Friday, 20 July 2018

On grey budgets and Fedspeak

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After recovering from UK budget boredom, Anthony Peters reads Yellen’s tea leaves. 

Although George Osborne’s budget speech in front of the House of Commons was a wonderful piece of stage managed drama, it probably has more impact on the individual citizen – in this particular case the grey haired one like myself or like my dinner host of last night who is still recovering from the celebrations to mark his 60th birthday – than it does on the economy as a whole. The market response was expected to be limited – outside the insurance sector which got clobbered on the back of the pension reforms announced (I’ll leave it to the investment banks’ equity and credit research departments to explain to the uninitiated exactly why).

Hence, the budget delivered, for the macro economist at least, a big snooze.

Meanwhile, Janet Yellen has taken full control of the FOMC and yesterday chaired her first meeting. The first thing that struck me when reading through the post-meeting statement is that Prof. Yellen has ceased to be Chairman of the FOMC and has become the Chair. I do hope she hasn’t, for in that powerful role one would not want anyone at all to feel tempted to sit on her. Mind you, knowing her track record I would also strongly advise not to attempt it.

That aside, the post-meeting statement was firm but still pretty dovish as it stated: “When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.” This clearly bins the 6½% unemployment threshold and gives back to the FOMC the freedom it had taken away from itself in pursuit of forward guidance.”

Going through the full statement, readers must surely be led to understand that the FOMC has told them exactly what it has in mind and what it will do in response but that it reserves the right not to do what it has promised to do without in effect having broken its promise. You just have to love “Fedspeak”.

QE as expected

As forecast by the world and his wife, a further US$10bn is to be withdrawn from the QE programme, thus leaving it at US$55bn. I admit to being slightly smug here as last summer when the market had its wobble over the reduction of QE I took a firm stance that withdrawing stimulus had nothing to do with raising rates and that therefore there was no reason to trash both the bond and the equity markets. So far I have not been wrong.

That does not, however, help us all that much as the lofty level of asset prices – I shall for the moment desist from referring to it as a bubble – might well be teetering on a knife’s edge. If equities are priced on the basis of a discounted cash-flow model and the discount factor applied is determined by the “ZIRP”, then an increase in rates ought to quite naturally lead to a repricing of stocks. On past form, once the fear of rising rates sets in, prices will begin to move and will, most probably, heavily overshoot to the downside.

The problem will be that – and this goes for bonds as well as for equities – a short sharp shock driven by a quick and decisive tightening of monetary policy is far better than a long drawn out process. But central banks, the Fed included, have made it clear that they will be moving cautiously and gradually which might conceivably leave markets with more of endless pain rather than of a painful end. Yikes!

This appears to be part of what led Narayana Kocherlakota, President of the Minneapolis Fed, to dissent. He evidently took some of the loose wording within the statement to leave too many escape hatches and trap doors in policy. Yellen has already gamely declared that she sees no bubble formations but then neither did Alan Greenspan, not even ten years after his so famous statement on irrational exuberance.

Maybe it is time for us to remind ourselves of what he actually said in front of the Economics Club of New York on December 5th 2006: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”.

I remember it well. Now you put that in your pipe and smoke it. 

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