Archive for April 2019


What should we make of current market signals?

For those foolish enough to pay attention to my predictions, here are a few thoughts on the current condition of the economy. First the data:

1. Stocks hitting all-time record levels.

2. The yield curve un-inverting, back to a normal slope.

3. But 2-year yields remain below 3-month yields.

4. Five-year TIPS spreads at 1.87% (implying PCE inflation closer to 1.62%.)

The TIPS spreads might be slightly biased by risk premia, etc., but overall I suspect that inflation expectations actually are below 2%, say in the 1.7% to 1.8% range, over the next 5 years.

The most interesting data point is:

5. A roughly 88% chance of a rate cut by January 2020, according to the fed funds futures.

Update: That seems to be an error on my part. CME Fedwatch lists a 70.7% chance of a rate cut.

Here I think it’s important not to obsess over a single data point, but look at the set of data as a picture that describes a complex scenario. Here’s my view:

The stock market clearly doesn’t expect a recession. That’s probably the least controversial thing I’ll say. Thus the strong expectation of a rate cut by 2020 is motivated by something other than recession fears. (At least I got that right back in December!) My best guess is that the fed funds futures market and the TIPS markets are seeing the same thing—“lowflation” is a real issue, under-appreciated by the Fed.

Now let’s go back to stocks—why isn’t lowflation a problem for stocks? Let’s start with the fact that while academic economists like me worry about the impact of lowflation on policy credibility, it doesn’t matter all that much to hard-headed investors, who don’t much care whether inflation averages 1.75% or 2.0%, as long as it’s associated with steady NGDP growth.

Then recall that most recent recessions were triggered by tight money policies aimed at restraining high inflation. And yes, that includes the 2008 recession. The markets now see the Fed in a long drawn out battle against lowflation, which means that we’ll likely go many years before the Fed would institute the sort of tight money policy that typically triggers a recession.

In other words, they see a sort of goldilocks economy, with the Fed consistently trying to nudge PCE inflation up from 1.75% to 2.0%. They see the rate cut that they anticipate in 2020 as being analogous to the 1995 rate cut, which paved the way for 5 golden years of growth.

Of course the markets may be wrong, but that’s my best guess as to what they anticipate. And since I’m a market monetarist, that’s also what I anticipate.

There are worse things than 5 more years of the Fed struggling to push inflation up from 1.75% to 2%, and I’ve lived through plenty of them. Cast your eyes over to Europe, described in this memorable line by Wolfgang Munchau:

It says a lot about the eurozone economy that it reached the top of its business cycle with short-term interest rate at -0.4 per cent.

File that under “very good sentences”.

To add insult to injury, the Fed is having a June conference aimed at improving its already fine performance, whereas the Europeans don’t seem to have a clue as to what went wrong with the euro. Sad!

PS. Hint: The problem with the euro is not the lack of a eurozone-wide fiscal policy, which would never work, it’s the failure of the ECB to maintain adequate growth in NGDP. In other words, the stubborn Germans and the enlightened European liberals are both wrong. I’m afraid there’s no hope for Europe.

PPS. I have a new 7-page policy brief at Mercatus that explains the basics of monetary policy. It’s basically for beginners.

The Swiss still have plenty of ammo

During the Great Recession, the Fed’s target interest rate never fell below 0.25%. The various QE programs pushed the monetary base up to a peak of just over 20% of GDP.

In contrast, the Swiss have reduced their target interest rate to negative 0.75%, and their monetary base has been increased to roughly 100% of GDP. So you might wonder if the Swiss are out of ammo. Far from it:

The Swiss National Bank can lower its subzero interest rates even further, President Thomas Jordan told newspaper Blick.

In the interview, Jordan affirmed the ongoing need for a deposit rate of minus 0.75 percent plus a pledge to intervene in currency markets, if necessary, adding the franc remains highly valued. . . .

“We always have the possibility of lowering rates further. We have already gone quite far, but still we’ve got the necessary room to maneuver,” he was quoted as saying in comments published in Saturday’s Blick. “And we can, if necessary, expand the balance sheet further via interventions.”

While the Swiss economy is currently doing pretty well, it’s nice to know that they have the necessary ammo for more stimulus, if needed. Indeed their willingness to employ this ammo is one of the reasons why the Swiss economy is doing OK.

If only the Fed had been willing to be more aggressive during the Great Recession. In that case there might have been only a mild recession, and no need for them to actually be so aggressive.

