Sunday, December 14, 2014

The US economy in 2015: Punch drunk, great DJ, but where is the Exit?

Fed Chairman William McChesney Martin once said  ( - apparently in a speech in 1955, and I paraphrase here), that that whole point of monetary policy should be to remove the punch bowl just as the party gets started". In the spirit of Christmas panto, and to continue the analogy, the drinks are now pretty strong (maybe shots?), and what's more, a talented DJ has just arrived and (s)he seems to really be dropping some great tunes and the party is beginning to look like it will roar!

The really interesting part to this story though, is what happens next? Does the host suddenly decide to hide the punch bowl and threaten to call the police to really put the dampers on things; or does the DJ run out of interesting tunes to drop because (s)he only brought a limited number of tunes; or is the DJ so good that it gets the neighbors involved to really spread the joy and make the whole party rock, with the distinct possibility that the police will show up in force, but only much later?

Those of you who know some economics will recognize the characters here: the DJ is the price of oil, the police represent inflation and the host is the central bank, with the punch bowl being accommodative monetary policy.  We all know that all 3 ingredients make the best parties - good drinks, often supplied by the host, no likelihood of police presence (perhaps because the neighbors are compliant and/or fun loving people) and a good selection of music to really get people in the right mood.

Now the economics.  OK, the precipitous fall in oil prices is good for most countries, and is even moderately good for the US, although it will definitely deliver some pain in some regions (like my own - South Texas).  But after watching an interview by the illustrious Simon Hobbs on CNBC, where he talked about signals that we are approaching the “end of the cycle” I got to thinking about whether Simon was correct, and whether the current oil price decline might soon sow the seeds of the end of the growth phase of the current business cycle.

So let’s look at some stylized facts:
i)   Business cycles typically last between 4 and 10 years;
ii) When the previous recession had, as it’s proximate cause the banking sector, research (by Reinhart and Rogoff) shows that the recovery is anemic;
iii) Central banks are pretty much exclusively focused on inflation and inflation targeting plus slack in the labor market these days; and
iv) Oil price rises tend to slow economies down.
So let’s see where we are on each of these stylized facts. 

First, given that these 4-10 year periodicities are roughly right, and I see no reason to believe that they are not, then as we recently passed the 5 year mark of the emergence from recession, we are definitely in the mid-stage if not heading into the late stage of the business cycle.

Second, the recovery from the previous downturn has been anemic, as anticipated, but this is partly due to the very tight restrictions on bank lending – these are now being relaxed, plus although the housing sector has not been wonderful of late, there are now signs that people are trying to move before the Fed increases rates sometime in 2015. Fanny Mae and Freddie Mac just announced a loosening of these lending standards, and the banks are already beginning to try to get better returns on their balance sheets.  

Third, central banks are expected to keep interest rates low for an extended period of time, principally because with falling oil prices inflation is not perceived to be a threat, at least if measured by core inflation, which excludes the effects of the volatile food and energy components of the CPI.  But in the US, the focus has been on the labor market and unemployment in particular.  So this points to a lagged reaction to accelerating economic growth by the Federal Reserve, and in other countries such as the UK and Canada as well.  Put another way, it means that the punch bowl might have been emptied but it has still not been removed, now that the party has got going.   Articles in the FT such as this obviously support this idea, and will likely bring forward some house purchases, while at the same time gearing investors up for a rapid rise in rates..

The figure below shows the current dislocation very clearly.  3 month T-bill yields are still almost zero, and yet growth is now above 2 percent. To state the obvious: in every business cycle except the current one, by this stage of the cycle interest rates have been higher.  

Fourth, when oil prices finally go up, they could rise just as fast as they have declined – and the fall in oil prices over the last few months has been dramatic (and the fall is likely not over yet). So if one believes that oil prices will first fall, because of lack of agreement on a coherent strategy in OPEC, then it stands to reason that at some point shale oil projects in the US will get taken offline as they will not be profitable at these low prices, and therefore supply will shrink to meet demand.  But at the same time, and no one really is talking about this aspect of things, lower oil prices mean greater demand for oil.  So in fact, although I would be surprised to see oil prices fall below $45, it would not be completely out of the question, as supply needs to shrink at the same time as plans in other industries reacts to the lower oil prices, stimulating demand. 

