Monday, December 21, 2015

Lions who have lost their roar? The Fed's monetary policy "normalization"


Anyone watching Janet Yellen's announcement back in September (see the statement here) that US interest rates were going to remain on hold (0-0.25% target range for the Fed funds rate back then) could have been mistaken that they were living in some kind of parallel universe.  Why would the Fed be concerned about “international developments” as a reason to hold off hiking rates?  Why did the Fed appear not to be worried about the possibility of not having any ammunition to fight future economic downturns, despite the fact that it is fairly well recognized that these downturns happen every 8-12 years?  Monetary policy has been in emergency mode for 9 years, and the Fed has refused to start to properly "normalize" monetary policy, despite the fact that the US is likely entering the late stages of the business cycle, and despite the fact that most of the US economic indicators had been showing fairly robust growth for quite a while.

Despite the fact that the US economy has been on a decent economic growth trajectory for several years now, the Fed appears to have been incredibly reluctant to raise rates, as though interest rate hikes would somehow cause a dramatic weakening of economic growth.  As one market commentator put it (and I paraphrase here), "the patient is still in the intensive care unit, although he's smiling, eating candies and watching TV".  In other words, by now, the patient should no longer be in intensive care, and perhaps not even hospitalized! 

So there was little economic justification then for the December rate hike announced last Wednesday (Dec 16th) – the economic data releases are signaling an even weaker US manufacturing sector than we had in September, corporate profit growth has turned negative, and the housing sector has not taken off as might have been expected in such a low interest rate environment, particularly when the expectation of higher rates was fairly widespread.  So although most market commentators focused on the mechanics of the hike, and the new monetary policy tools that have been put in place, I really don’t think that that was the point of the hike – the Fed had signaled that it wanted a hike in 2015 and after delaying for all sorts of (what turned out to be spurious) reasons, it would have taken some pretty tortured reasoning not to raise rates in December after such a hike had been telegraphed for so long.

But that is the problem with the Fed policy right now – they have fallen behind the curve in terms of the normalization of monetary policy, and they do not appear to know how best to normalize policy in a world where monetary policy is now diverging (ECB and Bank of Japan loosening, Fed tightening) with the consequent negative effects on economic growth from deteriorating exports as the US dollar appreciates, and lackluster US economic growth. 

One aspect of the normalization is not being talked about much in the media – the fact that when loosening monetary policy the Fed lowered rates first and then enacted QE – but very little QE withdrawal has occurred and yet the Fed has raised rates again. Clearly the Fed has decided that interest rates are a better signal to markets in the event that there is a future economic downturn, but nevertheless the withdrawal of QE needs to occur before we have policy normalization.  I think it is fairly clear that full normalization will therefore not be achieved before the next economic downturn, given that the business cycle has a periodicity of about 8-10 years. 

In terms of the yield curve then, we are seeing flattening in the curve, as short rates have moved up, but long rates have moved up much less in the wake of the rate hike.  Any further rate hikes will further flatten the yield curve and may even invert it, which of course the Fed would likely want to avoid.  So there clearly is an expectation by the Fed that recent wage pressures will feed into higher levels of inflation – something that we have yet to observe.

In a way, the December rate hike publicly acknowledged that the Fed should have raised rates earlier, and that the Fed now realizes it needs to play “catch up” if certain sectors in the economy are not going to overheat, and to ensure that there is some ammunition available if we have an economic downturn in the next couple of years.  If anyone had any doubts about this, it could be deduced from the press release – the “dot plots” showing Fed expectations that rates will be raised four times in 2016 – this is clearly way out of line with Wall Street analyst expectations that only 2 rate hikes would occur.  Some analysts were puzzled that this was “hawkish” and not consistent with the “dovish” nature of Yellen’s announcement, but I think they missed the point here.

In an opinion piece published some time ago in the FT, Andrew Sentance (see here) made the point that the Fed was "falling behind the curve" in raising rates so as to return to a more normal monetary stance.  I would take that one step further - the Fed is now still seriously behind the curve in terms of rate normalization, as it should have started raising rates back in 2014 – we should be at around the 3rd rate hike in my opinion.

One interesting thing that I did hear last week was a comment by Jean-Claude Trichet that the US is in the late stage of its business cycle, but that the euro area and Japan are still mid-way through their business cycle.  But that implies that there is now not just divergence in terms of central bank monetary policy, but also “de-coupling” of business cycles between the US, Europe and Japan. This is an interesting conjecture, and I am now working on a future blog which explores this idea.

