Must-Read: Larry Summers: Fed’s Current Strategy Ill Adapted to the Realities

Must-Read: Larry Summers is right.

If the Phillips Curve today still had the short-run slope in the gearing of expected inflation to recent past inflation that it appeared to have at the start of the 1980s, there might–but only might–be a case for the Federal Reserve’s current policy.

There is no reason for internal comity between the Board of Governors and the regional bank presidents to be a concern: Bernanke and Yellen have now had three full regional bank-appointment cycles to get bank presidents who are on the same page as the Board of Governors. The Federal Reserve always has and is understood to have the freedom to raise interest rates to maintain price stability when incoming data suggests that it is threatened: there is no need for talk to highball the chances of future rate increases when the current data flow does not suggest it will be needed. Thus I see no reasons at all to support a Fed policy posture other than that one that Larry Summers recommends: “signal[ling] its commitment to accelerating growth and avoiding a return to recession, even at some cost in terms of other risks…”

Larry Summers: Fed’s Current Strategy Ill Adapted to the Realities: “The current hawkish inclination of the Fed, with its chronic hope and belief that conditions will soon permit interest rate increases, is misguided…

…The greater danger is of too little rather than too much demand. A new Fed paradigm is therefore in order…. I would guess that from here the annual probability of recession is 25-30 percent. This seems to me the only way to interpret the yield curve. Markets anticipate only about 65 basis point of increase in short rates over the next 3 years. Whereas the Fed dots suggest that rates will normalize at 3.3 points, the market thinks that even 5 years from now they will be about 1.25 percent. Markets are thinking that recession will come at some point and when it does rates will go to near zero…. This implies that if the Fed is serious… about having a symmetric 2 percent inflation target then its near-term target should be in excess of 2 percent. Prior to the next recession–which will presumably be deflationary–the Fed should want inflation to be above its long term target…. The Fed’s dots forecasts refer to a modal scenario of continued recovery… [with] inflation rising to 2 percent only in 2018. Why shouldn’t they prefer a path with more demand, inflation at target sooner, more stimulus as recession insurance, and a small margin of extra inflation as a buffer against the next recession?….

The logic that led to the adoption of the 2 percent inflation target years ago suggests that it is too low now…. The case for a positive inflation target balances the benefits of stable money with the output cost of lowering inflation and two ways that positive inflation is helpful—the periodic need to have negative real rates, and inflation’s role in facilitating downward adjustment in real wages given nominal rigidities. All of the factors pointing towards a higher inflation target have gained force in recent years…. Experience has proven that Yellen was correct to be skeptical of the idea very low inflation rates would improve productivity. And it is plausible that the error in price indices has increased with the introduction of new categories of innovative and often free products…. If a two percent inflation target reflected a proper balance when it first came into vogue decades ago, a higher target is probably appropriate today….

Long term inflation expectations are depressed and declining…. The Fed has in the past counterbalanced declines in market inflation expectation measures by pointing to the relative stability in surveys-based measures. This argument is much harder to make now that consumer expectations of inflation have broken decisively below their all-time lows even as gas prices have been rising…. The Fed’s summary employment conditions index has been flashing yellow since the beginning of the year. Declines in this measure have presaged recession half of the time and uniformly been followed by rate reductions rather than rate increases….

The right concern for the Fed now should be to signal its commitment to accelerating growth and avoiding a return to recession, even at some cost in terms of other risks. This is not the Fed’s policy posture. Watching the Fed over the last year there is a Groundhog Day aspect. One senses they really want to raise rates and achieve a more ‘normal’ stance. But at the same time they do not want to tighten when the economy may be slowing or create financial turmoil. So they keep holding out the prospect of future rate increases and then find themselves unable to deliver. But they always revert to holding out the prospect of rate increases soon, partly for internal comity and partly to preserve optionality. Over the last 12 months nominal GDP has risen at a rate of only 3.3 percent. We hardly seem in danger of demand running away. Today we learned that Germany has followed Japan into negative 10 year rates. We are only one recession away from joining the club…

Tim Duy’s Five Questions for Janet Yellen


A very nice piece here from the very-sharp Tim Duy:

Tim Duy: Five Questions for Janet Yellen

Next week’s meeting of the Federal Open Market Committee (FOMC) includes a press conference with Chair Janet Yellen. These are five questions I would ask if I had the opportunity to do so in light of recent events.

