Archive for August 2015


Thinking out loud

Always dangerous to speculate when the market is changing minute by minute, but a few observations:

1.  Over at Econlog I did a post earlier this morning, suggesting that the China slowdown is reducing the Wicksellian equilibrium global interest rate.  Since central banks foolishly target interest rates rather than NGDP, this makes monetary policy more contractionary.

2.  Why does this seem to affect foreign markets more than the US market?  One possibility that that economies like Germany and Japan are more exposed to a global slowdown, as manufacturing exports are a bigger part of their economies. But that suggests the yen and euro should be falling against the dollar, whereas they are actually appreciating strongly.  Indeed the appreciation is so strong that one could easily attribute much of the recent stock market decline in Europe and Japan to their strengthening currencies.  Now of course I always say “never reason from a price change,” so let me emphasize that I am implicitly assuming the stronger yen and euro reflect tighter money, not surging growth expectations in Europe and Japan.  I don’t think anyone in their right mind believes global growth prospects have been rapidly improving in the last week, especially when you look at commodity and stock prices.

3.  The falling TIPS spreads and real interest rates suggest that AD expectations are falling in the US, but not anywhere near to recession levels.  After all, did anyone expect a recession last time the S&P was at this level?  Obviously not.  The tighter money in Europe and Japan suggests those economies will be hit harder than the US.

4.  If Europe and Japan are facing tighter money than the US, why would that be? Probably because markets think it would be easier for the Fed to at least partially offset this shock, via a delay in the interest rate increase.  Areas already at the zero bound would have to be more creative, and history has shown that central banks tend to be slower to react at the zero bound, especially when there are sudden and unanticipated shocks like this.  (It’s easier to offset anticipated shocks, like 2013’s fiscal austerity.)

This is all very speculative, and I don’t have a lot of confidence on my analysis. And as always, I don’t forecast asset prices, I merely try to ascertain what the market is forecasting.  Unfortunately the Hypermind market is still not very efficient.  It opened this morning at 3.6%, which was actually up slightly in the past few days.  I don’t think that reflects actual NGDP expectations.  Last I looked it was down to 3.4%, but of course efficient markets respond immediately to shocks.  This tells me that while the market is a nice demonstration project, there is no substitute for a very deep and liquid NGDP prediction market subsidized by Uncle Sam.  If it’s not the biggest $100 bill on the sidewalk, it’s right up there.

One other point.  I’m much more concerned by falling TIPS spreads and falling 30-year bond yields, than I am by falling equity prices.  Stocks often show large price breaks, without there being any change in the business cycle.

PS.  I agree with Lars Christensen’s analysis (except the part about China not becoming the biggest economy.  We face this problem because they already are the biggest.)  I think Lars is right about the two key mistakes being the Chinese yuan/dollar peg and Yellen’s tight money policy.

Nick Rowe’s wisdom, New Keynesianism vs. NeoFisherism, and Fed incompetence, all explained in one 7 minute bicycle video

Here it is.

HT:  Tyler Cowen

Fed policy is bankrupt

With each passing year it becomes more and more obvious that the current Federal Reserve policy regime is finished, and that a new regime will be needed.

The existing regime at the Fed relies on using interest rate control to steer monetary policy.  But they are also reluctant to cut nominal rates below zero.  That means that in a world of low real interest rates (which describes the world of the 21st century) the Fed will not be able to use monetary policy during recessions, if they maintain a low inflation target.

There are several possible solutions.  One solution (favored by Krugman and Blanchard) is to raise the inflation target to 4%.  Another possible solution is NGDPLT. Or NGDP futures targeting. But whatever the Fed decides, one thing is clear—the current policy regime is bankrupt.  The Fed hasn’t yet figured this out, but I suspect that at some level the markets have.  Not that market participants necessarily agree with my specific MM intellectual framework, but rather that they see the failure of the current regime.

I’m told that lots of market participants think low inflation is now a structural characteristic of the global economy, and cite all sorts of factors like cheap imports. Of course that’s nonsense, inflation is never a structural problem, it’s a policy choice. I think what they are actually intuiting is that the Fed is wrong—under the current policy regime we will have very low inflation for as far as the eye can see. And we are seeing that in the bond market.

Today the 30-year TIPS spread fell to 1.71%, a record low.  The 30-year bond yield is 2.74%.  At those rates the Fed won’t be able to use the short term nominal interest rate as a policy instrument during recessions.  The markets are telling the Fed that its policy regime no longer works.  Is the Fed listening?

Update:  The 30-year TIPS spread is not a record low, I relied on a FRED time series that only went back a few years.

Japan prediction from 2011, revisited

Back in 2011 most experts claimed there was nothing the Japanese could do to boost NGDP.  It was believed they were stuck in a liquidity trap.  Then in 2012 candidate Abe announced that he would implement a more expansionary monetary policy, including a 2% inflation target.  I suggested the policy would help, although they’d fall short of 2% inflation.  Mark Sadowski has a post showing the path of inflation.  (When Abenomics was announced in November 2012 the Nikkei was around 8700 and the yen at less than 80 to the dollar.)

