Category Archives: Policy

Cut Italy some slack

In the last few days the market has been getting worked up about the new Italian government and its deficit plans. Italy is well known to have the largest debt burden in the EU, and the largest as a % of GDP after Greece, and after all the problems Greece caused it is not surprising that expansion of Italy’s budget deficit is view with concern. But a bit of perspective is necessary. First of all, the proposed rise in the deficit is only to 2.4% of GDP – below the EU guideline limit of 3%. The Italian deficit has only been lower than this in three years since 2000, so this is hardly an unprecedented blowout. But the EU will not be criticising Italy for exceeding deficit guidelines, but for failing to do enough reduce their debt – which is currently at 130% of GDP, well above the EU guideline of 60%. To that extent, EU concern is understandable, but looking a little more closely it is hard to argue that this debt should be a major concern.

The debt level is a concern if it is rising year on year and starts to spiral out of control. But this is currently not the case in Italy, where the debt level has been stable since 2014, partly because Italy is running a primary budget surplus, as it has for many years, partly because the yield on Italy’s debt, and consequently Italian debt interest payments, have been falling steadily. So much so, that even though the debt level is close to its highs at 130% of GDP, net debt interest payments are at the lowest level since 2000 (and long before that) at 3.5% of GDP.

To determine the level of the deficit that is needed to reduce the debt level we need to do a little maths. Leaving aside some technicalities, the primary surplus needs to be greater than the debt level multiplied by the difference between the nominal growth rate and the nominal interest rate. Or:-

p > D(g-i) where p is the primary surplus, D is the debt level, g is the growth rate and i is the average debt yield.

In Italy’s case, D=130, and i=2.7%. g is the biggest problem, as this is averaging only around 2% in the last few years. Still, on that basis we need p> 130(0.02-0.027) = 0.91.

If Italy runs a deficit of 2.4% of GDP, with debt interest payments of 3.5% of GDP, it is running a primary surplus of 1.1% of GDP. This is lower than we have seen in recent years, but still greater than 0.91% and enough to keep the debt level stable, albeit barely reduce it.

Now, this is all very well for now while yields are low, but, you may ask, what happens if yields go up in the coming years as they seem likely to do when the ECB stops its QE and starts raising rates? This is a fair question, but Italy has protected itself to some extent by extending the average maturity of its debt to 7 years, so that any rise in yields will take some time to have a major effect.

But the bigger picture is this. The best way for Italy to exit the debt trap is to boost its (nominal) growth rate. While we can argue about the best way to do that, a modest fiscal boost won’t do any harm, while the impression that they are subject to an EU strait-jacket will not help. There are some minor signs of improvement in the Italian economy. The long term unemployment rate has started to fall, the growth rate has picked up modestly, and the current account is in increasing surplus. This, by the way, suggests that the Italian private sector is saving too much and holding back growth. A little more government spending and some boost to consumer confidence could be what is needed to keep growth accelerating.

While Italy’s debt does need to be dealt with in the longer run, the EU should see that attempting to impose austerity is not going to work either economically or politically. Trying to slap the new government into line will only foment more disaffection with the EU and likely create an even more anti-EU political movement. In any case, there isn’t much the EU can do to stop Italy’s government doing what it plans in the short-term. Things like the excessive deficit procedure take a long time to kick in and are pretty ineffective anyway. The biggest discipline on Italy will be the markets, and the best way for the EU to help Italy is to encourage the markets to cut Italy a little slack.

 

 

USDMXN way out of line with fundamentals

I am far from being an expert on Mexico, but I am aware of the basic story behind the weakness of the MXN in the last few years. General USD strength, concerns about protectionism under Trump and weakness in the oil price have all contributed, while related NAFTA negotiations and the election this year are helping to prevent a major recovery. But the extent of MXN weakness just looks way out of line with the available evidence. Of course, it is possible that trade arrangements with the US become more problematic, but the MXN is around 25% weaker than you would expect relative to “normal” valuation. That is, USD/MXN has typically traded around 70% above PPP in the last 20 years. With PPP currently around 8.90, this suggests the “normal” level would be around 15.15. The current price near 19 just seems to price in all but the very worst bad news, so that the risks from here lie overwhelmingly on the upside for the MXN.

The chart below illustrates just how far away from normal the MXN is. The only time in the last 30 years that we saw the MXN as weak as this was during the “Tequila crisis” of 1994/1995. This was a proper crisis. The current account started off with a deficit of nearly 6% of GDP and the liberalisation of markets led to a devaluation of the peso, a loss of confidence in the economy, a balance of payments crisis, a 6% decline in GDP in 1995 and ultimately a US led bailout. The current situation is comparatively benign. While the current account deficit has increased, it is not in worrying territory, and growth, though a little weaker than desirable, is reasonable. GDP per capita is around 30% higher relative to the US now than it was then. There are of course concerns surrounding the relationship with the US, but markets in general are no longer expecting Trump to carry through his more aggressive threats.

I’m not going to predict the outcomes of NAFTA negotiations, or the Mexican elections. As I say, I’m no expert on these issues. But valuations say that the MXN is substantially undervalued unless we get a replay of the Tequila Crisis, and even the pessimists aren’t forecasting that.

 

usdmxn

Source: OECD

Mexico current account

Source: World Bank, OECD

 

Rate hike won’t sustain GBP strength

I’ll make this short because I’ve covered this ground in this blog before, but recent gains in GBP in response to the latest inflation data and the more hawkish tone from the Bank of England at the September meeting make it worthwhile to go over it once again.

First, the basics. Higher inflation, other things equal, should mean a currency goes down, not up, in order to maintain the relative price level. The fact that currencies tend to rise in the short run with upside surprises in inflation is an anomaly seemingly based on a combination of money illusion and a historic expectation that higher inflation will trigger a response from the central bank that will actually mean higher real interest rates. This seems to be a distant memory of the 1970s and 80s, because it is hard to find occasions in the more recent past where higher inflation has triggered higher real rates (as opposed to just higher nominal rates) in the major economies. Of course, real rates have been falling steadily for years as a result of structural as opposed to cyclical factors, but even the cyclical upturns have seen precious little rise in real rates (see the FX market needs to rethink inflation, November 18 2016).

All this is relevant to the recent reaction to UK news. Inflation is above target and still rising, mainly in response to the decline in GBP seen after the Brexit vote. The MPC is now considering a rate rise in response. But the rate rise will come nowhere near full compensation for the rise in inflation seen since the Brexit vote. Real rates have fallen, and even if we see a 0.25% rise in the base rate soon they will still be well below where they were not just before the Brexit vote, but immediately after the BoE cut in rates after the vote (see chart below). While inflation has also risen elsewhere, it has not moved as much, and UK real rates remain unattractive, and will remain unattractive even if they move modestly higher.

Real UK base rate

uk real rates

Source: Bank of England

On top of this, there is the question of whether higher real rates in these circumstances, if they were to come, should be seen as positive for GBP. In general, higher real rates are theoretically positive for a currency, but in the current UK situation Carney’s speech yesterday makes it clear that his case for higher rates is based primarily on the expected inflationary consequences of Brexit. This is not the usual cyclical impact of rising demand, but a structural change that will reduce both demand and supply and raise prices, at least in the short run, with Brexit effectively acting as a de-globalisation. Carney’s case for higher real rates essentially rests on the belief that the Brexit impact on supply will be greater than the impact on demand. This is debatable (as he himself admits) and it is hard to instinctively see this as positive for GBP, because real rates will be rising because of reduced potential output due to reduced efficiency and lower productivity. Any benefit from higher portfolio inflows to seek out the higher real rates seems likely to be offset by reduced inward direct investment as a result.