The point here is that at some point oil prices could suddenly start to rise again, if for example OPEC suddenly agreed on a strategy to restrict output or if oil prices fell so low that they “overshoot” their new equilibrium value. In a way, this isn’t a bad thing, as the shale oil boom in the US has really gone too far, with drillers just everywhere in my part of the world – airborne pollution now a problem as well, and very little infrastructure to deal with the shipping and refining of these natural resource products.  So, as Schumpeter would say, some “creative destruction” is probably in order here, and lower prices will begin to better align oil demand with supply.  As of Friday, WTI oil closed at just about $63, so if this fall continues, some oil companies will soon definitely be cancelling future projects.

The chart below from BP shows some analysis of what we can expect in terms of the continuing fall in the oil price and how this will translate into lower upstream costs (the cost of oil exploration) down the road. The left panel shows where we are in terms of the fall in oil prices compared to previous rapid oil price declines. Previous declines have settled at anywhere between 50 and 70% declines, so we likely have further to fall yet until some kind of equilibrium is reached.  The period for oil prices to start rising again ranges from 5 months to 16 months, so we could be looking at lower oil prices persisting for a considerable amount of time. The right panel shows that in terms of costs, there appears to be a one year lag before costs fully reflect the fall in the oil price, as projects are cancelled and oil exploration is focuses on more certain and cheaper sources of oil.

How does this situation then potentially set us up for the next recession?  The problem here is that the fall in oil prices effectively stimulates the economy (like a good DJ can stimulate a party), by giving people more disposable income to spend, as filling their fuel tanks becomes a lot less expensive. At the same time, this accelerating growth will not show up as a problem at the Fed and at other central banks, as it gets excluded from their core measures of inflation, and they are still focused on labor market indicators (which are lagging indicators of economic growth).  So the Fed will likely be “behind the curve” when it comes to raising rates, something I believe we are already seeing, as they keep on pushing higher rates further into 2015.  

Moreover, given where government bond yields are, the Fed also appears to be very slow off the mark in terms of reversing QE – yields went up slightly when the bumper labor market statistics were released on  Friday Dec 5th, but came down again very quickly with a few other lackluster economic releases.  Market participants appeared somewhat surprised that bond yields had reacted so little – that in turn tells me that the Fed isn’t selling its bond holdings in any significant numbers, which is something I find quite alarming.

So that sets the stage for a medium term “foot on the accelerator pedal” to really boost growth in the oil dependent countries – notably the North American and European economies. The real problem occurs though when oil prices go back up. This will immediately slow growth, presumably when interest rates are higher, and the central bank meanwhile will be in no mood to be accommodative, as they will be busy trying to “normalize” monetary policy so as to fight any upcoming recession.  This situation though could be the trigger which causes the next economic downturn to occur.  To use the punch bowl analogy once again, this could create a great party, but the hangover could be serious, particularly if the party gets out of hand! 

Monday, November 3, 2014

What can wavelets tell us about long term US economic growth?

In this blog I always try and emphasize cyclical features of macroeconomic growth, as that is my main research interest right now. Given the extraordinary events taking place in the world of monetary policy in recent years, an important question to look at is where the long run US economic growth rate is going, as the argument has been made that the more fractured US labor market could lead to weaker economic growth going forward as US consumers are less willing to spend as they were before the great recession .

First, if you look at US economic growth, there has been a lot of talk about a decline in the long term US growth rate trend. What do I mean by this?  Recent (excellent) research by some economists at Fulcrum Investments highlighted in an FT article by Gavyn Davies (see here) used something called a "Dynamic Factor Model".  This research incorporated some tweaks in the overall model to allow it to "detect" where the long run US economic growth rate is headed.  Their results clearly show that long term US economic growth (and growth in other major developed economies) is heading downwards.  The figure below from their paper (which you can find here) shows the downward trend that they obtain for the long run US economic growth rate. In their paper the authors go on to repeat this analysis for the other major developed economies with very similar results.

Source: Antolin-Diaz, Dreschel and Petrella (2014), p21

Above the red line plots their long run growth rate, with the blue dotted lines showing 5 and 10 percent confidence intervals.  The black much more cyclical line shows the Congressional Budget Office's measure of the growth in potential output ( - the growth in the maximum output of the economy if all factors of production were employed).

On the face of it, the red line showing their measure of estimated growth looks pretty bad - it appears to move downwards over the 55 years plotted here.  But there are two points to bear in mind here though.

First, this measure does not use the official definition of economic growth, which is percentage change in real GDP per capita, as it is measured here as percentage change in real GDP.  In fact most economists do not either, as getting population estimates by quarter is extremely difficult and even if you do, they are only estimates as we only really take a proper guage on the US population every census year.  In other words, the figure above doesn't account for the change in population growth. This is important, as in all developed countries there has been a decline in the population growth rate, so some of this fall in the percentage change in real GDP would be expected.  Now the authors do attribute some of the fall in the growth rate to the fall in population growth, so this is not a fault with their analysis, but rather something that one would be expect to be reflected in the figure above, thus tending to support a fall in the long term growth rate.