(1) 1. What’s the deal with labor market conditions? You advocated for the creation of the Federal Reserve’s Labor Market Conditions Index (LMCI) to serve as a broader measure of the labor market and as an alternative to a narrow measure such as the unemployment rate. The LMCI declined for five consecutive months through May, the most recent release…. On June 6, however, you said that:

the job market has strengthened substantially, and I believe we are now close to eliminating the slack that has weighed on the labor market since the recession.

The LCMI signals that although the economy may be operating near full employment, it is now moving further away from that goal. Is it appropriate for the Fed to still be considering interest rate hikes when your measure is moving away from the goal of full employment? Or have you determined the LMCI is not a useful measure of labor market conditions?

(2) Has the effect of QE been underestimated? Since the Fed began and completed the process of ending quantitative easing (QE), the dollar has risen in value, the stock market rally has stalled, the yield curve has flattened, broader economic activity has slowed, and now we are experiencing a slowing in labor market activity. These are all traditionally signs of tighter monetary policy, but you have insisted that tapering is not tightening and that policy remains accommodative. Given these signs, is it possible or even likely that you have underestimated the effectiveness of QE and hence are now overestimating the level of financial accommodation?

(3) Optimal control or no? The Fed appears determined to hit its inflation target from below. In other words, the central bank is positioning policy to tighten despite inflation currently running below the 2 percent target in order to avoid an overshoot at a later date. In the past, however, you argued for an ‘optimal control’ approach that anticipated an explicit overshooting of the inflation target in order to more rapidly meet the Fed’s mandate of full employment. Under optimal control, it seems that given stalled progress on reducing underemployment, coupled with deteriorating labor market conditions, the Fed should now be explicitly aiming to overshoot the inflation target by keeping policy loose. Do you believe the optimal control approach you previously advocated is wrong? If so, what caused you to change your mind?

(4) An Evans Rule for all? Chicago Federal Reserve President Charles Evans remains concerned about asymmetric policy risks. Persistently below target inflation risks undermining the public’s belief that the Fed is committed to reaching its target. Such a loss of credibility hampers the ability to subsequently meet the central bank’s target. In contrast, the well-known effectiveness of traditional policy tools means there is less upside risk to inflation. Consequently, he argues for an updated version of the Evans Rule (or an earlier commitment to not hike rates as long as unemployment exceeded 6.5 percent and inflation was below 2.5 percent).
Specifically, Evans said:

In order to ensure confidence that the U.S. will get to 2 percent inflation, it may be best to hold off raising interest rates until core inflation is actually at 2 percent. The downside inflation risks seem big — losing credibility on the downside would make it all that more difficult to ever reach our inflation target. The upside risks on inflation seem smaller.

Recall that in your most recent speech you indicated unease with inflation expectations and — at least implicitly — recognized the asymmetry of policy risks:

It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.

This — especially when combined with your past support for an optimal control approach to policy — suggests that you should be amenable to adopting Evans’ position. Do you support Evans’ proposal that the Fed should stand down from rate hikes until the inflation target is reached? Why or why not?

(5) Just how much do you care about the rest of the world? Earlier this year, Federal Reserve Governor Lael Brainard suggested that the many developed economies operating at or below zero percent interest rates reduces the central bank’s capacity for raising rates:

‘Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies…

At last September’s FOMC press conference, you said that you thought the global forces were insufficient to restrain the path of U.S. monetary policy. In response to a question about ‘global interconnectedness’ preventing the U.S. from ever moving away from zero percent interest rates, you said:

I would be very surprised if that’s the case. That is not the way I see the outlook or the way the Committee sees the outlook. Can I completely rule it out? I can’t completely rule it out. But, really, that’s an extreme downside risk that in no way is near the center of my outlook.

