Williams v Summers: Half Full or Half Empty?

SF Federal Reserve President Williams last night delivered an interesting speech with the provocative title, Whither Inflation Targeting? A good portion of his speech echoed comments he made a few weeks ago, in Monetary Policy in a Low R-star World -- namely that the Fed could better fulfill its mandate under a modified monetary regime. But some of his comments pertained to the current policy decision and are worth considering further.

Williams starts by addressing employment, noting "a very strong labor market by any standard." Turning to inflation, he notes, "We’re not quite at our target yet, but the combination of fading transitory factors and a strong economy should help us get back to our 2 percent goal in the next year or two." In light of these views, Williams addresses the implication for rate policy, concluding, "...it makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later."

Contrast this with the views Larry Summers included in his comments yesterday. On employment, Summers noted, "Private sector GDP growth for the last year has averaged 1.3 percent a level that has since the 1960s always presaged recession." He continued, "Total work hours have over the last 6 months grown at nearly their slowest rate since early 2010." (I addressed this point in Is the US Near Maximum Employment?) As for inflation, Summers observed, "both market and survey measures of inflation expectations continue to decline."

What accounts for the discrepancy between the views of Williams and Summers? Is this simply a case of the glass being half full or half empty depending on one's perspective?

I believe the divergence in views can be explained in part by the divergence in their motives. As a current FOMC member, Williams shares Yellen's concern that the FOMC may not have sufficient room to reduce the IOER in response to the next recession, in which case the Fed would be subject to political pressure to expand the policy toolkit to include less traditional tools, such as negative interest rates and an expansion of assets available for purchase as part of the Fed's large scale asset purchase program. As we've discussed, various FOMC members appear uncomfortable with such tools -- hence the debate over the existing policy toolkit.

In contrast, I suspect Summers' best prospect for replacing Yellen as Fed Chair when her term expires in February 2018 is for the Fed to come under political pressure , without which there would be political pressure for Yellen's reappointment. More specifically, the Democratic party has moved considerably to the left since Summers was Treasury Secretary, and Summers needs to overcome critics such as Elizabeth Warren, who openly supported Yellen over Summers when the job was last available in 2013. By aggressively advocating a more dovish policy than Yellen, Summers may be positioning himself as an acceptable alternative to Yellen when the job is next available.

To be fair to both men, I suspect both genuinely believe in their respective positions. But people have a tendency to choose their beliefs to suit their interests, and I suspect Williams and Summers are as susceptible to this influence as are the rest of us.

Implications

The current incumbents on the FOMC have an interest in raising the policy rate ahead of the next recession to a level that would allow them to mount a sufficient response to the next recession with a combination of lower but positive IOER rates, forward guidance, and perhaps a modest increase in quantitative easing. As a result, I believe they'll make every effort to increase the IOER whenever the data permits -- and this includes financial market data (ie, asset prices). While I suspect the won't be able to hike as much as implied by the latest dot plot (or Yellens' fan chart), I imagine they will be able to hike more quickly than suggested by current market pricing -- particularly with the Oct16 Fed Funds futures contract currently at 99.565.

But in addition to the usual schism between hawks and doves, we're now seeing an increasingly active debate regarding the strategies and tactics with which the Fed pursues its mandate. On one side we have Yellen and David Reifschneider, deputy director of the division of research and statistics at the Board of Governors, who believe the Fed can continue targeting an inflation rate of 2% with its available tools. On the other hand, we have Williams, Olivier Blanchard, and others who believe the Fed should adopt a new strategy (such as a 4% inflation target or a switch to targeting nominal GDP) -- or at a minimum believe the Fed requires new tools, such as negative interest rates, in order to successfully pursue its objectives.

The problem for the market is the uncertainty that this open debate engenders. Williams argues that now is the the time to reconsider these strategies and tactics, given the current performance of the economy. But the market is facing considerable uncertainties already, including a change of administration in the US, Brexit, a constitutional referendum in Italy this November, elections in Germany and France next year, and a review of monetary policy In Japan.

As seen in the graph below, volatility in the rates and equity markets is already low by historical standards. It's difficult to see volatility remaining this low given the events on the calendar -- let alone a reappraisal and reimplementation of monetary policy strategies and tools at the Fed. My sense is that the growing debate over monetary policy at the Fed -- and elsewhere -- will only add to financial market volatility in coming quarters.