Second, I would argue that their definition of "long term" is not correct.  To me, long term means something that is measured over several business cycles, not just over one business cycle.  Just looking at the graph above, I would argue that for the period 1970 to 2000 their long term measure of the economic growth rate was actually pretty stable, but that their measure clearly turns downwards well after 2000. So their measure really drops decisively below 3% only in 2004 or thereabouts, only 10 years ago, and therefore not even a complete business cycle ago. To my way of thinking that is not a change in the long term growth rate, as it has only happened over the last business cycle.  Why does this matter?  Well it could be (as we all know from the Reinhart and Rogoff research) that the recovery from the last recession was weak because the last recession was caused by a systemic banking failure - something that takes a lot longer to recover from than a "regular" recession.

Often it is good to get a robustness check on the results from doing an exercise like this by looking at what alternative methodologies reveal about the fluctuations in economic growth that the US has experienced. So here I introduce another approach known as wavelet analysis.  This type of analysis operates in what scientists call the "time-frequency" domain, as it assumes a certain degree of (regular or irregular) cyclicality.

So let's first start with what wavelet analysis does.  It basically takes the data and extracts cycles that can be detected by the technique over different ranges of frequencies. This is done in certain preset ranges, and these ranges are dyadic ( - they increase in terms of powers of 2).  So for example the most basic cycles in a quarterly data series can be extracted at the 2 to 4 quarter cycle, then at a 4 to 8 quarter cycle, an 8 to 16 quarter cycle etc. When you run this type of wavelet analysis ( - technically it's called multiple overlap discrete wavelet analysis), you have to specify the maximum length of cycle you want to extract.  Here I specify a 16 year cycle to be the maximum cycle, so that means that we have 5 series of what are called "crystals" which include the different ranges of cycles up to a 16 year cycle. Then anything left over after cycles up to 16 years long are extracted, is also put into what is called the "wavelet smooth".  It contains any trend in the series plus any cycles in the data that can be detected that are longer than 16 years in length.

So what does this look like for US economic growth?

Source: Calculations by author
In the chart above I have broken down the fluctuations in US economic growth by cycle range, so lyd1 (the dark blue line) represents 2 to 4 quarter fluctuations in growth, lyd2 (the bright red line) represents 1 to 2 year cycles in growth etc.  The light brown line which is labelled lys5 represents everything left in the growth series after all the other cycles have been extracted, so it contains cycles longer than a 16 year duration and any trend left in the series. Following the wavelet literature, I will call this variable (lys5) the "smooth".

What I find is very different from the Fulcrum Investment research. It is clear that from around the late-1960s onwards the growth rate has fallen to a lower level than it was prior to this date. But from around 1983 we see another phenomena emerging in the data - that of the so-called "great moderation", which saw high frequency fluctuations (lyd1, lyd2 and lyd3) dampened down, but at the same time a more vigorous longer term cycle emerging, particularly in the "smooth". In a paper with Andrew Hughes Hallett (available here) we show that in fact there was likely volatility transfer from this more high frequency (shorter) cycles to the low frequency (longer) cycles. I will write more about this paper and it's implications in a future blog.

But what is clear is that the longer term trends shown by the wavelet smooth do not indicate a significant decline in the long term economic growth rate. In fact, quite the opposite: it shows that i) the longer term smooth has been falling for cyclical reasons, as it has rebounded nicely since the great recession, but also ii) the longer term trend (also captured by the smooth) is in fact moving upwards quite rapidly, signifying that the economy is still on a long cycle upswing right now. In fact it may indicate that there is a longer cycle in growth lurking in the data.

Of course which methodology is right will affect a whole lot of other variables in the economy - such as the stockmarket, the bond market, incomes and expenditures.

So which method is right?  Both methods have their advantages, but both also have disadvantages and statistical flaws. Probably the honest answer is that only time will tell!  

Thursday, September 11, 2014

The Scottish and Quebec Referendums Compared

Although I haven't made any statements on this issue, as a Brit I obviously have a viewpoint on whether Scottish independence would be good for Scotland and if so, whether this would be also good for the UK.