In summary, the case for GBP gains based on a more hawkish BoE seems very weak. Any rise in nominal rates looks unlikely to translate into a rise in real rates, and to the extent that real rates are higher than they would have been, it will likely only reflect the Bank’s concern that Brexit is going to undermine potential UK output growth by reducing productivity and undermining existing supply chains. Of course, that doesn’t mean GBP will reverse recent gains quickly (the market can remain irrational longer than you can remain solvent), but looking at the charts suggests to me that 1.38 would be a very good area to sell GBP/USD, while anything below 0.87 looks a buying area for EUR/GBP.

Riksbank policy – dangerous, myopic and unsustainable.

I’ve seen some fairly odd decisions made by various central banks in my 30 odd years in the markets. But they normally have some sort of explanation, even if you don’t agree with it. But in the case of the Riksbank decision last week, I honestly cannot understand the rationale for not only leaving rates and asset purchases unchanged, but also leaving projections for future policy unchanged, with the first rate hike not expected until 2018. It is frankly utterly bizarre, and smacks of an ill-conceived desire to maintain a weak currency – a desire that has no justification whatsoever given Sweden’s macroeconomic circumstances.

Even at the July meeting, it was quite hard to justify the super easy stance of the Riksbank. The economy has been growing at 3% +, the employment rate was at record levels, and inflation was only modestly below target. But despite having the strongest economy in the G10 Sweden was running one of the easiest monetary policies, with the repo rate at -0.5% and asset purchases continuing. At the September meeting the Riksbank had to consider the news that GDP growth had accelerated to 4% y/y in Q2, and inflation had risen to 2.4% on their targeted CPIF measure, above the 2% target for the first time since 2010. But the Riksbank decided not only to continue with their hyper-easy policy, but didn’t change the view that they wouldn’t raise rates until the second half of 2018. Why? Well according to the Riksbank:-

” For inflation to stabilise close to 2 per cent, it is important that economic activity continues to be strong and has an impact on price development. It is also important that the krona exchange rate does not appreciate too quickly.”

In their report the Riksbank accept that growth is stronger than expected, inflation higher than expected (and above target), resource utilisation is approaching historic highs, and the employment rate and household debt at record levels, but they still want to keep rates at historic lows. The only reason they appear to have is that they don’t want the currency to rise too fast as this would endanger the inflation target. This seems to me to be an incredibly short-sighted policy, which has been shown to be unstable and dangerous in many places in the past, the UK most notably.

Sweden is a very open economy, and the currency certainly will have a significant impact on inflation in the short-term. But in the end keeping interest rates at a level that is inappropriate for the economy in an attempt to prevent currency strength is courting disaster. The result will likely be continued strong growth in the short run, further rises in household debt and above target inflation. When the brakes do have to be applied they will have the be applied that much harder, sending the currency up that much quicker. Or if the Riksbank choose not to apply the brakes, perhaps because inflation doesn’t rise too much, they result will ultimately be that the excessive debt burden causes a crash.

This isn’t just about Sweden, it’s also about the weakness of the policy of inflation targeting. The inflation process may well have changed significantly in recent years, with wage growth failing to ignite despite low and falling unemployment in Sweden and the Anglo-Saxon economies. The path from policy to the economy to inflation has not only changed, it may be almost completely blocked. Inflation is being determined elsewhere by other factors. Setting interest rates to control inflation in the short to medium term is becoming a ridiculous endeavour, and attempts to control inflation by controlling the currency are taking huge risks with the economy.

But it’s not even the case that the Swedish krona is particularly strong. The Riksbank likes to use the nominal KIX index, which shows the SEK slightly on the strong side of recent averages, and they cite the recent rally as one of the reasons for their decision in September. But measures of the real exchange rate show it to be very much on the weak side of historical norms. Attempts by the Riksbank to stop it rising are ultimately futile. Sooner or later it will return to normal levels, and it is better to allow it when the economy is strong and running a substantial trade surplus. A strong currency is a good thing – it makes consumers richer. They will be able to spend more without increasing their debt, and the trade surplus might come down. Instead, the Riksbank are following an unsustainable and dangerous policy, tying their policy to a region (the Eurozone) which is years behind Sweden in its recovery.

sek

Source: Riksbank, BIS

Germany’s trade surplus is down to Germany not the ECB

In a speech in Berlin yesterday, Merkel said the German trade surplus was propelled by two factors over which the government had no influence, namely the euro’s exchange rate and the oil price. Well, there’s some truth in that, but not much. It’s fair to say that a weak euro probably does increase the trade surplus, though the impact of the exchange rate is quite delayed and weak. And a lower oil price does reduce the oil deficit, but there is still a substantial deficit in oil so you can hardly blame this for a trade surplus.  These factors may have led to a higher trade surplus than would otherwise have been the case, but they are not the primary cause of the large and persistent German trade surplus. That much is obvious just by looking at the German trade and current account surpluses in recent years. Yes, the surplus has increased a little in the last few years in response to the lower euro and the lower oil price, and is expected to be 8.8% of GDP in 2017. But the current account surplus was already 6.8% of GDP 10 years ago in 2007 and 7.1% of GDP 5 years ago in 2012. In 2007, the euro was around 10% higher in real effective terms (for Germany) than it is now, and the oil price was around $70 a barrel. In 2012 the euro was actually not very far from current levels in real effective terms (though stronger against the USD), and the oil price averaged around $110 per barrel. The German trade and current account surpluses were nevertheless still very large. Merkel’s attempts to claim that they are a function of a weak euro and a high oil price just won’t wash.

german stuff

Source: OECD

Merkel’s comments are an attempt to evade criticism of German policy, which have come most recently from the US but have been heard before in Europe. She is arguing that the problem is out of her control because she doesn’t want to take the measures necessary to reduce Germany’s trade surplus. What could be done? It is not an easy problem to solve, but she could make some contribution with easier fiscal policy. Her fiscal stance has been very conservative and makes Britain’s attempts at austerity look spendthrift. The German budget is expected to show a 0.5% of GDP surplus in 2017, following similar surpluses in the previous 3 years. This is certainly on the austere side, and government debt has been falling fairly rapidly as a result, expected to hit just 65% of GDP this year, back to 2008 levels after seeing a peak of 81.2% in 2010. Of course, the original target for this debt level was 60% of GDP, but much higher levels are sustainable with much lower real interest rates. The Eurozone average government debt is over 90% of GDP.

german stuff1

Source: BIS

However, the big problem is really the private sector rather than the public sector. The private sector save too much (or don’t invest enough). The proper monetary policy response to this is to keep interest rates as low as possible, so on that basis the ECB are doing exactly the right thing. But more could be done with fiscal policy in Germany, either with stimulative tax cuts, or more government spending. This would both directly encourage imports and, by forcing up wages and prices, would lead to improved lower real interest rates and reduced German competitiveness. Part of the reason for the big German trade surplus is the big wage competitiveness advantage built up in the aftermath of the creation of the euro. That’s why Germany has been running big trade and current account surpluses since the mid 2000s.

But Merkel doesn’t really want to do this. She doesn’t want to undermine Germany’s competitive advantage with the rest of Europe (as well as the rest of the world). She doesn’t want to run a less austere budgetary policy and alienate the conservative wing of the CDU. So she’s blaming the ECB and the oil price. The rest of Europe need to tell her she’s wrong. I see no chance that Draghi or the ECB will take any notice of her, so logically there is little reason for the Euro to benefit directly from her comments.  But with the political and economic winds behind it, there is little reason to oppose euro strength anyway. The CHF and GBP look the most vulnerable of the major currencies in this environment, though the USD could also suffer if rate expectations drop away significantly.

german stuff2

Source: EU Commission

The UK needs a weak pound

UK Chancellor Philip Hammond welcomed the rise in the pound that accompanied the announcement of the UK election last month. He should be careful about cheerleading GBP strength, because right now the UK is more in need of a weak pound than it has been for a long time, and a significant recovery in GBP could be a big problem for the UK economy.

