Why ‘they’ will never admit to ‘this’?

This ‘Wall Street Journal’ article is so familiar. As the Federal Reserve meets to raise interest rates, such a chorus always rises, no matter how ill-informed it is. Will the Federal Reserve trigger a recession becasue its rate hike will invert the yield curve? Will the Federal Reserve cause the stock market to crash?

It is all the Federal Reserve. There is one sliver of truth to that. It is and it has been the Federal Reserve. They set up the bubble with their extremely lax monetary policy – rates that remain too low for too long. Bubbles form and bubbles always burst. There has to be some trigger. The Federal Reserve’s belated tightening is the most obvious choice.

So, it is always the case that monetary policy normalisation causes the stock market to crash. Abnormal monetary policy – rates that are too low for long – causes bubbles to form and then they have to crash.

It is far easier to blame the Federal Reserve for causing asset prices to go down that make the wealthy feel poorer rather than blame oneself for ignoring risks and letting asset prices move too far ahead of and away from fundamental or blame fundamentals for keeping the punchbowl always topped up, no matter how ‘rowdy’ the party is.

This tweet captures the above well:

Let’s Be Clear. Many suggest recessions happen due to Fed tightening. Incorrect. Recessions happen AFTER bubbles created by extreme Fed loose policies are blown to be systemic. Recessions happen due to tightening TOO LATE. [Link]

Humans are reason-able. That is, we are capable of reason but as has been the case from the time we began to use ‘reason’, we have applied it to the cause of supporting our ‘un-reason’ or our prejudices.


The meaning of ‘symmetry’ in FOMC dictionary

In this blog post, all emphasis – bold and underlining – are mine.

This overall assessment incorporated the staff’s judgment that vulnerabilities associated with asset valuation pressures, while having come down a little in recent months, nonetheless continued to be elevated.

The staff judged vulnerabilities from financial-sector leverage and maturity and liquidity transformation to be low, vulnerabilities from household leverage as being in the low-to-moderate range, and vulnerabilities from leverage in the nonfinancial business sector as elevated.

The staff also characterized overall vulnerabilities to foreign financial stability as moderate while highlighting specific issues in some foreign economies, including–depending on the country–elevated asset valuation pressures, high private or sovereign debt burdens, and political uncertainties.

Those were from the Staff assessment of financial conditions presented to the Federal Reserve Open Market Committee for its meeting on May 1-2, 2018.

The Federal Reserve staff had begun to characterise the vulnerabilities associated with asset markets price pressures as elevated from July 2017, having upgraded it from ‘moderate’ as noted in the Minutes of the May 2017 meeting of the FOMC. But, this is the first time that they have called vulnerabilities associated with non-financial sector leverage as elevated.

However, when the FOMC participants discussed ‘financial stability’, they did not discuss the possibility that an accommodative monetary policy could cause both asset prices and leverage in the non-financial sector to become more elevated.

Then, there was the use of the word, ‘symmetric’. It figured eleven times in the Minutes of the FOMC meeting of May 11. That is the highest mention in recent meetings. I went all the way back to FOMC meetings in 2016. The word, ‘symmetric’ began to be mentioned in January 2017.

Here is the mention and the context:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances. [Link]

Then, from the March 2017 FOMC Meeting Minutes:

A few members expressed the view that the Committee should avoid policy actions or communications that might be interpreted as suggesting that the Committee’s 2 percent inflation objective was actually a ceiling. Several members observed that an explicit recognition in the statement that the Committee’s inflation goal was symmetric could help support inflation expectations at a level consistent with that goal, and it was noted that a symmetric inflation objective implied that the Committee would adjust the stance of monetary policy in response to inflation that was either persistently above or persistently below 2 percent. [Link]

The context in which the word, ‘symmetry’ was introduced in the FOMC Minutes is worth recalling. It was introduced in 2017 because the FOMC had decided that it was time to start rising interest rates a little faster than it had done in 2016 and in 2015. In those two years, it had raised them just once each year and that too by 25 bp.

The FOMC had to justify why it was raising them when inflation was not yet at or above 2.0%. So, it came up with the word, ‘symmetric’. That is, it would take action only if was persistently below 2.0% inflation or above it.

Now that inflation is above 2.0%, financial market is expecting that the FOMC might raise rates a bit more rapidly. That expectation is destabilising financial markets or so it is believed. I don’t buy that.

For the record, CPI inflation rate is 2.36%. Core CPI rate is 2.11% and PCE Core Inflation rate is 1.88%.

In order to calm the financial markets, the FOMC is reminding them that it is pursuing a ‘symmetric’ inflation goal. That is, just as it did not refrain from raising rates in 2017 as the inflation rate remained below 2.0% for a few months, it would not necessarily raise the Federal Funds rate more rapidly if inflation stayed above 2.0% for a few months. Only if the overshoot was permanent, would it take action. So, it would go about its task of normalising the monetary policy stance ‘gradually’ rather than ‘rapidly’ or ‘swiftly’.