I also have a unique perspective on this particular referendum, which pundits and policymakers are comparing directly to the 1995 Quebec referendum for separation from the rest of Canada. I happen to have been in Montreal, Quebec on the night of October 30th, 1995, and delivered a report for the Canadian Broadcasting Corporation radio in Eastern Canada by phone early on the morning of the 31st, so I guess I know a little bit about close referendums. That referendum was incredibly close, with the "No" (to separation) vote obtaining 50.58% of the vote, and an incredible 98.18% of the electorate turned out to vote.

The similarity between the two referendums is uncanny, but there are some important differences between the Scottish and Quebec referenda, which have not been stressed in the media (see here for a selection from the BBC).

First and probably most obviously, Scotland speaks the same language as the rest of the UK, whereas Quebec is the only province in Canada that has a majority of French speakers, so they basically speak a different a language. That linguistic identity gives the Quebecois an added reason to seek sovereignty as they are recognized as "distinct" within Canada - to put it bluntly, in linguistic terms they are the only province where French is the first language in Canada.  That is not the case in Scotland.  Whatever you might think, language does give identity to nations.

Secondly, there are the geographic differences.  If Scotland leaves the United Kingdom, this indeed is the end of the 307 years political and currency union and the United Kingdom would consist solely of England, Wales, Northern Ireland and some smaller territories. That could have dramatic political effects, but it wouldn't impede movement of factors of production between what remained of the UK.  That could not be said if Quebec had left Canada.  Any casual glance at a map of Canada reveals that an independent Quebec would basically split the rest of Canada in two.  In fact 20 years ago when Quebec separation was a distinct possibility I remember the large degree of anxiety in the debate in Eastern Canada as Eastern Provinces realized that they would be small economies physically separated from the powerhouse of Canada, which is Ontario, as well as with all the other Western Provinces which make up the rest of Canada.

The other big difference is in terms of currency. When Quebec was looking at sovereignty, the currency question was a major problem for the Partis Quebecois under Jacques Parizeau.  The Bank of Canada stated that there was no guarantee that Quebec could continue to use the Canadian dollar after separation from the rest of Canada.  That left a void in terms of what the Partis Quebecois could claim in terms of what might happen in the event that the referendum approved separation from the rest of Canada.  There was talk of Quebec adopting the US dollar, of creating a separate currency (the Quebec franc) and of just using the Canadian dollar against the will of the rest of Canada.  With Scotland the Bank of England (led by a Canadian, Mark Carney, who perhaps remembers the uncertainty that the Quebec referendum generated in Canada) has declared that Scotland would be able to use the UK pound for two years after independence. And although there would have to be a choice made after two years about what would happen to the currency for an independent Scotland, there are feasible options, such as the adoption of the euro, which wouldn't entail any loss of monetary sovereignty (as the Scots would be able to make an input into euro area monetary policy whereas if an independent Quebec had adopted the US dollar it would have had to accept a "made in the US" monetary policy). Certainly if the euro is on the cards for Scotland then they would need to move fairly rapidly to set up their own central bank, as member states are not permitted to join the euro unless they have a central bank.

Source: The Scotsman.
The point I am trying to make here is that Scottish independence is feasible economically ( - in contrast to commentators like Paul Krugman here and here, who seem to be fixated on comparing the Scottish situation to the instability of the early days of the euro area).  The big issue is whether it is desirable.  For the Scots it has just become a lot less desirable as two big UK banks (Royal Bank of Scotland and Lloyds) have said that they will move their headquarters south of the border, which would mean higher unemployment north of the border as those workers would be laid off or faced with moving south.  But on the other hand Scotland does have oil revenues, and does have a sizable industrial base already, so it would not be a complete disaster but would likely be mildly disruptive.  What is interesting as well is that in the final days before the Quebec referendum the Bank of Montreal, plus several other major Canadian companies headquartered in Canada also threatened to move their headquarters west to Toronto, so that is a commonality between the referendums ( - in fact the major move of Canadian corporations out of Quebec came after the first Quebec referendum in 1974).. But headquarters are usually symbolic in this instance as most of the business of banking has already located to where the clients are, and in Canada's case that is Toronto and in the UK's case that is most definitely London. So there wouldn't be a huge corporate downsizing in Scotland, and thus only a small number of private sector jobs lost. On the other hand, more government jobs would be created as UK government departments now serving Scotland from London would be redundant and new equivalent departments would be created in Edinburgh.  So from Scotland's perspective there are both economic costs and benefits which make the decision unclear.

