“Politicians” take their revenge – My weekly column

The world of politics and politicians wants to get its own back on the central banks. Central banks have been at the very heart of steering the economy since the start of the crisis at the very least, as they have been more present and reacted more swiftly than governments, bar a few exceptions such as coordinated fiscal stimulus moves in 2009.

Yet politicians are now wading in to tackle central banks’ domination at various levels. Firstly, Democrats are championing the MMT – Modern Monetary Theory – approach, suggesting that governments are responsible for managing the economy. Then we have the politicization of the central bank, with Donald Trump’s attempts to appoint members who are not renowned first and foremost as economic experts, or Erdogan taking control of the central bank in Turkey, while in India, Modi changes governor each time the current one no longer meets his requirements.

Politicians now want the pendulum to swing back in their direction as they seek to take back control after letting central banks play a key role in steering the economy. But it may not be that straightforward.

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A recap of central banks’ independence

Central banks have had a considerable grip on economic trends for the past several years. At the start of the 1980s, their role was to cut back inflation, after governments had let it spiral out of control. Paul Volcker went all out on this front, and this shift in the balance of power gained greater ground over time. Theoretical and empirical indications bore out this idea that an independent central bank was required to facilitate and optimize regulation of the economy.
When the euro area was set up, the central bank’s independence became the norm for member countries as well as several other countries.

Having two bodies to steer the economy and reform economic structures – the government and the central bank – was deemed wise. Work on coordination of economic policy has enhanced the way the two work together to make for more efficient running overall.

After the 2008 watershed, central banks’ crisis management moves increased their influence. Implementation of unconventional monetary policy in the US and the UK gave monetary authorities a major advantage, enabling governments to take on debt to address the aftershock of the financial crisis and spread out its effects over the longer term, while also covering this debt via vast purchase programs, or Quantitative Easing. Meanwhile, the development of forward guidance on expected future interest rate trends enabled central banks to steer investors’ expectations over the long term and avoid any potential unwanted rate trends.

In the euro area, the ECB became more independent when Mario Draghi took over at the helm: he made the monetary authority a true lender of last resort, gave the euro greater independence and shifted the central bank’s political balance that had been so troublesome for his predecessor to the detriment of real economic questions. Quantitative Easing and the forward guidance process also helped assert this greater independence.

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Doubts over this independence

Politicians have now seen that reality is running away from them and central banks have too much clout in controlling the economy.
Donald Trump swiftly explained that excessively high interest rates hampered US growth, but Jay Powell, the Chair he had himself appointed, held up under this pressure. The President is now endeavoring to stymie the monetary policy committee by appointing members who do not have the rights skills and experience, such as Stephen Moore and more recently Herman Cain, before he retracted. The White House’s nominations have to be approved by Congress so the game is not over yet, but a potential second term for Trump in 2020 could upturn this balance due to the seats on the board coming up for nomination. This is a huge risk for the Fed’s independence over the years ahead.
Republicans in Congress very recently wanted to set a well-defined framework for the Fed’s actions along the lines of the Taylor rule. This would clearly limit the central bank’s scope to make its own interpretations of the economic situation, with the risk of triggering excessive interest rates movements that could disrupt the pace of the economy in the long term.

In the shorter term, the main doubt over central banks comes from the American Democratic party and its most left-wing potential presidential election candidates.
Bernie Saunders and Alexandria Ocasio-Cortez (AOC) in particular want to give politics precedence over economics again, with politics leading and economics merely managing. They base their approach on Modern Monetary Theory, which suggests that the size of the deficit is not very important if debt is financed in local currency: against this backdrop, the economy is steered and adjusted via changes in spending and tax and no longer by movements on interest rates primarily.

With this approach, growth and inflation would thus be better steered by the government than the central bank. A number of economists are unconvinced by this method, which is a theory in name only: it is also worrying as when governments have taken control over the economy in the past, it has been to the detriment of the central bank and often ended with phases of marked instability. This particularly calls to mind hyperinflation in Germany, although this may seem an excessive viewpoint with evenhanded elected leaders.

