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anthony_doyle_100

“Global greying” could mean getting used to ultra-low bond yields

The developed world is going through an unprecedented demographic change – “global greying”. This change is having a massive impact on asset prices and resources as populations around the world get older and live longer. It is also having an impact on the effectiveness of monetary policy. We would typically expect older populations to be less sensitive to interest rate changes as they are largely creditors. Younger populations will generally accumulate debt as they set themselves up in life and are therefore more interest rate sensitive. The impact of demographics implies that to generate the same impact on growth and inflation, interest rate changes will need to become larger in older societies relative to younger societies.

Turning to the impact of demographics on inflation, labour force growth may provide some insight into the potential path of future inflation or at least give us some guide as to the long-term structural impact of an aging population on inflation dynamics. The theory is that a large, young generation is less productive than a smaller, older generation. As the large, young generation enters into the economy after leaving school/university the fall in productivity causes costs to rise and therefore inflation increases. Additionally, the younger generation is consumption and debt hungry as they start a family and buy homes. Eventually, the investment in the younger generation comes good and there is a large increase in productivity due to technological change and innovation. As consumers become savers, inflationary pressures in the economy start to subside.

The long-term interplay between US labour force growth and inflation is shown below. Inflation lags labour force growth by around two years as it takes some time for the economy to begin to benefit from productivity gains. As US labour force growth rises and falls over time, inflation generally follows a similar trend.

The long-term relationship between US labour force growth and inflation

The second chart looks at the same economic indicators, this time looking at 10 year growth in the labour force against inflation. Interestingly, this chart seems to show that the baby boomers entered into the workforce around the same time as the global economy experienced a supply-side oil price shock. The influx of new workers into the US economy is likely to have contributed to the great inflation of the 1970s. For the next thirty years or so, inflation fell as the economy enjoyed the technological advantages and productivity gains generated by the baby boomers. Looking forward, it appears that long-term deteriorating labour force growth may contribute to deflationary pressures within the US economy.

10 year US labour force growth and inflation

I am not saying that demographics are the only reason that inflation has fallen in recent years. The massive accumulation of private and public sector debt, globalisation and technological change are also secular trends worth monitoring. Rather I believe “global greying” and the impact of demographics on inflation and the real economy is an additional secular trend worth monitoring. Can central banks do anything in the face of this great generational shift should deflation become a reality? Interest rates are at record lows, quantitative easing has been implemented and we are yet to see the large impact on inflation that many economists expected.

Lower interest rates and the yield-dampening forces that exist in the global economy is a topic I previously covered here. In terms of bond markets, deflationary pressures are a “yield-dampener” and another reason why bond yields could remain low for some time and fall further from current levels over the longer-term.

 

stefan_isaacs_100

Exceptional measures: Eurozone yields to stay low for quite some time

Richard recently wrote about the exceptional times in bond markets. Despite bond yields at multi-century lows and central banks across the developed world undertaking massive balance sheet expansions the global recovery remains uneven.

Whilst the macro data in the US and UK continues to point to a decent if unspectacular recovery, the same cannot be said for the Eurozone. Indeed finding data to be overly optimistic about is no easy task. Both consumer and business confidence indicators continue to point to a subdued recovery; parts of Europe are technically back in recession and inflation readings continues to disappoint to the downside. The most recent CPI reading came in at a mere 0.4%, German breakevens currently price five year inflation at 0.6% and longer term expectations have shown signs of questioning the ECB’s ability to deliver on the inflation mandate.

Recognising the sheer size of the Eurozone banking system remains key to understanding the challenge Eurozone policymakers face. With a banking system over three times larger than the US (relative to GDP); significantly higher non-performing loans and massive pressure to deleverage as shown in the first chart below, it is unsurprising that the so called transmission mechanism appears damaged. The failure to pump credit into the Eurozone economy, especially into the periphery, continues to weigh on funding costs for SMEs & promote exceptionally high levels of unemployment. These are only now beginning to stabilise at elevated levels as shown in the second chart below.

