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Monetary Policy Outlook
<https://www.icloud.com/keynote/04J8D1PY_SMCpktDkzt6nFSTg>
<https://www.icloud.com/keynote/01xR7KnPK2V35NsBATSkXt1aQ>
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ttps://www.icloud.com/pages/0tWPFx06GAZVW3w451oD32ECA
>
My assigned topic today is the Federal Reserve. The Federal Reserve makes sense only in the
context of the government of the United States as a whole. Thus let me begin with a few
comments on Alec Phillips’s excellent presentation that began this conference.
He has been watching the details of Washington DC from inside Washington more closely than
I have from the Pacifi c coast. And that means that he may know too much to be able to focus
on the big picture.
If I were you, if I were trying to understand Washington, I would hold tight to four points:
1. The United States government is a 1700s Enlightenment Era complicated mechanical device
that is easily knocked out of alignment and into paralysis.
2. Since 1980, the Republican Party has increasingly elected presidents who are not executives
to manage the government and policy but rather communicators to reassure a broad range of
voters–increasingly and notably those who are traditionally in the Americas called the
_descamisados_–that the Republican Party understands and likes them.
3. This worked very well for the Republican Party as an institution and for the policies it
believes are good for the United States under President Reagan, when the management of
government was in the hands of the very impressive George Shultz and James Baker. This
worked not so well under President George W. Bush, for the Richard Cheney and Donald
Rumsfeld to whom the management of the government was committed, and who had been
very impressive as aides to President Ford in the 1970s, had both aged several bridges too far
in the intervening quarter century.
4. Now this process has reached its nadir, with a president who is little but a communicator, in
whom the Republican Party has little confi dence either in his preferences or in his judgment;
with no equivalents to the informal prime ministers of Reagan or Bush; with a strong right wing
block in the Republican House of Representatives caucus who fear that the president and their
leaders are eager to betray them to advance moderate policies; and with a strong centrist
block in the Republican Senate caucus fear that the president and their leaders are eager to
betray them to advance right wing policies.
We saw this just a week ago, when the Senate refused to allow its majority leader Mitch
McConnell to take the healthcare bill to a conference committee, because it could not trust him
to adequately represent their positions in the conference. And we do not know whether it was
close–whether there were only three Republican Senators breaking their ranks–or whether
there were 13, 10 of whom were grateful not to have to make their mistrust of their leader
public, because their votes were not needed to obtain the result they desired.
Unless the missing trust within the Republican legislative caucuses and between them and the
President can be built, very little will happen in the way of legislation, and then the cards will be
collected and redealt in November 2018.
All this was implicit in Alec Phillips’s presentation–in his discussion of how the next major bill,
the debt management bill, will probably pass with many if not a majority of Democratic Party
votes, and how it is no longer clear what the legislative path to a tax cut for high earners might
be.
But I think it is worth making it explicit...
On to the independent, only indirectly elected, and what many have called the most functional
branch of the government of the United States: the Federal Reserve...
<!--more-->I'm afraid I have to disappoint you with respect to what new economic thinking will
be brought to bear on our current problems. It won't be. Central banks are not good at new
economic thinking. They adopt new thinking only under pressure of immediate and exigent
circumstances.
It does not look likely that we will see such—and if we do see
such, we will then be in another unfavorable tail scenario, and will once again have other very
big things to worry about.
Let me briefly paint the background: a brief tour of things all of which you know. Let me then
go on to the problems facing central banks and to, as best as I can see it, the most likely future
with respect to what central banks will do as they try to manage the global economy over the
next one to fi ve years.
On the real production side we have what is now called "secular
stagnation". We had a roughly 10
%
fall in global north production as a result of the fi nancial
crisis that started in 2007 and continued through 2009. We had no subsequent catch-up: no
recovery of grouwth ground lost. And we have had a subsequent further slowing of trend
growth in measured GDP.
