The recently departed head of research says the RBA should have hiked rates higher to head off inflation, and the Board lacked the expertise to challenge the governor on rate decisions:
Acknowledgments
- Chris Joye: RBA story in the AFR
Richard Koo: Surviving in the Intellectually Bankrupt Monetary Policy Environment
Richard C. Koo, Chief Economist, Nomura Research Institute, at the ACATIS Value Konferenz 2016 in Frankfurt
Why QE doesn’t work.
I have the greatest respect for Richard Koo and his unconventional, balance-sheet-recession approach to economics.
It strikes me is that if central banks lower interest rates to stimulate borrowing and borrowing does not rise because borrowers are repaying debt to restore solvency, then it will backfire and hurt GDP. Households reliant on income from investments, especially in financial assets, will experience a significant loss of income from lower interest rates and will reduce their consumption accordingly. Falling consumption will cause a drop in GDP.
Investments in financial assets consist not only of household bank deposits and bonds, but also insurance sector and pension fund investments in financial assets (mainly bonds) which will raise insurance premiums and lower pensions as a result.
Oil price fall is caused by tighter monetary conditions | Lars Christensen
Lars Christensen is one of the founding members of the Market Monetarism school of economic thought, having coined the term himself. Market Monetarists advocate that central banks target nominal GDP, instead of inflation, in order to achieve more responsive monetary policy and more stable economic growth.
The Threat of Inflation
From the Trading Diary:
I received a message from a US reader suggesting I should “stay out of politics”.
I would love to stay out of politics. Frankly, I find it tiresome. Unfortunately, politics and the economy are so intertwined as to make the study of one meaningless without consideration of the other. I say “unfortunately” because a lot of the damage done to the economy is caused by the political system.
As for Donald Trump, I am a conservative but do not support him. He is not another Reagan who can lead from the center and inspire his country. If anything he is a polarizing force, more ego-driven than Nixon and just as unpredictable.
I hope I am wrong. Trump has many sound policies and has made some solid appointments to his team. Don’t believe everything you read from a hostile media. They could do a lot of good. Provided they are able to manage the elephant in the lifeboat — the destabilizing side of Trump’s nature.
Now that I have offended at least half of all US readers — slightly less than half if you listen to bleating about the majority vote — let me explain why politics and economics are so intertwined.
Apart from trade wars, which I will discuss at a later date, I see the main threat to the US economy as inflation.
Before I start, let me say that these dangers are not immediate and the present boom is likely to continue for the next 12 to 18 months. But they could quickly materialize, bringing the boom to a premature end, so it is best to keep a weather eye on them.
Inflation
Earlier this week I discussed why the inflation outlook is so important to stock market performance:
From Tim Wallace at The Sydney Morning Herald:
Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.
He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.
Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.
But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.
As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.
That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.
Harvard scholar Paul Schmelzing points out that inflation is starting to rear its head in both China and Germany, with producer prices rising. This may in part be a result of the falling value of the Yuan and Euro against the Dollar, resulting in higher domestic commodity prices.
The opposite, however, is true for the US, with a rising Dollar lowering import prices and acting as a headwind against inflation.
The consumer price index (CPI) is rising because of higher crude oil prices but core CPI (excluding food & energy) has remained fairly constant, around the 2.0 percent target, over the last five years.
So why the concern?
Well the Fed is more concerned about underlying inflation, best reflected by hourly wage rates, than the headline CPI figure.
A sharp rise in hourly earnings rates would force the Fed to respond with tighter monetary policy to take the heat out of the economy.
The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure. And tighter monetary normally leads to recession.
Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.
Hourly earnings growth is currently at 2.5 percent, so the Fed has some wiggle room and is only likely to react with tighter monetary policy when the figure reaches 3.0 percent.
Recent rate rises are more about normalizing interest rates — not taming inflation — and are not cause for alarm.
But Paul Schmelzing warns that the combination of a tight labor market and fiscal stimulus could fuel inflation and lead to a bear market in bonds similar to the 1960s.