Summers on the Fed's Toolbox

Larry Summers posted an excellent blog entry today, titled The Fed’s complacency about its current toolbox is unwarranted. The central message is clear from this title, but it's well worth considering his arguments in some detail, as they help clarify some of the market implications of upcoming policy decisions.

The crux of Summers' argument is a refutation of the most influential paper at Jackson Hole that wasn't on the agenda -- David Reifschneider's aptly titled, Gauging the Ability of the FOMC to Respond to Future Recessions, upon which Yellen drew heavily in her Jackson Hole speech, The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future. In general, Summers takes strong issue with Reifschneider's conclusion (shared by Yellen) that the Fed has ample tools with which to address the next recession. More specifically, he offers five specific critiques worth considering.

Summers' five critiques of Reifschneider's analysis

Summers' first critique is a response to Reifschneider's reliance on the Fed's FRB/US model rather than on empirical observation of the actual economy. In particular Summers advises:

"distrust conclusions reached primarily on the basis of model results.  Models are estimated or parameterized on the basis of historical data.  They can be expected to go wrong whenever the world changes in important ways."

I've made this point repeatedly myself and believe Summers' concern is appropriate in this case.

Summers continues by questioning Reifschneider's assumption that the IOER will increase to 3% before the onset of the next recession. Again, I've made similar arguments, in particular that market-based measures of inflation expectations are unlikely to increase toward their recent averages before the start of the next recession.

Summers' third critique is that Reifschneider is too dismissive of his finding that Fed policy will not fare as well given the zero lower bound under the assumption that the Fed will adopt an optimal control policy rather than a Taylor-style rule. While this is an interesting point, it's quite technical, and the Fed hasn't made any clear announcements that it's following an optimal control policy.

I have considerable sympathy with Summers' fourth critique:

"I suspect that prevailing views at the Fed about the efficacy of QE and forward guidance substantially exaggerate their likely impact. I don’t think the Fed has taken on board the lesson of the three year period since QE ended.  If longer term rates had risen after QE and forward guidance ended, this would surely have been taken as further evidence of their potency.  It follows that the fact that term spreads have fallen substantially since the end of unconventional policy ... should lead to more skepticism about their efficacy."

Again, I've made this point repeatedly, including in a recent blog post, Yellen at Jackson Hole. But Summers makes an additional, insightful observation about the net effects of QE, increased issuance by the Treasury, and the skewing of issuance toward longer maturities. In particular, Summers refers to work he published as a Brookings paper with Robin Greenwood, George Gund, Samuel Hanson, and Joshua Rudolph: Government Debt Management at the Zero Lower Bound, in which the authors report, "when measured in 10-year equivalents, the combined effect of maturity extension and the increased debt stock far outpace QE." Panel A of Figure 1 in that paper illustrates the point clearly.

In his blog post, Summers explains the implications succinctly.

"On the issue of QE Greenwood, Hanson, Rudolph and I show that the contrary to much of the discussion during the QE period the stock of longer term public debt that the market has to absorb went up not down.  The amount of longer term Federal debt that markets have to absorb is now as high as it has been in the last 50 years and long rates are extraordinarily low, as are term spreads.  This calls into question the idea that price pressures caused by changing relative supplies are likely to have large impacts at times like the present when markets are functioning."

Fifth, Summers questions Reifschneider's assumption regarding the potential decline in long-term rates with the onset of the next recession. In fact, it's worth quoting Summers at some length to appreciate the strength of his concern on this point.

"Reifschneider in his very careful paper shows that with a big recession rates would likely approach -6 percent, or even -9 percent, but for the zero lower bound.  I find the idea that forward guidance and QE could do the anything like the work of 600, let alone 900, basis points of rate cutting close to absurd.  Both QE and forward guidance are said to work by bringing down longer term rates.  The 10 year Treasury is now in the 1.6 percent range.  If the Fed returned Fed Funds to its lower bound level in the context of a recession, I would expect to see 10 year rates fall substantially perhaps to 1 percent without any QE or forward guidance.   How much room is there for unconventional policy to bring them down further?  Reifschneider ‘s assumption that there will be room for unconventional policy to bring down 10 year rates by hundreds of basis points seems to me very doubtful."

Again, I find Summers' argument persuasive on this count.

Market implications

So what are the market implications of Summers' critique?

