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.