Next blog though will be my annual look at investment ideas for 2016!


Happy Christmas to all my blog readers!




Sunday, September 13, 2015

Fed Policy: Do Two Wrongs Make A Right?

Deciding on monetary policy is not an easy task.  It requires an acute sense of economic wisdom in reading the signs that the economic data throws out, and also an actor's skill and sense of timing to ensure that the words are delivered in exactly the right form at the right time. The Fed has a monumental decision to take this week - whether to raise rates for the first time since July of 2006. That is over 9 years ago, and reflects how serious the last recession (or "great recession" as it's now called) was, not only in terms of it's initial depth, but also because of the way the recession was initiated (through the housing and financial sectors), through the consequent sluggish recovery.

But I think some in the media are under certain misconceptions about monetary policy.  Monetary policy is undoubtedly "abnormal" at the moment, with no real ability to lower rates if we go into another recession, and righting this "abnormality" is probably the strongest argument for lifting rates right now, as there doesn't appear to be any inflationary pressures on the horizon.  At least that is the official line I hear in the media, but more on this later.
Source: New York Times

The two strongest reasons I hear that the Fed shouldn't raise rates (see Larry Summers's FT blog outlining why he thinks the Fed should not raise rates now) are that US inflation rate (measured by CPI or PCE measures) is still under the Fed's 2% target, and that although the US labour market has recovered, the lower participation rate and stagnant wages still point to persistent weakness.  Add to this the new "emerging markets" Quantitative tightening argument made yesterday quite forcibly by Gavyn Davies in the FT (see here)

But when I read both Larry Summers's and Gavyn Davies's arguments, they seem rather weak to me, and for the following reasons:

i) "Normalization" is important.  As a central bank, the main instrument that the Fed has is interest rates. Using QE was an experiment, an experiment that other central banks are now using, but where there is considerable and continuing discussion regarding the effectiveness of this relatively new policy.  As we are now nearing the end of the current business cycle ( - business cycles typically have length of 4 to 10 years), the Fed needs to put some real teeth back into it's monetary policy instruments so that it has the ability to effectively ease if and when another sizable downturn occurs.

ii) Inflation.  Inflation is currently low basically because of the role of lower oil prices in bringing down input prices throughout most of the economy.  But once crude oil prices begin to rise again, which they inevitably will, the distortion of such a large fall in oil prices will work in the opposite direction - it will tend to bias inflation upwards rather than downwards.  Now although we do not know the full effect of lower oil prices on inflation, the Fed is using the measure of prices minus food and energy, which only takes out the direct effect of volatile energy prices, and not the further effect of energy prices as an input into the production of other goods and services.  So my point here is that inflation, even measured without food and energy prices, is still downwardly biased. A better indicator is probably wages, and they are increasing now at a 2.5% year over year rate (average weekly earnings on private nonfarm payrolls).  That implies that indeed we now are looking at some inflation in the system with the likelihood that even if current inflation levels are subdued, the actual future inflation rate is likely to incorporate these cost increases, and so inflation should be on an upward medium term trajectory.

Source: http://blogs.ft.com/gavyndavies/2015/09/13/will-emerging-economies-cause-global-quantitative-tightening/
iii) External factors.  The Fed does not set monetary policy on the basis of economic conditions external to the US.  Nevertheless, that has not stopped institutions like the IMF, the central bank of India, and other central banks from weighing in to urge the Fed not to raise rates in September.  Indeed, the sales of dollar reserves in the form of US government bonds has led to a tightening of interest rates which, as Gavyn Davies has pointed out in the FT, is an implicit tightening of policy in the medium term bond yields (around 10 years).  The figure on the right shows this trend, and indeed from a global perspective this trend is sufficiently large as to potentially swamp injections of liguidity through QE from both the ECB and the Bank of Japan. But I would argue that this is not relevant to the US - the US has to set monetary policy according to the economic and financial conditions in the US, and not elsewhere.  If the Fed starts to take these kinds of factors into account, then the Fed will no longer be setting US monetary policy - instead it will be setting global monetary policy, and this is not in it's mandate.