First, I suspect there's quite a reasonable chance that Hillary Clinton will win the upcoming election and that she'll appoint Summers to one of the open seats on the Federal Reserve Board of Governors. I also believe there's a good chance she subsequently would appoint Summers as Chairman when Yellen's term expires in February, 2018. And based on his writings in recent years, I believe he would be more creative and provide a greater degree of effective stimulus than his predecessor. In fact, I suspect the Fed's toolbox would be expanded even further under Summers -- but we can look forward to hearing more about his thoughts on that subject in Summers' next blog post. In any case, I believe market-based measures of inflation compensation would be at least 50 bp higher under Summers than they are currently. In fact, this may be a conservative estimate, as these measures are currently well below the averages seen in previous years.

Second, as I mentioned in my Yellen at Jackson Hole post, "if the Fed is willing only to use relatively conservative policy tools during the next downturn, we might expect the dollar to strengthen, ceteris paribus, at least relative to central banks that are willing to take relatively more activist policy measures." Summers' critique appears entirely consistent with that view.

Third, I believe many FOMC members are sympathetic to Summers' general concern, even if they don't agree with all his specific points. In particular, I've argued in Is the US Near Maximum Employment? that the FOMC is aware of the importance of raising the policy rate sufficiently ahead of the next recession. More specifically, speaking of FOMC members, I concluded:

"...for now, I suspect they'll increase the policy rate at a moderate pace, but with sufficient deliberation to avoid getting caught by the next recession with the rate still close to zero. More specifically, they may not manage to raise the IOER quickly enough to fulfill the expectations in the last dot plot -- or in Yellen's Jackson Hole fan chart. But I wouldn't be surprised if they managed to raise the policy rate somewhat more than is currently priced into the market."

Of course, this prediction runs counter to the advice of Summers, who would prefer a more stimulative monetary policy in conjunction with renewed fiscal stimulus. But while Summers' perspective is normative, mine is positive -- and it would appear we have a few more years yet before Summers assumes the Chair of the FOMC.

Is the US Near Maximum Employment?

Many of the recent comments from FOMC members suggest a desire to increase the IOER by another 25 bp before the end of the year, given favorable developments in the US labor market and recent progress in returning the inflation rate to the 2% goal.

The statistic most frequently cited to support the view that the labor market is near full employment (or maximum employment, as specified by the Federal Reserve Act), is the unemployment rate, currently at 4.9%. And as shown in the graph below, this rate appears consistent with the notion that that US employment is fairly 'full', even if it's not reached a maximum.

On the other hand, skeptics often note that the labor force participation rate has been declining, to 62.8% currently, down from 67.3% in the first half of 2000, suggesting a pool of available labor may be available to rejoin the labor force in the event labor demand increases further.

This last argument is often rebutted by referring to demographic changes over time, primarily those relating to age and gender given the post-war demographic bulge and the trend increase in the female participation rate throughout the latter half of the 20th century.

In an attempt to control for these changes, we show the percentage of men aged 25 to 54 who were employed over time (determined by combining various series from the Bureau of Labor Statistics).

There are three points particularly worth noting in this graph:

1. The much-discussed downward trend is clear.
2. The percentage dropped precipitously at the start of the last recession but has been increasing fairly steadily in recent years.
3. Despite the recent increase, the figure still has not recovered to the lowest point in any cycle shown -- in nearly 70 years of data.

The reported unemployment rate for this demographic is currently 3.9% -- precisely the average figure for the third quarter of 1988, when Reagan was finishing his second term. But in contrast, the percentage of men aged 25 to 54 who were employed average 89.6 in the third quarter of 1988, while the comparable figure at the moment is 84.7%

In other words, whether we consider the labor force participation rate for the entire population, or we attempt to control for changing demographics, we get the sense that the labor force could increase in size by roughly five percentage points (ie, an increase in employment closer to 6% greater than current levels) before employment should be considered to be at 'maximum' -- at least if history is any guide.

A variety of factors appear to be contributing to these trends, but two particularly interesting aspects are cited in a recent White House discussion paper, titled The Long-term Decline in Prime-Age Male Labor Force Participation. 

The first graph below shows labor force trends by birth cohort. Note that in addition to the standard decline with age, we see a decline over time -- ie, each cohort has a lower participation rate than the previous cohort, even controlling for age.

The next graph shows participation trends by level of educational attainment. Note that while the trend has been downward for each of the three groups represented in this graph, the rate of decline is proportional to educational attainment, with the participation rate decreasing most for those with a high school education or less.

