The Commitment Phobic Fed

Stock market investors have long understood that company guidance can be a double edged sword.  Investors use company guidance to make inferences about trading conditions and the level of conviction that insiders have about their own growth prospects.  But in periods of low earnings visibility, the supply of guidance shrinks at precisely the time that the demand for guidance from investors grows.  During the financial crisis for instance, many listed companies sought to manage their reputational risk by ceasing to give guidance to the market.

Central banks of course don’t have the luxury of ceasing communications to the market when macroeconomic uncertainty increases.  In fact, they should (and most do) talk more during such periods.  In his pioneering paper presented to the 2012 Jackson Hole symposium, Professor Michael Woodford argues that what central bank speak reveals about the bank’s policy reaction function has greater market impact than what the bank says about the economic outlook.  After all, investors can form their own views about the outlook based on alternative sources of information, notably the flow of economic data.

Central bank speak has taken on a new meaning for many central banks in recent years given the unprecedented nature of quantitative easing.  The volatile market reactions in recent months to the Fed’s mixed messages on the likely timing of tapering illustrates the perils of interpreting central bank speak.  The past week was no exception.

The fundamental problem that the Fed faces is that animal spirits remain dormant in the business and housing sector and this continues to weigh on the broader US recovery.  Despite the profit share of GDP being at a record high, corporate gearing remains low, firms continue to hoard cash, real business investment remains marginally below the peak from five years ago and businesses remain reluctant to hire new workers; the hiring rate of 3.2% remains close to historical lows.

Although the flow of residential investment has grown by one-third since 2010, it remains almost 50% below its 2006 peak.  Inflation expectations remain well anchored and various measures point to still substantial slack in the labour market: the employment to population ratio has barely recovered since the financial crisis, the unemployment rate remains above 7% and the participation rate continues to decline to its lowest level in over thirty years.

Given that the Fed Funds rate hit the zero lower bound a number of years ago, the Fed has used the two remaining levers available to it: quantitative easing and forward guidance on the Fed Funds rate.  In so doing, the Fed is seeking to revive animal spirits through the wealth effect – via higher asset prices – and by reducing the level of long term Treasury yields and mortgage rates.

What is crucial to the Fed’s task is using central bank speak to influence and manage investors’ expectations.  But this is turning out to be more difficult than the Fed had probably envisaged.  Woodford argues that the zero lower bound does not render monetary policy impotent, but that effective forward interest rate guidance can influence agents’ expectations of the term structure.  If the central bank can convince economic agents that it will keep interest rates close to zero for an extended period, then it will be more effective in bringing forward agents’ decisions to spend and invest, and in so doing, revive animal spirits.

The problem that the Fed faces relates to its reputation, credibility and commitment; how to credibly convince the market that it is going to commit to a certain course of action in the future.  Skeptikoi’s interpretation of Woodford’s thesis on forward interest rate guidance is that it is best achieved on a calendarised basis; the central bank commits to not raising the operating interest rate for a fixed period, with a clause giving the bank the flexibility to lengthen the amount of time if necessary (but not shorten it).  The market will be sceptical of a central bank’s commitment to keep rates low for an extended period if they believe that the bank will take away the punch bowl just as the recovery is taking hold.  Calendarised forward guidance is credible precisely because it locks central bank into a pre-determined course of action, thus denying the central bank the flexibility to tighten policy during this period.

But Fed speak suggests that it wants to have its cake and eat it too.  Rather than use calendarised forward guidance, it has adopted conditional forward guidance; the interest rate will remain close to zero until (deliberately ambiguous) thresholds relating to unemployment and inflation are hit.  Data dependent forward guidance allows the Fed to retain a fair degree of policy discretion and flexibility to change its course of action.  This represents an important trade-off for the Fed to manage between policy flexibility and committing to a certain course of action in the future.  But the Fed’s desire to retain policy flexibility undermines the efficacy of its forward guidance.  No wonder that markets are confused and frustrated by Fed speak.

Interestingly, the Fed’s decision to defer the tapering of its quantitative easing program demonstrates the central bank’s willingness to sacrifice some policy flexibility for credibility of a different kind.  The decision to defer speaks to the recent rise in uncertainty surrounding the outlook and the Fed’s determination to manage its reputational risk.  Rightly or wrongly, the Fed believes its credibility as a forecaster would be undermined if it needs to re-initiate QE after a decision to taper has been made.  But prior to its recent downgrade to its economic projections, its GDP growth forecasts of 2.45% and 3.25% for 2013 and 2014 respectively, sat well above consensus estimates.

Fed speak suggests that the central bank appears to be more concerned about managing its reputation as an economic forecaster than its credibility to committing to a future course of action of keeping the Fed Funds rate low for an extended period.  But Skeptikoi believes that the Fed’s credibility on forward rate guidance is more important to sustaining the recovery than its own track record as a forecaster.  To re-visit Woodford’s thesis, markets pay more attention to communications that reveal information about a central bank's policy reaction function than its views on the outlook.  

Skeptikoi can only speculate that the Fed’s commitment phobia on forward rate guidance stems from an aversion to inflation that has its antecedents in the spectre of the Great Inflation of the 1970s, a time in which many of the senior members of the Federal Reserve were in the formative (and impressionable) years of their economics training.  The Federal Reserve will continue to be confounded by the market’s reaction to its communications and markets will continue to be frustrated by a lack of clarity in Fed speak as long as the Fed's commitment phobia on forward rate guidance persists.