Banks have started the deleveraging process

Peripheral Europe

With previous demands for austerity in Europe preventing economies from running counter-cyclical fiscal policies and uneven progress in structural reform, the onus continues to fall on monetary policy and the ECB. And yet for a variety of reasons the response has fallen considerably short of that from the FED, BoE & BoJ, who have been happy to expand their balance sheets considerably.

Balance Sheets

The result has been, an overvalued Euro, imported disinflation and a lack of investment. Having offered re-financing cuts, forward guidance, massive liquidity in the form of the LTRO & TLTRO, the ECB will ultimately be forced to follow other central banks in undertaking broad asset purchases.

Whilst these broad asset purchases or QE are unlikely to be unveiled today, they are the only likely means in the near term, of ensuring that the banking system in Europe is able to extend significantly more credit to the real economy. This in turn should help to raise inflation expectations, boost potential growth and allow the ECB to fulfil its mandate.

In Europe exceptional times call for exceptional measures. The ECB isn’t done, even if certain members will have to be dragged kicking and screaming to the QE party. I expect European bond yields to stay low for quite some time.

richard_woolnough_100

Exceptional times

Interest rates – both short and long term – are at record lows in Europe. The driving force behind this is the belief that both employment and inflation will be lower for longer. This is something that concerns the ECB and Drahgi’s Jackson Hole speech implies further easing ahead. These appear to be exceptional times.

The story of how we got here is pretty simple: a global banking collapse in 2008, followed by a further severe bout of local damage to the banking system in Europe caused by the sovereign debt crisis in 2011 and 2012.

The chart below is an attempt to illustrate where true borrowing rates have been. Taking a proxy for the cost of finance and adding that to three month Euribor gives a better picture of real monetary conditions than by simply looking at the headline ECB rate. Monetary policy in the Euro crisis was tightened in the core, but more so in the periphery.

Slide1

In the following charts we break out the inflation and employment data of the core and the periphery. What we see is that where tighter monetary policy is applied unemployment is subsequently higher and inflation is lower. It is not surprising that the Euro area and particularly the periphery have been weak given the severe monetary shock they took in the Euro crisis. This suggests that monetary policy still works.

Slide2

Slide3

Going forward, real monetary policy has effectively been eased aggressively from the summer of 2012 through to now. This should provide a boost to the Euro area, and in particular the periphery. Monetary policy is generally assumed to work with an 18 month lag and interestingly unemployment is already heading down. I expect this trend will continue.

We are in exceptional times from an interest rate perspective, but from an economic perspective unemployment has been this high before from 1994 to 1997, and inflation was below 1.0% in 1999 and 2009.

When economics deviates from markets you have to decide which is correct. I think that monetary policy works, and the huge easing from 2012 will bring about falling unemployment and prevent significant deflation. Exceptionally low interest rates in Europe seem out of line with the current and potential future economic data.

Wolfgang Bauer

Race to the Bottom: Eurozone Inflation Rates

In principle, the European Central Bank (ECB) is well in line with its price stability objective, which it defines as a “year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. Nonetheless, July inflation numbers released last week bring the currency union as a whole dangerously close to deflationary territory. The aggregate HICP annual rate of change for the Eurozone fell to 0.4%, its lowest inflation print since October 2009.

But what has been driving this development? To answer this question we broke down HICP headline inflation numbers into three components: (i) food, alcohol and tobacco (FAT); (ii) energy; and (iii) core inflation, i.e., the remainder when stripping out (i) and (ii) from the headline figure. In the chart below we plotted the contributions of each of these three components to the headline number, calculated by multiplying the annualised monthly changes of the component indices by their respective weights within the overall HICP.