Taken together, these graphs are consistent with scenarios in which increased global competition over time among workers with less education results in wage pressures that motivate an increasing number of men in these cohorts to exit the labor force. While this interpretation also is consistent with many documented wages trends, I mean it only to be suggestive in this case, as my argument here doesn't rely on the specific mechanism responsible for the declines in labor participation rates. Rather, my argument is that the pool of available labor in the US is larger than one might infer simply by referencing the headline unemployment rate.

Of course, this argument isn't original. In fact, numerous members of the FOMC have discussed it in various speeches. For example, Governor Powell discussed this view at some length at a speech in June of this year. Governor Brainard discussed it in a speech in May. And Rosengren discussed it in a speech this April.

But if FOMC members are generally aware of these issues with the labor force participation rate, why are so many set on raising the policy rate at the moment, especially when inflation has been below target for such an extended period and when wage gains have been fairly disappointing for so many for so long?

My sense is that FOMC members are confronted with political considerations in additional to economic considerations. If FOMC members don't manage to increase the IOER much further before the onset of the next recession, members will have little scope to reduce the policy rate in response, particularly if they wish to avoid negative policy rates, as Yellen noted at Jackson Hole.

Yet FOMC members are certain to feel pressure to act forcefully during the next recession. And if there's little scope for reducing the policy rate, pressure will increase to take other measures, such as widening the scope of assets purchased as part of an expanded LSAP program. Even a forceful formulation of forward guidance would pose unwanted risks for the Fed, as Yellen outlined at Jackson Hole. And it's clear that the Fed has no intention -- or legal means -- of engaging in outright monetary financing. So engineering a material increase in the IOER would give FOMC members space to react to the next recession in a way that would soften political pressures that otherwise could be exerted.

So I expect that policy decisions will in fact be data dependent (including a dependence on financial market data). And I suspect quite a number of FOMC members otherwise would like to indulge a bias toward allowing the labor market to build strength sufficient to see an increase in real wages and perhaps even in unit labor costs. And perhaps they'll have a greater chance to indulge this tendency provided the expansion continues long enough and with enough vigor for the FOMC to increase the policy rate comfortably off the zero lower bound.

But for now, I suspect they'll increase the policy rate at a moderate pace, but with sufficient deliberation to avoid getting caught by the next recession with the rate still close to zero. More specifically, They may not manage to raise the IOER quickly enough to fulfill the expectations in the last dot plot -- or in Yellen's Jackson Hole fan chart. But I wouldn't be surprised if they managed to raise the policy rate somewhat more than is currently priced into the market, shown with the FOMC dots below. [Source: Bloomberg]

Fischer on equity prices and negative policy rates

Fresh from Jackson Hole, Stanley Fischer appeared on Bloomberg yesterday. Notable was this exchange with Tom Keene [emphasis mine]:

TK: "There is a raging debate about the efficacy of negative interest rates for central banks, for governments, and again for banking itself. What about the efficacy of negative rates for savers and the people of these different nations?"

SF: "Well, clearly there are different responses to negative rates. If you're a saver, they're very difficult to deal with and to accept, although typically they go along with quite decent equity prices. But we consider all that and we have to make trade-offs in economics all the time and the idea is the lower the interest rate the better it is for investors."

I suspect Keene is too much of a gentlemen to call Fischer on that response, so I'll note that Fischer's response is trivially true of the price of most any asset that can be valued via discounted cash flows.

For example, the graph below shows the price of a US principal STRIP maturing in February 2036, along with the level of the S&P 500 over the past three years.

The correlation between the two over this period has been 0.79. A simple regression of the S&P 500 value on the STRIP price produces an R-squared value of 0.62, suggesting 62% of the total variation of the S&P 500 index over the period could be explained by the variation in the STRIP price.

I'm not suggesting one can or should build an equity valuation model based on STRIPs prices. And the simple regression I've suggested is fraught will all sorts of econometric problems. But it highlights the underlying vacuity of Fischer's comment. For example, if Fischer had observed that negative policy rates "go along quite decent" with zero coupon bond prices, presumably even a gentleman like Keene would raise an eyebrow.

Fischer clearly knows better. But he does us all a disservice by answering an important question with a fairly trite answer. Nobody saving for retirement in 2036 should feel any better if the price of our zero coupon bond increases more quickly than would be expected given an assumption of constant yields, since the capital gains on the existing position will be precisely offset by the lower expected return of the position going forward. And unless expected corporate profits are increasing, nobody investing in S&P 500 stocks with an investment horizon date of 2036 should feel particularly pleased with higher stock prices. (I'm assuming no change in risk preferences, equity risk premia, etc.)

