What is happening in the US economy? On the plus side, we have the classic leading indicators: residential investment and consumers’ spending on durable goods are both fairly strong (the yield curve is probably broken as a leading indicator on account of the Fed’s activities). On the minus side, we have fiscal policy: a lot of tightening is inevitable in 2013, and the sequester, if it remains in place, will cause still more.
What about monetary policy? Is the right way to think about it that the Fed has been running a very loose policy, which is feeding into the economy with a lag of a year or more (which would not be unusual)? Or is the right way to think about it that the Fed has already done all it can, and has now exhausted its toolkit? Monetary policy at present seems to be all about moving inflation expectations, and inflation expectations may have got as high as they can go, given the Fed’s new 2% target (even within an optimal-policy framework, the Fed only has so much tolerance for inflation).
I am not sure what the right answers are for the economy. But happily, it is not the economy that I need to forecast, but the financial markets. I think that the contraction in the government deficit is likely to mean a contraction in the corporate surplus in 2013, because the household saving rate is already very low (so can’t fall much further) and the external position has not, so far, seemed inclined to move very much. Further, I think that financial markets have fully priced the extreme looseness of the Fed. Since a good way of looking at equities is that they are moved by trailing earnings and a risk premium that is closely correlated with credit spreads, equities ought not to be able to rise much further, even if, as seems likely, there is moderate growth in the economy and continued improvement in leading indicators.
It has been a part of my analysis that monetary policy has been too tight (based on the “liquidity trap” idea). The liquidity trap is caused by an excess of desired saving over desired investment. As the debt overhang is eliminated — households’ total liabilities are now changing at around 0% YOY — the excess of desired saving should abate. In an IS-MP model, the IS curve moves to the right. Hence, an interest rate of 0% will move from being quite tight to being moderately tight. In other words, monetary conditions may be becoming easier relative to the state of the economy. That could make for stronger growth this year than one would be led to expect from the considerations above.
George Osborne has announced a new approach: “fiscal conservatism and monetary activism”. He has instituted a discussion about changing the remit of the Bank of England. Ideas include allowing more time to hit the inflation target, a dual mandate and NGDP targeting. Mr. Carney has already said that he would like a discussion to happen, and to be concluded by the time he takes the helm.
I see this as desperation on the part of the government. The weakness of the economy continues to have a political cost, but thanks to the positions he has staked out and the ideology of his backbenchers, Mr. Osborne cannot switch to a more reasonable policy (i.e., less austerity or even fiscal expansion, which I would favour). So he is putting all his faith in monetary policy. I am rather sceptical about this. Real interest rates are already very low, and presumably the goal of more monetary expansion would be to lower them further. If they will not go any further, because inflation expectations remain relatively well anchored, then there will be little effect (except, perhaps, a money-flow effect on asset prices). Well, perhaps they will go further, and perhaps they won’t. The whole idea seems rather speculative compared to the solid solution of the government just spending more money.
Interest in the sequester appears to have waned in the media, and the Google search data suggests that it has waned in the public consciousness as well. As of Tuesday, search volume for “sequester” was down to 31% of its peak last Friday.
This is the week of the Fed’s stress tests. Banks that pass may be able to increase their dividends or buyback programmes. The stress scenarios are: 1) a six-quarter economic contraction combined with sharp increases in inflation and interest rates; and 2) unemployment rises above 12% and equities fall 52%. Banks must withstand these stresses without their capital falling below regulatory levels. That strikes me as quite a lot to ask: this is a reminder that there really has been some useful tightening of regulation in the wake of the financial crisis, and that there is a new acceptance of the right of the authorities to intervene in the business of financial institutions.