Another country with plenty of ammo is Argentina, where inflation is running at 50%. The Economist describes the problem this way:

Argentina’s macroeconomic policies are now consistent with lower inflation: the fiscal deficit is narrowing, interest rates are painfully high and the imf has boosted the central bank’s foreign-exchange reserves. But inflation has its own momentum: it is high, because it was high, and is expected to remain so.

That final sentence kind of makes my skin crawl. I get that rising inflation expectations can boost velocity, but let’s get serious. There’s no mystery here; there are actual concrete steps that lead to high inflation:

I guess Argentina doesn’t have a low birth rate like Japan. You know, the “demographics” that supposedly cause “lowflation”.

Steve Moore’s peculiar logic

This caught my eye:

Moore said on “This Week” that one of the most compelling reasons he should be on the Fed Board is because he was “one of the first economists” to criticize the Fed for raising interest rates in December.

“I got very angry about it and I said this was economic malpractice. It was a terrible decision by the Fed. The stock market fell by 2,500 points in the subsequent weeks of that,” he said. “And then, of course, the Fed had to reverse course, put its tail between its legs and admit that people like Donald Trump and I were right and that they were wrong.

Where to begin.  The Fed has not “admitted” that Trump was right.  Nor has it reversed the interest rate increase that Steve Moore thought was going to have a disastrous effect on the economy.  So how has the economy done since the Fed foolishly raised rates in December?  Moore continues:

“And incidentally, George, ever since then the economy has been on this surge.”  

So the Fed decision to raise rates has been followed by a “surge”.  And this proves that the Fed was mistaken to raise rates?

Presumably Moore has something else in mind, perhaps the Fed’s decision to back off from its plan for future rate increases.  But if the economy really is surging, I’m having trouble understanding how this proves the December rate increase was a mistake.  

If Moore were an average American I would not pick on his confusion over the distinction between interest rate increases and forward guidance.  But he’s not an average American, he’s a candidate for the Fed.  If he makes it to the Board I suspect that he’s going to be in way over his head, and hence relatively ineffective.  

PS.  Saturday’s post quoting Jonah Goldberg was highly critical of conservatives. In fairness, there are still a few sensible people out there:

Judge Andrew Napolitano

President Trump turned on Fox News personality Judge Andrew Napolitano after the legal analyst issued a sharp rebuke of the president’s actions outlined in special counsel Robert Mueller’s report as “immoral, criminal, defenseless and condemnable.”

J.W. Verret

J.W. Verret, a George Mason University law professor who served on President Donald Trump’s transition team, is calling on Congress to initiate impeachment proceedings in the wake of special counsel Robert Mueller’s report.

“This is serious stuff,” Verret told CNN’s Don Lemon in an interview Tuesday. “The Mueller report I think is something you can’t look away from. I mean you have to admit it: The emperor has no clothes.”

Mitt Romney

Republican Sen. Mitt Romney issued a sharp rebuke of President Donald Trump on Friday following the release of special counsel Robert Mueller’s report, saying he was “sickened” by details revealed in the document.

“I am sickened at the extent and pervasiveness of dishonesty and misdirection by individuals in the highest office of the land, including the President. I am also appalled that, among other things, fellow citizens working in a campaign for president welcomed help from Russia,” the Utah Republican said in a statement.

But the report “completely exonerated” Trump.

Tyler Cowen on Fed nominees.

Tyler Cowen has a Bloomberg post that discusses what type of person should be nominated for a position on the Board of Governors at the Fed. It’s a good piece and I don’t see anything with which to to disagree. The essay clearly explains why people like Herman Cain, Steve Moore and Scott Sumner should never get near the Board. But there are a couple of omissions that I’d like to discuss:

1. Tyler omits one of the most important criteria—personal integrity.

2.  The Fed’s structure should be changed.  As with the Bank of England, there should be a committee composed entirely of experts on monetary policy, and another committee of experts on bank regulation.  We don’t ask a single agency to do both securities industry and environmental regulations, so why have one committee do both monetary policy and banking regulation?  The two fields are completely unrelated.  Very few people are experts in both macro and micro.

3.  A more decentralized Fed would allow more weight to be placed on expertise for monetary policymakers, and relatively less weight on managerial skills.  Right now the Board basically runs the entire Fed, or at least the DC part of the Fed.  That’s a big organization.  I’d like a structure where having Bernanke or Yellen chair the monetary committee is just as effective as having Larry Summers chair the committee.  Right now, Summers would be the more effective chair, for the various reasons that Tyler outlines (political/managerial skills, etc.)  That’s unfortunate, as Bernanke and Yellen are slightly better monetary experts.