Given the events of the past six months — especially the refusal of longer-term U.S. Treasury yields to rise despite repeated hints of monetary tightening — have you reassessed your opinion? Do you view the risks of such an outcome as greater or lower than your assessment made last September?

Bottom Line: Most of these questions try to push Yellen to explain her past positions in light of the current data and actions. I think understanding how and why her positions change is critical to understanding how the Fed reacts to the conditions facing it. Making the so-called ‘reaction function’ clear remains the most important piece of the Fed’s communication strategy.

These five questions–“What’s the deal with labor market conditions?… Has the effect of QE been underestimated?… Optimal control or no?… An Evans Rule for all?… Just how much do you care about the rest of the world?”–are the right questions to ask. And Tim’s bottom line–“Push Yellen to explain her past positions in light of the current data and actions. I think understanding how and why her positions change is critical…. Making the so-called ‘reaction function’ clear remains the most important piece of the Fed’s communication strategy”–is the right bottom line.

After all, does this look like an economy crossing the line of potential output in an upward direction with growing and substantial gathering inflationary pressures to you?

Change in Labor Market Conditions Index FRED St Louis FedNewImage

The Federal Reserve is simply not doing a good job of communicating its reaction function. It is not doing a good job of linking its model of the economy to current data and past events. Inflation, production, and employment (but not the unemployment rate) have been disappointingly low relative to Federal Reserve expectations for each of the past nine years. These events should have led to substantial rethinking by the Federal Reserve of its model of the economy. And yet the model set forward by Yellen and Fischer (but not Evans and Brainard) appears to be very much the model they held to in the late 1990s, which was the model they believed in in the early 1980s: very strong gearing between recent-past inflation and expected inflation, and a Phillips Curve with a pronounced slope, even with inflation very low.

Unless my Visualization of the Cosmic All is grossly wrong along the relevant dimensions, this is not the right model of the current economy. There was never good reason to think that the bulk of the runup in inflation in the 1970s was due to excessive demand pressure and unemployment below the natural rate–it was, more probably, mostly due to supply shocks plus the lack of anchored expectations. Only if you highball the estimate of the Phillips Curve’s slope for the 1970s can you understand the fall in inflation in the early 1980s as due overwhelmingly to slack, rather than ascribing a component to the reanchoring of inflation expectations. Thus the way to bet is that the economy on its current trajectory will produce less upward pressure on current inflation and also on inflation expectations than the Federal Reserve currently projects.

But how will it react when the data once again disappoints Federal Reserve expectations–as it has? In June 2013, the Fed was predicting that annual GDP growth during the 2013-2015 period would average 2.9%, with longer-run growth of real potential GDP averaging 2.4%. Instead, annual growth has averaged 2.3% (or 2.2%, if estimates for the first half of 2016 are correct). Nor did it perform better on other measures. The Fed predicted an annual inflation rate, based on the personal consumption expenditures index, of 1.9% for 2015. The true number was 1.5%. Similarly, its average projection of the federal funds rate for 2015 was 1.5%. The figure is currently 0.25%. This three-year period, starting in 2013, in which the economy undershot the Fed’s expectations, follows a three-year period in which the economy likewise fell short of the Fed’s forecast. And that period followed a three-year period, starting in 2007, in which the Fed massively understated downside deflationary risks.

Yet the prevailing model does appear to be the model of the early 1980s. It continues to gear inflation expectations at unrealistically high levels based on past inflation. And it continues to rely on the unemployment rate as a stand-in for the state of the labor market, at the expense of other indicators. So the big questions are: Will that commitment break? What would make them revise their models of the economy? And how will those model revisions affect their policy reaction function map from data to interest rates?

