Wednesday, July 20, 2016

The Fed is Trapped in a Rate Hike Talk Cycle

The Wall Street Journal reports Fed officials are once again signaling their desire to raise interest rates: 
Federal Reserve officials are looking more confidently toward an interest-rate increase before year-end, possibly as early as September, now that financial markets have stabilized after Britain’s vote to leave the European Union and the economy shows signs of picking up. 
This narrative should sound familiar. Since mid-2014 the Fed has been talking up interest rate hikes--as seen by the movements in fed fund futures rate--but only has a 25 basis point rate increase to show for it. This is because the Fed's plans often bump up against unexpected economic developments. And lately, this seems to be happening in a cycle that goes as follows: the Fed talks up interest rate hikes → bad economic news emerges → the Fed dials down its rate hike talk → good economic news emerges → repeat cycle.

To see this cycle, recall what has happened this year. After the FOMC did its 25 basis point hike in December 2015, FOMC members were talking up four more rate hikes in 2016. Then in early 2016 concerns emerged about financial stress and the global economy that caused Fed officials to dial back their rate hike talk. By the time of the March FOMC meeting, some members were even concerned about raising rates in April. Over the next few months, however, incoming economic data was improving so Fed officials once again began dialing up their tightening talk. A rate hike at the June FOMC seemed possible. The rate hike rhetoric quickly changed, however, when the the awful May jobs report--only 38,000 jobs--came out on June 3. Indeed, the FOMC passed on a rate hike at its June meeting.  The Brexit vote reinforced those concerns.

Now the cycle is starting over. The gangbuster June employment report and strong retail sales are causing Fed officials to get itchy trigger fingers again, as seen in the above Wall Street Journal article. Fed officials are increasingly "confident" they can raise rates in September this year. But will they be able to follow through? Or will this cycle repeat itself?

It is almost inevitable, in my view, that this cycle will repeat itself for two reasons.

First, much of the bad economic news that has caused the Fed to repeatedly dial back its rate hike talk has not been a series of random events. Rather, they have been a byproduct of the rate hike rhetoric itself.Whenever the Fed talks up rate hikes it also talking up the value of the dollar which, in turn, creates a drag on many parts of the global economy. This is because a large swath of the global economy has its currency linked to the dollar and because there is almost $10 trillion in dollar denominated debt issued outside the United States. The former means Fed tightening gets exported to other countries (assuming capital flows) while the latter implies Fed tightening raises real debt burdens abroad. Since mid-2014, the Fed's rate hike talk has driven up the trade-weighted dollar about 20% and through these two channels has been the key reason for global economic slowdown over the past year. It also a key factor behind much of the global financial stress this year according to the Bank for International Settlements and Greg Ip.

Given the ongoing strength of the trade-weighted dollar, the above analysis implies the Fed cannot do much rate hike talking without triggering more global economic problems. The dollar growth has plateaued at about 20% growth and that seems to be the tolerable level for now. It is the first reason why Fed officials cannot credibly talk up rate hikes.

The second reason is that the Fed's desire to raise interest rates is pushing up against the Tsunami forces behind the global race to the bottom of safe asset yields. As seen in the figure below, long-term safe asset yields have been on a steady downward path since 2008 that has now pushed some of them below zero.

This downward march of interest rates has occurred prior to and after QE programs and is therefore not the result of central bank tinkering. Rather, it is the result of far bigger global market forces. One interpretation of this movement (based on the expectation theory of interest rates) is that the market expects future short-term interest rates to be increasingly lower. As Tim Duy notes, the Fed is fighting against this force and is unlikely to win. Put differently, interest rates are being suppressed by market forces despite the Fed's best efforts. The Fed will not be able to raise interest rates this year and maybe even next year.

Now the Fed could still force up its target interest rate temporarily. But it would learn the hard way what the Riksbank in 2010 and the ECB in 2011 learned: getting ahead of the recovery and market forces will only make matters worse. In the case of the ECB, it created another recession for the Eurozone. Ultimately, interest rates cannot be exogenously pushed up. They have to be endogenously pulled up by a healthy economy. Until this happens, the Fed is trapped in a self-defeating rate hike talk cycle.

