Trump and the Federal Reserve

Donald Trump hit out again recently at the Federal Reserve for its monetary policy management, taking it to task for hiking interest rates, which he claims would hamper US growth. But this is something of a bold statement given the White House’s fiscal policy.
The chart below depicts US unemployment and the government balance as a percentage of GDP, revealing that the two indicators have trended in a similar way over almost 60 years, each reflecting the US cycle. When economic activity is robust, jobless numbers decrease, while at the same time, tax income increases and spending to support the economy is lower, thereby improving the budget balance. This twofold trend has always worked well, even when Ronald Reagan embarked on economic stimulus at the start of the 1980s. Meanwhile, the budget surplus at the end of the 1990s is also an illustration of this trend, with Bill Clinton’s – fairly smart – moves to implement austerity policies to gain leeway in the event of a downturn in the cycle.

But the current period marks an exception. The cycle is robust, as reflected by the drop in unemployment to 3.7% in September 2018, hitting its lowest since 1969, yet the government balance is not improving, but rather it is deteriorating under the influence of Donald Trump’s policies. The public deficit stands at close to 5%, yet it should have fallen significantly on the back of the economic cycle. The government is driving economic stimulus at a time when the economy is running on full employment.

So it is reasonable for the Fed to take action to counter these excesses and avoid the emergence of persistent imbalances. We cannot rule out the possibility that fiscal policy will bolster domestic demand, triggering a significant surge in inflation and a larger external imbalance despite the White House’s protectionist measures (demand is rising sharply – due to tax cuts and increased spending – and supply does not have time to adjust, which leads to a swell in imports).

The Fed, as embodied by Chair Jay Powell, has clearly indicated that this policy is not sustainable in the medium term and that it must be offset, which is why the Fed is hiking interest ratesand it is right to do so – thereby setting the US economy on a more sustainable path for the medium term.

However, the risk lies in the event of a severe negative economic shock, as there would be no leeway for fiscal policy to adjust, and there would be no scope for raising the budget deficit or implementing a stimulus plan like Obama did in 2009, as the budget deficit is already extensive before a potential shock: the US economy would therefore be hampered over the long term. Trump’s policies will only help the better-off in society, who benefit from lower taxes, while the cost of this policy is spread out across the population via the ensuing increase in the public deficit. And this approach will create even more inequality in the longer term as some Republicans are alarmed at the extent of public debt and are arguing for a reduction in social spending to make this debt sustainable in the medium term. For now, America seems to have lost sight of the meaning of the words equality and fairness.unemploymentand budgetdeficitUS

No more samba in Brazil – My Tuesday column

This post is available in pdf format My Tuesday Column – 9 October 2018

Jair Bolsonaro has come out in the lead in the Brazilian presidential elections with 46%. Looking beyond his very divisive views on certain issues in Brazilian society (status for women, LGBT), on the Paris Agreement and the corruption of previous governments, along with his aim to end Brazil’s endemic violence by allowing Brazilians to take up arms, are there any economic foundations for his likely victory? (see here the Brazilian context of these elections)
This victory has very clear economic explanations. The Brazilian economy has been suffering since 2014 and the collapse in commodities prices. The recession over 2014-2015 and 2016 lasted a very long time, and was followed by a lackluster recovery, which was more of a stabilization than a real rebound. GDP in the second quarter of 2018 still fell 6% short of the 1Q 2014 figure.
This drastic situation can be attributed to two factors. The first is the country’s high dependency on commodities. Brazil enjoyed a very comfortable situation at the start of the current decade when China became its primary trading partner. Opportunities increased and commodities prices soared, so revenues were buoyant and did not encourage investment, creating a phenomenon known as Dutch disease, whereby commodities revenues were such that there was no incentive to invest in alternative businesses. But when Chinese growth began to slow and commodities prices took a nosedive, the Brazilian economy was unable to adapt, so it seized up and plunged into a severe recession.
The other factor is that Brazil devoted hefty financial resources to financing the football World Cup in 2014 and then the Olympic Games in 2016, so in a country with a massive current account deficit, this put a lot of pressure on financing. Funding for public infrastructure replaced investment in production, thereby making the country’s Dutch disease even worse.
The Brazilian population has paid a high price for the country’s brief moment of glory. Continue reading

