Wednesday, May 4, 2016

World growth: mediocre or pathetic?

The recent disappointing performance of the world economy has been labelled as the "new mediocre" by Christine Lagarde, the "new reality" by Olivier Blanchard and the "new normal" by many others.

How mediocre is global growth? The answer to this question heavily depends on the way we measure world GDP. Aggregating national GDPs can be done in two ways: using market exchange rates or using PPP (purchasing power parity). Because PPP puts larger weights on emerging markets and because these countries have shown faster growth rates in recent decades, the two measures have been diverging over time and now they offer a very different picture of the state of the world economy.

Below I plot world real GDP growth rates (smoothed by taking a 7-year centered average) measured at market exchange rates and PPP (both data are produced by the IMF).



During the early 80s both measures were identical because emerging markets did not grow faster than advanced economies (plus their relative size was smaller). Since the 90s the gap opens and reaches a maximum of about 1.5% a year during the mid 2000s, the time when emerging markets were growing at their fastest rate.

What do we make of the last decade? Using the PPP yardstick it simply looks like a return to the rates of early decades. The exceptional years where the 2003-2008 period where the world grew above 4%. Rates of 3-3.5% look normal.

But using market exchange rates recent data paints a picture of mediocrity (or worse). Rates in the range 2-2.5% are very low by historical standards. The last years feel like the worst years we have since in terms of growth.

Which of the two numbers is the right one? The use of PPP is justified when measuring improvements in living standards. The larger weight given to emerging markets makes sense given that the volume of goods and services they produce is larger than what a market exchange rate conversion suggests.

But from many other perspectives market exchange rates make more sense: financial flows are aggregated using market exchange rates so from the perspective of financial markets the market exchange rate GDP measure might be more precise. Also from the perspective of a multinational company looking at the world economy as a source of demand market exchange rates are likely to provide a better picture of the state of the world.

It is therefore not surprising that when we look at the state of the world economy what looks like returning to earlier growth rates for some might look like mediocre (or even pathetic) growth for others. Make sure you read the footnote before you check the next chart on the state of the world economy.

Antonio Fatás

[And talking about footnotes here are two: First, the data above includes forecasts for the years 2016-2018 to calculate the last years in the chart. Second, an interesting question is what happens to world growth rates as PPP rates change -- one day prices in emerging markets might be as high as those in advanced economies. This is not captured in the chart above. The IMF and others use the latest PPP estimates (2011) as a base for international prices when calculating PPP adjusted data for all years in the sample.]

Tuesday, March 29, 2016

Central Banks need to get real (not nominal)

While the ECB and Bank of Japan are exploring negative interest rates, the US Federal Reserve is preparing us for a slow and cautious increase in short-term interest rates. Long-term rates remain at very low levels and inflation expectations have come under pressure and also remain below what they were a few months or years ago. And as this is going on markets are trying to figure out if they like low or high interest rates. And even if they decide that they like low rates, are negative rates too low?

In all these debates there seems to be an unusual amount of what economists call money illusion or lack of understanding of the difference between nominal and real interest rates. This confusion, in my view, is partly motivated by the communication strategy of central banks that seem to obsess with the asymmetric nature of their inflation targets (for both the ECB and US Fed, inflation targets are defined as close but below 2%) and are not clear enough on their final goal and its timing.

How do we want interest rates to react to aggressive monetary policy? The common answer is that we want interest rates to go down. This is correct if we think in real terms: given inflation expectations (or actual inflation), we want interest rates to move down relative to those inflation levels. But in some cases, in particular when inflation expectations are lower than what central banks would like them to be, the central bank by being aggressive is targeting higher inflation expectations and this can possibly lead to higher nominal (long-term) interest rates.

This is what happened in the three rounds of quantitative easing by the US Federal Reserve. 10-Year interest rates went up which was a signal of increasing inflation expectations (and even higher expectations of future real interest rates). This was seen as a success.



But the behavior of long-term interest rates or inflation expectations in response to recent communications by central banks has gone in the opposite direction. Long-term rates have come down (in particular in the Euro area). But don't we want lower interest rates? Isn't this the objective of massive purchases of long-term assets by central banks? Yes if we talk about real interest rates but not obvious if we talk about nominal ones. What we really want is inflation expectations (and inflation) to increase and this is likely to keep long-term interest rates from falling so much. 

And here is where I feel the central banks are not helping themselves. There are two mistakes they are doing: in their messages about interest rates they do not distinguish clearly between nominal and real interest rates. What I want to do is to send a message that real interest rates will remain low for an extended period of time to ensure higher inflation ahead and to ensure that nominal interest rates increase in the future so that we can escape the zero lower bound. By talking only about nominal interest rates central banks are sending a signal that we will be stuck at the zero lower bound for a long time, a message that seems to be an admission of defeat. They cannot get out of this trap.

