Sunday, 29 December 2013

Short-term thinking

I was wandering over a rather damp golf course yesterday, thinking about the rapidly-growing consensus that QE isn't inflationary because inflation is lower now in the US than when QE started. The golf course where I torture animals by sending balls into the undergrowth at regularly intervals responded to talk of global warming and a couple of dry summers almost twenty years ago, by digging a great big lake to increase irrigation. It now seems that global warming makes for wet summers.

I'm not an expert on global warming. But it does strike me as odd that a sample of one, and a period of just a few years, can be seen seen as proof  of anything - either the effect of global warming on the weather, or the effect of QE on inflation.

We don't really know what the long-term effects of massive expansion of central bank balance sheets will be. Personally, I reckon the effect of QE is mostly on the price of the assets that the central banks buy and everything else follows from that. The amount of money in the economy is determined by demand for loans, and banks' willingness to expand their balance sheets, more than by central banks' own balance sheets, but the effect on asset prices is simpler. A central bank buys bonds, drives prices up and forces other bondholders to buy something else. That is bad for the currency if there are a lot of foreign holders of the bonds and good for equities supposing they compete with bonds for investors' cash. And as long as there is a global excess of goods and labour and the currency effect is small, why should it send up CPI inflation?

But if the QE doesn't send up consumer price inflation, that doesn't mean it has no effect or that it isn't dangerous. Rising bond prices may be 'good' for borrowers but go shopping for an annuity and you could feel differently. Sit and decide what to put your pension savings into and the high level of the equity market won't be so attractive, either. But hey, pensions are not in the CPI index, any more than house prices are, so there's nothing to worry about, right?

Away from QE though, I still think the disparity between the cost of money and the growth rate of the US and global economies is simply causing mis-allocation of capital. The gap between  Fed Funds and US GDP growth is heading back towards 4%. It's a recipe for asset price inflation, and a recipe for excessive valuation of assets, somewhere. I've plotted the GDP/Fed Funds relationship below, in both nominal and real terms. There are four cases of rates being far too low relative to GDP growth and they have all had a different impact. Ignoring the present, in 2004/6 easy money caused a credit bubble. In 92/95 easy Fed policy caused a credit and asset bubble in Asia, and only the easy policy in 75/78 showed up in higher CPI inflation.

My point is a simple one - if rates are too low,  we should expect there to be an impact, but should not assume automatically that the impact will be felt in CPI inflation. And the same is true of QE. We should expect over-easy money to cause distortions that will come home to roost in the real economy - just not necessarily on the 1-2-year time horizon that suits most observers.



p.s.... if rates are too low for too long, of course someone becomes addicted to cheap money. The same would be true of what cheap beer prices do to alcohol addiction. The turkeys come home to root when rates have to go up, and we find out who the addicts are. In 2008, it was the banks. In 2006 it was the Asian banks and property developers. So, who is over-leveraged this time?





Friday, 6 December 2013

The good, the bad and the ugly of the US labour market report.

I'm not sure whether the economics profession has ever spent quite so much time arguing about whether the monthly US labour market data are good or bad, as they do now. We used to debate whether the figures meant very much, given that they are subject to big revisions, but we did at least agree whether they were good, boring, or awful.

So, two charts below to provide a very short interpretation of the issues with the data. The top chart shows the unemployment rate (in yellow, inverted, since 1980), and the employment rate. Unemployment is the percentage of people in the labour force that have not got a job. The employment ratio is the number of people with jobs, divided by the total population. From 1983 until 2004, the two  moved together, falling unemployment seeing the employment rate rise, since then, things have got tougher. And since 2010, they tell very different stories. The unemployment rate has fallen steadily. Employment is growing at a rate of 1.7% per annum and payroll growth has been averaging about 170,000 per month for 5 years. The labour force has been growing much more slowly, so the unemployment rate has fallen. And you can draw a straight line through the data and conclude that a 3% fall in 4 years will get the unemployment rate under 6% in 2015. But while growth in the labour force is very weak, the population IS still growing and the employment rate is going nowhere. This is why so many people will tell you today that the fall in unemployment is the 'wrong sort of fall.













The second chart shows the two employment surveys, the household survey which asks people if they have a job and the establishment survey which asks companies how many people they employ. The headline non-farm payroll figure comes form the establishment survey, which is a larger sample. The unemployment rate comes from the household survey. The October data for the household survey were distorted by the Federal shutdown, and that caused the unemployment rate to rise, while employment fell. That is the white line. The Two lines mostly move together, though you can see they have crossed over since 2008. You can also see, I hope, that the household measure of employment has bounced in November, but has not recovered all the ground lost in October. So, if you take the household survey and look at the September-November outcome, jobs were not added. And in both surveys, you can see that employment is merely approaching the levels it was at in late 2007.

Overall, 1.7% employment growth is in line with the average of the last 50 years. That would be fine if we were not trying to recover from the worst recession of the last 50 years. The US economy is growing, but is not catching up lost ground. The unemployment rate is one measure which suggests that some, even much of the output lost in the recession has been lost for ever, and the future will simply see a normal growth path from a low level. Some US economists, including Larry Summers very publicly but also Janet Yellen, simply don't accept this. There is a belief that if the central bank maintains accommodative policy settings for long enough, they can recover some of this 'lost' output. Put it another way - if they ignore the falling unemployment rate maybe some of the people who have become disillusioned and left the labour market will go back to work. If they are wrong, US wage growth and then US inflation will go up if the economic recovery continues.

Personally, I admire the willingness of US policy-makers to throw away textbooks, re-write theories and refuse to accept that a 'new normal' economy is simply not as vibrant as the old one. The contrast with the lack of policy reaction to 0.1% GDP growth and 12% unemployment, is incredible. Refusing to accept the status quo is a bit like Oliver Twist asking for more gruel... it shakes things up.

Saturday, 16 November 2013

We don't work too much but we spend too much time at work

I've just posted a short piece about UK GDP, GDP per capita and what constitutes an economic recovery. A lot of people think that if GDP is going up but average real wages are falling and the overall financial position of many people is worse today than it was a year ago, then there is no economic recovery. It's hard to argue with that position.

But that's only part of the issue. 'GDP' is a measure of the total output of a country in monetary terms, but increasing total quantifiable output definitely isn't the only thing we should be trying to do.

Harry Eyres wrote a column for today's FT called Why work so hard? He quotes John Maynard Keynes' prediction that by 2030 we would all be much better off and would work far fewer hours. Keynes was right on the first, wrong on the second and Mr Eyres wants to understand why.

When I read the article I wondered whether Mr Eyres considers that writing articles for the FT is 'work' and would rather spend less time doing that and more time doing 'leisure' which is by definition more fun. Because if that's the case, he's doing a good job of kidding us, as his writing style suggests that travelling, reading, thinking and writing about the world as he sees it, is how he would spend his leisure time even if he did less 'work'. Journalists, especially ones who write  columns like the 'The Slow Lane' aren't typical, but the line between 'work' and  'leisure' is being blurred and many of those who say they would rather spend less time 'working' often really mean 'less time at work, in this job'.

There are, I think, three issues. The first is money, the second is how we choose to spend our time and the third is our jobs.

When Keynes said he thought we would work fewer hours, 'work' meant leaving home to earn money in a farm, factory, mine, docks or army (for the vast majority of people, at any rate). The difference between work and leisure was very clear and that is why we have measures such as GDP which count the output from 'work' and ignore everything else (most obviously housework). This also gave rise to a fixation with productivity, a measure of how much we can produce per hour. Give me a better machine and better training and I can produce more, faster. More, faster, means more money and that's good. And so Keynes believed that we would reach a point where we could earn enough money to have fun while working fewer hours.