Decomposition of Eurozone Inflation Numbers

Only a relatively small part of the substantial drop in HICP headline inflation from 3.0% in the end of 2011 to currently 0.4% can be attributed to core inflation. Admittedly, core inflation contribution has fallen from 1.1% to 0.6% in this time period but compared to the other two components it has been much more stable. This result intuitively makes sense as core inflation comprises very different items, such as clothing, healthcare and communications. The inherent diversification subdues core rate volatility as fluctuations in individual item levels are likely to balance out each other to a certain degree. The fall in Eurozone inflation has mainly been caused by FAT and energy. Whereas FAT and energy boosted headline inflation by 0.7% and 1.3%, respectively, in November 2011, by now both components have essentially become a drag, chipping off 0.1% each from the July 2014 aggregate figure. Declining inflation rates in the Eurozone can at least partially be explained by a strengthening of the Euro vs. USD (c. USD 1.27 per EUR in the beginning of 2012 to a peak level of c. USD 1.39 in early May 2014), having a deflationary effect on import prices. In recent months, when the exchange rate trend started to reverse, the oil price dropped sharply (c. USD 114 per barrel Brent in mid June 2014 to currently c. USD 102), which helped to put downward pressure on energy prices. It will be interesting to see how geopolitical developments in the Ukraine and the Middle East are going to affect energy inflation contributions in the months to come.

Now let’s turn towards inflation rates of individual countries. The two biggest Eurozone economies, Germany and France, showed July inflation rates clearly below 1% (0.8% and 0.6%, respectively). The periphery experienced either no inflation at all (Italy with 0%) or even deflation (Spain with -0.4%, Portugal with -0.7%, Greece with -0.8%). Undoubtedly, these numbers are low. But how do they compare with historical inflation rates? We took a look at the past ten years of inflation rate data (HICP annual rates of change, published monthly) for the Eurozone in total, its four main economies and, for comparison, the United States. For each entity, we ranked the numbers from smallest to largest and divided the range of inflation rates into three bands, containing the bottom 25%, middle 50% and top 25% of data points, respectively (see chart below). The white lines mark the border below which the bottom 10% of inflation rate prints are located for each data series. In addition, we highlighted the most recent inflation numbers as well as the figures from one and two years ago.

Current Inflation Numbers in Historic Context

We can draw a number of conclusions from this chart. For instance, inflation rate spans for Germany with 4.2% (-0.7% to 3.5%) and Italy with 4.3% (-0.1% to 4.2%) are significantly smaller than for Spain with 6.6% (-1.3% to 5.3%) and the U.S. with 7.7% (-2.1% to 5.6%). Most importantly, the chart puts the drop in European inflation rates over the past years into some statistical context. July 2012 inflation prints still rank within the middle 50%, or even in the top 25% in the case of Italy. Except for Germany, inflation rates exceeded the ECB’s upper limit of 2% back then. However, the most recent data points from July 2014 can all be found in the bottom 10% of the 10-year inflation rate ranges. German inflation is exactly at and the French figure slightly below their respective bottom 10% thresholds. Italy’s and Spain’s inflation rates have fallen deep into their bottom 10% ranges. Italy’s current 0% inflation figure marks in fact the country’s second lowest monthly reading within the past 10 years. In contrast, U.S. consumer price inflation is not on a downward trajectory but numbers have been bouncing back and forth between 1% and slightly above 2.0% over the past two years. The July 2012 print of 1.4%, for example, ranks in the bottom 25%, whereas inflation rates both for July 2013 and July 2014 sit with 2% within the middle 50%.

What does this mean for fixed income investors? For a start, the divergence of European and U.S. inflation rates, in combination with substantial differences in real GDP growth (Eurozone with -0.4% in 2013 and 0% in Q2 2014 vs. U.S. with 2.2% and 4.0%, respectively) and labour market strength (Eurozone with 11.9% unemployment rate in 2013 and 11.6% in Q2 2014 vs. U.S. with 7.4% and 6.2%, respectively), reinforces the argument of an on-going decoupling between the two economic areas. The progressive fall of Eurozone inflation rates well below the 2% level gives the ECB some room for manoeuvre. European interest rates are likely to stay at essentially zero for the time being, and we should not be surprised if more accommodative monetary policies, such as asset purchases, were implemented by the ECB going forward in an attempt to stimulate economic recovery.

Anjulie-Rusius_100

Falling soft commodity prices are a piece of cake

Higher agricultural commodity prices at the start of the year raised concerns about the impact these could have on retail food prices, should the trend prove persistent. Fortunately, the price of soft commodities (coffee, sugar, wheat etc) appears to have decoupled from that of hard commodities (gold, silver, platinum etc) in recent months. Indeed, data from the last seven quarters indicate that the price of many agricultural commodities have actually fallen, as the chart below shows.

