Notes From Underground: This Is the Week That Will Be

In the past I have criticized the CNBC tagline, “Live From The Most Powerful City In the World, New York.” I find it arrogant and devoid of any perspective. What makes a city powerful? In some sense I suppose it’s the ability to make and shape events around the globe. Wall Street may be a powerful money center but so is London and from a political and monetary sense Beijing has catapulted itself a spot among the most influential. Friday morning I did an interview with Gordon Long of the Financial Repression Authority, a must visit site for its archive of discussions on global macro issues. We were discussing the role of China in affecting U.S. monetary policy. Gordon Long has discussed the idea of an agreement reached in February at the G-20 meeting in Shanghai about an ACCORD to keep the U.S. dollar stable to weak in an effort to prevent the Chinese from actively pursuing a weaker YUAN for when the DOLLAR RALLIES THE YUAN IS ALSO PUSHED HIGHER AGAINST A BASKET OF DEVELOPED MARKET CURRENCIES AND CERTAINLY AGAINST OTHER EMERGING MARKET FX.

There is a THEORY that the Chinese promised not to rattle the markets with a sharp devaluation of the YUAN and the FED would hold interest rates so as not to put downward pressure on the Japanese YEN or other emerging market currencies. Many market participants believe this is the basis for the Shanghai Accord. John Brady of O’Brien and Associates has been quoted in many financial media publications noting the importance of the YEN/YUAN cross rate as having an increased importance because of the Accord. Think back to August 2015 when the Chinese surprised the markets with a MERE 3% devaluation  and the turmoil that followed into late August and September. China sent a message to the world that the global markets are too fragile to entertain a serious sea change from Beijing.

The FED did raise rates in December and for the following six weeks the DOLLAR rallied versus all currencies, including the YUAN, but after the late February meeting the DOLLAR has fallen and the FED has not raised rates. Is Yellen holding the line because the Chinese threatened to meet any FED rate rise with a devaluation of the YUAN? This is the basis of the conjecture of an accord. If such an agreement was made the market would know because secrets tend to leak through the press leaks from dissatisfied parties. As I discussed with Gordon Long, such an agreement would not be reminiscent of the Plaza Accord but more in line with the U.S. Treasury’s actions in June 1998.

In 1998, President Bill Clinton was headed to Beijing when the U.S. Treasury announced it was intervening to BUY YEN  against the DOLLAR. This unilateral intervention from the Treasury came right after Secretary Robert Rubin had delivered a speech proclaiming the importance of the U.S.’s strong dollar policy. As President Clinton was going to Beijing to set in motion trade deals and the opening up of Chinese markets to American technology, the Japanese yen had just experienced a year in which it had depreciated over 20% amid the proliferation of the CARRY TRADE, which resulted in many financial market actors shorting the YEN in an effort to attain higher returns in other global markets. The U.S. Treasury intervention caught many of the world’s most successful hedge funds short and led to huge losses. The intervention was sustained during the next few months. The Japanese were also caught off by the unilateral Treasury action and the Japanese government was very bothered that President Clinton did not stop in Tokyo on his Asian trip.

It appears that the U.S. is seeking to placate China again and avoid the potential financial disruption from a unilateral move by the authorities in Beijing. There has been a great deal of rhetoric form Secretary Jack Lew directed at the Japanese over MOF/BOJ efforts to weaken the yen. A major move in the middle of the BREXIT vote would certainly cause the British to favor an exit as the world would be forced to respond to any severe drop in global equity markets. If Japan moves to weaken the YEN the Chinese will certainly respond, but does this also tie the hands of the FED? This brings us to the G-7 meeting with the heads of state. The entire basis of the outcome will be quid pro-quos.