Personally, I have two problems with this attitude of FOMC:

(1) The Federal Reserve was very very slow to start off the blocks in 2015 and in 2016. After the tapering warning of 2013, it did not raise rates even once in 2014. It raised the rate once in 2015 and in 2016. It was too far behind the curve given the level of the inflation rates then and, more importantly, asset prices.

Corporate profits were contracting y/y for about seven quarters from March 2015 to September 2016. Profit growth was barely above 2% (y/y) in the quarter ending December 2014 and then it turned negative for the next seven quarters. See here.

But, what happened to S&P 500 index? The index barely budged. The S&P 500 index had gone up by more than 20% in 2013, by 10% in 2014 and declined 0.5% in 2015. It was up 19% in 2016 and another 23% in 2017.

The Federal Funds rate, in real terms, remains firmly in the negative territory, even now.

(2) What is the learning from the 2008 crisis, indeed? We all learnt that obsessive focus on inflation without regard to financial stability was the wrong framework for monetary policy.  Indeed, this blogger had written on umpteen occasions that in a well-functioning market economy, the central bank did not have to target prices of goods and services. They will regulate themselves. Instead, they should focus on the quantity of money and credit created, on financial stability and hence, by extension, on asset prices. Where is that awareness in the FOMC discussion that features the word, ‘symmetric’ eleven times? What does the FOMC gain by assuaging the sentiment in financial market when, according to its own staff, asset price pressures and leverage in the non-financial sector are ‘elevated’?

Should the FOMC really stick to a gradual removal of policy accommodation with the unemployment rate at 3.9% and with such elevated vulnerabilities associated with prices in asset markets and leverage in the non-financial sector?

It will end up losing, inevitably, whatever extension of the economic cycle it achieves with such ‘gradual’ removal of policy accommodation because when asset prices become more elevated – thanks to the Federal Reserve’s excessive emphasis on ‘symmetry’ – their eventual crash will be bigger with economic consequences that will be both likely more significant and longer lasting.

The 11-times repeat of ‘symmetry’ in the Minutes is indication of panic and obsession with ensuring that financial markets do not push the Treasury bond yield higher. That is because the Federal Reserve transmission mechanism to the real economy is through the financial markets and asset prices (bond and stock prices) or so, it is believed.

The bond market had obliged and the yield on the 10-year Treasury Note had dropped by 13 basis points – from 3.11% to 2.98%. So much for the independent minds of the financial markets and holding policymakers to account. Financial markets are about greed and not about being a check and balance on the errant ways of governments and central banks. They do that only to developing economies.

The Federal budget deficit is rising; debt is rising and yet, the bond market meekly rallies because the Federal Reserve had told them they would be gentle in rising rates! Contrast that with the bond market sell-off in 1994 as the Federal Reserve was raising rates slowly after holding rates at 3.0% for too long. The bond market began to rally only after the Federal Reserve had raised rates by 2.5% and that included a 75 basis point rate hike in October 1994!

Why is the FOMC anxious about the rise in bond yields?

It is because of the amount of debt that has piled up in the economy.

Why has such debt piled up?

It is precisely because of excessive concern for the amount of debt stock every time the FOMC contemplates a rate hike!

The vicious circle continues….

Unfortunate advice

Mohamed El-Erian has a column in Bloomberg advising the Federal Reserve not to raise rates and to release a boring statement. It is wrong advice. There may be a conflict of interest in issuing that advice. But, let us set that aside for the moment.

From a pure economic perspective, there is a case for the Federal Reserve to raise the interest rate by 25 basis points and to sound moderately hawkish. The Shiller P/E stands at 31.5 times. In absolute terms, the stock indices are still trading closer to their historical highs rather than lows. The nominal Federal Funds rate is still below 2.0% when the unemployment rate is 4.1%. The annual rise in average weekly earnings is 3.3% as of March 2018. Most measures of retail inflation are above 2.0%. The latest (April 2018) reading of the Purchasing Managers’ index shows that the manufacturing economy is running full steam ahead. The National Federation of Independent Businesses is reporting high sentiment readings, difficulty in hiring and paying increasingly higher wages to attract talent.

Even if the Fed were to hike the Federal Funds rate by 25 basis points and issue a hawkish statement and if financial asset prices were to decline meaningfully, so what? Haven’t Anna Cieslak and Annette Vissing-Jorgensen shown that the Federal Reserve models assume a higher impact on the real economy from financial asset prices than the real impact?

If this is the reason – read his article – that he is advocating a ‘tread cautiously’ line on the Federal Reserve, what is the difference between his advice and what the Federal Reserve under Bernanke, Yellen and Greenspan were doing? He was questioning their methods, their aims and the impact of their policy framework and actions on the real economy all along as they were encouraging risk-taking in undesirable areas.

Now, if the Federal Reserve were to follow his advice, what signal would it be sending to the financial market? Will it not signal that it is no different from the previous Federal Reserve regimes?

