Weekly Impressions - The new normal: Low and slow

Mr Draghi undershoots on expectations and inflation

Financial markets were clearly disappointed at the outcome of the meeting of the ECB’s Governing Council overnight, with the euro strengthening and global stock markets falling sharply despite the announcement that the ECB would extend its asset purchase program by six months, which is now intended to run to March 2017 or beyond if necessary.

At the September meeting, ECB President, Mr Mario Draghi, had clearly raised expectations of more monetary stimulus at the December meeting than was announced.  The market’s disappointment stems from the poor run of monthly inflation data since then; readings for the months of October (+0.2%) and November (-0.2%) were particularly disappointing.  As a result, the core Harmonised Index of Consumer Prices (which strips out food, energy & tobacco) is only 0.9% higher than a year earlier, a long way from the ECB’s inflation target. 

The ECB’s own staff projections indicated slightly weaker inflation dynamics than previously expected.  If the run of poor inflation data continue and if core inflation continues to undershoot its target by such a long way, Evidente expects more aggressive monetary stimulus – specifically a lift in the run rate of monthly asset purchases of 60 billion euro - at the next meeting of the Governing Council.

The global stock market response to the ECB’s announcement represents another nail in the coffin for the military analogy of currency wars.  The euro rose by 2½% against the US dollar.  But contrary to a key prediction of the currency wars thesis – that the lower US dollar would boost the competitiveness of exporters - US stock markets fell by over 1% following the announcement.

Lift-off this month would be premature...

At her testimony to Congress, Federal Reserve Chair, Ms Janet Yellen, laid the intellectual framework for lift off at the FOMC meeting later this month, citing three key factors.

  • Ongoing gains in the labour market suggest that inflation will return to its 2% target as the transitory effects of lower commodity prices and a stronger US dollar will wane.

  • Were the Fed to delay the normalisation of monetary policy for too long, it would risk having to hike interest rates quickly due to the lags in the operation of policy, thus lifting the likelihood of turmoil in financial markets.

  • Holding the federal funds rate at its current level for too long could encourage excessive risk-taking and thus undermine financial stability.

Evidente’s econometric modelling of US inflation suggests that if commodity prices and the US dollar remain unchanged from current levels, core inflation will rise over the course of next year but remain well below 2% by the end of 2016.

The proximity of the financial crisis suggests that the Fed is justified in being concerned about financial stability.  But more targeted macro-prudential policies designed to reduce the size and influence of the shadow banking sector, and lift the loss absorbing capital on the balance sheets of financial institutions would do far more to reduce systemic risk of the financial system.

Evidente remains of the view that the Federal Reserve will be committing a policy error by undertaking lift-off at a time when core inflation is undershooting its 2% target by over 50 basis points.  But of some comfort is an evolution of communication from Fed officials that the new normal of monetary policy normalisation will be low and slow.

...But the new normal will be low and slow

Governor Lael Brainard has invoked the Wicksellian concept that the appropriate pace and target for normalizing monetary policy depends centrally on understanding the neutral rate of interest; the level of the federal funds rate that is consistent with output growing close to its potential rate with full employment and stable inflation.  When the federal funds rate is below the nominal neutral rate, monetary policy is accommodative, and, when it is above the neutral rate, policy is contractionary.

Ms Brainard argues persuasively that the fact that the U.S. economy is growing at a pace only modestly above potential while core inflation remains restrained suggests that the nominal neutral rate may not be far above the nominal federal funds rate, even now.  Drawing on market measures of forward rates and surveys of economists, Ms Brainard suggests that the neutral rate will remain low (possibly close to zero) for some time to come.

Ms Brainard speculates that a higher expected equity risk premium (associated with risky investments) has contributed to the reduction in the neutral rate of interest.  A higher risk premium necessitates a lower risk-free rate to encourage the same amount of riskier investments as previously.  A higher risk premium is consistent with the earnings yield on stocks remaining broadly unchanged at a time when the risk free rate has trended down for years and can explain the sluggishness in growth of global capital investment during this recovery (see chart).

Ms Brainard concludes that the lower neutral rate means the normalization of the federal funds rate is likely to follow a more gradual and shallower path than in previous cycles.  Evidente expects the new normal of low and slow to be reflected in the language of the statement accompanying the decision to engage in lift-off, which should reduce the likelihood of a broad based sell-off in risk assets.