So to end this blog posting I want to make the case that 2 "wrongs" don't make a "right".  The Fed was wrong not to go in 2014 when it clearly had the chance to start the "normalization" process earlier in the growth phase of the business cycle.  For the reasons I have outlined above it would also be wrong not to increase rates now at the September meeting as well.  And yet there are still some commentators who suggest that it would be right not to raise rates this week.  My own assessment of the situation would be that the Fed would be falling seriously "behind the curve" on normalization of monetary policy, which could have extremely negative effects in 2016 or 2017 if and when the next recession arrives. Now the response to the points outlined here would undoubtedly be "but we could always do a QE4" - but no central bank really wants to extend the exceptional circumstances further unless absolutely necessary, and it would be a massive mistake if the Fed were to assume that the US economy could be effectively protected solely by a QE4. That would be like waging a battle with only air cover, and no infantry!




Sunday, June 28, 2015

How might Greece leave the euro area?

Legacy 1000 Drachma Greek banknote
After the bundling of all IMF payments into one "jumbo" payment at the end of the month (June), together with the continued gulf between the Greek government and the "troika" (IMF, EU and ECB) in the negotiations for new measures to be agreed upon to release the bailout funds, the signs have now turned ominous for Greece.  The fact that the Greek government has announced that all banks will remain closed for the whole of this week from Monday (June 29th) and that capital controls are now in place, signifies that indeed Grexit is now a distinct possibility. 

Now Grexit clearly does not imply that a new currency must be formed, but to get any of the longer term benefits from Grexit (such as reclaiming an independent Greek monetary policy), the only way that this can occur is with a new Greek currency.  As an article in the FT today makes clear (see here), this is not a quick or easy process - but nevertheless it is certainly a possible outcome.

Now, as I have repeatedly argued here, Grexit is likely the best long term option for the majority of Greek people (see my paper from the University of Auckland Europe Institute here for the long version, and my previous posts from this blog, which are responses to FT letters for a the shorter version).  But the short term pain in getting back to an independent monetary policy again could be crippling and intense, if not managed properly. 

So what are the possible options for this to occur, given that Greece is probably not going to be in a position to make payments on it's debt, or to keep the euro as it's currency?

So, as I see it, Greece's options are:

i) try and hang on to the euro, despite the fact that Greece might not be in the euro area anymore;
ii) introduce a new currency, and (try and) adopt an orderly/managed exchange rate depreciation;
iii) introduce a new currency, and just let the new currency float on the open market; and
iv) use a new currency, but with a dual exchange rate - a commercial and a financial rate.

So let's deal with each of these options in turn, and try to sort out whether the transition over to any of these options would be more "orderly" or "disorderly", which is the language chosen by economists to signal panic or extremely rapid movements in financial variables (such as the stock market, currency values, or interest rates).

In theory, Greece could try to hang on to the euro as it's national currency, even though it would be no longer part of the euro area. But there has to be some escape valve from the crunch that the country finds itself in, which, if this were a country with a flexible exchange rate, would be depreciation, and if it had a fixed exchange rate, would be devaluation.  The problem here is that Greece is part of a monetary union and therefore only has the option of leaving the euro and massive lowering of the value of its currency.  So continuing to use the euro has none of the advantages of the other options.  Where it does have advantages is in terms of making sure that the debts of the country do not spiral any further out of control, as the majority of the debt is in euros.

The second option, that of the introduction of a new currency is a much more likely scenario.  Now, for arguments sake, let's call this new currency the "New Drachma".  The easiest way to engineer an "orderly" exit from the euro area is to then adopt (and announce in advance) a policy of temporary capital controls and then an initial exchange rate with a commitment to devalue the New Drachma against the euro on a regular basis ( - what economists call a "crawling peg").  This way, "hot" money flows cannot happen, but at the same time, Greece will see a fall in it's currency over time.  This will hopefully help the import sector to adjust to the new reality, and not cause a complete collapse in the import sector.  What would this peg be against?  


The third option, that of the introduction of a new currency that is allowed to float against the euro, with no capital controls, will no doubt lead to a disorderly exit from the euro.  This may well cause an initial over-reaction and see an overshoot from where the currency ideally needs to depreciate to, which may send the economy into further death spirals as importing businesses collapse. On the plus side though, this would lead to an immediate adjustment, from which the Greek economy (given the experience of the central and eastern European countries that tried this in the 1990s), would likely recover after one of maybe two years of drastic re-configuring of the Greek economy.  As a New York Times article recently discussed though (see here), this is likely to be extremely problematic from a debt perspective though, as most of the debt is denominated in euros, so a falling New Drachma would increase the debt load of both the public and private sector considerably.  This is one of the reasons why the Syriza government is anxious to avoid this option.  