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Long-lasting shift

What matters here is not so much the theoretical approach, but rather the potential change it could trigger in the pecking order for the economy’s different managing authorities. If the pyramid of powers were to change, the central bank’s action would then depend on the government’s moves in a radical turnaround compared to the past 40 years. There are several points worth noting.

We will need to keep a close eye on the forthcoming replacement for Draghi and other members of the board at the ECB, as we keep this balance of power in mind, particularly as these changes will take place after the European elections.

However, the central banks have a major advantage: in the past, they have systematically stuck together during crisis periods to curb risks on liquidity. This ability to react and work together outside any political framework helped reduce both the length and the extent of crises. Yet we cannot spontaneously expect any similar behavior from governments in the long term, and coordination displayed at the time of stimulus measures in 2009 only lasted a short length of time, while this was not true of the central banks.

In a recent book, Paul De Grauwe suggested that the economy is like a pendulum swing back and forward between market and state in overall management of the economy. An excessive role for the market led to imbalances, which were corrected by greater government intervention as it took back control, leading to imbalances that were only evened out by accepting a greater role for the market…

This type of pendulum swing looks unlikely, but we must be realistic: politics and politicians have taken back greater power in both China and the US, particularly in China. Meanwhile the populist movement in Europe is primarily a political movement, and it seems unlikely that this trend will end soon and for such times as the middle classes do not derive the full benefits of growth.

This post is available in pdf format My Weekly Column – 23 April 2019

The Fed and the Global Environment

The change of the US monetary policy trend has been radical since the end of January.
At its January 29/30 meeting, the Fed said it was no longer committing to one or more rate hikes, which was confirmed in March when the “dots” chart was published, and it was going to stop the downsizing of its balance sheet, which it confirmed at its March meeting, indicating a balance sheet target of 17% of GDP in the autumn.
The key elements explaining this radical change lie in the international environment. The Fed sends the signal that because of the uncertain global environment, it wants to remain agile by no longer committing on future movements.It even gives the feeling of wanting to limit its “forward guidance” in order to have more leeway in its monetary policy management.

This role of the international environment may be a source of surprise as the economy is self-centered. Its opening rate is 14% in 2018 against 19% in the Euro zone.
A research by Laurent Ferrara and Charles-Emmanuel Teuf at the Banque de France, quoted by Fed’s Richard Clarida in a recent BdF colloquium, suggests that the international environment is a key factor in the reasoning behind FOMC’s decisions
The authors create an index containing terms related to the global economy, and integrate it into a Taylor formula. The addition of this indicator in the Taylor Formula , that links interest rate to economic activity and inflation, is significant. Greater attention to these external factors is driving the Fed to more accommodating behavior.
We can therefore better understand the change in tone of the US central bank since the beginning of the year. The international environment has deteriorated rapidly (see graph below) and the Fed is taking into account even if its economy remains robust.
See the initial post of Laurent Ferrara and Charles-Emmanuel Teuf on the Banque de France blog
The graph below traces the pace of their index from 1993 to 2017

Source: Ferrara – Teuf – Banque de France

The following graph shows a Global Economic Policy Uncertainty Index. It suggests and validates the wait-and-see attitude of the Fed in 2016, but emphasizes the opportunity given to it in 2018 to tighten the tone with lower tensions as measured by the index. The year 2019 actually suggests more wait-and-see.

The Macro 2 pagers – Low interest rates for a long time

The Macro 2 pager explains how the interest rates profile will remain low for an extended time. 
The central banks’ stimulus after the 2008 crisis has been caught up by an economy whose characteristics have changed and which can now accommodate only low rates thus conditioning the behavior of central banks.

The Macro 2 Pager – Interest Rates


The Fed wants to remain agile

The end of the reduction of the Fed’s balance sheet is what we have to keep in mind after the publication of the minutes of the last FOMC meeting. It will take place during the second half of this year.