1One clear exception was Brexit.

Monday, July 18, 2016

Macro Musings Podcast: Robert Hall

My latest Macro Musings podcast is with Robert Hall. Bob is a professor of economics at Stanford University. He is the former president of the American Economic Association, a member of the National Academy of Sciences, a fellow of the Econometric Society, and a fellow of the Society of Labor Economists. He has published widely in many areas of economics including labor, public finance, international finance, and macroeconomics. Bob is also chair of the National Bureau of Economic Research’s recession dating committee. 

Bob joined me to discuss how his recession dating committee determines the official turning points in the business cycle. We also cover his recent work on the the post-2009 slump and the causes behind it. Along way, we touch on the importance of the ZLB, secular stagnation, the global decline safe asset yields, and more. We close by discussing his preferred approach for monetary policy. It was a fascinating conversation throughout.

You can listen to the podcast via iTunes, Sound Cloud, Stitcher, or your favorite podcast app. You can also listen through the embedded player above. And remember to subscribe since more guest are coming!

Related Links:
Robert Hall's web page

Monday, July 11, 2016

Macro Musings Podcast: Mark Thoma

My latest Macro Musings podcast is with Mark Thoma of the University of Oregon, the Fiscal Times, and CBS Money. Mark is also the author of Economist's View, one of the original and premier blogs covering macroeconomic issues. 

Mark sat down with me to discuss a number of interesting questions. First, we covered the impact blogging has had on academic economists. Is blogging now required to be a successful academic economist? Will tenure one day be granted, in part, based on one's blogging efforts? Is blogging good PR for a university's department of economics? Finally, does blogging influence policy making? 

Second, we discussed recent macroeconomic issues. What caused the Great Recession? Was monetary and fiscal policy responsive enough to the crisis?  Could macroeconomic policy have done more? Is secular stagnation real and have we truly exhausted technical innovations? Is there a safe asset problem?

Finally, Mark discusses his work on the political business cycle. It was great conversation throughout. 

You can listen to the podcast via iTunes, Sound Cloud, Stitcher, or your favorite podcast app. You can also listen through the embedded player above. And remember to subscribe since more guest are coming!

Related Links:
Mark Thoma's webpage
Mark Thoma's twitter account
Other Macro Musing podcasts 

Monday, July 4, 2016

Macro Musings Podcast: Joseph Gagnon

My latest Macro Musings podcast is with Joe Gagnon of the Peterson Institute for International Economics. Joe is a senior fellow at the Peterson Institute of International Economics and formerly worked for the Federal Reserve Board of Governors as an associate director for both the Division of International Affairs and the Division of Monetary Affairs.

Joe joined me for a fascinating discussion on the Fed's large scale asset programs, also known as quantitative easing (QE). Drawing upon his experience at the Board of Governors as well as the literature on large scale asset purchase, Joe explains the theory and consequences of the Fed's QE programs. We also discuss the QE programs implemented by the Bank of Japan and the European Central Bank and consider whether central banks can "run out of ammunition." Finally, we also cover the outlook for the global economy and the implications of Brexit. It was a great conversation throughout.

You can listen to the podcast via iTunesSound Cloud, Stitcher, or your favorite podcast app. You can also listen through the embedded player above. And remember to subscribe since more guest are coming!

Friday, July 1, 2016

Brexit Post-Mortem

Okay, so Brexit did not cause the biggest money demand shock since 2008. Global equity markets, as noted by Kelly Evans, have regained much of their losses since the Brexit vote. Also, the initial surge in the trade-weighted dollar that had me worried appears to have peaked with just over 2 percent growth. This is good news that I did not expect.

