As the world seems to be struggling back to its feet after the great financial crisis, I want to draw attention to an area we need to be concerned about: the conduct of monetary policy in this integrated world. A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, as I will argue, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. To ensure stable and sustainable growth, the international rules of the game need to be revisited. Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle. … The current non-system in international monetary policy is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing.
In 1948, the behaviorist B.F. Skinner reported an experiment in which pigeons were presented with food at fixed intervals, with no relationship to any given pigeon’s behavior. Despite that lack of relationship, most of the pigeons developed distinct superstitious rituals and maneuvers, apparently believing that these actions resulted in food. As Skinner reported, “Their appearance as the result of accidental correlations with the presentation of the stimulus is unmistakable.” ... Superstition is a by-product of the search for patterns between events – usually occurring in close proximity. This kind of search for patterns is essential for the continuation of a species, but it also lends itself to false beliefs. As Foster and Kokko (2009) put it, “The inability of individuals – human or otherwise – to assign causal probabilities to all sets of events that occur around them… will often force them to make many incorrect causal associations, in order to establish those that are essential for survival.” ... The ability to infer cause and effect, based on the frequency with which one event co-occurs with some other event, is called “adaptive” or “Bayesian” learning. Humans, pigeons, and many animals have this ability to learn relationships in their world. Still, one thing that separates humans from animals is the ability to evaluate whether there is really any actual mechanistic link between cause and effect. When we stop looking for those links, and believe that one thing causes another because “it just does” – we give up the benefits of human intelligence and exchange them for the reflexive impulses of lemmings, sheep, and pigeons.
How will negative interest rates change the rules of the game for investors and policymakers? ... Traditional economic theory says that a com - bination of massive deficit spending and histori - cally low (not to mention negative) interest rates should produce a rip-roaring boom in which work - ers get generous raises, prices spike, and interest rates follow. Theory also says that, even in the rare case of nominal interest rates turning neg - ative, the rates can’t stay there because beyond this “zero bound,” savers and investors will with - draw their cash and store it themselves, emp - tying banks and crashing the financial system. ... Multiple factors provide possible explanations for this curious situation. Three in particular stand out: demographic changes, the impact of debt burdens, and uncertain implications of monetary policy (especially quantitative easing). ... In a June 2015 report, the Bank for Interna - tional Settlements echoed this sentiment by con - cluding that a policy of persistently low interest rates “runs the risk of entrenching instability and chronic weakness.” Such an environment makes several extreme—and, sometimes, mutu - ally exclusive—scenarios at least conceivable.
June Gloom, the fog and clouds that often linger here over the Southern California coast this time of year, appears to have spread to the Federal Reserve. ... We agree that QE must end. It has distorted incentives and inflated asset prices to artificial levels. But we think the Fed’s plan may be too hasty. ... Fog may be obscuring the Fed’s view of the economy – in particular, the structural impediments that will inhibit its ability to achieve higher growth and inflation. Mr. Bernanke said the Fed expects the unemployment rate to fall to about 7% by the middle of next year. However, we think this is a long shot. ... Mr. Bernanke’s remarks indicated that the Fed is taking a cyclical view of the economy. ... Our view of the economy places greater emphasis on structural factors. Wages continue to be dampened by globalization. Demographic trends, notably the aging of our society and the retirement of the Baby Boomers, will lead to a lower level of consumer demand. And then there’s the race against the machine; technology continues to eliminate jobs as opposed to provide them. ... It’s reasonable, of course, for Mr. Bernanke to try to prepare markets for the inevitable and necessary wind down of QE. But if he has to wave a white flag three months from now and say, “Sorry, we miscalculated,” the trust of markets and dampened volatility that has driven markets over the past two or three years could probably never be fully regained. It would take even longer for the fog over the economy to lift.
The New Normal is when plain logic no longer applies; when common sense takes the back seat. I have for a long time been defending the Federal Reserve Bank, and have not at all agreed with all those hawks who thought the Fed was sitting on its hands. Until recently, I felt very comfortable taking that view, but I am no longer so sure. Common sense suggests to me that the Fed ought to tighten a great deal more than they have already done, but does common sense apply? That is what this month’s Absolute Return Letter is about. ... something is not quite right, but what is it? Before I answer that question, let me share one more observation with you. Because the Fed is so inactive, there are signs of moral hazard growing in magnitude. Complacency appears to be sneaking in through the back door yet again. We humans never learn, do we? ... As GDP growth slows, more debt needs to be established in order to service existing debt, which will cause GDP growth to slow even further. I therefore think that, unless it suddenly becomes fashionable to default, debt will continue to rise and GDP growth will continue to slow in the years to come. ... I have changed my view in one important aspect. As debt levels continue to rise (short of any massive debt restructuring), governments will bend over backwards to keep interest rates at very low levels, as the only realistic alternative to low interest rates is default. ... Historically, when central banks have sat on their hands for too long, the end result has almost always been a bout of unpleasantly high inflation, and that has nothing whatsoever to do with the changing demographics.
The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood. ... To re-establish a shared understanding, we will need to reassess both the imperatives that justified the extraordinary actions and the imperatives about monetary policy that were claimed. This will require candidly acknowledging the uncertainty associated with the transmission mechanism and the challenge of decision-making in conditions of uncertainty. ... It appears to me that the Fed and other central banks have avoided being candid about the uncertainty in order to maintain their credibility. I think this is backwards. Central banks cannot and will not regain their credibility unless they are candid about the uncertainty and how they confront that uncertainty.
- Also: Financial Times - US Treasuries: On the cusp of a reversal < 5min
- Also: FiveThirtyEight - The Fed’s Favorite Inflation Predictors Aren’t Very Predictive < 5min
- Also: Absolute Return Partners - A Note on Inflation: Is it here or isn’t it? 5-15min
- Also: Janus - Show Me The Money < 5min
- Also: Financial Times - Three ways the economic and financial cycle could end < 5min