In tomorrow’s Financial Times, Gavyn Davies seem to be raising the same point about the FED and its global role in his article, “Reluctant Partners:The Fed and the Global Economy.” Davies entertains the notion of the FED being an isolationist and setting policy by what its mandate calls for: employment and inflation. Volcker and Greenspan could operate believing that if the U.S. economy was in order it would be beneficial for the entire globe. But the world has certainly changed as China has become a major part of the world economy and the U.S. percentage of global GDP continues to shrink on a relative basis. There is a battle between the FED and domestic money manager versus its role in the politics of a global community. This is what will play out in Japan this week as the world leaders of the G-7 nations try to contain the disruptive influence of a Politburo in Beijing, struggling to find its economic balance.

The Gavyn Davies article cites the work from economist Barry Eichengreen:

“As the U.S. economy grows more open and the rest of the world grows larger, international considerations …will impinge more directly on the central bank’s key objectives of price and economic stability. The Fed will have no choice but to incorporate those considerations more prominently into its policy decisions.”

There is a great deal of dissonance within the FED when it comes to entertaining the global headwinds. The outcome will play out in the G-7 communique as David Cameron and Prime Minister Abe both seek some relief from possible GLOBAL DISRUPTIONS. Brexit will be discussed as will Japanese demands for a global fiscal stimulus agenda. China won’t be in attendance but its presence will most certainly be felt. It seems like June 1998 all over again.

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11 Responses to “Notes From Underground: This Is the Week That Will Be”

  1. david cooper Says:

    you know yellen and stock managers don’t want to hike. it seems like an easy decision for more tough talk and doing nothing by the fed. only iblation might upset the apple cart or possibly brexit which is losing by a wider margin in the polls.

  2. Frank C. Says:

    All the Fed seems to singing off the same hymnal. Even the doves.

    Here is Boston Fed Rosengren’s a capella.

    https://next.ft.com/content/5ea7e4be-203f-11e6-9d4d-c11776a5124d

    The following is an edited transcript of a telephone interview between Eric Rosengren, the president of the Federal Reserve Bank of Boston, and Sam Fleming of the Financial Times, on May 20.

    Q: You have spoken of excessive market pessimism about the rates outlook. Part of the reason has been scepticism on Wall Street about the prospect for higher rates given they have been burnt in the past. We only got one hike in 2015 and the forecast for four this year went down to two. Why should they believe this time is different?

    A: The reason they should believe this time is different is that the economic conditions are changing over this period. If you go back to February there was a lot of financial market turbulence. The first quarter ended up being quite weak. Real GDP for the first quarter, at least from the preliminary report, was only half a per cent. You don’t need to tighten if the economy is weak and you are concerned about global market conditions potentially making it weaker.

    If instead you are in an environment where you think labour markets are tightening, that GDP is improving and inflation is moving to 2 per cent that is an environment where more normalised interest rates would make sense. The financial markets seem to have reacted to the announcement of the Federal Reserve minutes this week. And I think the Federal Reserve minutes were pretty clear that a number of conditions would be necessary but if those conditions were met it would be appropriate to raise rates.

    One of the conditions was economic growth picking up in the second quarter. Given that real GDP was only a half a per cent in the first quarter that is a relatively low threshold. If you look at how the data has actually been coming in I was a little surprised that there was not more of a market reaction to the very strong retail sales for April. If you look at the economic forecasters in the private sector most of them have raised their consumption forecasts for the second quarter to be in the range of 3 per cent to 3.5 per cent. When consumption is roughly two-thirds of GDP, a number that high for that major a component means that it is likely we will see growth around 2 per cent.

    We still have plenty of data — we have two more retail sales [reports] before we have the second quarter data in. At least the preliminary data has been pretty positive on the spending aspect.

    The second condition was labour markets continuing to strengthen. While the payrolls number was a little lower than market expectations it is still consistent with a gradually tightening labour market. 160,000 jobs is well above what we are going to need in order to take into account new workers coming into the labour force.

    If we were to continue to get 160,000 jobs [a month] it is less than what we were getting in the first quarter of a little bit above 200,000, but it is well above what we need to have a gradual tightening of labour markets.