That is exactly where Donald Trump is headed with a major infrastructure program likely to hit the ground next year. In a tightening labor market, the Fed would be forced to tighten monetary policy, slowing the economy and leading to another bear market in stocks as well as bonds.
Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.
~ Stone Gossard
Lighting a fuse
The Fed quit quantitative easing more than a year ago, limiting total assets on its balance sheet to $4.5 trillion. But more than $2.5 trillion of cash injected into the financial system had been deposited straight back into the Federal Reserve system by banks as excess reserves, earning 0.25% p.a.
Fresh money continued to leak into the financial system as banks drew down their excess reserves, highlighted above by the widening gap between Total Assets and Excess Reserves. In December 2015 the Fed doubled the rate payable on excess reserves to 0.50% p.a. The intention is clearly to attract more excess reserves and narrow the gap, or at least slow the rate at which excess reserves are being withdrawn to prevent further widening.
Easy money policies followed by central banks around the world are not achieving the desired result of reviving business investment. If we examine the Fed’s track record over the last two decades, sharp surges in business credit were accompanied by speculative bubbles — stocks ahead of the Dotcom crash and housing ahead of the GFC — with disastrous results. GDP failed to respond.
The latest rally in global markets is also driven by monetary easing, this time in China, with a massive surge in the money supply signaling PBOC intentions to print their way out of trouble (and into an even bigger hole).
Ineffectiveness of monetary policy in solving structural problems has often been described as “like pushing on a string”. But recent experience shows it is more like lighting a fuse.
This is a nightmare, which will pass away with the morning. For the resources of nature and men’s devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life …. and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time – perhaps for a long time.
~ John Maynard Keynes: The Great Slump of 1930
Citi: Brace for global recession | MacroBusiness
David Llewellyn-Smith quotes Willem Buiter at Citi:
….The main ‘game changers’ in our view are the emerging belief that even the US economy is no longer bullet-proof and that policymakers (in the US and elsewhere) may not be there to come to the rescue of their own economies, let alone the world economy, by propping up asset prices and aggregate demand. It is likely, in our view, that global growth will this year once again underperform (against long-term trends and previous year forecasts). Citi’s latest forecasts are for global growth of 2.5% in 2016 (based on market exchange rates and official statistics) and around 2.2% (adjusted for probable Chinese mismeasurement). But in our view, the risk of a global growth recession (growth below 2%) is high and rising.
…..even though monetary policy is at the point of strongly diminishing returns, it is likely to remain the principal instrument through which authorities in a range of countries will try to boost growth and inflation.
…..In most countries, the hurdles for a major fiscal stimulus remain high.
There are no free lunches: “propping up asset prices and aggregate demand” reduces the severity of recessions but inhibits the recovery, leading to prolonged periods of low growth. The further asset prices are allowed to fall, the stronger the recovery as investors (eventually) snap up ‘cheap’ assets. Maintaining high prices is sometimes necessary, as in 2009, to prevent a 1930s-style collapse of the banking system but we may pay the price for another decade.
RIP ZIRP | PIMCO
From Marc Seidner:
At this point, the evidence is close to overwhelming that the Federal Reserve will embark on a tightening cycle this year. The base case for markets should be a move in September. While the pace of tightening should be very shallow and the ultimate destination for interest rates considerably lower than historical experience, investors should not underestimate the potential volatility emanating from the first interest rate increase in nine years and the first move off of the zero bound in six years….
Read more at RIP ZIRP | PIMCO Blog.
Here’s How to Achieve Full Employment
Economic Policy Institute President Lawrence Mishel provides the U.S. House Committee on Education and the Workforce with a shopping list of measures he believes are necessary to achieve full employment. Some are right on the mark while others seem to have missed the basic rules of Supply and Demand taught in Econ 101. My comments are in bold.
The goals that economic policy must focus on are, thus, creating jobs and reaching robust full employment, generating broad-based wage growth, and improving the quality of jobs.