And this leads me to the second mistake of central banks: their asymmetric view of their inflation target. In the US, inflation and core inflation is slowly moving towards the 2% target. This is seen by some as a proof that the zero lower bound or the deflation trap has been defeated. But this is the wrong reading. The fact that the federal funds rate remains so close to 0% means that we are still at the zero lower bound or close enough to it and we should not be complacent with what we achieved. The US Federal Reserve should only call it a success when the federal funds rate is back to 3% or higher, safe away from 0%. But to get there we need to shoot for higher inflation, at least temporarily. The same message or even stronger applies to the ECB. 

In summary, success in escaping the zero lower bound should be judged by how central bank interest rates manage to move away from 0% not by how long they stay at 0%. Central banks are not communicating this clearly because of the fear that this would be interpreted as a message of future tightening of monetary policy. But by doing so they are hurting their ability to escape the deflation/lowflation trap.

Antonio Fatás




Thursday, March 10, 2016

ECB: I cannot do whatever it takes

The ECB just announced a further reduction in interest rates, extended its QE program by increasing the rate at which buys assets, beefed up the TLTRO program and extended its horizon. It all sounds like good news and many of these actions had been expected in the last meeting of 2015 and they did not happen. Markets reacted very positively on announcement but later, after the press conference, they went down to levels that were significantly below where they were before the announcement.

It is always hard to comment on why markets react in a certain way to monetary policy announcements but I must say that watching the press conference I learned about the state of desperation and possibly confusion of the ECB, which was not very reassuring. It might not be their fault, this is life when central banks hit the zero lower bound on interest rates and there is very little they can do. And the available tools are not easy to communicate to markets and the general public. An extra 20 billion for QE, including corporate bonds, loans to banks that have an interest rate contingent on the amount of net lending are all policies that are much harder to understand and calibrate (even for economists) than a reduction in interest rates.

So what did we learn yesterday? That the ECB wants to do more but that there is no magical tool that will get the Euro area out of where it is. That the ECB is willing to do more, despite some of the internal resistance, is good news. But the message (explicit and implicit) that they have clearly reached their limit is bad news. From the press conference it was clear that interest rates cannot go down any further. And when it comes to QE there is always room for enlarging the set of assets that are included in the program but the Bank of Japan has tried that for a while without great success.

In summary, the zero lower bound trap is a real one. In the absence of aggressive fiscal policy or a sudden and large improvement in the world economy, the ECB is going to have a hard time reaching its inflation target or helping the Euro zone economy return to normal growth rates.

Whatever it takes to fix this does not seem part of the tools that the ECB has at its disposal. And I do not want to think about what future ECB press conferences are going to look like.

Antonio Fatás

Thursday, February 4, 2016

A 2016 recession would be different

If the US or the Eurozone entered a recession this year, a few macroeconomic variables would look very different relative to previous recessions.

1. The Yield curve would be very steep. Unlike in any previous recession when the yield curve was flat or inverted.

















2. The real federal funds rate (or the ECB real repo rate) would be extremely low and would be at a level similar to that of the beginning of the expansion. Unlike in previous recessions where the real central bank interest rates was high relative to the beginning of the expansion.

3. And nominal central bank interest rates would be stuck at zero so there will be no room to lower them in response to the recession. Unlike in previous recessions where nominal interest rates came down by about 4-7 percentage point (this is also true for real interest rates, see previous chart).

So maybe this tells us that a recession is not about to happen. But if it is, the lack of space to implement traditional monetary policy tools should be a big concern for policy makers. If a recession ends up happening, helicopter money will likely become a policy option.

Antonio Fatás

Sunday, January 10, 2016

BIS redefines inflation (again)

An interview with Hyun Song Shin, economic adviser and head of research at the BIS, reposted in the BIS web site reminds us of the strange and heterodox views that the BIS (and others) have about the behavior of inflation. The views run contrary to most of what we all teach about inflation. They can only be understood if one has a very special and radical view on what determines inflation and are supported by a unique reading of the data. You probably need to read the whole interview to understand what I mean but here is a summary of the new BIS theory of inflation:

1. Inflation is a global phenomenon, not a national one. Monetary policy has very little influence on inflation, demographics and globalization are much more relevant factors.

2. The idea that monetary policy affects demand and possibly inflation is a "short-term" story that is too simple to understand the recent behavior of inflation.

3. Deflation is not that bad. The Great Depression is a special historical event that holds no lessons for what we have witnessed during the Great Recession.

4. While central banks are powerless at controlling domestic inflation, they are very powerful at distorting interest rates and rates of returns for long periods of time (decades).

5. Central banks have a problem when inflation is the only goal (they end up creating distortions in financial markets).

6. Monetary policy is a cause of all China's problems (he admits that there are other causes as well).

In summary, central banks are evil. Their only goal is to control inflation but they cannot really control it and because of their superpowers to distort all interest rates they only end up causing volatility and crises. And this is coming from an organization whose members are central banks and its mission is "to serve central banks". Surreal.

