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....

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..... 

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.