In an environment of economic volatility like the one in which we find ourselves today, a prudent central bank should do everything it can to raise expected and actual inflation, in order to gain the ability to stabilize the economy in any direction. If interest rates were well above zero, the Fed would have scope to raise them further in case of overheating or to lower them in response to adverse demand shocks.
But the Fed continues to neglect asymmetry, considering it only a second- or third-order phenomenon. It is not pushing for inflation at or above its target, even as optimal-control doctrines that themselves neglect asymmetry call for such a trajectory. Instead, by tightening policy by an amount that it cannot reliably gauge, it is narrowing its room for maneuver.

Looking at the current composition of the FOMC does not add to confidence:

  • On the left, Lael Brainard and Charles Evans certainly understand the situation–and have been right about almost everything they have opined on over the past eight years. Dan Tarullo shares their orientation, but these are not his issues.

  • On the right, Robert Kaplan and Patrick Harker replace hawks who were always certain, often wrong, and never open-minded–and are the products of failed searches: a job search is not supposed to choose a director of the search-consultant firm or the head of the search committee. Jeffrey Lacker and James Bullard and their staffs have been more wrong on monetary policy than the average FOMC member over the past eight years, but do not appear to have taken wrongness as a sign that their views of the economy might need a rethink. Esther George and Loretta Mester and their staffs feel the pain of a commercial banking sector in the current interest-rate environment, but I have never been convinced they understand how disastrous for commercial banks the medium- and long-term consequences of premature tightening and interest-rate liftoff would be.

  • In the neutral center, Jerome Powell does not appear to have views that differ from those of the committee as a whole. These are not Neel Kashkari’s issues: he is too good a bureaucrat to want to dissent from any consensus or near consensus on issues that are not his. And I simply do not have a read on Dennis Lockhart and his staff.

  • The active center is thus composed of Janet Yellen, Stanley Fischer, Bill Dudley, Eric Rosengren, and John Williams. Market risk and confusion is generated by uncertainty about their models of the economy, uncertainty about how they will revise their models as the data comes in, and uncertainty as to how they will react in committee, with six voices to their right calling for rapid interest-rate normalization and only three voices to their left worrying about asymmetric risks and policy traction.

When I listen to this center, one vibe I get is that the asymmetries are really not that great. Janet Yellen this March:

One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment. Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities. While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed…

Another vibe I get is more-or-less what Bernanke said back in 2009:

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity…. A monetary policy strategy aimed at pushing up longer-run inflation expectations in theory… could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored…

I cannot help but be struck by the difference between what I see as the attitude of the current Federal Reserve, anxious not to do anything to endanger its “credibility”, and the Greenspan Fed of the late 1990s, which assumed that it had credibility and that because it had credibility it was free to experiment with policies that seemed likely to be optimal in the moment precisely because markets understood its long-term objective function and trusted it, and hence would not take short-run policy moves as indicative of long-run policy instability. There is a sense in which credibility is like a gold reserve: It is there to be drawn on and used in emergencies. The gold standard collapsed into the Great Depression in the 1930s in large part because both the Bank of France and the Federal Reserve believed that their gold reserves should never decline, but always either stay stable of increase.

And I cannot help but be struck by the inconsistency between the two vibes. The claim that we need not worry about asymmetry because we are willing to undertake radical policy experimentation fits very badly with the claim that we dare not rock the boat because the anchoring of inflation expectations on the upside is very fragile. Combine these with excessive confidence in the current model–with a tendency to make policy based on the center of the fan of projected outcomes with little consideration of how wide that fan actually is–and I find myself with much less confidence in today’s Fed than I, four years ago, thought I would have today.

Must-Read: Gavyn Davies: Why Hasn’t the Productivity Crisis Caused a Bear Market (Yet)?