If that is what Mr. El-Erian wants, let it be said that it would not be in the interest of the Federal Reserve’s reputation and credibility for taking a line that is independent of the interests of financial markets. That reputation and credibility have been badly damaged in the last two decades.

Nor, will it be in the interests of the real economy to send a message to financial market participants that the Federal Reserve is reluctant to interfere with their risk-taking at the current lofty levels of prices in multiple assets.

A very unfortunate piece of advice.

EM Central Banks 1 – DM central banks 0

A brief news-summary in Bloomberg talks of how central banks in so-called developed nations ‘surprise’ the market the least and those in major emerging economies surprise the markets the most – i.e., deviating from economists’ forecasts of their monetary policy actions and interest rate decisions, etc. If so, EM Central Banks 1 – DM central banks 0.

The full report is available to Bloomberg subscribers. I do not have the access yet.

This brief summary says:

Central banks in developed economies signal clearly to the markets. [Link]

It is not a sign of independence. It is a sign of capture by financial markets and financial interests. There are no economic welfare gains to be captured by signalling policy moves to financial markets. Only more bonuses to the industry folks. Major central banks should be embarrassed about it. In contrast, policy surprises enhance policy effectiveness and impact on the real economy.

Interest rates and growth

This article by Rohan Chinchwadkar of IIM Tiruchi made me happy for more than one reason:

  • It is from a faculty member from one of the newer IIMs
  • It is well and simply written. It does not try to overdo its point
  • It sources a recent piece of international research
  • It shows a faculty member who is in touch with contemporary reserach. Good for students
  • It was well timed – on the eve of the RBI Monetary policy meeting
  • It presented a paper that had turned conventional wisdom on its head

Not much can be asked of an op.-ed.

Kudos to MINT for publishing it.

RBI dips into credibility balance

Quick off the blocks, Ms. Usha Thorat has written a good comment on the RBI monetary policy decision. Her last line was masterly.

As she points out in the first paragraph itself, RBI has increased the growth forecast, flagged fiscal policy risks and other inflation risks and yet, lowered the inflation forecast for the current financial year 2018-19. It is a tough one to explain away.

So, it is clear that they had set a goal for the policy meeting outcome today and worked backwards with the rationale. Of course, most human beings do that in most situations.

Frankly, there is so much uncertainty about both the growth and the inflation outcome right now for 2018-19 that one can pretty much justify any combination of projections.

Persnally, I would not set too much store by the recent uptick in some cyclical data. Hence, if I were in RBI, I would not have revised the growth projection higher.

Among the ‘forward looking’ surveys, the Consumer Confidence Survey must be a huge worry for the government. Together with inflation expectations, they present a double-whammy. Consumers are more pessimistic about their economic situation and expect inflation to be slightly higher as well! Would be a surprise if it is not reflected in the voting prefereences in the upcoming Assembly elections.

Consumer Confidence survey summary

Also, the Industrial Outlook survey (81st round) is not all that rosy. Check out Tables 15 and 16 on the availability of finance from banks and from foreign sources respectively.

Finally, one thought for the central bank’s credibility. The central bank sounded hawkish in February. Its Chief Economist keeps voting for rate increase. Suddenly, it turns soft on inflation forecast when all the logic (including faster GDP growth) points to the risk of a higher inflation rate.

But, financial markets do not call out the central bank for this ‘tangled web’ of projections. It takes them at face value and rallies! Mission accomplished! It does redound to the institution’s credibility that financial markets, instead of calling its bluff, lap up its projections and policy action.

What does it say about the financial markets, of course?  It continues to prove Eugene Fama wrong – day in and day out.

(Cheekily, I wonder if the decision,  the inflation projection, the growth projection and the dovish commentary are all a compensation for the Gandhi Nagar speech?)

Gross confusion here

At least, as reported by Reuters, Bill Gross appears to be all over the place. If global economies are leveraged to the hilt and if that means that intrest rates cannot go up without causing big dislocation/disruption/pain, then it risks adding to the pile of debt. This is a Catch-22 situation that Jerome Powell’s predecessors had landed him in. For the future of his country and for the future of the rest of the world too, some beginning has to be made somewhere.

If Powell is to be counselled against raising rates as indicated by him and his fellow FOMC members – 6 to 8 rate hikes of 25 basis points each in 2018 and in 2019 – then it is a counsel to allow more debt creation and a bigger eventual and inevitable pain.

This is what he had written, from which Reuters has written its report:

I write this – not in support of low interest rates and financial repression – indeed I have argued for the necessity of an eventual normal rebalancing if small savers and financial institutions such as pension funds and insurance companies are to continue to perform their critical capitalistic role. But I believe, as does Fed Governor Neel Kashkari, that our financial systems’ excesses cannot be expunged quickly by “liquidating assets” à la Andrew Mellon in the 1930’s, but by a mild and gradual re-entry back to privately influenced, as opposed to central bank suppressed, interest rates. 2% Fed Funds in a 2% inflationary world is the current limit in my opinion. [Link]

I am not sure I buy it fully. But, that does not mean that his point of view is any less valid than mine.