decide how to divvy them up. The assets are easy to identify: buildings, land, intellectual property, cash, etc. The parties may argue over their value, but everyone knows what the assets are. They won’t walk away.

Not so in a public bankruptcy. The primary asset of a city, county, or state is future tax revenue from households and businesses within its boundaries. The taxpayers can walk away. Even without moving, they can bypass sales taxes by shopping elsewhere. If property taxes are too high, they can sell and move. When they take a loss on the sale, the new owner will have established a property value that yields the city far less revenue than it used to receive.

Cities and states don’t have the ability to shed their pension liabilities. They are stuck with them, even as population and property values change.

We may soon see an example of this in Houston. Here in Texas, our property taxes are very high because we have no income tax. Your tax is a percentage of your home’s taxable value. So people argue to appraisal boards that their homes are falling apart and not worth anything like the appraised value. (Then they argue the opposite when it’s time to sell the home.)

About 200 entities in Harris County can charge taxes. That includes governments from Houston to Baytown to Hedwig Village, plus 20 independent school districts.

There’s a hospital district, port authority, several college districts, the flood control district, a multitude of utility districts, and the Harris County Department of Education. Some homes may fall within 10 or more jurisdictions.

What about those thousands of flooded homes in and around Houston; how much are they worth? Right now, I’d say their value is zero in many cases. Maybe they will have some value if it’s possible to rebuild, but at the very least they ought to receive a sharp discount from the tax collector this year.

Considering how many destroyed or unlivable properties there are all over South Texas, I suspect cities and counties will lose billions in revenue even as their expenses rise. That’s a small version of what I expect as city and state pension systems all over the US finally face reality.

Here in Dallas I pay about 2.7% in property taxes. When I bought my home over four years ago, I checked our local pension and was told we were 100% funded. I even mentioned in my letter that I was rather surprised. Turns out they lied. Now, realistic assessments suggest they will have to double the municipal tax rate (yes, I said double) to be able to fund fire and police pension funds. Not a terribly popular thing to do. At some point, look for taxpayers to desert the most-indebted cities and states. Then what? I don’t know. Every solution I can imagine is ugly.
Promises from Air

Most public pension plans are not fully funded. Earlier this year in “Disappearing Pensions” I shared this chart from my good friend Danielle DiMartino Booth:

Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade. You read that right – not doubled, tripled or quadrupled: quintupled.
That’s nice when it happens on a slot machine, not so nice when it’s money you owe.

You will also notice in the chart that much of that change happened in 2008. Why was that? That’s when the Fed took interest rates down to nearly zero, meaning it suddenly took more cash to fund future payments. Also, some strapped localities conserved cash by promising public workers more generous pension benefits in lieu of pay raises.

According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs. And that estimate is based on the aggressive assumptions of pension funds that they will get their predicted rate of returns (the “discount rate”).

Kentucky, for instance, has unfunded pension liabilities of $40 billion or more. This month the state budget director notified local governments that pension costs could jump 50-60% next year. That’s due to a proposed reduction in the system’s assumed rate of return from 7.5% to 6.25% – a step in the right direction but not nearly enough.

Think about this as an investor. Do you know a way to guarantee yourself even 6.25% average annual returns for the next 10–20 years? Of you don’t. Yes, some strategies have a good shot at doing it, but there’s no guarantee.

And if you believe Jeremy Grantham’s seven-year forecasts (I do: His 2009 growth forecast was spot on), then those pension funds have very little hope of getting their average 7% predicted rate of return, at least for the next seven years.

Now, here is the truth about pension liabilities. Let’s assume you have $1 billion in funding today. If you assume a 7% compound return – about the average for most pension funds – then that means in 30 years that $1 million will have grown to $8 billion (approximately). Now, what if it’s a 4% return? Using the Rule of 72, the $1 billion grows to around $3.5 billion, or less than half the future assets in 30 years if you assume 7%.

Remember that every dollar that is not funded today means that somewhere between four dollars and eight dollars will not be there in 30 years when somebody who is on a pension is expecting to get it. Worse, without proper funding, as the fund starts going negative, the funding ratio actually gets worse, sending it into a death spiral. The only way to bring it out of the spiral is with huge cuts to other needed services or with massive tax cuts to pension benefits.

The State of Kentucky’s unusually frank report regarding the state’s public pension liability sums up that state’s plight in one chart:

The news for Kentucky retirees is quite dire, especially considering what returns on investments are realistically likely to be. But there’s a make or break point somewhere. What if pension plans must either hit that 6% average annual return for 2018–2028 or declare bankruptcy and lose it all?

That’s a much greater problem, and it’s a rough equivalent of what state pension trustees have to do. Failing to generate the target returns doesn’t reduce the liability. It just means taxpayers must make up the difference.

But wait, it gets worse. The graph we showed earlier stated that unfunded pension liabilities for state and local governments was $2 trillion. But that assumes an average 7% compound return. What if we assume 4% compound returns? Now the admitted unfunded pension liability is $4 trillion. But what if we have a recession and the stock market goes down by the past average of more than 40%? Now you have an unfunded liability in the range of $7–8 trillion.

We throw the words a trillion dollars around, not realizing how much that actually is.
Combined state and local revenues for the US total around $2.6 trillion. Following the next recession (whenever that is), the unfunded pension liabilities for state and local governments will be roughly three times the revenue they are collecting today, and that’s before a recession reduces their revenues. Can you see the taxpayer stuck between a rock and a hard place? Two immovable objects meeting? The math just doesn’t work.

Pension trustees don’t face personal liability. They’re literally playing with someone else’s money. Some try very hard to be realistic and cautious. Others don’t. But even the most diligent can’t control when the next recession comes, or when the stock market will crash, leaving a gaping hole in their assets while liabilities keep right on rising.

I have had meetings with trustees of various government pensions. Many of them want to assume a more realistic discount rate, but the politicians in their state literally refuse to allow them to assume a reasonable discount rate, because owning up to reality would require them to increase their current pension funding dramatically. So they kick the can down the road.

Intentionally or not, state and local officials all over the US made pension promises that future officials can’t possibly keep. Many will be out of office when the bill comes due, protected from liability by sovereign immunity.

We are starting to see cities filing for bankruptcy. That small ripple will be a tsunami within 7–10 years.