The last option, that of some kind of dual exchange rate might be a good option given the struggle that the Greek government will still have to try to make interest payments on existing euro-denominated public debt. If the Greek government used a South African model for the exchange rate, then they would have a financial and a commercial New Drachma rate, where the financial rate would relate only to financial transactions, and all other transactions would occur at the commercial rate.  Note that this would still only require one currency. 

Out of these options, perhaps the best one is the fourth option, but there again, this is a difficult option to implement given that the market will want to see a quick fall in the value of the New Drachma, and yet because of capital controls on the financial side, this will not happen.  It will certainly not instill confidence among foreign investors however, as they will want to see the exchange rate fall to an extremely low level before even thinking of investing in the country.  Further, it will not help importers, and Greece imports a large amount of goods and services for use as intermediate inputs. 

Unfortunately, whatever route is chosen - either staying in the euro and accepting further austerity, or leaving the euro and trying to adjust to a new currency, it is going to be painful.

Sunday, June 21, 2015

Greece needs to leave the euro: Part IV

This is my response to a great article by Wolfgang Munchau in the FT on 21st June, 2015 which you can access here.
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As usual, a great article from Wolfgang Munchau.

In one sense Munchau is over-reacting to the prospect of Grexit, and in another sense I think his reaction is perhaps understated.  So let me explain.

First, Munchau states that "The pretence of irreversibility is what distinguishes a monetary union from a fixed exchange rate system with a shared currency."  This is not accurate, as irreversibility was completely absent from the Latin Monetary Union of 1865, which Greece actually joined in 1867, and then was ejected from in 1908 (as were the Papal States at an earlier date). While the intent of a monetary union is not reversibility, there is nothing to stop some reverse actions occurring while maintaining the rest of the monetary union. Grexit need not threaten the rest of the euro area.

Second, economists have always claimed that the euro area requires a fiscal union if it is to become more sustainable and less susceptible to asymmetric shocks or the development of non-synchronous growth in a particular member state.  That is clearly stated in the optimal currency area theory which should be the economic foundation which forms the basis for any monetary union.

What Munchau does not state, but I think will be the result of this week's events is the realization among EU policymakers that they now have to deal with the reality of a "two (or even three) speed" EU.  There has always been the hope among European federalists that one day the EU will have the euro as it's currency, but this is now unlikely to be the reality unless further action (such as fiscal union) is taken.

To me, as an economist, the lesson is that although monetary union in the EU has been conceived in a political space and embodies the political ambitions of the EU elite, it will not succeed unless its economic foundations are solid.  As economists such as Willem Buiter stated years ago, there was both "sense and nonsense" in the Maastricht Treaty, and now we are about to pay the price for ignoring international economics in favor of establishing grand European political projects.

Saturday, June 20, 2015

Greece needs to leave the euro: Part III

The is my comment in the FT to an article by Larry Summers on Greece which you can read here published on June 20th, 2015.

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Interesting article, but in my humble opinion pure hyperbole from Larry Summers.

Greece needs to leave the euro, and for reasons I have elucidated elsewhere ( - see my article here - http://www.patrickmcrowley.com/A_Note_on_How_To_Resolve_the_Euro_Area_Crisis_12-13.pdf - from the Europe Institute Journal of University of Auckland, NZ). But this needn't have the serious financial fallout that Summers refers to if handled properly, and for the following reasons:

i) We are not in the situation that we were in in 2010 - the other PIIGS member states are in much better shape, and although there will be concurrent rise in perceived default risk, the actual risks are all well contained, for the simple reason that the other economies are all now in expansion mode (or in the case of Italy, at least not in contraction mode). 

ii) This is not a situation that wasn't predicted by some pundits (including me), so plenty of preparations have been made for the fallout once Greece imposes capital controls, does an Argentianian freezing of all bank accounts, converts to a new (or legacy) currency and then sees a precipitous depreciation in the new currency.

iii) The Syriza government originally ran for election to government on getting out of the euro if austerity continued, so they will have fulfilled their mandate to the people of Greece, and although the pain will be sharp and incisive once the new currency depreciates, then the stage is set with a much more competitive economy, for economic growth.

Summers seems to wallow in some idealistic "coming together" of the two sides to avert crisis, but marriages do not necessarily always dissolve in crisis and likewise, this needs to be resolved in the best way possible for all parties concerned.  The Greeks need to leave the euro, the IMF needs to re-denominate the debt in SDRs and modify the conditions for repayment, and the Europeans need to take a haircut to give the Greeks the best chances of recovery, preferably with a payback trigger that is conditional on economic growth.