The UK economic situation is dangerous, not only because of Brexit, but because of the perilous position of the UK’s consumer finances. This is well illustrated by the chart below showing the financial balances of the three sectors of the UK economy, balanced by the position with the rest of the world.

sector balances

Source: ONS

The UK household deficit is at record levels, and as can be seen from the chart, the existence of a deficit is a rarity, seen only briefly in the late 80s and then for a few years in the mid 2000s. It is a danger signal. In both cases, the deficit was followed by a recession, as consumers retrenched, as can be seen from the chart below.

householdbalance and GDP

Source: ONS

The process see in the past is instructive. Most of the time, GDP grows as the household balance moves towards deficit, fuelled by deficit spending. However, when the household balance moves into deficit, it tends to reverse, and this has historically led to a recession. If this is not to happen this time around, the inevitable reversal in the household balance must be accomplished slowly while other sectors are adding to growth. With the government constrained by longer term budget issues, this really only leaves investment and net exports. This makes the danger from Brexit fairly obvious. If firms are worried about access to the single market then investment in the UK may be curtailed. Longer term, the terms of Brexit will be key for net exports, but shorter term, the export sector looks likely to be the healthiest, as UK exporters benefit from the combination of a lower pound and strengthening Eurozone domestic demand. But this is why a significant recovery in the pound is not desirable. It would both undermine export growth and discourage investment.

Is a recession inevitable when households retrench? Not necessarily – it will depend on the conditions. In 2000 when the dotcom bubble burst the UK avoided recession in spite of a very extended household sector which did retrench, because rate cuts encouraged firms to borrow. But this underlines how important business confidence is in the current UK cyclical situation. With no rate cuts available to encourage businesses or households to spend, confidence in the future is key if spending is to be maintained.

All this makes the timing of Brexit look extremely inopportune. In the mid 2000s, the household sector ran a financial deficit for a few years before the crash, but the crash was all the more severe when it came for that reason. If growth is maintained in the coming years ahead of Brexit, the situation will be similar when Brexit actually happens. If Brexit hurts exports and investment, there will be no safety net.

Policywise, this should make it clear to the government that “no deal” with the EU is not an option. The fear is that they will  believe their own publicity and see limited economic damage if they fail to get a deal. Or take the view that, politically at least, falling back on the WTO will be favourable to accepting a deal that is like EU membership only worse. Hopefully sense prevails.

But in the meantime, the UK economy needs to be managed into a position where it can deal with a potential shock. This means managing a retrenchment of household finances now – while exports are strong enough to offset the negative growth impact. Unfortunately, it is hard to think of a policy mix that will achieve the desired outcome of slower consumer spending with strong exports and investment. Higher rates would help increase saving, but would also likely undesirably boost the pound. Higher taxes wouldn’t reduce the household deficit, only consumer spending, but would give the government more scope to react to shocks in the future, so are probably desirable. Direct restrictions on consumer borrowing might also make sense. But a stronger pound would not be helpful. Hammond should not be talking it up.

Canada (and CAD longs) should be worried about the US border tax

usdcad

Trump has talked a lot about Mexico, imposing a border tax  and getting them to pay for the wall. USD/MXN has reacted aggressively, and although it is off its highs in common with the general USD dip in recent weeks, USD/MXN is still 60% higher than it was 2 years ago. But it seems to me the market ha been overly focused on Mexico when it comes to Trump’s trade policies. While he has been very vocal on the possibility of a tariff on Mexican and/or Chinese goods, the actual plan for a border tax adjustment looks much more likely to be along the lines proposed by the House Republicans. This would be part of a general tax reform involving a cut in the corporate tax rate to 20% and a “border adjustment tax” of 20%. Such a tax would likely be charged on all imports (while all exports would be tax-deductible) regardless of where the imports come from. It seems unlikely the new system would be focused on Mexico or any other single country. As such, it seems the reaction seen in USD/MXN is excessive relative to the reaction seen in other currency pairs.

This sort of tax is normally associated with consumption tax based systems like VAT. In that case, a tax is added to imports to level the playing field with domestic goods on which VAT has been charged, while exporters get VAT refunded. Although the US system isn’t a consumption tax based system, the idea is to switch the US system to a territorial system in which companies are only taxed on revenues earned domestically rather than the current worldwide system in which US companies are taxed on all revenues. The argument is then that the system (a destination based cash flow tax or DBCFT) will then be broadly equivalent to a consumption based tax system. There are several technical arguments about deduction for wages and land which mean that this is probably not correct, and the tax my consequently be against WTO rules. This may be a problem for the system in the long run, but establishing whether it breaches WTO rules and generating a response will take some time, and the short to medium term impact of such a policy, if implemented, is likely to be significant.

If such a system is implemented, it will immediately increase import prices and reduce export prices. From a trade perspective, it would effectively be equivalent to a devaluation of the USD by 20%. The academic response from trade economists to such a policy is that the market reaction would be for the USD to appreciate by 20%, leaving everything real effectively unchanged. But in practice this won’t happen. The level of the USD doesn’t only affect trade, but also asset values and capital flows, and changes in such flows in response to moves in the USD are often larger and almost always faster than changes in trade flows. It is also the case that some of the reaction has already happened, notably in the MXN. Even so some currencies are still likely to be affected if such a plan is put into practice, as it may be in time for the 2018 tax year.

While some impact can be expected on many currencies, of the liquid currencies the CAD seems much the most vulnerable. 75% of Canada’s exports go to the US, making up 4% of its GDP, so such a big move in the terms of trade would have a huge impact. Unlike USD/MXN, the CAD doesn’t start from a position of being cheap. The consumption based PPP for USD/CAD is around 1.30. Other major currencies may also be hit, but they are all less exposed to trade with the US. Many also start from a cheaper level (notably the EUR) and are more capital market determined (the EUR and the JPY). From a risk perspective, if such policies are perceived as damaging to US growth, the CAD could also be expected to suffer from the impact on risk appetite and commodity prices. Add to this the fact that the CAD has strongly outperformed rate spreads this year (see chart), so will probably weaken anyway if the market takes a positive view of Trump/Congress tax and spending plans, and the potential upside for USD/CAD looks substantial.

Policy mistakes should not always be reversed

cpimktfeb17-1

UK inflation is rising

The Bank of England cut rates by 25bp and increased asset purchases in August in anticipation of a loss of confidence after the Brexit vote on June 24. The objective was stated to be to “provide additional support to growth and to achieve a sustainable return of inflation to the target.” Subsequently, growth was substantially stronger than expected through the remainder of 2016, mainly due to strong consumer spending, funded by increased borrowing. Now, many (including myself) thought the cut was a mistake at the time. But we all make mistakes. The Bank’s assessment of the impact on confidence appears to have been incorrect. Of course, some might argue that growth was stronger because the Bank eased policy, and no-one can prove that is wrong, but I think it is far-fetched. The fact is that the majority of the population (or at least half) are in favour of Brexit, so there is no good reason why the vote should have undermined consumer confidence. Business confidence might have been damaged in the longer run, but very few investment decisions are changed in a short time frame, so if there is a negative impact, it is yet to be felt. In practice, the relative resilience of spending may convince businesses to hold their nerve until the new trade arrangements become clearer, which may well take some time, as long as growth doesn’t start to slip back.

So it certainly seems as if the Bank of England made a policy error. While there is still very likely to be a longer term supply side shock from Brexit, that may not happen for quite some time, and the demand side shock the Bank initially expected has not materialised thus far. So what should they do? Should they reverse their easing and admit their error? The latest Inflation Report certainly shows inflation is expected to move above target soon and stay above target for the whole forecast horizon, which would suggest there is a pretty good prima facie case to raise rates or at least halt the increase in asset purchases. But the best way to fix an error is not always to simply reverse policy. Unless the reversal is done very quickly, the environment faced is different from the one faced initially. Things have changed.