This is not to say, however, that Brexit has had no lasting negative effect on financial markets. One of the concerns I initially raised was that Brexit would accelerate the global race to the bottom for safe asset yields. The 10-year treasury yield is now drifting around 1.45 percent--an almost 30 basis point decline since the Brexit vote. The decline is almost 40 basis points if we look back to early June when polling first showed Brexit pulling ahead in the polls. A similar pattern occurs for the 10-year German bond yield as seen in the figure below.

This sustained decline in safe yields is a non-trivial matter. As I have noted before, at some point these ongoing declines in safe yields will hit an effective lower bound. When that happens something else will have to adjust if there is still demand for more safe assets. That something else will be real economic activity as shown by  Caballero, Fahri, and Gourinchas (2016). Brexit, in other words, has pushed the global economy closer to a recession. 

Brexit's effect on the dollar is also something we need to monitor. As I have explained before, the dollar is already up about 20 percent since mid-2014. It is a key reason the global economy has slowed down since this time. The dollar's strength is weighing down dollar block countries (like China) that peg to the dollar as well as causing problems for all those external debtors holding a whopping $10 trillion in dollar denominated debt. The dollars ongoing strength, in my view, is the biggest threat to the global economy. There is only so far the dollar's strength can go--or so much China can tinker on the margin with small devaluations--before we will see a repeat of the financial problems of last August and January.

Now the immediate impact of Brexit on the dollar is to have pushed it up just over 2 percentage points. This I would attribute to the elevated uncertainty coming from Brexit that has pushed more investors into safe dollar-denominated assets. This is a step in the wrong direction for the dollar. 

Brexit, however, has also delayed any expected rate hikes for this year and maybe even next year. This is why the dollar has not risen more. Take away this expected delay in interest rate hikes and the uncertainty shock would surely have pushed the dollar much higher. So, for now, Brexit may actually have given China and dollar-vulnerable countries a reprieve from a even stronger dollar.

But this very reprieve and the calm that has returned to equity markets may also be the global economy's undoing. It may embolden the Fed to start talking up interest rate hikes again. Put differently, the siren lure of the relative calm in financial markets may give Fed officials--who yearn for the normalization' of monetary policy--itchy trigger fingers again. Last time those hose itchy trigger fingers got going, they had talked up interest rate hikes so much that the dollar rose almost 25 percent and sparked financial stress around the world. This is what we want to avoid. 

Brexit, in short, has turned out better than I expected but is not without problems. It has precipitously lowered safe yields and has potentially put in motion the dynamics for a stronger dollar. 

P.S. Here is a Bloomberg TV interview I did that makes some of these same points. Here is a great article by Bloomberg's Luke Kawa that further explains my arguments in the interview. A similar point is made by Ylan Mui in the Washington Post. Finally, here is Vox's Timothy Lee explaining how the real threat to the EU is not Brexit, but the ECB and more fundamentally the Euro itself. He draws upon my new working paper on the Eurozone crisis that I highlighted here.

Monday, June 27, 2016

Macro Musings Podcast: Will Luther

My latest Macro Musings podcast is with Will Luther, assistant professor of economics at Kenyon College and an adjunct scholar with Cato's Center for Monetary and Financial Alternatives. Will joins me to discuss the origins of money and its implications for new cryptocurrencies today. It was a fascinating conversation throughout on a very important topic. 

There are two theories for the origin of money. The first theory, the state theory of money, posits governments are needed to provide credibility for money as a medium of exchange. The second theory, the spontaneous order theory, argues market actors will arrive at an acceptable medium of exchange on their own. Drawing on historical examples--including unofficial dollarization, the Somalia Shilling, and Russian Vodka--Will argues that both theories can be useful in explaining the emergence of money depending on place and time. We then turn to how these theories shed light on the rise of cryptocurrencies and blockchain technology. 

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player. And remember to subscribe since more guest are coming!

Related Links
Bitcoin is Memory--Will Luther

Friday, June 24, 2016

Brexit: the Biggest Global Monetary Shock Since 2008

Scott Sumner is right. Brexit is the biggest global monetary shock since 2008. This could be the tipping point that turns the existing global slowdown of 2016 into a global recession. Here is why.

