Everything on Hold

Markets remain obsessed with Spain while waiting for the Greek election. All the news stories are of the type: country X could suffer if Greece exits the euro. It is a hopeful point that all the politicians of countries X1, X2… Xn will be making this point to European politicians. Equally, other central bankers will be expressing their views to the ECB — in Mario Draghi’s case, via the famous MIT network (http://bloom.bg/LO3Plu) — and their views will be very much in favour of preventing disasters. Meanwhile, the debate within Europe (or, at least, between Angela Merkel and everyone else) continues, with the Commission sounding more assertive on Eurozone bonds, common banking supervision, allowing the ESM to recapitalise banks directly, and allowing Spain extra time to meet its deficit targets (on the argument that it is the only non-programme Eurozone country expected to be in recession in 2013).

Talking of the Commission, the EU’s executive body has just released fiscal reports on Eurozone countries and tells pretty-much all of the non-programme countries to increase austerity. Its opinions on this subject will have legal force once Eurozone members adopt the fiscal treaty. The fiscal treaty makes some sense, I suppose: it mirrors the balanced-budget rules of many US states (whether these are a good idea is a matter for debate, but the US is certainly integrated enough that they do not lead to state crises of the kind we are seeing in Europe). But it strikes me that, in building institutions for their United States of Europe, the Europeans are making the same mistake as those who see fiscal austerity as a great opportunity to shrink the size of the state: they are allowing their obsession to rule policy and failing to respond to the current environment. I am all for shrinking the size of the state as a proportion of the UK economy, but not now, in the middle of a recession. I am all against a United States of Europe, but if they must build such a thing, they should not be building this particular part right now, in the middle of a crisis which austerity alone is only going to make worse.

The Stimulative Mr. Rosengren

Eric Rosengren of the Boston Fed (not presently voting on the FOMC) has joined Charles Evans in calling for more stimulus. The options that he laid out were interesting. He talked about more QE, more OT, or further changes to Fed communications to clarify how long the Fed will keep rates low.

It struck me that, if the Fed’s objective is to reduce interest rates across the curve, there is not much more than it can do. Rate expectations are already extremely low at the front end of the futures curve. Moreover, I calculate that 10-year interest rates have just fallen to a level consistent with current short-term rates, assuming that the expected volatility of future rates is the same as their historical volatility. One has to ask: how much more can the Fed actually do? Of course, rates have only fallen this low because of pessimism about the economy, so the Fed could do more to keep them this low when prospects improve; and the expected future volatility of short-term rates is probably less than their historic volatility. This means that there is room for further action by the Fed. But if the 10-year rate fell another, say, 50bps, it would be getting about as low as it can go.

What would the Fed do then? It could drive the rate down still further, by reducing further the expected future volatility of short-term rates, but I wonder how far it would be prepared to go here. A stated expectation that the Fed Funds rate would not move for five years, say, might be a bridge too far. It could drive up inflation expectations, and thereby decrease real interest rates, but its recent history shows that there is only so far it would be prepared to go on that score. That leaves the option of employing QE in order either to finance an increase in government spending — which seems politically unlikely — or to finance parts of the real economy. Purchases of MBS or corporate bonds by the Fed would have a direct, positive effect on the economy.

This line of reasoning answers a question I have been asking for a while: if you communication policy has reduced interest rates along the curve, and your actions have convinced the market that you will hit or exceed your inflation target, then why would you do more QE? The answer is that QE is not all about reducing interest rates: there is also the direct effect of QE purchases (actually, the argument that QE reduces interest rates is not one that I find very persuasive).

Forgotten Emerging Markets

With all the focus on Europe, it is easy to forget about emerging markets. India has just reported growth of 5.3%, the lowest since 2010. China’s economic slowdown is continuing, as some charts in the World Bank’s latest report attest (http://bit.ly/LOaw6R). Brazil’s central bank rate has just been lowered to 8.5%, a record low.

Add to this a distinct weakening in the US data in the past month (my US leading index has ticked downwards), and there is reason for caution over my view that markets will likely rebound when the Greek and Spanish situations are resolved. If the economic picture elsewhere in the world looks distinctly worse by the time this happens, markets may not recover.