An Uneasy Truce In the Currency War and Bank of Japan's Policy Reboot

On September 21st the Bank of Japan (BOJ) plunged into a mission impossible kind of rebooting its monetary policy framework. The Bank switched to targeting the slope of yield curve, which sounded as if it overhauling more than three years of massive quantitative easing,  which did  very little to stimulate an economy that was stuck in the doldrums for more than two decades, yet in reality the mechanism to control the yield curve was the same as for the old policy.  While Governor Haruhiko Kuroda said the central bank will not hesitate to ease policy further, BOJ  did not force the rates further into the negative territory, and  announced that it wants to  keep rates steady at their current levels, which may indicate a temporary truce in the currency war among the central banks in order  to allow a smooth transition of the Chinese renminbi into the SDR reserve currency basket on October 1st. However,  the door is left open for the resumption of the war to weaken yen, if the Fed opts out again of the so-called normalisation policy in its December meeting.

The BOJ's press release read:

the Bank decided to introduce "QQE with Yield Curve Control" by strengthening the two previous policy frameworks (...). The new policy framework consists of two major components: the first is "yield curve control" in which the Bank will control short-term and long-term interest rates; and the second is an "inflation-overshooting commitment" in which the Bank commits itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of 2 percent and stays above the target in a stable manner. 

 The BOJ 's  unexpected  heterodox move to targeting yield curve, aiming  to maintain both the current short-term policy rate and the 10-year Japanese government bonds (JGBs) yield  at their current levels of minus 0.1 and  about zero per cent respectively, in conjunction with its modified ETFs purchase plan aimed at stimulating investment and growth is fraught with many perils. Not only this adventure would create more market distortions, but also adds to the prevailing uncertainty.   In order to mitigate the market anxiety, BOJ offered a nonbinding pledge of maintaining the current pace of the annual increase of  about 80 trillion yen  ($788 billion), -- which may  either  be too little or too large for achieving the zero per cent target yield for the 10-year JCB.  To wit, they may need to purchase more than the 80 trillion yen or to stop short of it, in order to achieve their target, depending on borrowers'  demand.

As for the Bank's inflation target, despite the fact that controlling the slope of the yield curve will most probably alter the transmission mechanism of the monetary policy and will introduce serious unintended consequences, the Bank announced its intention to exceed "the price stability target of 2 per cent", staying "above the target in a stable manner" by  the expansion of the monetary base.  It is, of course, unclear as how can  the BOJ engineer an inflationary process when, as a result of the global slowdown, the economy in all likelihood is heading towards a deep recession.

The desperate idea of controlling the yield curve and challenging the market forces was suggested by the former Fed chair Ben Bernanke  who wrote recently in his blog:

The Fed normally operates by influencing very short-term interest rates. However, we know that targeting rates for securities of longer durations is feasible, under some circumstances, since the Fed did it during World War II and the immediate postwar years. (...) Although the Fed’s pegs of 65 years ago were aimed at minimizing the cost of war finance, the same basic tool could be used today to advance the Fed’s macroeconomic objectives.  

Of course, the investment prospects were quite different from today's conditions of tepid demand and low productivity growth either during the war, when the American economy expanded at an unprecedented rate, war related demands directly consumed over one-third of the output of industry and the surge in productivity stemming from scientific and technological innovation more than doubled the corporate profitability; or in the period immediately after the war, with its the pent up demands, and productivity growth that benefitted from reconstruction activity and commercialization of numerous scientific and technological innovations during the war. Moreover,   the idea of manipulating the yield curve appears quite absurd from any theoretical perspectives of the term structure of interest rates, be it the liquidity premium theory, expectations hypothesis, preferred habitat theory, or market segmentation.

In general, yield  curve control like any other price control would distort the information content of prices, would generate distributional biases and would exacerbate the current feeble  level of capital formation.  Ironically, investigating the Operation Twist, launched in early 1961 by the incoming Kennedy Administration, that intended to manipulate the yield curve by raising  short-term rates while lowering, or at least not raising, long-term rates,  Bernanke,  Reinhart, and  Sack (2004) argued that if the financial pricing approximates the equilibrium, then trying to target  a ceiling on the long-term yields would be successful if those targets were  "broadly consistent with investor expectations about the future value of the policy rate." A condition that is hardly satisfied in today's situation of Japan. They wrote:

If investors doubted that rates would be kept low, this view would predict that the central bank would end up owning all or most of the targeted security. Moreover, even if large purchases of, say, a long-dated Treasury security were able to affect the yield on that security, the possibility exists that the yield on that security might become “disconnected” from the rest of the term structure and from private rates, thus reducing the economic impact of the policy.

Overall, the authors conclusion was that:

Operation Twist is widely viewed today as having been a failure, largely due to classic work by Modigliani and Sutch

Thus, it is surprising that in his recent commentary about the BOJ's move to yield curve targeting, Mr. Bernanke poses the question  "Is the BOJ’s switch to a long-term rate peg a good idea? "  and writes:

I think the announcements are good news overall, since they include a recommitment to the goal of ending deflation in Japan and the establishment of a new framework for pursuing that goal. As the BOJ noted explicitly, the Bank will now be able to cut either the short-term rate or its target for the longer-term JGB yield if future policy easing is needed. The follow-through will indeed be crucial: Japan has made significant progress toward ending deflation, but that progress could still be lost if the public questions the BOJ’s commitment to its inflation objective. The commitment to overshoot the inflation target will be constructive if it helps to kill market speculation that the BOJ was contemplating abandoning its fight.

 Of course, he reiterates his previous argument about the risk of pegging the long-term bond yields, which may cause a central bank's balance sheet to balloon, and states:

That risk is particularly acute if the peg is not credible—if market participants expect the peg to be abandoned in the near term, for example—because then bondholders will have a strong incentive to sell as quickly as possible. 

Surely,  because of its seriously harmful adverse selection effects,  it would be most rational for the agents to expect that the peg will be short lived.  Thus, it would be hard to imagine that the acute risk  identified by Mr. Bernanke would not be materialized.

