How deep would be the recent plunge in the stock market and how far the slowdown would last ?

On Wednesday, December 19, the Federal Reserve announced a 25 basis-point rate hike. In response, the Dow Jones Industrial Average and other major indexes tumbled. This development prompted several of my students to reach out, asking for an update on my July note, in which I had written:

“Based on theoretical considerations, the probability of a sharp economic slowdown has increased by an order of magnitude. There are reasons to believe that the short-term aggregate supply curve, as well as long-term potential output, have begun shifting to the right. At the same time, due to ‘borrowing from the future’ and the persistence of large budget deficits, aggregate demand is expected to shift leftward. The result would be the onset of recessionary forces whose amplitude could surpass those of the 2008–09 downturn.”

I must confess that last February—contrary to my broker’s advice—I decided to exit equities. As markets continued to climb, I had to endure his frequent complaints about my supposedly unwise decision. Yet in this note, I wish to reaffirm my argument: we are on the verge of a major and unsettling correction in the Dow, potentially down to the 14,000 level, which could herald the emergence of another financial crisis.

It should be emphasized, however, that markets rarely move in straight lines. Some short-term reversals of recent declines are to be expected, since—as the old saying goes—even a dead cat will bounce when dropped from a great height. More broadly, the economy may drift sideways for years, and we may well be facing a stagnating market through 2026, and perhaps beyond.

 

Dow Jones - 10 Year Daily Chart

To be sure, the Fed has been under scrutiny in recent months for its efforts to normalize monetary policy.  It had kept its benchmark interest rate anchored near zero for seven years, and in numerous occasions,   in these notes, we have discussed the futility and the risks of the QEs which have been exacerbating the global imbalances.   We have argued for a new global financial order based on a meaningful restructuring of global debts, and a fundamental rebalancing of the global imbalances.  Of course, we have been aware  that the Quantitative Easing policies (QEs) had provided some artificial support for the stock market, keeping it aloft, and we have been expecting that  with the onset of  Quantitative Tightening policies (QTs) we would  be seeing some opposite effects. However, these effects would pale in comparisons with the dramatic correction to be expected in response to  a rapidly deteriorating structural imbalances, associated with  high levels of governments and corporations debts, inflated central banks balance sheets, and trade conflicts.

It would be a misguided argument, drawn from a conventional stabilization policy analysis, to maintain that a correctly formulated set of QTs could somehow prevent the danger of the upcoming financial crisis. We  have argued that the impacts of conventional stabilization policies, including the unorthodox QEs and QTs  in a disequilibrium context, in which the equilibrium conditions in virtually all markets have been highly distorted, are not easily quantifiable. We have argued that the conventional methodology for calculating the output gap would be misleading in the current situation  in which, due to the prevailing  uncertainties, firms investment strategies  are focused on the utilization of contingent labour and contingent capital.

Unfortunately, the appearances, from time to time of,   quasi- equilibrium conditions, which have been local and highly unstable, have been misinterpreted by many analysts, including the policy makers, as the long-term global equilibrium. Although  such short-term equilibria, arising from agents' optimizations, under obstreperous QEs, had provided the illusive dynamics of a healthy growth, with the associated  increase in employment and consumer confidence, in reality they  were based on highly unstable supply and demand functions. Expectations of a soft-landing, in such a flimsy circumstances are a wishful thinking that always, and to a large extent,  aggravate  the severity of a crash. 

The Fed rate hike came in a background of  softening global growth,  relatively low inflation and  volatile stock market, with the monetary authority  expecting two more rate hikes in 2019,  as compared to their previous forward guidance of three increases next year.  Also, the Fed statement sounded  slightly more nervous, as it did not include  the qualifier 'some' in its previous statement, stating:

“The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”

Moreover, Chairman Jerome Powell said that he would keep reducing Fed's balance sheet by up to $50 billion per month. It should be noted that since the beginning  of the QT  process in October 2017, the Fed has trimmed its dangerously  inflated balance sheet by  a meager $365 billion to $4.14 trillion, relative to what is really needed, which is a virtually impossible to attain reduction of some $3 trillion.  According to the chairman:

“We thought carefully about how to normalize policy and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy to adjust to incoming data. I think that has been a good decision,”

Total Assets of the Federal Reserve ($million)

  

Year-on-year change in  the Federal Reserve balance sheet ($000)

