Monday, July 4, 2016

Brexit and long-term growth in the UK

A central tenet of those advocating that the UK remain in the EU has been that the UK economy would experience more robust growth within the EU that it would outside the EU, ostensibly because the UK trades extensively with EU member states, and this trade would be impaired permanently were the UK to leave the EU.

This view, or something similar, was ubiquitous throughout the debate. In fact, most proponents of the UK remaining in the EU didn't feel a need to provide any support for this argument. And even many people advocating that the UK should leave the EU didn't bother questioning this view. They often simply accepted that slower growth would result but concluded that this slower growth was a price worth paying for the competencies that would be reclaimed by the UK once it left the EU.

But is this view really so obvious?

Let's consider the thirty-four OECD member states as a set of countries with economic characteristics not too dissimilar from those of the UK economy. Over the past five years, the average annual real growth rate among these countries has been 1.56%. Of these, the average annual growth rate of the twenty-one countries that are also members of the EU was 1.01%, while the average annual growth rate of the thirteen non-EU member states was 2.45%. For comparison, the average annual growth rate of the fifteen OECD member states that are also part of EMU was 0.77%.

The impression is similar when the comparison uses ten years of data rather than five. In particular, the average annual growth rate of the thirty-four OECD countries over the past ten years has been 1.42%. Of these, the average annual growth rate for the EU member states was 0.90%, while the average annual growth rate for the non-EU member states was 2.27% Again, the subset of member states that were also part of EMU showed the worst performance, with an average annual growth rate of  0.70%.

Clearly, these comparisons are too simplistic to be used as the basis for an argument that the UK economy is likely to perform better outside of the EU than it would inside the EU. For example, this simple comparison doesn't take population growth into consideration, and it's well-known that many European countries have lower population growth rates than do countries in other parts of the world. On the other hand, with an EU unemployment rate of 8.8% (10.3% in the Eurozone), it seems implausible that European growth has been suffering due to a lack of available labor.

These simplistic comparisons also suffer from clear methodological issues. For example, it could be argued that average annual growth rates should be weighted by GDP or by population rather than using a simple, unweighted arithmetic average.

But the point of this simple comparison is not to persuade people that the UK economy is likely to grow more quickly outside the EU than inside. Rather, it's to suggest that we shouldn't simply accept the assertion that the UK economy will experience slower growth outside the EU. Given that average growth among OECD economies outside the EU has been better than average growth of OECD countries inside the EU over the past ten years, there's considerable room for skepticism here.

My view is that the relative performance of the UK economy outside the EU will depend largely on the choices made by the British people in the next few years. Already, Chancellor Osborne has indicated his intention to reduce the corporation tax rate in the UK to 15%, and this seems like an excellent start. Other key choices will involve the regulatory environment for financial services, which had been a traditional strength for the UK. And of course the new trade agreements negotiated with the EU will play an important role.

If the UK emphasizes its role as a leading global exporter of services (particularly financial services), I believe that increased trade with the US, China, India, and Africa can more than offset any reduction in trade with EU member states. And with a streamlined decision-making structure, the UK is in a position to institute another round of economic reforms that would build upon the reforms of the 1980s, helping to boost productivity beyond levels that otherwise could have been achieved within the EU.

Of course, there are some serious challenges ahead. In addition to resolving leadership issues in the Conservative party, the UK needs to negotiate its exit from the EU and new terms of trade with the EU. And then there are issues involving Scotland and Northern Ireland. Given these challenges, and particularly the associated uncertainty, I believe slower growth in the UK is virtually inevitable over the next few years.

But the simple statistics considered here give some reason for optimism that the UK economy can thrive outside the EU over the longer term, and my hope is that political leadership in the UK, with the support of the electorate, will use this opportunity to undertake a set of reforms that might not have been possible otherwise.

Sunday, July 3, 2016

Brexit and interest rates

I was asked a few days ago about my views on interest rates generally, and I thought I'd share my post-Brexit update.

My bullish view is based on my standard framework for thinking about nominal rates as being the sum of real rates and inflation compensation, which I consider in turn.

Real rates

The model I use for real rates is a straightforward consumption-based asset pricing model, standard in the finance literature. (See, for example, Consumption-Based Asset Pricing Models, by Rajnish Mehra.) In this framework, people allocate between consumption and investment each period so as to maximize their lifetime expected utility. One of the results is that real rates  in this framework are determined by three factors: time preference; consumption growth; and the demand for precautionary balances. 

