Anna and Annette on the Fed PUT

Anna Cieslak and Annette Vissing-Jorgensen had written another terrific paper – this time on the Fed PUT.

The highlights of the paper are as follows:

(1) Reaction of actual economic output (GDP growth) to excess stock market returns is small and is symmetric for stock market gains and losses.

(2) Reaction of unemployment to excess stock market returns is asymmetric. That is, unemployment rises more when stock market records losses than it falls when the stock market posts gains. But, the Federal Reserve expectations for unemployment change much more than actual unemployment changes themselves!

(3) Sensitivity of actual private consumption to negative stock market outcomes is small, especially in the 1994-2016 period. But, the focus of the Federal Reserve on the stock market is driven a lot by its concern over stock market declines on consumption.

(4) Before 1994, going back to September 1982, there is no significant relationship between the stock market and updates to Fed growth expectations.

(5) The Fed updates its macroeconomic expectations (about growth and unemployment)
in a way that is highly sensitive to stock market outcomes during the inter-meeting period. This relationship is pervasive starting from the mid-1990s, but is largely absent before that.

This paper and their earlier paper, ‘Stock returns over the FOMC cycle’ (with a third author) could very well be the harbingers of the long overdue reform of the monetary policy framework of the Federal Reserve or that of the reform of the Federal Reserve itself.

On rupee strength

Let me state at the outset that I am all for a strong currency PROVIDED economic fundamentals back it up. Strong capital inflows do not constitute ‘sound economic fundamentals’. They are hardly mirrors to fundamentals but of perceptions and that too of the relative variety. So too is the exchange rate. India’s economic growth is middling. It is unbalanced. Private capital formation is still missing. Savings rates have not risen.

So, the currency strength seems to be driven more by perception of India’s strength especially in comparison to other emerging economies, including China, rather than due to intrinsic strengths. That is why, perhaps, RBI has been intervening and that India’s foreign exchange reserves are rising.

This comment is not to take exception to Mr. Ninan’s Op.-Ed today in Business Standard. But, to raise one minor quibble. He had written:

The solution, suggested in this column seven months ago, is to focus on the source of the dollar surpluses: capital inflows, and debt inflows in particular.

Data do not support him – except for the last few months – that India’s dollar debt and equity flows had gone up. If anything, up to December 2016, India’s external debt and Net International Investment Position (IIP) positions have only improved. More repayments (outflows) than borrowings (inflows). Since February this year, India has witnessed strong Foreign Portfolio Investment (FPI) – both debt and equity.

Therefore, the point remains and he is right that India has not earned the right to have a strong currency. Most important of all fundamentals for a strong currency is productivity. India does not have the data because the bulk of the employment in the country is informal. Whether it is 75% or 92%, it does not matter. It is too high.

India is currently not facing headwinds or competitive disadvantage in a big way because other countries, including China, are not actively seeking to depreciate their currencies. That is something to keep in mind and watch out for. Chief Economic Advisor has indeed produced a chart of rising Indian rupee versus the Chinese yuan in his recent VKRV Rao Memorial Lecture. India does have a big bilateral trade deficit with China.

A friend helpfully points out that the focus on the INR/CNY bilateral exchange rate might be a road or bridge to nowhere. He said,

Between 2005 and 2015 the INR depreciated almost 90% against the CNY on nominal basis and about 60% on real effective basis while the bilateral trade deficit went up 24 times from around USD2bn to USD48bn. Not saying currency does not matter but in such cases global supply chains and productivity differentials seem to matter much more than currency divergence.

It is an excellent point. He is very right. I am reminded of what BIS wrote in its 2016 Annual Report on the declining usefulness of exchange rate depreciation for export growth:

Recent studies generally suggest that trade exchange rate elasticities have
declined in response to changes in trade structures, including currency denomination, hedging and the increasing importance of global value chains. For instance, a World Bank study finds that manufacturing export exchange rate elasticities almost halved between 1996 and 2012, with almost half of this decrease due to the spreading of global supply chains. [page 53 – Link]

Second, India’s overall REER has appreciated by about 7% to 9% in the last one year, depending on the metric that one chooses, from among the several that RBI publishes on a monthly basis.