Japan's  Evolution of Yield Curves 

It is interesting to note that investors are quite sensitive to the slope of the yield curve. In fact the reason yield curves are informationally rich stems from the ease that bond markets respond to maturity preferences as well as other market conditions. For instance, before the BOJ's announcement, as the above chart demonstrates, concerns over a possible change in the BOJ's monetary policy  caused  an upward shift in the country's  yield curve, as investors worried that the Bank's introduction of more risks along various maturities  would cause a decline in their prices, which may also have encouraged a large and abrupt exit of the other bondholders, similarly the downward shift of the curve relative to the end of 2015 was largely related to investors' concerns about the global slowdown after China's  stockmarket crash.

Japan's Government Bond  Yield Curve, Source MarketWatch 

Acknowledging the fact that an excessive decline and flattening of the yield curve , as were observed this summer, may have a negative impact on economic activity due to raising  uncertainty associated with financial stability,  the BOJ noted that  short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. However, it ignores the fact that by targeting various maturities it would alter the transmission mechanism and the nature of those impacts would change.

Evidently, the Bank hopes that  the link between the impact of interest rates and the shape of the yield curve would change favourably as firms explore new ways of raising funds such as issuing super-long-term corporate bonds, which presumably could offer higher yields to improve the business prospects for pension funds  and insurance companies. However, one should not discount the reasonable probability of an steeper yield curve arising from an adverse selection process, whereby the good businesses may judge the new policies as distortionary and thus exit the market, while riskier firms with poorer prospects would be crowded in.

Mr. Kuroda has acknowledged that the BOJ may introduce more fluctuations  in the bond market,  stating: "Now we have a yield curve control, the amount of bonds we buy could fluctuate." This, of course, would introduce an added source of uncertainty in the market, whereby the participants not only must try to decipher the price signals, but also must now predict the quality of the information of the policy makers and the nature their reaction.

Japan's Bank Lending

It is important to note that, as the above chart shows, despite BOJ's three years of ultra-loose policy  the Japanese  bank lending has remained stagnant over that period, mainly reflecting the prevailing global uncertainty.   It is not clear that  a wishful thinking about the ability to target the yield curve or to allow inflation to overshoot its 2 percent target will alter the bank lending, particularly  at a time when virtually all central banks' are experiencing a loss of policy effectiveness.

A key factor contributing to the recent lack of capital formation has been the distortionary impacts of BOJ's purchase of ETFs , at an annual rate of around 5.7 trillion yen ($56.12 billion), as part of its QQE program, which have been approximately  proportional to the ETF's market values of the three indexes: the Topix, the Nikkei 225 and the JPX Nikkei 400. As well,  300 billion yen of ETFs were committed to "supporting firms proactively investing in physical and human capital". This policy, as a matter of course, would arbitrarily discriminates in favour of the firms that are publicly traded against  those that are not, and the criteria of investing in physical and human capital raise the question as what expertise  the BOJ possesses in order to  assess and select these  investment. But apart from such problems,  the market was further distorted in favour of those firms registered in the Nikkei index, which is weighted by the price of individual stocks, compared to other indexes, such as the broader Topix, which are weighted by market capitalization.

The BOJ's  rebooting aimed at rectifying some of these distortions is utterly vexing. The Bank arbitrarily divides the 5.7 trillion yen into two parts, the first part, which  includes a $3.7 million yen would still  favour the purchase of the Nikkei-based ETFs over the other two aforementioned indexes. The second part includes the remaining 2.7 trillion yen that would be aimed only at funds tracking the Topix index. It is not clear  how these modification would improve the investment climate.

As the chart below demonstrates, despite a lack of productivity growth businesses have added markedly  to employment since 2012, indicating  that Japanese businesses, like their counterparts in the U.S. and Europe, have  also been  opting for intensive margin mode of of production, and instead of investing in capital formation were using more labour intensive technologies that would allow a greater use of contingent labour in a highly uncertain post-global-financial-crisis era.

Japan's Labour Productivity, and Employment

The problem is that BOJ's QE policy,  implemented over the 2001-06 period,   resulted in a drastic shrinkage of Japan's production possibility frontier because of its various  distortionary impacts, resulting in a prolonged stagnation of the  productivity growth, which  has caused the economy to stall. Haphazardly, similar to other central banks, the BOJ attributes its policy ineffectiveness to a fall in  the unobservable natural rate of interest, which  is supposed to have disguised the insufficient  size of the policy accommodation.  For Instance, in his 23 May 2016 speech  Mr Hiroshi Nakaso, Deputy Governor of the BOJ, has stated that:

 Japan's natural rate of interest had been falling due to the decline in the potential growth rate; at the same time, real interest rates remained high due to the zero lower bound on nominal short-term interest rates and the decline in inflation expectations. As a result, QE did not provide sufficiently accommodative financial conditions. 

A similar reasoning was used by the US Fed's chair, Ms. Yellen who on September 21st  invoked the specter of a falling neutral rate of interest, an unobservable variable, as the main  reason for why the current ultra-low policy rate is only modestly  accommodative, and thus does not justify a September rise in the policy rate, or in her words:

"With the federal funds rate modestly below the neutral rate, the current stance of monetary policy should be viewed as modestly accommodative, which is appropriate to foster further progress toward our objectives, 

and  in the same vein, the ECB  president, Mario Draghi,   using the term 'real return', defined as ''generated by the balance of saving and investment in the economy", instead of 'neutral' or 'natural'  has also used a similar argument in his May 2016 speech:

Over the past decades, however, we have seen long-term yields trending down in real terms as well, independent of the cyclical stance of monetary policy.  (...) The forces at play are fairly intuitive: if there is an excess of saving, then savers are competing with each other to find somebody willing to borrow their funds. That will drive interest rates lower. At the same time, if the economic return on investment has fallen, for instance due to lower productivity growth, then entrepreneurs will only be willing to borrow at commensurately lower rates. 