 Some analysts were quick to blame President Trump for this sorry state of affairs. According to CNBC;

The end of 2018 makes clearer every day that the president himself represents a fundamental problem for America's economy and national security alike. Trump's erratic behavior and weak leadership have unsettled Wall Street and Washington alike — and there's every reason to expect things will get worse. :

While, I am not certainly a fan of president Trump's shenanigans and at times his irrational behaviour, nevertheless,  I find this kind of accusation bordering to nothing more than a cheapshot. On the other hand it is hard to understand  Treasury Secretary Steven Mnuchin's declaration on the weekend of December 22, that markets have enough liquidity for lending. Yes, it is true that according to Goldman and Sachs data the large Banks have now 39% more liquidity as compared to 2010, and the comparative rates for trust banks and regional banks in the US are 73% and 71% respectively. However, in  a world with close to $1.3 quadrillion of financial debt instruments, including derivatives, and a global GDP of close to $90 trillion these percentages would be meaningless, particularly  in the event of a major financial crisis, when the Fed balance sheet has increased close to 500 percent, and the US public debt has increased by about 63% over this time span.

The problem is that with the imminent appearance of a severe recession the policy makers may decide to resort to another round of QE, which unfortunately would be even more ineffective than the previous rounds. Furthermore, with the federal funds rate target at a range of 2.25 percent to 2.5 percent, the Fed will not simply have enough ammunition for an effective interest rate response. The fact is that the discussion about the level of neutral rate at this juncture is a red herring. Nobody  can predict the new long-term equilibrium conditions before the cleansing of all excesses.

Economic growth, has already exhibits a decline from its 4.2 percent rise in the second quarter, and it is clear that it will be slowing  dramatically in 2019, as not only the impacts of artificial boosters such as tax cuts and spending increases wanes, but more seriously as the global uncertainty that is flared up already, triggered by Brexit,  European financial situation, debt overhang in China, massive global corporate debt  and the trade war exerts its impact.  These impacts could be magnified by the rise of artificial intelligence-driven electronic trading as it accelerates  financial transactions, allowing them to be conducted across multiple markets at the same time. Thus, a possibility of an emerging sudden deflationary dynamics cannot be ruled out.

The European Saga

According to the European Financial Stability Review, November 2018;

The euro area financial stability environment has become more challenging since the publication of the previous Financial Stability Review in May. On the positive side, a growing economy and improved banking sector resilience have continued to support the financial stability environment in the euro area.

As for the Brexit, the Bank of England has already warned Britain would be tipped into a recession worse than the financial crisis in the event of a no-deal disorderly Brexit. The Bank's analysis of various EU withdrawal scenarios, shows that in the event of a disorderly Brexit, Britain's GDP could fall by 8%. The Bank of England has also investigated the impact of an stress scenario on the British financial institutions.  The scenario assumes, gross domestic product would fall by 4.7 per cent in the UK and 2.4 per cent worldwide, while residential property prices in the UK would fall by a third and the BoE’s base rate would rise to 4 per cent.

Under this relatively optimistic  scenario, British lenders would be able to withstand a global recession more severe than a disorderly Brexit.  The test indicates that British banks would be able to keep lending to customers even if there were a major financial crisis, while continuing to pay billions of pounds in fines and compensation to address wrongdoing.   “The test shows the UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the [2008] global financial crisis,” the BoE wrote in the introduction to the stress test results. Despite, the fact that the results appear to have been presented to appease the bickering Brexiteer politicians,  still  the Bank's efforts are more encouraging than those of the Fed, which perhaps being worry of provoking President Trump's wrath  has been resistant to conduct broad-based, macro stress tests on its systemically important financial institutions (sifis).

Some central bankers are more vocal with regard to their  concerns about the upcoming financial crisis. For instance,   Bank of France governor Francois Villeroy de Galhau  has stated: “To measure the global impact of shocks, we need in particular to have macro stress tests of liquidity, including for investment funds."   In France, where national debt is set to hit 98.7 percent of GDP in 2018, president Macron, who thought pursuing a Gerhard Schröder's type of more business-friendly reforms,  would be improving its long-run growth potential suddenly faced with the so-called ‘yellow vest’ protests. Outraged by his wage and welfare reducing policies, under a highly skewed distribution of income in favour of rich, Gilet June  protesters torched cars, attacked shop windows and clashed with police. The president was forced to deliver a much-watched mea culpa in mid-December to mollify protestors, and offered a handful of concessions; raising the minimum wage and slashing some taxes that would push next year’s fiscal deficit well beyond the EU-mandated threshold of 3.0% of GDP.  The French government has warned of slower economic growth as a result of the protests and Bruno Le Maire, the country's finance minister,  has stated that the current protests would cost France 0.1 percentage point of quarterly economic growth. France growth  rate was a meager 0.4 percent in the third quarter from the previous quarter.