    The unemployment rate is currently at 5 per cent. If we get gradual tightening of labour markets it will be pretty close to most people’s estimate of full employment. For some people it is already there. For myself I have a slightly lower measure of the natural rate — it would be at 4.7 per cent. I am expecting to be there by the end of the year. So labour markets are tightening.

    Then on the inflation front, which is the third criteria that was laid out in the minutes, I think we are making progress on getting to inflation at 2 per cent. Some of it is reflecting global market conditions — oil prices have definitely risen from the lows we were seeing earlier in the year. While the dollar has appreciated the last couple of days, it has more broadly depreciated over the past two months. And the core PCE number is at 1.6 per cent which is higher than most of the observations we were getting over the course of 2015.

    The reason I am more confident is we are getting better data. And so if we get a lot of weak data we don’t need to be tightening, but if we start to get data that is consistent with us reaching our dual mandate then that is an environment where we should have a more normalised interest rate.

    Q: The way you have set out those tests and the progress made against those tests it sounds like you have almost already made up your mind that we need to see higher rates at the next meeting.

    A: We are still a month away from the actual meeting. We are going to get another employment rate in early June. We are going to get a second retail sales report. So I want to be sensitive to how the data comes in, but I would say that most of the conditions that were laid out in the minutes as of right now seem to be … on the verge of broadly being met. We have more data to observe before we actually go into the meeting. If we were to get a lot of weak data between now and when the meeting occurs that would obviously influence how I was seeing the economy. Just focused so far on what we have seen to date since the last FOMC meeting, and broadly all that data has been pretty supportive of the criteria that were laid out in the minutes.

    Q: We don’t get any more inflation data before the meeting.

    A: We have the inflation reports but obviously we get information from the movement of oil prices, the movement of the dollar, we get some labour market indicators, for example average hourly earnings, what is happening in labour markets. There are other things that are relevant to thinking about what the path of inflation is going to be. But I agree with you that in terms of PCE or CPI report we have most of the data we are going to have.

    Q: It did feel from the minutes that the committee is a bit divided over whether they will have those clear signals by June. Even more felt those conditions might not be met by June than those who felt they probably would be.

    A: I can’t comment on other people’s views or what was discussed in the meeting. I can say from my own viewpoint that the June meeting has occurred in the third month of the second quarter. So while we don’t have all the data and we won’t have a second-quarter GDP number, we will have plenty of statistical techniques that will give us a reasonable idea of what we expect second-quarter GDP to be … Even when we get the preliminary GDP report like what we have for the first quarter it is subject to a fair amount of revisions as well in the second and third report. It is not that we don’t have much information, it is that we don’t have complete information. I do think we will have had two labour market reports, two retail sales reports, so that there will be a fair bit of information that should give us a pretty good idea of what is happening. And we will obviously be able to monitor what is happening in terms of financial conditions as well.

    Q: Do you see the vote in the UK on a possible Brexit as a reason to wait until July?

    A: Votes by themselves shouldn’t be a reason for altering monetary policy. If we were experiencing significant changes in financial conditions that made us significantly alter the outlook going forward that would be something that we should take into account.

    But the fact that there happens to be an election or not be an election on a particular date by itself should not be determinative … What we care about is we will have data on the second quarter but ideally we want to see the third and fourth quarter making the same kind of progress that we are hopefully going to be seeing in the second quarter and if there were events to alter our expectation for how the economy was going to evolve in the future that we obviously should take into account before we tighten rates.

    If there is nothing that is altering our overall forecast for the economy that shouldn’t influence the timing of a decision.

    Q: One reason the markets were pencilling in a very shallow path were the Fed communications in March. People felt there was a very cautious message being portrayed by the Fed. Do you think in retrospect there was a communications miscue?

