Why Interest Rates Are So Inconceivably Low?

In a recent article in the Washington Post professor Larry Summers has argued that the fact that the U.S. 10- and 30-year interest rates reached all-time lows of 1.32 percent and 2.10 percent on July 6th this year, as well as the record-low 10-year interest rates in Germany, France, Switzerland and Australia reflect a heightened recognition of the importance of the “Secular Stagnation” risks. He wrote:

There is a growing sense that the world is demand-short — that the real interest rates necessary to equate investment and saving at full employment are very low and often may be unattainable given the bounds on nominal interest rate reductions. The result is very low long-term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future.

Thus, theoretically speaking, according to professor Summers the configurations of the supply and demand functions for investment funds now suggest a very low real interest rate  (most probably implying a negative rate at the full-employment level) which is unattainable due to the close-to-zero lower bound nominal rate. This argument as previously laid out by him and his co-authors Eggertsson and Mehrotra in Secular Stagnation in the Open Economy (NBER Working Paper No. 22172, April 2016) is based on Alvin Hansen’s idea of secular stagnation suggesting that:

the industrial world is plagued by an increasing propensity to save and a declining propensity to invest. The result is a declining equilibrium real interest rate, a tendency for lower bounds on interest rates to constrain their ability to find equilibrium levels, and a consequent persistence of inadequate demand leading to slow growth, sub-target inflation, and excessive non-employment.

Believing that the sluggish growth and low inflationary expectations are consequences of these low long-term real interest rates, Summers expresses concern that:

policymakers still have not made sufficiently radical adjustments in their worldview to reflect this new reality of a world where generating adequate nominal GDP growth is likely to be the primary macroeconomic policy challenge for the next decade.

But why there is an increase in global propensity to save? Are the interest rates providing relevant signals about the global saving propensity at the current sluggish economic environment? Moreover, what is the rationality for this bizarre economic agents' inter-temporal choice in such uncertain times? We note that Professor Summers' argument is grounded on the Swedish economist Knut Wicksell's thory of "Natural Interest Rate". Substituting the term "neutral rate" for the Wicksellian "natural rate" concept, he writes:

Secular stagnation occurs when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central-bank policies. At that point, desired levels of saving exceed desired levels of investment, leading to shortfalls in demand and stunted growth.

We note that the Wicksellian theory is a general equilibrium theory in which the financial rate of interest that borrowers actually pay must be equalized to the natural rate of interest that is determined by the marginal return on the fully employed real capital. If the financial rate is below the natural rate the demand for investment will rise as businesses can borrow at the lower financial rates and invest the funds into high-returning projects. However, the information signals that a Wicksellian paradigm could emit are not meant for a disequilibrium environment in which the real capital is underutilized and businesses are postponing investment in irreversible fixed capital and opt for waiting.

When due to the prevailing uncertainty businesses refrain from investment and when in their capacity planning they resort to utilizing contingent labour and capital instead of moving towards their long term minimum average cost capacity the Wicksellian equilibrium theory would be an inappropriate analytical framework.  In fact, the concept of the natural rate of interest in a disequilibrium environment would be an oxymoron. The low and negative interest rates, are the prices savers are willing to pay to have access to a relatively less risky liquidity in these uncertain times. The factors influencing such inter-temporal preference is derived from a risk aversion motive.

As we have argued in the past, the economic agents are concerned about the precarious state of the global finance, the banking frailties, the high levels of various global debts, and a fast spread of political uncertainty. The sluggish growth and lack of demand are the consequences of a very disorderly structural adjustment in a perilous financial environment in which the old rules of the game have been abandoned and no new rules have yet been established.

The low interest rate thus is an indication of market assessment of the growth rate of potential output. As the following chart from Quartz show we have been in this situation also in the depression of 1930's.

This blog has referred in the past:

 “ to the suggestions of the prominent Swedish economist Gustav Cassel who in Brussels conference had recommended a re-balancing of the world flow of funds based on Purchasing Power Parity. A Cassel type of PPP adjustment does not necessarily require a gold-standard regime. A return to a Purchasing Price Parity can be grounded on a composite index of industrial materials. This process would create a realistic correspondence between the nominal world of finance and the real world of goods and services. A global annual GDP of 75 trillion dollars does not need to be lubricated by 600 trillion dollars of toxic assets."

We have also emphasized a need for restructuring of global debt and a need for a new global Marshall-type plan.  We also reminded the readers that:

in the eve of the London conference of 1933, the British Prime Minister Ramsay Macdonald, who understood the significance of the need for a global restructuring to establish a global financial balance, opined that the conference might possibly save democracy from the world’s economic challenges.”

Will the Global Economy Survive the Brexit

  Pavel Constantin,  Romania, June 22, 2016 Caglecartoons.com,

UK's vote to become the first country to leave the EU, has the potential to start a motion that could unravel the post-war global financial structure and with it a deep plunging of the global growth. To be clear, the Brexit itself is not the culprit as we have argued before the global financial system has been in an extremely perilous situation over the past decade.

It is unfortunate that Brexit has happened in such  uncertain times when the US political situation is in such a precarious state  with the two highly  divisive presidential candidates; of whom one   is so out of touch with the global economic fundamentals that he constantly adds to the prevailing uncertainty by his uniformed and misguided policy statements and the other’s “extremely careless” use of a private email address and server has been mischievously exploited to render her as a completely ineffective leader, should she win the election. Meanwhile, the US economy is slowing down and a significantly higher dollar, partially reflecting the increased global risk, is exacerbating the global economic disorder.

In Asia, both China and Japan's economic and political situations leave a lot to be desired. A tepid global demand is intensifying the adverse impact of Brexit on Chinese exports at the time when the rise of dollar, vis-à-vis Europe’s currencies, may force China to react yet again by allowing a more rapid depreciation of its renminbi, which is scheduled to be included in the IMF’s basket of currencies making up the Special Drawing Right (SDR) effective October 1, 2016.  The country’s growth, after averaging almost 10 percent between 2006 and 2014, slowed to 6.8 percent in 2015 and it may slow to about 5.8 percent this year.   The  promised economic restructuring and the consolidation of inefficient state enterprises with chronic oversupply now appear of remote possibility, while the probabilities of political and social unrest should not be underestimated.