We still go to 'work' for money, but quite a lot of people would do the same thing in their leisure time as they do at work. One of the tragedies of our society is that so many old people suffer from loneliness and that's one reason why people work. You go to work to get paid, but it becomes a centre of your social life. I've seen too many men retire and then age 5 years in a few months and slowly vegetate because they have no idea what to do with their time, to believe that a life of enforced 'leisure' is so appealing that it should be the dominant goal of my working life.

I choose economics as a way to spend time, for work or in leisure. It would have been nice to have played golf this morning but frost having intervened, I've spent a couple of enjoyable hours reading. Was that work or leisure? The answer is that today, it's leisure because I'm not being paid. And that's a good thing because otherwise, I'd have to count all the hours I spend thinking about financial markets as 'work' and that would immediately make me less productive.

But here the difference between 'work' and 'job' becomes more important. How many teachers, doctors, nurses, or policemen for that matter went into the profession for love, but became disillusioned because of how they spend their time. If I could work from home whenever it was convenient; and surf the web, chat with friends and socialise when I was at 'work' that would not make less productive, it would just make me happier. Firms create insane levels of bureaucracy, of measurement and of time-wasting, partly in order to justify 'work'.

I'll give an example from financial market research. Almost every fund manager or other investor I have ever asked, has told me that what he or she wants from investment bank research teams are short, timely, thought-provoking ideas. They haven't got time to read long pieces, unless every single word is necessary to help them make money (and even then they want a one-page precis). They don't much like multi-authored 'house view' pieces because these tend to group-think consensus. They prefer high-conviction, spur of the moment pieces, or research that was the product of incredibly detailed analysis but summed up in a few words or even better, a single chart.  And I know more and more who think 140 characters is about right for a research note.

So how do the world's investment banks react to this plea for brevity and strong opinion? By doing the exact opposite, of course. 'Less is more' is a great philosophy but persuading an employer that it would be a better idea to write less and go and spend four hours thinking on the golf course on a Monday morning, isn't easy.

So, Mr Eyres, I don't want to work fewer hours, but I don't want to waste time doing the wrong kind of work in the wrong place, either. I just need to persuade my employer to pay for my work, irrespective of where I do it.

Which takes me to another FT story, written by Izabella Kaminska on the Alphaville Blog. It considers The rise of the non-monetised economy but is worth a read on many levels. Ms Kaminska is paid to write pieces about foraging for mushrooms and wondering what to give her godchildren as presents, but as I pointed out earlier, maybe journalists aren't typical when we consider what is work and what is leisure.


When rising GDP isn't a 'recovery'. Part 1

There's a debate on LBC radio this morning about the prospects for and the nature of, the economic recovery currently underway in the UK. Here are a few facts, as I see them. Firstly, the UK's current recovery is the most pathetically weak of any in the last hundred years, including the period after the Great Depression. Secondly, real GDP is now growing and most forward-looking indicators suggest that it will continue to do so. And thirdly, so far real GDP per capita has not recovered noticeably, with the GDP recovery itself mostly due to an increase in the population.

I wrote about the economic implications of population growth a couple of weeks ago. An influx of people looking for work in the UK is keeping wages down, boosting demand and will in due course help boost output. But it is also placing huge demands on antiquated infrastructure (transport, utilities, education and the health system) which is a factor behind the UK's inflation rate being higher than it is in a lot of other countries. This is not the only reason the UK has higher inflation but it plays a large part. And so, wage growth is depressed,as new workers compete for jobs and real wages fall. Overall demand is boosted as new arrivals find somewhere to live and spend money; Housing costs go up in the South East as supply fails to keep up with demand. And that leads to a debate about whether there really is a recovery at all. I think there's a completely separate debate to be had about GDP as a measure of economic success. I'll get more coffee as I swap a frosted golf course for sun shining through the living room window, and then get into that but first I'll finish up on the UK 'recovery'.

Stronger growth and above-target inflation are beginning to put pressure on the Bank of England Governor and his MPC colleagues to increase interest rates. They are resisting this pressure, preferring to delay any policy tightening until the unemployment rate has fallen a good bit further. The pressure won't go away and with ex-MPC members debating the economic outlook and policy implications, I suspect that the MPC will struggle to maintain a united front through 2014.  Low rates will go on supporting house prices in the capital and South East (which is increasingly not seen as a good thing by the majority of people). Meanwhile, the pound is recovering some of the fall which followed the 2008 crisis. This is a good thing. The weak pound pushed up import prices and hurt consumer demand, more than it boosted exports (largely because the UK's main export markets in Europe were and remain very weak). A de facto policy of using sterling weakness to help re-balance the economy towards manufacturing was in my opinion both a mistake and a failure.

I suspect the difference between a recovery in 'GDP' and a recovery in real per capital disposable incomes will be a major source of political debate in the next couple of years. As, inevitably, will the social consequences of immigration. I am optimistic that the economy will benefit over time from being the go-to place for anyone in Europe who wants a job, but I do wish that this would trigger a response in terms of investment in the education, transport and regional development that would allow recovery to be shared across the UK and across economic sectors. Apart from anything else, if the UK doesn't do that, we'll have a truly terrifying trade deficit in about 5 years' time.




Sunday, 10 November 2013

Twitter and Starbucks

One of the most tweeted articles this week was This one, which purports to tell any tweeter how much money Twitter 'owes' him or her. That's a tongue in cheek way of saying that we can value Twitter on the basis of the number of tweets that have been sent. And anyone who sends them, adds to the value of the company.

This misses the 'point' of Twitter (and social media in general) in the same way as thinking that Starbucks is a coffee shop misses the point. I'll start with the latter. A few weeks ago, when the weather was still warm, I was wandering merrily from one fund manager to another in Boston, updating on views about the world and the relationship between our employers. When I wasn't sure how to get to the next appointment, I darted into the nearest coffee shop. The salesman who was with me (and doesn't know his way around Boston nearly well enough) pointed out that Starbucks charges a lot for coffee.  I sent him to buy me a tall latte and told him I wasn't here for the coffee. I use Starbucks because I know I can get quick access to wifi and make sure I know the way to my next meeting, while enjoying some air conditioning in a relatively clean and comfortable environment. The coffee's OK, but incidental. The price of the coffee is high, if that's all you go there for, but it's cheap if you want to arrive, cooler and on time, at your next meeting.

Others have different uses for Starbucks but the common factor is that few if any are there for the coffee alone. And so it is with Twitter. I tweet because I want dialogue. I want dialogue because I want to know what other people think. If you don't know what people think,  how can you expect to know how they will react to economic data, policy decisions or any other news that comes over the wires? Anticipating how markets will react to news is more important than knowing what the news will be, most of the time. I also read tweets because they are an incredibly efficient way of filtering the daily news. I follow people who will tell me, while I'm still in bed in the morning, what the important stories of the day are in the Wall Street Journal, FT, Economist, New York Times, Reuters, Bloomberg, Le Monde, Die Welt, Spiegel, Guardian, Telegraph, Nouvel Observateur, and more. I've got people who I've never met scouring the web for me to find  blog posts, central bank research papers and snippets of information I might find useful.

I don't suppose for a second that the majority of Twitter fans like it for the same reasons as me, any more than other people think air conditioning and wifi are Starbucks' key selling point in Boston. My only question for twitter of course, is how it plans to make enough money to justify the fancy market capitalisation. Starbucks, at least, sells those over-priced cappuccinos


Why 'QE' needed in Europe and unnecessary in the US

Two Fed papers last week argue, effectively, that US monetary policy needs to be even looser for even longer. The ECB cut interest rates. The press tell us that the Bank of England is more optimistic on growth, and on falling unemployment but the MPC will re-emphasise its commitment to keep rates low. I think the Federal Reserve in the US should be cutting back its bond purchases, while the ECB should be buying in size. That doesn't mean either is very likely. Far from it, sadly.

