Why is the business cycle elongating?

First, let me wish all my Econoblog readers a Merry Christmas and a Happy New Year!!

Economists have traditionally put the business cycle at between 3 to 8 years long.  But of the last 4 business cycles 2 out of the last 4 have lasted longer than the 8 year limit that economists typically look at.  In fact counting this business cycle, which officially hits 10 years (or 120 months) in December 2017, 3 out of the last 5 business cycles have had periodicity longer than the 8 year economist "consensus" upper limit.

For those geeky enough to be interested in US business cycles see the table below which is lifted from the NBER website.  The longest expansion we have seen in the US economy was through the 1990s through until the tech stock bubble in 2001, which lasted a full 128 months, 8 months than where we are right now.

Source: NBER website

But this then begs another question.  What are the specific reasons as to why the current cycle would be elongated, and how persistent will these effects be in preventing us from entering the contractionary phase of the business cycle?  Well there are several reasons why I believe economists and economic commentators think that we might have an elongated cycle this time.  I will run through each of these reasons below, but to summarize these reason up front:

1.  We started the expansionary phase from a lower base, as the "great recession" of 2007-09 was more severe than all previous downturns with the exception of the "great depression";  

2.  Quantitative Easing (QE) has provided an additional stimulus which combined with the usual countercyclical fiscal policy, allowed the economy to achieve escape velocity, but QE is only now being unwound;

3.  The tax reform bill just passed by the Trump administration, plus the Infrastructure spending bill that the Trump administration has promised in the first half of 2018, will continue the fiscal stimulus for the economy through at least 2018, and possibly to the end of 2019; and

4.  That the "great moderation" which started in the 1980s, has seen a dramatically lowering in volatility for short term cycles in growth, but due to a couple of reasons, this cyclical volatility has transferred to longer cycles in growth which, for the moment implies that the usual business cycle frequency of 3 to 8 years quoted by economists is now incorrect.

So let's start with the first reason.  The main insight here comes from the Great depression, and the fact that when a macroeconomy experiences a really deep recession, where the financial sector is involved, the recovery will be slow and arduous.  The accompanying chart from an IMF publication shows this quite clearly.  The horizontal axis shows the number of quarters into the recession and the reaction of various economic variables (averaged across countries and across time). So for example, residential investment starts to recover after around 4 quarters for non-financial recessions, but for financial recessions that recovery starts 11 quarters after the beginning of the recession.  As the great recession was caused by both the housing market and the financial markets, the recovery pattern has clearly been slower than for other recent recessions in the US. This is also clearly seen in GDP growth itself, which is shown below.  The most recent recession is the first recession since the Great depression where the economy was recovering from a financial recession and it is clear from the rate of growth coming out of the recent recession that the economy has had difficulty growing above roughly a 2% rate.

Source: BEA and authors calcs

While the logic of this argument appears sound, there are a couple of things to notice about the nature of the reasoning here.  First, the fact that the great recession was a financial recession would tend to suggest that the business cycle elongation will be only relevant for this current recovery rather than for business cycles in general. If this reason is correct, then the macroeconomy should return to its usual 3-8 year cycle after the next recession.  Second, it also flies in the face of business cycle dating that we referenced above - the business cycle has definitely been getting longer, and has not remained within the usual 3-8 year periodicity that economists so often cite.

The second reason as to why the current business cycle will be elongated is monetary policy. The amount of stimulus provided by central banks has continued to rise albeit at a slower pace.  As the graph below shows, the US is now reversing it's massive QE program, and that is one of the reasons why rates are rising in the US relative to rates elsewhere.  If we look at the chart below, we can see that indeed Global QE is still rising, mostly thanks to the ECB, who have still not started to taper.  That in itself is a massive boost to financial companies around the world as central banks have brought large amounts of financial assets off the commercial bank balance sheets, thus freeing up capital to be lent elsewhere, and stabilizing balance sheets.  If we look at this in terms of the rate of change of QE globally, we come up with a different impression, which is given by the chart below ( - please ignore the forecasts of a research group which were made in 2015).  These liquidity injections clearly have largely dissipated for most central banks, but net injections are still continuing.as reversals have not yet been substantial enough to make an impact on the total, and some central banks are still continuing their QE buying programs.