Jobs
Policies that help to achieve full employment are the following:
1. The Federal Reserve Board needs to target a full employment with wage growth matching productivity.
The most important economic policy decisions being made about job growth in the next few years are those of the Federal Reserve Board as it determines the scale and pace at which it raises interest rates. Let’s be clear that the decision to raise interest rates is a decision to slow the economy and weaken job and wage growth. There are many false concerns about accelerating wage growth and exploding inflation based on the mistaken sense that we are at or near full employment. Policymakers should not seek to slow the economy until wage growth is comfortably running at the 3.5 to 4.0 percent rate, the wage growth consistent with a 2 percent inflation target (since trend productivity is 1.5 to 2.0 percent, wage growth 2 percent faster than this yields rising unit labor costs, and therefore inflation, of 2 percent). The key danger is slowing the economy too soon rather than too late.
Fed monetary policy should not target one sector of the economy (i.e. wages) but the whole economy (i.e. nominal GDP).
2. Targeted employment programs
Even at 4 percent unemployment, there will be many communities that will still be suffering substantial unemployment, especially low-wage workers and many black and Hispanic workers. To obtain full employment for all, we will need to undertake policies that can direct jobs to areas of high unemployment……
Government programs don’t create jobs, they merely redistribute income from the taxed to the subsidised.
3. Public investment and infrastructure
There is widespread agreement that we face a substantial shortfall of public investment in transportation, broadband, R&D, and education. Undertaking a sustained (for at least a decade) program of public investment can create jobs and raise our productivity and growth…..
Agree. But we must invest in productive assets that generate income that can be used to repay the debt. Else we are left with a pile of debt and no means to repay it.
Policies that do not help us reach full employment include:
1. Corporate tax reform
There are many false claims that corporate tax reform is needed to make us competitive and bring us growth. First off, the evidence is that the corporate tax rates U.S. firms actually pay (their “effective rates”) are not higher than those of other advanced countries. Second, the tax reform that is being discussed is “revenue neutral,” necessarily meaning that tax rates on average are actually not being reduced; for every firm or sector that will see a lower tax rate, another will see a higher tax rate. It is hard to see how such tax reform sparks growth.
Zero-sum thinking. If we want to increase employment, we need to increase investment. Tax rates and allowances should encourage domestic investment rather than offshore expansion.
2. Cutting taxes
There will surely be many efforts in this Congress to cut corporate taxes and reduce taxes on capital income (e.g., capital gains, dividends) and individual marginal tax rates, especially on those with the highest incomes. It’s easy to see how those strategies will not work….
Same as above. We need to encourage investment by private corporations.
3. Raising interest rates
There are those worried about inflation who are calling on the Federal Reserve Board to raise interest rates soon and steadily thereafter. Their fears are, in my analysis, unfounded. But we should be clear that those seeking higher interest rates are asking our monetary policymakers to slow economic growth and job creation and reflect a far-too-pessimistic assumption of how far we can lower unemployment, seemingly aiming for unemployment at current levels or between 5.0 and 5.5 percent….
Agreed. Raising interest rates too soon is as dangerous as raising too late.
Wage growth
It is a welcome development that policymakers and presidential candidates in both parties have now acknowledged that stagnant wages are a critical economic challenge…… Over the 40 years since 1973, there has been productivity growth of 74 percent, yet the compensation (wages and benefits) of a typical worker grew far less, just 9 percent (again, mostly in the latter 1990s)……
Wage stagnation is conventionally described as being about globalization and technological change, explanations offered in the spirit of saying it is caused by trends we neither can nor want to restrain. In fact, technological change has had very little to do with wage stagnation. Such an explanation is grounded in the notion that workers have insufficient skills so employers are paying them less, while those with higher wages and skills (say, college graduates) are highly demanded so that employers are bidding up their wages…….
Misses the point. Technology has enabled employers in manufacturing, finance and service industries to cut the number of employees to a fraction of their former size.
Globalization has, in fact, served to suppress wage growth for non-college-educated workers (roughly two-thirds of the workforce). However, such trends as import competition from low-wage countries did not naturally develop; they were pushed by trade agreements and the tolerance of misaligned and manipulated exchange rates that undercut U.S. producers.
