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

The flattening of the US yield curve is a source of concern – This time is not different

Jerome Powell said that the yield curve flattening was not a source of concern and that it wasn’t showing a risk of recession as the economy is following a strong trajectory.

This point of view can be challenged for at least two reasons

1 – A negative yield curve (10 year rate below 2 year rate on government bonds) has always been a signal of recession with a lead of 18 to 24 months. The following graph is clear. Each negative yield curve is followed by a recession with a lag. The current spread is lower than 30 basis points, almost one increase of the fed funds rate.

We expect this yield curve profile for the end of this year due to the tighter monetary policy and therefore we have a strong probability of recession for 2020.

2 – The yield curve flattening reflects higher short term rates and no strong expectations on the long duration side showing that investors do not forecast a bright and strong future.

The tighter monetary policy means that the funding of the economy will be constrained for consumers and companies. We’ve seen recently that companies’ debt (as % of GDP) is at a record high and that consumer credit is still increasing rapidly. The impact of higher short term rates will be negative for both of them.

On the real estate market, around 50% of the financing is coming from brokers whose funding is linked to short term rates. For them too the situation will dramatically changed.

Moreover, an expected tighter monetary policy has provoked higher mortgage rates which will be damaging for households as real wages are no longer creeping up.

The argument saying that “this time is different” must be related to the discussion Reinhardt et Rogoff had in their famous book “This time is different”. Investors always think that the situation, at the moment they live it, is different from what was observed in the past with same type of signal. Reinhardt and Rogoff just say that it is not different on financial markets. An unbalanced situation must be adjusted. Current sources of “this time is different” argument are based on the neutral and non observable long term rate and also on the Fed’s balance sheet operations that have an impact on long bonds through the Fed’s reinvestment of their portfolio proceeds

In other words, the impact of higher short term rates will be negative on the US private sector and could be the source of the expected lower momentum on the economic activity. It it just the impact of a tighter monetary policy as we’ve always seen it in the past. This time is not different.

A discussion of Jay Powell’s speech at the congress can be read in the following FT article

www.ft.com/content/116455e2-8a33-11e8-bf9e-8771d5404543

Corporations Are Investing In Stock Buybacks That Don’t Pay

The Trump tax cuts were supposed to trigger a boom in business investment and wage growth. Instead, corporations are plowing record amounts of money into stock buybacks that don’t even reliably increase their share prices.
Continue reading nymag.com/daily/intelligencer/2018/07/corporations-are-investing-in-stock-buybacks-that-dont-pay.html