For the UK's perspective it is clearly undesirable, as not only would they lose those oil revenues, but also it would alter the political equilibrium for years to come ( - as the Scots tend to either vote Labour or vote for the Scottish Nationalist Party (SNP), with a small number of constituency seats going to the Liberal Democrats), so that conservative governments would be elected in what remains of the UK for years to come. Single party dominant (uncompetitive) democracies are unhealthy ( - just look at South Africa if you need an example of this), and lead to complacency and corruption.  Also, losing part of the UK that is fairly well off will bring down the overall GDP per capita of the UK as the weight of the poorer parts of the UK (Wales and Northern Ireland) would be higher. Of course as only the Scots get to vote, the rest of the UK is beginning to realize these ramifications and is now turning up the heat to assure the Scots that they will gain greater political powers if they stay inside the UK, as did the Canadian government when it was clear that the Quebec referendum would be extremely close.

The decision is not an easy one, as not only is it a single decision that will affect a country for a long time to come, but also it is not a decision that would be easy to reverse for the Scots. This is what economists call "dynamic inconsistency" - in other words, what might be good in the short term, might not be good in the longer term or vice versa. I read a recent article in the New Statesman (see here) that talks about the "velvet divorce" between the Czech Republic and the Slovak Republic at the end of 1992, and how incredibly painful it was to begin with, but that now the Slovak Republic appears to be doing better than the Czech Republic in terms of economic growth.  The main point is that the economics depends on the terms of the divorce, which is a difficult thing to determine in advance. Nevertheless, the English are unlikely to make it easy for the Scots, so I think the first few years of Scottish independence would be extremely rocky.

As the 18th September (polling day) nears, I wouldn't be surprised to see the type of spontaneous outpourings of nationalistic pride in the current UK that would be similar to the mass rally that occurred in Montreal before the Quebec referendum, and indeed this type of emotional outpouring can sway undecided voters. The danger though is that the vote is extremely close, as this encourages the SNP to consider another attempt in the future ( - what the Quebecois used to call the "neverendum"), and indeed although the "No" side of the campaign has the powerful argument that independence is very difficult to reverse once it is achieved, the opposite holds true as well - that future referendums might then occur. The best outcome is that the vote is decisive - with either the "Yes" or "No" side gaining at least 55% of the vote.  Of course, that now appears unlikely, with all the polls that I am currently seeing indicate a very close run race..

Thursday, August 7, 2014

The Unlikely Miracle of an Immaculate Monetary Exit

Recently, The Economist magazine reported (see here) that Richard Barwell of the Royal Bank of Scotland had made the comment that, for central banks to withdraw from the massive monetary stimulus they have delivered to the economy without any problems, then the stimulus should be withdrawn before the economy really is back on track again, and also for "central banks' economic forecasts to be unerringly accurate".  But in my view there is much more to this than just the timing of the withdrawal of the stimulus, particularly in the US, or the accuracy of central bank forecasts.

If one looks at the 10 and 30 year US government bond yields going back to the beginning of 2008, so just before the "great recession" started, from the chart below you can see that 10 year bonds were at 4% and 30 year bonds were at 5%.  What is astonishing about this chart is the big fall in US long bond yields that occurred in the late summer of 2011, and you might immediately assume that this marked the beginning of one of the "QE" programs of quantitative easing mounted by the Fed.  But you'd be entirely wrong here - it was essentially the beginning of "operation twist", where the Fed committed to buying more longer term Treasuries, or moving further down the maturity spectrum by buying more longer term bonds and selling shorter term ones.

We have never returned to those post-recession higher levels for 30 year bond yields ( - the 4-5% range), nor the 10 year bond ( - 3-4% range), despite having inflation that is roughly the same, if not higher than during that period.  Even during the "taper tantrums" of 2013, 30 year rates never quite got to 4%, and 10 year bond yields only briefly touched 3%.  Not only that, but the gap between the yield rates has been shrinking so that since early 2013 it is a full 0.5% smaller.

Let's have a look at real bond yields for the same maturity bonds (courtesy of the US Treasury's bond pages here). What's clear is that the "operation twist" announcement sent US 10 year real bond yields into negative territory for all of 2012 and the first half of 2013.  It's also noticeable that US real long bond yields are now not negative ( - but of course short term bond rates are). But it is also clear that it would be pretty exceptional circumstances that would send the US 10 year real bond yield into negative territory. In other words, to quote the pop band Yazz - "the only way is up"!