In this case, the most notable change has been the decline in the pound. This has been good in some ways, as it has helped sustain manufacturing an export confidence in the face of uncertain future trade relationships, but it will lead to substantially higher inflation going forward, starting quite soon, as higher import prices feed through to CPI. It has also already led to higher inflation expectations. The key question as to whether this is sufficient reason to reverse the policy easing is whether the coming rise in inflation leads to an increase in wages and other factors generating domestically generated inflation. At this stage this is not clear, and is important. If wages don’t respond, we will see a sharp decline in real income growth as inflation rises, and if we also see a rise in rates from the Bank, there is a danger this will lead to a sharp decline in consumer confidence, potentially at the same time as sterling rises in response to a rise in rates. This could make the current optimism about the UK economy evaporate quite quickly.

So at this stage it seems sensible to wait. Inflation is coming, and it would be as well to see how this impacts spending and confidence before acting to reverse the move made in August. There has been a lot of British bravado since the Brexit vote, but high levels of debt and declining real incomes, plus the uncertainty surrounding the trade relationship with the EU and elsewhere, suggest that confidence is likely to be fragile. After making a policy mistake it is important not to compound it. The Bank mustn’t act looking in the rear view mirror.

 

 

Corbyn’s cap is a bad idea

corbyn

This is not just a fashion statement, though the Mao style cap is not likely to endear Corbyn to Middle England or improve his electoral chances. It also refers to his idea of a wage cap at somewhere between his own salary (137k) and 50m. He sensibly backed away from that idea as the day went on yesterday, but unfortunately has tarnished the whole idea of dealing with excessively high pay with his ill thought out plan. Excessive  pay is an important issue, but the key point is that it is excessive, not that it is high.

He gave footballers’ high pay as an example, but footballers’ high pay is a very poor example. Footballers are talented, and are paid a lot because their talent is in demand. Their ability is broadly measurable and certainly observable, even though there may be some disagreements about the contributions that players make, and clubs compete for their services in the open market. In general they are highly trained, have committed their whole lives to honing their specific skills, and are competing in an extremely competitive market. Pay is high, but reflects both high demand for their services and the very low probability of being successful.

Compare this with the chief executive of a large public company. The skills required are more amorphous. Leadership, strategic thinking, man management, and ruthlessness may all be required, but it is very hard to quantify whether CEOs are making a difference. If their companies are outperforming in their sector it may be a partial guide, but that may be because of their workers or company specific factors unrelated to them. Nevertheless, it’s necessary to measure performance in some way, and the company’s performance is a better guide to CEO performance than most, because the CEO’s objective should presumably be to maximise shareholder value (subject to some constraints of acceptable behaviour). Other employees can no doubt have more specific objectives, but for CEOs the bottom line should be the…er….bottom line.

But the argument many give for paying CEOs of large companies big salaries is that the larger the company, the greater the potential for the CEO to add value. If a CEO makes a decision that raises revenue by 1% it makes a difference of 100m for a company with 1obn in annual revenue, but only 10m for a company with 1bn in annual revenue. But this cuts both ways. If the company underperforms by 1% the CEO will be losing the company more money the larger the company is. This suggests that larger companies’ CEO salaries should be more volatile. Potentially larger but more dependent on performance. But you don’t see too many pay deals where the CEO has to pay the company money, so any deal has to accept that the CEO gets a basic salary that can only be increased by the bonus. On this logic, surely the larger the company the lower the CEO’s basic salary should be and the higher the gearing to performance.

Anyway, this is the sort of detail that Mr Corbyn didn’t seem to consider before jumping into the debate with both feet. A salary cap is precisely the wrong way of going about things, as it would just mean a lot of underperforming CEOs earning a lot of money regardless of performance. Admittedly this is not very different from the current situation, but with lower salaries, given the general lack of sensitivity of CEO salaries to performance. In that sense Corbyn is right in recognising there is a problem, but his solution was initially ill thought out, and subsequent attempts at a more sensible presentation of ideas have been tarnished by his initial floundering.

 

ECB promises are worthless

draghi

There has been much discussion about whether the ECB has tapered or not. They have reduced the size of their monthly purchases but extended them until the end of the 2017 rather than the expected 6 months from March, so that the promised total of asset purchases is actually greater than had been expected (the market was looking for a promised 6 months of EUR80bn = 480bn but they have 9 months of 60bn = 540bn). But this is still a tapering. Why? Because promises are worthless.

The ECB’s “guarantee” that purchases will be at least 60bn a month for at least 9 months is no such thing. Of course, they are very likely to stick to the letter of this promise, but if circumstances changed so that a tightening of monetary policy was necessary, would they really choose not to enact one? How irresponsible would that be? If they did fail to respond to the need to tighten the markets would react anyway. Anticipation of higher inflation would lead to substantially higher bond yields regardless of whether the ECB chose to continue with a policy that is clearly misguided.

There is a clear logical problem with the ECB (or any other central bank) making promises about future policy while at the same time pledging to stick to its remit of hitting its inflation (or any other) target. While in practice it is unlikely to have a problem sticking to its promises, that is because the promises are well within the range of policy options that they would design to hit their targets under normal circumstances. Had the ECB chosen to go with 80bn a month for 6 months, the odds are they would have extended this again beyond 6 months, probably with smaller volume, since even Draghi has admitted that they are unlikely to stop their asset purchases dead, but  rather taper off. But unexpected things can happen, and if they do the ECB may be forced to renege on their promises. If a tightening in policy is necessary, they might choose a different method and thus stick to the letter of their promise, but the promise itself is still valueless if there are circumstances in which the ECB would renege, whether in spirit or in letter.

The market has chosen to accept Draghi’s protests and not see the taper as a taper. But it is a taper. Future policy promises are worth nothing because central banks will do what they perceive is right at the time, and will effectively override any policies they have committed to if circumstances demand. It is time the markets stopped taking notice of this nonsensical approach of promises. Forward guidance is one thing – providing an idea of what they expect to do – though events have shown even this is wrong often enough to have very limited value. Promises are a step too far, and imply either omniscience  – so that there can never be a need to renege on a promise – or irresponsibility – with central banks prepared to sacrifice correct policy to stick to a promise they made under different circumstances. Central banks are not omniscient, and should not be irresponsible – so promises of this short are worthless and worse, potentially damaging.

The FX market needs to rethink inflation

Though you wouldn’t think it to see the way the market reacts, inflation is bad for currencies. If your prices rise relative to other countries your currency needs to fall to . equalise prices. Countries with high inflation have typically seen sharply declining currencies to offset the effect on relative prices. But typically, when inflation comes out higher than expected in the major economies, the market responds by pushing the currency in question up, not down. Why? Because the assumption is that the relevant central bank will raise rates to combat inflation pressures or not cut rates as much as it would otherwise, more than offsetting the move in inflation. Or at least that yields will rise to more than compensate for the rise in inflation. But the world doesn’t actually work like that, and hasn’t worked like that since at least the financial crisis and probably before.

The charts below show US and German CPI inflation plotted against real 3 month T-bill rates and real 10 year yields. If the FX market was right and central banks and markets responded to higher (lower) inflation with higher (lower) real yields, you would expect there to be a positive correlation between inflation and real yields. Broadly speaking that was the case in the 80s, though only broadly speaking. Not much happened in the 90s, with inflation and real yields broadly steady on a trend basis. But from around 2004 there has been a very clear negative correlation between inflation and real yields. Inflation has mostly fallen, and when it has, real yields have risen. Why? Because either central banks have had more pressing concerns than current inflation, as was the case immediately after the 2008 crash, or because they reached a lower bound in yields preventing them from reducing real yields any further, so effectively nominal rates were fixed. This means that a decline in inflation has, ex post, actually made a currency more not less attractive for the last 10 years.

us-cpi-real-yields-1us-cpi-real-yields-2cpi-and-real-yields

Source: FRED, FX Economics

Now, it may be that there will come a point where central banks and markets start to react to higher inflation by pushing real rates up. In the US, this may not be too far away, but it still looks a long way off in the Eurozone and Japan, where higher inflation would be seen as a good thing and won’t be offset by higher nominal short term rates, never mind higher real rates. Although the markets may allow longer term yields to rise somewhat, it is still doubtful that rises in inflation will be offset by higher real yields (i.e nominal yields rising more than inflation) in the near term. Even if they are, the point about higher nominal yields is that they compensate the FX market for the decline in the currency that will happen because of inflation. A rise in inflation accompanied by an equal rise in yields should in theory have no immediate effect on a currency. The currency should be expected to be a little weaker going forward because of higher inflation, but the investor is exactly compensated for the lower expected value with higher yields.

