ECB, heal thyself: How Europe’s low inflation impedes fiscal and structural reform

Sep 8th 2014, 16:22 by G.I. | WASHINGTON, D.C

Europe does not yet have its equivalent of Japan’s Abenomics, but Mario Draghi, president of the European Central Bank, pretty much advocated it in his press conference last week. Europe, he said, needs fiscal, monetary and structural policy working together, the three arrows of Abenomics. He acknowledged the ECB’s duty of getting inflation, now 0.3%, back up to its target of near 2%. But the ECB, he said, can’t rescue Europe alone: it needs help from fiscal and structural reforms.

Of course, he’s right that monetary policy can’t initiate fiscal consolidation or liberalize product and labour markets, and that both those things are essential to Europe’s long term health. But the ECB can help determine whether either of those things succeeds. For Europe’s fiscal and regulatory policy makers to do their jobs, it will help immensely if the ECB does its own.

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A less dovish Yellen, a more dovish Draghi

Aug 23rd 2014, 4:14 by G.I. | JACKSON HOLE, WY.

The contradictory signals generated by American labour market data in the last year have provided grist for both hawks and doves at the Federal Reserve. For hawks, the rapid decline in the unemployment rate shows slack in the economy is disappearing so the Fed should tighten soon. For doves, the low rate of wage growth suggests there’s plenty of slack and tightening should wait.

Since becoming chair, Janet Yellen has usually been in the second camp, on balance interpreting the data as suggesting there wasn’t any urgency about raising rates. Her speech to the Kansas City Fed’s Economic Symposium on Friday in Jackson Hole, Wyoming struck a different tone. True, it covered both sides of the debate without coming down on either; Ian Shepherdson counted “1 coulds, 20 buts, 11 woulds, 7 mights, and a magnificent 56 ifs.” But she raised enough questions about the dovish case to suggest her own convictions are weakening. She was not telegraphing the case for raising rates soon. But it should be a wake-up call for investors who assume she would spin all the labour data that comes her way in a dovish direction.

The spontaneous combustion theory of inflation

Jun 26th 2014, 15:42 by G.I. | WASHINGTON, D.C.

In the last few weeks, ominous warnings of inflation’s imminent resurgence have multiplied, prompted by recent upside surprises on core inflation and the cavalier dismissal by Janet Yellen, the Fed chair, of those reports as “noise. “

On factual, theoretical and strategic grounds, I find the panic over inflation perplexing.
First, factual. Yes, core CPI inflation has rebounded to 2% from 1.6% in February and today we learned that core PCE inflation has risen to 1.5% from 1.1%. What should we infer from this? Nothing. In the short run inflation oscillates because of idiosyncratic movements in various components, such as rent, health care and imported commodities, but over longer periods, it is remarkably inertial: the best forecast of inflation over the next five years is inflation over the past five years. The nearby chart illustrates this;

core inflation fell below 1% in 2010 and rose above 2% in 2012; neither marked the start of a new trend. There is no reason to think the recent run of high monthly readings is a new trend, either. The Fed, to its credit, didn’t freak out when core inflation was scraping 1% earlier this year; it predicted that as the downward pressure from imported goods inflation and health care faded, overall inflation would move toward its 2% target, and it has. Yes, it has done so slightly faster than expected but this is no more cause for concern than learning a patient will be discharged from the intensive care unit in six weeks instead of eight. Second, theoretical.  If you have a forecast of higher inflation, it helps to have a theory of the inflation determination process behind it. Inflation is a continuous rise in the price level; the obersvation that the price level has risen recently is not a theory any more than a patient’s high temperature is a theory of infectious disease. Many critics think the prolonged period of low real rates and the large size of the Fed’s balance sheet are in and of themselves inflationary, but this is divorced from any consideration for why real rates are negative and the Fed’s balance sheet so large in the first place. Charlie Evans, president of the Federal Reserve Bank of Chicago, calls this “the spontaneous combustion theory of inflation… Households and businesses simply wake up one day and expect higher inflation is coming without any further improvement in economic fundamentals.”
There are many competing theories for the inflation determination process. What do they tell us?  The New Keynesian theory, to which the Fed subscribes, considers inflation a function of slack and expectations. The evidence is pretty persuasive that while slack has shrunk in the last five years (and perhaps faster than expected because of diminished potential), it remains ample. Expectations, likewise, have oscillated but shown no trend up or down.
You may dismiss this model because slack is hard to measure and expectations are a lagging indicator. Perhaps you prefer to look at costs (as a mechanical price mark-up model does). Labour is the main component of costs, and as the nearby chart shows,

