Commentary on Political Economy

Tuesday 5 February 2019


In anticipation of our piece on Minsky, here is a gem from Ambrose-Pritchard.

When the US Federal Reserve suddenly abandons monetary tightening so late into the economic cycle, a recession usually follows within three to six months. The damage below the waterline is by then already irreversible.
Jerome Powell's abrupt shift has bought the crumbling world economy some time.
Jerome Powell's abrupt shift has bought the crumbling world economy some time.CREDIT:AP
There are crucial exceptions to this post-war rule of thumb. It did not hold after the Fed retreat during the East Asian crisis of 1998 or the pause after the Chinese currency scare in 2016.
Pre-emptive action came soon enough to keep the cycle alive, and to fuel another blistering rally on global asset markets. In both cases low inflation gave the Fed latitude.
It is a fair bet that last week's double-barrelled capitulation by the Fed on rate rises and quantitative tightening (QT) will again rescue the crumbling world economy. It should avert a bloodbath that was starting to look all too likely late last year.
"The Fed may have just pushed back the next recession," said Tim Duy from Fed Watch. Future rate rises have been taken off the table. Markets are already pricing in rate cuts later this year.
Jay Powell has rowed back drastically on QT. The Fed will never fully unwind the bloated balance sheet -accumulated over three rounds of -post-Lehman bond purchases. Krishna Guha, from Evercore ISI, expects its holdings of securities to stabilise at $US3.5-$US3.7 trillion ($4.8-$5.1 trillion), much higher than previously suggested.
World finance no longer has to face the slow torture of Fed bond sales running at $US50 billion a month all this year and into the early 2020s. Mr Powell may start tapering in the second quarter. This is a powerful tonic for a dollarised international system that has never been so sensitive to Fed actions, or so leveraged to US borrowing rates.
Michael Darda, from MKM, says the Fed has read the writing on the wall and chosen not to play Russian roulette with the business cycle. "The current set-up is for a nearly perfect soft landing," he said.
It has been a close run thing for the global economy over the last two months. A 17 per cent collapse in Chinese non-commodity imports in December - with a nosedive in electronics and semiconductor trade across Asia - has been graduating from ominous to potentially dangerous.
Mark Williams, chief Asia economist at Capital Economics, said "alarm bells" have been ringing. His proxy measure of Chinese GDP growth has dropped to 4 per cent. This is an economic slump for China and it has pulled Korea, Japan and parts of Europe into a contractionary vortex.
"On some measures, industrial production in the eurozone is now deteriorating at its fastest pace since 2009," said Capital Economics. Fresh Chinese stimulus is in the pipeline. Beijing's central economic work conference before Christmas amounted to policy capitulation by Beijing as well.
"Signs of stability are emerging for those who squint hard enough," says John Normand from JP Morgan. The bank's global manufacturing survey shows that new orders are ticking up again. But nothing is yet bankable. Like it or not, Mr Powell has been forced to err on the side of easy money, keeping open the spigot of dollar liquidity for a global system that has racked up $US12 trillion of offshore dollar liabilities. World debt is 30 percentage points of GDP higher than the pre-Lehman peak. Nobody dares put this precarious edifice through a stress test.
"We have got to be very careful. There must not be unforced errors," said the International Monetary Fund's top firefighter, David Lipton.
Mr Lipton said in Davos that the Fed may not be able to repeat the emergency actions that saved the world's financial system on October 2008. Specifically, it might be constrained from extending "swap lines" worth up to $US1 trillion to fellow central banks. This is the vital defence needed stop a chain-reaction turning into a global conflagration.
China;s economy remains a primary concern.
China;s economy remains a primary concern.CREDIT:BLOOMBERG
European and Asian banks borrow on the offshore capital markets at maturities as low as three months for worldwide lending in dollars. This source of funding can seize up suddenly. Only the Fed has ability to print limitless dollars to plug the gap in such a crisis.
Mr Lipton said swaps require a "fiscal backstop" and therefore the acquiescence of Donald Trump and US Congress. Would Washington agree to an instant bailout of foreign banks in the current climate? "I wonder whether they will be so willing to extend the swap lines," he said.
Former Fed chief Ben Bernanke says the Dodd-Frank Act and other measures since 2008 have stripped the Fed and US regulators of powers to halt fire-sale liquidation in a crisis.
They can no longer rescue individual companies (there must be at least five, and they must be solvent), or lend to non-banks, or offer blanket guarantees of bank debt and money market funds. It took lightning-fast action and $US1.5 trillion of emergency loans to stop the meltdown in 2008. Could the Fed again shore up the markets for commercial paper and asset-backed securities?
Olivier Blanchard, from the Peterson Institute, said it required over 850 basis points of rate cuts in the US to fight the Great Recession - directly or synthetically through quantitative easing. Any such response today is impossible. The lesser risk therefore for the Fed is to "run the economy hot" to build up a buffer.
"We have no ability to turn the economy around," says Martin Feldstein, president of the US National Bureau of Economic Research.
"When the next recession comes, we don't have any strategy to deal with it. Fiscal deficits are heading for $US1 trillion dollars and the debt ratio is already twice as high as a decade ago," he said.
Jay Powell's hawkish rhetoric in December - above all his insistence that QT would continue on "autopilot" - was clearly a mistake.
David Lipton, the First Deputy Managing Director of the IMF.
David Lipton, the First Deputy Managing Director of the IMF.CREDIT:BLOOMBERG
The question for investors is whether the Fed's December error is reversible. The Fed's shift on QT is a circuit-breaker. It lifts the future growth rate of the broad M3 money supply through standard "quantity theory of money" mechanisms, something that the New Keynesian "creditists" at the Fed have persistently refused to acknowledge.
Fed staff have had a strange blind spot over the flow effects of bond sales. They justified QE in the first place as a way to lift asset prices, yet implausibly denied that reversing it might have the opposite effect.
They ignored warnings from traders that QT was shrinking the reserve balances of US banks and making it harder for them to provide dollar liquidity to offshore funding markets. They did not adapt the pace of QT when these bond sales collided with massive note issuance by the US Treasury to fund Mr Trump's fiscal deficits - despite warnings from the governor of India's reserve bank that this was crucifying emerging markets.
Yet Mr Powell is not an ivory tower ideologue wedded to the theories of some defunct economist. He is a gentleman practitioner with an alert ear to markets.
For whatever reason he has now ditched Fed orthodoxy on the balance sheet. His instincts may just have bought the world economy another year.
Telegraph, London

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