Monday, 17 April 2017

Ben Bernanke and the case for lower for even longer

Michael Kiley and John Roberts, two Federal reserve economists,  have produced a beautiful paper on Monetary policy in a low-interest rate world which in turn prompted ex Fed Chairman (and easy policy champion par excellence) Ben Bernanke to write not one but two articles in Brookings last week:  How big a problem is the zero lower bound on interest rates? and The zero lower bound on interest rates: How should the Fed respond?

Mr Bernanke's man points can be summed up with a few quotes:

Using econometric models to simulate the performance of the U.S. economy, Kiley and Roberts (KR) find that, under certain assumptions, in the future short-term interest rates could be at zero as much as 30 to 40 percent of the time, hobbling the ability of the Fed to ease monetary policy when needed. As a result, their simulations predict that future economic performance will be poor on average, with inflation well below the Fed’s 2 percent target and output below its potential.

One potential solution to this problem, suggested by leading economists like Olivier Blanchard, is for the Fed to raise its inflation target.....There are, however, some reasons that raising the Fed’s inflation target might not be such a good idea....Another alternative would be to try to implement the optimal “make-up” strategy, in which the Fed commits to compensating for the effects of the ZLB by holding rates low for a time after the ZLB no longer binds, with the length of the make-up period explicitly depending on the severity of the ZLB episode. KR consider several policies of this type and show in their simulations that such policies reduce the frequency of ZLB episodes and largely eliminate their costs, while keeping average inflation close to 2 percent. 

The basic premise of the Kiley/Roberts paper is that if the 'neutral' real interest rate is as low as 1% (which is broadly what most analyses conclude), then the neutral nominal rate with a 2% inflation target is 3%. And if neutral rates in minimal terms are at 3%, rather than, say 6%, then the chances that rates ought to be below zero at some pint in the economic cycle are high. which, in turn, causes a huge problem if the zero lower bound makes getting inflation back up to target in economic downturn harder. And that means that there's a bias, with a risk that inflation will be below target more frequently and output below potential more frequently, risking a vicious spiral as the central bank fails to get output back on trend. Hence the Bernanke solution - a deliberate policy of keeping policy to easy into an economic upswing, temporarily ignoring upside inflationary risks. 

This is interesting because it seems (to me, anyway) that this is exactly what current fed policy looks like. Old-fashioned measures of a potential output suggest that with the economy at or close to full employment (the weakness of wage growth notwithstanding), there isn't much slack left. So rates 'ought' to be headed to neutral (3% in nominal terms) pretty briskly. And yet, while the FOMC 'dot-plot' does get to 3% 'in the longer run',  insouciance at the market pricing which undershoots the dots, and the tone of Fed commentary, both suggest that there is a deliberate bias not to rush. 
Measures of neutral real rates (mind you, however we look at them we're a long way below neutral). 

I have one fundamental issue with the whole argument however, and that's the idea that potential output is in some way related to inflation in the shortish-term. Downward-pressure on inflation from globalisation and more recently from technology,  means that 'potential output' needs to be thought of in terms that go beyond 'non-inflationary output'. 

This means that if measures of 'neutral' rates are trying to be consistent with steady low inflation, they will be inconsistent with wider stability, in asset prices, in the balance of payments and in debt levels in particular. Of course, that brings me back to Claudio Borio and the importance of a financial stability-oriented monetary policy framework. 

Two slightly more market-related conclusions are firstly that despite the BIS' work, and in contrast to other central banks, the Fed still has a bias deep within its core, to favour 'lower for longer' policies, and secondly  that the dollar's previous major bull markets have come when real rates in the US have been well-known above all measures of r*. To say that's not the case at the moment would be a huge under-statement. 


Saturday, 1 April 2017

The rise and rise of debt, correlation and commotion

The rise and rise of debt, correlation and commotion

Trilemma/dilemma + The Second Machine Age  + Financial Sector Drag vs Secular Stagnation  =

If economics is perceived as a dismal science then the onus on economists is to make it less so.
If I could only persuade my teenage children to read one book, one magazine article and one slide-show of a speech in order to pique their interest in the subject, I'd have them read the Economist on Helen Rey's Trilemma, look through the slides of Claudio Borio's speech to the NABE a few weeks ago, and then settle down to read Brynjolfsson and Mcafee's "The Second machine Age" over the Easter holidays.

The chart captures the whole of my career, which started after I left university in 1984. Lower and lower real interest rates, higher and higher debt levels.

Professor Rey argues, convincingly, that in today's connected global economy, if you have relatively free capital flows you can't have monetary independence whether you let you exchange rate float freely or not.  She observes, in the process, that asset price movements are correlate and are to a significant degree a function of the policies of the US Federal Reserve. Put it another way - Fed policy drives all markets, and increases asset correlation as well as leading us to a world where risk is either 'on' or 'off'.

Claudio Borio makes the simple observation that monetary policy which is consistent with equilibrium in the real economy but not in the financial sector, isn't an equilibrium interest rate at all. This is so obviously true it took a genius to point it out. If interest rate-setting central banks are only judged by a mandate of an inflation target and an economy at full employment,  they may have a tendency to set rates at levels which allow the kind of ever-upward march in debt levels seen in the chart. If they took the idea of financial stability seriously, they would set policy differently, but it's not directly part of their mandate and as we can all see at the moment, fear of too-low consumer price inflation is still delivering interest rats that risk increasing global debt.

The Second Machine Age is just a great book in its own right. But it does help explain why low unemployment might not be associated with wage-induced inflation and indeed why inflation might stay low regardless of where interest rates are set by the Fed, the ECB and any other central bank.

If technology is the main driver of subdued wage growth and inflation; if US interest rates are set at levels to keep inflation down when it's down anyway; and if the rest of us import Fed policy through the global finance system, then we can just get used to asset price volatility being depressed, asset prices being hyper-correlated, debt levels going up and the profit share of GDP in most countries. marching slowly higher. All with sporadic episodes when markets that can't adequately price risk are exposed to sudden re-pricing on (often politically-inspired) surprises.