As we have argued in various posts in this forum, the Wicksellian natural rate is an equilibrium long-term concept that is irrelevant for the consideration of short term transitory dynamics in getting on toward a new equilibrium. In fact, this theoretical sloppiness  causes serious inconsistencies in the arguments  of  central banks that invoke this excuse. Hence,  the whole idea that the unobservable natural rate has declined is a non sequitur argument. In fact, a decline in the potential growth rate would be diminishing the size of the output gap which should be positive for the inflation and inflationary expectations. In a frictionless market the resulting real interest rate decline should induce capital formation and growth. In contrast, when there are uncertainty and policy distortions the investors will wait, producers would shift to intensive margin and therefore any speculation about the latent neutral rate in a disequilibrium state would be absurd.

What caused the Japanese lack of productivity growth, were the slow growth  of the 1990- 2005 period  and its associated lack of capital formation, resulting in a decline in Japan's growth potential by  the second half of the 2000's which was aggravated by the global financial crisis and inappropriate policy responses.The economy contracted severely and the year-on-year rate of  consumer price exhibited  deflationary tendencies. The decline in the capital formation and a shrinkage of Japan's production possibility frontier  triggered  a slowdown in Japan's productivity growth.

Japan's CPI Inflation and Core Inflation Rates

As the above chart shows, despite the BoJ’s large QE programme and negative interest rates , which have contributed to pushing the yields on about $13 trillion  of government debt globally below zero, the country is now slipping  back into deflation.

What about the currency wars? One may speculate, with some reasonable likelihood,  that perhaps there were a tacit understanding  among the US, Eurozone, Japan and China's authorities, in the recent G20 meetings, that  the near recessionary situation in China  and the prospects of renminbi devaluation, which on October 1st this year is supposed to become part of the new SDR basket of reserve currency,  warrant  a relatively less volatile exchange market. Thus,  the September inaction by the Fed,  the BOJ and the ECB would allow the US dollar not to appreciate and would help to maintain a less volatile currency markets,  which would buy some times for the China's monetary authority to deal with the country's economic slowdown. In this regard it is interesting to note that on September 22nd, the spokesman for the IMF, discussing the question of inclusion of renminbi in the SDR  has said:

[I]n the last 12 to 18 months there have been a lot of changes in the value of currencies or exchange rates (...) if the underlying  currencies are volatile, then the [SDR] basket will move more. It depends on how the currencies move against each other in the periods ahead. (...)

[I]n simple terms we look at the average exchange rate of the basket currency over the last three months that will end on September 30th, and that’s one determiner. The other is that the value of the SDR basket is unchanged as a result of the transition, and from that we can determine what currency amounts using those average exchange rates will give you the rates that the IMF Executive Board has decided. And that can only be determined on September 30th because we are using exchange rates that run all the way through September 30th. So that will be decided on September 30th.

US Dollar to Japan's Yen and to China's  Yuan Exchange Rate

To conclude, BOJ's policy shift toward yield targeting would create further economic distortions that would hamper growth. The BOJ may be  successful in influencing short-term bond yields into negative yields. But, as Governor Kuroda himself has admitted,   negative rates particularly hit the profit of financial institutions, while low long-term yields hurt some other businesses by forcing them to put aside more money for long-term pension obligations. All these indicate that the current truce in the currency war would be a short-lived one.

Bank of Japan's Monetary Policy Actions, Source: BOJ

Lurching Between Hope and Despair; Is a Chinese Hard Landing Inevitable?

China is  still grappling with spreading financial imbalances and trepidations arising from its distortionary  overextended export-led industrial structure that could result in severe socio-political challenges. Back in the July last year, this forum predicted  the continuous weakness in China’s stock markets and interpreted it as a leading sign of the troubles ahead for the China's real economy. We wrote the Chinese stock market crash : 

is providing leading signals about the direction of China’s economy and its medium term outlook. (...) The Chinese economy is badly distorted by following a lopsided export-led-growth model for far too long.

 A week later China’s stock market dropped by another 8 per cent, and  by January 14^th  this year, Shanghai index had dropped more than 20 per cent from its December high, which led George Soros to argue:

"The Chinese left it too long to address the changeover in the growth model that they have to adopt from — investment and export-led to domestic-led. So a hard landing is practically unavoidable," 

Obviously concerned about the fragile state of the economy, Chinese President Xi Jinping in his recent keynote speech in the G20 summit in Hangzhou  stated:

China’s reform has entered the deep water zone where tough challenges must be met. We have the resolve to make painful self-adjustments and tackle problems that have built up over many years, particularly underlying issues and entrenched interests and carry reform through to the end. We will continue to carry out supply-side structural reform, resolve major problems in economic development and improve the performance of the supply system by optimizing factors allocation and adjusting industrial structure. With these efforts, we can energize the market and achieve coordinated development. We will continue to explore new institutional mechanism, break through the resistance of vested interests, exercise law-based governance and better leverage both the decisive role of the market in resource allocation and the role of the government.

China's outdated and inefficient export-led model is the main source of its overcapacity, which is devouring a massive amount of the newly generated credit without an adequate pay-off. In fact, the bulk of the country's investment is undertaken by the local governments that have been the main source of a sharp surge in credit growth,  endorsed by the central authorities. The government has impelled provinces to issue massive volumes of new bonds, apparently to replace the more costly bank debt but in actuality has generated a marked increase in the public investment. As a result over the past 24 months China's domestic credit has expanded more than the corresponding amount in 2008-9, which was created to stimulate growth after the global financial crisis. However due to the 'adverse selection' problem, the newly generated credit has lost three-fourth of its effectiveness in generating growth. Meaning, to generate one yuan of additional GDP it now takes nearly four yuan of new borrowing relative to a slightly higher than one yuan of credit that was required before the financial crisis. 