The US has high (but falling) unemployment and even higher under-employment. It is also an economy with rising real wages and substantial deficits on both the trade and current account balances. It has low consumer price inflation, however we choose to measure it, and a fair degree of asset price inflation by most measures. The economy is growing, but not fast enough to satisfy the desires of those who want to see unemployment fall faster. Two additional observations: the post-crisis environment has seen historically weak growth in output per worker/hour; and this anaemic recovery  is associated with growing inequality that is likely to be the single biggest factor is US politics in the coming years.

US consumption growth remains strong relative to output (those pesky deficits) but investment remains weak (hence the weak employment and low productivity). Inflation isn't a problem, in either direction (this is not deflation, and real wages are rising). Under-investment should be the focus for policy-makers.  John Maynard Keynes might point out that it is not written in law for total aggregate demand to be at a level which ensures the economy is on a path to full employment, and the public sector should step in. There are obvious problems associated with that, of course - starting with the level of the national debt and  moving on the toxicity of the politics around both the debt level and how to ease fiscal policy.

One thing the doctor might well order, is a policy of currency softness. Grabbing jobs back from overseas, helping domestic products compete better with imports, these are desirable in an economy with a manufacturing base and a need of investment.But QE? Not really. QE has boosted asset prices, but that hasn't done anything to hep investment. . QE has done much to make owners of Picassos and Greenwich mansions happier, but while it has helped direct some investment flows towards corporate bonds (good) it has pushed more towards equities and EM assets and it still isn't clear how that helps US companies raise money for productive investment. TARP did more to help banks lend than QE has done. And a small rise in short-term rates might even  help money flow round the SME sector of the US economy more productively.

QE seems the wrong policy when what is needed is to encourage private sector entrepreneurs and companies to invest in plant, equipment and people in order to boost output, and therefore employment and wages. And that in turn, is what is needed to reverse the widening inequality that unchecked, will become an ever bigger social blight.

Contrast all this with the Eurozone. In many European countries wages and prices are now falling in tandem. The current account surplus is huge, and growing fast. Bank lending continues to contract. Consumption is weak and unemployment terrifyingly high. Youth unemployment should be the single biggest issue in the political debate as an entire generation of voters will at some point realise they have been abandoned by their leaders. The Euro Area problem is that investment is weak but consumption even weaker - overall aggregate demand needs a huge boost.

And then there is the debt... public sector debt levels are too high everywhere and private sector debt levels are too high in several countries. With weak nominal GDP growth, these debt levels will go on growing relative to GDP unless one of three things happen - default reduces the debt, austerity creates a downward spiral of increased savings and falling demand that might at some point find an equilibrium debt/GDP level, albeit at a level of unemployment, real incomes and overall GDP that is too awful to contemplate, or policy-makers breathe some inflation back into the system.

In the Euro Area, QE (buying bonds in substantial quantities through a series of auctions, as the Fed does), would encourage the banking sector to lend more and hold fewer government bonds. That would be a good thing. It might weaken the Euro, which would be a very good thing indeed. It might send asset prices and increase inequality but the Euro Area, unlike the US, has a political system and social structure that can counter this. And if it boosted consumption through wealth effects, then that would be a god thing. A weaker currency, a reduced current account surplus, and a boost to bank lending? Bring it on. With banks encouraged to 'cut assets' (i.e, shrink their balance sheets) it makes sense for the central bank to boost its own balance sheet (at least temporarily) to plug the gap they leave behind. I don't think that's the same thing, at all, as 1920s money printing in Germany.


Thursday, 31 October 2013

In honour of plumbers

In the days of Ottmar Issing and Juergen Stark, high-powered economists ruled the ECB but times have changed and the current environment requires a new breed of central banker. I'll call them plumbers, but that is not intended in any way to belittle them. They are, led by Mario Draghi, more practical and more adept at coping with a deply flawed monetary system that has been put under stress. Indeed, perhaps the best comparison is between architects, necessary to design a building, set policy targets and understand the way the world works and plumbers, who don't look for perfection but simply try and keep the building from falling apart, finding a way to get the hot water from the boiler to the radiators and the dirty water out into the drains rather than all over the living room.

In term of architecture and economics what does the Euro Zone need? A fiscal union with a common taxation and spending policy; a single risk-free interest rate and instrument; a genuine monetary union that can police the financial system, raise levies to provide the funds for future bailouts and provide guarantees for retail depositors. All of this is as likely as pigs flying over the Eurotower on their way to a rave in Wilhelm-Epsein Straße. 

By the same token, what 'should' Europe's central bank do faced with rising uemployment, a rapidly growing current account surplus, shrinking banks' balance sheets, a huge output gap and an inflation rate falling towards zero? They should have, some time ago, worked with government to create a European TARP, to re-capitalise banks and create a 'bad bank' for impaired assets. They should now be injecting money intravenously into the system through large-scale bond purchases, and there would be nothing wrong with an Abenomics-like policy of talking down the currency, front-loading fiscal easing and structural reform of the labour market and pension system.

Some people will disagree with some or all of these policies. But what they have in common is that they, too, won't happen. 'Proper' QE is against self-imposed European rules. Talking down the currency is not in the ECB's mandate. Another set of rules demand austerity with slippage rather than either outright austerity or Keynesian expansion. And as for all getting together to re-capitalise banks, it needed to happen 5 years ago.

So what is left? When Mario Draghi arrived at the ECB he was a breath of fresh air, slicing the growth forecast, announcing the LTRO, getting money moving around the system. Then a series of vague promises and incompletely-defined promises to buy government debt and bank debt if needed were introduced. Purists look at all these policies and question whether there is any substance behind them but the yields on spanish and Italian debt just goes on falling. Others are alarmed by the way the ECB is lending money to banks to buy their own government's sovereign debt. And we all worry about the fact that with little or nominal GDP growth, debt levels are doomed to rise steadily until they are unsustainable (if they aren't already). But the Euro Area house still stands and a bloke with a wrench and some tape is making sure the money flows around the system. That's what the plumber-in-chief has achieved while he waits for his political masters to build a better structure. Hey, it's a lot better than the alternative....

Saturday, 26 October 2013

Storm coming


There's a storm coming, apparently, to rival October 1987's. I was in London when that storm hit, and didn't notice anything had happened until I got to work.  But down here in Higher Coombe, we did lose a lot of trees, including much of a beech row. Since I am down in Devon now, I wandered out with a camera because there isn't anything I can do to prevent a storm blowing trees down, but I'm fond of them. The top picture shows a beautiful beech row that is almost intact on our neighbour's deer farm.  I took the picture as much for the colours as the trees.


The second picture is of the Mardle, my favourite stream, after which I named this blog.



And the third picture is of a couple of the beech trees in a row by the house, that survived 1987.  I hope the latest storm, if it comes, leaves the beech trees alone.


The World's Strongest Property Market

In 2010, I managed to get stuck in Dubai thanks to the intrusion of an Icelandic volcano.
I went soon after Dubai world had re-structured its debt after property prices fell. The grandiosity of some of the developments in Dubai (the Palm, the idea of a ski slope with artificial snow and lifts in a desert shopping mall, to name but two) made for plenty of humorous headlines but in fact, Dubai had been pushed off the front pages of the papers by the Greek debt crisis, which erupted just days after Dubai's woes started to scare investors in November 2009. Between then and June 2010, the Euro's value fell from $1.50 to $1.20.

This week, I returned to the region. Dubai is booming. GDP growth close to 5%, property prices rising faster than anywhere else in the world. Much excitement has been triggered by a report by Jones Lang Lasalle which has snappy headlines telling us rices are rising at an unsustainable rate, though it also says that measures taken double land registration taxes will help cool the market. Goldman Sachs say it's alright, so we shouldn't worry. It’s not a bubble, it’s just a boom, see.

At first glance, my assumption was that this was Ben Bernanke’s mad monetary policy at work again. Dubai has a fixed exchange rate with the dollar, which means they import US interest rates. If your economy is growing at nearly 5% and money is cheap, you'll get asset booms (or bubbles). In the Middle East, that means insatiable demand for premiership football teams, and rising property prices. So here we go again, I thought.