But wait, it gets still worse. (Do you see a trend here?) Many state and local governments have actually 100% funded their pension plans. Some states and local governments have even overfunded them – assuming they get their projected returns. What that really means is that the unfunded liabilities are more concentrated, and they show up in unlikely places. You think Texas is doing well? Look at some of our cities and weep. Look, too, at other seemingly semi-prosperous cities all over the country. Do you think the suburbs of Dallas will want to see their taxes increased to help out the city? If you do, I may have a bridge to sell you – unless you would rather have oceanfront properties in Arizona.

This issue is going to set neighbor against neighbor and retirees against taxpayers. It will become one of the most heated battles of my lifetime. It will make the Trump-Clinton campaigns look like a school kids’ tiddlywinks smackdown.

I was heavily involved in politics at both the national and local levels in the 80s and 90s and much of the 2000s. Trust me, local politics is far nastier and more vicious. And there is nothing more local than police and firefighters and teachers seeing their pensions cut because the money isn’t there. Tax increases of up to 100% are going to become commonplace. But even these new revenues won’t be enough… because we will be acting with too little, too late.

This is the core problem. Our political system gives some people incentives to make unrealistic promises while also absolving them of liability for doing so. It also places the costs of those must-break promises on innocent parties, i.e. the retirees who did their jobs and rightly expect the compensation they were told they would receive.

So at its heart the pension crisis is really not a financial problem. It’s a moral and ethical problem of making and breaking promises that profoundly impact people’s lives. Our culture puts a high value on integrity: doing what you said you would do.

We take a job because the compensation package includes x, y and z. Then someone says no, we can’t give you z, so quit and go elsewhere.

The pension problem is going to get worse as more and more retirees get stuck with broken promises, and as taxpayers get handed higher and higher bills. These are irreconcilable demands in many cases. It’s not possible to keep contradictory promises.

What’s the endgame? I think much of the US will end up like Puerto Rico. But the hardship map will be more random than you can possibly imagine. Some sort of authority – whether bankruptcy courts or something else – will have to seize pension assets and figure out who gets hurt and how much. Some courts in some states will require taxes to go up. But courts don’t have taxing authority, so they can only require cities to pay, but with what money and from whom?

In many states we literally don’t have the laws and courts in place with authority to deal with this. And just try passing a law that allows for states or cities to file bankruptcy in order to get out of their pension obligations.

The struggle will get ugly, and innocent people on both sides will be hurt. We hear stories about retired police chiefs and teachers with lifetime six-digit pensions and so on. Those aberrations (if you look at the national salary picture) are a problem, but the more distressing cases are the firefighters, teachers, police officers, or humble civil servants who served the public for decades, never making much money but looking forward to a somewhat comfortable retirement. How do you tell these people that they can’t have a livable pension? We will see many human tragedies.

On the other side will be homeowners and small business owners, already struggling in a changing economy and then being told their taxes will double. This may actually happen in Dallas; and if it does, we won’t be alone for long.

The website Pension Tsunami posts scores of articles, written all across America, about pension problems. We find out today that in places like New York and Chicago and Cook County, pension funds have more retirees collecting than workers paying into the fund. There are more retired cops in New York and Chicago than there are working cops. And the numbers of retirees just keep growing. On an individual basis, it is smart for the Chicago police officer to retire as early possible, locking in benefits, go on to another job that offers more retirement benefits, and round out a career by working at least three years at a private job that qualifies the officer for Social Security. Many police and fire pensions are based on the last three years of income; so in the last three years before they retire, these diligent public servants work enormous amounts of overtime, increasing their annual pay and thus their final pension payouts.

As I’ve said, this is the crisis we can’t muddle through. While the federal government (and I realize this is economic heresy) can print money if it has to, state and local governments can’t print. They actually have to tax to pay their bills. It’s the law. It’s also an arrangement with real potential to cause political and social upheaval that Americans have not seen in decades. The storm is only beginning. Think Hurricane Harvey on steroids, but all over America. Of all the intractable economic problems I see in the future (and I have a vivid imagination), this is the most daunting.

Chicago, Lisbon, Denver, Lugano, and Hong Kong

I will be in Chicago the afternoon of August 26, meeting with clients and friends, and then I’ll speak at the Wisconsin Real Estate Alumni conference the morning of the 28th, before returning to Dallas that afternoon and flying with Shane to Lisbon the next day. My hosts are graciously giving me a few extra days to explore Lisbon, and Portugal is one of the last two Western European countries I have never been to. After this, only Luxembourg is left, so the next time I’m in Brussels or Amsterdam on a Sunday, I’m going to get on a train and go have lunch in Luxembourg.

On Wednesday morning the 27th I will be on CNBC with my friend Rick Santelli. As usual, we’ll talk about whatever’s on the top of Rick’s mind at the moment. It makes for a hellaciously fun discussion.

I return to Dallas to speak at the Dallas Money Show on October 5–6. You can click on the link for details. I will speak at an alternative investments conference in Denver on October 23–24 (details in future letters) and return to Denver on November 6 and 7, speaking for the CFA Society and holding meetings. After a lot of small back-and-forth flights in November, I’ll end up in Lugano, Switzerland, right before Thanksgiving. Busy month! Then there will be a (currently) lightly scheduled December, followed by an early trip to Hong Kong in January. It looks like Lacy Hunt and his wife, JK, will join Shane and me there. Lacy and I will come back home exhausted from trying to keep up with the bundles of indefatigable energy that JK and Shane are.

Boston was a very intriguing two full days of meetings. There is the potential to expand the services that my firms can offer readers and investors into areas that I never knew might be possible. It is truly exciting, and I hope we can pull it off.

I am off to meet with a close friend from out of town and compare notes on the world, one of my favorite things to do. I know we all have times when we wish we were being more productive, when we wondering why are we here and not moving the ball forward. But when I get to spend time with good friends, old or new, I somehow never feel that way. And while our pension systems may be going to hell in a handbasket, friendships will remain forever. You have a great week.

Your wishing I could see a better path forward analyst,

Nobody seems to know why there’s no US inflation

As the Federal Reserve meets this week, officials are flummoxed by restrained price rises

by Sam Fleming in Washington


Ron Paul, at least, has no regrets. The former Texas Congressman is one of the most prominent voices among those Americans who have long been deeply suspicious of the US central bank and its power to print money. When he ran for president in 2012, he assailed then Federal Reserve chairman Ben Bernanke for debasing the currency and risking an inflationary upsurge by pumping trillions of dollars into the financial system.

