After Jackson Hole, Clear Road Ahead?

In terms of forward guidance I think the Fed Chairman's speech provided little direction, but Friday's precious metal price action into the close and the various sell side notes that I have seen suggest that this, at least initially, is too bearish a conclusion. The following excerpt from the speech, in particular, was taken as clear evidence of more and aggressive easing in the pipeline. 

As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.

Great emphasis has been attached to the chairman's use of the word "grave" as a clear tell-tell sign of more easing to come. I find this quite interesting since it is one of the first instances of such "new speak" interpretation of the Fed's statements akin to the good old days of Trichet and the utterance of (strong) vigilance. Needless to say, next week's jobs market report has suddenly been propelled to a key market event and every single US data point will now be watched with caution. On that note, the next ISM reading as well as consumption figures will be equally important to watch. 

I think Tim Duy’s interpretation is the right one then (hat tip Calculated Risk) with my emphasis.

On net, Bernanke's speech leads me to believe the odds of additional easing at the next FOMC meeting are somewhat higher (and above 50%) than I had previously believed. His defense of nontraditional action to date and focus on unemployment points in that direction. This is the bandwagon the financial press will jump on. Still, the backward looking nature of the speech and the obvious concern that the Fed has limited ability to offset the factors currently holding back more rapid improvement in labor markets, however, leave me wary that Bernanke remains hesitant to take additional action at this juncture. This suggests to me that additional easing is not a no-brainer, but perhaps that is just my internal bias talking.

On balance the main point for me is that the recent change in economic data clearly merits policy change on the basis of the Fed's reaction function. 

The unemployment rate in the US is sticky and the Fed has been persistently concerned about this which is indeed a strong signal to the policy bias especially as inflation expectations are well behaved. Inflation has come down significantly in the US running at 1.4% YoY and the Taylor Rule rate is now declining (though still in level terms way above 0 but that has more to do with the inputs than anything else). We have had two consecutive months of sub-50 ISM readings and consumption growth appears to be rolling over. My interpretation of the forward looking indicators is that they look better than the consensus suggests, but the Fed lives in the here and now and will act accordingly.

Another interesting point here is that despite the visible and strong recovery in the growth rates of US housing market indicators, Bernanke mentions the level of the housing market and not the change which suggest that the despite a good run of data with respect to the change in housing market indicators the level is still seen as depressed. 

The bottom line is that some form of easing is coming but what I find highly uncertain is the timing and aggressiveness of such easing. The August minutes had already stipulated potential moves for the Fed in the form of an extension of the low interest rate commitment, lowering interest rates on excess reserves as well as an extension of Operation Twist or outright asset purchases (probably through MBS securities). But which of these measures will be employed and in what order?

One thing for example which I find very interesting is the glaring gap between Bernanke's discussion of the effectiveness of unconventional monetary policy and its effect on the real economy (i.e. labour market). In that sense, it seems quite clear to me that quantitative easing can have a strong effect in the context of imminent deflation risks and strong downward pressures in asset prices. In such an environment the portfolio effect and, indeed, outright price effect from aggressive central bank action can be very effective. 

However, whether quantitative easing can be effective in countering a structural and sticky unemployment rate (and indeed a structurally declining labour force participation rate) seems much more uncertain to me. Obviously, this goes back to the point that the Fed is the wrong tool for the job at hand, but it also raises the issue of what kind of easing the Fed is planning here.

Of the measures mentioned above one of the only things which would have an effect on the labour market (from a theoretical point of view) is an extension of the low interest rate commitment. This would be a signal to companies that their cost of capital would remain low and incentivise investment and thus, in theory, additional labour input. But such a process is slow and arguably a weak remedy in the context of structural labour market issues.

More generally, we must ask ourselves whether an extension of the low interest rate commitment be enough for the market Clearly not and in any case, an extension much beyond Bernanke’s term would be meaningless as the looming presidential election has created uncertainty as to how strong this commitment is, if for example Bernanke is faced with a Republican president.

What about an extension of Operation Twist then? If this is combined with an expansion of the balance sheet through purchases of MBS I think this could be an effective medicine (although in general I find it hard to see how it could meaningfully affect the labour market). However, the theoretical argument here is fair. By influencing long rates the Fed is likely to stand the greatest chance of supporting the ongoing recovery in the housing market and thus, by derivative, the US economy. 

Ultimately, I see two sources of uncertainty here. Firstly, it is not clear to me that the US economy is heading into a hole in the second half of 2012 to an extent that would allow very strong Fed action. Secondly, while the Fed clearly seems committed and perhaps even pre-committed to more easing the nature of such easing and its scope is still very uncertain to me. The upside risk attached to much stronger easing is clearly there (not least because we also have the ECB coming in with policy measures soon), but the spectre of grave disappointment has not been completely extinguished in my view. 