    A: A lot of financial and economic indicators have swung a bit between the first and second quarter. If you remember what was happening in February it was an environment where global stock markets had declined significantly and I would say particularly in Europe, and European bank stocks had in particular been quite negative. And there was a lot of concern about what Chinese growth was going to be. Our own growth forecasts were going down, so that the first quarter preliminary number … was only a half a per cent.

    So in an environment where your own economy is growing weakly and you are seeing plenty of headwinds from abroad, that is an environment where you are probably not going to need to be altering monetary policy. But stock markets globally have improved quite significantly. The data has been coming in better and not only in the United States but in many other parts of the world.

    Some of the headwinds we thought might be a significant problem as recently as March seem to be a little bit less of a significant problem as we go into June. So you have to communicate what you know at the time.

    We should reflect how incoming data would influence our expectations of the future and make alterations based on that. Some of the movement that we have seen is reflecting the actual data that have changed between earlier in the year and what we are seeing right now.

    Q: There has been discussion this week as to whether the Fed is being excessively swung by market movements in its decisions over when to move policy.

    A: We are very focused on inflation and employment and those are related to how we see spending data and financial market conditions. If financial market conditions move significantly enough that it alters our forecast we should be taking that into account. With volatility that doesn’t change our forecast at all, then that shouldn’t influence policy. It really matters exactly what the context is.

    The labour market data has continued to improve, the unemployment rate is pretty low by historical standards, we have only raised interest rates once. When you are close to estimates of full employment and you are talking about a fed funds rate that is roughly 35 basis points, that is pretty low given we are pretty close to full employment. If you think the economy is improving and you think you are going to get growth a little bit above 2 per cent and you think labour markets are going to tighten and we are going to hit our 2 per cent inflation target then that is an environment where a more normalised interest rate path makes sense.

    Q: You have been seen as one of the more dovish policymakers. What was the turning point that made you more optimistic?

    A: When the unemployment rate is quite high and the inflation rate is quite low that is an environment where we should have quite accommodative policy. If you get to full employment and inflation closer to our inflation target then that is an environment where we want a more normalised interest rate environment. It is reflecting the fact that I am sensitive to where the data is in relation to the two mandates Congress has given us …

    When we were very far away I was calling for aggressive monetary policy action to make sure we did get back to full employment and did get back to a 2 per cent inflation rate. I think that has been justified because the US has moved with a little more alacrity than some of our trading partners in terms of getting back closer to our inflation target, and in the United States we have the employment target as well.

    So it is really being data dependent and the conditions that the economy have at a particular time are going to influence whether I think we should be more accommodative or less accommodative. Because we are closer to full employment and because we are closer to our inflation target I am more confident now that a more normalised situation makes sense.

    Q: How many increases to you expect to see this year?

    A: I am not sure it is that useful to give numbers of rate increases. It is more important to be tracing what is happening in the data. My forecast is we are going to grow a little bit above 2 per cent and are going to get a gradual increase in the inflation rate towards 2 per cent. The labour market tightening is slowly going to be reflected in higher average hourly earnings and better ECI [Employment Cost Index] numbers. If that actually occurs a fairly gradual path will be appropriate. If conditions around the world were to provide significant headwinds, we don’t need to be doing a lot of tightening and if the economy were to grow much more than I expected then I am going to be arguing for raising rates more quickly.

    Relatively small changes in the outlook can have a pretty significant influence. The difference between 3 per cent GDP and 2 per cent GDP is well within standard errors that you have for GDP reports. If we are getting 3 per cent growth for the second half vs 2 per cent growth you are going to have a very different view of what is appropriate monetary policy. So I think we need to continue to be reasonably data dependent. As long as we are getting progress that is gradual, like we have been seeing, then that is an environment where gradual increases are quite appropriate.

    Q: When you think about financial stability, one of the objections to using rates to deal with these concerns is they are arguably a very blunt tool to deal with isolated problems in a few particular markets. How do you respond to that objection?