So why do FX markets react as they do? Because it is clear that they see higher inflation as a positive thing for currencies because of the perceived implication for yields and central bank policy. It may simply be money illusion. That is, higher inflation, will at the margin, mean higher nominal rates, but at this stage and for the last 10 years this has not meant higher real rates, as is clear from the charts. Or is it just that the market is stuck in some sort of 80s mindset imposed on it by people who have simply observed the past – i.e. that higher than expected inflation typically meant currencies rallied, so all the models (carbon and silicon) are programmed that way for evermore?

Whatever the reason, it’s time the market woke up and smelled the coffee.  Central banks are not straining at the leash to raise real rates to head off rising inflation. In fact, the (broadly) effective zero lower bound in nominal rates has meant many are hoping to get inflation higher precisely because it’s the only way they can get real rates lower.

So higher inflation should be seen for what it is. It is an effective real currency appreciation. Prices are higher relative to the rest of the world just as they would be if the currency had fallen. The proper FX market response to that is to reduce the value of the currency to equalise domestic and foreign prices accordingly, not to push the currency up in the expectation of a central bank response that isn’t going to come, and if it did wouldn’t fully offset the inflation move anyway.

 

 

 

 

A crisis for UK democracy?

power-of-the-press-5-638

A bit on the markets in a minute, but first a bit of a rant.

If the Daily Mail call High Court judges “enemies of the people” simply for saying that parliament has to sanction the triggering of Article 50, what will it do if some MPs choose to vote against the wishes of their constituents?

This is a difficult issue for some MPs. After all, some are in constituencies that voted to Remain but themselves support Brexit. Others are in Leave constituencies but were in favour of Remaining. The Daily Mail would argue that the people have spoken with the referendum, but the result was close, and had more young people voted might have gone the other way. It might go the other way if it was done again today. So in my view MPs should vote in line with their own views. But they won’t. Even if they are in “Remain” constituencies, and are pro-Remain themselves, very few MPs will vote down a bill to trigger Article 50. Partly because they will be put on the front page of the Daily Mail if they do. And they remember what happened to Jo Cox. This is not a good way to govern a country, and reminiscent of some unpleasant regimes.

Unless MPs are prepared to act as responsible human beings and stand up to their party, the press and the noisy section of their constituents, they are becoming an irrelevance. They are mere ciphers. They are not being allowed to make their own decisions about anything important. It is important to have a role for personal conscience.

The further irony is that Brexit was (according to the Leave camp anyway) supposed to be about taking back control of our government from the EU. But if MPs are effectively just servants of the government, we are effectively being governed by royal prerogative. Come back Oliver Cromwell.

Anyway, rant over. The markets.

Sterling has managed a little rally in response to the High Court decision that parliament has to trigger Article 50, but this doesn’t look like it will be enough to sustain a strong rally in GBP for at least two reasons.

1) Although GBP is now a lot cheaper than it was, it is not dramatically cheap against the USD or the EUR given the big UK current account deficit and the lack of (real) yield attraction available in GBP.

2) Even if the High Court decision is upheld by the Supreme Court, it doesn’t mean no Brexit. Brexit is still extremely likely to happen. There might be some impact on the shape of the Brexit, but even this isn’t clear. If the government sticks to its guns on rejecting free movement and the EU sticks to its guns on making free movement a condition for single market access, it seems doubtful that parliament will really be able to have much real effect. What does seem likely (though not certain) is that there will be a significant delay in triggering Article 50 because of the time it is likely to take to put a bill through the Commons and Lords (average time one year). There could be a simple resolution to speed things along, but this would mean parliament would have to have its say at a later date.

So the vote has created extra uncertainty around Brexit, and has perhaps increased the chances of a softer version and a longer delay. This is mildly supportive for GBP, but some argue that the delay and uncertainty only makes things worse as firms are unable to plan for the future. I’d say this is outweighed by the increased chance of a softer Brexit, but not so much as to justify a dramatic GBP rally. EUR/GBP may manage to get back to the 0.86 area, but unless there is a lot more promise of a soft Brexit or some evidence on Eurozone weakness and/or UK strength gains beyond this are hard to justify. Still, it looks like it might be enough to stabilise GBP in the 0.86-0.91 range.

I have put this in terms of EUR/GBP rather than GBP/USD because coming into the US election the picture for the USD is obviously very uncertain. Most take the view that a Clinton victory will be USD positive, and market behaviour in the run up to the election suggests this is the case, but with a Clinton victory now priced as around an 80% chance, the market reaction may not be huge. The Fed is very likely to hike if markets respond positively – even neutrally – to the election, and that should be enough to sustain the USD against most currencies, though which currencies it gains most against will to some extent depend on the (uncertain) medium term equity market reaction to the combination of a Clinton win and higher US rates.

This is all pretty much the consensus view, and I’m not going to speculate too much on what happens if Trump wins, except to say that I’m not sure the impact will be that sustained. In the end, Washington will put fairly substantial limits on what he is able to do.

EUR weighed down by GBP not Draghi

eurandgbp

Looking at the markets, it seems as if Draghi said that the ECB would be easing further come December, or at the very least March. The EUR has gone into a tailspin since the ECB meeting, and journalists are queuing up to blame Draghi. The trouble is, no-one seems quite sure what he said that triggered the move. One headline said “Euro close to 8-month lows vs dollar Friday after ECB chief Mario Draghi ruled out an abrupt end to QE.” Another headline “Euro wallows near March lows after Draghi quashes tapering talk”. So did he quash taper talk, or did he say the ECB would taper? Because if you don’t end abruptly, you taper (it’s one or the other). And which is better for the EUR? Because when it was suggested that the ECB would taper a month or so ago (by some unnamed committee member that Draghi emphasised had no insight) the EUR went up. So presumably if they don’t taper it goes down? Except Draghi said they would taper. Which I would have thought was sensible, and less likely to be EUR positive than an abrupt end to QE if anyone thought about it. Which all probably goes to show how silly the original “taper tantrum” was, but doesn’t really explain why the EUR has been so weak since Draghi’s press conference, especially since the effects of the initial taper tantrum were fairly short-lived in any case because on reflection most saw that the initial story didn’t mean a great deal, true or not.

In reality I don’t think the market really saw anything new in Draghi’s comments, but in the absence of anything new, the downtrend in EUR/USD remains in place. EUR/USD has been in a downtrend since the Brexit vote, and with the market expecting a Fed rate hike in December and currently seeing a probable Clinton victory as favourable (presumably because it is essentially the status quo – no nasty surprises), the burden of proof is now on those that want to oppose the EUR/USD downtrend. It is interesting that the Brexit situation appears to be the key factor that has pushed EUR/USD lower, though the UK is a small economy by comparison to the US and Eurozone giants. It is certainly the case that EUR/USD has never regained the 1.1377 high seen on June 24 and had been edging higher into the vote. It is hard to see that the economic news form the two economies since then has been particularly USD positive or EUR negative. If anything the opposite is true. Certainly since the beginning of this year the performance of the Eurozone in both growth and inflation has been broadly in line with expectations, while US growth has significantly underperformed. In fact, the OECD currently expect US GDP growth to be weaker than the Eurozone’s this year, and although many expect the Fed to raise rates in December, this is significantly less tightening than had been anticipated  at the start of the year.