The US Central Bank does not want to be too constrained in the management of its monetary policy. The pace that was taken and the level targeted until then could add to the difficulty of the good calibrage of the monetary policy.

The Fed clearly does not want to be constrained in its choices because the global environment which is now more uncertain.

The way Yellen initiated the downsizing movement of the balance sheet was possibly compatible with a stable and predictable international environment. The arrival of Trump has created noise and spillover effects because of its policies. Now the Fed must take into account these noises and the risk of contagion which are attached to them.

The Fed does not yield to Trump by not raising rates, but it does not raise them in order to be able to intervene quickly to contain the negative effects of the policy pursued at the White House. She wants to be agile to limit risks. It’s well thought out.

The Fed muddies the waters

The latest FOMC meeting on January 29 and 30 saw confirmation of the halt to monetary normalization, with the end to the Fed funds hike cycle and an easing in the Fed’s balance sheet management (reduction) policy, although the exact terms of this remain to be seen. 
The most surprising part about this decision is that it was dictated by the threat of shocks from external factors (Brexit, China, etc.) rather than the desire to tackle any domestic problem, marking the first time that the Fed has taken this kind of decision to normalize monetary policy without making a direct reference to its domestic economic situation. 
Yet the shift in monetary policy direction could have been based on purely internal considerations rather than referring to potential external shocks, so this move raises a number of questions.

The Federal Reserve puts an end to normalization – My weekly column

The post is available in pdf format My Weekly Column – February 4

The US Federal Reserve decided to bring its monetary policy normalization to an end during its meetings on January 29 and 30, 2019.
The interest rate hike cycle had kicked off slowly in December 2015 and stepped up a pace a year later, as nine interest rate hikes pushed the Fed Funds rate up from 0.25% (upper end of range) to 2.5% in December 2018.
During last week’s press conference, the Fed Chair indicated that Fed Funds are now in the range of neutral, in response to the first question from journalists: there is no longer an accommodative or a tightening slant. Powell’s confidence in the strength of the US economy suggests that the end to normalization should not just be seen as hitting the pause button for a while.

The rate hike cycle has been long and slow-moving if we compare to the Fed’s previous series of tightening moves from 2004 for example. A comparison with this period also reveals that real interest rates on Fed funds were much higher then than they are now. The figure is currently marginally above the level witnessed at the start of the normalization process in December 2015, unlike the situation after 2004, when the economy was much more restricted, while this is not the case in the current economic situation.

A comparison of current real interest rates with previous phases of monetary tightening shows that today’s situation is completely different to these episodes.
Real interest rates in November 2018 stood at around 0.4% (inflation figures for December are not yet available on the PCE index), which is much lower than figures in 2006, 1999 or 1990. Does this mean that the US economy is too weak to be able to deal with a real rate above 1%? This would be extremely worrying and would undermine Jerome Powell’s comments that the US economy is in a good place.

It is difficult to understand why US normalization is coming to an end when we look at the economy, as unemployment is near its low, so the central bank should be tightening the reins. The Fed’s projections for 2019 and 2020 are for figures above the country’s potential growth rate and this also fits with the economists’ consensus, at least for 2019. Against this backdrop, monetary policy needs to be tighter to ensure that growth does not create imbalances that then have to be addressed, and this was the message from Powell in 2018, when he suggested that fiscal policy (too aggressive for an economy running on full employment) would need to be offset by tighter monetary policy to rebalance the policy mix. During the press conference on Wednesday January 30, he did not raise this question: the issue was side-stepped, but yet the analysis still remains the same. There are only two possible economic explanations for the halt to normalization: either there are expectations of a severe downgrade to projections when they are updated in March, but this would not be consistent with Powell’s comments; or the Fed is doing whatever it takes to extend the economic cycle at any cost, with the end to the rate hike cycle aimed at cutting back mortgage rates and taking the pressure off the real estate market. However, with the overall economy remaining robust, the risk of this type of move is that it could lead to imbalances that would be difficult to eliminate. This is the opposite approach to the Fed’s strategy right throughout 2018, so it would be a strange tactic.