Slide1

Coffee prices are now at a five month low, after fears of a shortage of coffee beans from Brazil have receded. The supply of sugar has increased year-on-year, while wheat prices have also fallen due to increased harvests and easing crop concerns.

In order to gauge the collective effect of these changing agricultural commodity prices and how they could potentially feed through into UK inflation, I have constructed a simple cake index, teaming up Global Commodity Price data with some basic recipes from the BBC Good Food website. Given that sponge and individual cakes are two of the representative items included in the CPI 2014 basket of goods – and that food and drink items make up 11.2% of the overall CPI index – combining the commodities in this way gives an indication of how future changes might affect the average consumer.

The graph below shows the results of the cake index, demonstrating the change in various cake costs (since October 2012) versus the UK CPI (yoy %). What’s interesting is the generally downward trend of all cake indices in the last seven quarters. Sponge cake and plain scones look particularly good value in recent months, owing to the high proportion of wheat in their recipes. Apple cake unsurprisingly provides a price signal for its key ingredient (the price of apples has fallen 4% YTD), while coffee cake gives a less pronounced but similar effect. The good news – particularly for lovers of chocolate cake – is that despite the persistent increase in the cost of cocoa, the price of other cake constituents such as sugar, wheat and palm oil (used as a proxy for butter) have all fallen sufficiently to offset this, bringing the price of chocolate cake lower in recent months.

Slide2

Despite the recent June increase in CPI to 1.9% yoy, due to the lag between raw commodity prices and their general price level, we should perhaps expect to see deflation feeding into cake prices and the overall food constituent of CPI in the coming months. Therefore although it is unclear who exactly was the first to declare “let them eat cake!”, this person may have been on to something. Personally, I’d recommend the (relatively cheap) scones.

Ana_Gil_100

The reliability of market and consumer inflation expectations

After yesterday’s poor U.S. GDP number and despite Mark Carney’s seemingly dovish testimony before the Treasury Select Committee, the Bank of England is increasingly looking like it will be the first of the major central banks to hike rates. At this stage, the BoE can retain its dovish stance because inflation is not an issue. However, in an environment of falling unemployment, early signs of a pick-up in wage inflation, rising house prices and stronger economic growth, consumers and markets may increasingly begin to focus on inflation. In anticipation, we think now is a good time to compare the inflation forecasting performance of markets and consumers.

In the graphs below we have compared UK RPI bond breakevens (a measure of market inflation expectations) with the Bank of England’s Gfk NOP Inflation Attitudes Survey (i.e. a UK household survey with over 1900 respondents consisting of nine questions on expectations for interest rates and inflation). An important point to note is that the analysis compares realised inflation (% yoy) with what survey expectations and breakeven rates indicated 2 years before.

How reliable are inflation expectations?

The comparison presents a number of interesting results:

Unexpected deflation: Both the survey and breakevens underestimated actual RPI inflation outcomes between 2006-2008 (in other words, nobody anticipated the inflationary shock coming from higher commodity/energy prices).  In 2008, UK RPI was rising at an annual rate of 5.2% as high oil prices were feeding through into higher energy bills. Market and consumer inflation expectations largely ignored the higher inflation numbers, a sign the central bank inflation targeting credibility remained strong.

UK RPI turned negative in 2009 as the world plunged into recession and the BOE cut interest rates. The market eventually began to price in deflation but only after RPI turned negative. For example, in November 2008 the 2 year breakeven was -1.4%, the actual RPI print in November 2010 was 4.7%. Owing 2 year gilt linkers relative to conventional 2 year gilts directly after the financial crisis was a great trade.

Deflation (and recessions) appear particularly hard to forecast, for consumers and markets alike. This is because consumers and markets tend to anchor their future expectations off current inflation (and growth) readings.

Post-crisis unanchoring:  Consumer inflation expectations generally underestimated realised inflation up until the global financial crisis, and has overestimated it since then, a possible sign that the crisis-recession years may have affected consumer views on the BoE’s commitment to fight inflation. Between 2000 and 2009, 2 year-ahead expected inflation averaged 2.5%. Since 2009, it has averaged 3.4%, almost one percentage point higher; suggesting a lower level of confidence that price stability will be achieved and also reflecting the higher RPI prints post 2009.