Time preference: This is typically considered to be a slow-moving quantity based on inherent preferences.  In fact, the bigger changes over time in this component may come from demographic changes. For example, it's probably no coincidence that real rates in the US were high when the baby-boomers were just graduating from college, when time preference is thought to be relatively high. But this component probably moves too slowly to have much relevance in a market call over a standard investment horizon of a few months to a few years.

Consumption growth: People who expect their consumption opportunities to grow over time typically can improve their lifetime expected utility by engaging in consumption smoothing via borrowing and lending. Since consumption growth most often results from productivity growth, the productivity growth rate is the critical determinant for this component. Productivity growth in the West has been low relative to its own history and relative to other parts of the world, in part because of low rates of investment, particularly in long-lived assets such as structures. Given the considerable increase in uncertainty posed by Brexit (and by the upcoming US elections), I believe investment is likely to weaken further in most Western economies, exerting further downward pressure on productivity growth and therefore also on real interest rates.

Precautionary balances: When people perceive a need to increase precautionary balances, the increased saving typically exerts downward pressure on real rates, to clear the markets for savings and investment. My view is that Brexit represents a shock that will increase the demand for precautionary balances, in the UK but also in the rest of Europe. As a result, I believe this component will exert further downward pressure on real interest rates.

So overall, I expect real interest rates will decline further.

Inflation compensation

Inflation is notoriously difficult to model. But I'm generally persuaded by Milton Friedman's old adage that "inflation is caused by too much money chasing too few goods." Given my expectation that the UK is quite likely to experience a recession (or at least a quarter of negative growth) in the next few quarters, and my view that Europe is likely to experience at least a reduction in current growth rates (if not a recession), I don't believe either economy is going to be characterized by too much money chasing too few goods. 

We might make a case that inflation in the US may continue increasing, particularly given the state of the labor market. But inflation dynamics in open, integrated economies tend to be correlated, as per the graph below, so I'm reluctant to forecast a different outcome for inflation in the US. Further, with the labor force participation rate so low, I suspect there's more slack in the US labor market than would be suggested by the 4.7% unemployment rate.

Of course, it's not unusual for spot inflation and inflation compensation to move in different directions, as seen in the graph below, showing the USD 5Y5Y forward inflation swap rate along with US CPI YoY NSA. 

But note that the recent discrepancy has been for the inflation swap rate to decline relative to the spot inflation rate. My expectation is that a narrowing of this gap is likely to result disproportionately from a decrease in the spot inflation rate, given my views regarding growth in the largest segments of the Western economies.

So my expectation is that inflation compensation is likely to decline as well.

Nominal rates

Given my expectation that global real rates will decline and my expectation that inflation compensation in most Western markets will decline, my overall view is that nominal rates in most Western markets will decline, including in the US, the UK and the Eurozone.

Of course, there are clear risks to this view. For example, we could experience another oil price shock (more likely related to supply than to demand), which would result in an increase in the inflation component. It could be that labor markets in some of these regions are tighter than I appreciate, leading to an increase in unit labor costs (particularly given low productivity growth rates). And currency depreciations can cause temporary increases in inflation in some markets (eg, Sweden and the UK). For example, my central expectation is that spot inflation is likely to increase in the UK for a few quarters to a few years, depending on the timing and the extent of the depreciation of the the pound. But I don't believe that will affect the longer-dated inflation compensation components, and I expect the rally in Gilts will continue over the coming months.

Saturday, June 18, 2016

Demise of the Dots?

St Louis Fed President Bullard made news yesterday with the publication of a note titled, The St. Louis Fed’s New Characterization of the Outlook for the U.S. Economy, in which he argues for replacing the current FOMC notion of a long-run steady state with a regime-dependent policy framework. In particular, Bullard argues that FOMC member interest rate projections (the 'dot plots') have been consistent neither with market pricing nor with actual rate outcomes over time and that these projections should be replaced with a regime-dependent policy, in which policy is made under the assumption of indefinite regime persistence. In fact, Bullard declined to offer a long-run projection at the June 14-15 meeting, given his emphasis on this new framework.

In the media call coinciding with the release of his note, Bullard offered the view that inflation expectations likely would increase were his colleagues on the FOMC to adopt this framework, presumably because the policy rate that Bullard believes is appropriate for the current regime is only 0.63% -- well below the projections currently offered by his colleagues (and previously by Bullard) under the existing framework.

A key characteristic of Bullard's framework (mentioned four times in six pages of text) is the notion that economic regime switches are not forecastable. In fact, given the importance of this presumption in Bullard's argument, it's worth considering this concept in greater detail.

Nowhere in his note or the accompanying media call does Bullard define the sense in which he uses the term forecastable. But unless Bullard has some rather specific definition in mind, a reasonable presumption would be that regime switches could be characterized as forecastable if their associated states could be identified via observation and if the probability of entering those states could be quantified -- or at least characterized (eg, into high, medium, and low categories).