That also makes sense when considering both inflation and real GDP.  Current inflation is 2.1% on a year over year basis in June,   and current real economic growth on a year over year basis in Q2 is at 2.43%, not at all bad, considering the set back to output that the economy had in Q1 due to all the bad weather. Heck, some components in the CPI are just skyrocketing - such as Meat, Poultry, Fish and Eggs (up 7.5% yoy).  These are all products that we eat, and no doubt they will feed into higher grocery bills pretty quickly.  These levels of macroeconomic performance hardly warrant long interest rates in nominal terms at 2.5% or in real terms at 0.25%.
In other words, I would expect to be seeing both short and long interest rates at much higher levels than they are right now, but particularly longer rates, given that the economy is likely to be going through more rapid growth going forward than it has in the recent past.  All these predictions about continuing sluggishness in the economy have been underpinned by the Fed's continuing commitment to low interest rates ( - Yellen's claim that the FOMC is in "no hurry" to raise rates), and their "gradualist" ( - some might say irresponsible) and non-differentiated taper. 
And that is the danger.  The "gradualist" approach might be just a tad too gradual - and stimulative.  As central bankers are fond of saying, the Fed's job is to pull away the punch bowl just as the party gets going. But in my view the trouble is that the Fed is still spiking the drinks, when already some of the party guests appear to be a little tipsy. 
One of the biggest dangers that Fed Chairperson Janet Yellen faces is that she doesn't act quickly enough. After previous recessions, the Fed was often too late in tightening policy and the result was having to rapidly adjust interest rates upwards extremely quickly. Unfortunately the slowdown in Q1 might have laid a trap for the new Fed Chairperson, in that it was a brief blip that has perhaps served to obscure what is really happening with the real economy.
All I can say is that I hope I am wrong here, and that the Fed is on course, but I think as each week passes the likelihood is that it is falling rapidly behind the curve on this recovery, and probably more worrisome, as the long bond yields show, that the bond markets have bought the Fed's arguments, lock, stock and barrel.

Sunday, June 1, 2014

March Madness, then April Fools, and they didn't go away in May!!

So spring is now over in South Texas as temperatures head back into the 90s and 100s after a colder than usual winter.  But of course the transition from winter to summer is punctuated with March Madness and then the foolishness of April, before the academics and market participants traditionally "go away in May".  This March and April have been particularly crazy, what with more cold weather in March and April, and some really eye popping things going on in the real economy as well as the financial markets.  With bond yields heading lower for no apparent sane reason, I was thinking that this must be an extended bout of March madness and April fools, and that things will correct themselves in May, but alas things have now started to get completely out of hand.
US PPI food (mom): Source BLS

US PPI (yoy): Source BLS

Any economist looking at the PPI numbers released last week for April (see for a breakdown) would interpret this as an uptick in inflation.  The chart taken directly from the BLS website below for year over year producer price inflation shows this.  But what is more surprising is that the food component of the index appears to be definitely showing a spike upwards.  The next chart shows this for the food component of PPI on a month over month basis (2.1%), which comes in at a 5.2% year over year rate.  Now I don't know about you, but I tend to have to eat food, and so this will likely feed through (sorry about the pun) into the CPI pretty quickly, and will affect a whole bunch of things, including supermarket prices, eating out, cruise prices, and anything where food is involved.  
Source: US Treasury website
Now given this, I would have thought that bond yields would have "popped" as a signal (albeit not completely confirmed) that the PPI increases would be a pre-cursor to higher inflation and therefore a quicker move to monetary policy tightening.  But no, bond yields didn't increase, or stay constant, they moved sharply lower. The figure below shows how at the longer end bond yields definitely moved in a downwards direction, while short rates still appear to be anchored at almost zero by Fed monetary policy. This is fast becoming unsustainable as we shift gears to a more growth-inflationary environment. Anyone who has booked an airline ticket, bought a vehicle or been to a supermarket lately knows that prices are definitely moving up as the economy firms.

Now there are some economists who seem to think that the negative Q1 US GDP figures (-1% quarter over quarter at an annual rate) point to an economy teetering on recession or at least in a slowdown or holding pattern.  I think they are dead wrong.  Why?  Well first the way in which the US measures it's economic growth is strange to say the least. I know that -1% shrinkage in the US economy sounds bad, but this is simply due to the compounding of what was a bad weather related quarter.  A more sensible way (which most other countries use) to measure economic growth is to use the year over year change in real GDP.  If we do this, we find that real GDP increased by 2.05 percent - which is not exactly a roaring economy, but it is not bad at all.  Second, with strange weather patterns, it becomes really hard to work out the seasonal adjustments that should be done on the data.  If you use a quarter on quarter measure to assess economic growth, then you have to do seasonal adjustment and any errors are then compounded when you multiply up the figure to an annualized rate.  Using a year over year rate obviates all those problems as you don't have to worry about seasonal adjustment as you are comparing figures from the same season of the year.  