Surprisingly similar forecasts: Breakeven and survey rates differed only slightly over the sample period, with the largest gap (400bps) opening up in October 2008 after the Lehman crash. This was probably caused by the forced unwind of leveraged long inflation trades combined with a huge flight to quality bid for nominal government bonds, which distorted the market implied inflation rate. The average differential through the period (excluding years 08-09) is just 8bps. Nevertheless, breakevens seem to track RPI better since consumer surveys are usually carried out on a quarterly basis whilst the former are traded and re-valued with higher frequency. This makes them better at capturing quick moves and turning points in inflation.

Future expectations: Over the next 2 years, both consumers and markets expect RPI to rise above the current level of 2.6%. With a 2.7% implied breakeven, 2-year gilt linkers look relatively inexpensive today.

Of course, breakevens are far from being a perfect measure of inflation, as they embed inflation and liquidity risks premia, but they do appear to be better predictors of future inflation relative to consumer surveys. That does not mean survey-based data does not provide us with useful information, and for this purpose we launched the M&G YouGov Inflation Expectations Survey last year (available here). Consumer inflation expectations affect a number of economic variables, including consumer confidence, retail spending, and unit labour costs. However, during inflection points, such as the one we may be going through at present and in a world of approaching shifts in monetary policy, the timeliness of breakevens could represent an advantage that makes it worthwhile to follow them carefully.

stefan_isaacs_100

Is Europe (still) turning Japanese? A lesson from the 90’s

Seven years since the start of the financial crisis and it’s ever harder to dismiss the notion that Europe is turning Japanese.

Now this is far from a new comparison, and the suggestions made by many since 2008 that the developed world was on course to repeat Japan’s experience now appear wide of the mark (we’ve discussed our own view of the topic previously here and here). The substantial pick-up in growth in many developed economies, notably the US and UK, instead indicates that many are escaping their liquidity traps and finding their own paths, rather than blindly following Japan’s road to oblivion. Super-expansionary policy measures, it can be argued, have largely been successful.

Not so, though, in Europe, where Japan’s lesson doesn’t yet seem to have been taken on board. And here, the bond market is certainly taking the notion seriously. 10 year bund yields have collapsed from just shy of 2% at the turn of the year and the inflation market is pricing in a mere 1.4% inflation for the next 10 years; significantly below the ECB’s quantitative definition of price stability.

So just how reasonable is the comparison with Japan and what could fixed income investors expect if history repeats itself?

The prelude to the recent European experience wasn’t all that different to that of Japan in the late 1980s. Overly loose financial conditions resulted in a property boom, elevated stock markets and the usual fall from grace that typically follows. As is the case today in Europe, Japan was left with an over-sized and weakened banking system, and an over-indebted and aging population. Both Japan and Europe were either unable or unwilling to run countercyclical policies and found that the monetary transmission mechanism became impaired. Both also laboured under periods of strong currency appreciation – though the Japanese experience was the more extreme – and the constant reality of household and banking sector deleveraging. The failure to deal swiftly and decisively with its banking sector woes – unlike the example of the US – continues to limit lending to the wider Eurozone economy, much as was the case in Japan during the 1990s and beyond. And despite the fact that Japanese demographics may look much worse than Europe’s do today, back in the 1990s they were far more comparable to those in Europe currently.

Probably the most glaring difference in the two experiences is centred around the labour market response. Whereas Eurozone unemployment has risen substantially post crisis, the Japanese experience involved greater downward pressure on wages with relatively fewer job losses and a more significant downward impact on prices.

With such obvious similarities between the two positions, and whilst acknowledging some notable differences, it’s surely worthwhile looking at the Japanese bond market response.

As you would expect from an economy mired in deflation, Japan’s experience over two decades has been characterised by extremely low bond yields (chart 1). Low government bond yields likely encouraged investors to chase yield and invest in corporate bonds, pushing spreads down (chart 2) and creating a virtuous circle that ensured low default rates and low bond yields – a situation that remains true some 23 years later.