“We don’t have prices in the consumer market going up like in the 1970s but we should not be surprised if that happens,” says Mr Paul, who once brandished a silver coin as he lectured the former Fed chair on Capitol Hill.

Elsewhere, certainty is harder to come by. As the Fed meets in Washington tomorrow, US central bankers, and their counterparts across the world, are genuinely flummoxed by recent low inflation readings.Despite a recovery that is now the third-longest on record, America is trapped not in a 1970s-style, double-digit inflationary upsurge, but a slow-inflation quandary.

Price growth jumped in August, driven by energy and accommodation prices, yet investors still doubt inflation will be strong enough to merit more than a couple of interest-rate rises before the end of 2018.

The uncertain outlook has confounded Fed policymakers just as the central bank prepares for a leadership overhaul in the new year. President Donald Trump, who will decide shortly on the replacement for current Fed chair Janet Yellen, has managed to be on both sides of the question — slamming low rates last year during the election but welcoming them this year.

“It is a puzzle and raises a real question what the Fed should do next; I would have thought we would have been seeing more inflation pressures by now,” says Jon Faust, a former adviser to Ms Yellen at the Fed now at Johns Hopkins University. “At a time when there is a confusing economic picture we don’t know who will be judging that picture in a few months’ time at the Fed. That added uncertainty is not a good thing.”

Having lifted rates twice this year in the face of this dreary inflation, the Fed is expected to keep the target range for its key rate at 1-1.25 per cent on Wednesday, even as it announces the gradual unwinding of its quantitative easing programme. Ms Yellen is likely to leave open the prospect of a further rate rise in December, as she banks on diminishing slack in the economy driving up prices amid a global growth rebound.

Yet the Fed’s 2 per cent inflation target still appears out of reach — stripping out food and energy costs, it has not attained that rate for half a decade. It has been a quarter of a century since the Fed’s favoured measure of inflation — personal consumption expenditures excluding food and energy — last punched up above the still relatively sedate level of 3 per cent. It was just 1.4 per cent in the year to July. Wage growth, meanwhile, remains well below its pre-crisis pace at just 2.5 per cent.

In 2015 Ms Yellen set out a clear road map to higher goods and services inflation, making the traditional central bankers’ argument that diminishing spare capacity would ultimately stoke up price and wage pressures. The trouble is that even as the economy grows steadily and joblessness falls to 4.4 per cent, inflation has this year undershot the levels suggested by her model.

Part of the problem is that the link between low unemployment and higher price growth embodied in the so-called Phillips curve has looked fragile for decades. Some officials suspect the Fed can afford an even stronger labour market without worrying about excessive price growth.

On one level, sluggish inflation combined with respectable growth is far from a bad thing — central bankers in the 1970s would have looked on the current paradigm with envy. But if inflation hovers too low it leaves the economy uncomfortably close to deflation and could damage the credibility of an institution that is meant to target 2 per cent inflation. Low rates and low inflation leave little rate-cutting firepower when the next downturn strikes.

Fed chair: two hawkish contenders

Kevin Warsh                                                                John Taylor

Weak inflation may also prompt the central bank to leave policy so loose that it inadvertently stokes up a cycle of boom and bust — something the Fed has repeatedly been accused of doing in recent decades. That worry has reasserted itself thanks to soaring asset valuations. “The risk is that you are going to end up with interest rates that are too low relative to what is consistent with financial and macroeconomic stability,” says Claudio Borio, head of the monetary and economic department at the Bank for International Settlements. “If inflation doesn’t show up, it will be hard to move interest rates up at the right speed to address this issue.”

A five-month-long string of weak figures this year has prompted some Fed policymakers, including Bill Dudley of the New York Fed and Rob Kaplan of the Dallas Fed, to start asking searching questions. Are globalisation and technological advances restraining inflation at a time when a cyclical pick-up might otherwise drive it higher?

“These two forces are colliding,” Mr Kaplan told the Financial Times last month. “The cyclical forces we have understood historically; the structural forces are somewhat new, particularly technology-enabled disruption.”

Some policymakers cite the increased ease with which shoppers can compare prices on the internet and the impact these changes have on brand loyalty and pricing power. Amazon is entering grocery retail via Whole Foods, while the hotel sector is being overturned by Airbnb.

Rick Rieder, chief investment officer of fixed income at BlackRock, sees more price disruption to come, as artificial intelligence promises to further transform some industries.

Research from Adobe Analytics shows what online competition is doing in some fields. Online prices of furniture and bedding are down 8.3 per cent over the past two years, whereas the equivalent category in the consumer price index, which includes offline sales, has dropped less than half that amount. Sporting goods prices online are down 10 per cent, compared to 3.7 per cent in the CPI. Online clothing prices are down 6.5 per cent in the same period, compared with a 4.1 per cent offline drop.

Janet Yellen is likely to leave open the prospect of a further rate rise in December © FT montage / Dreamstime/Bloomberg

Goods price deflation is not new in the US, and Pete Klenow of Stanford University says comparisons between online and offline prices baskets can be tricky because of their different constructions. While some Fed officials argue that technology is eroding companies’ ability to lift prices, Goldman Sachs analysts recently found an increase in corporate pricing power over the past 20 years, consistent with a rise in profit margins and industry concentration.

Goldman economists also question arguments that ecommerce, which accounts for around 8 per cent of retail sales — is having an appreciable impact on broader inflation. The effects of online competition on traditional retailers’ pricing may be no larger than those seen during the rise of “big box” superstore chains like Walmart.

Other analysts have been looking closely at the labour market, linking paltry wage growth to the soggy inflation readings. Catherine Mann, the chief economist at the OECD, the Paris-based club of mostly rich nations, says higher job insecurity and lower labour force mobility in the US may be stifling calls for higher wages. “Workers and producers are unsure that the market is actually going to be robust enough to support higher wage and price demands.”

While goods price inflation has been negative for much of the post-crisis period, Ms Mann highlights a weakening in services price inflation from 3 per cent before the crisis to closer to 2 per cent now. She is examining the growing role of services jobs held disproportionately by women who are paid less than men. “It is really tough to get inflation up if wages are not rising,” she says.

At the Fed, some officials struggle to see why big structural factors would have intervened to crush inflation numbers. Instead, the Fed has suggested this year’s dull outcomes are being driven by a series of coincidental, one-off drags, including a fall in wireless data prices.

