As the Federal Reserve contemplates lift-off in December from seven years of near-zero interest rates, policy makers should not ignore the global backdrop.
I’m not talking about equity markets, whose tremors were instrumental in encouraging the Fed to take a pass on a rate increase at the September meeting. I refer instead to the broad-based collapse in industrial commodity prices, including oil, copper and nickel. While the 60% decline in crude oil prices CLF6, -1.23% since June 2014 reflects both an increase in output — a result of hydraulic fracturing in the U.S. — and a decline in demand, the commodity-wide rout points to reduced global appetite for these essential industrial materials, especially from China.
These demand-sensitive indicators tend to match the ebb and flow of the business cycle, for obvious reasons. When Manley Johnson was vice chairman of the Fed from 1986-1990, he and his assistant, Bob Keleher, introduced the idea of auction-market indicators as a guide to the stance of Fed policy. Specifically, the Treasury yield curve, the foreign exchange value of the dollar and commodity prices could provide real-time feedback on whether monetary policy was too tight or too easy.
The intuition is simple: too simple, in fact, for a profession enamored of econometric models. Raw-materials prices are sensitive to changes in worldwide demand. A strong or rising dollar, symptomatic of increased capital inflows seeking a higher real return, makes U.S. exports more expensive and reduces trade’s contribution to growth. And the yield curve is a picture worth a thousand words. When the spread between short and long rates is wide, it provides an incentive for banks to create credit (i.e. to lend) and is therefore expansionary. An inverted curve, on the other hand, with the Fed pushing short rates above long rates, is a sure-fire sign that the Fed is too tight.
Currently two of the three indicators are suggesting that economic growth is hardly robust. While the spread between the funds rate and the 10-year Treasury rate is still steep by historical standards, an index of industrial commodities just set a 6 1/2-year low. The trade-weighted dollar index is at a 12-year high. The dollar is trading close to parity with the euro, something last seen 13 years ago.
The current Fed, led by Janet Yellen, is hyper-focused on the labor market. While there is no shortage of predictions that the 5% unemployment rate is a warning sign that the economy is growing faster than its potential, I doubt this business cycle is going to end with a labor market bursting at the seams and a wage-price spiral. Even Yellen admits that the unemployment rate is an inaccurate measure of labor-market slack because of high rates of underemployment and low labor-force participation.
Of course, no two business cycles are exactly alike. Some are characterized by soaring inflation, which the Fed attempts to tame with higher interest rates. Recession is generally the unavoidable consequence. Others are characterized by soaring asset prices. When the music — and the flow of credit — stops, so does economic growth. Still others are compounded by financial crises; an impaired banking system makes recovery that much harder.
What all business cycles have in common is the driver, in the form of the central bank, which uses interest rates to stimulate or temper aggregate demand. The fact that the funds rate has been exceptionally low for an extended period, to borrow Fed parlance, without generating either strong growth or higher inflation suggests that today’s economy requires ultra-low interest rates just to sustain itself. It means that the neutral rate, or the rate required to keep the economy growing at its non-inflationary potential in perpetuity, is no longer 4% or even the 3.5% projected by the Fed at its September meeting. Both cyclical and structural forces are conspiring to reduce the unobservable natural rate.
There are other troubling signs for a Fed about ready to embark on even a limited tightening cycle, according to Michael Darda, chief economist at MKM Partners. Credit spreads have been widening, both for Baa-rated and for high-yield corporate bonds. Market-based indicators of inflation expectations continue to fall. And nominal growth is limping along.
“We have the prospect of the Fed starting to tighten on Dec. 16 into the teeth of credit stress, a big decline in market-based inflation expectations and a slowdown in nominal growth,” Darda says. “It may work out OK, but to me it’s a risky setup.”
Wait, the $18 trillion U.S. economy, the world’s largest, can’t withstand a 25 basis point increase in its overnight interbank rate?
It may not sound like a lot, but Darda provides some perspective.
In 2000, the Bank of Japan raised rates once by 25 basis points. Result: “deflationary recession,” he says. The BOJ repeated the escapade in 2006-2007, raising rates twice by a total of 50 basis points, with the same result. The Japanese economy is in recession once again with its benchmark rate at 0%.
Darda points to the European Central Bank, which implemented “an ill-timed 50-basis-point rate increase” in 2011, sending the eurozone back into recession and the benchmark rate even lower than before to 0.05%.
The Fed is regularly criticized for keeping rates too low for too long; for penalizing savers; and for encouraging investors to take risks by depressing the yield on risk-free Treasuries through its various asset-purchase programs.