So we need some change in market perceptions for the EUR to stop falling, at least until we reach the key levels in the 1.05-1.08 area in EUR/USD. A less negative view of Brexit from the perspective of both the UK and the Eurozone is the most obvious potential trigger, though that doesn’t seem imminent with the EU ruling out negotiation until the UK invokes Article 50, which most likely will be in Q1 2017. The other main possibility is a change in the perception of the Fed, though the way things have turned out this year suggests that even if the Fed don’t raise rates in December, the hit to USD strength may only be temporary unless the ECB turn out to be unexpectedly hawkish at their December meeting. The third chance of a Trump victory is one I hope we don’t have to consider.

Fed hike overpriced

us-gdp

The latest OECD forecast for 2016 US GDP growth is 1.4%. That would be the lowest since the recovery began – i.e the lowest since the -2.8% in 2009. It is also lower than the 1.5% forecast for the Eurozone, and lower than the 1.7% forecast for the UK. Yet the market is currently pricing a 70% probability of the FOMC raising its funds rate target by December, while all the talk is about when the UK will cut rates again and whether the ECB will ease again. Of course, current growth is not necessarily the prime determinant of the Fed’s decision. They are forward-looking, and focus on dual targets of inflation and employment, but growth is the major consideration for both these objectives, and while future growth is expected to be better, growth has disappointed all this year so forecasts of future strong growth require a degree of optimism. We have the Q3 GDP data for the US on October 28th. The consensus forecast is still around 2.7%, but the Atlanta Fed GDPNow model is currently showing a forecast of 1.9%. If we were to get another sub-2% growth number in Q3, the probability of the Fed tightening in December would surely dip sharply.

Of course, the reason most are looking for a December rate hike is not because they have done a deep assessment of the economic rationale and put a lot of trust in their forecasts of growth and inflation. It is because they think the Fed have said they will. The three dissents at the September FOMC notably included former arch-dove Eric Rosengren, and many see this as a signal that the Fed is preparing for a December move. But the latest speech from Yellen ought to cast a bit of doubt on this assessment. Yellen didn’t specifically indicate a policy intention, but she did suggest a possible willingness to try to run a faster economy in order to recover some of the lost output seen since the recession. As she put it – “If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market.” If she wants to try this, raising rates when growth hasn’t reached 2% in any of the last three quarters, as would be the case if Q3 GDP comes in sub 2%, doesn’t seem to be a sensible tactic. We certainly don’t have “robust aggregate demand” on this reading.

The tightness of the labour market is perhaps the best argument for higher rates. Traditional economics has tended to focus on the labour market as the main driver of inflation, as a tight market drives up wages and costs. However, there are three points to make on this. First, that although the US is no doubt close to full employment, the unemployment rate in the US hasn’t fallen in the last year, at least partly because of the weakness in growth. Second, average weekly earnings growth hasn’t been rising. If anything it’s been falling, with the 3 mth y/y average dipping below 2% in October for the first time since February 2014. Third, Yellen’s latest speech highlights that the labour market hasn’t really been the driver of inflation in recent years. As she notes “the influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis.” So although the unemployment rate is quite low by historic standards, it’s not falling and doesn’t appear to be putting upward pressure on wages.

As for inflation, the Fed’s preferred measure – the PCE deflator – is steady at 1% and hasn’t been above 2% since 2012. While oil price fluctuations may move it short-term, it is not currently an issue the Fed has to worry about. If anything, the concern is still to convince the market and the public that inflation is likely to rise from here. Recent years have proved that deflation is a much harder issue to deal with.

So I find it very hard to make a case for higher rates based on the current state of growth, inflation and unemployment, and the latest speech from Yellen suggests to me that she does too. The rate hike last December was based on much stronger growth expectations and some evidence that growth is moving back above trend looks necessary to me to justify another move. Given her recent speech I suspect Yellen feels the same.

Now, there are of course other arguments for raising rates. The side-effects of holding rates very low are generally perceived to be damaging, with savers penalised and asset owners rewarded. Inequality increases as a result. But this is a reason to want rates higher in the longer run, not necessarily now.

It will take a lot to change the market’s mind on the Fed, but it seems to me that the current 70% probability priced in for a (November or) December hike is overly confident. The Q3 GDP data may change this view, but it may require a Fed comment or two to move expectations even if the GDP data do disappoint, given the market’s current tendency to need to be led by the nose. Many on the Fed who want a hike clearly aren’t really basing it on the current behaviour of the economy.

 

Merkel must spend more

 

merkel1

I seem to have left my purse at home

Yesterday’s ECB press conference was, for the most part, fairly lacklustre. No unexpected measures, Draghi sounding quite bored, forecasts very little changed. Markets had vaguely hoped for at least the promise of more action, but got nothing new. But towards the end there were some interesting comments which, together with the G20 statement last week, underline that the ECB and other central banks are telling governments  – specifically Germany – that there isn’t much more monetary policy can do and it is time for some fiscal action. Draghi’s two comments on this were to state that governments which had scope to do more on fiscal policy should, and he noted that Germany had scope to do more. He also agreed strongly with a questioner who noted the weakness of German wage growth and underlined that higher wage growth in Germany was very much desired. In other words, he told Germany they should be spending more money.

There are a few things the German government can do directly about wage growth. The can pay government employees more, and they can raise the minimum wage, but the majority of wage deals are struck without direct government involvement. As Draghi also noted in answer to another question, Europe is not a planned economy. But without stronger German wage growth, it is very hard to get inflation up in Europe, as German wage costs provide an effective ceiling in many industries to wage costs in the rest of Europe. It was precisely because wage costs elsewhere in the Eurozone rose so much faster than in Germany in the 2000s that the rest of Europe became so uncompetitive, and a lot of this was because German wages barely rose at all. Nominal wage costs in Germany rose less than 1% from 2000 to 2008. That’s in total, not per year.  Given the relative weakness of the rest of the Eurozone, unless Germany can get inflation above the 1.5-2% target, there is no chance that the European average can get up there, and to do that, wage costs have to rise a lot faster. So Draghi is putting pressure on Germany to inflate.

There is plenty the German government can do. German is running a (marginal) budget surplus. The government can borrow at negative rates. It is hard to see the downside to expanding borrowing aggressively and spending on infrastructure, especially since they need to find jobs to give all the extra refugees they are letting in (or wage growth will fall further). It would even provide the ECB with more debt for their QE program. It would not just be a good thing for the Eurozone, it would be a good thing for Germany, where I’m told the roads are in dire need of  attention.

Another way of looking at this is to note that the German current account surplus last year was 8.5% of GDP, and is forecast to be over 9% this year. 9%!!!!!! The UK is worried about it’s deficit of 6% (and rightly so) but the UK problem is at least partly the lack of demand from the Eurozone, and the rest of the Eurozone also struggles because Germany doesn’t import enough. Germany is the main guilty party. It needs to reduce it’s current account surplus by expanding demand. There is no way of doing this by monetary policy any more, as rates are as low as possible already. The government needs to take responsibility by increasing investment.

Why Germany hasn’t gone down this route already is a mystery to me. It seems to have something to do with the fiscal conservatives who believe in balancing your budget without regard to the cycle, the needs of the EU as a whole, or anything that has been written on economics since the 19th century. But it really is time to get real, and Draghi and the G20 are ramping up the pressure on Merkel, Schaeuble and co.  It used to be that Japan was the main guilty party for running massive trade surpluses, then China. Now it’s Germany, and action is overdue.

current-accounts

Source: OECD

From an FX perspective, such actions would be supportive for the EUR in the short term, and some may not like that, but amassing a massive current account surplus is far more damaging in the long term, as it will either prevent a European recovery or cause the EUR will surge higher in the next US downturn as capital outflows dry up.

 

 

 

 

Carney, Prince of pessimism

hamlet

“There is nothing either good or bad, but thinking makes it so”. Hamlet

The most striking thing to me about yesterday’s raft of information and decisions from the Bank of England was the willingness to act on the basis of forecasts of significant near term economic weakness based on, let’s face it, remarkably little solid evidence. This has continued the trend of the Bank supporting the view that the Brexit vote is a disaster and will lead to a major economic slowdown, a view that is becoming self-perpetuating.