Of course even in my ideal system the chair of the monetary committee would need some managerial/political/communication skills, but certainly less than today.  I’d like a structure where Bernanke and Yellen’s managerial skills are completely adequate, although I’m under no illusions that any plausible structure would make me a good candidate for the Fed.

Off topic, another Bloomberg piece had this to say:

At times last year Fed policy makers sounded open to using higher interest rates to lean against potentially over-exuberant financial markets, said Jonathan Wright, a professor at Johns Hopkins University and a former Fed economist.

Case in point: New York Fed President John Williams said in October that the central bank’s rate increases would help reduce risk-taking in financial markets, though he added that was not their principal purpose.

Backed Off

Such talk has since faded. “There doesn’t seem to be the same idea of having tighter monetary policy so as to lessen the risk of asset bubbles developing,” Wright said.

This isn’t surprising to market monetarists, who predicted that if the Fed tried to target financial stability they would lose control of their inflation/employment target. Fortunately, the Fed has seen the light. If only they’d asked us a few years ago and not wasted all that effort on the chimera of using monetary policy to prevent asset price “bubbles”.

NGDP growth and interest rates

NGDP growth in Q1 came in at 3.8%, a bit less than expected. As a result, bond yields declined. Indeed NGDP growth has been slowing ever since hitting a peak of 7.6% in 2018:Q2.

One word of caution. Due to the government shutdown this data is likely to be revised—statisticians were missing some trade data. The 0.6% GDP inflation rate seems a bit odd, perhaps it will also be revised. Year-over-year data is probably more reliable.

The media focuses on RGDP, which came in higher than expected, but it’s NGDP that drives interest rates in the long run.

Commenters keep telling me that money is too tight, but I see 5.1% NGDP growth over the past 4 quarters. Don’t assume that rising interest rates imply tight money.

The RGDP growth was strong, which is good news for supply-siders. There is a caveat however, some experts say the internals were somewhat weaker, with growth being distorted by transitory factors. Time will tell.

PCE inflation was only 1.7% year-over-year. That’s a problem, and perhaps that signals that money is a bit too tight, but since unemployment is below the Fed’s estimate of the natural rate it’s a fairly small problem.

I expect NGDP growth to continue slowing over time, but given my recent track record no one should take my predictions very seriously. Overall, I think the Fed’s doing a very good job at the moment, but the regime still has serious flaws that may show up if the economy is hit by a shock.

I also see the recent strength as one more nail in the “long and variable lags” theory. In December, forecasters widely anticipated a slowdown in the economy. Then the Fed issued some dovish comments and the asset markets immediately perked up. By March the underlying economic data was also showing increased strength. Monetary policy affects the economy within a month or two. Without the Fed policy adjustment in January, the first quarter would have been weaker.

PS. In other news, Bloomberg reports:

The U.S. and China have agreed on a currency provision in their potential trade agreement, Treasury Secretary Steven Mnuchin said in February. Bloomberg News reported earlier that the U.S. was asking China to keep the value of the yuan stable to neutralize any effort to soften the blow of U.S. tariffs.

China won’t engage in currency depreciation that “harms other countries,” Xi said on Friday, adding the yuan will be kept at a “reasonable, equilibrium level,” and the market will play a bigger role in setting the exchange rate.

Well okay!!

I suspect the Chinese know exactly how Trump retaliated against North Korea when they failed to live up to their promise to denuclearize.

The Bloomberg article was accompanied by perhaps the funniest headline of the year:

China’s Xi Signals Approval for Trump’s Trade War Demand

Trump demands reasonable, equilibrium exchange rates that don’t harm other countries!!

PPS. Who would have expected the most devastating takedown of modern conservatism to be penned by the author of Liberal Fascism?

Whether you call it the party line, right-wing political correctness, or simply a desire to cater to the president’s fragile ego, it’s simply not acceptable to publicly criticize Trump on the right. Prominent religious leaders feel compelled to dismiss Trump’s sordid sexual history. Passionate constitutionalists simply shrug or celebrate Trump’s words and deeds, no matter how contrary they may be to constitutional principles. You have to gush about his genius when there’s little discernible wisdom in what he does, and you must marvel at his courage when there’s none to be seen. Credit for Trump’s wins is all his; blame for his losses is all somebody else’s. . . .

Indeed, the demand that everyone see the emperor’s new clothes is so powerful that criticizing — or even being inconvenient to — the president’s preferred messaging is seen not only as a kind of treason but as proof that the critic isn’t really a conservative at all.

And people wonder why I call it a cult.