Note that this reason would also only imply a temporary one-time elongation of the business cycle, and so doesn't explain why the most recent business cycles appear to have been on a elongating trend.

The third reason is due to the recent US fiscal stimulus in the form of the tax reform and the possible infrastructure package that President Trump has promised next year. This will affect the US, but does come with likely additional public debt implications, which will tend to crowd out investment and in normal circumstances would drive interest rates up.  But the tax reform essentially increases the return on US investment (purchase of plant, machinery and equipment), which will tend to increase private investment, thereby offsetting the crowding out effect.  So on balance, with the individual income tax reductions, these corporate tax changes should further stimulate the US economy, bolstering the monetary policy argument above. Once again, this is a one-time effect, and does not explain the lengthening of the business cycle.

The last reason why we might be seeing an elongation of the business cycle can be explained by recent research that I have been doing with Professor Andrew Hughes Hallett of George Mason University.  The empirical argument is shown in the figure below.

This analysis is called a "multiresolution decomposition" or MRD, and the technique essentially extracts the processes embedded within the series over different frequency ranges which are represented by the series d1 to d5 which are shown in the figure. We have 2 papers, the first of which showed statistically that the longer cycles embedded in real GDP growth (shown by d5 and d6 above (which relate to cyclical activity ranging from above 8 -16 years and from 16 - 32 years respectively) have become more volatile since the early 1980s, while the higher volatility cycles in real GDP (shown by d1 to d4, corresponding to cycles from 2 quarters to 8 years), have become less volatile [see below for academic references].

The second paper, which has been published as a discussion paper by the central bank of Finland (Suomen Pankki) [again see below for academic reference], goes through a lengthy analysis of the theoretical models typically used by macroeconomists to show the factors that could potentially cause this lengthening of the business cycle.  To cut a long story short, the factors that could be shifting volatility in the process that drive economic growth from shorter cycles to longer cycles turn out to be i) an increase in inflation aversion; and ii) a reduction in output stabilization. So let us look at each of these parameters in turn.

Has there been an increase in inflation aversion moving from the pre-mid-1980s period through to the post-mid-1980s period?  I would assert that yes, there has been, and this is due to the fact that many central banks instituted inflation targeting and if he could have done so, we know that ex Fed Chairman Ben Bernanke would have done so.  So has there been a reduction in output stabilization?  That is, has there been a reluctance to fully engage fiscal policy to it's maximum effect during downturns and to offset any rapid growth in the economy?  I think the evidence, once again, is that yes, we are seeing less output stabilization in US fiscal policy for certain, and perhaps a little more emphasis on stabilization by the Fed.  The net effect though would still be for less emphasis on output stabilization.  Now why do I assert that this is the case?  I think the evidence has been on show during the last week in the US.  As we know we are entering the final stages of the business cycle, the Trump administration has effectively announced a tax stimulus package which then will cause a spurt in growth as well as a one time elongation of the business cycle.  This tax reform package is definitely not output stabilization in the classic sense of counter-cyclical fiscal policy.

So note here that this fourth explanation would help to explain a permanent elongation of the business cycle since the mid-1980s.

But what about the markets in all of this?  One of the best visualizations I have seen relating to business cycles and the stock market came in a piece of research out of Goldman Sachs in late November this year (see below).

The figure shows that we are now approaching the 9th year of a bull market, with no signs of any correction coming.  This is not quite the record run yet, but it is fast approaching the 9.1 years of the 1920s bull market.

My own feeling about the financial markets is that we are beginning to move into "borrowed time", and that as soon as these one-time stimulus factors have passed, the downturn will happen. Whether that is in late-2018, 2019 or 2020 I am unsure.  But if there is one thing I am definitely sure of it is that the next downturn is coming sooner or later.

References

Crowley, P. and Hughes Hallett, A. (2015), "Great moderation or “Will o’ the Wisp”? A time–frequency decomposition of GDP for the US and UK", Journal of Macroeconomics, Vol 44, pp82-97.