So to the left I have plotted the log change in real US GDP ( - this is just the same as doing a % yoy change calculation).  It is clear that even with the really bad weather that the US economy experienced in the 1st quarter, that the economy is humming along, and in year over year terms, the rate is roughly in line with what we've been seeing for the past couple of years.  

But of course, this means that without the bad weather, the year over year rate might have been significantly higher, perhaps a full 0.5% higher, in which case the economy in fact would have been expanding at it's fastest rate since the last recession ended.  

Now if my view is right, the Fed must be starting to get worried that what it is (not) doing is being misinterpreted as a signal to the markets that it will not move if inflation really does start to move higher as it looks to be doing right now.  When I hear Janet Yellen stating that interest rates will remain low for the next 5 to 8 years, I think some in the market interpret this as easy money for the next 5 years at least, but what they don't seem to understand is that the economy is cyclical. 5 years have now passed since the end of the last recession, so that as we move forward over the next 3 years another downturn becomes more and more likely. In other words, given the history of business cycles we are likely already more than half way through the current growth phase of the business cycle. The Fed therefore will likely have to move fast in order to "normalize" monetary policy so it can be prepared for the next economic downturn.  And in that last sentence you notice that I am not saying "if" it comes - no, it will come alright, and in my next econoblog I will show how some of the research that I am doing looks at these cycles in growth highlights the continuing fluctuations in growth patterns and how they can be interpreted as following a cyclical pattern.

Monday, April 7, 2014

Why is the Fed ignoring a "differentiated taper"?

“I believe I am a sensible central banker and these are unusual times” - Janet Yellen, Testimony before Congress, February 11th, 2014.

In watching Janet Yellen's Testimony before Congress in February, and in reading Edward Luce's excellent commentary on the Fed in the FT (see here), it struck me that although Janet Yellen appears to be boxed in in terms of having an appropriate policy tool to get us out of the apparent slow growth US economy we now find ourselves in (see here for the latest Larry Summers opine about secular deflation), she is not.  And I'm not referring to "forward guidance" as the appropriate policy tool ( - a tool which I think has been ridiculous and based on flawed thinking).

As usual with these things, the answer is staring her right in the face.  Yes, the taper itself offers up the solution.  How?  Well in one of my previous blogs I outlined one exit strategy (see here) that I thought might be appropriate for the Fed to adopt. Although the Fed is currently reducing the purchases of both T Bills and mortgage backed securities (MBSs) at equal rates by $5bn each to $35bn of Treasuries and $30bn of MBSs (as most recently announced by the Fed on March 19th in the Fed's press release), this doesn't make too much sense to me in the current climate.

Why is this?  First, the Federal government Treasury interest rates really need to rise, and to be honest the Fed should be selling Treasuries right now, and certainly not buying anymore, given their recent (unwarranted) rally.

Second, the Federal government purchases were a way of stimulating the economy in two ways during the Federal government's economic stimulus a couple of years back - that is now not necessary as the stimulus is over and if anything the government deficit is rapidly shrinking. The chart below shows the US government budget deficit over the last decade, and we are now below the levels of deficits in terms of % of GDP that we experienced in the last major recessions, and more to the point, the trend line looks promising in terms of where we are going.

Third, with enough geopolitical risks in the rest of the world, I think it is safe to say that US Treasuries have enough demand support to weather a withdrawal of Fed support, so these purchases are really not optimal in terms of the objectives of monetary policy.

So I would argue that the Fed should heavily cut back on its purchases of US Treasuries while at the same time continuing to stimulate the housing market through purchases of MBSs.  I am calling this a "differentiated taper" as instead of just cutting purchases of both US Treasuries and MBSs, we can lower the overall amount of purchases while at the same time having a differential effect on the markets for each type of security.

Why is the concept of a "differentiated taper" important?  The reason why is that purchases of MBSs have an indirect impact on the housing market, as it lowers mortgage rates, thereby stimulating the construction of new housing.  Specifically, it should stimulate the employment of both blue and white collar workers in the construction industry, as more housing construction equals more hiring of architects, builders, contractors and subcontractors. What does purchases of government Treasury securities get us?  Lower borrowing rates for government, that's for sure, but not much else. Certainly there is no stimulus to the job market there right now as the government is cutting back on spending to move towards a balanced budget.