What Summers fails to mention as the downside is that the consequences for the impetus for European integration are much more serious.  The euro was meant to be a further step forward in the "ever-deepening" economic and political integration of the European Union.  It was never envisaged that a member of the single currency should leave, so Greece's departure portends a complete re-think on the role of the euro in the framework for European integration.  It points to the embedding of a two or even three speed Europe, which makes it much harder for political enthusiasts of integration to cook up (even in the longer term) further grand integration initiatives. 

I think that that European politicians and civil servants need to understand that just because something is labeled "European" doesn't mean that it is necessarily going to be the best option for all European Union member states. 

Tuesday, June 16, 2015

Greece needs to leave the euro: Part II

My response to a great article by Martin Wolf in the FT on 6/16/2015 which you can read here.

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Excellent article by Martin Wolf, but not really too revealing on what the options might be. 

Governments are responsible to their voters, not to the holders of the country's national debt.  When you look at that chart of real domestic demand at around 68 percent of where it was in 2008, you also understand that the Greek government needs to stick to it's guns this time. 

The sad thing is that these negotiations have not allowed any latitude for new measures, such as perhaps the conversion of some of the existing debt to consols, or the future sale of some Greek assets (Mykonos?) - they have almost exclusively focused on extracting further austerity measures from the Greek negotiators.

Given the lack of any imaginative initiatives on the part of the negoatiators, the unsuitability of Greece for belonging to the euro area (due to it not satisfying the optimal currency area critieria), as well as it not properly fulfilling the Maastricht criteria for joining the euro in the first place, the Greek government now needs to plan it's exit from the euro.

Despite Mr. Wolf's concerns about Grexit, I really don't think these specific circumstances apply to any other euro area member states, so the prospect of any contagion is minimal..

The really sad thing is that this whole Grexit thng has been kicked so far down the road as far as it has. The can is looking pretty crushed and deformed now, having been kicked so much - so now is the time to take the can off the road and put it in the garbage, or recycle it! 

Tuesday, June 2, 2015

Greece needs to leave the euro: Part I

I wrote this comment in reply to a great article published by Martin Wolf in the FT today (6/3/2015) which you can find here 

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Good article, but in my humble opinion some misconceptions.  


First, Martin Wolf makes the point that the euro area is not an OCA.  As my research has clearly shown (see my Bank of Finland discussion paper on this issue published 2 years ago  http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Pages/dp2013_33.aspx), Greece does not have, and never did have, business cycles (or any other cycles for that matter) that are synchronous with the rest of the euro area.  It is simply not a good fit with the rest of the euro area, without (according to the OCA theory) there being sizable offsets which consist of fiscal transfers and much higher labor mobility.  And this is the case both ex-ante, and ex-post.  So, given this empirically proven stylized fact:

Second, the Greek government is simply wasting it's time and energy negotiating something that will not result in any long term membership of the euro - it will just be "another shot of medicine to help the dying patient".  I understand that the fact that the Greek government is actually negotiating is a necessary political pre-requisite to leaving the euro, but let's not drag this sorry Greek tragedy on any further than needs be, as this just prolongs and likely exacerbates the suffering of the Greek people.  

Third, Martin Wolf says that this will have a profound effect on the euro area and reverse the integration dynamic.  Well, hmmm, Greece is a little country the size of the State of Rhode Island in the context of the US - so it's not as if Spain or Italy were leaving. The euro area is 16 years old - and so its longevity won't depend on one small member deciding to leave early on it's evolution.  Also, the UK leaving the EU would have a much bigger impact on the integration dynamic than Greece leaving the euro area. 

Lastly, Wolf clearly wants Greece to stay inside the euro when he says that "This must be seen as a long game".  I mean how long do you want this game to be?  Governments simply don't think long term as their time horizons are short term or medium term at best. So the Syriza government really has the choice of alienating it's supporters and signing up to something that it promised never to sign up to, or pulling Greece out of the euro, which will create some chaos to begin with unless they have a proper plan B in place.  

If I were the Greek finance minister right now (which thankfully I am not), I would be furiously planning and comparing different strategies for a euro exit, as inevitably, that's what is the most likely outcome here.  
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Now in part 2 of this blog, which will come out in the next couple of days, I will outline what I think the options are for Grexit.