as well now
as someone coming from California and as
mr. Donovan said before these numbers
are in some strong sense fake news these
are numbers of real goods and services
produced and sold at the market valued
at prices that pretty much track how
much it costs us this year to make what
we made last year and they do not take
adequate account of the invention of new
commodities and of new types of
commodities and their contribution to
human wellbeing and they also do not
take proper account of the fact that
more and more of human activity that
would have been called economic is in
some sense moving away from the idea of
purchasing and consuming and using
material things that is the way that the
Google chief economist and my former
teacher Hal Varian puts it human beings
combine physical goods on the one hand
services on the other information on the
third and communication on the fourth in
order to shape the universe to their
will and to accomplish their purposes
and while it is certainly true that the
fi nancial crisis and it's aftermath have
slowed our ability to produce and deploy
material goods and services how fast
that's growing our ability to
communicate and our ability to inform or
miss inform ourselves as continued to
grow at a pace even more rapid than
before
that if we had true numbers they would
have been showing an acceleration of the
pace of human economic progress in the
1990s
and thousands followed by a downward
shock in 2007 would they have shown
anything like a decline in the rate of
growth probably not but for most of your
perspectives as people in fi nance as
intermediaries with clients with people
who depend on you for advice and fi rm
management the fact that there is an
Information Age economy off there in the
background that is by and large not
fully tracked by these numbers is pretty
much irrelevant because that information
age economy does not enter into
production the circuit of production
purchase and sale on fully instead
information goods are currently at
increasingly produced and fi nanced by
the fumes coming off of the ability to
sell the eyeballs of people paying
attention to information to advertisers
and that does not enter into measures of
real GDP from your perspective from the
perspective of real fi nancial flows
there is secular stagnation there has
been a sharp drop of the level of
production in the global north followed
by no recovery to previous trend and in
fact the slowing of previous trend and
that shows itself in nominal long
government bond rates across the global
north it's starting in 1995 back when
inflation wasn't the range of 3 to 4
percent rather than the 1/2 to 2 percent
it is now starting in the mid 1990s any
fear that there would be returned to the
inflationary decade of the 1970s was
long gone and yet long term government
bond rates both nominal and real were
far higher than they are now
since the mid 1990s there has been a
continual but sometimes interrupted
process both of convergence of bond
rates and also of
lowering of bond rates which has
produced a world awash in savings which
has produced a world in which virtually
every fi nancial advisor and trader who
was ever short bonds for any extended
period of time has likely lost their job
or at least had a lot of explaining to
do has created a world in which lots of
people expect there to be capital gains
on the long bonds that they hold because
that's the world that they grew up and
yet we now looking at long bond yields
cannot imagine that this will continue
for far so we have a world that appears
awash in savings at least from the
fi nancial market price tests or perhaps
a world desperately short of properly
safe assets in which there are returns
to risk bearing and returns to
entrepreneurship and returns to
acquiring market power of one sort or
another but not returns to simply owning
and applying fi nancial capital which is
a very different world growing forward
than the world of the past generation
during which holding fi nancial capital
and investing it long term has produced
not just the interest yield on bonds but
healthy capital gains as well with
little return to fi nancial capital there
is also remarkably little return into
bearing duration risk which poses
potential systemic problems because
there are a lot of fi nancial
institutions and a lot of money whose
business model depended on accepting
duration risk and trying to cut and
minimize costs and that's not been a
terribly effective business model for
almost a decade
now but organizations that are used to
barring duration risk if they seek to
gain returns by barring other kinds of
risks they may well not have the proper
management not have the prop
culture not of the proper knowledge base
to do so and there is a return to
bearing various forms of corporate and
default risk but in the u.s. at least
it's only 150 basis points per year and
that includes exposure to major
fi nancial shocks which you can ride out
only if your organization is well
capitalized and if the sources of your
money are patient and if you yourself
and your entire bureaucracy can be
patient and be willing to let positions
ride for a year to see what happens all
the way up the chain
those are hard positions for
organizations to establish and hold and
then there's going further down further
down the risk spectrum to equities and
we still have a 4
%
per year real
earnings yield on equities in the global
north hanging up there which is 4
percent real each year which is a very
attractive return in the current
environment in which little else offers
are attractive return but is that 4
percent real really there it hinges on
there being no sharp rise back to normal