We must remember that REER adjusts for inflation in India relative to that of other countries (trading partners). Inflation is an indirect measure of productivity. Therefore, REER is productivity adjusted in that sense. Even so, the rupee has appreciated in the last one-year or so. That could be a concern for whom export quality or excellence is not a core strength.

But, it has not hurt India much because crude oil has not sustained its price recovery of last year into 2017. This might persist for quite some time. If anything, the risk of further downside for crude oil price is higher than upside for crude oil. That is a good news for India. That is one reason India’s current account is not showing any strain from the rupee strength. Of course, the strength has been somewhat recent only.

It might be then that the Indian interest rates are still too high, relative to that of other countries. Perhaps, RBI is too tight. But, then who knows if India’s inflation has become sustainably low? RBI has not lowered rates because liquidity is otherwise ample, both in domestic financial institutions and from overseas. Their monetary policy might be tight, temporarily, but it has to be shown over time that it has become unsustainably too tight for too long, before the blame can be fully laid at its doors for the strength of the currency.

In sum, the situation calls for observation. The traffic light is amber. It is not red, signalling danger. Those were the days when Germany and Japan could become export powerhouses despite currency strength. It is true that no country depreciates its way to economic prosperity.

In the days of financial globalisation, it is unfortunately and equally true that no country can appreciate its way to external sustainability.

Trivially important

This is trivia: Looks like it is not good news for King’s XI Punjab if Hashim Amla scored centuries. They lost both the matches in which he scored centuries in this IPL season. One is random. Is two a pattern? Kidding. He is a class act, no doubt.

Journal of Economic Perspectives (JEP) has recommended ‘Can India Grow?’ for reading in its Spring 2017 issue. Its Editor Tim Taylor had blogged on our book in detail, earlier. I had probably flagged it already.

Anna Cieslak and Annette Vissing-Jorgensen have a terrific new paper on the Economic Meaning of FED Put. Will blog on it separately. I think these authors would  trigger a reform of the Federal Reserve. All strength to them.

The Volatility Index on S&P 500 (VIX) had breached 10% and closed at 9.77% yesterday. It is a historical low. The previous low was 9.89% on January 24, 2007. Ahem.

Looks like Presidential impeachment in a market classified as emerging is a BUY signal. Brazil stocks had breezed through a recession and Presidential impeachment. It is being repeated in Korea. I suppose one gets ready to buy Venezuela shortly?

Will Obama’s USD400K speaking fees have attracted the critical attention that it has, but for the issues that were thrown up during the American Presidential elections?

This is important.

The Euro over the Gold Standard

I just chanced upon this piece two days ago. It is meant to be a provocative piece and not a defence of Gold Standard. If one could tolerate Euro and its institutional setting, why not tolerate a Gold Standard? That is the question he poses and answers and the question does not answer why Euro could be tolerated or should be tolerated. That argument is not made, looking at costs and benefits.

Telling someone to tolerate random shocks arising out of fluctuations in gold supply and production because they are tolerating random shocks or are forced to tolerate random shocks from member country situations in the Eurozone and the consequent monetary policy responses is not particularly helpful.

In the days of trillions of dollars of capital flows dwarfing trade flows, it makes no sense to motivate an argument based on trade considerations alone. Yes, floating exchange rates do not offer any protection against spillovers and sudden starts and stops of capital flows. But, that does not prove that fixed exchange rates are better. The logic is flawed.

Floating exchange rates may not help. But, fixed exchange rates most certainly don’t. See the difference? Gold Standard is most certainly an extreme version of fixing. To actualise it and make it work for the real economy, one needs to confront the demon of financial flows and, more generally, financialisation.

An example would help clarify things. A this very mature stage of the economic cycle and an even more advanced stage of the market cycle, the SEC has approved a passive ETF on NASDAQ leveraged four times for public distribution. Under these circumstances, no regime would work – fixed or floating or the Gold Standard.