Japan’s economic malaise is also worsening and Abenomics appears dead after the Brexit.  A frightening fiscal debt level, a stagnant economy and an ineffective monetary policy with a damaging negative interest rate must now deal with the consequences of an appreciating yen against several currencies which will reduce its exports,   weigh heavily on its industrial sector’s earnings and undermine the country’s domestic investment prospects.

Of course, the brunt of the Brexit mishap will be felt mainly in Europe, and particularly in the UK where British pound has plunged to hit a record low of $1.28 since June 1985. The pound also fell to a near three-year low against the euro at €1.17. On the stock market, shares in domestic companies, such as supermarkets, housebuilders and banks, took the biggest hit on July 6^th after the Bank of England unveiled a four-point plan to cope with the Brexit crisis. With the economy dependent on his ability to act quickly, decisively and with full access to information, governor Carney provided a timely reassurance that “The bank can be expected to take whatever action is needed to promote monetary and financial stability, and as a consequence, support the real economy.” This was a reminiscent of the 2012 Mario Draghi’s pledge to do “whatever it takes” to save the euro, which has only been successful as far as it has postponed the day of reckoning for euro.   The bank of England has eased special capital requirements for banks, providing an estimated extra £150bn for lending, which would not be nearly enough to prevent the risk of a global contagion.

Of course, the answer to Brexit cannot be monetary policy.  The limits of central banking in Japan, Eurozone, and the US have already been observed. The answer to Brexit is not even in the hands of Europeans ( the UK included). The world global financial disorder requires an urgent restructuring to get rid of the global toxic debts, establishment of a purchasing-power-parity-based exchange rate system, and a Marshall-type plan to invest on global digital infrastructure, renewable energy, and eradication of poverty and diseases. Unfortunately, the world is faced with lack of credible and visionary leaders to push for such an agenda.   

On Currency Wars, Helicopter Money, and Negative interest Rates; "It's a Mad, Mad, Mad, Mad World!"

In its 1963 review of Stanley Keramer’s "It's a Mad, Mad, Mad, Mad World!", a film about a group of amusing characters fighting each other and ravaging the landscape over buried treasure, New York Times wrote:

It's a wonderfully crazy and colorful collection of "chase" comedy, so crowded with plot and people that it almost splits the seams of its huge Cinerama packing and its 3-hour-and-12-minute length. It's mad, as it says, with its profusion of so many stars, so many "names," playing leading to 5-second bit roles, that it seems to be a celebrities' parade. And it is also, for all its crackpot clowning and its racing and colliding of automobiles, a pretty severe satirizing of the money madness and motorized momentum of our age.

The piece is a fitting description of central banks’ engagement in the currency war over fragile global demand for exports where there have been no victors as economies remain ravaged and prospects get gloomier. The war that has been raging since 2010 has intensified this year, mainly because of the ineffectiveness of monetary policies’ in generating growth. Even though that global financial imbalances are responsible for various countries’ output and labour market gaps and large twine deficits policy makers are wishfully keeping their monetary stance extremely loose to perhaps gain the so-called “escape velocity” to break free of these predicaments.

Not surprisingly, “Currency war” is a desperate measure, which includes the bizarre negative interest rate that inflicts cruel horrors on pensioners, savers and fixed income earners. It is damaging Banks and insurance companies’ business models, and at a macro level it destroys and distorts market signals as well as market infrastructures.

In Japan, a covert currency war was declared by the newly elected government of Prime Minister Shinzo Abe at the end of 2012, when his government demanded that Bank of Japan should adopt a higher inflation rate target, to which the Bank obliged by its large-scale asset purchases. Subsequently, when the Greenback fell below 108 yen for the first time in 17 months on April 7th this year, Japan’s finance minister Taro Aso cautioned against a rapid rise in the yen, saying he would take necessary steps to offset “one-sided” moves in the currency market.

“A rapid move toward either yen rise or yen fall is not desirable. It is desirable that currencies are stable at levels that match the economy’s fundamentals. (…)

As the G20 confirms, excess volatility and disorderly moves in the exchange market hurts (economy), so we are watching currency moves with a sense of urgency. We will take necessary steps under certain circumstances,”

Aso warned. However, in the first quarter of this year, Aso's negative policy interest rates and the prospects of more intensified currency wars backfired and caused a sharp appreciation of the yen against the dollar and adversely affected the equity market.

On the other side of the Pacific, in her currency-war's battle cry on March 16th, the Federal Reserve chair, Janet Yellen, warned her counterparts at various central banks that in a world with highly integrated capital markets, monetary policy actions in any country will have spillover effects to other countries through exchange rates;

That’s true of our monetary policy, and it’s true of other countries’ monetary policies. In part, that shows up through movements in exchange rates, and those movements are a factor that any country needs to take into account in deciding what is the appropriate stance of monetary policy. So the fact that there are these linkages is an important factor in designing a monetary policy.

Hence, she implicitly served notice that she cannot ignore the adverse effects of the other central banks' policy moves on the U.S. economy and reiterated the Fed policy objective to maintain a weak dollar as a policy tool to insure against a growth slowdown, despite the fact that the US inflation is now virtually on the target. She noted that:

“Manufacturing and net exports have continued to be hard hit by slow global growth and the significant appreciation of the dollar since 2014. These same global developments have also weighed on business investment by limiting firms' expected sales, thereby reducing their demand for capital goods; partly as a result, recent indicators of capital spending and business sentiment have been lackluster.”