French public debt stands at 100% of GDP – My Tuesday column

This post is available in pdf format My Tuesday Column – 1 October 2018

French public debt stands at close to 100% of GDP, but is this really a cause for concern?
No – it is important not to overstate the importance of this figure. French statistics body INSEE made the news as it measured public debt at over 100% of GDP for 2017, when it included railway operator SNCF’s debt. However, this is no longer the case, with debt accounting for 99% of GDP in the second quarter of 2018.
The chart shows two phases in French public debt trends – before and after the 2008 financial crisis. The State increased its debt issues and thereby smoothed the way for macroeconomic adjustment to the crisis by spreading out the shock that hit the French economy over the longer term.
We can see that the figure then rises again after 2010, but this is not a specific feature to France. It reflects slower growth in the French economy over the longer term, and a welfare set-up that failed to change to adapt to this new trend: so soaring public debt denotes a sluggish adjustment from French institutions.
In other words, the primary role of public debt is to help spread the load at times of economic shocks, but it skyrockets when the economy is slow to adjust to new economic conditions.dettemaastrichtFrance-en.png

Is the 100% of GDP threshold a problem or not?
The figure itself is impressive and somewhat symbolic, but it is not necessarily damaging for economic momentum per se. Japanese public debt stands at 240% of GDP, yet the country has come through the financial crisis better than others judging by per-capita GDP: the country does not seem to be in danger of default.
The real problem is that we do not know just when public debt can actually become detrimental. Rogoff and Reinhart indicated in their research that public debt begins to dent growth when it moves beyond 90% of GDP, and this rule at least partly spurred on the European Commission’s austerity policy in 2011 and 2012. However, this argument does not hold water: R&R’s calculations were wrong and there is no rule on excessive public debt. Continue reading

The Federal Reserve has increased its rate by 25bp and will continue to tighten in 2019

The Federal Reserve raised its benchmark interest rate by 25 basis points. The effective rate will evolve in a corridor between 2% and 2.25%.
The dots graph reflecting monetary policy committee members’ expectations suggests 3 rate increases in 2019, 1 in 2020 and none in 2021.
This profile, for 2019 and 2020, is unchanged from last June forecasts. The introduction of 2021, an additional year, nevertheless shows the end of the monetary tightening. It is set a final point to hardening with a slightly higher interest rate than long-term anticipation. The Fed’s rate would then evolve in a corridor ranging from 3.25% to 3.5% against a long-term equilibrium rate of 3%. The Fed needs to move above the latter to be restrictive and avoid the formation of imbalances that could harm the economy.

The press release is identical for the most part to that of June (see here the comparison). The changing part is important, however, since the Fed no longer refers to the accommodative nature of its monetary policy. It is now close to neutrality. Continue reading

Is the ISM index a bubble?

The ISM index for the manufacturing sector is, in August, at its highest since May 2004. It was then at 61.3 versus 61.4 in May 2004.
The reading of this index is puzzling for different reasons
1 – Since 2011, the average growth in the US is 2.2% but the trend was 2.7% between 2000 and 2007. But the ISM index was, on average, higher since 2011 than before the crisis. Its average was 54.1 from January 2011 to August 2018 but only 52.1 from January 2000 to December 2007. A higher ISM index doesn’t not reflect a stronger growth momentum. We can see that also when looking at the manufacturing production index. On the same periods, the annual growth rate was 1.8% from 2000 to 2007 but 1.15% from 2011 to July 2018.
In other words, the index is higher than in the past while growth is lower. 
2 – There is a robust index calculated by the Federal Reserve of Chicago. The CFNAI (Chicago Fed National Activity Index) is the synthesis of 85 indicators (industrial production, employment, personal income,….). It’s reading is easy with an average at zero and a standard deviation of one.
The CFNAI is an accurate measure of the business cycle based on observed variables. Usually the two profiles are consistent as the graph shows.
Recent data show a persistent divergence between the two. The CFNAI is close to 0 while the ISM is at a high historical level. It is probably too high giving a wrong signal of the US growth strength.ismcfnai-summer2018.png

The Fed’s strategy, the dollar and the emerging markets

The Fed’s meeting today is an opportunity to show the dramatic monetary policy divergence between the US central bank and the ECB and the risk for a stronger greenback.
The first graph shows the gap between monetary policies’ expectations in the two countries. The measure here is the 2 year rate in 1 year. The time scale begins with the Euro Area inception in 1999.
The divergence between the two central banks’ strategy has never been so important. It’s a strong support for the US dollar which will continue to appreciate and it’s a source of risks for emerging countries. The strong probability of a US tighter monetary policy in a foreseeable future will support capital outflows reducing liquidity on these markets. MPexpectationsdetail Continue reading