Crowley, P. and Hughes Hallett, A. (2014), “Volatility transfers between cycles: A theory of why the "great moderation" was more mirage than moderation”, Bank of Finland Discussion Paper 24/2014.

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.  

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! 

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.

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 http://www.bls.gov/ppi/ 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.

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!

Taper talk and inflation expectations

Any student of economics knows from his or her money and banking course that there are two different effects that occur when you inject money into the economy.  The first is called the "liquidity effect" and it operates when the money supply is increased.  It operates in the short run when prices are sticky, so that no price adjustments take place.  Using the diagram below, you would just increase the supply of money, hence shifting the vertical M curve to the right in the diagram below.  That lowers interest rates.  Of course that should lower interest rates in normal circumstances, unless you hit extremely low interest rates in which case you could find yourself on the flat portion of the L or money demand curve.  In this case, as Keynes pointed out, you find yourself in a so-called "liquidity trap".  In a liquidity trap, increasing money supply will not lower interest rates further, so will not stimulate the economy. We used to teach this as an academic curiosity until it occurred in Japan ( - a zero bound on interest rates), but now most monetary economists realize that it is not just a curiosity - it can happen, and it did, even in the US!!

That is the reason why we have QE, or quantitative easing.  It is a way of stimulating the economy without relying on pushing official interest rates lower. In the longer run though, prices are flexible, and they adjust to changes in the money supply, according to the quantity theory of money.  The mechanism whereby this transition happens though is related to the so-called Fisher effect.  The Fischer effect basically says that higher inflation rates should be reflected one for one in higher nominal interest rates. So as inflation begins to rise after a monetary injection, at some point we should see interest rates rising. Obviously though the Fisher effect only works if you have a response in inflation.  At the moment, as the chart below shows, we really don't see too much response in inflation during 2013 ( - this includes the data release for August, released today, September 17th).

The key thing though is that it is really not actual inflation that matters as interest rates are a forward looking variable.  The interest rate is how much you charge or are charged for lending or borrowing from now into the future.  So it is really inflation expectations that are important here, as they are the equivalent forward looking variable, rather than the current level of inflation.

Luckily the Federal Reserve Bank of Cleveland has come up with some new methodology for teasing out inflation expectations from inflation swsps (a financial derivative in which investors swap a fixed payment for payments based on the CPI), which run the gamut from one to 30 years. The results of this academic work by Joseph G. Haubrich, George Pennacchi, and Peter Ritchken of the Cleveland Fed is updated every month on a special Cleveland Fed website which can be found here.

I have reproduced the current chart of Inflation expectations from the Cleveland Fed's methodology in the chart on the left.  What is striking is that if we use the ten year swaps we appear to be at a turning point in terms of expectations.  Inflation expectations now appear to be potentially moving up again. And that means that if 10 year bond rates are yielding just over 2.8%, that given that inflation expectations are roughly 2%, that the real interest rates, in other words the real gain lenders get from loaning their money out is around 0.8%.

The real interest rate is important in an economy because it signals the rewards from lending.  For very short term loans these are now negative - in other words it is not worth lending short term for most banks.  We can see this if we calculate the short term real interest rate - which is given as say a 2 year bond yield minus the expected inflation rate over a 2 year horizon.

Short term real rates are about -3%.  This means that the Fed has really pushed short term interest rates down to an incredibly low level - well we know this already from my previous blog which you can read here.

But in terms of policy implications, and what needs to happen this week at the Fed's monetary policy meeting, is that these short term lending rates need to rise to turn the real interest rate positive again.  That means that in fact the Fed should, if anything, extract much more short term credit from the market when it tapers than long term credit so as to allow short term nominal interest rates to run to more normal levels again and make it profitable to lend short term.  At the moment, in one sense, the Fed's critics are right - the Fed's monetary policy is distorting the yield curve, and the sooner the Fed extricates itself from this the better.

European meltdown?