There is however, an additional driver of demand that didn’t exist in the mad credit frenzy of 2003-2008 - the influx of money and people that has come as a result of the Arab Spring. The rich are either sending their money to the Gulf, or sending themselves there too. It isn’t easy to quantify but the planes are full, the hotels are booming and the anecdotal evidence is plain to see. Reuters estimated earlier this year that DH30bn flowed into the region last year and this year, Cyprus (this year's weakest residential property market), Syria and Egypt will all have added to the flow of money.

I don't know how this will play out in Dubai and the UAE. But global excess money is chasing real assets because the returns on financial ones are derisory and the inflow. And the longer QE and ZIRP continue in the US, the worse it will get. Money is mis-priced and the Gulf boom is being pumped up by money fleeing the crisis in the Middle East and North Africa. Eventually, rates will go up in the US, putting pressure on some borrowers and on any lenders who have too much regional or sectoral concentration. Which is quite a few of the banks in the Gulf.

Meanwhile, at least Dubai was able to re-structure its debt, get help from the rest of the UAE, and let property and asset prices adjust quickly. Spare a thought for Greece, which went into the crisis at the same time but is left with an overvalued currency, struggled to re-structure its debt and even if GDP won't fall for ever, isn't enjoying a bounce and won't any time soon.

Wednesday, 9 October 2013

Short post on social media...

On Monday I sent a morning note out, observing that everyone will have had their fill of the observation 'we don't expect a US default' but that as the October 17th deadline to resolve the issue of the US debt ceiling draws closer we need to ponder  how hard that deadline is and meanwhile, asset prices may remain under pressure.

I was glad, therefore, that the following chart was posted on a market blog by well-known blogger/tweeter/commentator Joe Weisenthal.


The chart shows how the 'hard' line in the sand for the US running out of any wiggle room on its finances comes a bit later, either on October 31 or November 1 when big payments are due.

So I re-tweeted the picture from a restaurant as follows:

Happy Halloween. Doomsday is Nov1 RT: CHART OF THE DAY: This chart destroys the debt ceiling truthers.

Sunday, 6 October 2013

Groundhog Day for England

Is there a house price bubble? It's the topic du jour. Well, here's the simplest chart evidence for the view that whatever we want to call the current rise in house prices, it isn't 'a bubble' .

It's certainly fair to say that on official data and across the UK as a whole, the ratio of average house prices to earnings is a long way below the 2007 peak. And since mortgage rates are a lot lower than they were in previous cycles, the ratio of mortgage payments to house prices is even lower. But that tells only part of the story, certainly for London and the South East.

I borrowed three times my 25-year old economist's salary to buy my first flat in North London, in 1987. If a younger me turned up at the age of 25 today having seen economists' salaries merely keep up with national wage trends, he/she would have to borrow nearly seven times his/her salary. Not to mention the fact that the 25% deposit my father produced in his generosity would need to be nearly six times as big now. It's no wonder that while people still want to get on the housing ladder, they are doing so much later and my 24-year old self would have probably gone on flat-sharing for a few more years.

I watched the rise in house prices, then the fall, got married and got a bit older. We moved house in 1994, selling the first flat for almost exactly the same amount as I had paid for it.  But that was OK. 1993 had been a good year for 32-year old economists, so we were able to buy a house, once again with a 25% deposit, in cheaper but trendy Tuffnel Park. And it was there our children were born.

Now I can imagine another slightly younger self, following foolishly in my footsteps, who is 32 today, married and thinking about family. Average wages have nearly doubled since 1994 but unfortunately, Tuffnel Park house prices have risen twice as much again.  So he'll still need to be able to borrow 6 times his salary and find a truly mind-blowing deposit to get onto the North London house ladder. He will doubtless be staying in his flat for a bit longer, weighing up the merits of moving further out of town (but dismayed to find you have to go a long way London before prices fall enough).

My younger self would probably buy a flat later, get married later, have children later and retire older. And that is exactly what is happening. As for the generation following him I don't know what they would do, because my younger self isn't going to be enthusiastic about moving again when he sees how much stamp duty he might have to pay. He'll probably opt to stay in his first family home in London, thank his lucky stars he ever got on the housing ladder at all, and only move when he cashes in his savings and retires. In the meantime, another generation of bright young British and European economists will have moved into flats in London, met each other, fallen in love and started trawling estate agents' windows in search of a place where they can start a family. But the good people of Tuffnel Park can no longer afford to move 'up' to  Hampstead or Primrose Hill, so sellers are reluctant, turnover is low and prices as susceptible to bubble-like characteristics as it's possible to be when you're not in a bubble....

The UK economy is blessed with a rapidly growing labour force that boosts growth potential and provides far better prospects for getting the government's gargantuan debt levels under control than is the case in some other European economies. But failure to diversify the economy through regional and educational policy has left the population growth centred on London, with its antiquated  infrastructure. This economic cycle is rapidly beginning to look just like every other economic cycle of the last 30 years, led by housing and doomed to end with UK interest rates peaking above those elsewhere and the housing market going into reverse in a few years' time. I'll enjoy the positives from stronger demand growth, worry about what happens to the trade balance, hope that higher interest rates deliver a stronger currency which make holidays  and imports cheaper, but I'll bemoan the chronic lack of vision that allows a whole country to wander into its own version of Groundhog Day.







Saturday, 28 September 2013

Slowing US labour force growth, wages and Transatlantic inflation trends

Two weeks of travelling in the US and Europe and finally, a Saturday morning in Highgate. Markets have had the 'notaper' from Ben Bernanke, the 'No QE' from Mark Carney and the 'No negotiation on Obamacare' which threatens to bring the US government to a halt. Hey ho. And in the foolish world of financial markets on we go to another monthly Labor Report, next Friday.

When it was still summertime, I threw out some observations on the Phillips Curve, which seems to work well in Japan, a bit in the US and very poorly in the UK. The US labour market remains hugely important for monetary policy, even if Mr Bernanke went to some pains to make us understand there are no automatic consequences of a falling unemployment rate. Markets will still be watching  the jobs data (very) closely. So, here's a quote from July's Chicago Fed letter

"For the unemployment rate to decline, the U.S. economy needs to generate above-trend 
job growth. We currently estimate trend employment growth to be around 80,000 jobs 
per month, and we expect it to decline over the remainder of the decade, due largely 
to changing labor force demographics and slower population growth" 

That's a much lower estimate of trend employment growth than I might have come up with in the pub on a Thursday night. The August payroll gain was a 'disappointing' 169k and in the last twelve months the range has been between 332k and 104k, in other words, consistently well above trend. Hence the falling unemployment rate. But, this solid employment growth hasn't prevented GDP from growing by a relatively measly 1.6% in real terms. The bottom line, if I take the fine analysis from the folks at the Chicago Fed to heart, is that even if job creation continues at what Americans consider to be a paltry rate (180k or so per month of late), the unemployment rate will go on falling steadily.

Now if you don;'t believe there is any such thing as a 'NAIRU', you won't care about that. But you should be worried if you are one of those people who do think there is an unemployment rate below which wage growth accelerates (small rant here for me to repeat that the empirical connection between unemployment and wage growth is much less awful than that between unemployment and inflation).