With large French and German banks owning billions of Italian sovereign debt, including BNP Paribas  €9.8 billion, BPCE   €8.5 billion and Crédit Agricole €7.6 billion, at the end of 2017, the chronic financial problems of Italy is the prime trigger for a financial crisis that could spread across the EU. These problems include  Italy's huge accumulation of nonperforming loans on its banks’ balance sheets, amidst of the efforts by its populist government to spend money, that it doesn’t have, to improve the country's long lasting lethargic growth  Rome's debt is more than  €2 trillion and 131 percent of its GDP, the second highest in the EU after Greece.

And Finally China's Slowdown

In China a weaker credit growth, slowing global demand and higher U.S. tariffs on Chinese shipments  are affecting its investment and export prospects, and thus its GDP.  Her GDP growth slowed to 6.5 percent in the third quarter, the weakest pace since the global financial crisis, and with the recent data  showing softness in November factory output and retail sales, it is quite clear that the economy is already slowing down. China's official Purchasing Managers' Index (PMI)  fell to 50, from its previous level of 50.2. A reading below 50 indicates that an economy is contracting. The last time China saw a no-growth headline figure was in July 2016:

China's  domestic  economic imbalances are serious.  The country's regional banks are heavily incentivized to keep loss-making companies alive. To avoid  the appearance of  loan losses, the banks extend loans to zombie firms,  allowing them , in the short term, to maintain an illusion of profitability.  The asset quality of many banks  are quite poor, and  they rely heavily on interbank borrowing as source  of funding, which can dry up fast when it is most needed during a financial crisis. For instance,  according to  data from 244 Chinese lenders,  the share of deposits in total liabilities at regional banks fell from 73 per cent to 64 per cent between 2013 and 2017.   Once banks levering up through non-deposit sources, the cost of funds increases and the odds for an interest rate shock or a liquidity shock rise substantially.

The country's debt levels are soaring  from 140 percent of GDP in 2008 to more than 260 per cent now. Despite  four reductions to banks' reserve requirements, tax cuts and increased construction spending, lending remains tight and money supply now sits near record lows.

  

The evidence for the upcoming recession!

(c) Guity Novin

These posts have been interrupted for a number of reasons.  Nevertheless, I must add that, had  they continued uninterrupted their information contents would have been severely limited. This is  because  the election of President Trump and his unconventional approach to economic policies have introduced a paradigm shift, reducing substantially the signals-to -noise ratio of many economic models.  It should also be added that there were other unusual noise-creating events in Europe, including  Brexit, the financial situation in southern Europe; particularly with regard to the  Italian debt problem, and finally the geopolitical and trade tensions.

Many of these sources of uncertainty are still unresolved, but one has a bit of more clear perspective with regards to  their possible trajectories.  Of course, as many commentators have already mentioned the 4.1percent growth in the second quarter is just a one-quarter- performance of economic growth, and it is not reasonable  to consider it as signifying the emergence of an upward sloping economic trend.  In other words,  the growth may not be sustainable.

Of course,  the  global economy has gone  through a synchronized  recovery in its major economies, mainly stimulated by a very expansionary monetary policy -- that its adverse impacts are somehow disguised by the increased noise in the data.This note will argue that based on some theoretical guesses  the probability of a sharp economic slowdown has increased by an order of  magnitude. There are reasons to believe that the short-term aggregate supply curve and the long term potential have began to shift to the right, while because of "borrowing  from the future" and large budget deficit  the aggregate demand will shift to the left. The result would be the onset of recessionary forces that their amplitude  could be wider than the previous one in 2008-09.