Consequently, Ms. Yellen left interest rates unchanged and signaled her resolve to fight currency wars by hinting at only two further contingent rate hikes this year relative to the effect that, heading into 2016, the market was pricing in four rate hikes. “Importantly”, she emphasized:

“this forecast is not a plan set in stone that will be carried out regardless of economic developments. Instead, monetary policy will, as always, respond to the economy’s twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals assigned to us by the Congress.”

In the ECB, Governor Mario Draghi has also manifested his determination to intensify his initial opening salvo of introducing QEs in March 2015, which at the time he said the effort would run at least until September 2016, with an initial value of 1.1 trillion euros. Then in December, he cut ECB’s deposit rate deeper into negative territory, arguing:

"We have the power to act. We have the determination to act. We have the commitment to act,"

He intensified the ECB barrage in this ruthless race to the bottom for currencies this March with a fresh round of monetary stimulus including pushing the Bank’s key deposit rate deeper into a historic negative territory of -0.4 per cent and stepping up the pace of quantitative easing (QE) from 60 billion euros to 80 billion euros a month. Moreover, he cut the Bank’s benchmark interest rate from 0.05 percent to an all-time low of 0 percent, while announcing plans to extend its bond-buying program to include corporate bonds as well as government bonds, in a futile effort to raise the Eurozone inflation rate in a recessionary environment.

Surprisingly, some market participants have interpreted Draghi’s move as “de-emphasizing the role that the exchange rate plays in easing financial conditions," not taking into consideration that most probably the higher euro level may have been caused by the collateral damage in the currency wars and not by Mr. Draghi’s statement that: “We don’t anticipate it will be necessary to reduce rates further,” which was interpreted by some as to mean a shift away from the "currency war" – i.e, the -0.4 percent will be the ECB's last rate cut in the negative territory.

Looking forward, it is reasonable to maintain the hypothesis that the euro will depreciate against the dollar when Mr. Draghi would realize that his offer of ceasefire has not been accepted and will be forced to do ‘whatever is needed’ again to prevent a depression.

What about Britain, where the central bank has left its key interest rate at a record low for seven years? The readers of this blog may recall that in August last year we raised concerns about the British economy’s pace of growth and productivity, cautioning:

The fact that growth in the UK productivity has been subdued in the past eight years is a clear indication that British investors are still quite hesitant to invest strategically to enhance competitiveness.

Furthermore, we argued that Britain’s moderate investment growth would not be sufficient for the needed restructuring and the crucially necessary enhancement of her competitiveness. Sure enough the recent data showed that Britain's industrial output -- which makes up 15 percent of Britain's economy -- shrank at 1.5 per cent, the fastest rate in more than three years over the three months to February and the trade deficit ballooned to its widest in eight years.

In fact Britain's National Institute of Economic and Social Research (NIESR) now estimates that the overall economic growth in the first three months of 2016 had almost halved to just 0.3 percent, which would be the weakest rate of growth since the end of 2012.

Since August, the British pound depreciated by 7 per cent, however this decline has not been engineered by the Bank of England. Recall that last August we wrote:

A participation in the current currency war, even when British pound has appreciated 20% on a trade-weighted basis since March 2013, would not be an option. As it would either worsen the public sector net borrowing, or further reduce the effectiveness of monetary policy, and exacerbating household high level of debt.

In fact,  the Sterling depretiation was driven mainly by the uncertainty associated with the BREXIT.

The Outlook

 Unfortunately, despite the ineffectiveness of unconventional policies in reviving the potential growth and productivity and the severe damages that these policies afflict on the market infrastructure and trade, Ms. Yellen has stated in her recent speech that;

Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy--specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.   

While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Her influential predecessor Mr. Bernanke has gone even further and in his recent blog has advocated Helicopter money:

I consider the merits of helicopter money as a (presumably last-resort) strategy for policymakers. I make two points. First, in theory at least, helicopter money could prove a valuable tool. In particular, it has the attractive feature that it should work even when more conventional monetary policies are ineffective and the initial level of government debt is high. However, second, as a practical matter, the use of helicopter money would involve some difficult issues of implementation. These include (1) the need to integrate the approach with standard monetary policy frameworks and (2) the challenge of achieving the necessary coordination between fiscal and monetary policymakers, without compromising central bank independence or long-run fiscal discipline. I propose some tentative solutions for these problems.

Apparently, Ms. Yellen, Mr. Bernanke and other central bankers do not believe in any intertemporal optimization, i.e., too much borrowing now only transfers consumption across time from the future toward present. This partly explains why currency wars, lower interest rates, and various QE programs have done little to restore growth.

Policy makers should realize how important the role of capital formation in the supply side is. They should realize that for a successful working of international trade currency values, like any other price signals, must be informative about their relative purchasing power, and these can only be discovered in transparent markets, where the fundamental relationships between financial assets and the real sectors are respected -- where the banks are healthy and tax payers are not on the hook for the rescue of Too-Big-to-Fail zombie banks.

Central Bankers' Weekend at Bernie's! Will the Shanghai's Ceasefire in Currency War hold?

Monetary authorities around the world are busily introducing ineffective policies that they hope would create growth. As a result the state of the global economy increasingly looks like approaching the instant when Wile E Coyote runs off a cliff, but keeps spinning his legs, unaware that an impending hard landing is practically unavoidable.  Actually, the unresponsive world economy can be represented by yet another illustrative allegory, the movie Weekend at Bernie's, where two financial professionals (a metaphor for the central bankers), who have discovered a large insurance fraud scam in their company (a metaphor for Too Big to Fail, QEs, or negative interest rates, etc.), are invited to a party at their boss’s beach house over Labor Day. Only when they get there, they discover that their boss Bernie (the global economy) is dead from what looks like a drug-overdose (the massive $225 trillion of debt, and $600 trillion of toxic assets.)  Instead of doing the right thing the two executives decide it better to pretend he’s still alive so they can keep partying! 