Which brings me to a completely different topic - the Beveridge Curve. The US Federal Reserve employs armies of really talented economists, not only at the Chicago Fed. So, here is a great paper from Rand Ghayad at the  Boston Fed (many thanks to Mike Green in New York for sending it to me). The Beveridge curve shows the relationship between job vacancies and the unemployment rate, which reflects the amount of friction in the labour market. There ought to be a low unemployment rate when there are lots of spare jobs going, obviously. Mr Ghayad is one of many to observe an outward shift in the Beveridge Curve, which suggests that it take more vacancies to get the US unemployment rate down than it used to. In my simple mind, that indicates more friction in the labour market. Mr Ghayad shows that this is mostly driven by those who have been out of work for longer periods of time and proposes that much of this is due to changes in how long people can receive unemployment benefits in the US. But a shift outwards in the Beveridge Curve tends to suggest that more of the unemployed are not looking for jobs as hard as they used to, or are unsuited to them. They could be people who have been out of work for a long time who no-one will hire, or they could be unemployed CDO structurers, who are ill-suited to most other tasks. We used to call such people 'outsiders' in an insider/outsider theory of the labour market which explains why the long-term unemployed don't put downward pressure on wage growth elsewhere, and why the only people who ever get to manage premiership football teams, are people who manage top-class football teams somewhere else in Europe.  Professor Dennis Snower who is now the head of the Kiel Institute, had the misfortune of having to teach me about this 30 years ago. In Phillips Curve parlance, a shift outwards in the Beveridge Curve, increases the NAIRU level and if that is what is going on in the US, there is a likelihood that we will see a pick-up in wage growth as the unemployment rate falls from here.

On weekdays, when I'm earning my living as a fixed income strategist, I may worry about faster wage growth. On Saturday mornings, I say bring it on! But it does raise questions about the relationship between inflation and wage growth and it raises the intriguing question of whether the labour share of GDP, pummelled ever lower in recent years, is finally going to turn higher, at the expense of the profit share. Nice for people, not so nice for shareholders...

UK Inflation....

US wage growth (at 2.2% per annum) isn't affecting inflation (the core PCE deflator is languishing at 1.2% per annum). That may partly be because inflation is driven more by demand than wages. So if wage growth goes up because the labour force and population are growing more slowly, that also reflects sluggish overall demand. This is a neat theory to fit the facts, but is also immediately focuses my mind back on the UK. Because here, we are seeing an acceleration in population and labour force growth, notably in the South East of the country. This helps anchor wage growth, but also helps push up inflation. It pushes up inflation in the same way as is seen more frequently in emerging market economies, where population growth is a really big driver. The sectors of the UK CPI which are growing faster than overall inflation at the moment are food, drink & tobacco, housing, utilities, health and education. Away from food and drink, the price of utilities, health, education, and other services are going up largely because a growing population requires investment to increase capacity (more trains, tubes, water pipes, power stations, nurses and bin collectors) which is passed on to consumers because a cash-strapped government won;'t make the investment for us.  There is good news in the latest CPI data, insofar as the price of coffee and tea, beer, shoes and cars are all falling while photographic equipment prices are falling fastest of all, but I can't help thinking that the fact UK inflation is higher than it is in the US, or Euro Area, has more to do with structural strains on services than anything else. Meanwhile, a growing population will continue to anchor wage growth (so we can all grumble) and push up the one price that doesn't get properly reflected in the CPI data - that of flats and houses.



Sunday, 8 September 2013

Summer's over, tapering's coming but money is still easy.

I went for a walk this morning - 2 hours before I saw anybody at all. Water levels are low but rising. Summer's over. Stay-vacation visitors to Devon enjoyed the best weather in years in August but the pub is quiet now and the moor is empty.





















The chart shows the 3-month average US unemployment rate. I put a trendline through it for fun. The fall in the unemployment rate is progressing at a very steady rate and on the current trajectory, will get to 6.9% by next April, 6.4% by the end of 2014. If the Federal reserve wants to have completed its 'tapering' programme and stopped buying bonds by the time the unemployment rate gets below 7%, they're going to have get going.


A falling unemployment rate is almost always better than the alternative. But the current downward trend is not accompanied by strong GDP growth, or strong real disposable income growth, or inflation Hence the unhappiness in some circles at the idea the Federal Reserve may be thinking about easing back on the monetary throttle.


That brings me back to the trend line. Most Americans, having seen an unemployment rate of 4 1/2% without any major inflation threat in the last cycle, can't see why 7% is the magic number today. Others argue, reasonably, that the unemployment rate is distorted by part-time work, and by people leaving the labour force.

The Fed references unemployment and inflation in its forward guidance for interest rates for two reasons. Firstly, because of a long-held belief there is a relationship between falling inflation and higher consumer price inflation. The evidence is dodgy. And secondly because it believes there is a relationship between inflation and the amount of spare capacity in the economy, but that is too complicated to talk about directly, so the unemployment rate is used as a proxy for describing the output gap. I wish policy-makers would resist the temptation to treat the rest of us as idiots and just say - we will keep policy easy until we're scared growth is so strong it might push inflation up.

The framework to policy does nothing for credibility and helps fuel the debate about where policy should go. But ultimately, the message we are going to hear, over and over again, is that 'tapering is not tightening'. The steady decline in the unemployment rate is going to be one factor, along with the strength of the ISM surveys and the housing recovery, to justify slowing the pace of bond-buying slightly. This month or next month? To my mind that's a tactical decision and in a perverse way, I think the Fed may feel that buying fewer bonds after a period of upward adjustment in yields gives them a better chance that they can slow their buying without causing untoward volatility.  But if they then start to really emphasise the fact that rates are on hold for a lot longer, and point repeatedly to the benign inflation backdrop - the core PCE deflator at 1.4% for starters - we will all eventually realise that monetary policy remains exceptionally accommodative.

Super-easy policy has driven and will drive asset price inflation. The adjustment that came from the shock news that super-easy policy won't really be left in place in perpetuity should begin to come to an end when tapering starts. Some people tell me equity valuations are high, others than M&A makes corporate bonds less attractive. EM outflows continue and maybe that promises more weakness. There are reasons for every single 'risk' asset to remain under the cosh even when the spike in bond yields finishes. But I'm a simple enough fool to know that something is going to have a fantastic autumnal rally on the back of near-zero rates. It would be nice if it were farmland prices, I suppose....

Monday, 2 September 2013

Ro-Ro for Dummies

Hélène Rey's paper on how the global capital flow cycle is largely driven by Fed policy and risk aversion ...http://www.kc.frb.org/publicat/sympos/2013/2013Rey.pdf went down a storm at the Fed's Jackson Hole symposium. The paper is definitely worth a read. My one-line summary for market participants is that this is an analysis of 'risk-on/risk-off' for posh people. That is to say, it puts an econometric framework around something we all observe all the time. It serves a very useful purpose in the process though, by allowing policy-makers to grasp what it is that drives the Ro-Ro phenomenon. See this next post from Laura Tyson on the bumpy ride facing emerging markets.

There is now broad agreement that the volatility in emerging markets has been caused first by the Fed's QE policies, which squeezed money out of US-based investment and into higher-yielding assets, often emerging market ones, and secondly the merest hint that super-easy policy can't last for ever, which has triggered a shocking reverse of these flows.

For the sake of light entertainment, I have reproduced an old chart below, which shows US real GDP and real rates, how they mostly move together and we have seen a number of periods when a big gap has ben allowed to develop. When real rates are too low relative to the real economy, asset bubbles have had a tendency to follow.




That's all nice and familiar, but Professor Rey's paper prompted me to re-draw it putting global growth against US real rates. The pattern's the same and the size of the current gap tells its own story. The world cannot escape the effects of US monetary policy and since 2012, Fed rates have been dramatically out of line with global growth.


Most people agree that what the world 'needs' is a new global financial system to avoid the volatility caused by  risk-on/risk-off. You don't always get what you need. The Fed isn't going to start setting domestic monetary policy to suit the global economy when that doesn't suit the US economy. In practise, I think that the alternative, and what professor Rey suggests is likely, is that capital controls will increasingly be seen as a reasonable response to crisis.