Bullard clearly believes regime shifts can be identified, since he includes in his note a schematic (in this case, a binomial tree) in which he not only lists these states but also illustrates the dependencies between the states. So Bullard's view that regime switches are not forecastable appears to rely on a view that it's not possible to characterize the probabilities of entering these regimes.

While I appreciate the empirical difficulty of estimating parameters of regime-switching models, particularly when the frequency of regime switches is low, this difficulty in and of itself doesn't prohibit the characterization of regime-switching probabilities. In this regard, I'm reminded of Phil Tetlock's research on forecasting, which for many years has involved asking a large sample of participants to associate probabilities with a wide variety of outcomes, most of which have no precedent. For example, one question currently being asked at Tetlock's web site involves the upcoming US Presidential election: Will an independent or third-party candidate win at least 5% of the popular vote? Probabilities offered for this question appear in graphical form going back to early April and have increased from roughly 5% at that time to 25% as of June 13.

As far as I'm aware, there's nothing preventing Bullard and his colleagues at the St Louis Fed from associating probabilities in a similar manner to the various regimes they identify for the economy. As a result, I don't see the inherent forecasting problem that appears so central to Bullard's argument. At a minimum, perhaps Bullard could simply engage Tetlock to organize an economic forecasting competition for the St Louis Fed.

Otherwise, I see two other economic problems with Bullard's argument. First, he argues that government bond yields in the current regime are subject to a large liquidity premium, which he estimates to be 137 bp. In the presence of such a large liquidity premium, presumably government bond yields in the market would be well below the yields that would prevail under the pure expectations hypothesis of interest rates. And in that case, one would expect market yields to be well below the interest rate projections offered by FOMC members. But of course this discrepancy is one of the factors motivating Bullard to dispense with the current framework. At a minimum, the discrepancy between FOMC member projections and actual market outcomes is less of a conundrum if the liquidity premium for government debt is as large as Bullard estimates.

Second, Bullard's estimate of this liquidity premium appears based in part on the notion that returns to capital in the economy more generally are not low and that this premium applies only to government bonds. In a footnote Bullard cites Ricardo Lagos' paper, Asset Prices and Liquidity in an Exchange Economy, but the data set used in this paper (at least in the working paper I've read) is not contemporary and therefore of limited use in characterizing the current situation.

More important, I suspect Bullard may be comparing ex post realized returns on equity and other forms of capital to ex ante expected returns implicit in government bond yields. For example, the realized return on many bond funds in recent years has been greater than the stated ex ante yields on the bonds, since these yields have been declining, resulting in capital appreciation of the bonds. Of course a similar effect is present with equities (ie, as the expected return of an equity declines, ceteris paribus, it's realized return increases).

Specific issues aside, an intriguing question is whether Bullard's attempt at leading the FOMC members away from their dot plots will be successful. My expectation is that Bullard won't persuade many of his colleagues on the FOMC to adopt his perspective, given the problems with his framework and the fact that some members of the FOMC (eg, Fischer) are formidable theoreticians

On the other hand, Bullard has a point in noting that actual market outcomes have been well below the FOMC projections since the advent of the dot plots. As FOMC communication policy continues to evolve, it's not hard to imagine the dots being replaced with something relying less on point estimates, such as the repo rate fan charts provided by the Riksbank. Alternatively, it's not to hard to envision the FOMC dispensing with the dot plots altogether in the next few years, given the repeated discrepancy between FOMC projections and actual market outcomes.

Finally, it's worth noting that Bullard's attempt to exert more intellectual leadership on the FOMC may be a sign that Yellen doesn't have as firm control over her FOMC as Bernanke and (especially) Greenspan did over their Committees. In particular, it's difficult to imagine anyone on the FOMC under Greenspan taking any action that could be interpreted as undermining the Chairman, such as failing to submit a long-run projection when requested. In this regard, it's also worth noting the efforts of Minneapolis Fed President (and recent gubernatorial candidate) Neel Kashkari to exert leadership on the Too Big to Fail issue, which appears to have bedeviled Yellen at times (eg, when questioned by Senator Warren during semi-annual appearances before the Senate Banking Committee.)

For now, Bullard appears to have created a slightly awkward situation, in which he'll be declining to offer a long-run projection while his colleagues continue to provide theirs. While I suspect this will have no discernible outcome on actual policy over the next few quarters, over time it may add to a sense of diminishing coordination among Committee members, with the FOMC operating increasingly like the MPC at the Bank of England. And in the meantime, it will be interesting to see the way Yellen and particularly Fischer respond to Bullard's proposal and the economic analysis on which it's based.