The ECB and BOJ have generated little growth with their 0% rates. It may not count for much, but the Fed has done a better job than its overseas counterparts.
http://www.marketwatch.com/story/th...interest-rates-just-to-stay-afloat-2015-11-25
I’m not talking about equity markets, whose tremors were instrumental in encouraging the Fed to take a pass on a rate increase at the September meeting. I refer instead to the broad-based collapse in industrial commodity prices, including oil, copper and nickel. While the 60% decline in crude oil prices CLF6, -1.23% since June 2014 reflects both an increase in output — a result of hydraulic fracturing in the U.S. — and a decline in demand, the commodity-wide rout points to reduced global appetite for these essential industrial materials, especially from China.
These demand-sensitive indicators tend to match the ebb and flow of the business cycle, for obvious reasons. When Manley Johnson was vice chairman of the Fed from 1986-1990, he and his assistant, Bob Keleher, introduced the idea of auction-market indicators as a guide to the stance of Fed policy. Specifically, the Treasury yield curve, the foreign exchange value of the dollar and commodity prices could provide real-time feedback on whether monetary policy was too tight or too easy.
The intuition is simple: too simple, in fact, for a profession enamored of econometric models. Raw-materials prices are sensitive to changes in worldwide demand. A strong or rising dollar, symptomatic of increased capital inflows seeking a higher real return, makes U.S. exports more expensive and reduces trade’s contribution to growth. And the yield curve is a picture worth a thousand words. When the spread between short and long rates is wide, it provides an incentive for banks to create credit (i.e. to lend) and is therefore expansionary. An inverted curve, on the other hand, with the Fed pushing short rates above long rates, is a sure-fire sign that the Fed is too tight.
Currently two of the three indicators are suggesting that economic growth is hardly robust. While the spread between the funds rate and the 10-year Treasury rate is still steep by historical standards, an index of industrial commodities just set a 6 1/2-year low. The trade-weighted dollar index is at a 12-year high. The dollar is trading close to parity with the euro, something last seen 13 years ago.
The current Fed, led by Janet Yellen, is hyper-focused on the labor market. While there is no shortage of predictions that the 5% unemployment rate is a warning sign that the economy is growing faster than its potential, I doubt this business cycle is going to end with a labor market bursting at the seams and a wage-price spiral. Even Yellen admits that the unemployment rate is an inaccurate measure of labor-market slack because of high rates of underemployment and low labor-force participation.
Of course, no two business cycles are exactly alike. Some are characterized by soaring inflation, which the Fed attempts to tame with higher interest rates. Recession is generally the unavoidable consequence. Others are characterized by soaring asset prices. When the music — and the flow of credit — stops, so does economic growth. Still others are compounded by financial crises; an impaired banking system makes recovery that much harder.
What all business cycles have in common is the driver, in the form of the central bank, which uses interest rates to stimulate or temper aggregate demand. The fact that the funds rate has been exceptionally low for an extended period, to borrow Fed parlance, without generating either strong growth or higher inflation suggests that today’s economy requires ultra-low interest rates just to sustain itself. It means that the neutral rate, or the rate required to keep the economy growing at its non-inflationary potential in perpetuity, is no longer 4% or even the 3.5% projected by the Fed at its September meeting. Both cyclical and structural forces are conspiring to reduce the unobservable natural rate.
There are other troubling signs for a Fed about ready to embark on even a limited tightening cycle, according to Michael Darda, chief economist at MKM Partners. Credit spreads have been widening, both for Baa-rated and for high-yield corporate bonds. Market-based indicators of inflation expectations continue to fall. And nominal growth is limping along.
“We have the prospect of the Fed starting to tighten on Dec. 16 into the teeth of credit stress, a big decline in market-based inflation expectations and a slowdown in nominal growth,” Darda says. “It may work out OK, but to me it’s a risky setup.”
Wait, the $18 trillion U.S. economy, the world’s largest, can’t withstand a 25 basis point increase in its overnight interbank rate?
It may not sound like a lot, but Darda provides some perspective.
In 2000, the Bank of Japan raised rates once by 25 basis points. Result: “deflationary recession,” he says. The BOJ repeated the escapade in 2006-2007, raising rates twice by a total of 50 basis points, with the same result. The Japanese economy is in recession once again with its benchmark rate at 0%.
Darda points to the European Central Bank, which implemented “an ill-timed 50-basis-point rate increase” in 2011, sending the eurozone back into recession and the benchmark rate even lower than before to 0.05%.
The Fed is regularly criticized for keeping rates too low for too long; for penalizing savers; and for encouraging investors to take risks by depressing the yield on risk-free Treasuries through its various asset-purchase programs.
The ECB and BOJ have generated little growth with their 0% rates. It may not count for much, but the Fed has done a better job than its overseas counterparts.
http://www.marketwatch.com/story/th...interest-rates-just-to-stay-afloat-2015-11-25