Like the young executives in Weekend at Bernie's central bankers around the world have been increasingly using unconventional policies to prop up the global economy, expecting to convince investors that their policies are working and hoping nobody would notice all the Bernie's vital signs have been extinguished, i.e., the transmission mechanism of monetary policy is shattered . The world’s largest four central banks bought assets worth $1.2 trillion in 2015, similar to the amounts purchased post-Lehman and during the 2013 euro-area crisis, with a very little impact on growth. Meanwhile, they are futilely waiting for cheaper oil impacts come to rescue and give a boost to the world economy.  The fact that growth has not yet accelerated after the collapse of oil prices is blamed on the lag structure of impacts and not on the prevailing global uncertainty about the outlook that has weighed seriously on financial markets.

Negative Interest Rates, and market Volatility 

Both the Bank of Japan and the European Central Bank cut rates further into negative territory this year, and both saw their currencies strengthen. This is largely because markets has started to realize that these prop ups are not able to revitalize the economy. Particularly, when in the words of Governor Carney in his G20 speech in Shanghai

 “Volatility has spilled over into corporate bond markets with US high-yield spreads at levels last seen during the euro-area crisis. The default rate implied by the US high-yield CDX index is more than double its long-run average. And sterling and US dollar investment grade corporate bond spreads are more than 75bp higher over the past year. "

That volatility has not disappeared, it will show up soon with Brexit referendum and in the meanwhile, after the latest Fed’s move, is morphed into more of exchange rate volatility.  

Business Fixed Investment, and Intensive Margin

While, the FOMC statement in March  reported that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months, it also noted that business fixed investment and net exports have been soft. Undeniably, the strong US job gains in the absence of strong fixed investment, contrary to Fed’s reading, cannot point to additional strengthening of the labor market. As we have repeatedly argued in the past the strong job gains have been mostly emanating from a greater business focus on intensive margin due to the prevailing uncertainty. An intensive margin implies that instead of investing on latest technology firms hire more labour and utilize their existing equipment capacity more intensely. The substitution of transitory labour intensive tactics ( such as introduction of extra production shifts for part-time workers) instead of committing to irreversible longer-term fixed-capital investment has been the main reason for increased use of contingent employment and weak wage growth.

   

By the mid-March, the experience of five consecutive weekly gain for various stock indexes including the Dow, S&P and Nasdaq created the impression that the recent weakness in markets is over.  Recall that the weakness has been observed since the Fed’s December interest rate rise.  Many market analysts were excited that an estimated loss of more than 6 trillion dollars since early January has been recovered, and  reported that their earlier  concerns about slowing global growth is now waning and the outlook for commodity prices has improved.  Nobody, mentioned any fundamental factors. Some attributed the recovery to a rather sharp rise in oil prices and expectations of higher US growth, despite the global slowdown.

High Debt, Banks' Non-performing Loans, and Shanghai's Accord

Yet these factors pale in significance when viewed against global debt, including the U.S. gross national debt  that according  to some estimates would reach a level of $24 trillion by 2020, or just over 100% of gross domestic product, which can surge to $27 trillion if Mr. Trump’s tax cuts are implemented, assuming, of course, that the global economy withstands the shock to international trade stemming from his anti-trade rhetoric. Similarly European sovereign and private debts are quite high while banks’ non-performing loans are disturbingly rising. These are fundamental factors which would not allow a return to a smooth normal growth path – even if policymakers are content with a slow growth trajectory. Wile E Coyote has now reached the edge of debt and QEs cliff.

Given the urgency of the moment, many of us expected that the G20’s February 25th meeting in Shanghai would come up with some fundamental agreement to rebalance the global economy,   would try to readjust  values of   various currencies by employing some version of Purchasing Power Parity, and would restructure  debts. It was hoped that such policies would rescue the banking sector before a full blown financial crisis set in.    Regrettably, once again the International Monetary Fund (IMF) did come up with an entirely inappropriate policy recommendation and instead of arguing for resolving the global financial imbalances, a restructuring of global debts, and an end to currency wars, argued for a coordinated stimulus program!   Fortunately, it was soundly rebuffed by both Germany and the United States.

Nevertheless, the flurry of erratic monetary policy announcements after the Shanghai meeting has led some to conclude that there must have been a secret Plaza type Accord in Shanghai to adjust exchange rates and create some semblance of truce in the currency wars. However, for that  hypothetical accord to be successful the necessary conditions are transparency and completeness, neither of which exist.  In other words the accord must deal with the astronomical global debt, and must provide a framework for the orderly currency readjustments.    All in all, though, judging from the inconsistency of various monetary policies it appears that a putative Shanghai accord, even if exits, would be ineffective and short lived.

  

This is evident from the ECB’s March 10th policy announcement of an array of new unconventional policies.  Mr. Draghi  cut the three official interest rates;   increased the volume of asset purchases; offered more generous terms on targeted longer-term refinancing operations, and introduced a liquidity facility for banks pegged to the quantity of loans on their balance sheet. Given the ineffectiveness of these measures, the only motive that may be detected  for their introduction is a hope for a further depreciation of euro. However, this tactical move in the current currency wars, backfired, as it has been the case for Japan. Both currencies appreciated instead of depreciating. 

Being oblivious to the longer-term damaging impacts of negative interest rates on the financial sector, and their  distortionary impacts on intertemporal preferences,  ECB  reduced euro area deposit rate further down into the negative zone (from -0.3 to -0.4) per cent.  As the chart below shows, it is hard to believe that this move will have any real impact on growth, or will cause a change in the provision of liquidity. The only impact would be on the expected slope of the yield curve of up to ten-year maturity, which now is expected to remain relatively flat for a longer period, exerting more damage to the already fragile banks’ balance sheet.

A flat yield curve removes the banks’ maturity transformation opportunities.  A bank’s ability of intermediation in the credit market, to transform short-term savings into long-term loans, is critically compromised  by the flat slope of the yield curve.  Thus, banks’ profitability is now seriously impaired. Long term rates are low because markets are anticipating a hard landing is inevitable.