Last week I did a talk for the second time on the European Financial crisis.  Each time I do this talk something nasty seems to happen afterwards. This time it is Irish banks and the impending bailout for the Irish government - last time it was Greece and it's bond market crisis and then the subsequent bailout.  In Europe the din from the masses is increasingly talking of doom and gloom with contagion to Portugal and Spain hitting the financial headlines. Even respected FT commentators are now "twittering" about the demise of the euro (see Gideon Rachman at http://www.ft.com/cms/s/0/85b62490-f66e-11df-846a-00144feab49a.html#axzz165SsmUg9) and Samuel Brittan at http://www.samuelbrittan.co.uk/text381_p.html). 

This is dangerous stuff, as the demise of the euro would indeed have far-reaching consequences way beyond Europe. The ramifications of the most successful example of economic integration to date failing because of market forces and contagion would have global consequences way beyond Europe. The prospects of further Asian economic integration would likely be dashed, and monetary integration that is supposed to occur in South America and Africa would quietly be dropped. Not only that, but the critics of market forces stopping governments ( - who are after all democratically elected) from achieving regional integration objectives would likely spark a big backlash against the financial markets in continental Europe. The British, on the other hand, would likely be thanking their lucky stars that they never took the plunge and joined the euro in the first place.

But despite all the hubris and chatter, there are several important points that the mainstream media appeared to have missed when reporting on Greece and Ireland.  The first is that these are small countries, and that the euro area will remain intact while some countries might decide that it is in their best interest to leave.  As long as these are only small players the euro will likely survive. The second point (outlined in David Mayes's excellent piece on banking regulation that was recently in a review that I edited - now published online at http://www.eustudies.org/files/eusa_review/fall10final3.pdf) is that with a single market in financial services there is an urgent need for banking regulation at a supranational level.  Hopefully EU member state countries will accept the transference of sovereignty in this area to a supranational banking regulator in the not-too-distant future.  The Irish crisis could easily have been averted had this already been in place.  The third is that given the crisis in public finances within Europe, there will hopefully be some agreement on transference of sovereignty in fiscal matters to the supranational level (just among the euro area member states?) perhaps in the same way that Australia has centralized it's debt issuance for it's states.  The fourth, and probably most important point is that it is in noone's interest to see this crisis spread through contagion as it will affect banks in all member states giving rise to even more problems with public finances throughout the euro area, so that action will likely be much more likely now that European leaders have seen the effects of papering over problems with the Stability and Growth pact or allowing inertia to set in in the ongoing evolution of economic integration within Europe. 

As Jean Monnet, one of the founding fathers of the European Union once said "People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them."

April US interest rate outlook

The Fed minutes were released yesterday (see http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm) and showed that (apart from one member) the FOMC was not worried about inflation quite yet, but it obviously doesn't stop the hawks ruminating on when the current "super-easy" monetary policy will be reversed.  Clearly this is now on the market's mind, and with impeccable timing a  friend recently pointed me to a site http://www.stocktiming.com/Tuesday-DailyMarketUpdate.htm which has an interesting graph of 30-year bond yields breaking out from a 17-year declining trend.  Several comments are in order from a macro perspective.

First, a declining trend cannot continue forever - a break was inevitable, it is the timing that is interesting - we are at a point where clearly the balance of risk is beginning to shift from deflationary pressures to inflationary pressures.  This has clear implications for investors - while the US bond market was a great place to be during the downturn, it will not be such a great place to be anymore!!

Second, the inflation hawks really need to relax - there are so many uncertainties as to how and when the US economy will really pick up steam that it really doesn't make a whole lot of sense to worry about inflation quite yet.  An orderly withdrawal by the Fed and a falling US budget deficit will help to ease pressures as well, so the pressures are likely to be moderate at best.

Third, if this were a short, sharp recession (like the early 1980s recession), then I would say that indeed there is a risk of a strong bounce back which could put the authorities off balance, but given the depth of the recession and the mixed economic signs that we continue to see coming out of it, this looks like it is going to be a slow recovery, which will allow policymakers to make adjustments in a timely fashion which will put the lid on runaway inflation.