 Mr Xi has acknowledged that economic reform is "crucial to maintaining medium-high rate of growth under the new normal", and that "China will take sure and firm steps in advancing reform and will not slow down its pace". However, reforms have been painfully slow, more specifically with regard to China's most pressing challenges i.e., state-owned enterprises (SOEs) that are burdened with excess capacity, and  the alarming level of debts. China's central government manages 111 companies. In addition, around 25,000 SOEs are managed by the local governments. Since the 1990s, SOEs have been consolidated through closures and mergers but this downsizing came to a halt in 2007-2008 when the government rolled out a stimulus programme to cushion the effects of the global financial crisis and finance went into factory constructions and equipment without the demand to meet this supply. Many of these enterprises are restrained by a massive debt burden, as an  estimated 40 per cent of new debt is used to service the existing loans, and a large number of firms' debt services are more than their earnings before tax.

Despit the fact that the reform of SOE is of high priority for the Chinese government, there has been little progress in gaining efficiency, reducing overcapacity and utilizing technological advances in these entities. In September 2015, China released  the long-delayed guidelines for reforming these firms that included introducing "mixed ownership" by bringing in private investment.  The main aims of guidelines are to improve the prospects for domestic growth and enhance the export competitiveness of its largest firms known as yangqi, that are inflicted by low productivity, weak balance sheet, and serious corruption.  However, "decisive results" are expected by 2020!

In a futile attempt to resuscitate the export-led model, Mr. Xi acknowledging the fact that  in today's globalized economy "countries are closely linked in their development and they all rise and fall together," and stressing the point that  "no country could seek development on its own."  However, global  expansionary policies have become ineffective and cannot generate demand for China's export-oriented industries. Mr. Xi argued:

The world economy is now in profound adjustments and moving along a twisted path to recovery. It stands at a crucial juncture where new growth drivers are taking the place of old ones. The dynamism provided by the last round of scientific and industrial revolution is waning while new impetus for growth is still in the making. Currently, protectionism is rising; global trade and investment are sluggish; the multilateral trading regime faces bottlenecks in development, and the emergence of various regional trade arrangements have led to fragmentation of rules.

As we have argued in this forum before, the new impetus for growth, stemming from  smart materials, internet of things, cloud computing,  Big Data , Nanotechnology and so on is huge. However, what hampers the growth is financial imbalances and the associated uncertainty that restrict private capital formation.   Based on the recent data it appears that China’s economy has grown close to  6.7 per cent  in the first half of 2016, mainly due to a sharp increase in credit. In August, China's total fixed-asset investment  grew 8.1 per cent  from the year before,  a rebound from July’s 3.9 per cent. Yet, growth was concentrated in investment by the SOEs, which grew 21.4 per cent in the first eight months of the year, offsetting a decelerating growth in the private  investment to  2.1 percent, over the same period. Thanks to credit growth and an ensuing speculatively-driven housing boom together with increased fiscal spending of 12.7 per cent China's factory output and retail sales grew faster than expected in August. However reflecting an expected sharp decline in private-sector fixed-asset investment, continued deleveraging and fragile global demand; the prospects for the upcoming quarters are now getting gloomier.

 Of course, a more than likely severe slowdown of world’s second-largest economy will have global consequences. China with its  biggest banking sector in the world that boasts an asset base of equivalent to 40 per cent of global GDP, its second largest stock market  that worths $6 trillion  and its third largest bond market, at $7.5 trillion is massively contributing to the global growth, and its slowdown would sharply exacerbate  the already fragile growth in a financially imbalanced world.  More specifically, an estimated 0.2 percentage points of the global growth would be wiped out as a result of direct impacts of each  one-percentage-point decline in Chinese GDP growth rate.  The indirect impacts  from a decline in international trade,  slowing of global growth, and increased uncertainty could  be  as large as 0.4 percentage points.  Thus, a slowdown of Chinese economy by 3 percentage points, to say 3.7 per cent in the coming quarters, would shave about 1.2 percentage points from the currently tepid global growth, i.e. would generate a global recession, which would be particularly devastating for commodity exporters around the world.

Unfortunately in his speech,  president  Xi did not mention that China’s debt-to-GDP ratio that has surged from 150 per cent to more than 260 per cent over the past decade. This is stemming from an unsustainable credit growth aimed at achieving  unrealistic high export-led growth targets that are based on specious economic models.  According to a statement by China's State Council the country's three government-owned banks i.e., the China Development Bank, the Export-Import Bank of China and the Agricultural Development Bank of China are instructed to expand credit to investment projects. According to Bloomberg these banks have raised a combined 3.4 trillion yuan ($509 billion) through bond sales and low-rate credit from the People’s Bank of China, and according to Economist

In the past year alone, China has spent nearly $200 billion to prop up the stock market; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country. 

China's  Annual GDP Growth Rate

Fixed Asset Investment Growth

China's Balance of Trade, $bn.

Clearly, the recent surge in credit growth and fiscal policy cannot be substituted for the normal market forces and soon the country will have to deal with the recessionary market impulses as the impacts of expansionary fiscal  policy vanish and as the authorities would inevitably refrain from credit expansionary policies due to their damaging "adverse selection" consequences, among them for instance  more than doubling of the non-performing loans   over the past two years which now stands at 5.5 per cent  of bank's total lending. China needs to tap into its enormous domestic consumption potentials through market forces. Chinese investments in export-led growth and its speculative investments in real estate market should be diverted into investments in health care, education and other personal services, utilities, transportation and communications. A robust domestically oriented sector would  provide supports for domestic manufacturing and related services. Perhaps the upcoming sharp deceleration would trigger a move toward this rebalancing of the economy.

World's 20 largest Economies -2015 E
Percentage share of total global nominal GDP in US$

Will the Fed raise rates this September? A question of fixed rule and method.

  

'' o ere, quae res nec modum habet neque consilium, ratione modoque tractari non volt, in amore haec sunt mala, bellum, pax rursum : haec si quis tempestatis prope ritu mobilia et caeca fluitantia sorte laboret reddere certa sibi, nihilo plus explicet ac si insanire paret certa ratione modoque."