In terms of helping the global economy the US Federal Reserves’ policy action on March 16th was not much different.   Ms. Yellen markedly revised the pace at which her bank expects to lift interest rates, justifying the revision by referring to global worries that could adversely impact America’s recovery. This was despite the fact that core inflation in the US, excluding the deflationary impact of lower oil prices, has now ticked up to 2.3 per cent, which is above target for headline inflation of 2 per cent.  Ms. Yellen has halved the number of rate increases that are expected for 2016 to two 25 basis points moves.

However, given our argument with regard to economy’s greater use of intensive margin, the inflation scenario is now much more complicated.   The use of intensive margin indicates a lower growth of the aggregate potential output, as investment for extensive margin is being delayed or abandoned. This would imply a lower non-accelerating inflationary rate of unemployment (NIRU).  A lower potential growth rate determined by an aggregate short-term cost function would cause inflation rate to pulsate in accordance with the on-off use of contingent factors of production. The impact of these bouts of inflation rate on the expected inflation could become a potent source of stagflation.

It is certainly true that the US is now worryingly more exposed to the global volatility.  The alleged surprise of those that consider the Fed’s mandate is to worry about the US inflation and unemployment, or that did not expect a greater Fed's sensitivity to the worldwide repercussions of US monetary policy decisions, is at best disingenuous. It is hard to believe that Fed is not using a structural model in which some forms of covered or uncovered interest rate parity relationships play an important role in determining the value of the US dollar against other currencies.  In other words, global events would impact the Fed’s policy rate setting via this channel, and then reverberate through the balance of trade. As soon as one uses a structural model with some interest parity conditions the sensitivity to global impacts would be a foregone  conclusion. 

Of course, Fed must be acutely aware that all over the world there are now over $7 trillion worth of bonds with negative yields. In other words both governments and banks are now being paid to borrow from the various central banks in the euro area, Japan, Sweden, Denmark, and Suisse.   This would elevate the already unsustainable   level of global debt. A hard landing is becoming even more devastating and painful, when banks are now more vulnerable, more exposed, and larger.   

On the Arrival of 70's Stagflation: It's like deja-vu, all over again!

The US Labor Department data on February 19th, showed core Consumer Price Index, which excludes the more volatile food and energy components, increased 0.3 percent in January, the biggest gain since August 2011. The annual core CPI advanced 2.2 percent, compared to the market expectations of 2.1 per cent, the largest rise since June 2012 and exceeded the 1.9 percent average annualized increase over the last 10 years.

This trend would get the Federal Reserve closer to its 2 percent target on the PCE inflation and together with a tightening labor market, provides some impetus for additional rate hikes. According to the minutes of Federal Reserve's January 26-27 policy meeting, policymakers still expected to raise rates and even discussed whether a hike was warranted in that month, but after a lengthy discussion on global risks they said tighter financial conditions may be "roughly equivalent" to further hikes!

It appears, that the U.S. economy is headed for stagflation. Clearly, Fed’s signals with regard to a need for early and modest action toward "normalizing" policy with the ultimate goal of staying ahead of the inflation curve is proving unhelpful and is adding to the current extraordinary uncertainty.  In brief, as we have argued before in this forum, businesses’ capacity planning horizon has shortened in recent times and this is one of the key contributing  causes of the emerging stagflation .

Firms' survival strategy is now determined by their optimization along their short-term cost functions, and this is evident from the lack of investment in capital formation. The reluctance to commit capital to irreversible fixed investment and waiting for uncertainty to abate, stemming from the prevailing global imbalances and their impacts on credits that are rooted in extraordinary amount of global debt overhangs, rising non-performing loans, slowdown in China, and oil price shocks are causing a decline in the potential GDP growth.

Firms caught in these circumstances have resorted  to contingency capital and labour planning to meet any conjectural increases in demand, and this is corroborated by a rise in part-time work and the stagnating wages. These effects are artificially reducing the official unemployment rate. It should be noted that these effects are exacerbating the Not-in-Labor-Force population problem, which based on BLS estimate is 12-times the number of “officially unemployed”, and is  expected to steadily rise.

The use of contingent workforce is increasingly widespread and rising particularly during these uncertain times. Firms use this short-term optimization tactic because it will provide extra flexibility and cut labour costs sharply, by eliminating the need to pay contractual fixed wages, benefits, sick days and vacation days, or overtime. Moreover, it isn’t necessary to withhold taxes, pension plan contributions, or employment insurance premiums and so on, and  payroll, benefits administration, and HR costs are also reduced.

 Although to our  knowledge, the literature on job search has not yet investigated the impact of a greater use of contingent workforce on regular-jobs’ search costs, it stands to reason  to expect that these costs must have risen markedly for the unemployed in particular. This is why many unemployed workers are deciding to provide their services through a temporary agency, or work as intermittent workers, “casual” workers, and other types of works without a standard employer-employee relationship, which are all referred to in the U.S. as “contingent workers”, and are playing a significant role in the stagnation part of the stagflation.

As well, all the needed ingredients are in place to create the inflation part of the stagflation, and in this regard Fed’s policies have become inconsequential from a stabilization policy perspective. Since a hypothetical rise in interest rate would intensify the stagnating part of the stagflation, and on the other hand a reducing interest rate would add to its inflationary part and simultaneously  would aggravate the prevailing macroeconomics’ imbalances.

The underlying reasons for the fact that inflation had remained weak in recent quarters have been articulated quite well by the Fed’s recent release;

“Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” 

In other words, because of the mathematics of calculating the annual inflation rate, those parts of the inflation weakness arising from impacts of lower oil price and lower import prices stemming from the US dollar appreciation, which are transitory and normally should be expected to disappear after a year would linger for a while, because of the fact that oil price declines have been staggered and have not occurred all at the same time, and thus  their adverse impacts on annual inflation rate may be enduring for more than one year. Nonetheless, sooner or later, they will disappear.