Have the extraordinary measures of central bankers been increasing corporate profits? The graph below shows that natural log of US corporate profits, with adjustment for inventory valuation and capital consumption, since 1947, along with a simple trend line. [Source: Bureau of Economic Analysis]

Again, this is a rather crude analysis, but there's nothing here to suggest extraordinary measures have been increasing corporate profits.

My sense is that too many people are confusing a decrease in future expected returns with an increase in expected future profits. If equity prices increase because of upward revisions to estimates of future corporate profits, that's good news. If equity prices increase because future expected returns are decreasing, that's not good news -- at least not for people with investment horizons that include the period of lower expected returns. Investors are simply having to pay more for future expected profits.

If I were an investment adviser with a client who wanted to increase his current consumption because his retirement investment in 2036-maturity STRIPs had increased in value, I'd be guilty of malpractice if I told him this was a good idea. Why is Stanley Fischer suggesting with a smile that negative policy rates "go along with quite decent equity prices"? Tom Keene asked a serious question, We all deserve a serious answer.

My view is that the no central banks exert much influence on expected future returns, which are determined instead by the market-clearing actions of savers and investors. Expected future returns aren't low because central bankers have been keeping policy rates low. Rather, central bankers have been keeping policy rates low because low rates are required these days for there to be any chance that the markets for savings and investment will clear. The real shame in Fischer's answer is that it obfuscates the issue, maintaining an exaggerated impression of the importance of central bankers and creating a false impression in the minds of policy makers and the public that we can enjoy better economic performance without reforms.

And with that in mind, the real issue facing bond market investors in the coming months is not whether FOMC members will choose to hike in September or December -- it's the choice voters make in November, and the potential for more fundamental reform during the 115th US Congress.

Yellen at Jackson Hole

The headline quote from Yellen's Jackson Hole speech was

"... in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months."

Though it's also worth noting the caveat that followed:

"Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee's outlook."

Combining Yellen's comment with recent comments from other FOMC members, the overall impression is that the policy rate is likely to increase by another 25 bp at either the meeting ending September 21 or the one ending December 14.

But the main point of Yellen's speech, titled "The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future", is to consider future policy frameworks, consistent with the theme of this year's symposium, "Designing Resilient Monetary Policy Frameworks for the Future."

In this regard, perhaps the most informative aspect of Yellen's speech was the inclusion of a fan chart for future policy rates.

Yellen's fan chart should be viewed in the context of changes in the framework suggested by other FOMC members. For example, Jim Bullard recently announced a new analytic framework to be used by the St Louis Fed, in which policy is made for the current regime, which is presumed to prevail indefinitely, without any attempt to identify probabilities for shifts to other regimes. In a related blog post, Demise of the Dots, I wrote: 

"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."

In this sense, Yellen's fan chart can be seen as a response to the critiques of Bullard and others that the dot plots have failed systematically to forecast actual outcomes or, apparently, to influence market pricing. With Yellen's speech, I suspect the days of the dots are numbered, to be replaced by the fan chart, which has long become a standard communication tool among a number of central banks.

This particular fan chart is notable for two other characteristics  First, the width of the fan is a function of the root mean square prediction error of private and government forecasters over the past twenty years. In other words, the width of this fan chart is not necessarily an indication of the current forecast uncertainty in the minds of Yellen or of her colleagues on the FOMC. Of course, it could be that their best guess of the current forecast uncertainty is equal to the prediction error over the past twenty years – but that certainly need not be the case. For example, the forecast uncertainty could come from a calibrated DSGE model instead, In this case, Yellen seems merely to be clarifying that there is a considerable degree of uncertainty around policy rate forecasts in general rather than characterizing the degree of uncertainty that she believes characterizes this particular forecast.

Second, the fan chart is constructed so that there is no probability mass whatsoever lower than 0.125%. In other words, Yellen is offering an explicit view that the policy rate will not become negative. Again, she needn’t have made this choice. She could have made the fan chart symmetric around the central values, in which case a nontrivial probability would be associated with negative policy rates. As a result, we have yet another clear example of Yellen explicitly steering us away from negative rate scenarios. 

In the same context, it’s also worth noting that in the text of the speech Yellen refers to the zero lower bound rather than to the effective lower bound, a term used for example by Benoît Cœuré in his remarks, Again, we get a clear indication that Yellen does not wish to introduce negative interest rates into the mix of potential policies actively being considered.