 ' My master, a thing that admits of neither method nor sense cannot be handled by rule and method. In love inhere these evils—first war, then peace : things almost as fickle as the weather, shifting about by blind chance, and if one were to try to reduce them to fixed rule for himself, he would no more set them right than if he aimed at going mad by fixed rule and method.'  --     Horace, Satires

Global economic growth has been rapidly approaching a stagflation state with the inflationary pressures being concentrated on the asset prices. There are some staggering  $11.4 trillion of global sovereign debt, primarily in Europe and Japan, carrying negative yields, while in the U.S. yields are also getting very low. The market has become quite jittery, as we saw on September 9th, when participants reacted to some hawkish comments from the FOMC members and downloaded their positions causing a half trillion dollars decline in the value of equities.

Fears of an imminent rate rise were eased three days later after  Lael Brainard, a member of the Board of Governors of the Fed, urged “prudence” in removing the central bank’s accommodative policies. Reportedly, market had anxiously expected the usually dovish Ms. Brainard might deliver a hawkish speech recommending a rise in the Fed funds rate, that has been held in a range between 0.25 to 0.5 per cent  since December.

Overall, some FOMC members appear to feel little sense of urgency about raising rates because of the low inflation, while others seem to reckon that with the labor market gap being closed the extremely accommodative policy rate is no longer warranted. The truth is that both groups are looking at irrelevant indicators and the fact that inflation is holding below the Fed’s 2 per cent target or the unemployment rate  is at 4.9 per cent are disconnected from today's globally imbalanced economic conditions that have drastically altered the transmission mechanism of monetary policy in all the major advanced countries.

In her Jackson Hole lecture, Ms. Yellen  referred to the updated estimates from the model developed by Laubach and Williams (2003) that indicate that the real long-run neutral or "equilibrium" short-term interest rate in the United States is currently about 2-1/2 percentage points lower than it was on average in the 1980s and 1990. She also referenced to a papers by Holston, Laubach, and Williams (2016) that find similar declines in equilibrium rates for the euro area, Canada, and the United Kingdom  and attributed  these declines to factors like slower growth in the working-age populations of many countries, smaller productivity gains in the advanced economies, a decreased propensity to spend in the wake of the financial crises around the world since the late 1990s, and perhaps a paucity of attractive capital projects worldwide. As we have argued in the past the  neutral rate is a long-run equilibrium concept that cannot be applied to a short-run disequilibrium situation like today's.

Theoretically the neutral rate should be equal to the rate of growth of potential output, associated with the efficient production possibility frontier, and given the incredible technological advances it is hard to believe that the potential growth rate has declined because of slower growth in working -age population which on the supply side can easily be offset by the advances of robotics and AI technologies, and on the demand side by increased demand for a wide spectrum of new smart goods and services.  All other factors in her list are stemming from a shrinkage in the production possibility frontier due to the global financial imbalances that have generated a prolong and deep uncertainty and has adversely affected the global capital formation.  

Of course, the main reason for her  focusing on the neutral rate as Ms.Yellen has articulated is to answer the following question:

 Would an average federal funds rate of about 3 percent impair the Fed's ability to fight recessions? Based on the FOMC's behavior in past recessions, one might think that such a low interest rate could substantially impair policy effectiveness. 

Then, looking at the experiences of the past nine recessions, Ms. Yellen notes that:

the FOMC cut the federal funds rate by amounts ranging from about 3 percentage points to more than 10 percentage points. On average, the FOMC reduced rates by about 5-1/2 percentage points, which seems to suggest that the FOMC would face a shortfall of about 2-1/2 percentage points for dealing with an average-sized recession. 

However, she finds this simple comparison exaggerates the limitations on policy, since  a large portion of the rate cuts that subsequently occurred during these recessions represented the undoing of the earlier tight stance of monetary policy.  Thus she maintains that:

Of course, this situation could occur again in the future. But if it did, the federal funds rate at the onset of the recession would be well above its normal level, and the FOMC would be able to cut short-term interest rates by substantially more than 3 percentage points. 

So the main reason for the Fed's urge to raise the policy rate would be to push it above the normal level (that is supposed to be very low in the present time), so that in the event of the next recession the FOMC would be having enough room to respond by reducing it. Given that the next recession is almost upon us this introduces a bizarre and volatile policy response.Of course, if the transmission mechanism is broken then declines in the policy rate, no matter by what magnitude, would be ineffective as is witnessed in Japan and eurozone.

In August last year asking the same question about the possibility of Fed raising rates in September 2015 I wrote:

In my estimation Fed cannot risk raising rates in such  critical times and therefore it won't. A rising rate at current market conditions one month before October, that historically is associated with a stock market correction, could be the psychological trigger that would disturb the current fragile local equilibrium, pushing the US and the whole global system along a path towards instability and a full-fledged financial crisis exhibiting a collapse of investment, debt deflation, and thus leading to insolvent debtors and a weaker banking system – that would be 1937 all over again!

Had it not been for a marked  increase in  the prevailing uncertainty that has rendered  the decision of the Fed " almost as fickle as the weather, shifting about by blind chance",  as evinced by a lack of consensus among various FOMC's participants I  would have also reached for the very same conclusion again, i.e., the possibility of a September inaction this year.

Ms. Yellen, like Mr. Draghi, in her Jackson Hole lecture  implicitly maintained that the transmission mechanism of monetary policy has been working  well and that Fed's new unconventional policy tools have been effective. She maintained that the reason for the disappointingly slow growth rates has been related to various headwinds the economy faced in recent times. She stated:

In light of the slowness of the economic recovery, some have questioned the effectiveness of asset purchases and extended forward rate guidance. But this criticism fails to consider the unusual headwinds the economy faced after the crisis. Those headwinds included substantial household and business deleveraging, unfavorable demand shocks from abroad, a period of contractionary fiscal policy, and unusually tight credit, especially for housing.