So if I were working at the Fed right now I would at the least be recommending a "differential taper" with an increase in purchases of MBSs of around $10bn, and a reduction in purchases of Treasuries by the Fed of around $20bn. This still balances out to a "taper" of $10bn, but it is differentiated, by stimulating the housing market, while allowing a longer term correction to the yield curve, a correction in my view that is now sorely needed.  

Monday, January 6, 2014

2014 and the Business Cycle: Continuing Recovery and Another Year of Opportunity in the Stockmarkets?

First off, Happy New Year to all my Econoblog readers.  If you want a review of 2013, rather than rabbittng on here, I thought I would just point you to a wonderful article in The Atlantic on the Most Important Economic Trends in 2013 which you can find here. In this Econoblog I want to look ahead to what might happen in 2014, as some eminent economists have been doing at the most recent American Economics Association meeting..

As the business cycle is now in heading into the later part of the cycle, with the danger of recession and deflation receding, most countries will experience accelerating growth this year.  Although markets are jittery about the Fed’s signal to taper monetary policy, this is long overdue in my view, and will only have a marginal effect on economic growth in the US and other developing countries.  The economic process of re-invigorating the economy through stimulus has now done its magic, and in North America, Europe and now Japan, the growth dynamic has started to take on a life of its own, so that the agents of stimulus can now withdraw their assistance as a catalyst for economic growth.

So there are 2 further issues here – first, how will economic growth be distributed among the developed countries, and second, given what is going on in the developed world, what are the prospects for the developing countries.

Although the consensus is almost uniformally positive for the US for 2014, it is still probably the most uncertain country in the developing world to forecast for 2014, as there are so many factors that might impinge upon economic growth rates. The most notable are fiscal matters and the political problems in Congress, the ongoing taper, and when the actual tightening of monetary policy will begin, how movements in long term interest rates will impact the housing market and also lastly, how the dollar will behave during the upcoming year.  If the current truce in Congress yields more bi-partisan consensus on how to move ahead in other contentious areas (such as immigration reform, for example), then this could boost growth as confidence is at least partially restored in the US political process.  Given a brighter fiscal outlook, this would mean that Fed purchases of government bonds could be slowed much more quickly than Mortgage backed securities (MBS), which would allow a residual boost to the housing market rather than propping up a shaky Federal government credit rating. Longer term interest rates are key in determining the course of mortgage rates, and if the Fed keeps these low enough for long enough, the housing market could really boom, setting off a real investment boom in the rest of the economy.  Of course everything could go the other way as well, leading to a further downgrade in the credit rating of US debt, a Fed that ends up having to reverse the taper because of a sagging labor market, and a housing market that experiences a bubble because of prices rising too far too fast. 
In my view, the history of economic cycles points to a positive future though for the US, and although some of the shorter term cyclical effects will be present, the dominant longer term cyclical features will push the US forward without any major internal economic dislocations, leading to another good year for both the housing and stock markets.  This of course implies another bad year for the bond market with yields moving upwards to levels more typically associated with this stage of the business cycle.

But perhaps the best opportunities in North America lie not in the US, but in Canada.  The Canadian market has been extremely stable through the recent turmoil and the Canadian stockmarket has really not shown much of a return compared with its US counterpart, which in my opinion is almost counter-intuitive, but is probably based on the perception that Canada has an economy based much more on commodities than the US does.  Nevertheless, in my view the Canadian market still has much less downside risk that the US market does, and much more upside.

Japan and the EU have less potential for growth as demographic factors restrain both entities. The fact that Abenomics seems to continue to deliver the goods will push Japanese markets higher and lead to the deflationary threat receding.  In the EU the resurgence of the northern member states will continue and the Southern member states will start to emerge from the difficult deflationary period they have been in. 

The biggest risks, but also the biggest rewards in 2014, lie in the developing world.  Developing country markets were rocked by the initial announcement of a taper, but now that the ongoing taper and then tightening has been priced into the markets the real effects on the developing markets should be apparent. As monetary tightening occurs in the US, so the liquidity glut will start to disappear, putting some pressure on developing countries.  Now the big question is, how big will the impact be on countries like the BRICSA countries.  Brazil should be cushioned by the massive infrastructure spending going on there for the Olympics and the World Cup, while Russia really is not dependent on the stimulus as it is natural resource prices that really drive the Russian market.  South Africa is certainly not a large holder of US bonds so the taper will likely have minimal effects on that country.  No, the biggest risk is in both China and India, where both countries have a significant interest in holdings of US debt. 

Given the negative announcement effect of the Fed’s taper, I believe that possibly the best performing markets will be in Canada, parts of Latin America, Africa and parts of Europe next year. Now I have put my neck on the line, let's see what happens!

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