And finally, a sensible observation from Gene Frieda as the emerging market 'crisis' shows signs of easing. Emerging markets need to use the time that is afforded by floating exchange rates and large currency reserve pools to get to grips with domestic credit creation. They imported cheap rates from the Fed, and for too long too many have allowed credit to expand dangerously. Then, as US rates move up or simply dream about moving up, the credit cycle is turned on its head. The EM boom has had a nasty shock as US yields rise. Things can quieten down if the US market does. But one day, the Fed will hike rates.

Saturday, 31 August 2013

Krugman, Phillips and Carney

A recent post by Paul Krugman defending the Phillips Curve and the unemployment/wage trade-off. I'd never dream of challenging someone so much better at economics than me but I've long believed that this is a defunct trade-off. The labour market is global, surely, and that means that workers have little bargaining power even if unemployment falls. There are exceptions in some industries, of course  but my underlying view is that the world has moved on. Not only that but here in the UK at least, consumer price inflation has been incredibly sticky and resistant to downward pressure from recession. Wage growth and inflation have become increasingly unrelated, or so it seems. 

Professor Krugman is much wiser than me and heaven forbid me from actually disagreeing, so I have spent part of the week playing with data. What I ended up concluding was: 1) The wage/unemployment trade-off in the US is OK but the inflation unemployment trade-off is all but invisible. 2) If you want to see a properly operating Phillips curve, go to Japan. And 3) if you want to see somewhere where the inflation/unemployment trade-off is far, far worse than in the US, come to the UK. Which makes the decision to put inflation and unemployment at the hart of the MPC's monetary policy framework, a little odd. And indeed the risk that we face is that although growth remains weak, and wages remain under downward pressure, inflation will remain high, eroding the credibility of the MPC's 'forward guidance'. 

In the interest of understanding the Krugman piece, I did my best to recreate the chart he uses to show that there is indeed a decent wage/unemployment trade-off in the US, using annual data from 1985 to 2012. That is below.
So far, so good! But if I then plot the same scatter chart for the Fed's favourite inflation measure, the core PCE deflator, I get much less helpful results.... 

I guess there's a relationship of sorts but really? This may not matter to someone who is defending the Philips curve, but the Fed is targeting the core PCE deflator, and so that is to a large degree what matters to policy. 

There are all sorts of reasons why this matters for the US (not least  don't be surprised to see unemployment fall while inflation remains very well behaved) but I really wanted to compare what is happening there to what is happening elsewhere. So look at the same charts for Japan...


Now that's a Phillips curve trade-off. A less internationalised labour market? And bizarrely, this is good news for Japan. In many countries, news that inflation is going up and unemployment falling would be a source of concern but if what you want to do is escape a 20 year deflationary disaster, this is great. Inflation expectations are going up and the so far, Abenomics is delivering. I think monetary reflation can work.

OK, now for the horror show.... here are the same charts for the UK....


So... since 1985 there's been very little relationship between wage growth and unemployment but insofar as one exists, higher unemployment correlates with faster wage growth. There's a far better correlation between inflation and unemployment but unfortunately the sign is wrong.  The upward slope means that low inflation co-exists with low unemployment. This says nothing about causality but it does suggest that the idea of a wage/unemployment trade-off in the UK, is perhaps a bit out of date. Maybe the economy grows faster with low unemployment, or maybe British workers are being forced to compete with workers elsewhere to prevent jobs leaving the country?

The unemployment/inflation trade-off is used as an easier way of looking at a trade-off between inflation and economic slack. We view falling unemployment as a sign that the economy is getting closer to its potential growth rate. Likewise, we look at inflation as a measure of slack, a sub-par economy taking inflation rates lower. But when so much of what drives inflation has nothing to do with the strength of the economy, that doesn't quite work. Transport, education,  water, gas, and electricity prices are all regulated to a greater or lesser degree. Rail fares and utility prices through a formula agreed with the government in order to encourage much-needed investment. The price rises to pay for cross-rail, a new generation of nuclear reactors, or repair to Victorian water and rail network, have nothing to do with the strength of the economy. Indeed, when the economy is struggling, any suppliers of services that are subsidised by the government (like local authorities), see their subsidy fall and have to respond by pushing price up faster.

I wish the MPC hadn't put inflation and unemployment explicitly into the mix for their forward guidance. I know they have left themselves so much wiggle room that they can ignore persistently high inflation, falling unemployment and focus on soft growth, but this just looks like a  policy import that makes no sense over here.

I hope to find find time to write about this, a cracking argument for capital controls from a London Business School professor, tomorrow evening....


Thursday, 15 August 2013

QE, credit rationing and an obsession with housing

So what did central bank long-term asset purchases (QE) achieve?  There has been a fair amount of noise in the press after two Fed economists, Vasco Curdia and Andrea Ferrero, published a paper seeking to answer the question

The paper concludes that the effects are small and indeed, that forward guidance around the future path of interest rates is more important. Overall, they estimate that the boost to GDP from QE and the Fed’s forward guidance amounted to about 0.13%, while inflation was boosted by around 0.03%. Cue a typical response from The Telegraph, in which Richard Evans wrote ‘Did QE punish savers for nothing?’

The view within the Fed seems to be that the effects of QE are entirely due to the downward pressure that asset purchases have on bond yields. Hence the importance of forward guidance. Driving down long-dated bond yields helps, but locking in expectations of a protracted period of very low short-term rates helps more.  Personally, I think this is a pessimistic view of what QE has achieved, while also failing to address what I see as two negative side-effects of - firstly that it QE distorts asset markets and risks creating imbalances which will be dangerous in the long run, and secondly that it does nothing to address the weakness of loan supply, and demand for individuals and small businesses, only really helping those who can tap into capital markets (directly or indirectly). 

The UK MPC explicitly recognised the crowding out effect of QE from the start. UK investors sold gilts to the Bank of England and used the money to buy something else. The hope was that this would divert money towards the parts of the economy that were in need of investment. You could be forgiven for concluding that they mostly bought houses or foreign assets, since the housing market recovered and the pound fell and you could reasonably argue whether that helped growth much, but that's another story. 

I've always though the UK interpretation was more realistic - QE 'works' both by lowering borrowing rates and by forcing investors into less conservative asset allocation decisions. I have also, in the process, concluded that QE results in money being cheaper for those who can get it, but does not alter the fact that money is ‘tighter’ or more rationed overall. I reach that conclusion because large-cap companies and higher-grade borrowers who can tap capital markets directly, are helped by the effects of. If, in the UK, the Bank of England buys gilts off private investors, it stands to reason that some of that cash can be re-deployed in the corporate bond market instead, easing access for borrowers. But it doesn't do anything to alter the fact that banks are shrinking their balance sheets and bank lending is being constrained.

One counter to this is that the weakness of bank lending is down to weakness in demand, rather than a limit on supply. Thorsten Beck of Tilburg University  in particular, has done a lot of research and written reams on why SME borrowing has been cut back since the credit crisis. I would observe, that since the first 6 months of 2013 have seen UK non-financial private institutions issue, in net terms, GBP 11.8bn of new capital while over the same period  M4 lending shrank by £54bn, and monetary financial institutions net cash raising has been a repayment of £41bn, there is at least cause to wonder if QE has kept capital markets working while the banking system has been shrinking. Maybe that is because the SMEs, which are reliant on the banking system for funding don't want to expand, but at first glance it looks as though they are faring less well in this regard than their bigger competitors. 

Meanwhile, the margins that banks have been charging for loans have tended to be wider in the post-crisis period than they were before, and that does at least raise the possibility that the reason loan demand was weak, was that the price of loans were high. Is that rationing? A shift in the cost of funds for bond (and equity) issuers, relative to the cost of funds to anyone calling their friendly local bank manager, definitely rations money.



But it all comes down to housing, apparently....

At this point, I observe that 1) there is some (but not conclusive) evidence that QE has helped big companies more than smaller ones; 2) that if the US view that forward guidance is more important the UK is in trouble because forward guidance has sent UK market interest rates sharply higher; and 3) the good news is that bank loan spreads seem to be narrowing a bit, that the Bank's credit survey indicates that both demand for and supply of credit is increasing, and economic recovery (albeit patchy) is underway. 

