Thursday, 3 July 2014

Ahead of Today's ECB Press Conference

Ahead of the ECB press conference this afternoon, it’s worth reviewing the challenges the ECB faces in its efforts to boost inflation.

The main strategy the ECB is pursuing is to weaken the currency, in an attempt to increase the euro-denominated price of imports into the Eurozone and to lower the prices of Eurozone goods and services denominated in other currencies. The main tactic it’s employing in pursuit of this strategy is to lower its policy rates, widening the interest rate differences between the euro and other currencies.

The first challenge with this approach is that is relies heavily on the notion that exchange rates can be managed by managing interest rate differentials. It’s true that the literature on the uncovered interest rate parity puzzle finds a general tendency for high-yielding currencies to appreciate. But the proposed mechanisms that bring about this correlation are not well understood at a conceptual level, and this literature doesn’t suggest that a central bank can expect to manage the exchange rate via interest rate policy. At a minimum, the experience of the euro over the past month suggests the ECB faces a real challenge in weakening the currency via rate policy.

The second challenge is that the Eurozone isn’t a mid-sized, open economy, like the UK, which experienced an increase in its inflation rate after a depreciation of sterling. As a result, the currency depreciation required to increase the Eurozone inflation rate by, say, 50 bp, is presumably much larger than the depreciation required for a similar increase in the UK inflation rate. To put these moves in perspective, sterling depreciated roughly 30% relative to the dollar in 2008. A similar move in the euro would bring the currency to just below parity against the dollar. With this in mind, it seems highly improbable that a difference in the policy rates of 35 bp will lead to a depreciation of the euro sufficient to produce a noticeable increase in the Eurozone inflation rate.

In the bigger picture, the main potential internal catalysts for growth in the Eurozone are probably fiscal stimulus and labor market reforms. The latter are increasingly unlikely given favorable pricing of peripheral debt currently, while the former are under discussion within the EU but face serious constraints, given the negotiating stance taken by the northern EMU member states.

The potential external catalyst for growth in the Eurozone is an increase in export demand, consistent with the ECB strategy. But I believe an increase in export demand will only take place in an environment of more robust global growth. In particular, I don’t believe the ECB will be able to increase export demand noticeably unless it can engineer a significant currency depreciation. And I don’t believe the ECB will be successful in engineering a significant currency devaluation simply by increasing the policy rate difference with the US by 10 bp.

No doubt Draghi will be asked about his exchange rate strategy at today’s press conference, particularly as the euro has richened back to its level at the time of the June press conference. And no doubt he’ll reiterate that the ECB is prepared to use unconventional instruments, including large-scale asset purchases. And in this regard it’s worth noting Draghi’s comments during the last press conference on the timing of policy changes with respect to persistent low inflation, “…the longer it lasts, the higher the risks. And that's what we are reacting to. We are reacting to a risk of a too-prolonged period of low inflation.”

During the height of the euro sovereign debt crisis, peripheral spreads and the euro were negatively correlated, as the euro weakened in response to higher peripheral spreads. At the moment, I expect this negative correlation will continue, as peripheral spreads narrow in response to any currency strength. In particular, unless the euro weakens or unless global growth increases, the ECB will feel an increasing need to conduct large-scale asset purchases. My expectations for the next few months are that the euro is unlikely to weaken by an amount that would boost inflation noticeably and that global growth is likely to remain modest so that peripheral spreads will continue to narrow as the prospects for large-scale asset purchases increase. But today's press conference will provide another opportunity for assessing the views of the Governing Council on the issue.

Wednesday, 2 July 2014

Yellen, Employment, and Financial Stability

The two most interesting events for the bond market this week are likely to be Yellen’s IMF speech later today and nonfarm payrolls tomorrow. I’ll discuss each of these two events in turn and then comment on the link between the two.

Yellen's IMF Speech on Financial Stability

The topic of Yellen’s speech, financial stability, is particularly appropriate given the current critique that highly accommodative policies among the big four central banks are resulting in overvaluations in various markets (eg, housing, bonds, credit, equities) and prompting households and firms to take undue risks.

Just this weekend, at the start of the BIS AGM, General Manager Jaime Caruana summarized this critique succinctly. Speaking of the various effects of “extraordinarily accommodative” monetary policy, he noted, “There is a threat to financial stability too, as ultra-low interest rates promote debt accumulation and risk-taking.” And he concluded his comments on monetary policy by suggesting, “After years of easy money, we need to pay more attention to the risks of normalising too late.”

Yellen’s recent comments suggest she’s currently more sanguine about these risks. For example, at the June 18 FOMC press conference,  Greg Ip asked Yellen specifically, “Will financial stability considerations play a role in when and how fast the Committee normalizes interest rates?” Yellen’s response was fairly direct. “I don’t see them shaping monetary policy in an important way right now. I don’t see a broad-based increase in leverage, rapid increase in credit growth or maturity transformation, the kinds of broad trends that would suggest to me that the level of financial stability risks has risen above a moderate level.”

However, the larger discussion among central bankers is about the ways in which financial stability should influence their overall policy frameworks. For example, simple rule-based approaches, such as the Taylor rule, don’t address the issue of financial stability. And yet many central bankers believe there is a political and social imperative post crisis to include financial stability in their policy frameworks. The challenge for each central bank then is to develop a framework that addresses financial stability in a way that reflects its particular mandate.

