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Monday
Apr072014

The lower bound of central bank effectiveness

I have a bit of time on my hands at the moment to read stuff that I otherwise wouldn't have time to read. For example I am currently reading Michael Lewis' new book Flash Boys about the ins and outs of high frequency trading. I will probably have more to say about that one in a few weeks, but for now I want to point to this recent BIS speech by former BOJ governor Masaaki Shirakawa. 

I recommend you to read it in its entirety, it is worth the effort. Two points in particular are worth highlighting.

Firstly, Shirakawa provides a non-consensus yet apt narrative on the interaction between central bank's noble quest for price stability and the formation of asset bubbles. Drawing on the experienced of relative price stability that prevailed in Japan in the late 1980s an important link is drawn between the traditional pursuit of key central banking objective and sowing the seeds of financial instability. 

(my emphasis)

During the bubble period of the mid- and late 1980s, the rate  of inflation of the consumer price index (CPI) was quite subdued at about 1%  (Figure 3). This was followed, as we all know, by a period of sub-par growth,  financial crisis and deflation. This bears striking similarities with the Great  Moderation experienced by many industrial economies in the mid-2000s; namely, a  period of benign price developments that was followed by severe economic  downturn and financial crisis.  

I don’t mean to say that price stability itself creates problems or bubbles, but  there exists a subtle link between the two.12 A prolonged period of high growth  coupled with low inflation gives rise to optimistic sentiment, which is at least partly  responsible for fostering financial bubbles. In addition, low inflation tends to justify  prolonged monetary easing, which in turn can become one of factors contributing  to the formation of bubbles.13  We should not treat these experiences lightly.

We have to start by recognising  this odd reality of bubbles being accompanied by price stability, yet then followed  by instability of the financial system, subsequently bringing about low growth and  often inflation that is lower than desired. From such a long-run perspective, we have  to admit that central banks that have accommodated asset price bubbles failed to  achieve economic stability, given that both financial and price stability are essential  elements of economic stability. We also cannot separate the bubble period from its  damaging aftermath, intertwined as they are through leverage and deleverage and  through overly optimistic pricing followed by its correction. We certainly cannot say  that problems can be solved by focusing solely on the latter period. We have to  think deeply about how best to relate the price stability mandate to financial  stability when the central bank conducts monetary policy.

What is interesting about the account above is that it takes a structural view on what unintended consequences that modern monetary policy might entail. Price stability may then be an imminently reasonable cyclical yardstick for monetary policy but the underlying effects on the economy might no be benign on a net basis. The obvious counterargument is then what monetary policy makers should do instead. However, I think the train of thought above deserves mention even without answering that question. 

The second point that I think is worth mentioning from the speech is the following on the link between the natural rate of interest and demographics. 

(my emphasis)

Japan is now experiencing rapid ageing, at a pace that is unprecedented in  modern economic history. Rapid ageing or, more precisely, the rapid rise in the  “dependency rate”, is one of factors lowering potential growth and hence the  natural rate of interest.18 It is noteworthy that there is a clear correlation between  the potential growth rate and the long-term expected inflation rate in Japan  (Figure 11). I can only say that we cannot fully understand Japanese macroeconomic  performance without understanding its demography, and how it interacts with the  economy and society.

I have argued a similar point on many occasions and while I am not completely in agreement with the Summers/Krugman notion of a secular stagnation, I think it is important to develop the idea further. In short, a rapidly ageing population may be one the key reasons that a central bank (and an economy) stuck in ZIRP may find it nearly impossible to escape. While this may represent nothing but an interesting theoretical issue for economic modelers it takes on a grave practical in the context of the large and growing debt burdens that modern societies find themselves with at exactly the wrong time in their economic life cycle. Larry Summers may have inadvertently stumbled across the crux of the issue in today's FT;

"We do not have a strong basis for supposing that reductions in interest rates from very low levels have a big impact on spending decisions. Any spending they do induce tends to represent a pulling forward rather than an augmentation of demand."

I think this is very good representation of our current malaise. Through the lens of someone looking at economies with rapidly ageing populations we can simply say that this problem arises because there isn't any consumption to pull forward! Fisher's interest theory was always valid, it is merely that in the context of a rapidly ageing population the consumption smoothing mechanism breaks for obvious and quite logical reasons.  Quite simply, even in ZIRP you are not stealing a sufficient amount of "future" growth to kick-start the recovery because such future growth is not there. 

Central banks can do many things (chiefly of which exactly is to influence intertemporal decisions), but they cannot conjure growth and inflation from thin air.

 

Thursday
Apr032014

Over and out for Forward Guidance

I'll try anything once, twice if I like it, three times to make sure."

So said Mae West, the late American actress and entertainer, whose upbeat line is often used to denote a positive and openminded approach to life.  Yet, just because you try it once does not mean that you have to like it. For example, I recently travelled from London to New York only to stay for 18 hours. Spending 12 hours in airplane over the course of a full day is decidedly not something I intend to do again if I can help it. 

I wonder whether Yellen would heed Mrs West's dictum in the context of trying to define what "a considerable time" really means or perhaps when it comes to putting a number on the elusive NAIRU? Unfortunately for Yellen she does not, unlike me, have to luxury of only trying once. She will be forced to try over and over again until she gets it right and it might be a bumpy ride.  