That Matthew Klein is not serious about the Gold Standard is evident from his recourse to the ‘snake oil economics’ of Martin Sandbu. I stopped wasting time on reading that gentleman’s writings more than a year ago. One cannot resort to debt write-downs, as one would do a morning walk every day to stay fit and healthy. Nor is wage flexibility a solution these days, except in blogs. It never probably was a solution except for Britain in the Gold Standard era. That was a different period and the difference was not just about the Gold Standard.

Second, he disappoints with his standard, run-of-the-mill baseless assertion that Draghi saved the Euro and that Trichet almost buried it. Economists who know about policy lags, the impossibility of counterfactuals and the unintended consequences of policy decisions would not make such glib assertions. First, had Trichet used up all the monetary policy bullets, Draghi may not have had many bullets left to fire. Two, we do not know how history would play out and whether Draghi would be reviled or revered. It is still very early days. The lagged effects of ‘whatever it takes’ have not yet played out.

Further, Mr. Klein is surprisingly sloppy with facts. The monetary policy response to German reunification happened in the 1990s before the Euro and ECB were reality. That was the German Bundesbank. They were tight and that led to the two European Exchange Rate Mechanism (ERM) crises including the famous ejection of the pound sterling from the ERM. Indeed, only then, did the Euro project come alive from 1993 onwards.

But for the Bundesbank’s tight monetary policy battling German money supply increase and the temporarily higher inflation, the ERM fissures wold not have been exposed, speculators would not have targeted it, the European currencies would not have come out of their sub-optimal policy straitjacket and economic growth in continental Europe and the UK would not have resumed from around 1994 or 1995.

ECB in fact loosened monetary policy in 2001-02, notwithstanding that the Euro had just plumbed new lows in October 2000. European real short rates were below normal and below average up to 2004 or so. In fact, those were engineered for Germany that was hurting from the collapse of the technology bubble. Therefore, monetary conditions were too loose for Spain, Italy and Greece. Their real estate booms ensued and turned into bubbles later.

With those facts and chronology addressed, let us revert to his arguments on the Gold Standard.

My blog is named, ‘The Gold Standard’. One can appreciate my predilections here. But, even then, I would concede that the enabling conditions simply do not exist for considering the Gold Standard. What the world needs is something far less radical than that but still a very radical departure from the current central bank orthodoxy.

The world abandoned fixed exchange rates (Bretton Woods/Official Global Dollar Standard) in 1973. I has experimented with floating exchange rates and discretionary central banking. The data point in favour of ‘discretionary central banking’ (alternatively, against rule-based central banking) was one – the Great Depression. Now, forty-four years later, the costs have begun to exceed benefits vastly – in many ways – economic, political and social.

Discretionary central banking with unrestrained ability to create reserves providing the basis for unfettered money creation by commercial banks does not make for a stable system at all. Nor is it social welfare enhancing. The blind and empirically unverified faith in the transmission from asset prices to the real economy and the indifference to the distributional consequences of such a faith/belief need to be abandoned.

The onus lies with the Federal Reserve, the intellectual leader in global central banking and the Wall Street alumni who govern other central banks.

The world has walked too far down the path of discretionary monetary and financial recklessness to return to the Gold Standard. Some simple changes, as suggested above, would do for now.

(p.s: Matthew Klein has put up a brilliant post rebutting the arguments of Steve Rattner on U.S. tax cuts. Very well worth a read)

Is modern central banking an elaborate waste of time? – part 2

In response to this blog post (frankly, a slightly shorter and more abrupt version of it sent as an email), a friend responded with three comments. I address his comments here.

He wrote the following:

  1. The role of monetary policy may have become even more relevant in managing financial stability.
  2. There is a compelling case that central banks (their autonomy and inflation-fighting mandate) contributed to reining in reckless governments.
  3. None of these refute the case for monetary policy nor is there any strong case that (either research or historical evidence) markets can do the job of calibrating interest rates in response to inflation.