However, there is no danger of creating memories in the data, arising from the persistence of inflation weakness. Meaning inflation expectations would remain anchored. Obviously then, the inflationary pressures would be reinforced by the above mentioned  lower rate of potential GDP growth rate that would reduce the impact of the notional output gap (measured against the theoretical longer-term cost functions) .

 This stagflation could be exacerbated by the appreciation of the US dollar real effective exchange rate, which has been showing a trend, owing to a kind of currency wars, and a relatively safer haven quality of the US vis-à-vis other countries that entice the  inflow of capital. The February 17th data on the producer price inflation registering a 0.1 percent increase appear to suggest that this process is already started.

Will Banks survive this Minsky Moment?

The global financial imbalances have pushed the banking sector off the cliff edge. On February 11th after yet another volatile day in stock markets, bank stocks crushed amid a selloff that has erased more than $4 trillion from global equities this year -- another Minsky Moment is almost upon us. The global distress embraced industry's titans such as Goldman Sachs, Morgan Stanley, Société Générale, Deutsche Bank, Barclays and Credit Suisse among others. Shares of Goldman Sachs and Morgan Stanley, the two American equity-trading giants, dropped by close to 10% below their tangible book value, a theoretical gauge of how much of their worth they could salvage if liquidated.

American financial stocks are down by 19%. French and German banks like Société Générale and Deutsche Bank saw their shares fall by more than 10%, while Italian banks shares have plunged by 31% and those of Greek by an alarming 60%. The European banking shares have lost around 27 percent so far this year. The index of major banking shares in the UK at one point hit its lowest levels since the depths of the recession. Asian banks were also afflicted, for instance Japanese banks’ shares have dropped by 36% this year. The readers of this blog may recall that this outcome were consistently warned against in this forum. Indeed, in July 2015 we wrote:

While $107 billion dollar Greek debt to European banking sector appears manageable, even a rather modest money multiplier inflate that amount to a quite frightening level. In fact, since the inception of the euro in 2001, the German, French, and Dutch banks bought a huge amount of Greek, Portuguese, Spanish and Italian sovereign debts by leveraging their equity capital—this was European version of the US subprime mortgage fiasco. Thus, the balance sheets of these banks, levered up in some cases by forty to one or more, is in a very fragile state. The stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. In the words of a December 2014 BIS report, “ample monetary stimulus fueled investors' risk appetite and boosted a search for higher-yielding assets”.

We are witnessing another financial contagion, where initial deterioration in banks’ balance sheet resulting from a number of adverse shocks such as the oil market predicaments, China's slowdown, and currency wars are rapidly spreading and the risk quality of financial sector’s loans is plunging into a dark abyss. While market anxieties, reflected in increased intra-euro area spreads and higher term premia, were appearing somewhat abated by ECBs policies; it is now clear that its unconventional monetary policies are ineffective and incapable of correcting the fundamental fragilities.

The risk of low market liquidity has reappeared again with a vengeance. Confidence among large banks with respect to their ability to make markets must be collapsing. ECB like a number of other central banks had hoped that its asset purchase program would eventually support nominal growth and as a result banks’ profitability would be improving. It was assumed that by a simulated shrinkage of banks’ balance sheets and some regulatory improvements in various capital and leverage ratios the lingering post-Big-Recession challenges would be behind us.



However, as the above chart demonstrates shares in institutions from Goldman Sachs to Deutsche Bank have endured a serious slide. Central banks may be able to discount the fact that, as shown by Reinhart and Rogoff, at least in the United States, the ex post probability of being in a financial crisis era has been about 13 percent of the time since the country’s independence – i.e., once about every 8 years. However, they cannot deny that the recent intensification of banking stress as net interest margins are being disappeared under the low interest rate environment and flattening yield curves, has created a severe systemic risk. It is quite clear that the legacy of sovereign debt crisis is still haunting and stock of non-performing loans are on the rise proceeding from the plight of the oil and related services sectors, as well as the expected poor performance of companies that are adversely affected by the slowdown in China, or those that have invested heavily on luxury London real estates which hedge funds are beginning to short.

 For much of the last few years various central banks have been performing an extensive set of “stress testing” their balance sheets against a chain of purportedly worst-case economic scenarios, in order to identify which banks do not have sufficient capital to meet the hypothetical shocks, gauging the amount of recapitalisation the banks require. However, policy makers are well aware that no bank can survive these tests when confidence in the banking system has been shattered. As well, nobody knows how the structural parameters of the underlying models for these tests have changed in response to unconventional policies such as negative interest rates. In other words the results of these tests are at best unreliable. The same can be said of calculations that, for instance, show European banks are holding €700m worth of capital more than they were at the time of the last crisis and have disposed of their riskiest assets. These would be misleading if there is a crisis of cofience. Banks’ financial strength is under a question mark and the probabilities of large banks reporting large losses  are not trivial.

The crisis is not just concentrated on the banking sector, negative and very low interest rates are overturning the financial business models of pension funds and insurance companies that must constantly struggle to immunize their long-term liabilities (retirement, long-term disability, nursing home or other long-term care). They do this by financing at a comparable investment horizon with a sufficient yield, so that there would be no interest mismatch or duration conflict. However, now more than US$7 trillion in government bonds (mostly from Europe and Japan)  comes with negative yield, which have caused something of an existential crisis in the global life insurance industry. European regulators have warned that some major insurers may have to be bailed out if the crisis continues, where payout yields continue to outstrip returns in sovereign bonds.

 In the coming weeks we are going to witness more debilitating shocks from the emerging markets, including Saudi Arabia, Venezuela, Turkey, and Brazil. Italian and Greek banks are still fragile. The National Bank of Greece is down 94% this year. In just six weeks, this share has lost almost all of its market value. For many insolvency is just around the corner owing to low oil prices and policy extravaganza. The banking system is in dire need of recapitalization but it is not clear how can this be done? The new "bail-in" rules in Europe mean that senior bondholders and depositors with balances above the guarantee of €100,000 will have to help pay for it, which adds to stress. Of course, North American, and Asian countries will also contribute to various adverse shocks, as the global imbalances and risky balance sheets are interlinked and ubiquitous.