in the labor share of value added and it
hinges on there being no reversal of
current valuation ratios for equities
and when you look at valuations for
equities even if you're not Robert
children who insists that long time
earnings yields of above 6 percent or so
are unsustainable inevitably followed by
a return back to 6 percent even if you
are not Robert Shiller you look at
equities you look at equity
capitalizations and you have to see that
the dangers not just of a large V but of
an L of a permanent decline in valuation
ratios
in the rise that we saw in the 1990s is
defi nitely out there so live dangerously
inequities accept the fact that your
returns will be very low if you invest
in safe assets try to assure your
investors and others that well they got
the returns to the safe debt you hold
back in the past generation as interests
young as interest rates on government
that collapsed and as the value of your
long government bond positions went up
and it's certainly true that they got
their returns last decade of the decade
before but they don't want to be
reminded of that it is perhaps the most
diffi cult situation to try to manage
money in that we have ever seen short of
something like the Great Depression and
the coming of World War two the last
piece of background is that back twenty
years ago when I worked for the Clinton
administration people from the United
States would come to Europe and would
lecture them about euro sclerosis about
the absence of a European
entrepreneurial and technological
culture about labor market rigidities
about how much better the US more
market-oriented economy was performing
along every direction well that is no
longer the case not only our people in
America not moving in search of
opportunity it's also the case that over
the past generation the u.s. is
market-oriented flexible labor market
has produced a labor market in which
fewer Americans want to true even work
to fi nd jobs than people in Europe do in
which their rate of investment in human
capital is lower and in which when our
our economy looks profoundly unhealthy
in a manner that does not reach but is
in some ways reminisce
of what happened to the economies of the
former Soviet Union in the 1990s that
the economies east of the Iron Curtain
were the only economies outside the aids
ridden economies of Africa that saw
substantial declines in life expectancy
Qaeda ever since the great influenza of
1919 and 1920 of great peacetime
declines in life expectancy in 40
%
of
the counties in America women have
shorter life expectancy now from they
had 20 years ago so that's the
background a background of one in which
perhaps economic growth has not slowed
down but the ability to make money off
of that economic growth by producing and
selling goods and services has
defi nitely slowed down and that makes a
world awash in savings in which it is
diffi cult to deploy money and expect
returns without taking on major risks
without being lucky enough to fi nd
impressive entrepreneurs to back and
kind of risk entrepreneurs and without
kind of being willing to fi gure out some
way to attempt to substantially acquire
market power in one form or another all
of which are very diffi cult things to do
especially if one is in the fi nancial
sector and thus trying to reach through
to what happens to the management's of
the corporations of the operating
corporations when invested so with that
background what are central banks likely
to do over the next one to fi ve years
well fi rst of all the European Central
Bank and the Bank of England are likely
to follow the Federal Reserve over the
past 15 years or so they have all been
relying on the Federal Reserve to expand
the
see space in which they operate and they
are likely to continue to do so over the
next one to fi ve years to stay the
course to attempt to take advantage of
Federal Reserve rate increases to
perhaps reduce the values of their
currencies a little bit to provide a
boost to exports but not to innovate in
the policy space greatly unless they are
given permission and example by the
Federal Reserve to do so and the Federal
Reserve is unlikely to engage in policy
innovation over the next one to fi ve
years
right now the consensus on the Federal
Reserve is with the exception of
governor Lael Brainard and perhaps bank
president Charlie Evans and perhaps Bank
president John Williams has recently
been moving into a position more like
that of opposition to the current
consensus from the left but even he is
not fully there yet the Federal Reserve
thinks that the US economy is near full
employment that u.s. measured potential
output growth is 2
%
per year and that it
is the business of the Federal Reserve
for fi nancial stability reasons to
normalize interest rates as rapidly as
possible both to make it somewhat
expensive to borrow and to provide it
with room to take action to fi ght
additional and that negative demand
shocks should they happen in the near
future that means that any positive
shock to growth or inflation in the
United States will see the Federal
Reserve raise interest rates
farther and faster than it is currently
planning hence do not expect real growth
in the US to accelerate above 2
%
per
year if it does the Federal Reserve will
take that as permission to raise
interest rates faster in order to push
it back down to 2
%
greater do expect
federal funds rates to rise at about 3/4
of a percent per year
as long as the economy can stand it
without recession do not expect bad news
bad news about inflation well good news
about inflation news that inflation is
lower than expected to affect Federal
Reserve interest rates rises as much the