My responses to each of them are as follows:

(1) That is precisely what I had said in the earlier blog post. They – central banks – have a role in banking regulation and in maintaining financial stability. The latter requires different targets and different instruments. Importantly, it requires a big mindset change and also to recognise and get out of ‘capture’ by the financial industry. The blame is squarely with the Federal Reserve and all the revolving door appointees now seen not just in the Federal Reserve but also in ECB and in BoE.

‘Inflation targeting’ was (a) a response to the 1970s high inflation and (b) a war against labour. They succeeded because globalisation, technological advances and commodity prices doused inflation in a big way. The first two took the wind out of the sails of labour bargaining power. Labour arbitrage on a global scale was enabled. There is brilliant and very persuasive correlation between the inflation rates in the US and in the UK and wage growth.

I had used those charts in my piece for ‘Evergreen Gavekal’. Pl. read my piece for EVA Gavekal, if you had not done so.

(2) Absolutely not. They did nothing of the kind.  The proof of the pudding is in the data. In the last thirty-five years since 1980, Government debt/GDP ratio had risen inexorably from 30 to 40% of GDP to more than 105% of GDP. Very powerful failure of central banks role in reining in’ governments – nothing of that sort happened. Nor did the market do so.

(3) The case for central banking is different from the case for inflation targeting. Actually, for discussion sake, I would go further. The world would be fine without central banking. There would be accidents. But, there is no basis a priori basis to argue that they would be worse than what we have been encountering in the last thirty-five years.

Indeed, it is possible to argue the opposite. Central banking is like insurance. It has turned out to be the source of moral hazard. Without them, the risk premium on debt would be much higher both for government and for non-government debt because there would be no backstop. Growth and markets would be more volatile and hence, excesses would be self-correcting.

We need a banking regulator and, as long as, central banking does not address financial stability, front and square, I would argue that they are more harmful than helpful to the real economy.

On the second part of your sentence, I am absolutely convinced that markets have been distorted by central banks’ focus on short-term rates and inflation. Markets have been seduced or drugged not to take the long-term view. Without central banks, markets have no one to backstop them. They would price risk far better than they have done in the last thirty-five years. That is as true of bond markets as they are of equity markets.

As a compromise, I can agree that central banking with rules of the game – domestic and external – rather than ‘discretionary central banking’ will make for a better world than what it is today. All things are cyclical. The time for ‘discretionary central banking’ is up. It has run its course. At the minimum, the cycle of ‘discretionary central banking with inflation targeting mandate’ is over. At the maximum, there is a serious case for contemplating a world without central banks.

This is not a rant nor is it some form of nihilism to propose the abolition of central banking, as it prevails today, particularly in the advanced world. Indeed, this blogger believes that quite a big chunk of the problem can be solved if the Federal Reserve Board in the United States could be fixed. That is possible by finding people to fill positions falling vacant in the next 12 to 24 months who do not share the prevailing Federal Reserve orthodoxy on asset prices transmission to the real economy, on leaning vs. cleaning, on ties to Wall Street and on the relevance of transparency and forward guidance for the real economy.

But, it would be useful to consider an extreme proposal intellectually such as considering doing with central banking altogether for it would make other useful and urgent reform proposals seem less radical.

Just to be doubly sure, radical proposals or thoughts on central banking (and modern financial capitalism) have emerged from William White, Mervyn King, Raghuram Rajan, John Kay, Paul Volcker, et al.

Critics need clearer heads

I just read an article by Danielle DiMartino Booth (‘The Bernanke Doctrine is played out’ in ‘Bloomberg View’).  I left the following comment on the article:

I have been reading Ms. Booth’s commentary. They almost always provide a new angle to any story. However, I am not sure if I get the angle in this one. It is clear that the Federal Reserve dare not mention asset prices or financial stability as considerations for raising rates.

Two examples: in 1999-2000, when Greenspan embarked upon a tightening mission (175 bp.), he invoked Wicksellian natural rate of interest. That was his belated, indirect and vicarious acknowledgement of the stock market bubble that he had helped spawn with his aggressive rate cuts to the 1997-98 Asian crisis, Russian Default and then the imagined and exaggerated Y2K fears. His favourite measure of inflation – PCE Core Inflation Rate – never breached 2% (y/y) during his tightening phase.