Aggregate Short-run Supply and Long-run potentials have began to shift to the right:

A shift to the right of  the aggregate short-run supply curve is usually stemming from declines in costs of production, which are induced by technological progress.  However, the shift this time has its origin in some increased trade policy noise. In particular, the U.S. administration's protectionist trade policies including the proposed 10 percent tariff on $200 billion in Chinese goods,  and its predecessor of $50 billion of  tariffs on imports from China have disturbed the equilibrium conditions  in the associated markets, providing incentives for some entrepreneurs to enter into the markets to substitute the imported supply from China-- i.e.,   a shift of the short-term aggregate supply to the right.  This would have been positive had the Say's law that 'supply create its own demand'  would have been operative, which we would argue it wouldn't happen  in the current circumstances.

 A  50 per cent reduction in the value of imported goods from China last year, and the expected  retaliatory  measures by China  would, of course, be of major adverse consequences for employment and demand, which will be exacerbated by the increasing  production costs due to the imposition of tariffs -- more on the demand shift later in this article.

Furthermore, the rightward shift in the Short Run Aggregate Supply is enhanced by corporate tax cuts, which are also expected to simulate business spending on capital and equipment. In fact, companies have already started to invest again. Unfortunately, a well established prediction of the economic theory is that tariffs would distort the nature of such investments. This is because relative price signals would be sending wrong information about the prospects of goods that are relatively inferior, aginst the goods that would enhance the competitiveness of the economy. Thus investors invest in wrong projects, a mistake that many less-developed countries committed during 1950-60s. 

 It is easy to see that as a result of these capital expenditures, the long-term potential would transiently shift to the right.

A Shift of Aggregate Demand to the Left

  We have already mentioned some reasons for the expected leftward shift in the aggregate demand. However, the main force behind this expected shift would arise from  a necessarily drastic fiscal tightening in order to reduce the budget deficit, which according to the Congressional Budget Office estimates would be about $1tn over the next fiscal year. The uncertainty, unleashed by these cuts would, of course, exacerbate the consumer entrenchment and the leftward shift in aggregate demand,.

Both rational businesses and consumers, anticipating a rising prices due to tariffs have began to "borrow from future"  i.e., buying consumer and capital goods  before tariffs take effect and raise the prices of those goods. The halt of these purchases  during a fiscal tightening period would remove  their stabilizing effects and would aggravate  the uncertainty.

Of course, the impact of tariffs on prices in the short term would cause an upward movement along the aggregate demand curve which would be adding to the complexity of the  gauging  the magnitude of the leftward shift in  aggregate demand by policymakers.

Global Economy

According to World Bank forecasts global growth this year will reach 3.1 percent, as compared to about  3 percent rate for 2017. The growth is expected to be mainly concentrated in emerging economies, which will be rising to  4.5 percent  this year relative to 4.3 percent in 2017. This global growth pattern does not bode well for the sustainability of global growth,  as it emanates  from a greater sensitivity of emerging markets to advanced economies growth-- which itself is  a consequence of the export-led-growth strategies of these countries. This situation is exacerbated by the trade wars with China,  a country that would be unable to reduce her  burden of debt, now at about 260 percent of national output, with a shrinking global trade.

 Meanwhile, central banks need to refurbish their monetary policy instruments in order to be able to fight the upcoming recession. In other words they need to raise interest rate - for the ironic reason that this would enable them to reduce them by a sufficient amount that could provide  effective stimulus in a fight against the expected recession. Recall that the  current recovery has been fostered by the extraordinary monetary expansions of the Federal Reserve, ECB and Bank of Japan, which included negative interest rates via expansion of their balance sheets by purchase of risky  assets on a massive scale.

On the Reignition of a Global Banking Crisis: The Case of Deutsche Bank

The intensification of banking crisis signals at the end of September has created tumultuous conditions for the stability of the global economy.   Deutsche Bank's predicaments, with its worldwide interconnectedness and operational linkages  are aggravating   the  global financial imbalances and threatening the market toward a disorderly resolution. Expressing concerns about the precarious state of the European banking sector that stems from leveraging their equity capital since the inception of euro, in some cases by forty to one or more, we wrote on July 2015 that:

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”.

Then on February this year, after the global bank stocks crushed amid a selloff that erased more than $4 trillion from global equities, with shares of Goldman Sachs and Morgan Stanley dropping by close to 10 per cent  below their tangible book value,  French and German banks like Société Générale and Deutsche Bank seeing their shares fall by more than 10 per cent ,  Italian and Greek banks by 31 per cent  and 60 per cent  and Japanese banks by 36 per cent   we argued that  the legacy of sovereign debt crisis is still haunting the banking sector and wrote:

 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.