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

As an aside, Japanese default rates have remained exceptionally low, despite the country’s two decades of stagnation. Low interest rates, high levels of liquidity, and the refusal to allow any issuers to default or restructure created a country overrun by zombie banks and companies. This has resulted in lower productivity and so lower long-term growth potential – far from ideal, but not a bad thing in the short-to-medium term for a corporate bond investor. With this in mind, European credit spreads approaching historically tight levels, as seen today, can be easily justified.

Can European defaults stay as low as for the past 30 years

Europe currently finds itself in a similar position to that of Japan several years into its crisis. Outright deflation may seem some way off, although the risk of inflation expectations becoming unanchored clearly exists and has been much alluded to of late. Japan’s biggest mistake was likely the relative lack of action on the part of the BOJ. It will be interesting to see what, if any response, the ECB sees as appropriate on June 5th and in subsequent months.

BoJ basic discount and ECB main refinancing rates

Though it is probably too early to call for the ‘Japanification’ of Europe, a long-term policy of ECB supported liquidity, low bond yields and tight spreads doesn’t seem too farfetched. The ECB have said they are ready to act. They should be. The warning signs are there for all to see.

ben_lord_100

Deflation spreading in Europe

The ECB has already demonstrated an unusually, and perhaps worryingly, high tolerance of low inflation readings, with no additional action having been taken despite Eurozone HICP at 0.5% year-on-year as inflation continues to fall in many countries.

(Dis)inflation

Why might this be? One reason might be that while it is very concerned about deflation, at this point in time the ECB does not have a clear idea of what the right tool is to relieve disinflationary pressure, or how to implement it. Another reason might be that it is not particularly concerned about the threat of disinflation and so is happy to wait for the numbers to rise.

With regards to the latter of these possibilities, Mario Draghi discussed the low inflation numbers in January in Davos as being part of a relative price adjustment between European economies, and as being an improvement in competitiveness. One implication from this argument has to be that the lowest inflation numbers are being seen only in the periphery, and that as a result the much needed price adjustment between periphery and core is starting to take place. The other implication from this argument is that the ECB is happy to let this adjustment happen.

The chart below, however, shows inflation in Germany, France, the Netherlands, Spain and Italy (which together make up around 80% of Eurozone GDP) in terms of constant tax rates on a headline basis. This is important because fiscal reforms can have significant impacts on inflation numbers, when perhaps these should be stripped out as being temporary and artificial. The most obvious example of this would be a country implementing a hike in VAT, in which case inflation will jump upwards for a period until the base effect is removed some time later. This chart, alarmingly, shows that Spain, Italy and the Netherlands are now all experiencing deflation on a constant tax basis. It also shows that France is close to the precipice, with inflation on this basis at 0.2% year on year.

(Dis)inflation at constant tax rates even worse

A further concern from the above two charts ties in to the ECB’s argument that the low inflation numbers in the periphery are a temporary phenomenon on a path to important and desirable internal adjustments to competitiveness. This argument might hold if the periphery is seeing low inflation, while the core is seeing stable, on-target or slightly above-target inflation that brings Eurozone inflation as a whole, to close to but below 2%. However, both the above charts show that the trend of disinflation is affecting more than just the periphery in isolation, and this calls Draghi’s competitiveness argument into serious question. The ECB might be well advised to get ahead of this worrying trend and act soon.

richard_woolnough_100

Deflating the deflation myth

There is currently a huge economic fear of deflation. This fear is basically built on the following three pillars.

First, that deflation would result in consumers delaying any purchases of goods and services as they will be cheaper tomorrow than they are today. Secondly, that debt will become unsustainable for borrowers as the debt will not be inflated away, creating defaults, recession and further deflation. And finally, that monetary policy will no longer be effective as interest rates have hit the zero bound, once again resulting in a deflationary spiral.

The first point is an example of economic theory not translating into economic practice. Individuals are not perfectly rational on timing when to buy discretionary goods. For example, people will borrow at a high interest rate to consume goods now that they could consume later at a cheaper price. One can also see how individuals constantly purchase discretionary consumer goods that are going to be cheaper and better quality in the future (for example: computers, phones, and televisions). Therefore the argument that deflation stops purchases does not hold up in the real world.