Must-Read: This by the very sharp Gavyn Davies seems to me to be wrong. An ebbing of the current shortage of risk-bearing capacity would produce a further boom in equities. Central banks’ focus on a 2%/year inflation target makes it very difficult to envision any improvement in the economy leading to be a rapid increase in the wage share. Some unknown future negative shock to the economy could certainly produce a large bear market in equities. But a return to more normal risk attitudes in markets and a continuation of business-as-usual are very unlikely to do so:

Gavyn Davies: Why Hasn’t the Productivity Crisis Caused a Bear Market (Yet)?: “The 2016 calendar year may well see productivity growth in the US economy slumping to around 0.5 per cent, a catastrophic outcome…

…The productivity slowdown has often been called a ‘puzzle’, because it has coincided with a period of rapid technological change in the internet sector…. [But] many of the obvious benefits of the internet revolution appear to increase human welfare without leading to increases in market transactions and nominal GDP. Furthermore, there are several other plausible reasons for the productivity slowdown, including low business investment and a loss of economic dynamism since the financial crash. There is however a different puzzle connected to the productivity slowdown. Given that it has greatly reduced the level and expected growth rate in nominal GDP, why has it had so little apparent impact on equities, an asset class that depends on the level and expected future growth of corporate earnings?…

The conclusion is that the damaging impact of the productivity slump on the S&P 500 has so far been masked by other factors, but there are signs that this might be changing…. The drop in productivity growth has been accompanied by a decline in the yield on safe assets (government bonds), so the discount rate to be applied to future corporate earnings and dividends has declined…. There are however some other reasons…. The share of profits in the economy has risen to historic peak levels, and the dividend payout ratio has also increased…. So does this mean that investors can sit back and relax in the face of a productivity crisis that will clearly damage the outlook for the global economy very seriously? I doubt whether this aberration can last forever. The decline in the real bond yield may be reaching its limits…. And the sharp falls in the unemployment rate, especially in the US, could cause greater wage pressure and a decline in the profit share in GDP…

Must-Read: Tim Duy: Curious

Must-Read: Tim Duy: Curious: “I find the Fed’s current obsession with raising interest rates curious to say the least…

…To me… it appears that by raising rates now the Fed is risking falling short on its employment mandate at a time when the price mandate is also challenged. And falling short on the employment mandate now suggests an economy with sufficient slack to prevent reaching that price mandate. And that is without considering neither the balance of risks to the outlook nor the possibility that escaping the zero bound requires approaching the inflation target from above rather than below. Consequently, it seems that the case for a rate hike in June should be quite weak….

What is driving so many FOMC participants to the rate hike camp?… First, they believe that tapering and ending QE was not tightening…. Second, the Fed may be too enamored with… the idea of normalization…. They have already decided that the equilibrium fed funds rate is north of 3 percent, and hence assume that the current rate is highly accommodative. They thus see a large distance that needs to be covered, and feel an urge to start sooner than later…

Notes on the global economy as of early April 2016

A Note on the Likelihood of Recession: With global inflation currently more than quiescent, there is no chance that global recovery will be—as Rudi Dornbusch used to say—assassinated by inflation-fighting central banks raising interest rates.

As for recovery being assassinated by financial chaos, we face a paradox here: Financial risks that policymakers and economists can see are those that bankers can see and hedge against as well. It is only the financial risks that policymakers and economists do not see that are truly dangerous. Many back in 2005 saw the global imbalance of China’s export surplus and feared disaster from a fall in the dollar coupled with the discovery of money-center institutions having sold massive amounts of unhedged dollar puts. Very few, if any–even among those who believed US housing was a massive bubble likely to pop—feared that any problems created thereby would not be rapidly handled and neutralized by the Federal Reserve.

The most likely danger of recession is thus absent, and the second most likely danger is unknowable.

That leaves the third: a global economy that drifts into a downturn because both fiscal and monetary policymakers sit on their hands and refuse to use the stimulative demand management tools they have.