Wednesday, June 8, 2016

A stealth helicopter drop?

As growth in developed markets has remained lackluster, increasing attention has focused on monetary financing, with high-profile proponents including Willem Buiter and Aidar Turner.

Apart from the economic effectiveness of a helicopter drop, an important issue is whether the means for accomplishing the monetary financing are permissible in various jurisdictions. For example, writing in his Brookings blog, Bernanke offers that a People's QE "would certainly be illegal in most or all jurisdictions." And it's well-established that monetary financing is prohibited by EMU members states by Article 123 of the Treaty for the Functioning of the European Union. (See my earlier blog entry of 13-Nov-11 for more on this point.)

But in this respect, it's useful to consider the effect of a permanent increase in the money supply used to finance purchases of sovereign debt. From a 2013 interview, Michael Woodford addresses the relation between the helicopter drop and permanent QE:
It is possible for exactly the same equilibrium to be supported by a policy of either sort. On the one hand (traditional quantitative easing), one might increase the monetary base through a purchase of government bonds by the central bank, and commit to maintain the monetary base permanently at the higher level. On the other (‘helicopter money’), one might print new base money to finance a transfer to the public, and commit never to retire the newly issued money. Suppose that in either case, the path of government purchases is the same, and taxes are raised to the extent necessary to finance those purchases and to service the outstanding government debt, after transfers of the central bank’s seignorage income to the Treasury. Assuming the same size of permanent increase in the monetary base, the perfect foresight equilibrium is the same in both cases. Note that the fiscal consequences of the two policies are actually the same. Under the quantitative easing policy, the central bank acquires assets, but it rebates the interest paid on the government bonds back to the Treasury, so that the budgets of all parties are the same as if no government bonds were actually acquired, as is explicitly the case with helicopter money.
Woodford goes on to explain the critical role of public expectations:
The effects could be different if, in practice, the consequences for future policy were not perceived the same way by the public. Under quantitative easing, people might not expect the increase in the monetary base to be permanent – after all, it was not in the case of Japan’s quantitative easing policy in the period 2001-2006, and US and UK policymakers insist that the expansions of those central banks’ balance sheets won’t be permanent, either – and in that case, there is no reason for demand to increase. Perhaps in the case of helicopter money, it would be more likely that the intention to maintain a permanently higher monetary base would be believed. Also, in this case, the fact people get an immediate transfer should lead them to believe that they can afford to spend more, even if they don’t think about or understand the consequences of the change for future conditions, which is not true in the case of quantitative easing.
If the key criterion determining observational equivalence between helicopter money and quantitative easing is the perceived permanence of the latter, then the stage appears set for monetary financing to become a fait accompli merely by affecting public perceptions. And this could happen in one of two ways.

First, in permitted jurisdictions, central bankers could simply announce that principal and interest payments on sovereign holdings will be rolled over continually. In that case, taxpayers would perceive no budget constraint associated with the additional spending financed with printed money, and the proposition of Ricardian equivalence under rational expectations would no longer hold.

But there is a second way in which these public perceptions might change -- namely, taxpayers might simply adapt their expectations as central bankers reinforce the precedent of rolling over these bond purchases year after year. Already, the eventual reduction of the central bank balance sheet appears no longer to be on the agenda in many jurisdictions. Fiscal authorities, market participants, and financial journalists appear to have become inured to the prospect of elevated central bank balance sheets persisting indefinitely. And now that the Fed pays interest on reserves, it has severed the link between the supply of money market funds, the demand for such funds, and the price of these funds. The FOMC now can run a balance sheet policy independent of its rate policy, as has been the case with other central banks, such as the Bank of England and the ECB.

My sense is that it's rather unlikely that western central bankers will announce that their purchases of sovereign debt should be considered permanent, given the sensitivities involved. For example, in a speech earlier today before the German Institute for Economic Research in Berlin, French Central Bank Governor Fran├žois Villeroy de Galhau noted [emphasis his]:
I think that so-called “helicopter money” would bring more harm than good: we do not need it and it is not on the table.
However, it wouldn't surprise me if current large-scale, sovereign debt purchases remained on the balance sheets of the Federal Reserve, the Bank of England, the ECB, the Bank of Japan, the Riksbank, etc for a sufficiently long period for taxpayer expectations to adjust so as to consider the status quo as the new norm. In fact, it wouldn't surprise me if central bankers responded to the next downturn in the economic cycle by purchasing still more sovereign debt, in the name of fulfilling existing mandates.