The problem is simple yet vexing for the Fed (and quite possibly the BOE too). It is steadily becoming impossible for the Fed to maintain the illusion of forward guidance and this poses problems. Forward guidance always worked incredibly well in theory for an economy stuck at the zero bound with a gaping negative output gap. It even worked in practice, but with the US economy starting to show signs of returning to steady positive growth (albeit that such growth might be weak overall) time horizons are getting increasingly squeezed. 

This was obviously highlighted with last week’s FOMC where short rates rose sharply and Eurodollar futures sold off. As we saw in the market for risk asset, such bear flattening is not something investors like too much. All the commotion arguably came as the Fed revised up its interest rate projections for 2015 and 2016. This won't really surprise any investors who tend to keep a close eye on fixed income markets in the US. However the key problem is that this renders forward guidance impotent. In short, rate hikes are now being priced in on a substantial level within a, for market participants, relevant and important time horizon. In a normal world where interest rates are price along a continuous spectrum this is normal but in a world of forward guidance which denotes a binary world where the central bank pre-commits to a specific interest rate regime (ZIRP) it renders such policy very difficult to sustain. 

One reason for last week's change in communication could be that Fed is genuinely turning more hawkish (in anticipation of a tighter labour market and wage pressures). After all, markets cannot expect interest rates to stay at zero forever. However, Yellen’ comments at the beginning of this week suggest otherwise, and herein also lies the problem. The communication of forward guidance is now almost impossible for the Fed; as investors know all too well, it is impossible to put the proverbial toothpaste back in the tube. 

Still, this seems exactly what Yellen attempted to do on Monday. Here is Macro Man [1]with a relevant observation in this regard.

(...) Yellen took pains to point out reasons why much of the current unemployment is cyclical rather than structural.   Among the arguments employed were the low level of wage growth.  While it is certainly true that wage growth is below long-term norms, it is somewhat disingenuous to suggest that it has been stagnant.  Indeed, private sector wage growth (the only type she has any power whatsoever to impact) has accelerated smartly over the past eighteen months, and now rests above the average level that prevailed when the past two Fed tightening cycles commenced.

So, the doves are back in charge it seems, but investors are not stupid. Whatever the Fed decides to do forward guidance is now a dead policy. It is time to find a new recipe regardless of whether Yellen and the rest of the FOMC agree with Mae West's morale or not. 

---

[1] - Readers should note that this is the original Macro Man wielding the pen here. To the extent that you can get excited over anything in the blogosphere, it is genuinely uplifting to have the good ol' MM back (with or without his knee caps!). 

Monday
Mar242014

The big disconnect between leverage and spreads

Matt King from Citigroup usually serves up nice presentations, but his past few highlighting the increasingly problematic increase in leverage among non-financial corporates is particularly illuminating. The latest installment is full of illuminating charts, but it will suffice to focus on the one below, 

Source: Citgroup, Matt King (March 2014)

 

Since 1988 there has been a relative close, and logical, correlation between higher corporate leverage and higher spreads, but not this time around. It is difficult to find a clearer picture of the effect of a structurally low interest rate regime (ZIRP) run simultaneously by global major central banks.

One of the most obvious consequences of persistently low interest rates in the past 2-3 years has been the increase in leverage for non-financial corporates (with access to the debt markets). A new bubble is brewing and if you look at the sectors of the economy that have responded to low interest rates (i.e. who have had room to lever up) the picture falls squarely on non-financial corporates. 

Yet, when presenting this view to clients in the past 6-12 months I have received strong push back. Net debt is still low I am told and corporate cash balances have improved. All this is true, but I have already given a hint to my rebuttal. We need to look at non-financial corporates and indeed, we need to drill down to sector level. 

First of all, let us quickly dispense with the notion that US corporates are sitting on large cash balances. This is true when judged from afar, but cash reserves are very concentrated. 

 

The reason for this skew is mainly banks and the likes of General Electric, Berkshire Hathaway, Apple etc. This is simply to say then that the notion of US corporates being awash with cash does not hold up to scrutiny as a general market characteristic. This is supported by the expecteced relationship between higher net debt and a lower liquidity position (measured by the Quick Ratio). 

 

So while the market based information is telling us that spreads and leverage are now disconnected, fundamentals remain in-line with theory. Companies with higher net debt also have poorer liquidity positions [1]. The final piece of evidence I would like to point to just how distorted overall net debt data is by the financial sector.

 

Including the financial sector will consequently give a picture of steadily declining leverage to new lows in the past 5 years. However, this is deeply misleading. If we strip out financials (which in any case is logical as their balance sheets look completely different from non-financial corporates') net debt per share has ascended new highs in the past 2-3 years. Mind you, these figures are both indexed and inflation adjusted so there is no nominal money illusion to blame for the results either. 

There are now more corporate bonds outstanding in the US than there are mortgage backed securities. This is a significant data point. The heart of the next crisis and debt bubble will be non-financial corporate debt (particularly in the energy and materials sector). Investors should take note. 

---

[1] - The relationship between net debt per share and the Quick Ratio is non-linear due to the fact that the Quick Ratio is bounded by zero at its lower bound (while net debt per share is unbounded). 

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