Overlearning from History and the RBA's Nominal Recession

Most of the recent media’s focus on the Reserve Bank of Australia (RBA) has been on the withering character assessment of Kevin Rudd from RBA board member and former Woolworths CEO, Roger Corbett.  Which is a shame, because the focus should be on the fact that the June quarter National Accounts revealed that in the 2013 financial year, Australia experienced its deepest nominal recession for two decades, due largely to excessively tight monetary policy.

Although many economists focus on the real GDP estimates, Skeptikoi believes that nominal GDP – which captures growth in real GDP and inflation - is a better indicator of the household and business sectors’ cash flows.  The June quarter National Accounts revealed that the nominal economy expanded at an annual average rate of 2.5% in the 2013 financial year.  This represents the softest outcome since the last recession, when nominal GDP grew by less than 2% in 1992.  And it is well below trend growth in nominal GDP, of 5-6%.

The widely used metric for defining a recession in Australia is two consecutive quarterly declines in real GDP.  By this standard, Australia has not had a recession in over two decades.  But if a more comprehensive measure of a recession is used, based on annual average growth in nominal GDP falling below a trigger of 4%, then Australia has just experienced its worst nominal recession since 1992.  By this measure, the economy was also in recession in the 2010 financial year, a period in which average annual growth in nominal GDP was only 3%.

There is a small but growing view that central banks ought to augment or replace inflation targeting with a nominal GDP targeting framework.  On this report card, the RBA scores a fail for two of the past four years.  The 15% decline in the terms of trade from its peak, the associated downgrade to the mining sector’s future growth prospects and persistently high value of the Australian dollar are not responsible for the worst nominal GDP growth outcome for two decades.  Skeptikoi believes that the RBA ‘owns’ the nominal recession.  Despite the record low official cash rate of 2.5%, monetary conditions in Australia remain tight.  Credit growth is tepid, the housing recovery is uneven (approvals for private sector detached dwellings remain at a cyclical low) and the much anticipated handover from mining sector capex to non-mining sector capex remains a long way off. 

The National Accounts provided some encouraging signs.  Nominal GDP posted a 0.9% gain in the June quarter which lifted annualised growth for the June half to 4.5%, while financial sector profits grew by almost 3% to a record high and the terms of trade increased for the second consecutive quarter – albeit marginally – thanks largely to higher iron ore prices.  But non-financial sector profits have now declined for six of the past seven quarters and households remain cautious; the household saving ratio continued to creep up and has averaged more than 10% for the past five years, a level not seen since the mid-1980s.

Animal spirits in the business sector remain dormant and this is unlikely to change in the near-term, even given the likely resolution of uncertainty following the Federal election.  In it updated Economic Statement release in early August, the Treasury downgraded its growth projection for nominal GDP to 4.25% for the 2014 financial year, enough to lift Australia out of its nominal recession, but only just.  The reporting season and cautious guidance comments provided by the ASX200 companies provide further evidence of the unfolding shortfall in aggregate demand.  Large companies including RIO Tinto, BHP, Woolworths, Telstra, Woodside Petroleum, Brambles, Coca Cola Amatail (the list goes on) announced plans to further boost productivity, pare back costs, defer capex plans where feasible and in some instances reduce capex from current levels.

Companies continue to either hoard cash – net gearing levels remain close to record lows – or cater to the market’s insatiable appetite for income; the aggregate dividend payout ratio for the ASX200 has lifted to 70%, close to an historical high.  Corporate Australia’s focus on cost containment is reflected in weakness of the National Accounts measure of unit labour costs – productivity adjusted wages.  Despite a modest 0.8% rise in the June quarter, unit labour costs have stagnated over the past year, the first time this has happened since 1999 (ex the financial crisis).  The guidance comments from the ASX200 companies in the reporting season suggest that growth in unit labour costs (and inflation) will remain well contained, providing scope for the RBA to further ease policy.

The Economist magazine attributes the reluctance of the Obama administration to intervene in Syria to the lessons learnt from the occupations of Iraq and Afghanistan.  Skeptikoi believes that the RBA has been a reluctant rate cutter due to similar ‘overlearning from history’; the view that central banks contributed to the financial crisis by keeping policy too accommodative for too long in the aftermath of the dotcom bust.  The moral hazard view of the crisis largely discounts the role of a range of other proximate factors, notably a glut in global savings and strong demand for safe haven assets.  Importantly it is not clear that the counterfactual of tighter monetary policies through the early to mid-2000s would have prevented the financial crisis, particularly given that long term interest rates – which at the time central banks had little power to influence – continued to decline to record lows during this time.

The RBA would be well placed to learn the lessons from policy errors committed by the Federal Reserve over the past century.  David and Christina Romer present a persuasive thesis that the most dangerous idea in the history of the Federal Reserve is that monetary policy doesn’t matter, a view which they argue contributed to the Great Inflation of the 1970s and Great Depression.  The more the RBA seeks to jawbone the Australian dollar lower – without much success - the more Skeptikoi is convinced that the RBA continues to under-estimate the power of monetary policy to re-balance the economy, revive the business sector’s animal spirits and boost nominal GDP.  In time, Skeptikoi hopes that the RBA’s record as a reluctant rate cutter and its ownership of Australia’s nominal recession will come under greater scrutiny.