However, when I call up people who work at British banks and quiz them about the data, they tell me that a large part of the answer comes from the UK’s obsession with real estate (in all its forms). Pre-crisis, up to 70% of lending was to real estate in one form or another – mortgages, companies investing in real estate, developers buying land, pension funds treating it as an asset class and so on After the crisis, two things happened. The first was that regulators told the banks they had far too much exposure to this sector. So they have retrenched. And secondly, bankers found out they had forgotten how to lend to anyone else. A generation of lending officers at the major banks don’t really know how to lend money to an engineering firm to buy new equipment to ‘make stuff’.  They haven’t ever really had to do it as the UK’s manufacturing base has been left to rot. They know how to lend money to a property developer to buy, develop and sell a piece of land or a block of flats. 

The net result is a lack of lending.  The banks needed to shrink balance sheets. They also paid more for capital that they could lend out. And they weren't very good at trying to lend to those parts of the economy that might have wanted money. Meanwhile, without doubt, the appetite to borrow has decreased in the real estate sector. .

So the collapse in bank lending is because the UK economy is just doing a really bad job of re-engineering itself away from an over-dependence on real estate. But hey, it's not all bad news! The housing market is recovering. And according to the RICS survey this week, it is recovering around the country. Maybe that's why the banks are  lending. Maybe that's  why credit demand is picking up. It’s all linked. QE has helped the housing market, and an economy which is (still, after all these years) crazily over-sensitive to real estate, is feeling better about itself. And bankers can get back to the only kind of lending they really understand. Once upon a time, we were a nation of shopkeepers, but the High Street was made redundant and now we are a nation of on-line shoppers and house-owners... 

Of course, if this is true, there's a big risk we just see a property bubble reflate itself, the economy give the impression of thriving for a couple of years and then we'll be back in a mess but hey, that's better than never having any fun at all and maybe the wise politicians who run the country will use the recovery to invest in regional, educational and industrial policies to really help re-balance the economy away from finance real estate, towards manufacturing and other 'real' industries. Maybe..... 

Wednesday, 7 August 2013

The forward guidance Hokey-Cokey

The Bank of England’s monetary policy committee, led by the redoubtable Canadian Mark Carney, is adopting ‘forward guidance’ with a commitment to keep policy rates at 0.5%) as long as the unemployment rate is above 7%, unless doing so makes them fear missing their inflation target, or causes inflation expectations to rise too much or causes financial instability.

The market reaction was firstly to sell the pound and lower interest rate expectations ahead of the release of the Inflation Report and the forward guidance announcement.  Then, the pound was sold and rate expectations lowered with even more vigour as the news was released, only for the market to think again, turn around and buy the pound, selling short-dated gilts as the day wore on.  Sterling has ended the day about a percentage point higher against both euro and dollar, short sterling futures have sold off (modestly, having reversed the earlier gains) and gilt yields aren’t very different from where they were yesterday. The FTSE 100 is about 1% lower, performing better than the Nikkei but falling more than the S&P.

This seems a bit like the Threadneedle Street Hokey Cokey!

The purpose of forward guidance is to ensure that those involved in the wider economy, rather than those active in financial markets, understand that interest rates will stay low for ‘a long time’. That allows people to be confident that the period of super-low rates won’t be reversed suddenly. As for the conditions attached to the forward guidance, they are there to make sure that no-one fears that the central bank is being irresponsible. Of course, that’s completely impossible – some people think current rate levels are daft, as it is. The choice of conditions which would requires the MPC to change course is chosen to be both ‘credible (ie, to show the Bank is doing its job properly) and unlikely to be met (ie, they don’t actually want to be raising rates before the unemployment gets below 7%).

So, how did Mr Carney do? Any inflation hawk will simply turn around and point out that making unemployment a specific target of monetary policy, as well as inflation, is dangerous. In practise, even the Bundesbank used to care about unemployment, but making lower unemployment an objective does mean the central bank mandate has changed from fighting inflation to helping the economy.

My main concern – and to be fair this was the case long before the announcement was made - is that targeting lower unemployment subject to where inflation (specifically CPI inflation) implicitly assumes that there is still a clear trade-off between the two, and the monetary policy should focus on the trade-off.  And if that assumption is wrong, there is a very real risk that any specific unemployment/CPI target that the Bank came up with, was in danger of being either too easy to hit or too likely to miss.

What happens if GDP growth continues to be sluggish (likely) but is accompanied by a further fall in unemployment (possible), while consumer prices rise but wage growth remains very weak (also likely)? At the moment the economy is growing at an annual rate of 1.4% (in terms of GDP), and the Bank of England forecasts (optimistically) a steady acceleration from here. Even this pace of GDP growth is seeing employment increase, albeit with much criticism of the kind of jobs that are created (see the whole debate around zero hours contracts). Economic growth may not slow and employment may continue to grow too, but  if we are creating 'the wrong sort of job',  why would we see a pick-up in wage growth. Maybe, as the economy shifts from a financial service focus to a manufacturing one, we will see wage growth pick up as skills shortages in manufacturing grow. Maybe we will see downward pressure on financial services compensation ease and maybe, even, growth will deliver better tax revenues and as the fiscal position improves we will see public sector wage growth pick up. But mostly, there is plenty of excess labour globally and that is what is making wage-bargaining so one-sided even in economies with some kind of economic recovery. But even if wage growth remains low, that won’t keep CPI inflation down. This week saw the news that rail fares may rise by 5% or more on some commuter lines in the terms of the deal with rail operators. Gas, electricity, transport and education prices are all insensitive to what happens to wages or indeed to the economy. CPI inflation in the UK is supply, not demand-driven and worse still, it isn’t supply of labour which drives it.

So my first concern is that at a time when rates should say low and help the economy rehabilitate, the focus on unemployment and CPI inflation threatens to get in the way. Mr Carney would not want to tighten in the face of modest growth, but not doing so would undermine BOE credibility, perhaps severely. And my second concern is that by telling markets rates are staying lower for longer but giving them unemployment and CPI inflation as guides to when things may change, we will see markets price in very low rates for 2 or 3 years, and then assume a steep rise in rates thereafter. And since markets are by their nature forward-looking, pricing in the steep rate rise in the 3-5-year horizon risks undermining any good work from the forward-guidance in terms of anchoring rate expectations in the first place. If I am to price in higher rates 5 years ahead, I will sell gilts and buy the pound now. Which I exactly what happened after the initial positive reaction to the policy announcement.

I expect we will now see a whispering campaign to clarify what forward guidance really means, and to make sue that we all understand firstly  that the MCP remains firmly focusd on fighting inflation, and secondly how clear they are that rates are likely to be down at these lvels for years to come. but I don't know if inflation expectations can be re-anchored, or if the nagging fear that when rates start to rise, they will go up quite a lot further and faster than those elsewhere, can be soothed with a few words.

Holidays, work and railway tracks

The French President is going to spend his summer holidays close to Paris,  in a hunting lodge atVersailles. Shades of Louis XIV? ask the papers. The British Prime Minister has jetted off to Portugal, carefully choosing to fly Easyjet. So the press has chosen to debate his holiday attire, down to what length of shorts it is acceptable for a middle-aged politician to wear these days. 

The amount of jibberish written about how and where people spend their 'holidays' is staggering. The sartorial nonsense is peculiarly British (Mr Cameron, wear something comfortable, that your wife approves of, and ignore the fashion snobs). The pressure on M. Le President to go on holiday but not actually be seen enjoying himself is equally French. But it all makes me wonder how old-fashioned (but not ancient) notions of holidays are surviving in a new era. 