To the extent Yellen is successful in further reducing the perceived, subjective probabilities of negative rate scenarios in future Fed policy, this should impart a slight upward bias toward higher rates along the yield curve (assuming such a reduction has no effect on term premia along the yield curve, due for example from further QE). For the same reason, such a reduction would be expected to impart a slight upward bias in the dollar, in particular relative to currencies in which policy rates are currently negative or in which there is a realistic prospect of negative policy rates in the future.

This effect should be modest given that Yellen has previously steered market participants away from consideration of negative policy rates in the past. But it's worth keeping in mind as the policy debate progresses.

QE and Forward Guidance

One of the reasons Yellen has been able to avoid entertaining the possibility of negative nominal policy rates is that she's been relying fairly heavily on forward guidance and large-scale asset purchases. However, my sense is that trust in these tools may be somewhat misplaced.

Like her colleagues, Yellen frequently cites the effectiveness of large-scale asset purchases at stimulating the economy and boosting inflation above the level it would have been without such purchases. I've long been skeptical of these arguments (see, for example, my blog post of April, 2009, How Easy is Quantitative Easing?). But for now I'll simply direct readers to the large body of work questioning QE, starting with The Central-Bank Balance Sheet as an Instrument of Monetary Policy by Woodford and Cúrdia, from which I quote:

"We have found that explicitly modeling the role of the central-bank balance sheet in equilibrium determination need not imply any role for “quantitative easing” as an additional tool of stabilization policy, even when the zero lower bound on the policy rate is reached. While different results might be obtained under alternative theoretical assumptions, our reading of the Bank of Japan’s experience with quantitative easing leads us to suspect that our theoretical irrelevance result is likely close to the truth."

Michael Woodford also has useful observations regarding forward guidance, which I discuss in a recent blog post, Fischer on Woodford on Forward Guidance. As summarized by Stanley Fischer:

"...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."

In contrast, it's worth quoting from Yellens' Jackson Hole speech on this subject.

"...if future policymakers responded to a severe recession by announcing their intention to keep the federal funds rate near zero for a very long time after the economy had substantially recovered and followed through on that guidance, then they might inadvertently encourage excessive risk-taking and so undermine financial stability."

Of course, Yellen is correct in her analysis. History-dependent monetary policy could have unintended and undesirable consequences. But this is the price one must be prepared to pay for forward guidance to have any chance of being effective. And it's clear from Yellen's concerns that the Fed is likely to hedge its forward guidance commitments -- just as it did when it attempted to use forward guidance starting in 2008, and just as the Bank of England did when it attempted to use forward guidance in 2013. In fact, as an example of forward guidance that was destined from the start to be ineffective, it's worth quoting from the Bank of England August 2013 statement on the subject.

"The Committee intends at a minimum to maintain the current highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to either price stability or to financial stability."

The MPC then listed three knockout conditions that would free it from this forward commitment, each of which involved the subjective judgment of policy makers. 

Unless Yellen and her colleagues on the FOMC are willing to commit along the lines outlined by Fischer and Woodford, we shouldn't expect forward guidance to be a particularly effective tool in the Fed's arsenal going forward.

If Yellen eschews more activist monetary approaches, such as negative nominal policy rates and monetary financing (helicopter drops), if the effectiveness of QE is questionable (or at least waning), and if her variant of forward guidance is unlikely to make a commitment any less conditional than her previous commitments, what, if anything, can we conclude about policy in the years ahead?

Market-based measures of inflation compensation are already low relative to historical values. For example, the 10Y breakeven inflation rate in the US is currently, just under 1.50% -- more than 50 bp below the average over the past five years. Similarly, the 5Y5Y inflation swap rate is just under 2.0% -- 60 bp below its five-year average and 90 bp below the ten-year average of 2.9% from July 2004 through July 2014. 

When the US economy next enters a recession, my expectation is that QE and the Fed's version of forward guidance are unlikely to boost these rates materially. And while I'm not forecasting the date by which the next recession is likely to start, I'd be somewhat surprised if these market-based measures of inflation have increased by 50 bp by then.

Likewise, if the Fed is willing only to use relatively conservative policy tools during the next downturn, we might expect the dollar to strengthen, ceteris paribus, at least relative to central banks that are willing to take relatively more activist policy measures.

Of course, a lot can change  between now and the onset of the next recession in the US, including the Fed Chair and the composition of the FOMC. But for now we have a clear sense that Yellen has a decided preference for the more modest of the recent policy innovations among central banks, with consequent implications for market pricing.

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.

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.