The growing interest in helicopter money may become moot at some point, if central bank watchers come to view continual reinvestment of principal and interest as a permanent feature, In that case, there will be no need to fire up the metaphorical helicopters; central bankers would have achieved via stealth the monetary financing that otherwise would have involved a fractious debate -- and very likely a violation of legal protections in various jurisdictions.

Tuesday, June 7, 2016

Fischer on Woodford on Forward Guidance

As we approach next week's FOMC meeting, it's worth reflecting on comments Stanley Fischer offered a few weeks ago at a conference honoring Michael Woodford. On the topic of forward guidance, Fischer noted [emphasis mine]:
At the ZLB [zero lower bound], explicit forward guidance can potentially offset a lot of the distortion, by, in effect, reducing all interest rates across the maturity spectrum at least up to the time that policy changes. Indeed, as shown by Eggertson and Woodford (2003), optimal forward guidance should commit to maintain lower interest rates during the recovery than would otherwise have been warranted by economic conditions. Importantly, the appropriate commitment can be framed as a history dependent policy function responding only to the history of the price level and the output gap, in such a way that the impact on policy decisions of economic conditions at the lower bound continue, even as the economy recovers.
For further explanation , it's worth quoting from Eggertson and Woodford:
...the private sector must be convinced that the central bank will not conduct policy in a way that is purely forward-looking, i.e., taking account at each point in time only of the possible paths that the economy could follow from that date onward.
And from Woodford's influential 2012 Jackson Hole paper:
In the case of forward guidance, it has been tempting for central bankers to believe that they can affect financial conditions simply by offering forecasts of likely future policy, while not really tying their hands with regard to future policy decisions. But instead, I shall argue that the most effective form of forward guidance involves advance commitment to definite criteria for future policy decisions
Later in the same paper:
In practice, the most logical way to make such commitment achievable and credible is by publicly stating the commitment, in a way that is sufficiently unambiguous to make it embarrassing for policymakers to simply ignore the existence of the commitment when making decisions at a later time.
Now consider the language the FOMC has been using in this regard (from the 27-Apr-16 Statement):
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
Consistent with Woodford's analysis, FOMC members suggest the policy rate is likely to remain below long-run levels for some time. But they also inform us that policy depends on incoming data. Contrary to Woodford's advice, there's nothing history-dependent in FOMC guidance. This seems nothing more than a forecast of future economic conditions. And there's no obvious reason for market participants to believe FOMC members are particularly good at forecasting future economic conditions.

This raises a number of questions:
  1. Which form of forward guidance do FOMC members see as having been employed -- the innocuous forecasts about which Woodford warns, or the history-dependent version that requires keeping policy rates lower than they would be were FOMC members following a purely forward-looking policy?
  2. If the latter, do current FOMC members feel bound by policy commitments made by a previous FOMC?
  3. If current FOMC members do feel an obligation to follow a history-dependent policy, are they likely to honor this obligation -- or are they hoping that market participants have short memories and that any damage to their credibility would be relatively limited and short-lived?
  4. If they decide to follow a history-dependent policy, will they manage to communicate this effectively to market participants?
  5. And if they do follow a history-dependent policy, will they gain credibility in the eyes of market participants for maintaining a consistent commitment, or will they lose credibility with market participants for falling behind the curve?
My sense is that most FOMC members are either unaware or unappreciative of the distinction between history-dependent policy and purely forward-looking policy. And those that appreciate the distinction (eg, Fischer) probably believe most market participants are either unaware or unappreciative of the distinction. As a result, they probably perceive that their credibility is more likely to suffer in the event they allow themselves to get behind the curve than in the event that they fail to keep the policy rate lower than they would otherwise in order to maintain consistency with an earlier policy of forward guidance.

That's not to say that many of these members won't argue for a low-rate policy for other reasons. For example, given that the inflation rate has been below target for years, there are a number of reasons (eg, real debt burdens) that they might prefer a period of above-target inflation. But it seems unlikely that history-dependent forward guidance will feature among these reasons for keeping rates low.

Having said that, Fischer was quite explicit about history-dependent policy in the comments cited above. Could this be his way of "publicly stating the commitment, in a way that is sufficiently unambiguous to make it embarrassing for policymakers to simply ignore the existence of the commitment when making decisions at a later time?" And though Yellen's recent comments didn't include references to history-dependence, they did result in a re-evaluation among market participants about the likelihood of a further rate hike at next week's meeting.

Beyond this rate cycle, comments regarding forward guidance are important because they'll likely serve as precedent for policy the next time the zero lower bound is reached. And given the nature of the current recovery, it seems likely that the next recession, whenever it comes, will confront FOMC members yet again with the zero lower bound.