In these circumstances, Italy’s high level of non-performing loans is particularly troubling. Apologists argue that if Italy’s recovery can be sustained they should eventually start to come down, but this is a big if. The fact that over half of the riskiest loans of the country out of €200 billion are covered by special provisions is not particularly helpful. The “bailed in” rules, which have become fully operative for many European countries this year, can trigger a new wave of bankruptcies. As a sign of this many faceted domino effect, it is of note that Goldman Sachs and JP Morgan are now faced with large stakes in Italian oil services company Saipem following their completion of a €3.5 bn (£2.7 bn) share issue with prices that have been falling precipitously.

 The prospect that central banks in Europe and Japan will delve even lower into negative rate territory, and the likelihood that Federal Reserve abandoning its move to normalization are creating further uncertainty and contributing to a more volatile market. It is mind bugling that until now none of the US presidential candidates in the both parties’ presidential debates have not shown even a remote interest on discussing this ominous conditions. Meanwhile, European finance ministers who will meet at the end of February in Shanghai in China have decided to call on the Group of 20 biggest world economies to boost global economic growth. They still do not realize that the culprit is a broken financial structure and as Japan experience has demonstrated no amount of infrastructural investment by itself can create growth.

As we have argued before this crisis is aggravated by global illiquidity arising from sever distortion of credit markets and its incapacitating impacts on supply of bank credit. This illiquidity cannot be expunged unless and until a drastic global restructuring of the enormous global debt overhang is underway. In other words, a comprehensive global strategy is urgently needed which must encompass necessarily a readjustment in valuation of foreign exchange rates based on their purchasing power parity. Furthermore, a drastic overhaul of the operational environment is needed to stop the smothering effects of arbitrarily created rules and regulations that are creating distortionary arbitrage opportunities, moral hazards and adverse selection problems. In this respect, the so-called idiosyncratic tailored approaches would be the most perilous strategy, as no agency can claim to have an in-depth grasp of the various dimensions of the current global imbalances.

What is truly needed is a set of clear principle-based rules that would allow the market mechanisms to do their critical functions of price discovery and determine the efficient allocation of resources. The most important market principle in this approach is the resolution of the Too-Big-to-Fail. TBTF problem. However, a reintroducing of Glass-Steagall separations of businesses without other fundamental restructuring would only exacerbate the impacts of distortions. The main concern is not that banks may lose market share. As, undoubtedly, the “shadow banking” environment is also being affected by the scarcity of liquidity and will be contributing to the severity of the ongoing financial crisis. Other purported policy options such as various macroprudential regulations, “the swap push out rule”, “ring fence” banking activity, and “Volcker rule”, that are supposed to limit or ban TBTF firms’ are also inappropriate in the absence of a comprehensive structural overhaul of the system.

What will trigger the next global bust?

After the first of its eight regularly scheduled meetings for 2016 at the end of January the Fed’s FOMC declared that the U.S. economy lost momentum at the end of 2015. "Economic growth slowed late last year," its statement read, noting that the job market had improved. The positive information about the job market was intended to soften the blow of a disappointing growth. We have seen a similar pattern in the recent press releases of other central banks. It is of note that the February release of the U.S. employment data showed that the January unemployment rate was validating the Fed's median forecast for the long-run sustainable level of unemployment — or "full employment" at 4.9 per cent. But, does unemployment rate measure labor market strength?

As it has been argued before in this forum, the employment growth in the present conditions does not provide any useful information with regard to the vigour of economy, simply because it does not control for the greater reliance of the markets on the contingent labour. In other words, due to the prevailing uncertainty firms are shying away from investment and are aiming to utilize various tactical labour-intensive responses in order to satisfy the increased demand that they do not perceive to be sustainable over the medium to longer run. Thus, they rely on part-time workers to operate with existing machinery and equipment, introduce more overtime if necessary and lease used equipment – in short they are utilizing tactical contingent factors of production instead of investing strategically in productivity enhancing technology. By the same token the January rise in participation rate and wage rate are not reliable indicators of the labour market strength at this juncture.

All in all, the sense of panic in the global markets that has been observed since the start of the year, and was predicted in this blog last year, is well-founded. The world is getting much closer to another painful bust, not because of the slowdown in China and its $10 trillion economy, or the fact that the current so-called “recovery” has lasted for 28 quarters (as compared to the average post WW II of less than 20 quarters) or the current fragility of European and Japanese economies, but because of the global economic fundamentals that are afflicted alarmingly by the destructive effects of very low interest rates, exacerbated by other unconventional monetary policies, including QEs .

An increasing number of countries and regions are having negative rates; including Switzerland (-0.75%), Denmark (-0.65%), Sweden (-0.35%), ECB (-0.3%) and  Japan (-0.1%). Others, including the U.S. and Canada have talked about the possibility of moving toward adopting negative rates if the situation warrants. After fueling the expectations of interest rate hikes, in her latest communiqué Bank of England has shown a dovish inclination, with all nine members of the Monetary Policy Committee voting to keep rates on hold. While the U.K. markets now expect the Bank Rate, at 0.5 per cent for more than six years, to remain fixed until well into 2018. The February 4th Bank of England's quarterly Inflation Report, suggested markets expect a notional rate of 1.1 per cent by the start of 2019, while in November it reported that the market expected 1.1 per cent at the end of 2016, 1.7 per cent by the end of 2017 and 2.3 per cent by the end of 2018. Thus, one cannot rule out a negative interest rate in the UK by the mid-2017. The Bank of Japan that surprised markets by adopting negative interest rates at the end of January 2016, a move aimed at boosting a stumbling economic recovery and warding off deflation has maintained that it would cut rates further into negative territory if it needed to push borrowing costs even lower. It said the policy would continue as long as needed to achieve an inflation target of 2%.

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”.