The second point that borrowers will go bust is also wrong. We have had a huge period of disinflation over the last 30 years in the G7 due to technological advances and globalisation. Yet individuals and corporates have not defaulted as their future earnings disappointed due to lower than expected inflation.

The third point that monetary policy becomes unworkable with negative inflation is harder to explore, as there are few recent real world examples. In a deflationary world, real interest rates will likely be positive which would limit the stimulatory effects of monetary policy. This is problematic, as monetary policy loses its potency at both the zero bound and if inflation is very high. This makes the job of targeting a particular inflation rate (normally 2%) much more difficult.

What should the central bank do if there is naturally low deflation, perhaps due to technological progress and globalisation? One response could be to head this off by running very loose monetary policy to stop the economy experiencing deflation, meaning the central bank would attempt to move GDP growth up from trend to hit an inflation goal. Consequences of this loose monetary policy may include a large increase in investment or an overly tight labour market. Such a policy stance would have dangers in itself, as we saw post 2001. Interest rates that were too low contributed to a credit bubble that exploded in 2008.

Price levels need to adjust relative to each other to allow the marketplace to move resources, innovate, and attempt to allocate labour and capital efficiently. We are used to this happening in a positive inflation world. If naturally good deflation is being generated maybe authorities should welcome a world of zero inflation or deflation if it is accompanied by acceptable economic growth. Central banks need to take into account real world inflationary and deflationary trends that are not a monetary phenomenon and set their policies around that. Central bankers should be as relaxed undershooting their inflation target as they are about overshooting.

Under certain circumstances central banks should be prepared to permit deflation. This includes an environment with a naturally deflating price level and acceptable economic growth. By accepting deflation, central banks may generate a more stable and efficient economic outcome in the long run.

anthony_doyle_100

A Fed taper is on the table

The FOMC took markets and economists by surprise in September this year when the committee members decided to hold off from tapering and maintain its bond-buying programme at $85bn per month. Three months down the road and the consensus for the December meeting outcome is that the Fed will not reduce the pace of MBS or treasury purchases. Consensus has been wrong before; will it be wrong again tomorrow? We think it will be a closer call than many expect.

In our opinion, there are several good reasons for the Fed to taper very slowly. Firstly, inflation is a non-issue, below target and close to lows not seen for decades. Secondly, the 30 year mortgage rate has risen from 3.5% in May to around 4.5% today, impacting US housing affordability and already tightening policy for the Fed. Thirdly, there is continued concern that 2014 may bring a return of the political brinkmanship that characterised late September, with the US Treasury signalling that the debt limit will have to be raised by February or early March to avoid default. Ultimately, the Fed is nowhere near hiking the FOMC funds rate.

There is no doubt after the September decision that tapering is truly data dependent and in this sense, macro matters. Fortunately, Ben Bernanke has told us what economic variables he and the FOMC will be looking at a press conference in June. The Fed wants to see a broad based improvement in three economic variables – employment, growth and inflation – before reducing the scale of bond buying.

The table below shows that the data has improved across the board. Annualised GDP is stronger, the unemployment rate is lower and the CPI is only 1.2%. Other key leading economic indicators like the ISM and consumer confidence are higher while markets are in a remarkably similar place to where they were three months ago with the 10 year yield at 2.86%.

US macroeconomic indicators chart

After the surprise of September’s announcement, we believe that every FOMC meeting from here on out is “live” – that is, there is a good chance that the Fed may act to reduce its bond-buying programme in some way until it reaches balance sheet neutrality. A reduction in bond purchases is not a tightening of policy, we view it as a positive sign that policymakers believe that the US economy is finally healing after the destruction of the financial crisis. As I wrote in September, interest rate policy is set to remain very accommodative for a long time, even after balance sheet neutrality has been achieved.

Given the positive developments in the US economy over the past three months, the December FOMC announcement could announce a) a small reduction in bond buying and b) an adjustment of the unemployment rate threshold or a lower bound on inflation. Whatever the case, quantitative easing is getting closer to making its swansong.

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