Antonio Fatás


Monday, November 23, 2015

Counting backwards to the next recession

In most advanced economies business cycles can be well characterized by a succession of long expansion phases that are interrupted by short recessions. Given this pattern it is sometimes natural to think about the length of expansions as a key feature that describes the business cycle. While other variables matter (such as the depth and length of recessions), in the case of the US and to some extent in the case of European countries, the parameter that has changed the most across cycles is the length of the expansion phase.

In the case of the US (using the NBER business cycle dates), in the post-WWII period expansions have lasted from 12 months in the expansion ending in 1981to 120 months in the expansion ending in 2001. The current expansion is already 77 months long, longer than the previous expansion of 2001-2007.

While counting months is not a good way to forecast the timing of the next recession it is at least a reminder that there is another recession waiting for us in the not-so-distant future. And when we start counting backwards to the next recession a key questions is whether we will be ready for it. In particular, will monetary policy be back to normal and able to react to it?

Interest rates have not yet moved away from zero in either Europe, the U.S. or Japan. This is, of course, very unusual given the length of the expansion. Another way to see how unusual monetary policy and interest rates look like is to plot the difference between long-term rates and the central bank rate.
For the case of the US we can see that this difference (the term premium) has stayed very high since the 2008-09 recession. Unlike in previous expansion where after two to four years the term premium started declining (mostly through increases in the short-term rate), in this case the number remains unusually high. 

There is a positive reading of the chart that suggests that we are far from the next recession. Under the assumption that the term premium has to get very close to zero before a recession happens, it will take a while before we see the next one. But that reading ignores the fact that today short-term rates are not normal, they are stuck at the zero lower bound. Recessions do not happen because the term premium decreases, recessions happen for other reasons and it happens to be that the term premium moves with the cycle. But this expansion is not like the others because of the constraints on short-term rates so it might possibly be that the difference with long-term rates will this time be a really bad indicator of how close we are to a recession.

And this second reading the chart reminds us of the risk that we are facing if the next recession is somewhere in the near future and monetary policy has not had the time to go back to normal, to go back to levels of short term rates that allow for a decrease in these rates that is consistent with what we have seen in previous recession. And entering the next recession in Europe or the U.S. with interest rates that are too close to zero does not sound like a good idea and in addition there is a lot of uncertainty given that we have not seen such a case in the recent business cycles. 

So in addition to all the reasons why we want economic conditions and monetary policy to quickly go back to normal, there is an additional sense of urgency from the scenario that in the near future there is either a domestic or global event that causes the next recession. So in a world with very low interest rates central banks and government need to look forward and make sure that planning for the next recession is part of their strategy to ensure the fastest possible recovery from the previous one.

Antonio Fatás

Thursday, October 29, 2015

The missing lowflation revolution

It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%. Other central banks have spent similar number of years (or much longer in the case of Japan) stuck at the zero lower bound. In these eight years central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends.

Some of these trends have challenged the traditional view of academic economists and policy makers about how an economy works. Some of the facts that very few would have anticipated:
- The idea that central banks cannot lift inflation rates closer to their targets over such a long horizon.
- The fact that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output.
- The slow (or inexistent) natural tendency of the economy to adjust by itself to a new equilibrium.

To be fair, some of these facts are not a complete surprise and correspond well with the description of depressed economies that have hit the zero lower bound level of interest rates because of deflation or "lowflation". We had been warned about this by those who had studied the Japanese experience: both Krugman and Bernanke, among others, had described these dynamics for the case of Japan. But my guess is that even those who agreed with this reading of the Japanese economy would have never thought that we would see the same thing happening in other advanced economies. Most thought that this was just a unique example of incompetence among Japanese policy makers.

Now we have learned that either all central bankers are as incompetent as the Bank of Japan in the 90s or that the phenomenon is a lot more natural, and likely to be repeated, in economies with low inflation, more so when the natural real interest rates is very low.

But if this scenario is more likely to happen going forward it might be time to rethink our economic policy framework. Some obvious proposals include raising the inflation target and considering "helicopter money" as a tool for central banks. But neither of these proposals is getting a lot of traction

My own sense is that the view among academics and policy makers is not changing fast enough and some are just assuming that this would be a one-time event that will not be repeated in the future (even if we are still not out of the current event!).

The comparison with the 70s when stagflation produced a large change in the way academic and policy makers thought about their models and about the framework for monetary policy is striking. During those year a high inflation and low growth environment created a revolution among academics (moving away from the simple Phillips Curve) and policy makers (switching to anti-inflationary and independent central banks). How many more years of zero interest rate will it take to witness a similar change in our economic analysis?

Antonio Fatás