If they are right, the jump in inflation last month could herald further gains — with an extra lift potentially from the recent dollar depreciation. Yet Fed rate-setters are split over the outlook, and market confidence in Fed forecasts has ebbed. Charles Plosser, a former president of the Philadelphia Federal Reserve, says: “I do think economists need to work harder on understanding the inflation process.”

The shortfalls are by no means confined to the US. In the euro area, a sharp drop in unemployment across the region is yet to be matched by a strong pick-up in wages — without which officials fear inflation will fail to hit its goal of just under 2 per cent.

Mario Draghi, president of the European Central Bank, said this year that “backward-looking” negotiation of nominal wages that reference low inflation rates may be restraining prices. Many of the new jobs are also in temporary or part-time employment, which may slow the growth of nominal wages as well. At the Bank of Japan, meanwhile, officials’ struggles with achieving inflation targets are well documented.

In the US, whose monetary policy has global reach, questions about inflation are compounded by the uncertainty over who will call the shots from February. Mr Trump will have the opportunity to appoint up to five new Fed board members by next year, but attempting to predict his choices seems futile given the capricious nature of his personnel decisions.

Chart showing sluggish wage growth

Some analysts argue that the central bank could end up drifting in a hawkish direction — which would worry economists with a firm eye on low inflation. Mr Trump may not reappoint Ms Yellen, who inhabits the dovish end of the policy spectrum. A number of the alternative candidates for chair have shown signs of more hawkish leanings — among them the Stanford academics Kevin Warsh and John Taylor.

On the other hand, Mr Trump has called himself a “low-rates person” and there are precedents for presidents leaning on Fed leadership to keep policy loose — even when inflation threatens to start to pick up. Richard Nixon pressured Arthur Burns to keep rates low in the early 1970s, for example. While an inflationary upsurge may currently seem unlikely, economists have such a thin grasp on what drives inflation that it is far from impossible — as observers including Mr Paul continue to warn.

If inflation fails to reassert itself, the Fed and other central banks will find it harder to balance the need for low rates against the hazardous side-effects loose policy engenders in markets. Mr Faust says: “If the central bank keeps pushing it can make inflation go up — but the question is whether some other excess bubbles up first.”

The low-inflation enigma looks set to continue bedevilling policy not only in the US but across the world.

Additional reporting by Claire Jones in Frankfurt

The Persistence of Global Imbalances

Carmen Reinhart


JACKSON HOLE, WYOMING – The primary focus of this year’s Federal Reserve Bank of Kansas City symposium in Jackson Hole, Wyoming, which convenes the world’s leading central bankers, was not explicitly monetary policy. Fed Chair Janet Yellen’s opening remarks emphasized the changes in regulatory policy that followed the 2008 global financial crisis, while European Central Bank President Mario Draghi’s luncheon address dwelled on the need for continued reforms in Europe to sustain the eurozone’s recent economic recovery.
But it was global trade and finance – the key forces shaping the economic outlook and financial market conditions with which central bankers grapple – that took center stage. On the effects of the globalization of trade in goods and services, the discussion emphasized the costs to domestic employment, wages, and inequality. On the finance side, international capital flows and global imbalances were the primary focus.
And here, the old adage applies: the more things change, the more they stay the same. For most of the last four decades, the United States has been a net importer of capital from the rest of the world.
From the start of the previous century until the early 1980s, the US seldom recorded a deficit on its external current account (see chart). The current account reflects an economy’s saving-investment balance. When saving exceeds investment, the result is a current-account surplus, and the economy becomes a lender to the rest of the world. After it emerged as a world power at the end of World War I, the US became a net supplier of capital to the rest of the world.
Current Account Balances, Actual and Forecast (2017-2022): US, China, and Germany
(% of GDP)
Current account balance
Sources: Historical Statistics of the United States, Economic Report of the President, IMF World Economic Outlook. 
In 1987, the economist C. Fred Bergsten was among the first to point out that global imbalances had begun to climb toward uncharted territory. “The United States, the creator of the postwar economic system and home of the world’s key currency,” he wrote, “has become the largest debtor nation ever known to mankind – and its red ink will continue to flow at least into the 1990s. Japan, widely viewed as a developing country only a generation ago, has become by far the largest creditor – and its massive buildup of foreign assets will continue expanding rapidly as far ahead as one can predict.”
Japan was singled out as a particular culprit of the soaring global imbalances, because its current-account surplus topped 4% of its GDP in 1986, while the Bank of Japan amassed record levels of US Treasury securities. Japan adopted “voluntary” caps on some exports to the US and, under the Plaza Accord of late 1985, helped orchestrate yen revaluation relative to the dollar.
At the end of the 1980s, however, the yen strengthened, Japanese asset bubbles in real estate and equities burst, and Japan’s growth rate plummeted. At around the same time, South Korea temporarily emerged as a key culprit behind the US trade deficit. In 1987-1988, South Korea’s current-account surplus climbed above 6% of GDP, with currency manipulation often cited for the rise in external saving.
The same charge has dogged China, which, with its spectacular export-led growth, record official purchases of US assets, and fixed (or semi-fixed) exchange rate, today continues to dominate discussion of global imbalances. And, indeed, there is some evidence to support claims that currency manipulation and unfair trading practices have been key drivers, at least over some sub-periods.
But China’s current-account surplus has been shrinking faster than the International Monetary Fund and many forecasters had anticipated. After climbing to almost 10% of GDP during 2006-2008, the external surplus currently is oscillating in the 1-2% range. Furthermore, despite some moderation in the first quarter of this year, private capital flight from China continues.
Enter Germany. As China’s current-account surplus shrinks, Germany’s is climbing to record levels (see chart). US President Donald Trump’s suggestion that these surpluses are a byproduct of unfair trade practices rings stridently hollow. As Germany does not have its own currency, it is also a stretch to suggest that it benefits from currency manipulation (though the ECB’s quantitative easing policies have been cited in that context).
While Germany is singled out on account of its size, it is by no means unique among the advanced economies in maintaining a sizable external surplus. As of 2017, Austria, Denmark, Ireland, Japan, Luxembourg, Netherlands, Norway, Sweden, and Switzerland have substantial current-account surpluses, relative to their respective GDP. So do other Asian economies.
The US has run chronic current-account deficits for almost two generations. Pointing the finger at surplus countries is getting old. In the discussion at Jackson Hole, someone asked whether international pressure could be exerted on the surplus countries to spend more and save less.
When the same question was put to the US in its era of surpluses at the end of World War II, when the concern was a global shortage of dollars, it was dismissed unequivocally.
The US has recorded external surpluses in only three of the 38 years since 1980. Tax policy has favored debt accumulation by households at the expense of saving, and a significant productivity slowdown is affecting US international competitiveness. As Ethan Ilzetzky, Kenneth Rogoff, and I document, because of the absence of alternatives, the dollar’s status as the world’s major reserve currency remains unchallenged, making it easy for the US to continue to finance current-account deficits. But the fact that it is easy does not make it a good idea.