This small paragraph hits on the key reason for wage stagnation in the US. Workers are not only competing in a global labor market, but against countries who have manipulated their exchange rate to gain a competitive advantage.
There are two sets of policies that have greatly contributed to wage stagnation that receive far too little attention. One set is aggregate factors, which include factors that lead to excessive unemployment and others that have driven the financialization of the economy and excessive executive pay growth (which fueled the doubling of the top 1 percent’s wage and income growth). The other set of factors are the business practices, eroded labor standards, and weakened labor market institutions that have suppressed wage growth. I will examine these in turn.
Aggregate factors
1. Excessive unemployment
Unemployment has remained substantially above full employment for much of the last 40 years, especially relative to the post-war period before then. Since high unemployment depresses wages more for low-wage than middle-wage workers and more for middle-wage than high-wage workers, these slack conditions generate wage inequality. ……
The excessive unemployment in recent decades reflects a monetary policy overly concerned about inflation relative to unemployment and hostile to any signs of wage growth……
2. Unleashing the top 1 percent: finance and executive pay
The major forces behind the extraordinary income growth and the doubling of the top 1 percent’s income share since 1979 were the expansion of the finance sector (and escalating pay in that sector) and the remarkable growth of executive pay …… restraining the growth of such income will not adversely affect the size of our economy. Moreover, the failure to restrain these incomes leaves less income available to the vast majority……
Zero-sum thinking.
Labor standards, labor market institutions, and business practices
There are a variety of policies within the direct purview of this committee that can greatly help to lift wage growth:
1. Raising the minimum wageThe main reason wages at the lowest levels lag those at the middle has been the erosion of the value of the minimum wage, a policy undertaken in the 1980s that has never fully been reversed. The inflation-adjusted minimum wage is now about 25 percent below its 1968 level……
Will reduce demand for domestic labor and increase demand for offshoring jobs.
2. Updating overtime rules
The share of salaried workers eligible for overtime has fallen from 65 percent in 1975 to just 11 percent today……
This will continue for as long as the manufacturing sector is white-anted by offshoring jobs.
3. Strengthening rights to collective bargaining
The single largest factor suppressing wage growth for middle-wage workers over the last few decades has been the erosion of collective bargaining (which can explain one-third of the rise of wage inequality among men, and one-fifth among women)……
How will this improve Supply and Demand?
4. Regularizing undocumented workers
Regularizing undocumented workers will not only lift their wages but will also lift wages of those working in the same fields of work…..
How will this improve Supply and Demand?
5. Ending forced arbitration
One way for employees to challenge discriminatory or unfair personnel practices and wages is to go to court or a government agency that oversees such discrimination. However, a majority of large firms force their workers to give up their access to court and government agency remedies and agree to settle such disputes over wages and discrimination only in arbitration systems set up and overseen by the employers themselves…..
How will this improve Supply and Demand?
6. Modernizing labor standards: sick leave, paid family leave
We have not only seen the erosion of protections in the labor standards set up in the New Deal, we have also seen the United States fail to adopt new labor standards that respond to emerging needs……
No issue with this. But how will it improve Supply and Demand?
7. Closing race and gender inequities
Generating broader-based wage growth must also include efforts to close race and gender inequities that have been ever present in our labor markets…….
No issue with this. But how will it improve Supply and Demand?
8. Fair contracting
These new contracting rules can help reduce wage theft, obtain greater racial and gender equity and generally support wage growth……No issue with this. But how will it improve Supply and Demand?
9. Tackling misclassification, wage theft, prevailing wages
There are a variety of other policies that can support wage growth. Too many workers are deemed independent contractors by their employers when they are really employees……
No issue with this. But how will it improve Supply and Demand?
Policies that will not facilitate broad-based wage growth
1. Tax cuts: individual or corporate
The failure of wages to grow cannot be cured through tax cuts. Such policies are sometimes offered as propelling long-run job gains and economic growth (though they are not aimed at securing a stronger recovery from a recession, as the conservatives who offer tax cuts do not believe in counter-cyclical fiscal policy). These policies are not effective tools to promote growth, but even if they did create growth, it is clear that growth by itself will not lift wages of the typical worker…….