    A: I wouldn’t argue it is the only tool or even the first tool you should use. We have a wide variety of bank supervisory tools and macroprudential tools that can potentially be deployed. We had guidance that has been focused on commercial real estate. There was a reiteration of the guidance that was issued at the end of 2006. There has been more recent guidance highlighting that risk management should be stepped up if you are taking a big exposure in commercial real estate. I think that is appropriate. And there are those supervisory tools.

    I think we should continue to ask ourselves are we doing what we need to do to make sure that commercial real estate doesn’t grow to the point where it becomes a financial stability concern. The reason I have highlighted commercial real estate is it is an interest-sensitive sector. The kind of interest rates that borrowers are facing does influence their willingness to engage in commercial real estate.

    When you look at financial stability that have occurred historically around the world they have tended to be related to leveraged lending relative to an asset that people didn’t anticipate was going to reverse particularly quickly. That has tended to be residential real estate like we experienced in 2007-08, and commercial real estate which for example we witnessed in New England in the late ‘80s and early ‘90s and ended being a problem for the mid-Atlantic states as well as the west coast during that time period.

    We have had instances where real estate prices growing at unsustainable levels and being funded by leveraged institutions can potentially be a problem. One of the challenges with commercial real estate is that a lot of the commercial real estate is done by non-banking organisations. If you look at the buildings that get acquired in Boston they are frequently pension funds, life insurers — they may be domestic, they may be foreign.

    So our ability to influence that just with supervisory tools may be more limited than we desire. So I would want to look at all the tools we are having. If one of the reasons why commercial real estate was having price appreciation to the degree it that it was was the fact that we had interest rates low for a long period of time I would think about the constellation of tools that we have and make sure we are appropriately using all those tools to try to get the right outcome.

    Q: Credit growth is heating up in some other sectors too, including credit cards and auto loans. Do you see signs of excesses outside commercial real estate?

    A: I’d say the most obvious one is commercial real estate. There is more subprime lending occurring in auto lending but I would say that is probably not an area I would be particularly concerned with. Someone who takes out a loan on a car that they can’t afford to pay — that is a problem for that individual but the likelihood that it becomes a problem for the economy more broadly … the loans tend to be shorter term.

    Most people if there is any payment they are going to make it is their car loan because you can’t get to work in the United States very easily in many places unless you actually have a car. Frequently people prioritise car loans above all other expenditure so they can continue to get to their job. And the likelihood that you would have such a broad impact from so many people defaulting and so many of the cars being repossessed, it doesn’t strike me as a scenario that is going to result in a serious macroeconomic outcome.

    The kinds of shocks we have seen have tended to be much more related to real estate and that is why I am more focused on real estate.

    Q: Do you think we could be heading for an overshoot in inflation?

    A: There are still people concerned that we are not going to get to the target … It is quite reasonable that we will get close to the 2 per cent target on the current path that we are on. The economy is improving but at a relatively slow rate. The inflation rate has been improving but at a very slow rate as well. So I think we are on the right path. It is not obvious to me right now that we are necessarily going to overshoot.

    But one of the things that I highlighted in that New Hampshire talk is that [there are] both benefits and costs for waiting. The benefits tend to be accruing to the labour market and hopefully getting labour force participation to improve, getting more marginal workers back into the workforce is obviously beneficial for that worker and to the economy.

    But there are also some potential costs. We talked about one, which is financial stability. A second one is that in the past we have tended to overshoot the natural rate of employment and when we overshoot significantly on the natural rate of unemployment it takes a while for the inflationary pressures to pick up but we are not so good at slowing down the economy and getting right at the Nairu [non-accelerating inflation rate of unemployment].

    So if you look at the unemployment rate curve you tend to blow through the natural rate and when you start tightening you tend to get a recession shading. So it tends to be much more abrupt than we were hoping. Which means we are not like a thermostat where you can easily calibrate the difference between 70 degrees and 68 degrees … When we start tightening we tend to get more of a reaction in the economy than we are hoping for.