First, Brexit is adding further strength to an already overvalued dollar. The trade weighted dollar had appreciated roughly 25 percent between mid-2015 and early-2016. That is a very sharp increase in so short a time. It has come down some, but not much as seen in the figure below (red line):

The figure also shows that this sudden increase in the dollar is closely tied to the policy divergence between the Fed and the ECB (blue line). That is, as the Fed began talking up interest rate hikes in mid-2014 the ECB was talking up the easing of monetary policy. The rise in the blue line shows this policy divergence1

Brexit is now adding fuel to this dollar fire. The dollar has appreciated almost 4 percent since the Brexit fate became clear last evening, as seen in the figure below.

Why does a strengthening dollar matter? There are two reasons. First, over 40 percent of the world economy ties its currency to the dollar in some form. This can be seen in the figure below. That means when the dollar strengthens, these currencies strengthen too. This is the curse of the so called 'dollar block' countries--they import their monetary policy from abroad. Via this channel, Brexit has just further tightened monetary conditions in all these countries. This added pressure makes it likely China will be forced to devalue soon. And we saw how well that went last time it was tried.

The second reason the rising dollar matters is the rapid growth of what the BIS calls the 'parallel dollar system'. This is a system of dollar loans and dollar debt securities that has emerged outside the United States. This dollar credit to and from non-U.S. residents has tripled since 2000, while non-resident Euro and Yen financing has remained relatively stable. In fact, the dollar's share of this non-resident credit growth has increased from 62% to 75% according to BIS data. This means there is a lot of dollar-denominated debt outside the United States that is very vulnerable to dollar shocks. Brexit just increased the real debt burden of these borrowers. 

So between tightening monetary conditions for the  dollar bloc countries and increasing real debt burdens for all the non-resident issuers of dollar debt, the global economy has been hit with a large dollar shock. Put more crudely, the strong dollar noose that has been choking emerging economies since mid-2014 has now been complemented by the opening of  trap door on the gallows via Brexit. This makes the strangulation of global economy complete. 

A second reason Brexit might be pushing the global economy into a global recession is that it hastening the the frantic race to bottom on safe yields. As I noted in a recent post, yields on safe assets around the world have been going down since the demand for safe assets remain unmet. Given global capital markets this also means there is a race to the bottom on safe yields as noted by Caballero, Fahri, and Gourinchas (2016) :
In the open economy, the scarcity of safe assets spreads from one country to the other via the capital account. Net safe asset producers export these assets to net safe asset absorbers until interest rates are equalized across countries. As the global scarcity of safe assets intensifies, interest rates drop and capital flows increase to restore equilibrium in global and local safe asset markets. Once the ZLB is reached, output becomes the adjustment variable again. 
Brexit massively intensified this race to the bottom as seen in the the 10-year yield below. Incredibly, the yield fell from 1.74 to 1.43 this evening! Brexit, in other words, just jolted the demand for safe, liquid assets in a major way. 

This frantic race to the bottom of safe yields will eventually run up against the effective lower bound (ELB). When that happens something else will have to adjust. And that something is output, as noted by Caballero, Fahri, and Gourinchas (2016)

So there you have it. The world has been hit with a massive global monetary shock. And via dollar bloc countries, the parallel dollar system, and the shortage of safe asset problem this monetary shock may be what pushes an already slowing global economy into a global recession.

Will central bankers and finance ministries be ready for it? I hope so.

Update: For some soul searching on the why of Brexit, see my previous post.

1The blue line shows the spread between the 1-year US treasury rate and the 1-year Euro rate. Based on the expectation hypothesis, the 1-year interest rate approximately equals the expected average of short-term interest rates over the same horizon. Consequently, if 1-year rates are going up it implies short-term rates are expected to rise on average over the next year. The spread between the treasury and euro rates, then, reveals the expected divergence between the expected path of policy interest rates over the next year.