Monday, June 1, 2015

One Answer to the Curious Case of Residual Seasonality in US Real GDP

Source: CNBC on my TV!
Recently, Steve Liesman from CNBC here in the US pointed out that something was wrong with the US real GDP statistics.  He noted, and here I attach a picture of my TV at home showing his findings, that since 1985, Q1 real GDP growth for the US has been weaker than for other quarters.  Of course this should not be the case given that statistical seasonal adjustments are supposed to take account of any seasonality in the data and automatically adjust for this.  So we clearly have a problem with the US real GDP data, but I believe that Bureau of Economic Analysis (BEA) who produce the data, are going to fix this going back a few years, for their revisions in July.

In a way, this is extremely problematic though, and it stems from the way in which the media in the US reports it's GDP figures.  In Europe and elsewhere in the world, the standard way to report economic growth is by calculating growth as % year over year change in real GDP, which automatically adjusts for any "residual seasonality" in the statistics.  But in the US, GDP figures are reported as "quarter on quarter growth expressed as an annualized rate" - which therefore does rely much more on an accurate adjustment for seasonality in the GDP figures.

Now you are probably thinking - "well who cares?"  Well unfortunately these figures are very important, not only in terms of setting the tone of the US stockmarket, but also in terms of policy measures, such as the adjustments of interest rates by the Fed!  Many of the market commentators saw the revised GDP figures last week with the "Second estimate" of Q1 GDP showing a contraction of 0.7% in (annualized growth in) real GDP as a blow to the recovery and tried to blame this on everything from the port strike on the West coast to the frigid weather in the first quarter. Even commentators said that the economy is too weak for the Fed to move in June to increase interest rates.

But I thought that for this week's blog I would take the real GDP growth figures and re-express them in terms of Year over Year growth. So that's exactly what I have done in the figure below.  This, I would argue is a much better way to judge our economic growth, and when you look at it this way, it is really not too shabby in my view.

Source: BEA.gov; Data calcs: Blog author
Now viewed in this light, a 0.7% contraction, turns into a 2.7% growth rate, which was an acceleration from Q4 of 2014.  Now if you look at the figure above, you'll see that although although consumer spending (C) is drifting in an upwards direction, it is 7.4% increase in private investment spending (I) that appears to have caused the uptick in the GDP % yoy growth data for Q1. Note also that since turning negative in 2010, government spending (G) has also moved into positive territory.

Now what of the international sector.  Well here, if you look at the data, the news isn't good whichever way you report it.  If you use the % YOY method that I use here, you will find that exports fell 22.7% YOY, and imports increased 6.5% YOY.  And in the investment category, if you take out the accumulation of inventories from the figures, investment only increased by 5.2%, which although still impressive, does suggest that business investment still needs to be boosted by consumer spending, which is still quite hesitant.

But from my own perspective, these figures bolster my view that although the Fed probably won't do a rate rise in June or July, they should.  The economy is growing as strongly as it has been at pretty much any time since 2010 when you measure economic growth in the best way possible, by using the %YOY method!  Also, while I know that the strength of the US dollar matters (more on that for another post), the main measure of robust growth in an economy is domestic spending or "absorption".  If the US Treasury and Fed have an exchange rate policy of benign neglect for the US dollar, then the movement of the US dollar should not dictate or effect the direction or timing of monetary policy.


Friday, April 24, 2015

Putting Some Perspective on the March Jobs Figures

The jobs numbers released last month were, by any measure, a tepid take on the performance of the US economy in March at 126,000, and despite the fact that the Bureau of Labor Statistics (BLS) also tempered the first pass at the spectacular job figures for February, which were revised down to a net 264,000 new jobs created, the consensus on Wall Street was that the economy was sagging.  This led to all sorts of speculation that now the Fed wouldn't raise rates until the fall or even into the back end of this year, but I think all this Fedspeak is frankly misguided.  The Fed is simply NOT going to base it's judgement on one month's numbers, and particularly a month that was, by any standards, unseasonally cold and unusual.  So to get this out of the way right at the beginning of this blog, I will state for the record that I still think the Fed will raise rates in June, and September at the very latest, for reasons I have elucidated in previous blogs postings.  My reasoning hasn't changed here, and no slightly weaker sets of data will affect the business cycle and monetary policy "normalizing" arguments.

But I digress.  What I want to address here is the BLS labor data released last month, and the reasons why I think the data will get revised upwards, and even if it doesn't, why it really doesn't merit the type of response it got from the markets.  So first, I know that most of the readers of my blog will recognize that one month's numbers do not a trend make - and this data point, in my view, was simply a blip on an irregular cyclical pattern. Now if we get April and May numbers below 100,000, then I will change my view, but one datapoint in the 100,000s range should cause panic, and particularly not at the Fed, as other data on wage increases suggest that wage increases are now accelerating which points to a tightening labor market, which is not surprising given that we're now at a 5.5% unemployment rate.