    So it makes me a little tentative to hope we would overshoot significantly, because I am not so sure we are good at fine-tuning the economy. History would say we haven’t. Ideally what you would see is long periods where we are around the estimates of full employment. That is not actually what you see.

    Q: If things go wrong and the US does slow significantly and the Fed needs to reverse course how confident are you in the tools the Fed has at its disposal and do you include negative rates among those tools?

    A: That is not my outlook that we will have a big negative shock, but if a big negative shock were to occur we should think about all the possible tools. I think the global experience so far is probably more positive on quantitative easing than on negative interest rates … if I were to pick a tool for the United States the first tool would be to lower the short term interest rates, depending on when this shock were to occur. Hopefully we have some latitude to lower short-term rates.

    I would think the next tool would probably be to revisit quantitative easing which has proved fairly successful in the US and other parts of the world. And then if that doesn’t work we have to explore a wide variety of other alternatives — there is forward guidance, and obviously negative interest rates have been tried in some countries. The results on negative interest rates to date look to be mixed.

    • yra Says:

      Frank–thanks for the link to an important post but if I asked Rosengren I would posit two questions:1,What do you expect the market reaction to be if you against a rate rise[9-1 again] and is Nehru more important then NAIRU as a guide to the wage situation?

  3. Asherz Says:

    The Plaza Accord and the Shanghai Accord had the same goal in mind. And the LOCATION was key to understanding the necessity of these policy-making confabs.
    The Plaza Accord in 1985 followed Paul Volcker’s successful breaking of the stifling inflation five years earlier, with huge interest rate increases that resulted in the dollar appreciation. The negative effect on US trade required a weakening of the dollar and so the Plaza Hotel in New York (then the most powerful city in the world) was chosen.
    In February 2016 a highly problematic China, (the many problems need not be enumerated here) the world’s second largest economy, necessitated a weaker dollar which again had been too strong, as the Yuan is pegged to the reserve currency. And so Shanghai was chosen to address that nation’s woes.And we saw the dollar weaken soon thereafter.
    But the world’s third largest economy, Japan, has suffered with these moves, resulting in some countervailing forces. Trying to work out of this maze is almost as difficult as the conundrum faced in the EU as we have a corpus of a dynamic Germany integrated with sick peripheral states.
    A month from today you have the Brexit referendum, and the outcome is really to close to call. Add to this the Fed’s third mandate to be market oriented even more than data dependent.
    Putting this hodge-podge together makes one dizzy and Warren Buffet’s advice on not having to swing at every pitch but wait for the one you like, makes eminent sense for the trader today. Golf or fishing, choose your relaxation and stay away from the pits until the fog of the markets begins to clear.

  4. ShockedToFindGambling Says:

    Yra- Good blog.

    IMO, the more important factor in the FOMC’s decision to tighten (or not) is White House pressure on Yellen, not to rock das boot, prior to the Election, and thereby give the Election to Trump.

    I remember Yellen was called to the White House recently, but I never heard a rational explanation why she went.

  5. Chicken Says:

    Perhaps the White house asked Yellen over for tea and crumpets b/c they needed to do some fact checking?

    Not sure how the FED responds to BREXIT before it occurs, this involves a strategy departure from reactionary to being proactive. Such proactive responses are certainly unprecedented, for them!

  6. Chicken Says:

    Harker says today, the Fed might have to use ‘aggressive policy actions’ to fend off runaway inflation, which has consistently remained under 2%, for years.

    What is that GDP growth again, less than 2%, right? Growth my butt, the FED doesn’t want growth, they want to bring forward default.

    Rinse and repeat

  7. Chicken Says:

    Several euro-banks have been doing quite well lately.

  8. Chicken Says:

    Dow Jumps triple digits to fresh 2016 highs, Germany’s hedge fund manager, Mr. Draghi at work?

    Austerian, Austrian, Australian, which is it, none of the above?

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