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

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

The Fed will stay on the path to higher rates in 2019 – My Monday column

This post is available in pdf format Federal Reserve – My monday Column

The Federal Reserve meets on September 25 and 26, and a 25bps hike to the fed funds rate is expected, putting the effective rate in a range of between 2% and 2.25%, with another hike expected in December. The Fed now seems to agree on these four monetary tightening moves for 2018, so the next big question is 2019. During the latest update of economic and financial projections from the members of the Federal Open Markets Committee (FOMC) in June, three interest rate hikes were expected in 2019. How can we get a clearer idea of what’s to come?
Four interest rates are now confirmed by the Fed. I had mentioned this scenario at the start of the year due to the White House’s implementation of expansionary fiscal policy and I have not changed my mind: the hike to the fed funds rate is just a way to iron out the imbalances caused by this policy that seeks to fuel domestic demand.

This domestic momentum reflects the impact of two factors: the first is the direct effect of tax cuts and rising public spending, and we can see the positive effects of this twofold approach for demand; the other component is trade policy that aims to use domestic production to replace imports, thereby sharply driving up demand for companies’ goods and services.
So the White House has adopted a two-pronged approach: on the one hand it bolsters domestic demand and the other it directs this additional demand towards US companies rather than imports.
This internal momentum will have at least two direct consequences: the first is the risk of inflation because demand is strong and because of higher import duties. Continue reading

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

What the Fed Is Missing

A complement to my recent post on the signal brought by an inverted yield curve on the economic activity.

The Federal Reserve isn’t worried about the yield curve, and it has reason why. The problem: It is pretty much the same reason it wasn’t worried about the yield curve before the financial crisis.
— Read it here www.wsj.com/articles/what-the-fed-is-missing-again-1532268000

A Former Central Banker Tells Other Central Bankers: “Stay Away From Davos” –

An interesting point of view on the role and the place of central bankers in the political spectrum.

In an interview with ProMarket, former Bank of England deputy governor Sir Paul Tucker explains why the “unelected power” of central bankers threatens our system of government.

Sir Paul Tucker
The European Central Bank found itself under renewed scrutiny this month, after Italy accused it of buying too few Italian sovereign bonds, allegedly in an effort to pressure the country’s new populist government to adopt more conventional economic policies.

The accusation was yet another example of the curious position the ECB has repeatedly found itself in ever since the central bank’s president Mario Draghi promised to “do whatever it takes” to preserve the euro in 2012. But it was also part of a larger, global wave of populist attacks against central banks. In Turkey, President Erdogan has repeatedly attacked the country’s central bank for raising interest rates, even going so far as to threaten the bank’s independence. In Britain, Environment Secretary Michael Gove has assailed the Bank of England and other central banks for their loose monetary policies, arguing that these policies benefited a small minority of “crony capitalists” who had “rigged the system” in their favor.

This political backlash came as no surprise to Sir Paul Tucker, the former deputy governor at the Bank of England and a research fellow at the Harvard Kennedy School of Government. Central bankers, Tucker writes in his timely new book Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, have emerged from the financial crisis with enormous new powers, entrusted by governments with the ultimate responsibility of making the economic recovery work. This change, he writes, relied on the “false hope” that central banks can create long-term prosperity. It is also fundamentally different than the response to the Great Depression, which was led by elected officials, not central bankers. Their expanded responsibilities, argues Tucker, have also turned central bankers into the “poster boys and girls” of unelected power, a process which ultimately erodes the legitimacy not only of central banks, but also our system of government as a whole.

Tucker, the chair of the Systemic Risk Council, a non-partisan think tank composed of former government officials and financial and legal experts, is a lifelong central banker. His book, an ambitious tome that stretches over 656 dense pages, is both a philosophical treatise on the limits of the administrative state and a passionate call for fellow technocrats to heed the lessons of recent political upheavals, pull back their power, and engage the public in a wider debate.

We recently sat with Tucker, who visited the Stigler Center in May for a series of interrelated lunch seminars, for an interview on politics, regulatory capture, and central banking’s crisis of legitimacy.

Read the interview promarket.org/former-central-banker-tells-central-bankers-stay-away-davos/