In 2001-08, the Fed might have officially stopped raising interest rates in 2006 but it kept up with its hawkish rhetoric up to 2007 August. That too was a nod to financial stability concerns arising out of the bubble that their monetary policy had created.

Now, again, the Federal Reserve had waited for too long to raise rates. When they did, they did too little over the last two years: 2015 and 2016.

[Geopolitical concerns or capture cannot be ruled out. They might have been worried about the impact on China, had they tightened somewhat more steadily than they had actually done. Or, they were under the spell of China and financial markets for less benign and less intellectual considerations. We will never know. As theoretical possibilities, they cannot be ruled out.]

So, even though standard economic arguments might weaken the case for sustained hiking of interest rates, they are well aware that, in many respects, they had created another asset bubble monster, the world over, again: stocks, real estate, emerging market bonds, high yield bonds, stock buybacks and M&A. There has been a big surge into U.S. domestic equities in the last few months – remarkably since Nov. 2016 reversing the long spell of equity fund withdrawals. That could be a sign of ‘panic buying’. May be, the Federal Reserve is watching all of this and is tightening accordingly – again, too little too late.

But, it dare not say why it is doing so. That is their intellectual blind spot.

So, to ask them to stop tightening because inflation measures are not warranting one, is confounding. Then, why were they being criticised for being too lax and being asleep at the wheel in 2005-07?

The message to them must be to come clean on why they are tightening and admit to the inadequacy of their models that delayed tightening for this long rather than beseeching them not to tighten further. That would only further aggravate the global bubbles in the various markets mentioned above.

Any crash from then on would be more painful, if it is not already going to be so.

In sum, critics should be clear-headed; only then can we offer clear advice to the policymakers.

Is modern central banking an elaborate waste of time?

I had cited this paper several times in my articles, papers and use it extensively in my courses. Interest rates hardly matter for investment decisions except when they are too high. Hurdle rates do not change much for small rate changes. That was evidence from America.

Now, while searching for this (we will talk about it separately) I came across this paper. This is evidence from Australia. Here are some key sentences from the abstract:

Liaison and survey evidence indicate that Australian firms tend to require expected returns on capital expenditure to exceed high ‘hurdle rates’ of return that are often well above the cost of capital and do not change very often. In addition, many firms require the investment outlay to be recouped within a few years, requiring even greater implied rates of return. As a consequence, the capital expenditure decisions of many Australian firms are not directly sensitive to changes in interest rates. Furthermore, although both the hurdle rate of return and the payback period offer an objective decision rule on which to base expenditure decisions, the overall decision process is often highly subjective, so that ‘animal spirits’ can play a significant role.

​Really, it opens up many questions on central banking (particularly in advanced nations) and their elaborate pretensions to doing something very important.

Earlier, George Cooper argued elegantly that well-functioning market economies do not need central bankers to target inflation. Market forces will do the job (“The origin of financial crises”, 2008)

With respect to the economic cycle, central banks do an elaborate job of raising and lowering interest rates by 25 basis points or 50 basis points, etc.

To be sure, animal spirits need to be revived in a downturn. Governments can do that job. Some good jawboning would work? Time-bound and targeted tax reliefs and subsidies?

With all their self-importance, modern central banking (has been in the service of financial markets. It takes care of their post-central banking career, speaking engagements and book contracts.

In reality, they should be ensuring financial stability and hence, economic stability. If they do, they would be hurting the financial services industry and its short-term fortunes, profits and executive compensation. Buddies would not be buddies anymore. Friendships formed in Universities would be in vain.  They won’t help to secure chunky speaking fees.

So, in the name of the economy, of labour, central bankers of advanced nations (with Federal Reserve being the principal villain) continue to serve the most unproductive and predatory capitalists – the financial markets and the financial services industry!

Clearly, this is one swamp that Trump has to drain. That looks like a long shot though.