Apart from the the fact that those headwinds should have been and could have been predicted by any decent model,  she did not mention the lack of capital formation, low productivity growth and a greater use of contingent capacity that have arose from the global financial imbalances.  Referencing  a study by Engen,  Laubach, and Reifschneider (2015)  Ms. Yellen argued that the Federal Reserve's forward guidance and asset purchase policies "have put appreciable downward pressure on long-term interest rates and, as a result, helped spur growth in demand for goods and services, lower the unemployment rate, and prevent inflation from falling further below our 2 percent objective." Obviously, if the model underlying the transmission mechanism have been outdated then one cannot rely on the inferences derived from a wrong model.

Nevertheless, many FOMC members, like Mr Kaplan the president  of the Dallas Fed, have acknowledged the fact that the world has become much more interconnected over the past several decades, and  global trade and financial markets  have expanded such that an economic deterioration  in one country can have  greater adverse effects on other economies. In other words, the parameters and the functional forms of economic models with regard to the trade of goods and services, capital flows,  labor market dynamics,  asset allocations  and global investment demand for “safe” assets have changed.  `In Mr Kaplan words:

Because financial markets trade in real time, market strains or other challenges in one market now have the potential to rapidly affect currency, debt and equity markets globally. We certainly saw the effects of this interconnectedness during the 2008–09 financial crisis. More recently, and on a much smaller scale, we saw how turmoil in currencies and local markets in certain countries in early 2016 helped lead to global market volatility and a rapid tightening of overall financial conditions.

Moreover, as we have argued in our previous post it is very hard to maintain the hypothesis that the transmission mechanism is still working

 in a market which agents,  in the optimization of their objective  functions, are able to take account of the possible policy actions.  In fact, the transmission mechanism has been disrupted at various critical connections precisely because of this ability and this is why the forecasting models that  central banks are using  are persistently overpredicting the economy's growth rates and why investors are reluctant to invest. 

A rise in interest rate will put upward pressures on the US dollar, reducing the American competitiveness in the global market, when many regions are engaged in currency wars to support their exports. Last year I was proved correct in my call that the Fed will not raise the interest rate in its September meetings. I also was correct in predicting that a December rise will destabilize markets after the new year's holidays. This year the case is even stronger because of the Brexit and because of the presidential election.  As I argued last year:

The Fed indeed has created a catch 22 situation; as higher rates are needed badly, but any action towards raising rates would be extremely destabilizing. This is why I have been calling for an emergency global finance conference similar to the Brussels conference that took place   between the 24th of September and the 8th of October 1920.  That international conference was called

“with a view to  studying the financial crisis and looking for the means of remedying it and mitigating the dangerous  consequences arising from it.”

In such a conference 3 key issues must be on the agenda (1.) a halt in the currency wars and  a move toward rationalizing  currency relationships based on the law of one price. (2.) A restructuring of the current unsustainable levels of debt  and (3.) a coordinated global fiscal policy to improve the international trade infrastructure .  

Mr. Draghi's Transmission Mechanism of Monetary Policy

The European Central Bank's Governing Council in its September meeting kept the monetary policy unchanged  leaving  the main refinancing rate at zero, the deposit rate at minus 0.4 per cent and asset purchases at 80 billion euros ($90 billion) a month. Following the familiar pattern of revising down the optimist projections by the IMF and other central banks, the ECB also lowered its growth forecast for 2017, to 1.6 per cent from 1.7 per cent and revised down its inflation forecast for 2016, to 1.2 per cent from 1.3 per cent.

In spite of negative interest rates and quantitative easing, eurozone's growth slowed to 0.3 per cent in the second quarter, from 0.5 per cent  in the first quarter, and headline inflation remained unchanged in August at 0.2 per cent, reflecting in part the lagged effects of oil prices. Furthermore, core, or underlying inflation rate that excludes energy, food, alcohol and tobacco was also lower, at 0.8 per cent in August, as compared to 0.9 per cent in the previous month.

ECB Balance Sheet, Total Assets €3,330,487 mn.

Euro Area Headline Inflation Rate

Euro Area Core Inflation Rate

Inflation has been close to zero since the late 2014 and in fact below 1 per cent since the late 2013. In other words, assuming an upward measurement error,  of the kind discussed by Bernanke and Mishkin (1997) and Camba-Mendez (2003),  of say 0.5 per cent, then one may maintain the hypothesis that eurozone has been very close to a deflationary mode over the past few quarters. The region grew by just 1.6 per cent in 2015 with much of the expansion deriving from the ECB's purchase of more than €1 trillion ($1.1 trillion) of securities so far,  which  has diminished bond yields to abnormally low levels.

While acknowledging that the current negative interest rate introduces challenges for the policy makers, Mr. Draghi suggested that:

Right now the transmission mechanism is really working very well. It's never worked better.

It is very hard to validate this assertion in a market which agents,  in the optimization of their objective  functions, are able to take account of the possible policy actions.  In fact, the transmission mechanism has been disrupted at various critical connections precisely because of this ability and this is why the forecasting models that  central banks are using  are persistently overpredicting the economy's growth rates and why investors are reluctant to invest.

The  ECB’s ability to stimulate aggregate demand by lowering interest rates and devaluing euro has been seriously undermined by the disruption in the transmission mechanism as bond holders prefer to hold on to their bonds despite the fact that an estimated 28 per cent of Eurozone bonds' yields are lower than the deposit rate and  52 per cent of its government bonds  are yielding negative returns. The comparable figures  for German bonds are  66 per cent  and about 85 percent.  Of course, part of the excess demand for bonds stems from the QE's rules that restrict the ECB purchases to  only one third of most bond issues and any bonds yielding less than minus 0.4 per cent.   The rules also restricts the scale of purchases in each country to the size of its economy in the eurozone. For instance in Germany this amounts to  a monthly purchase  of about  €10bn of government debt. Nevertheless, because of excess demand for the German government deb their prices have increased  and more than half  of the country's bonds are now yielding less than the  minus 0.4 per cent which excludes them from the QE.