Zero-sum thinking. Compare economic growth in high-tax countries to growth in low tax countries and you will find this a highly effective policy tool.
2. Increasing college or community college completion
……advancing education completion is not an effective overall policy to generate higher wages……. What is needed are policies that lift wages of high school graduates, community college graduates, and college graduates, not simply a policy that changes the number of workers in each category.
Better available skills-base leads to increased competitiveness in global labor market and more investment opportunities in the domestic market.
3. Deregulation
There is no solid basis for believing that deregulation will lead to greater productivity growth or that doing so will lead to wage growth. Deregulation of finance certainly was a major factor in the financial crisis and relaxing Dodd–Frank rules will only make our economy more susceptible to crisis.
What we need is (simple) well-regulated markets rather than (complex) over-regulation.
4. Policies to promote long-term growth
Policies that can substantially help reduce unemployment in the next two years are welcomed and can serve to raise wage growth. Policies aimed at raising longer-term growth prospects may be beneficial but will not help wages soon or necessarily lead to wage growth in future years. This can be seen in the decoupling of wage growth from productivity over the last 40 years. Simply increasing investments and productivity will not necessarily improve the wages of a typical worker. What is missing are mechanisms that relink productivity and wage growth. Without such policies, an agenda of “growth” is playing “pretend” when it comes to wages.
Long-term investment is the only way forward. To dismiss this in favor of short-term band-aid solutions is nuts!
My proposal is a lot simpler, consisting of only five steps:
- Invest in productive infrastructure.
- A simplified tax regime with low rates and few deductions apart from incentives to increase domestic investment.
- Restrict capital inflows through trade agreements and maintain a fair exchange rate.
- Fed monetary policy supportive in the short-term but with long-term target of neutral debt growth — in line with GDP (nominal).
- Move education up the priority list for government spending. Improve the education standards and training of teachers — they are the lifeblood of the system — rather than increasing numbers.
Interest on Reserves, Settlement, and the Effectiveness of Monetary Policy
Joshua R. Hendrickson suggests that paying interest on excess reserves at the Fed reduces the effectiveness of monetary policy. Money paid to purchase Treasuries finds its way back to the Fed in the form of excess reserves. Here is the abstract from his paper:
Over the last several years, the Federal Reserve has conducted a series of large scale asset purchases. The effectiveness of these purchases is dependent on the monetary transmission mechanism. Federal Reserve chairman Ben Bernanke has argued that large scale assets purchase are effective because they induce portfolio reallocations that ultimately lead to changes in economic activity. Despite these claims, a large fraction of the expansion of the monetary base is held as excess reserves by commercial banks. Concurrent with the large scale asset purchases, the Federal Reserve began paying interest on reserves and enacted changes in its Payment System Risk policy that have effectively made reserves and interest-bearing assets perfect substitutes. This paper demonstrates that these policy changes have had statistically and economically significant effects on the demand for reserves and simply that the effectiveness of conventional monetary policy has been significantly weakened.
Read the entire paper at Interest on Reserves, Settlement, and the Effectiveness of Monetary Policy |
Joshua R. Hendrickson.
Fed’s Fisher Slams Congress Over Fiscal Policy | WSJ
Rob Curran at WSJ reports on a speech by Dallas Fed President Richard Fisher:
Speaking at a luncheon hosted by financial-industry trade group the Dallas Estate Planning Council at the Dallas Country Club, Mr. Fisher said the central bank has done all it can to stimulate the U.S. economy. He said members of Congress–both Republicans and Democrats–have failed to do their part. Elected officials have “sold our children–and our grandchildren–down the river,” Mr. Fisher said. “We haven’t had a budget for five years; no one knows what their taxes are going to be; no one knows what spending is going to be.”
The Dallas Fed president has long maintained that the missing ingredient in the economic recovery is a sound fiscal policy.
via Fed’s Fisher Slams Congress Over Fiscal Policy – Real Time Economics – WSJ.