Indeed, share price of Deutsche Bank  that has had three massive re-capitalisations  since the financial crisis of 2008-09, and had passed the ECB's stress test this July, underwent a highly volatile session on September 30th, when its shares crashed by more than 7 per cent  in the US and Germany in the early hours of trading, after reports that some hedge funds were trimming their exposure to the bank. This was after Deutsche's share price had plummeted close to 30-year lows earlier in that week, when reports surfaced that the US Department of Justice intended to impose a $14 billion fine for mortgage-backed toxic security  in the run-up to the financial crisis. However, after an Agence France-Presse report that the bank was nearing a deal with  the U.S. authorities, to reduce its fine to $5.4 billion its share was partly recovered, trimming its year-to-date loss to a still-sizable 46 per cent.

Nevertheless, the volatility was a clear sign that market anxiety about  European economy has reached its  critical limit. This is in the context of a very fragile global economy, where the  distortionary impacts of QEs and negative interest rates together with costly Basel-III regulations  have reduced  financial institutions  earning prospects in a market where competitions by highly agile and low-cost fintech companies are becoming more aggressive. 

Deutsche Bank is the 12th largest bank in the world (8th largest non-Chinese bank) with a market valuation of about €67 billion, which operates in 70 countries. However, its balance sheet is contaminated by a massive amount of toxic assets, particularly concentrated in its investment banking unit, which constituted much of its earnings  before the financial crisis of 2008-09. The negative interest rate and financial regulations have fundamentally overturned its  traditional  business model. The bank  as a balance-sheet lender  tended to be heavily reliant on net interest income, but its net interest margins have been severely slashed as a result of ECB's negative interest rate policies, while at the same time the bank has been under pressure  to recapitalize in order to build a larger financial buffer. In a low growth environment with limited investment opportunities the bank,  like other European banks, has seen its profit margins being  plummeted  to  a record low.

More specifically, Deutsche Bank's $1.75 billion 6 per cent Additional Tier 1 bonds (AT1), known as contingent convertible capital instruments or CoCo bonds,  callable in 2022 became  under severe downward pressure when were bided at 69.55 cents on the euro, and when the US Department of Justice asked Deutsche to pay the aforementioned massive fine to settle an investigation into its selling of toxic mortgage-backed securities. This was lower than  February's sell-off low of 70.2 cents on the euro -- 83 cents earlier in September.

CoCo bonds with 6 per cent coupon

Chief executive  of Deutsche Bank, John Cryan, who  two days earlier in an interview with the German tabloid Bild   had stated that a capital increase was "currently not an issue" was forced to issue an statement on September 30th, highlighting  the bank's resilient financial position, emphasizing that it has an "extremely comfortable buffer" when it comes to liquidity. “There are forces now under way in the markets that want to weaken confidence in us,” he wrote. “Our job now is to ensure that this distorted perception does not more strongly influence our day-to-day business,” Cryan added. "At no time in the last two decades has Deutsche Bank been as safe as it is today," reporting that the bank's liquidity reserves amounted to more than 215 billion euros. As well, in a brief to journalists, Deutsche Bank pointed out that most of it's 200 derivatives-clearing clients had stayed with the bank, and that its recent risk management  efforts only affected the bank's sales and trading operations, and not areas such as corporate finance or transaction banking. Felix Hufeld, the head of Germany's financial regulator Bafin, told the Sunday edition of the "Frankfurter Allgemeine" newspaper: "I warn people not to let themselves be drawn into a kind of downward spiral of negative perception."

Nevertheless, the  alarming situation was aggravated when the German finance ministry refuted a report on the weekly newspaper Die Zeit that suggested the German government was working on a contingency plan for Deutsche Bank, which could include taking a government stake in the bank. It is of note that bank made a loss of €6.8 billion in 2015 and is expected to show another €1.6 billion loss this year. According to Reuters a Milan judge had on October 1st charged 13 people over questionable past derivative transactions by the Banca Monte dei Paschi di Siena, which six of them were former managers of Deutsche Bank.  It is noteworthy to recall that as we wrote, on August,  Monte dei Paschi was the only bank this summer that was reported insolvent in the European Banking Authority(EBA)'stress test, with a common equity tier one (CET1) ratio of -2.44 per cent, requiring emergency recapitalisation. It too has a balance sheet contaminated with massive amount of toxic debt.