Global Growth Forecasts - Seeing is Believing?

I reckon it must be quite tough at the moment to be an analyst or a money mover/manager. This is not only because of difficult markets and a very opaque economic outlook, but more so because as we move into year's end we are flooded by a veritable tsunami of sell and buy side research  on the big themes of 2009 and those to come in 2010. Naturally, we should be able to deal with such information overflow without much difficulty, but still; the amount of incoming pages of, often very interesting, research is massive.

Now, we can add another to the list in the form of the latest quarterly review from BIS which is a whopper of a publication filled with interesting articles, data, and charts. I have just scanned the "overview" and thus only scratched the surface but still, and in case you have spent the last 6 months on a beach, the first 10 pages provide a nice summary of a Q3/Q4 of 2009 dominated by an outright risky asset rally as well as a rebound in economic activity driven by especially stimulus (and inventories) and the expectation that favorable policies will stay in effect well into 2010. They do mention Dubai, and while I agree that this was indeed significant I think we defer the importance of this for the time being since risky assets seem, for now, to have shrugged off the implications.

From early September to late November, a steady stream of mostly positive macroeconomic news reassured investors that the global economy had in fact turned around, but investor confidence remained fragile. This was clearly illustrated towards the end of the period under review, when prices of risky assets dropped sharply as investors reacted nervously to news that government-owned Dubai World had asked for a delay in some payments on its debt.

Market participants expected the recovery to continue, but at times grew wary about its pace and shape due to uncertainty about the timing and speed of withdrawal of monetary and fiscal stimulus as well as the associated risks to future economic activity. The unease was compounded by the unevenness of the recovery among different regions of the world, which in turn was seen as increasing the risk that harmful imbalances could build, thereby adding to challenges for policymakers. In this environment, market developments continued to be driven to a significant degree by ongoing and expected policy stimulus, and in particular by expansionary monetary policy. As investors priced in expectations that interest
rates in major advanced economies would remain low prices of risky assets continued to go up. Equity prices generally rose, in particular in emerging markets.

Now, this is all well and good of course and while most of the charts and graphs passed by without further notice as I scrolled down the pages one in particular caught my glance.

You see, in my capability of a part time analyst for a small consultancy shop I also have to perform a rudimentary forecasting exercise of GDP for the major economies of the world.  Today I did just that and as I really don't have time to develop an inhouse econometric framework to produce quarterly GDP forecasts I simply average over a number of big ticket research houses' forecasts (e.g. Citi, Soc Gen, Nomura, BNP etc) [1]. And wouldn't you know it, the graphs which sprung from my excel sheet looked very much like the ones above.

So my main question is.  Do we really think this is a plausible outcome?

In my own report I found myself tying my argument up in knots qualifying and hedging my analysis to reflect the fact that only in the best of all possible worlds will be allowed to simply move on into a V-shaped recovery. Especially, and while I have no problem accepting the idea that emerging economies may continue to exhibit impressive growth rates, the story in the advanced economies will be different. Growth will be lower than before and in some cases it will be outright zero or negative for an extended period. In fact, it strikes me as quite odd that we are able to produce such forecasts when the data tells us that conditional on a withdrawal of stimulus the world is bound to look very different.

Allow me to offer just a few examples in the form of the very real risks of "double dip" recessions in Japan and in Germany as well as the mounting issue, not of if, but when we will see the next major sovereign default. On the latter point, Greece finds itself in the eye of the storm at the moment, but this is really a much more structural issue and as it becomes abundantly clear that ongoing fiscal deficits cannot be maintained for ever, growth will plummet in key economies and further exacerbate the structural problem. I mean, what you only have to do at this point is to pick Greece, Spain, the US etc and then substract the boost from government and monetary stimulus. What would be the growth rates you come up with. Well, in so many words, they would be grim! This is naturally precisely why policy makers have acted as they have but to use a well worn market metaphor; at some point the cyclical boost will have to give way for a structural recovery and thus as the proverbial tide rolls back, we will see who forgot to put on their swim suits (or who did not have money to buy one in the first place). In fact, the distinction between cyclical and structural factor are important now more than ever and even though this is basic market/economy research 1-0-1, it is worthwhile remembering it anyway. Tim Duy provides a timely example on how to master this distinction in the context of the US economy in his recent Fed Watch (hat tip: Mark Thoma).

In terms of the global forecast, I can only say that once we break the numbers and outlook down to its core it becomes clear that we are in a much more shaky position than current sentiment suggests.

But, for now seeing, it seems, is indeed believing.

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[1] Sssh ... don't tell our client this