unit labour costs are up just 1.2% in the last year. This, too, is a noisy series, as it is driven by both wages and output per hour; but it’s hard to see a worrisome trend. Wages have barely kept up with prices since the recovery began which means the benefits of productivity growth (meager though they are) have gone predominantly to profit margins, which touched a new high of 12.7% in the fourth quarter. They dipped in the first quarter, but they’ll probably bounce back after GDP reverses its drop. So profit margins could accommodate some acceleration in labour costs and remain comfortably wide. What if you consider inflation always and everywhere a monetary phenomenon? I consider the money supply pretty useless for forecasting anything, but even if were a monetarist, I wouldn’t be worried. Quantitative easing has significantly expanded the monetary base, but that expansion will end once QE stops later this year. Meanwhile, this has not fueled broader measures of money and credit: M2 is up just 6.5% in the last year, slightly faster than last year but still well below rates of growth recorded in 2011 and 2012 (which, you’ll recall, did not signal an inflation breakout).

Third, strategic. I recently attended a conference at the Hoover Institution on central banking where many of the presenting scholars were deeply concerned the Federal Reserve’s unorthodox policies would lead to an eruption of inflation before long. Many cited the 1970s when the Fed kept real interest rates too low for too long in the mistaken belief the economy was operating below potential. What these analyses ignore is the asymmetry of risks facing the economy. Of course, the Fed might wait too long to tighten and inflation could eventually rise above the 2% target. But, leaving aside how costly such a deviation would be, the Fed has demonstrated it knows how to get inflation back down, even if the process can be costly. By contrast, recent history shows how few effective tools central banks have for reversing inflation that falls too far, or turns to deflation. Either outcome raises the prospect of real interest rates that are too high and unemployment above its natural rate for years to come. Given this asymmetry, overshooting inflation is clearly a lesser evil than undershooting inflation. This, more than anything else, is why the panic over inflation is misplaced.

Explaining the bond market selloff: Traders versus economists

Jul 11th 2013, 21:34 by G.I. | WASHINGTON, D.C.

Traders and economists both spend their days studying markets, yet I’m struck by how differently they approach the subject. Since traders profit from finding mispricings, they are biased to believe that prices are more often wrong than right. Fundamentals matter, but traders believe they are routinely overwhelmed by psychology, liquidity and other non fundamental factors.
Economists, by contrast, grow up believing prices are usually right. The intersection of  supply and demand curves explains in elegant, intuitive and internally consistent fashion how each individual buyer and seller can have a different idea of what a price should be, yet their interactions collectively yield a single, objectively correct price. Economists don’t dispute the role of psychology – they’ve handed out Nobel prizes for precisely that – but the organizing principle of their lives is that market prices are usually an unbiased distillation of fundamental determinants.
These different world views help explain why traders have always been suspicious of quantitative easing (QE) and economists dismissive of those suspicions.

The week in American monetary policy: Parsing the Federal Reserve

May 24th 2013, 18:39 by G.I. | WASHINGTON, D.C.

The Federal Reserve left a lot of people scratching their heads this week. Between Chairman Ben Bernanke’s testimony, and the release of the minutes to the May 1^st Federal Open Market Committee, investors were struggling to figure whether an end to easy monetary policy was nigh. A headline in today’s The Wall Street Journal declares: “In Bid for Clarity, Fed Delivers Opacity.” Here is what I think is essential to understand about what the Fed is doing, what we learned this week, and why more crossed signals are likely ahead.

1. The Fed has two exits to manage, not one.

Technology and productivity: The hollow promise of the iEconomy

Feb 28th 2013, 21:44 by G.I. | WASHINGTON, D.C.

IN THE battle between David Einhorn and Apple over the latter’s $137 billion cash hoard lies a deeper lesson about the outlook for the economy. Mr Einhorn, an activist investor, says Apple clings to its money out of a “Depression mentality”. Perhaps. But the more mundane explanation is that Apple, like many of the world’s big companies today, is generating more cash from its existing product line than it can usefully plough back into new projects.

And that’s a problem. Apple is the most creative, innovative and envied technology company of our time, yet investors clearly doubt its ability to keep churning out hits at current margins, valuing it at just 10 times this year’s earnings, a ratio more appropriate for a mature value company.