Will  Deutsche Bank's crisis trigger  a  new global financial crisis?  Can the new crisis be  as severe as the 2008 that was triggered by the collapse  Lehman Brothers which created a deep freeze in credit markets?

Capital ratio versus regulator requirement (as of the second quarter '16)

Source: Credit Suisse, company data

Regional distribution of Deutsche Bank Share Ownership: in per cent year-end 2016

Source: IMF. Staff calculations based on the Diebold and Yilmaz (2014) methodology and daily equity returns from Oct. 11, 2007, to Feb. 26, 2016. Groupe BPCE and the Agricultural Bank of China (ABC) not included due to lack of public traded data and short sample size.

Contagion of Bank Share Prices  

 Reflecting the interconnectedness of banking sector, as the above chart indicates, there are strong correlations among the banks' share prices.   In fact, Goldman  Sachs  share prices,   despite the fact that  has been benefiting from a relatively stronger U.S. economy,  have been exhibiting somewhat strong correlations  with those of Credit Suisse  and Deutsche Bank  since August 2015. One also needs to be reminded that Deutsche Bank's recent crisis hit bank shares across Europe with Lloyds Banking group, Barclays and Royal Bank of Scotland all falling by more than 4 per cent per cent at the start of trading in London. Commerzbank, Germany's second-biggest lender, was down by nearly 6 per cent. Swiss, French and Italian banks were down by about the same amount.  Thus, should  anxiety takes over, and investors dump holdings indiscriminately, this interconnectedness has the potential to generate a massive tsunami that would be impossible for the overstretched central banks to fight against. Such financial tsunami would slush the value of even non-toxic assets on bank balance sheets, devastating even the more robust financial institutions. As Deutsche Bank with its massive size rely less heavily on its deposit-taking  activity and its earnings have been concentrated in its investment banking operations it is especially prone to reignite market anxiety.

The German officials , of course, have denied any attempt on a rescue plan to help Deutsche Bank, as new rules introduced to prevent misguided investments by large financial institutions prohibit taxpayer-financed bailouts. German  authorities have been quite vocal in their oppositions to relax   these regulations, spurning a recent rescue proposal by the Italian government, allowing them to inject public funds into the Italian banking system. Germans have been steadfast in criticizing  southern Europeans for the euro-zone financial crisis and admonishing them for their lack of fiscal discipline. Thus, after so many non-German European banks  being collapsed or drifted  into insolvency because of unavailability of public funds, it would be politically perilous to relax the rules to rescue their own bank.

Even if Deutsche Bank would not be the bank that would trigger  the next financial crisis, there are many other vulnerable banks that are also suffering from negative interest rates, high-cost regulations and competitions from fintech companies that could do so.  Some  of them like Barclays, Credit Suisse, Royal Bank of Scotland and UBS are also being investigated by the US Department of Justice for their roles in creating toxic  residential mortgage-backed securities. Should a hefty fine be imposed on them that would affect their share prices and the resulting  reverberations would almost certainly affects the share prices of those banks that have already agreed to pay a fine to settle allegations of misleading mortgage bond investors including  Goldman Sachs (more than $5 billion ), Wells Fargo  ( $1.2 billion), Bank of America ( almost $16.7 billion) and JPMorgan ($13 billion).


The seething financial crisis of course cannot be detached from the current tepid global productivity growth and lack of capital formation that have caused the global production possibility frontier to shrink. The deriving policy responses in the form of QEs and negative interest rates that have eroded the financial institutions profitability and altered the traditional  behavioral relationships in the  saving investment markets,  have created a vicious circle. Governments facing a shrinking tax revenue and rising expenditures are becoming more and more dependent on the banks purchasing their debt, and the banks become reliant on government to earn returns.   This is why recent  Standard and Poor’s data show that banks across the EU have been investing more heavily in government debt, increasing their exposures. In fact, Western European banks have more than doubled their holdings of their own governments’ debt from a low of €355 billion in September 2008 to €791 billion today. Such a massive exposures between states and financial institutions adversely affects the health of both. Against this backdrop, a German bailout of its largest bank would only exacerbate such a tendency.  Once again we repeat our suggested remedy.

The world urgently needs a global financial accord to cleanse the system of its toxic assets, realign currencies, and reestablish trade links. 

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 .