Donald Trump’s debt to Deutsche Bank

As others shied away, the German bank lent money for several projects. But the president and lender face increased scrutiny over their ties

by: Ben McLannahan, Kara Scannell and Gary Silverman in New York

When Donald Trump sued Deutsche Bank in late 2008, it was “classic Trump”, according to the German bank, which sued him back.

The New York property developer was trying to wriggle out of $40m of personal guarantees he had supplied on a $640m loan to build Trump International Hotel & Tower in downtown Chicago. The Lehman Brothers crisis was an unimaginable event that should get him off the hook, he argued. The future US president sought damages of $3bn — because the Deutsche-led consortium of lenders had just played a part in wrecking the world economy.

The two sides sparred for a while before settling out of court. And within a couple of years Deutsche was back as Mr Trump’s go-to lender, continuing a relationship that has endured for decades, even as other big banks have deserted the litigation-prone developer.

In June, Mr Trump disclosed outstanding loans from Deutsche of at least $130m, secured against properties in Miami and Washington in addition to the condominium-hotel in Chicago. The total is likely to be about $300m, according to people familiar with his borrowings.

“Deutsche seem to come through for him on a pretty regular basis,” says a person involved in the refinancing of the General Motors Building in Manhattan, one of the bank’s breakthrough US deals with Mr Trump, in the late 1990s.

“They stepped into a void,” says another restructuring expert.

But the elevation of the Queens-born developer to the presidency has cast a new complexion on the relationship. Deutsche faces various legal proceedings in the US, including an investigation by the Department of Justice into a Russian money-laundering scheme for which the bank paid about $600m of fines to other regulators in January. It is also facing a probe by the DoJ into whether Deutsche’s traders, and those of other banks, manipulated the prices of US Treasuries.

Separately some Democrat lawmakers are seeking records from Deutsche to see whether there are any financial links between Russia and Mr Trump.

The guarantees that Mr Trump provided over a portion of the outstanding loans, which do not mature for another six or seven years, could add a further complication to relations with Deutsche. If the loans default, the Frankfurt-based bank could in theory go after Mr Trump’s other assets. In December Alan Garten, general counsel of the Trump Organization, told Bloomberg that the guarantees were not a long-term problem, because the loans were structured to ultimately become standard debt backed by property.

Deutsche declined to comment on legal matters, the structuring of its loans, the nature of the guarantees or its relationship with Mr Trump. Spokespeople for the Trump Organization did not respond to emails.

The entanglements raise serious questions over conflicts of interest, says Norman Eisen, ethics chief in the Obama White House, and chairman of Citizens for Responsibility and Ethics in Washington. In January the bipartisan pressure group sued Mr Trump over alleged violations of the constitution’s foreign emoluments clause; oral arguments are set for October.

“Whether it’s the investigation, the regulatory climate and a hundred other ways that Deutsche Bank is affected by the federal government, if they have this leverage over Donald Trump now, having seen how he operates, I think it’s entirely legitimate to question whether he’ll be even-handed,” says Mr Eisen. “It is a source for concern.”

When Mr Trump was looking for capital in the mid-1990s, he found a good match in Deutsche. The German bank, dominant in its domestic market, was desperate to grow in the US. In particular, the bank saw a niche in serving rich developers who had hit a few bumps along the way, such as Harry Macklowe and Ian Bruce Eichner, both celebrated owners and losers of New York real estate.

Such clients were a “perfect fit”, says one former Deutsche banker. The field was relatively clear, as many US and Japanese banks burnt by losses from the early 1990s downturn gave them a wide berth. In addition, the bank could sell them extra services through its private-client business, which was bolstered by the 1999 acquisition of Bankers Trust.

“Sometimes a business will look at a client who can’t do business elsewhere,” says another former Deutsche managing director. “It makes the overall picture economic.”

A client like Mr Trump would be offered a choice of terms, according to a person familiar with the deals: an interest rate of, say, Libor plus 500 basis points with a guarantee, or Libor plus 800 without.

Deutsche’s key recruit was Jon Vaccaro from Citibank, who arrived as global head of commercial real estate in 1997. Other important figures for Mr Trump, over the years, were Mike Offit and Steve Stuart, a duo who joined from Goldman Sachs, and Eric Schwartz, a recruit from Moody’s who became the developer’s primary point of contact.

Jared Kushner (left), the president’s son-in-law, pictured in 2014 with Rosemary Vrablic, Trump's long-time wealth manager who moved to a senior banker role at Deutsche’s private wealth business

Some of the appointments gave Deutsche more clout in boardrooms and on the party circuit.

Tobin “Toby” Cobb, formerly of Donaldson, Lufkin & Jenrette, is the son of two US ambassadors. Justin Kennedy, a trader who arrived from Goldman to become one of Mr Trump’s most trusted associates over a 12-year spell at Deutsche, is the son of a Supreme Court justice. Mr Cobb, Mr Kennedy, Mr Stuart and Mr Offit could not be reached for comment.

Through a spokesperson, Mr Schwartz and Mr Vaccaro declined to comment.

Deutsche’s big real estate push came against the backdrop of rapid growth in the commercial mortgage-backed securities (CMBS) market, which allowed the bank to lay off much of the default risk to outside investors.

The market had got going in the early 1990s, as banks blanched at lending without personal guarantees. But developers did not generally want to give them. The solution was often a non-recourse loan that the banks could package into CMBS for a fee. Deutsche became a keen underwriter.

CMBS issuance exploded between 1997, when the total US market was worth about $37bn, and 2007, when it peaked at $229bn.