US Non-farm payrolls (sa)
2007 to date
The points I would like to make about this datapoint are as follows: when one looks at this data on a longer term basis then there does appear to be a small drop off in employment but this also happened at the beginning of 2012 or 2014, and the economy bounced back nicely from those points. But probably most importantly, the March datapoint was not an outlier, it was just a little disappointing. This is shown in the figure to the left.


US Non-farm payrolls (sa)
1939 to present
So why should it have been disappointing? I think there are clearly 2 reason - first, and probably most importantly, the layoffs that are now occurring in the energy sector given that the oil price is clearly not doing following the "v" shape that some expected.  The "j" (on it's side) shape of price trajectory that we are now seeing means that although the highly indebted small and mid-sized oil companies will have to lay off workers, the larger oil companies will be much better able to tough it out.  These oil layoffs, therefore, will be very much one shot deals, which although now occurring, will not trail beyond around 3 months in my estimation.

The other reason for such a tepid growth figure is that the north of the country once again got a really cold blast this winter, and as I was up in Boston in March (seeing Thomas Piketty speak among other things), so I can personally corroborate that fact!  In fact by some measures that part of the country got record amounts of snow this year. Now the figures are "seasonally adjusted" so do take account of the lower level of labor market activity in different seasons, but the statistical methodology can only account for the average level of seasonality - it cannot detect outliers - so these will inevitably show up in the data, which, I believe, they did.

Now the second point I would like to make is that when you observe the full sweep of non-farm payroll figures going back to the beginning of the series (see the figure above), what is clear is that although the figures in the upturn that we have seen might be slightly lower than those observed in the 1992-2000 period, they are certainly not out of line with figures from previous decades.  In fact the level of net job creation appears to be very much in line with what we observed in the 2003-2006 period and back in the 1960s as well. In other words it is somewhat of a myth that jobs have not been created at the same rate that they have been in the past, as it depends which "past" business cycle you look at!

In fact one of the biggest observations I see from this longer series is that there appears to be several highly irregular cycles at work in the data - and although obviously the negative observations occur mostly during recessions, the positive datapoints also appear to show a lot of cyclical behaviour.  That obviously calls for some analysis - and so I will definitely be using this dataset for a future academic paper.  Stay tuned folks!




Saturday, January 3, 2015

The Global Economy in 2015

Happy 2015 to all my Econoblog readers!  I spent NYE in London by Tower Bridge enjoying a distant view of the spectacular fireworks display (see image on left) that London put on this year ( - but for the first time with a charge for the best viewing spots). Being in London certainly gives you a reminder of how globalized the world has become, as I heard at least 10 languages being spoken in the space of one particular day there. And of course these days the global economy is interconnected as never before with people and funds flowing freely across borders. A few years ago, when we hit the "great recession", there was talk of the reverse of globalization, and although some firms might have pulled back from such a large commitment of resources to international projects and expansion, I believe that this was only a lull, and not a reversal. Today, I was greeted in a British restaurant by a Danish front of house manager, served by a waittress from the Czech Republic and my table was cleared by a Hungarian. This would be almost unimaginable even ten years ago.

The reason why I bring this up is that I believe that the state of the global economy and trends at the global level are very important.  Paul Krugman also emphasized this in his most recent blog (see here) which shows that recent trends have basically transferred income from the developed country working classes to the developing country middle classes (in countries such as China and India). But those are long term trends, trends that will continue slowly over future decades.

Our focus here is what really matters in 2015. In my previous blog posting (see here), I have made the case that oil prices will stay reasonably low for at least 18 months, so that for the most part of 2015 oil prices will not be on an increasing trajectory.  So let's deal with each continent in turn.

Source: Wall Street Journal, Jan 2, 2015
In North America, the Fed has said it will begin to tighten, but will only do so slowly, which means that growth will accelerate here, leaving the Fed further behind the curve, as lower oil prices give a deflationary impulse to the CPI until the end of June.  This will allow the housing market to properly recover, as even with the upward move in interest rates, the amount of the rise will be relatively small, leaving mortgage rates still close to historic lows. In my view, this, coupled with the relaxation of mortgage conditions, will lead to increased demand for mortgages as rental rates are now very high compared with costs of home ownership. That means that although a very modest rise in interest rates will occur, it will still allow strong growth, falling unemployment and a buoyant stockmarket, with the retail and technology sectors doing particularly well.