Federal Reserve will take any shocks
downward shocks to inflation as evidence
of temporary factors of not of a
permanent change and we will not see a
stop to normalization we might see at
most a small slowing of it
by contrast a negative shock to its
demand in the United States if the
Federal Reserve becomes convinced that a
recession is coming it will quickly
return the federal funds rate to zero
and thereafter it will tend to dither
without another major fi nancial crisis
on the order of what we saw of 2007 to
2009
it will dither with many tools but with
none of them that have proven powerful
at affecting the level of demand economy
that's what the Federal Reserve is
likely to do and other central banks arm
in new Europe are maneuvering in a
context in which the Federal Reserve is
the policy leader the Bank of Japan is
now approaching a situation in which
Japanese employment and growth is
healthy enough that it can no longer be
flashing emergency act red action needed
and needs to start is thinking it needs
to start turning its hand to dealing
with the overhang of Japanese debt and
the Chinese government the Chinese
government's monetary and other policies
will be overwhelmingly determined by
things that happen in internal Chinese
politics that I am not terribly
competent to evaluate they simply
attempt to stay the course and not
introduce additional uncertainty and
additional confusing
into a political situation that with the
rise and maintenance of power by Zhi
Jinping looks at least like somewhat of
a deviation from the Oleg ARCIC
succession consensus pattern established
in the aftermath of the rule of Deng
Xiaoping now I think the Federal Reserve
is likely making a mistake here I tend
to think that governor Lael Brainard
arguments are the more convincing that I
think the Federal Reserve could be more
aggressive you know at promoting growth
that I think that prime age employment
the population numbers in the u.s. still
show considerable labor markets left but
given that the unemployment rate shows
mere full employment
that's a contest people can differ about
that I tend to think that wage growth
shows no labor side pricing power for
workers yet the Federal Reserve trusts
the unemployment rate much more than it
trusts other indicators and that has it
convinced that it is time for is to
normalize interest rates
hence the slow tightening cycle that it
is currently embarked on and will
continue to embark on as long as even as
long as inflation remains subdued that
it was back in the 1990s not 1950s
that's a bad type of that alan greenspan
declared that 2
%
per year measured
inflation was effective price stability
the Bernanke Yellen Federal Reserve
decided that it pushed the envelope of
that by declaring that the price index
that applied to was the personal
consumption expenditures deflator rather
the consumer price index that gave them
an extra half a percentage point to play
with because 2
%
inflation on the PCE
deflator is close to two and a half
percent inflation on the Consumer Price
Index
since January 2009 they have
persistently undershot this 2
%
per year
PCE deflator kind of chain deflator kind
of target an undershoot cumulating the
four percentage points in the price
level by now with recent price news not
suggesting any inflationary spiral
developing soon and yet throughout this
nearly past decade at every opportunity
the Federal Open Market Committee has
reached for excuses not to believe what
the inflation numbers are telling them
to believe imminent return of inflation
to its 2 percent PCE target and ignoring
evidence that the tightening cycle
announced in 2013 for the end of 2014
and then postponed for two years to 2016
that this tightening cycle was premature
and the market the market agrees with me
the market also does not see anything
like a return of inflation in the United
States to anything like its pre 2007
trend of two and a half percent per year
on the Consumer Price Index so the
inflation breakeven gives us a window
not a great window but somewhat of a
window into what market expectations are
and so we see that the marginal
investors and traders are kind of out
here with Lael Brainard and me in terms
of our view about what the likely
consequences of Federal Reserve policies
are going to be modulus all of this that
various kinds of semi disaster and
disaster scenarios both down the
downside as far as inflation and demand
are concerned debt on the upside tend
not to be priced in to whatever
fi nancial markets are doing that as John
Maynard Keynes
back in 1936 although I paraphrase that
there is virtually no percentage to Ana
banker to price or investor to who with
clients to accurately price in tail
events because if you succeed the very
fact of your success is regarded as
evidence that your judgment was not so
much wrong but that your judgment was
deviant and the last thing one wants in
a money manager is someone whose
judgment is very deviant and if you are
wrong if whatever particular tail risk
you are hedging against does not come
true then you are underperforming your
peers and the fact that you had in some
sense a better assessment of tail risks
and they did if we could rerun the
economy 10,000 times does not enter into
anyone's calculus at all so do not
expect the Federal Reserve to deliver
much if anything in the way of expanded
demand in the US and thus either rising
substantially rising asset prices for
equities or any substrate or any
substantial increase in the u.s. demand
for imports from elsewhere in the world
do expect US interest rates at the short
end to rise for about 3/4 of a percent
per year until the US yield curve starts
to invert at the 10-year Treasury level