Former executives in Deutsche’s commercial real estate business say they were given the freedom to develop their business. Neither Josef Ackermann, a Swiss banker who became the bank’s first non-German chief executive in September 2002, or Anshu Jain, who succeeded him as co-chief executive in 2012, tightened the reins, says one former employee. “The organisation was very fractured.” Mr Ackermann and Mr Jain declined to comment.

“Deutsche’s culture in New York and London is more of a conglomeration of outsiders versus homegrown talent, and sometimes they’re at odds with each other,” says David Hendler, an ex-Wall Street bank analyst who now runs Viola Risk Advisors.

A couple of decades earlier, before Deutsche began its expansion and while Mr Trump was still making a name for himself in New York real estate, plenty more banks were willing to deal with Mr Trump. Citibank, for example, led deals including the Trump Plaza, the largest casino in Atlantic City at the time, and Trump Shuttle, an east coast airline the developer launched in 1989. Manufacturers Hanover, bought by Chemical Bank in 1991, and Chemical, which bought Chase Manhattan in 1996 and took the name, also took part in several deals, along with Bankers Trust.

Democratic lawmaker Maxine Waters has sought a broad range of financial records from Deutsche to look for links between Moscow and Donald Trump © Bloomberg

“He put out good product,” remembers one ex-Deutsche banker. “His buildings were high-quality, he got good rents from retail and he sold condos for high prices.”

Steve Witkoff, chairman and chief executive of the Witkoff Group, a luxury condo developer who considers himself a friend of Mr Trump, adds: “I think he is one of the best out there.”

But things changed in 1990, when Mr Trump overextended himself in Atlantic City through bank loans and junk bonds, while suffering with the rest of the industry in a New York property downturn. One warning sign was a $100m working-capital loan from Bankers Trust: Mr Trump was using it to service mortgages and pay debt, rather than fund day-to-day operations, according to a person familiar with discussions. Before long, the four lead banks — Citi, Chemical, ManiHani and Bankers Trust — sat down on behalf of 68 other lenders to thrash out a restructuring of $4bn of debt, including $800m of guarantees.

Mr Trump lost control of wide swaths of his empire and the banks took “significant” hits on their investments, according to the person familiar with the talks.

The experience convinced a lot of banks that lending to Mr Trump was more trouble than it was worth. Neither Citi nor Chase, for example, has lent to Mr Trump since the big debt restructuring of the early 1990s, according to syndicated loan data tracked by Dealogic. Both banks declined to comment on their relationships with Mr Trump.

After Mr Vaccaro left in 2010 for Cantor Fitzgerald, via a brief stint at Ranieri Partners, Deutsche’s commercial real estate business was taken over by Jonathan Pollack, now at Blackstone, then Matt Borstein in 2015. But by then, the primary point of contact for Mr Trump was Rosemary Vrablic, his long-time wealth manager who had joined Deutsche’s private banking unit in 2006 from Merrill Lynch.

A refinancing on the GM building in Manhattan was one of Deutsche’s breakthrough US deals with Mr Trump © Getty

In 2013, when Mr Trump was bidding for a 60-year lease to redevelop the Old Post Office building in Washington, he turned to his friend Tom Barrack, a real estate mogul who spoke at the Republican National Convention last year on behalf of candidate Trump, to provide the initial financing.

A year later, when the financing was coming due, the Trump Organization swapped out Mr Barrack’s part of the deal and turned again to Deutsche. The bank supplied a $170m loan via its private banking unit, which houses Ms Vrablic’s business, according to filings made with Washington DC’s Office of Tax and Revenue.

Loans for the Old Post Office building and Chicago hotel tower are not due until 2024, when Mr Trump would be in the final year of a second term in the White House, if re-elected. The $50m-plus mortgage on the Doral golf course resort in Miami, comes due in 2023.

John Cryan, Deutsche’s chief executive since 2015, has been trying to put an end to the bank’s slew of legal and regulatory troubles in the US. Last December the bank struck a $7.2bn settlement with the DoJ for mis-selling residential mortgage-backed securities in the run-up to the crisis; in April it became the first big bank to be penalised for violations of the Volcker ban on proprietary trading.

The chief executive assured investors last month that Deutsche had made “significant progress” on its remaining slate of investigations.

Maxine Waters, however, a Democratic congresswoman representing Los Angeles, is determined to keep the bank in regulators’ crosshairs. As the ranking member of the House financial services committee, she is demanding a broad range of financial records from Deutsche, to look for links between Moscow and Mr Trump, his close family members, business associates and others he has dealt with in the past. Deutsche has refused to supply the materials requested, saying it must respect “laws and internal policies designed to protect confidential customer information”.

In July, after two failed attempts to obtain records from Deutsche, Ms Waters and three Democratic colleagues brought a resolution to the floor of the Capitol building to compel the Treasury Department’s financial crimes enforcement network to turn over documents.

The Democrats are seeking documents, records and any suspicious activity reports referencing loans the bank extended involving Bayrock, a developer in several real estate deals including the Trump SoHo hotel, and several Russian banks, including Sberbank, Vnesheconombank Group and VTB Group.

The resolution was voted down on party lines. But Ms Waters’ face is one of a dozen images that flash across the screen showing the “enemies” of the president in an ad released this month by a campaign for his re-election.

The congresswoman is right to keep up the pressure, says Mr Eisen. “The pending investigation, the regulatory issues . . . the potential leverage as these loans come due, all of these issues demonstrate why a president should not maintain his active business interests when he steps into the White House.”

Brazil and the crisis of the liberal world order

Polarised politics and the rise of nationalism echo Trump’s US and Brexit Britain

by: Gideon Rachman

Fernando Henrique Cardoso has seen the bad times, the boom times, and now the crisis. As president of Brazil from 1995 to 2002, he consolidated the country’s democracy and reformed its economy. In the following decade the surge in Brazil’s fortunes caught the world’s attention, and the country was awarded both the World Cup and the Olympics.

But sitting in his office in São Paulo last week, Mr Cardoso, now 86, calmly acknowledged that Brazil faces “a moral and economic crisis”. The economy shrank by almost 8 per cent in 2015 and 2016. President Dilma Rousseff was impeached and removed from office last year. The current president, Michel Temer, and some 40 per cent of the members of Congress are under investigation over corruption.

This Brazilian crisis has global implications. In the good times, the country became a symbol of the triumph of liberal politics and economics around the world. In the bad times, however, Brazil’s plight has become a symptom of a global crisis in the liberal order.