In Europe, Greece remains the big problem. The "renegotiation of austerity" promised by the leftist party there, Syriza, led by Alexis Tsipras, has already sparked major fears in Europe of a showdown over the so-called Stability and Growth pact and the economic pain and suffering it has inflicted upon Greece. Although an exit from the euro (or "Grexit") has apparently been taken off the table for the moment ( - perhaps to make the leftist coalition more electable?), there is no reason why it could not be put back on the table once Syriza is in a position of power. That would leave the EU with a very interesting problem: do they make concessions to the Greeks and risk having the Portuguese, Spanish and Italians insisting on similar loosening of fiscal austerity conditions?  Or do they just allow the Greeks to then openly talk about exit from the euro, with all the instability that that would cause. Clearly, until the Greek situation is resolved, the uncertainty in Europe will prevent the euro area from emerging from its economic torpor anytime soon.  This means that the euro will remain under considerable pressure.

On monetary stimulus in the euro area, I think that Mario Draghi will continue to try and talk the euro area out of a mild recession, but there is just no consensus on how to do a really large and effective QE in Europe (despite what the pundits say -see here on this), so that although the limited measures still in place in Europe will continue, and may be expanded, no dramatic new programs will be announced unless things take a serious turn for the worse.  Worse here means either deflation appearing or a Grexit occurring and other member states threaten to leave the euro area. This is not beyond the realm of possibility, given that Germany it appears, thinks that the euro area could cope with a Grexit (see here).

The situation in the UK in particular, will also be rather uncertain in 2015.  Elections will occur in May of 2015, and there is considerable uncertainty as to which party or parties will take power. This means that the pound could depreciate in the first part of the year, and then could depreciate further in the second part of the year if a Labour government is formed, or rebound if some form of Conservative government is elected. The Bank of England will only change interest rates in the second half of the year, depending on how fiscal policy changes after the elections. Nevertheless, the UK should have accelerating economic growth as house prices continue to rise in the London area, and the wealth effect takes hold inducing higher levels of spending.

Source: http://krugman.blogs.nytimes.com/2015/01/02/britains-success-story/
The chart above to the left shows how the UK has fallen behind both the US and France due to the austerity measures imposed by the Conservative-Liberal coalition government. The trajectory shown in the figure though suggests a rate of growth of income in the UK similar to that in the US has now emerged. Note how weak income growth is in France though. Both Italy and Spain are experiencing worse rates of economic growth, which gives you a picture of how bad things are right now in the euro area.

Done by author: Data sourced from BoJ and FRED

In Japan, Abeonomics has not really yielded results yet, but there are promising signs that with the hefty new QE announced late last year that Japan's economy will finally emerge from the deflationary slump it has been in over the past couple of decades.  Unfortunately though the other half of the sales tax hike should moderate any uptick in growth coming from the monetary side, which means that even though a new stimulus package was unveiled in Japan on Dec 27th (see here), with a public debt to GDP ratio just under 250%, there is really very little room for any more action here. What is more promising is that there might be further monetary stimulus, which in my judgement is still needed to really get us on a path to achieving the Bank of Japan's 2% inflation target.  The chart on the right above shows that in fact although base money has been significantly stimulated by qualitative and quantitative easing (QQE) in Japan, M2 as a % of GDP appears to have now bottomed in the first quarter of 2014 (right hand axis, in %), and so although real GDP growth is still negative (left hand axis in YOY growth in % using seasonally adjusted data), there appears to be dogged determination by the central bank governor, Haruhiko Kuroda, to stimulate the economy by QQE until Japan finally starts moving in the right direction again. In my view perhaps in 2015 the QQE monetary stimulus may finally have some tangible effect, as expectations of the general public and the financial markets begin to change.

As for the rest of Asia, I see the Chinese economy still growing at a rapid clip, but until the euro area recovers (as it is the biggest customer for the Chinese), the Chinese economy will still have some headwinds. India is probably the most interesting place to invest in Asia right now, although of course whether Narendra Modi can actually achieve the reforms that he wishes to put in place, given the fractious nature of democracy in the country, is anybody's guess. But the potential is nevertheless there, with India now starting to emerge out of the shadows I believe that India will begin to catch up with China in terms of its economic growth trajectory.

In the rest of the world, I think Africa's economy will improve in 2015, as will that of South America, given that 2014 has delivered some hard lessons in how governments and political ambitions can often interfere with delivering and then maximizing economic growth.  

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