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.
Saturday, 28 September 2013
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....
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.
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....
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.
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...
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. .
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.
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.
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