Mr Draghi maintained that for the time being, the ECB's downward revisions are not substantial enough to warrant a change in policy, and despite the distortionary impacts of the negative interest rates and QE,  he asserted that these policies have been "very effective", since:

While in the previous time we had observed fragmentation and very subdued credit developments, now we can say fragmentation is over and credit is growing constantly.

Of course, credit may be growing constantly, but because of the adverse selection problem this growing credit is not channeled into most productive ventures that could expand the economy's efficient production frontier. As theory envisages the high-risk borrowers are flooding the supply side  of the bond markets while the high quality borrowers are leaving the market because of the increased risk. As a result of getting into this slippery slope  some are now  suggesting the possibility  that ECB, like Bank of Japan, may be forced to purchase stocks. Mr. Draghi  expressed his determination to provide more stimulus if needed and reported that the  bank has asked staff members  to re-evaluate the design of the QE program,  which may hint  to the possibility of a widening of the program to include equities in order to circumvent  the bond shortages.

One has to ponder on the equity-based QE policy's extreme distortionary risks -- e.g.,  how the ECB would  choose among the winners and losers in various sectors and in various countries or would the bank be able to purchase  the promising startups' stocks with high  productivity prospects when the market information is plagued with high levels of noise in this climate of global uncertainty, or would the ECB be focusing on stock purchase  of the Too-Big-To-Fail corporations with low productivity prospects?  The number of such questions would be incredibly large. In any event, eurozone growth is expected to flatline over the next several years like those of many other advanced economies.

 In fact, the ineffectiveness of the ECB's non-conventional policies is already evinced by a recent ECB working paper    that suggests  that in recent years inflation expectations in the eurozone have shown some signs of de-anchoring,  implying  a loss of ECB's credibility due to the lack of information content in its inflation forecasts that has caused the professional forecasters to ignore the bank's inflation targets in their inflation expectations formation. The authors write:

Continuous analysis of de-anchoring risks is crucial in monetary policy, especially in the current low inflation environment. Monetary policy credibility is built gradually over the years, but we cannot rule out the possibility that it may deteriorate quite rapidly. 

When analysing anchoring of inflation expectations, we also need to examine when the inflation target is expected to be reached. Risks of de-anchoring are potentially increasing, if the time when the target will be reached has been postponed in economic agents’ expectations. 

As we have argued in the past, the slowdown of growth and policy ineffectiveness are global phenomena stemming from the current global financial imbalances, currency wars, and a fragile banking system, that are being exacerbated by the QEs and other unconventional policies. The fact that German and French business sentiment fell unexpectedly in August, especially among manufacturers, is another sign of the ECB's loss of credibility to deal with this global predicament.  Even the ECB's resort  to the currency war  has resulted in an upward pressure on euro due to generating a current account surplus that cannot be offset by outflow of the scarce capital from the region, due to the fragility of its banking system.

Euro Area Productivity

As the above chart indicates, the eurozone productivity growth  has slowed markedly over the post-recession period. The ever-so-slight  positive slope in the trend productivity of the recent years  has been basically concentrated in countries like France and Italy which have experienced a rise in their unemployment rates, indicating that the recent unemployeds in these countries have been mostly among the least productive labourers.  

In contrast, productivity growth has been stagnating in Germany,  a fully-employed economy with balanced public finances and a surging current account surplus of 9 percent of GDP.  Registering 1.8 per cent annual growth rate  in the first half of this year, German economy is running almost one percentage point above its potential and is attracting  inflow of funds from the low productivity countries. German GDP growth in the second quarter was tepid 0.4 per cent, down from a 0.7 per cent  in the first quarter and its business investment exhibiting the same wait-and-see pattern as the rest of the advanced economies.

Despite this anaemic productivity growth Mr. Draghi's advice to Germany, an export-reliant country, is that it must increase its unit labour cost by allowing wages to increase. He suggested that:

Countries who have fiscal space should use it. Germany has fiscal space.

But in today's circumstances  Germany's fiscal space has to be used to increase the productivity of eurozone's pripheries, otherwise it will be adding to imbalances.  However, this would imply a centrally planned model which would be destined to failure.

German Productivity

French Productivity

Italian Productivity

German Unemployment rate

French Unemployment Rate

Italian Unemployment Rate

In August 2015 we argued here in this forum that:

Consistent with Ben Bernanke’s option price of waiting it would be quite rational for businesses to postpone their strategic investment plans at times of currency wars and global volatility, and focus instead on their contingent capacity limits. Thus, business surveys instead of picking up reports of capacity utilization rates relative to the long term capacity associated with the firm’s minimum long-term average costs would detect signals of capacity tightening due to delays in implementation of irreversible phases of investment. This observation can also be validated by indicators such as investment profile and productivity growth. Note that productivity growth — defined as the rate of change of output minus rate of change of hour worked — will rise when investors invest to expand the production possibility frontier which usually would  reduce their cost structure through adoption of new innovative technologies.

Last February we argued here that:

It appears that central banks have forgotten a number of basic macroeconomic facts; 

i. The liquidity demand will become inelastic around the potential output, and potential output itself shrinks when there is no capital formation and plenty of uncertainty. Moreover, reducing the interest rate cannot affect the growth rate of real output when aggregate demand becomes insensitive towards changes in the policy rate. The conventional theory suggests that the impact of increased liquidity should be translated in higher inflation rates. However, this could be the case if and only if the newly created liquidity can enter into the markets, via consumption and investment which is not the case in today’s economic environment. One can argue that in today’s economy either central Banks have lost their ability to create liquidity, or to the extent that they are able to do so firms’ change of behaviour has offset it. In other words the liquidity created by central banks is hoarded by firms. Businesses are not investing, because they do not see a sustained level of increased demand, and negative interest rates cannot force them to invest because they have invented new instruments and innovative tactics in order to hoard liquidity.

ii. If central banks are aiming at a currency war, to increase their market share of exports, they must have forgotten that these wars worsen the already highly toxic trade environment. In fact, this is the classic case of ‘fallacy of composition”

It appears that in his Brussels Economic Forum lecture, on June 2016,  Mr. Draghi was agreeing  with that kind of analysis  and correctly acknowledging that;

There is also emerging evidence that growing below potential for too long can erode that potential through its effect on productivity growth. When uncertainty is high, a “wait-and-see” attitude can cause the most productive firms not to expand as much as they would otherwise. (...) The cost of delay, then, is that labour and productivity suffer, and the output gap closes in the “wrong way” – instead of output rising towards potential, it is potential that falls towards current output.