Here there is, I think, some reason to fear. A passage from a recent speech by the nearly-godlike Stan Fischer was flagged to me by Tim Duy:

If the recent financial market developments lead to a sustained tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years–including in the second half of 2011–that have left little visible imprint on the economy, and it is still early to judge the ramifications of the increased market volatility of the first seven weeks of 2016. As Chair Yellen said in her testimony to the Congress two weeks ago, while “global financial developments could produce a slowing in the economy, I think we want to be careful not to jump to a premature conclusion about what is in store for the U.S. economy”…

And Tim commented:

This… again misses the Fed’s response to financial turmoil…. I really do not understand how Fed officials can continue to dismiss market turmoil using comparisons to past episodes when those episodes triggered a monetary policy response. They don’t quite seem to understand the endogeneity in the system…

However, anything that could be called a “global recession” in the near term still looks like a less than 20% chance to me. But that is up from a 5% chance nine months ago.

A Note on China: I do not understand China. And I know I do not understand China. Perhaps that gives me an advantage in analyzing China, perhaps not. The relevant long-run fundamentals of China seem to me to be two:

  1. Your typical wealthy Chinese plutocrat-political clan seeks in the long run to have perhaps 1/3 of its wealth outside of China as insurance against political risks, and thus seeks an opportunity to export capital from China.
  2. Your typical North Atlantic business or investment group sees returns from further massive investments in China as uncertain and sees political risks as large but as capable of resolution over the next decade, and so will delay investing in China.

That means renminbi weakness as a background trend behind shorter-term financial- and political-business cycles. And that has to shape what the real risks are (large) and opportunities (smaller).

A Note on the Non-Need for a New Plaza Accord: I would say that international monetary affairs in the Global North high now need not an accord but, rather, the right kind of discord.

At my Berkeley office I dwell in the zone of influence of the truly formidable Barry Eichengreen. His strongly, and I believe correctly, argued view is essentially that he set out in Eichengreen and Sachs (1986): that what we need is not an accord but a currency war. Global North blocs—the U.S., Britain, the Eurozone, Japan—leapfrogging each other with aggressive competitive devaluations every four months or so are likely to produce positive monetary spillovers as large as anything that monetary policy could now produce.

But what could monetary policy now produce?

My career analytical nadir was my memo to my Treasury bosses in 1993 that NAFTA was likely to put upward pressure on the peso. My second-worst was my confident prediction at the end of 2008 that within three years North Atlantic nominal demand would be back to its pre-2008 trend. My third has been my prediction that Abenomics would be an obvious and substantial success. That third prediction was based on my reading of the 1930s, in which four aggressive reflationary régime changes—that of Neville Chamberlain as Chancellor of the Exchequer in 1931, that of Takahashi Korekiyo as Finance Minister in 1932, that of Hjalmar Horace Greeley Schacht as Reichsbank President in 1933, and that of Franklin Delano Roosevelt as President in 1933—had been substantial successes. The mixed success of Abenomics thus tells me that my views of what monetary policy tools would work and how well they would work are almost surely wrong, and that I need to rethink.

Thus as far as monetary policy is concerned I am at sea.

With respect to fiscal policy, however, I am much more confident: Blanchard and Leigh (2013) is convincing. DeLong and Summers (2012) is correct. Coordinated North Atlantic fiscal expansion—unless the money is spent in a truly perverse fashion—is highly likely to boost production with North Atlantic-wide multipliers of around 3 and to reduce debt-to-GDP ratios. Whether it will generate enough inflation to be unwelcome hinges on the state of aggregate supply in the North Atlantic. And there we are so far outside the bounds of previous experience that I do not think anyone can or should speak with confidence.

A Note on Negative Interest Rates: Cash should be a very attractive asset vis-a-vis Treasury bonds at any negative or, indeed, slightly positive interest rate. Containers full of durable, storable commodities should be a very attractive asset vis-a-vis cash—and more so vis-a-vis Treasury bonds and even cash at a wider range of interest rates up to nearly the long-term expected rate of inflation. The only way I can understand current strong demand for the interest-bearing securities and, indeed, the cash of reserve currency-issuing sovereigns possessing exorbitant privilege is that 2008-9 and the political reaction thereto has cast the existence of the Bagehot lender-of-last-resort into grave doubt. Thus we not only have East Asian and other sovereigns desperate for reserves to avoid another 1998, we have every major financial institution desperate to avoid another fall of 2008. These economic agents seem to me to be no longer pursuing sensible risk-return optimization strategies. Instead, they seem to seek enough reserves to surmount any possible future crisis so that they can stay in the game and then earn profits whenever normalization and the future come.