By cutting subsidies, controlling inflation, pursuing privatisation and opening the economy up to competition, Mr Cardoso laid the foundations for a long economic expansion. His successor as president, Luiz Inácio da Silva, known as “Lula”, was a leftist who built on the liberal reforms that he had inherited. In the Lula era, Brazil’s notorious inequality was attacked through social programmes that attracted global praise.

As a country with a population of 207m — roughly half of South America — Brazil became an informal spokesman for the continent and an emerging world order. Through the Brics group of Brazil, Russia, India, China and South Africa, Brazil pushed for a global rebalancing of power, in a way that seemed both overdue and unthreatening. Former US president Barack Obama publicly embraced Lula, saying: “I love this guy.”

But this year, Lula was convicted of corruption, and may now be barred from seeking re-election in next year’s presidential poll. His downfall is a symbol of the disappointed hopes of many poorer Brazilians. With the economy in crisis, inequality rising again, and the “car wash” corruption scandal in full flow, the Brazilian political class is widely despised. Voters are increasingly cynical and deeply polarised.

In a pattern now familiar in the US and Europe, populist politicians are using the crisis to move into the mainstream. An early opinion poll for the 2018 presidential election show Jair Bolsonaro, a far-right nationalist, in second place behind Lula. Mr Bolsonaro, a former military officer, has a political style that makes Donald Trump seem gentle. He dedicated his vote to impeach the president to Colonel Brilhante Ustra, who ran a squad that tortured Ms Rousseff when she was a political prisoner during Brazil’s military dictatorship.

Like Rodrigo Duterte, the wild-man president of the Philippines, Mr Bolsonaro is building his popularity by promising to get tough on crime. The fact that Rio de Janeiro is in the grip of a violent crime wave make his appeals for a restoration of “order” widely popular. In Brazil last week, most pundits saw Mr Bolsonaro as too extreme to win. But the reassurances I received in well-appointed offices reminded me uncomfortably of conversations in Washington in 2015, when a Trump victory was deemed inconceivable.

Whether Mr Bolsonaro wins or not, his emergence as a serious political figure is a sign of the bitter polarisation of Brazilian politics. Many on the left argue that both Lula and Dilma are victims of an illegitimate coup by a rightwing establishment. The conservative response is that their Workers’ party built its power on corruption, patronage and wasteful spending, which dragged the economy down. The invective on both sides is strongly reminiscent of the partisanship gripping Trump’s America and Brexit Britain.

Brazil’s crisis has its own internal causes and logic. But it also fits a global pattern. Mr Cardoso’s reforms took place in an era when liberal economic and political ideas were in the ascendancy around the world. He became president six years after the fall of the Berlin Wall and 10 years after the end of military rule in Brazil. Other developing and middle-income countries, such as China, India, Mexico and Poland, were also following the path of liberal, economic reform. And Bill Clinton, a proud “globalist”, was in the White House.

But the financial crisis of 2008 sparked a backlash against “neoliberalism”. The current US president now denounces globalism and preaches protectionism. Nationalist strongmen are in power in Beijing, Delhi, Moscow and Ankara. Mr Cardoso, a multilingual professor, belongs to a different era when technocrats and academics were in charge.

And yet Brazilian liberals are far from ready to admit defeat. The corruption scandal has turned politics upside down, but many hope it will be the basis for a more just and efficient Brazil. The depth of the current economic crisis may also force Brazil to return to the path of economic reform, with a renewed attack on subsidies and clientelism. And Mr Cardoso is adamant that the political progress of the previous decades will endure. In the past, he says, “Brazilians all knew the names of the top generals . . . But now everybody knows the names of the judges and prosecutors. That’s progress.”

The Fed, a Decade After the Crisis, Is About to Embark on the Great Unwinding

After a historic buildup of its bond portfolio to support the U.S. economy, the central bank plans to shrink its holdings, entering uncharted territory

By Nick Timiraos

WASHINGTON—The Federal Reserve resorted to a series of shock-and-awe stimulus campaigns to stabilize the economy after the financial crisis. Now the Fed is preparing the final move to unwind its support—and it wants to be as boring as possible.

The central bank is likely to announce Wednesday it will start slowly shrinking its $4.2 trillion portfolio of mortgage and Treasury bonds purchased during and after the financial crisis. It will do so passively by allowing some bonds to mature without replacing them.

The markets haven’t blinked at Fed signals for many months that this moment was nearing.

But plenty could still go wrong. The central bank has never before had such a large balance sheet or attempted to do this.

If it succeeds, the central bank will quietly close a chapter on an extraordinary policy experiment that lowered borrowing costs for homeowners, businesses and consumers, and will provide a model for other central banks that followed suit. A misstep could disrupt growth at a time when major economies are finally expanding in sync.

Chairwoman Janet Yellen’s management of the process will shape the final verdict on whether the bond-buying was successful, which in turn could determine whether it remains a policy tool for future downturns.

“She has reached agreement in a way that is really impressive. Markets didn’t freak out.

Nobody said ‘boo,’ ” said Austan Goolsbee, who headed the White House Council of Economic Advisers in 2010-2011. Now, he said, “The final exam, with the grade yet to be determined, is can the Fed actually get out of this stuff.”

Other central banks that adopted such programs are watching, particularly the European Central Bank, which is considering whether to wind down its asset purchases next year.

When central bankers began these unconventional campaigns, “we had no idea what we should buy, how much, for how long,” said David Blanchflower, a Dartmouth economist who was on the Bank of England’s monetary policy committee from 2006 to 2009. Similarly, “there is no idea on the way going out.”

Markets’ ho-hum reaction so far prompted J.P. Morgan Chase & Co.’s James Dimon to warn this summer against complacency. The Fed’s unwind “could be a little more disruptive than people think,” the CEO said at a conference in Paris. With other central banks set to pull back on stimulus, “the tide is going out.”

Added Matthew Jozoff, J.P. Morgan’s mortgage-debt strategist: “We have never seen a central bank exit out of $1 trillion of mortgage-backed securities, so we are concerned about how this is going to go.”

What could go wrong is hard to predict. When the Fed discussed plans to pare its purchases of new bonds in 2013, a tumble in prices sent yields soaring, in what was called the taper tantrum.

The unanticipated turmoil included capital outflows from emerging markets. Fed officials’ desire to avoid a replay has driven careful planning for the balance-sheet wind-down, according to current and former Fed officials.