To some, this might be comforting. After all, while the Dow may be flirting with an all-time high, Apple’s valuation suggests there isn’t much irrational exuberance going around.

But in another way it’s rather distressing. Let’s go back to the spring of 2000, at the peak of the Nasdaq bubble, when Cisco Systems embodied the hype and hope of technology. Cisco was, briefly, the world’s most valued company, with a market cap of $555 billion. Unlike many dotcoms, Cisco was nicely profitable, but not nearly as profitable as investors thought it would be one day: it traded at 135 times that year’s earnings. (Click on the nearby table for a comparison.) Compared with Apple, Cisco was a veritable spendthrift. Despite sales that were barely one-sixth of Apple’s today, its R&D budget was almost as large. Its cash pile, at $20 billion, was big enough (evidence that the phenomenon of cash-rich tech giants is not new), but then, there was no widespread clamour that Cisco hand it back it to shareholders; no one doubted Cisco would find a higher returning use for it.

What QE means for the world: Positive-sum currency wars

Feb 14th 2013, 23:24 by G.I. | WASHINGTON, D.C.

Brazil’s finance minister coined the term “currency wars” in 2010 to describe how the Federal Reserve’s quantitative easing was pushing up other countries’ currencies. Headline writers and policy makers have resurrected the phrase to describe the Japanese government and central bank’s pursuit of a much more aggressive monetary policy, motivated in part by the strength of the yen.

The clear implication of the term “war” is that these policies are zero-sum games: America and Japan are trying to push down their currencies to boost exports and limit imports, and thereby divert demand from their trading partners to themselves. Currency warriors regularly invoke the 1930s as a cautionary tale. In their retelling, countries that abandoned the gold standard enjoyed a de facto devaluation, luring others into beggar-thy-neighbor devaluations that sucked the world into vortex of protectionism and economic self-destruction.

But as our leader this week argues, this story fundamentally misrepresents what is going on now, and as I will argue below, what went on in the 1930s. To understand why, consider how monetary policy influences the trade balance and the exchange rate.

The economics of the platinum coin option: Platinomics

Jan 9th 2013, 4:04 by G.I. | WASHINGTON, D.C.

In the many years I’ve spent scrutinizing monetary policy, I had never devoted more than a thought to coins. In the scheme of all things monetary, they seemed, well, pocket change.

Needless to say, the prospect of the Treasury issuing a $1 trillion platinum coin to circumvent the debt ceiling changes that. I won’t repeat the details; you can get up to speed by reading Matthew O’Brien of The Atlantic here and my colleague here. If nothing else, unpicking the consequences is a fun exercise. I’ve concluded the economics are more complicated and more benign than appreciated, but the political consequences are graver.

American growth vs. the world: At the top of an underperforming class

Dec 17th 2012, 22:13 by G.I. | WASHINGTON

[Greg Ip] FOR those who started out the year optimists on American growth (such as me), 2012 was sobering. It looks like America will end the year having grown about 2%, according to Deutsche Bank, marginally below the average pace since the recovery began in mid-2009.Why was it disappointing? In great part part because the rest of the world had an even worse year. Take a look at the nearby table. Of the world’s four major developed economies plus China, America was the only country to grow roughly as fast as the International Monetary Fund projected in the fall of 2011. Europe and the U.K. actually contracted, while China (and several other emerging economies) grew notably less briskly.

The Senate tax bill: A dreadful third option

Dec 14th 2012, 19:54 by G.I. | WASHINGTON, D.C.

Negotiations over the fiscal cliff appear to have stalled. A meeting last night between President Barack Obama and John Boehner, the Republican speaker of the House of Representatives, produced no apparent narrowing in their positions.Since negotiations began, very little progress has been made: Mr Obama initially asked for $1.6 trillion in tax increases over the coming decade, later lowered to $1.4 trillion, and offered $400 billion in spending cuts.

Mr Boehner has, in return, offered $800 billion in higher revenue by eliminating tax expenditures (i.e., no increase in rates), and asking for $600 billion in entitlement cuts. Both sides say they are waiting for the other to specify details of their demands, in particular on spending. Mr Boehner is apparently headed home to his Ohio district for the weekend, a sign that no progress is being made.

Until this point there have been two likely outcomes: no deal at all and the country going over the cliff, or a grand bargain. But there is third option.