As to dysfunctionalities—so far I see no signs of massive malinvestments in physical or organizational capital that will pay large negative societal returns, and I see no taking of extraordinarily risky large positions by too-big-to-fail entities. I feel that dysfunctional asset prices that produce dysfunctional investments and dysfunctional portfolios. But I cannot see what they are…

Must-read: Macro Advisers: Now-Cast: Personal income and outlays way undershot expectations…

Must-Read: Macro Advisers: Now-Cast: First-quarter real GDP growth at 1.0%/year:

Https macroadvisers bluematrix com sellside EmailDocViewer encrypt 07856b96 a505 4d8c 9910 fdea16842f37 mime pdf co macroadvisers id jbdelong uclink berkeley edu source mail

They will probably be angry at me for posting this, but it is genuine news: personal income and outlays way undershot expectations, and so they have marked down their estimate for first-quarter 2016 real GDP growth from the 1.9%/year it was five days ago to 1.0%/year now.

Certainly makes last December look like a bad time to stop sniffing glue the zero-interest-rate policy, doesn’t it?

Must-read: Olivier Blanchard et al.: “Reality Check for the Global Economy”

Olivier Blanchard et al.: Reality Check for the Global Economy: “After five years of disappointing recovery throughout the major economies…

…almost everyone is ready to believe the worst. The widespread large declines in global asset prices indicate a significant divergence between what financial markets fear and what most mainstream macroeconomic forecasts are showing for the world economy. Having some clarity to distinguish between the more solid underlying economic outlook and the shadows thrown by financial puppetry is critical to avoid an unnecessary recession.

In this Briefing, a group of PIIE scholars came together to provide a reality check for the global economy. They set out what is known, both about macroeconomic dynamics and policy capabilities, in a context where distrust of both mainstream economic analysis and policymakers’ credibility has become excessive. Global economic fundamentals today are not so grim, though there is room for improvement in key areas including China, the United States, European banks, Brazil and Latin America, oil markets, global trade, and monetary policy options.

In particular, we argue: The relative forecasting ability of financial markets for the real economy has probably gone down postcrisis (Adam S. Posen). The US economy remains at a relatively low, though slightly elevated, risk of recession (David Stockton). The positive effects of the decline in the price of oil on the US economy have taken longer to materialize than was expected, but they will strengthen looking forward (Olivier Blanchard and Julien Acalin). Chinese economic growth is, at a minimum, well above current fear-driven estimates, and that growth is predominantly service sector–based and therefore sustainable (Nicholas Lardy). The slowdown in growth of global trade reflects weak global investment and a medium-term adjustment to the past creation of global supply chains and is not a harbinger of further contraction (Caroline Freund). The European banking system is in transition to a stronger state, and the problems evident in Italy are not enough to throw Europe’s economy off course (Nicolas Véron). Brazil’s economy while dysfunctional is far more likely to experience years of higher inflation than any overt fiscal or balance of payments crisis (Monica de Bolle). Latin America more generally has run into problems of slow productivity growth but is not doomed by the commodity cycle (José De Gregorio). Monetary policy remains potent, with multiple possible avenues for additional stimulus if needed, starting with effective quantitative easing on private assets (Joseph Gagnon).

Must-read: Paul Krugman: “Bonds on the Run”

Must-Read: Paul Krugman: Bonds on the Run: “Something scary is going on in financial markets…

…Bond prices in particular are indicating near-panic…. Bond markets are a bit less flighty than stocks, and also more closely tied to the economic outlook. (A weak economy has mixed effects on stocks–low profits but also low interest rates–while it has an unambiguous effect on bonds.)… Plunging rates tell us is that markets are expecting very weak economies and possibly deflation for years to come, if not full-blown crisis…. A very bad place into which to elect a member of a party that has spent the past 7 years inveighing against both fiscal and monetary stimulus, and has learned nothing from the utter failure of its predictions to come true.