Screen Shot 2015-08-20 at 11.34.31 AM

Mark also generously quoted from a 2011 post of mine that I’d forgotten about.

Just to be clear, it is quite possible (likely in my view) that Japan could get another 2% of RGDP by switching to a 3% NGDP target.  But it would be a one-time gain, as their labor market got less rigid.  Unemployment might fall to 2% or 3%, but trend growth shouldn’t change.

In fact, RGDP growth was 2.4% in the first year of Abenomics, and has been roughly zero since.  Recall that zero is the new trend growth for Japan, due to their rapidly falling working age population. Yes, I was a bit lucky, but as Napoleon once said “give me lucky generals.”  (or something vaguely like that, probably in French, not English.)

Marcus Nunes has a new post that quotes from the recent FOMC meeting:

There was push back against hesitating. A number of officials argued that a rate increase could convey confidence to the world about the economic outlook and that the Fed needed to move in acknowledgment of the progress the economy had already made toward normalcy.

Yes, tighter money from the Fed is just what global markets are looking for right now, to regain confidence.

You can’t make this stuff up.  While traveling I saw a story that the new President of the Dallas Fed is going to be a management professor.

PS.  I have a new post at Econlog.

All hail Kocherlakota!

To put the following quote in perspective, let’s first summarize how the Fed views the world:

1.  The Fed successfully targets inflation at 2%.

2.  This can only occur if the Fed is able and willing to steer the nominal economy, i.e. NGDP.  So the path of NGDP is determined by Fed actions (or perhaps errors of omission.)

3.  Although the Fed believes it steers the nominal economy, it never takes the blame for bad outcomes, in real time. Later on it might admit that it caused the Great Contraction and Great Inflation (indeed it has admitted to those two crimes) but not in real time, not while it’s committing the crimes.  Thus in 2008-09 it did not admit that the failure to cut interest rates between April and October 2008 was a huge contractionary mistake.

4.  Instead, in real time the nominal economy is assumed to move of its own accord (even though the Fed’s model says they drive NGDP) and the Fed is a like a firefighter who comes in to rescue the economy, when it misbehaves.

But now we have Minneapolis Fed President Narayana Kocherlakota in the WSJ admitting that on a few occasions the Fed actually causes the fire.  And he’s admitting this in real time, not just that they were too contractionary when the sharply cut the base between October 1929 and October 1930, or too expansionary when they cut interest rates in 1967.  They are too contractionary right now.

I participate in the meetings of the Federal Open Market Committee, the monetary policy-making arm of the Federal Reserve. In that capacity, I’m often asked by members of the public about the biggest danger facing the economy. My answer is that monetary policy itself poses the biggest danger.

Many observers have called for the FOMC to tighten monetary policy by raising interest rates in the near term. But such a course would create profound economic risks for the U.S. economy.

Why would a near-term tightening of monetary policy be so problematic? Because given the prevailing economic conditions, higher interest rates would push the economy away from the FOMC’s economic goals, not toward them.

Congress has mandated that the Fed promote price stability and maximum employment. The FOMC has translated its price-stability mandate into a target 2% inflation rate, as measured by the personal consumption expenditures price index. Inflation has run consistently below that objective for more than three years and is currently at 0.3%.

The outlook is for more of the same. Most private forecasters do not see inflation reaching 2% for the next two years. Government bond yields are consistent with that same subdued inflation outlook. In June the FOMC’s own staff forecast was that inflation would remain below the committee’s 2% target until the 2020s.

The U.S. inflation outlook thus provides no justification for policy tightening at this juncture. Given that outlook, the FOMC should ease, not tighten, monetary policy by, for example, buying more long-term assets or by reducing the interest rate that it pays on excess reserves held by banks. Along these lines, the board of directors of the Minneapolis Fed has for the past few months been recommending a reduction in the interest rate that the Federal Reserve charges banks for discount window loans.

Now, this is not to say that increasing the federal-funds rate by a mere quarter of one percentage point, as many advise, would in and of itself have a huge direct impact on the U.S. economy. But even a small change toward tighter policy would send a strong message to financial markets.  [Emphasis added]

I’ve also said the Fed should cut rates now.  Indeed I’ve said just about everything Kocherlakota says here. How did Kocherlakota ever get appointed to the Fed? They need to screen candidates more carefully.

PS.  The 5-year TIPS spread has now fallen to 1.2%, and the 30-year is at 1.75%. Question, what’s the all-time low for the 30-year spread?

PPS.  So much for those who said the Fed wasn’t doing enough in 2013 and 2014 because of the zero rate bound.  They are about to raise rates!  But while many Keynesians were a little bit wrong they can at least point to the conservatives, who have been wrong about monetary policy so many years in a row it’s becoming almost comical.

HT:  Michael Darda