Warnings about monetary overkill by central banks are growing louder. This time the insurgency is coming from within America's New Keynesian elite.
That matters. It suggests that the Federal Reserve may be closer to a blissful “policy pivot” than markets think. The moment that investors discern signs of any such Fed capitulation, there will be a massive bear-trap rally in battered global equities – at least until the bulls are hit by the oncoming steam-train of deflating profits.
Episodes of Fed tightening are often brutal for the rest of the world. This one is especially ferocious. The broad dollar index is at an epic high, which means slow torture for emerging and frontier markets with $4.2 trillion of debt denominated in dollars. There is $13.4 trillion of offshore dollar debt outside US jurisdiction (BIS data) with no clear lender-of-last-resort. South Korea is already having to approach the Fed for dollar swap lines.
Borrowers are being hit by the double shock of both the higher dollar and surging dollar loan-rates. Some of this debt must be rolled over on the three-month lending markets, with a rising risk premium for good measure.
Not only is the Fed rushing through jumbo rises of 75 points each meeting, it is also draining global dollar liquidity with $95bn a month of quantitative tightening (QT). It has never done the two together before. And it does not understand how QE/QT actually works, as admitted cheerfully by one Ben Bernanke, Nobel Prize laureate as of yesterday.
Its model deems QT to be little more than background noise. The San Francisco Fed says $2.5 trillion of balance sheet reduction equals a rate rise of just 50 points. Bond traders think the authors must be living on another planet.
Monetarists have been warning for months that the Fed model misunderstands the potency of QT. They have been screaming from the rooftops that key measures of the money supply are collapsing on both sides of the Atlantic. They fear that the world will careen into a horrible slump unless the central banks ease off soon.
It goes without saying that the policy establishment will never listen to monetarists, laughable sooth-sayers in their olympian (and unfair) view. New Keynesians worship at the altar of the Dynamic Stochastic General Equilibrium model. But the establishment will listen to their own kind.
Maurice Obstfeld, former chief economist at the International Monetary Fund, says the central banks are on a mission to salvage lost credibility. They risk flipping from the error of overly-loose money eighteen months ago to the opposite error of overly-tight money today. “The present danger is that they collectively go too far and drive the world economy into an unnecessarily harsh contraction,” he said.
“Just as central banks misread the factors driving inflation in 2021, they may be underestimating the speed with which inflation could fall as their economies slow. By simultaneously all going in the same direction, they risk reinforcing each other’s policy impacts without taking that feedback loop into account. The highly globalised nature of today’s world economy amplifies the risk,” he said.
This message has been picked up by Lael Brainard, the Fed’s vice-chairman and intellectual bellwether,, who said on Monday that synchronised tightening is "larger than the sum of its parts", and that it raised the risk of blowback into the US economy itself. The same warnings have been coming from the US Treasury.
Ben Bernanke flagged the dangers of a strong dollar and the capital exodus from emerging markets yesterday. Without naming the British gilt market, he said financial stress in the international system was building up and posed a threat. “We really have to pay close attention,” he said.
Lael Brainard stated that lagged effects of past rate rises had not yet been felt and that the US economy might already be slowing faster than expected. This change in tone is significant. If markets are not yet dialling down the Fed’s “terminal rate” for this cycle, perhaps they should be.
Professor Obstfeld, now at Berkeley and the Peterson Institute, told me there has been a conceptual error at the heart of central bank policy this year. They have misread the Phillips Curve – crudely, the trade-off between inflation and unemployment.
They assume that the curve is “flat” and therefore that it will take massive monetary punishment, a violent recession, and a purge of the labour force to bring inflation back down again – once the inflation genie has been let out of the box. But the curve may have steepened more than they realise. In which case, the whole assumption underpinning policy by the Fed and the European Central Bank is a fallacy.
He took particular issue with comments by Isabel Schnabel, Germany’s member on the ECB’s executive board, who said that central banks must be even tougher in this cycle because they can’t control the level of spare capacity in the global economy – the so-called global slack hypothesis.
“She is saying that they all have to hit the brakes harder, and everybody does it at the same time. It is a non sequitur. Central banks should be less zealous,” he said.
Former Fed economist Claudia Sahm – known for the Sahm Rule, an early warning indicator for recessions – has been running a campaign trying to deter her former Alma Mater from tipping the whole world into a crisis.
Crucially, the high priest of New Keynesian doctrine, Nobel economist Paul Krugman, has also joined the critics over recent weeks. He is focussed on the Beveridge Curve, named after British economist William Beveridge, the father of the welfare state.
This posits a relationship between inflation and job offerings (JOLTS in the US). The number of vacancies for unfilled jobs reached a staggering 12 million earlier this year, double the number of apparent job-seekers. This is highly inflationary under the standard Beveridge rule.
But a miracle is starting to happen. The JOLTS figure plummeted in August, and has dropped by almost two million since March. This suggests that the data has been distorted by the bizarre effects of Covid and that the inflation impulse is fading fast.
“Until very recently, it looked as if restoring the pre-pandemic vacancy ratio would indeed require something like 5pc unemployment. In fact, more than 40pc of the apparent excess in vacancies has vanished over the past few months, with no significant rise in unemployment,” said professor Krugman.
Inflation expectations five years ahead – measured by the 5-year/5-year forward rate – are actually lower today than the peak in 2018. The pace of wage rises is only modestly higher.
This is nothing like the Great Inflation of the 1970s. That episode built up over a decade or more: this is a one-off price shock caused by Covid. Globalisation and the China Effect are acting as disinflationary counterweights. So are integrated world capital markets, digital technology, and indeed ageing.
Fed chairman Jay Powell famously wants to be the Paul Volcker of our times, not the discredited Arthur Burns of the 1970s. Perhaps the risk that should worry him more is becoming a latter day Eugene Meyer, the forebear who presided over the collapse of the international financial system from 1930 to 1933.
Time to switch gears Mr Chairman.
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