In his Marjolin lecture, organised by the Deutsche Bundesbank, Frankfurt, on February 4th 2016, Mario Draghi, President of the ECB, touched upon some of the challenges faced by central banks. Perhaps somewhat optimistically he asserted that “Today, more than 60 years [after its inception,] monetary integration in the euro area is both complete and secure.” Be it as it may, he then divided the challenges into two categories; those “that are common to all central banks in advanced economies, which are linked to a global low inflation environment (read ‘ linked to a global anemic growth’)” and those “ that are special to [ECB] in the euro area”. As for the common challenges to all central banks in advanced economies, he formulated the most fundamental question as “can our price stability mandates still be delivered?” This, of course, is a sanitized way to express the concern about ever-increasing probability of the upcoming bust. He went on to say:

And in several of those economies, long-term inflation expectations, based on market prices, remain below our numerical definitions of price stability. That has led some to question whether it makes sense for central banks to pursue expansionary policies to meet their inflation objectives. Are they fighting a futile battle against forces beyond their control?

In other words, translated into a general equilibrium framework, Draghi's explanation may be reformulated to suggest that the economic growth rates in several advanced economies have remained below their equilibrium level, and this has led some to question the effectiveness of monetary policy to close their output gaps. Mr. Draghi then explored three causes of “too low inflation”, or what others have called secular stagnation.

I. The structural factors that cannot be addressed through domestic monetary stimulus. As a result, 2% inflation target is no longer realistic. Somewhat surprisingly, the conclusion from this line of argument according to ECB is that “Central banks should adjust their objectives downwards accordingly”.

It would have been nice if some references were offered for the reader to enable one to explore the logic of this conclusion. A more rational conclusion would be since monetary policy is ineffective to generate growth (and inflation) there is a need for other policies. In any event, Mr. Draghi, refers to Friedman's edict that “inflation is always, ultimately, a monetary phenomenon” and “It could thus always be controlled in the medium-term by a committed monetary authority”. However, this edict is based on two crucial assumptions that are violated in this uncertain times (a) the edict assumes that the level velocity of money remains fixed and (b) the level of potential output also remains unchanged over medium term. However, when due to uncertainty firms operate below their efficient production frontier and use contingent factors of production one cannot assume that the Fisher or Friedman quantity theory of money can still deliver the edict, as both velocity and potential output subside in response to the option price of waiting for uncertainty.

II. The positive global supply shocks eliminates the need for central banks reaction, as they can simply redefine the medium-term horizon and wait for inflation to hit the target.

Mr. Draghi correctly notes that “a succession of supply shocks, such as the steep falls in oil prices we have experienced recently can cause a downward adjustment of inflation expectations if central banks do nothing."  This is because  a positive supply shock would reduce the cost of production and exert downward pressures on inflation. Thus, a policy response in the form of lowering of interest rate and the resulting exchange rate depreciation would stimulate the aggregate demand, causing inflation to get back toward its target level and allowing the interest rate to return to its natural Wicksellian level, as well the exchange rate would return to its equilibrium PPP levels gradually.

However, Mr. Draghi discounts the argument that “central banks fighting disinflation are inhibited by the lower bound on interest rates”.

We now have plenty of evidence that, if we have the will to meet our objective, we have the instruments. As the ECB and others have demonstrated, the lower bound for policy rates, wherever it might be, is not at zero. And we have also shown how non-standard tools can be used to deliver monetary stimulus even without altering much the overnight rate, and produce equivalent effects. For example, the non-standard measures the ECB has taken since summer 2014 have produced a pass-through equivalent to a 100 basis point rate cut in “normal” conditions.

On this issue, of course, the jury is still out and it would be too soon to celebrate under a “mission accomplished” banner. These are not normal times when central banks credibility would allow them to stabilize a volatile situation, particularly when the volatility is caused by their own action. The fact that QEs have become successively less effective is a clear sign of the restraining impacts of a lower bound. Another sign is the slope of term structure of interest rates. The slope changes when longer-term interest rates do not respond to changes in the policy rate. The central banks’ balance sheets have become far too inflated for them to act as credible provider of contingent funds in central counterparty clearing mechanisms in these abnormal times. This adds to uncertainty and inhibits capital formation, which are direct consequences of the lower bound. The purging of the central banks QE-contaminated balance sheets would not be that easy, and their longer-term adverse impacts on finance are gradually but surely appearing on the medium-term horizon. In particular, the devastating impacts of these policies would exert themselves during the upcoming bust sometime over the next two years. Of course, a bust can be triggered much sooner for instance by a geopolitical shock, rising unrest by the unemployed European youth, or a natural disaster.

III. Central banks do more harm than good. “In particular, expansionary monetary policies at home lead to the accumulation of excessive foreign currency debt or asset price bubbles abroad, especially in emerging markets. And when these financial imbalances eventually unwind, it weakens global growth and only adds to global disinflation”. These imbalances are, of course, part of the concerns in this blog too. In addition to distortions created in emerging markets we are also worried about the sectoral distortions of these policies on domestic economies. Low interest rates are fueling housing bubbles, and hampering the investment in productivity growth.

In response to these concerns Mr. Draghi asks:

what would be the alternative? Would it help emerging markets if advanced economy central banks failed on their mandates? Would that be more likely to contribute to global growth? Clearly, the answer is no. The stability of large economies is vital to their trading partners and to the global economy, and diverting monetary policy away from that aim when our economies are still fragile would not be in their interest.

The problem is that there is no evidence that these policies have been contributing to stability or to a sustainable global growth. The systemic risk has been elevated stemming from a false sense of security, manufactured by central banks, that has given rise to moral hazards and adverse selection risk. However, the markets are not stupid and recent volatility is a clear indicator of such anxieties. The markets are waiting for a trigger to signal makets' bust and this time around no QEs will be capable of providing any help. We have suggested a way out of this predicament in our previous posts, based on Gustav Cassel recommendations of 1937 Brussels conference. That would be the alternative policy.