The same idea of wait-and-see has been supported by John Cryan, the chief executive of Deutsche Bank, in a recent commentary published in Germany's Handelsblatt newspaper stating that:

"companies are holding back due to the ongoing uncertainty with investments and are rarely requesting loans."

This is  a clear sign of a disruption in transmission mechanism. Europe is sliding fast toward a deep recession.

On the discombobulating productivity growth slowdown

 In her  Jackson Hole lecture Ms. Yellen has stated:

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans' living standards.

As the following chart shows  labour productivity has been growing at a slower pace in recent years. Moreover,  according to the revised estimates by the US Labor Department nonfarm business productivity measured as the goods and services produced by American workers per hour, decreased at a 0.6 per cent seasonally adjusted annual rate in the second quarter. This was the sharpest year-on-year decline over the past three years.

US labor productivity in the nonfarm business sector

This  was also the third consecutive quarter of decline the longest slide in worker productivity since the late 1979. In terms of year-over-year change  labour productivity was down 0.4  per cent in the second quarter, the first annual decline in three years.

It is worth to remind ourselves that productivity is the denominator in the unit labour cost ratio, with the numerator being the real wage, meaning  higher productivity would increase the country's competitiveness by reducing the unit labour cost. When  prodctivity grows at the same pace as the real wage it offset the adverse impact of the latter on  a country's competitiveness in the export markets. Unit labor costs rose at a 4.3 per cent annual rate, a 2.6 per cent rise from a year ago, reflecting  in part a 1.1 per cent rise in real  hourly wage per hour in the second quarter.

The strong productivity growth exhibited in the chart in the late 1990s has been attributed to the investment surge in the information technology that resulted in a marked reduction of the unit labour cost, which  boosted the GDP growth.

The productivity slowdown of recent years, as we have persistently argued in this forum, emanates from the effects of the global financial imbalances and high levels of global indebtedness  that have caused high level of uncertainty, whereby  businesses  postpone their irreversible capital expenditures and shift to an intensive margin mode of production. As a result of weak investment the economy's production frontier has not expanded and thus productivity growth has shrunk. This is a global phenomenon , which has been affecting international trade, encouraging currency wars and  spreading  poverty. Lower production frontier and rising unit labour costs have also diminished corporate profits and has aggravated  the financial imbalances.

As we have argued in the past  a lower productivity arising from a prolonged shift towards intensive margin mode of production would lower the economy’s potential growth. Many central banks around the world have already lowered their expectations for future growth and interest rates, without acknowledging the high level of debts and a fragile financial system as the main culprit. The consequential  uncertainty acting as a barrier to capital formation has created a vicious circle towards a rapidly approaching stagflation.

We believe the  alternative hypothesis put forward to explain the  productivity slowdown cannot be maintained with a sufficient confidence. For instance, it is hard to believe that in spite of  the recent advances in high tech communication, smart materials,  Internet of Things, large scale sensor network applications,  Big Data, cloud computing, supply chains  so on and so forth a  secular trend  toward a more modest efficiency gains, as compared to past advances, has been emerged.

It is also difficult to maintain the hypothesis of errors in measurement of productivity when the global economy is clearly slowing down, and businesses are delaying their capital expenditure plans. In the US fixed nonresidential investment, which is comprises about twenty per cent the economy --  has declined for the past three quarters  and new orders for nondefense capital goods excluding aircraf has declined on a year-over-year basis almost continuously for the past year and a half.

The situation is not materially different in Europe and Asia. In fact, investments have exhibited the same pattern of decline as aggregate demand since the 2015. The situation has deteriorated fast since the early 2016. During the second quarter, total investments declined 3.4 percent from the year earlier, and subtracted 1.68 percentage points from the GDP growth.

As the following chart shows the total factor productivity, TFP, that captures the efficiency with which labor and capital are combined to generate output ,  over the past four quarters ending in the second quarter of 2016, has fell at a rate of minus 0.7 per cent while Utilization-adjusted Total Factor Productivity has fell at rate of minus 0.32 per cent. This is another  clear indication of a shift towards intensive margin mode of production. We have in the past examined other evidence in favour of uncertainty hypothesis deriving from financial imbalances and will not repeat the argument here again. Suffice to remind readers that a greater use of contingent labour in the current capacity planning by businesses has resulted in wages falling behind productivity growth.

Total Factor Productivity Rate (Four quarter per cent change in natural log) Source: FRBSF

Another evidence for greater use of contingent labor is the fact that in  addition to the officially reported 7.8 million people currently out of work, there are 8 million individuals in involuntary part-time jobs. Furthermore, there are the 2 million of long-term unemployed and another 2 million of virtually unemployable persons that their only hope for finding a job is through demand for contingent labour.

Getting some of these 16 million people back on the payrolls will require a major capital formation so as  generate a favourable shift in the aggregate labor demand which has been lacking. As well, the slowing international trade need to be boosted. It is of note that in the first six months of this year, the U.S. trade deficit was running at an annual rate of $712 billion. That negative trade balance accounts for 4 percent of the economy, and it is currently taking half a percentage point off the growth of the domestic demand. For aggregate demand to grow at a healthy pace the global financial markets need to return to equilibrium, excessive global debts have to be restructured, and currency wars must be ended.