The Fed launched its bond buying in late 2008, at the depth of the financial crisis, to shore up money-market funds, companies and banks.

A government takeover of housing-finance giants Fannie Mae and Freddie Mac had failed to thaw the mortgage market. So the Fed began buying hundreds of billions of dollars of their debt and mortgage-backed securities to get mortgage rates down. Rates fall as bond prices rise.

“Imagine in your neighborhood no one is buying houses, and all of sudden someone buys 50% of the houses for sale. That is going to stabilize prices,” said David Spector, chief executive of mortgage originator PennyMac Financial Services Inc.

The Fed later decided it needed to do more to support the economic recovery, and over the next three years it launched two other bond-buying rounds to lower long-term interest rates and keep inflation from going below zero.

September 2008, Ben Bernanke, then Fed chairman, and then-Treasury Secretary Henry Paulson met with congressional leaders Photo: DAVID BRODY/Bloomberg News 

Buying long-term bonds sends some investors into riskier assets, buoying stocks, corporate bonds and real estate. Ultralow interest rates allowed millions of Americans to refinance, reducing foreclosures and freeing up cash for spending.

“They saw an effect similar to a tax cut,” said Mr. Spector of PennyMac.

Problems some critics warned about, such as roaring inflation and currency debasement, haven’t materialized. Labor markets have tightened, dropping unemployment to a 16-year low in July, while price pressures have been muted.

At the same time, the bond-buying has fueled concerns about frothy asset values, such as in commercial real estate. And while financial markets have boomed, economic growth and business investment have been unspectacular

Research published by the Fed in April estimated its purchases have reduced by around 1 percentage point what economists call a “term premium,” the extra yield investors demand for the risk of lending over a longer term.

Fed economists estimated this stimulus would decline slightly this year as markets anticipate the end of bond reinvestments. When the Fed’s balance sheet returns to a more normal level, the term premium could still be around 0.25 percentage point lower than if the bond programs had never occurred.

The Fed, though it stopped adding to its holdings of bonds in 2014, has continued to reinvest the proceeds of those that mature. It owns $1.7 trillion in mortgage bonds issued by government-related entities, or around 29% of the market, and around $2.4 trillion in Treasurys, which is 17% of that market.

In June, the Fed said when it started to shrink its balance sheet it would do so by allowing a small initial amount of bonds—$4 billion of mortgages and $6 billion in Treasurys per month—to run off the portfolio without reinvestment. Every quarter, it will let a slightly larger amount do so, up to a maximum of $20 billion in mortgages and $30 billion in Treasurys per month.

For the next year or so, the Fed should still end up buying bonds in most months, since only a small fraction will mature and go not replaced, said Richard Clarida, an economist at Pacific Investment Management Co., or Pimco. He compared the start of the plan to losing weight by eating only two desserts a day instead of three.

One question the central bank hasn’t yet decided: How large should its balance sheet be at the end of the process?

Its holdings have swelled to $4.5 trillion from less than $900 billion before 2008. Though they will fall, the Fed will end up with more assets than it had before the crisis because its liabilities have grown—there’s more currency in circulation. The balance sheet size could settle out at between $2.4 trillion and $3.5 trillion sometime early next decade, New York Fed President William Dudley said in a speech earlier this month.

That would mean the Fed would end up selling only around $1 trillion to $2 trillion in securities after having added $3.7 trillion between 2008 and 2014.

One reason markets have been relatively unfazed is that central banks in Europe and Japan are still purchasing assets. Mr. Spector of PennyMac expects the start of the Fed’s unwinding to have little effect on mortgage rates, which in early September hit their lowest levels of the year.

Expansionary monetary policy in Europe and Japan could postpone or defer any volatility from the wind-down of the Fed´s balance sheet. Percentage change since 2003 in the balance sheets of major central Banks.

The Fed wants to move now because the economy is on stronger footing. Its large holdings have become a political liability, with critics saying the mortgage-debt buying, in particular, exceeded the Fed’s mandate once normal market functioning had been restored.

Central bankers are “comfortable with the extraordinary actions they took during the crisis, and they know not everybody is,” said Lou Crandall, chief economist at financial research firm Wrightson ICAP. “If the unwind is successful, it will bolster the case for” similar bond buying in the future.

Hanging over the discussions has been the question of who will lead the Fed next year. Ms. Yellen’s term expires in February, and Vice Chairman Stanley Fischer is giving up his seat.

There are three other vacancies on the seven-seat board of governors.

By reaching unanimous agreement on the balance-sheet plan this year, the Fed has essentially resolved the issue for any Yellen successor and given more certainty to markets, just as Ben Bernanke in 2013 announced plans to gradually reduce the Fed’s purchases before his term as chairman ended in 2014.

The balance-sheet plan bears hallmarks of Ms. Yellen’s meticulous, leave-nothing-to-chance leadership, say current and former Fed officials. The core of it came together three years ago.

Officials said they would raise the federal-funds rate before starting on the balance sheet, and wouldn’t be bond sellers.
Bank of Japan Governor Haruhiko Kuroda, Fed Chairwoman Janet Yellen and European Central Bank President Mario Draghi at Jackson Hole in August Photo: David Paul Morris/Bloomberg News 

The rate-setting committee ramped up discussions at its March 2017 meeting, weighing questions such as whether to set a fixed calendar or to condition a wind-down on economic conditions; the pros and cons of a phasing out of reinvestments vs. stopping cold turkey; and whether to treat mortgage bonds and Treasurys differently.

After the March discussion, a majority—around 10 of the committee’s 17 members—appeared to form a consensus: The Fed’s plans should be predictable and passive. Tapering the pace of bond reinvestments would extend the process by a year, reducing the chance of spike in bond yields.

It should be as exciting as watching paint dry, Philadelphia Fed President Patrick Harker later said.

In regular calls and meetings to gain more feedback from committee members after the March meeting, Ms. Yellen gently highlighted the growing consensus to those who had different ideas.

Meantime, when minutes of the meeting revealed details of the discussion, markets shrugged, helping to move off the fence some who worried about acting too soon. By the Fed’s June meeting, officials who were uneasy about moving ahead with rate increases voiced little concern about starting the balance-sheet plan, largely because it was so gradual.

“We won’t know until we actually take the action, but I’m reasonably confident that it’s not likely to be much of an event,” said Boston Fed President Eric Rosengren. “We communicated it better this time.”