Email chatter:

JGB ten years at 0. Wow. Just wow. What a widowmaker…. Excepting buying assets at the dawn of QE, every EXPLICIT trade that hinged on relying on industrial core Central Bank inflation credibility has been a widowmaker…

It is starting to look, I must say, that [the U.S. Fed’s] triggering the taper tantrum and then doubling down on the proposition that triggering the taper tantrum was not an error is going to be judged very harshly when people look back at this decade or so from now…

I’m adding [U.S.] Q4 at a bit over 1%…. Q1 gets to 2%, but some of that is the mild winter. I do have growth staying in the 2 to 2 1/2% range after that, but I have to admit that assumes that exports crawl back to some growth, the consumer stays steadfast, there’s some inventory rebuilding, and S&L spending holds up–much of that is a wing and a prayer…

I have been much more wrong about, and much more worried by, their failure to deliver in the last 12-18 months when their intent was to raise inflation. Nowhere so more than Japan, where they did everything largely as prescribed…

it is over-ambitious to assume that projections about exchange rate expectations dominate over other factors. There is long demonstrated home bias, reinforced by Reinhart-esque longstanding structures and practices of financial repression. In the data, it is bizarre but evident over decades that Japanese private capital flows are opposite of most places: when the economy slows (speeds up), net capital flows are in (out), so the exchange rate moves the ‘wrong’ way…

Richard Koo has been saying that stout talk from the Fed about boosting rates (Jim Bullard is one thing, but say it ain’t so, Stan) is helping to spook the market. I’m getting inclined to agree…

“Whatever it takes” worked for Draghi as a signal of long-term commitment and a regime shift from Trichet. From Kuroda, my take is it was viewed as an act of desperation. Accordingly, Japanese investors took more about this as bad news on the Japanese economy and about BOJ capabilities than they did as evidence of stimulus…

The tendency of my dear friends to never admit error or wish to retrace steps bug[s] me…. Independence is to be used, and stop being so frigging afraid of Paul Ryan! QE4, anybody?…

The broader and more significant issue of why what the BOJ has done has not been enough to sustainably raise inflation, and it hasn’t worked in EU and US either…

Must-read: Tim Duy: “On The Dispersion, Or Lack Thereof, of Economic Weakness”

Must-Read: Tim Duy: On The Dispersion, Or Lack Thereof, of Economic Weakness: “I direct you to my fellow Oregon economist Josh Lehner…

…who correctly notes that in comparison to past recessions, the decline in manufacturing activity is not well-disbursed across the sector…. During a recession, the vast majority of manufacturing industries (or all!) are declining. We are nowhere near that point…. And if manufacturing is not even in recession, it is difficult to see that the US economy [as a whole] is in recession. Or even nearing it…. A recession in Texas does not a US recession make….

Aside from the recession risk, there is another important aspect of Davies’s chart–discounting manufacturing, it indicates growth of just 2% in the US…. I suspect that is the direction we will be heading by the end of the year if not sooner. Key sources of growth, such as autos, multifamily housing, and technology, that helped propel the economy closer to fully employment are likely leveling off. If so, that means the economy is at an inflection point as it transitions back to trend. The Fed expects that process will require addition tightening. The financial markets aren’t so confident.

Must-read: Gavyn Davies: “China devaluation – a necessary evil?”

Must-Read: Gavyn Davies: China devaluation – a necessary evil?: “The 9 percent drop in global equity prices in the first two weeks of 2016…

…is certainly alarming, even for those of us who believe that the outlook for the world activity has not deteriorated much recently. The fundamental cause is the same as it was last August – a clash between a severe loss of credibility in Chinese economic policy and a Federal Reserve that still seems determined to continue tightening US monetary policy without much regard to international risks and a slowing domestic economy (see the hawkish Bill Dudley speech on Friday)…