The most active line of research on this issue within the Fed involves the use of a loss function that penalizes the policy maker for deviations from his mandated objectives. In the quadratic version of this loss function (discussed most frequently at the Fed), the penalty increases as the square of the deviation. For example, if the inflation objective is 2% and the actual inflation rate is 3.5%, the penalty is considered to be 2.25 (ie, [3.5-2]^2 ). The strategy of the policy maker then is to minimize the sum of the expected deviation from target and the expected value of the squared deviation from target (ie, the variance). In the case of the Fed, there would be two targets: inflation, and employment.

The relevant aspect of this approach is that it presents the policy maker with a trade-off between the mean and the variance of the deviations from target. As a result, the policy maker may intentionally follow a policy in which inflation and/or unemployment are expected to deviate from their targeted values if the policy results in a reduction in the variances of these deviations from their targets. Or as Kocherlakota put it in a speech in April of last year, “…the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives.”

There are quite a number of potential problems in adopting this approach. For example, the Fed would need to have models for inflation and unemployment that specify their variances as well as their expected values. In a speech in March of this year (ie, while still a Board member), Jeremy Stein suggested that bond term premiums and credit spreads would be useful variables in this context. In particular, he suggested, “…monetary policy should be less accommodative--by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level--when estimates of risk premiums in the bond market are abnormally low.”

Stein’s comment highlights not only the modelling challenges inherent in the loss function approach but also the political difficulties the Fed is likely to encounter were it to adopt this framework. For example, one can imagine the heated comments Yellen would receive from members of Congress during her semi-annual testimony if she acknowledged that the Fed was intentionally sacrificing the jobs of their constituents because the yield curve was too flat.

An additional economic and political challenge would be to specify an appropriate employment target, which presumably would need to vary over time. And for a Fed so clearly committed to transparency, attempts to communicate policy formulated with a quadratic loss function would pose a considerable challenge.
Given Yellen’s recent comments, I don’t expect her to announce a major shift in the Fed’s framework in today’s IMF speech. But I do believe it’s possible that she’ll provide an update on Fed research into this issue, as part of an evolution in the Fed policy framework, similar to the evolution in the Fed’s specification of a 2% inflation objective under Bernanke.

As for the immediate implications, I expect Yellen will reiterate that the observed degrees of indebtedness and leverage in the economy don’t point to the sorts of financial imbalances that would pose a risk to financial stability. Note that in her recent comments she’s avoided using asset prices per se as a metric for assessing financial stability, preferring instead to focus on the exposures within the household, financial, and corporate sectors.

Thursday's Nonfarm Payrolls Report 

In this context, it’s also worth considering the immediate implications of this week’s payrolls report on Fed policy. The median estimate of economists surveyed by Bloomberg is currently 213 K, with the unemployment rate remaining at 6.3%.  Figures in line with these expectations would be consistent with a continuing decline in the available slack in the labor markets.

But the problem facing the FOMC is not to estimate the pace with which resource slack is declining. Rather, it’s to estimate the point at which the slack will be depleted, at which time increasing labor costs would be expected to exert upward pressure on the inflation rate. And to estimate the level of labor slack (as opposed to its change), one needs to take a view on the effect of quite a number of factors, such as the pace of retirements, hysteresis, and changes to various government programs, such as unemployment, disability, SNAP, and health care.

Given the difficulty of estimating labor slack directly, the Fed also finds it useful to monitor wage developments, given the reasonable expectation that unit labor costs will begin to increase as slack in the labor market is eliminated. For example, during her testimony before the Joint Economic Committee on May 7, Yellen noted, “most measures of labor compensation have been rising slowly--another signal that a substantial amount of slack remains in the labor market.”

Yellen also referenced the unemployment rate and labor costs during the press conference following the June 18 FOMC meeting. On the unemployment rate, she offered, “…many of my colleagues and I would see a portion of the decline in the unemployment rate as perhaps not representing a diminution of slack in the labor market.” And she later noted, “My own expectation is that as the labor market begins to tighten, we will see wage growth pick up … so households are getting a real increase in their take-home pay. She continued, “Within limits, it’s not a threat to inflation…” She then noted, “If we were to fail to see that, frankly, I would worry about downside risk to consumer spending.”

Financial Stability and Employment in the Context of Monetary Policy

As the unemployment rate continues to decline, and as real and financial assets continue to richen, I expect the calls for the FOMC to hike rates will grow louder, including calls from members of the Committee. But I also expect that Yellen will continue to argue that unit labor costs are more useful than the unemployment rate in gauging slack in the labor market and that exposures in the household, financial, and corporate sectors are more important than asset prices in assessing risks to financial stability.

I expect these developments will occur in the context of a continuing trend in the asset markets in which the capital available for investment exceeds the demand for capital to invest, resulting in a general reduction in expected returns across asset markets, consistent with higher equity prices, tighter credit spreads, higher house prices, and lower real yields. But as the inflation hawks become increasingly vocal in H2, I expect we’ll see some upward pressure on the 1Y-5Y segment of the yield curve and upward pressure on longer-dated breakeven inflation rates. I also expect we’ll see greater volatility along the curve in general, particularly in the 1Y-5Y segment.