Now, of course, the Bank of England has to try to act on the basis of forecasts, and if it merely responds to coincident or lagging indicators of the economy it risks being seen to be “behind the curve” or setting policy “looking in the rear view mirror”. But we are in a unique situation here. No-one has ever left the EU before. We don’t know what the UK trade arrangements will be in the future, and these will in any case not be in place for more than another two years. The Bank takes the view that the ultimate result will be some reduction in UK supply capacity in 2019 and beyond, though it admits the extent of this effect is very uncertain. Fair enough. But the measures announced yesterday were not really intended to deal with this, but with the short-term demand reaction. It is here that I think the Bank is on very shaky ground, for several reasons.

First of all, we should need no reminding that the Bank’s record of forecasting under Carney has been woeful, from the initial unexpectedly sharp decline in unemployment which quickly left his conditions for raising rates looking ridiculous, to the more recent indications that rates were likely to go up rather than down. Carney’s reputation as an “unreliable boyfriend” is therefore to some extent justified, though I would argue his fault is not so much a lack of foresight – as all forecasters know, being wrong is the norm – as suggesting he has more confidence in his foresight and consequently his understanding of the correct policy path than he had any real right to. Of course, there are uncertainty bands around all the Bank of England Inflation report forecasts, but Carney has always tried to provide an impression of greater commitment to a view than these suggest, in contrast to his predecessor Lord King, who increasingly emphasised that neither he nor anyone else knew the answers to many of the questions he was asked.

So it would be foolish to take the Bank’s forecasts as gospel, even in normal times, and one of the main points made by the Bank yesterday was that these were more uncertain times than usual and that there had been “sharp rises in indicators of uncertainty in recent months”. Once again, fair enough, But the Bank goes on to conclude that such uncertainty could lead to a reduction in spending, particularly major spending commitments. Well, maybe, but maybe not. The impact of uncertainty is very – er – uncertain. Uncertainty squared, if you like.

Of course, as former MPC member Charles Goodhart has noted, we always think the situation is uncertain, and this is not an excuse for doing nothing. That only leads to vacillation. The Bank has taken a view that further monetary accommodation is needed because the risks are on the downside. Again, as Goodhart has pointed out, the impact of these measures is unlikely to be very large, as monetary policy has close to run out of bullets, but they are unlikely to do any harm, at least directly.

So my problem is not with the measures per se, or even the broad slant of the analysis, but with the presentation.  The Bank accepts that there is a lot of uncertainty, and worries that this will lead to less spending. But the reaction of people and businesses is not set in stone. It is about confidence and sentiment. The Bank’s policy reaction is not so much about the actual shape of the trade relations in years to come, but the reaction of firms and consumers to worrying about it. The best way of dealing with this is not to say – “yes, things are pretty awful, so here are some measures that might be a bit of a help if things turn out to be as bad as we fear”. It is to take as positive approach as possible, say that we don’t really know what is going to happen down the road, but there is no real need to change our behaviour now as the picture in two or three years time is really entirely unknown. Brexit may not even be the most important thing that happens over that period. For instance, if the Eurozone’s nascent recovery continues, helped by some expansionary fiscal policy, it may swamp any negative Brexit impact (if there is any).

Now, there is of course some need for transparency, and Carney has taken the view that it was the responsibility of the Bank to put out its best guess of the impact of Brexit ahead of the vote. But I feel this was the first error that has been compounded by subsequent acts. You don’t have to believe, like some on the Treasury Select Committee, that there was a sinister political motive behind the Bank’s negative forecasts ahead of the vote, to think that a more humble view would have been far less damaging. If the Bank had merely said that the impact was uncertain and it would react when there was some greater clarity, the idea that a big slowdown was inevitable would not have become so ingrained, and firms and consumers would be less inclined to believe they should put off big spending projects. The latest Bank action might still have been the same, but could have been presented as an insurance policy rather than a reaction to an inevitable sharp downturn. Now we are in danger of talking ourselves into a downturn, and producing a fiscal expansion we can ill afford to offset it.

Perhaps Carney should have spent more time reading Shakespeare rather than learning about DSGE models. Then he would know that “there is nothing good or bad but thinking makes it so”.

We already have helicopter money

There has been a lot of chat about helicopter money potentially being the next new monetary policy measure to be tried after all the others have tried and failed to stimulate the developed economies. I have just watched Professor Willem Buiter telling Bloomberg that it makes sense but won’t happen because of political opposition. But it seems to me we already have it, even though it hasn’t been announced as such.

To explain. Helicopter money as suggested by Buiter and others is, in his words, a fiscal stimulus (whether in the form of adding money to every bank account or in the form of infrastructure spending) financed not be issuance of government debt but by the central bank “printing” money. While this has not officially happened, it seems to me there is no real difference between quantitative easing and helicopter money. While some might argue that there has been no fiscal stimulus directly financed by a central bank, QE is financing fiscal spending.  The fact is the central bank is buying government debt. To argue whether the fiscal spending is “new” or not is sophistry. And whether this happens in the primary or secondary markets is really irrelevant – issuance finishes up with the central bank with the primary dealers effectively acting as passive intermediary.

Now, fiscal policy settings may not have been consciously altered, but to take the UK as an example, the Bank of England started buying assets (gilts) in 2009 when the UK government budget deficit was 10.8% of GDP. How can anyone argue that the Bank was not financing government spending in doing so, and thus creating “helicopter money”. Who knows what the fiscal policy setting would have been had the Bank not enacted QE? Presumably government bond yields would have been higher had they not done so.

Now, some will argue that the difference between QE and helicopter money is that QE is not permanent. The central bank’s holdings of assets are still part of government debt and will (or at least could) be sold back to the market at some point. The fiscal expansion is still treated as an addition to the budget deficit, even if the debt is bought by the central bank. But isn’t this really a fiction? I think it’s much more likely that the central banks’ accumulated assets will never be sold back to the market and will simply be refinanced on any maturity. In any case, this a decision that will be taken at the time of maturity, and I sincerely doubt anyone’s behaviour is assuming the sale of the Bank of England’s (or the Fed’s or the BoJ’s) stock of debt.

So yes, a fiscal expansion financed by the central bank buying government debt is not just a possibility, it is a possibility that has already happened. Whether central banks will be prepared to finance future fiscal expansion is unclear, but independent central banks may choose to do so if they feel it is in keeping with their mandate (usually of inflation targeting) which many think it is. Certainly, some on the ECB would be willing to expand QE to accommodate increased fiscal spending, and several have indicated that an increase in fiscal spending is desirable in some countries. However, the structure of the Eurozone makes it more difficult to enact there than elsewhere, where there are unitary fiscal authorities with single central banks. The Italian government debt level may still be seen as problematic even if a lot of it is owed to the ECB. The same is not true of the UK debt if it is owed to the Bank of England. I suspect the Bank will find a way to grant the UK government quite favourable terms.

 

Bias at the Bank?

First of all, let me declare my own view on Brexit, in case anyone thinks what follows represents my own bias (which it may do but I’ll be up front about it). I am voting to stay in the EU, but as much for political/emotional as economic reasons.

Having said that, I believe Carney was showing bias in his positive view of the EU at the Treasury Select Committee hearing yesterday. One reason was presented by Jacob Rees-Mogg, who questioned his statistical arguments as being speculative, and I think that is right, as even Carney admitted that many of the points arguing that the EU had helped boost capital inflows and growth were “arguable”.