The summer holiday was born of industrialisation, urbanisation and improved transport. Not to mention a desire to promote healthy living. The victorians built railway lines that allowed factories to close and send their employees to Blackpool, Dawlish and Scarborough to breath fresh air.  After the second world war the French promoted St Tropez for Brigitte Bardot and La Baule for Monsieur Hulot. And then along came Carry on Camping and Carry on Abroad. 

Once upon a time of course, there were no summer holidays. An agricultural society doesn't have them in summer, a subsistence economy doesn't have them at all. Wealth makes them possible and workers' rights makes paid holidays the norm. Perhaps  it's no surprise that we cherish them, or indeed that we're so horribly snobbish about them. Ibiza is better than Majorca is better than Benidorm.  Salcombe is better than Torquay  is better than Paignton, apparently. 

Yet I can't help feeling this downing of tools is a bit out of date.  I don't suppose for a second that David Cameron is really cut off from his work in his Portuguese hidey-hole. I don't go away without three phones and a couple of computers, so goodness knows what kind of communications gizmos are in his hand luggage.  In any case, waking at 7 in Spain is a lie-in compared to London and the last thing anyone else wants me to do is disturb them. So a swim, a cup of coffee, a check on the overnight news,  still leaves me time to read for a couple of hours before the children wake up. 

One reason I work on holiday is that I have more time to think, far away from commuting and  meetings. Another is that work  is (much) more fun than making sandcastles. That may confirm what a sad old fool I am but really, why would we spend so many hours studying for jobs, climbing (and then sliding back down) greasy corporate poles, if we didn't actually like it? If I was a professional footballer maybe I would need to rest tired muscles and bruised bones but an economist just needs time to think. 

Ah yes - thinking time.  The key to understanding financial markets, as much as anything else, is to avoid "thinking on railway lines"; that is, being willing to challenge consensual ways of looking at the world and in particular, being willing to challenge one's own thought processes.

There are two ways of doing this. The first is to expose thoughts to criticism from people who have no incentive to agree with me just for politeness' sake. There are people to challenge a view that,say, QE lowers the cost of credit but does so mainly for the best creditors - governments and those who can issue corporate bonds, rather than small businesses  - but those people are easier to find outside my work and social groups. And the second is to think, re-think and then think some more. And that requires time, and a lack of distractions. 

Since people who question my views are best found away from the office and since endless  meetings are the hallmarks of any office, it stands to reason the best place to really think outside railway lines, is as far from the office as possible. Maybe the question isn't why people work on holiday but why they spend so much of their working time in an office. This obviously doesn't apply to all jobs, but even so, for many I suspect that the answer has more to do with custom, habit and insecurity than anything else. 

Saturday, 22 June 2013

There was an old lady who swallowed a fly...

There was an old lady who swallowed a fly. I don't know why she swallowed a fly; perhaps she'll die.

I don't know if you know this nursery rhyme, but the fly was the least of the old lady's problems.  She subsequently swallowed a spider (which wriggled and tickled and tickled inside here) to catch the fly. Then a bird (wasn't that weird), to catch the spider. A cat, dog, cow and finally a horse followed. She's dead, of course.

I can't help thinking that US monetary policy since the defeat of inflation in the 1980s bears some similarities to the behaviour to the old lady in the nursery rhyme. The Federal Reserve is charged with running policy in such a way as to keep inflation under control and the economy at full employment. But inflation is being kept at bay more by a global labour market and technological innovation than by anything the Fed is doing. The Fed doesn't have to 'do' anything very much to control consumer prices and this affects policy. Fed policy is geared towards reacting to periods of falling unemployment by ever-so-cautiously tightening (or un-loosening) monetary policy, because that 'seems the right thing to do'.

By contrast, at the first sign of economic trouble, the lack of inflation means that the Fed can go all in, cutting rates, allowing the dollar to fall and encouraging those who can to borrow more, in order to boost demand and help create the jobs that will get the economy back on an even keel. Indeed, we have been forced to re-think 'all-in' as we saw the Fed cut rates to 3% in 1993, then to 1% after the dot-com bubble burst and now almost to zero, with a huge QE programme on top.

Meanwhile, the United States' overall debt level has gone on going up. That's "OK" because 'net debt' is offset by asset price gains, and 'debt-servicing' is kept down by low rates. The periods of low rates have caused asset bubbles - sometimes in the US, more often elsewhere. But one man's bubble is another man's boom and asset price inflation is apparently less dangerous than consumer price inflation. Never mind that it represents a huge transfer of wealth from one generation to another, that it dramatically increases economic inequality or that asset prices have a nasty habit of coming back into line with the underlying trend of the economy eventually. What we are concerned with, is the unemployment rate and the only thing that could deflect the Fed's attention would be consumer - not asset - price  inflation.

So having swallowed a recession in 1990, the US sent down a 3% policy spider to catch it. Then a bird in 1998. Then a cat in 2001 and a dog in 2008. On that basis, the cow comes next and then the horse, and it all goes wrong. I thought that 2008 was going to represent the last leg of what the Bank Credit Analyst terms the Great Debt Super-cycle. I was wrong. But was it the second-last, or the third-last?

The Phillips curve - a dinosaur
At the heart of this, is the fact that monetary policy-making is still dominated by the Phillips Curve. AWH Phillips established that there was a correlation between inflation and the unemployment rate in the UK, between the mid-19th and mid-20th centuries. The conclusion was that high unemployment pushes wages down, and low unemployment pushes them up, and this is what drives inflation. Sounds simple and plausible. Milton Friedman responded by introducing the concept of the NAIRU (non-accelerating inflation rate of unemployment) arguing that since the labour force is  rational, you can't just pick a point on the Phillips curve where you choose a combination of unemployment and inflation. Unemployment would tend to gravitate back to NAIRU, and you could only hold it below that by accepting rising inflation and indeed, could only get inflation back down by keeping unemployment high.

I was reminded of how out-dated the Phillips curveseems when I read a post by  the BBC's Economics Editor, Stephanie Flanders in which she argues that the cause of the relatively low unemployment rate the UK enjoys now, is falling wages. That fits in with the Phillips curve view of the world, except in the small detail that the causality is the wrong way round. Low wages keep unemployment down, as opposed to high unemployment driving wages down. So what is driving the wage growth down in the UK?

The world of AWH Phillips was one of a closed economy where people could move between industries, but not between countries. It works less well when labour can move pretty freely around the world and when productive capacity and employment can also move at the drop of a hat, to places where labour is cheaper, or perhaps where tax rates are lower. And the Phillips curve doesn't work at all if we can't even measure unemployment.

A global labour market makes casual measurement of one country's unemployment rate somewhat redundant. When goods-producers can shift production at a moment's notice to a more competitive location, the going wage rate is determined internationally, not as a result of a domestic Phillips curve. When people can come and go from one country to another, they drive down costs in many new industries. Coffee shops stand out. And as a piece I read last week by Paul Krugman argues, an economy where the biggest and most successful companies don't actually employ many people, you have to look at the labour market differently. Not least when the driving force deciding where they hire people is the corporate tax rate more than the wag rate. Finally,  when we have seen a collapse in labour market participation rates in this cycle, we simply have no idea what even one country's real unemployment rate is. The 'underemployed' are people who aren't recorded as looking for work, but would love to work (or at least earn) more. And they will act as an anchor wage growth even as the 'official' unemployment rate falls.

The warning from all of this is that economic recovery may not drive inflation up, because I can't see what drives wage growth up in developed economies in this cycle. But while that's good, what it does, is lead to continued unbalanced monetary policy. The FOMC must know that current policy settings are dangerous, just as you would have thought the old lady would know swallowing a cat was a bit risky. But  there's no CPI inflation and that means that if the US economy were to lose a bit of momentum, perhaps as a result of a falling stock market and rising mortgage rates, the Fed would be sorely tempted to re-inject some monetary accommodation -  a metaphorical dog to get after the unemployment rate...