But even if that is wrong and you can make a strong statistical argument for membership of the EU having boosted growth and investment in the past, there is no guarantee that that will be the case in the future. Past performance, as Mr Carney should know if he reads the small print to investment advice, is not necessarily a guide to the future. The EU now is different to the EU in the past. Whether being a member is positive for growth and investment will depend to some extent on the arrangements Britain makes with the EU but also on the EU itself and whether it can shake off its persistent economic malaise of recent years . I would agree with the “Remain” campaign that the benefits from leaving are currently pretty nebulous in terms of the things that we would no longer have to do to comply with EU law as it stands, but the terms in the future could change and “ever closer union” could mean an increasing EU straitjacket on the UK.

Now Mr Carney would no doubt argue that he was making no claims for the future but rather just producing the evidence available. Well, yes, but the choice to do so is in itself a decision. Bias is about the questions you ask as well as the answers you give. If you ask the right questions you know you will get the answers you want.

To be fair to Mr Carney, he did say that the decision on Brexit was not purely an economic one, though conveniently that statement justified him providing a pro-EU view with the economic analysis and still being able to claim he wasn’t taking a position on Brexit.

Carney also said that he had not discussed what he was going to say with David Cameron. But since it is part of the Bank’s remit to support the government’s economic policy and maintain financial stability a pro-EU view is almost prescribed. There is little doubt that Brexit would create uncertainties in the short term, even if the impact on markets is more unpredictable than most claim, and the short term could turn out to be quite short.

So in this case, I agree with Jacob Rees-Mogg. It would have been better for Carney to have been far more scrupulously neutral. Not that many voters probably care much what he thinks. After all, while the previous BoE governor Lord King has also said he is not expressing a view on Brexit, his recent comments have been very negative about the Eurozone and could be seen to favour the “Leave” camp, even though he makes it clear that Britain is inextricably linked to the EU regardless of the decision. And while Lord King isn’t everyone’s cup of tea, he will at least still be living here after the referendum, and is  deeply rooted in the UK and has also experienced the whole period of EU membership, the ERM debacle, the financial crisis, etc., and is not beholden to any government or political party. I would suggest his views consequently carry rather more natural weight.

 

Cheer up Mr Draghi

The Eurozone economy is a long way from being healthy, so it’s understandable that the market remains inclined to believe in more ECB easing at the March 10 meeting. I’m not going to go too far into the details of what the market expects, but a rate cut of 10bp or more and an increase in QE both now seem pretty much expected, along with possible tiering of deposit rates to limit the impact on banks. Of course, last time  market went in with this expectation is got a bloody nose, with the ECB only producing a  10bp cut in the deposit rate in December, so positioning is likely to be a little more cautious this time around. But the ECB do seem less likely to disappoint the market this time, both because of less committed market expectations and because Mr Draghi will be very conscious of the risks of a EUR rally if he fails to produce a significant easing.

But while that may be what they will do, I’m not at all sure it’s what they should do. The ECB’s behaviour is looking to me to be increasingly overactive and is starting to look panicky, which seems to me to be creating rather than relieving concerns about the economy.  It’s true that here has been a manufacturing slowdown since the last meeting, but no more so than elsewhere – indeed rather less so than in the US. PMIs have dipped but still indicate slow growth – we are not back in recession. Inflation is a little lower than expected or desired, especially the latest February number, but inflation can be quite volatile on a month to month basis and it is rash to make major policy decisions based on one month’s number. After all, while the market was disappointed by December’s easing, it is still the case that the ECB did ease as recently as December.  Two easings in 3 monthswould suggest some need to panic, and I don’t think that’s a story the ECB should be telling. While they eased twice in 3 months in 2014, it was against the background of a very strong exchange rate. This time around, they have a weak exchange rate and inflation is being significantly subdued by a weak oil price. Core inflation dropped to 0.7% in February, but was 1% in January which was above where it was when they eased in 2014.That monetary conditions are being eased further even though the outlook looks better than in the past may reflect policy having bee too tight for too long, but this perma-easy stance with a hair trigger for further easing carries its dangers.

Firstly, there seems little reason to believe that a further ECB easing will have any significant impact. The ECB themselves indicate that loan growth is improving already and the pass through from any further exchange rate weakness is unlikely to be very large given the weakness of emerging market currencies. What the region could do with is an expansion of fiscal policy from those that can afford it (Germany). A modest deposit rate cut, especially if it is tiered to protect banks (and by implication savings rates) will have minimal impact. Secondly, the ECB seems to me to be underestimating the value of promoting confidence. A more upbeat assessment of the economy and an indication that they have some belief that the (substantial) policy measures already put in place were taking effect and would continue to take effect in the coming months would have a more positive impact. Gloom and doom and a further monetary easing both undermines confidence and takes the pressure off government to do anything on the fiscal side.

None of this means the ECB won’t ease next week. Indeed, the risk of market disappointment now means they probably need to given the expectations that have built up, in large part because of ECB rhetoric. But it would sensible if this time around Draghi emphasised some of the positives rather than indicating the potential for further action. Sensible because he is probably not going to be able to squeeze anything more out of the hawks on the committee anyway, unless there is clear evidence of a dive into recession, and even if he could it would be unlikely to have much impact. An attempt to build some confidence and perhaps encourage governments to take their share of the burden would, I think, be more effective than threats of ever more negative rates.

Don’t get fooled again

Since my last post on here, we have had ECB and Fed communications. While Draghi managed to sound concerned enough about the recent data and weak inflation outlook to send EUR/USD down around 1.5 figures, and get about 80% of analysts looking for a deposit rate cut in March, the Fed statement was only marginally more dovish than last time, downgrading domestic demand growth to “solid” from “moderate”. Both expressed some concern about weaker energy prices and the effect on inflation and inflation expectations, and about weaker exports.

In the end, EUR/USD is back where it was before the ECB meeting, but it seems to me the economic assessments being offered here are a little topsy-turvy. Has there really been much change in the Eurozone picture since December? Sure, the January business and economic climate indicators have dipped to the lowest since August, but then December was the high of last year, so the level isn’t particularly worrying, and sentiment may well have been affected by the equity market tumble at the beginning of the year rather than anything concrete. Inflation is a little weaker than expected, but essentially because of lower oil prices, and these have now bounced a bit.

Draghi’s downbeat assessment in January “heightened uncertainties regarding developments in the global economy, as well as to broader geopolitical risks. These risks have the potential to weigh on global growth and foreign demand for euro area exports and on confidence more widely.”

Draghi’s downbeat assessment in December  “heightened uncertainties regarding developments in the global economy as well as to broader geopolitical risks. These risks have the potential to weigh on global growth and foreign demand for euro area exports and on confidence more widely.”

So these aren’t really new concerns, and while a strong majority seems to think they cut the depo rate in March, it seems a bit previous to assume this given pretty limited data, and given the fairly implacable opposition from the conservative wing of the ECB last time. cCan the market really take the same stance as last time after getting so badly burnt? Not without more convincing data would be my view.

In the US, the data has been fairly universally disappointing including today’s durable goods report, but manufacturing is especially weak. Employment is, however, holding up, though the market never seems to acknowledge that employment is typically a lagging indicator. Tomorrow’s Q4 GDP release is expected to come out at just 0.8% annualised – that’s 0.2% in q/q European terms. The Fed seems fairly immune to the weakness of the numbers, partly because they tend to get revised a lot, but on the basis of the numbers alone there really isn’t a case for thinking about another rate hike in H1. If employment growth ever catches up with this growth weakness in a real way we can forget about another hike this year.

In summary, it’s early days, but right now I can’t see why the market would want to hold long USD positions against pretty much any of the majors. If you are looking for growth we’re not seeing it in the US – you are much better looking at Sweden. The long USD position is already well held on rate expectation grounds, so there is a limit to the USD’s safe haven appeal if growth is weak everywhere. The JPY or EUR would make more sense. But EUR/USD and USD sentiment are supertankers, so we may not see immediate USD weakness, and the higher EUR/USD goes the bigger the chance that the ECB do act, so EUR upside is likely to prove a bit of a struggle. But if the oil price continues to rally, the case for more ECB easing will be hard to make. So coming into the next ECB meeting – don’t get fooled again.