The December Rate Hike

By William Labasi-Sammartino

In this month’s highly anticipated Fed decision, it is widely expected that the Federal funds rate  will be raised. At time of writing, futures markets point to a near certain increase and a similar consensus is emerging from financial media outlets. Even though it may seem that the Fed leaves us absolutely clueless of their next move, we can actually estimate the appropriate nominal interest rate by trying out different rules which have historically predicted Fed behaviour. The Taylor rule is the most important.

The Taylor rule

In a famous 1993 paper(1), Stanford economist John B. Taylor estimates the Fed’s behaviour from the Volcker Disinflation to the the beginning of the 90s.

ff=  1.5π + 0.5yt + 1

π is the inflation rate, ff is the Fed Funds rates, and y is the output gap. It’s important to recognize that the nominal interest rate increases faster than inflation. Modified Taylor rules have replaced the coefficient on the output gap for 1 and have found to be more accurate. In any case, Taylor’s rule works well in explaining Fed policy until the early 2000s:

Screen Shot 2016-12-03 at 1.08.53 PM.png

Under this rule, interest rates behave as expected: If inflation is on target at 2% and the output gap is 0, we should see interest rates at 4%. A caveat that should be highlighted — especially in light of our recent discussion on the level of the natural level of interest — is that Taylor’s original equation assumes a constant 2% interest rate that is consistent with full employment. A more detailed rule gives us room to change some of these assumptions:

fft=rt* + πt + 0.5(πt-πT)+0.5yt

where πT is the inflation target and rt* is the interest rate consistent with full employment. Without redrawing the curve, we can still see that the regular estimates are too high since rt*has recently been at much lower levels (around 0). The Taylor rule nevertheless gives us an idea of where monetary policy should be heading. Given the uptick in inflation and unemployment being at its natural rate, the current Fed funds rate is too low.

How monetary policy can offset swings in aggregate demand

We have inadvertently outlined a mechanism detailing how the Taylor rule could be used by the Fed to offset fiscal policy. If the US government ramps up fiscal policy, the Fed would be forced to react by raising interest rates so inflation doesn’t get out of control. This is one of the reasons why spending increases from a Trump presidency would therefore have limited stimulative effect on the demand-side of the economy. But this could also work in reverse: how does the Taylor rule work in a severe recession? As seen in the graph, the Fed should lower rates. If deflation and the output gap become problematic, the Taylor rule might actually dictate a negative rate which is obviously impossible to achieve under current arrangements. The point is that in normal circumstances, the Fed could offset any changes in aggregate demand — negative or positive. As previously mentioned, this exercise becomes a bit trickier when rates are at zero and they should be lower (when the economy is in a liquidity trap).

Even if there is more to a central bank’s reaction function than a simple interest rate rule, this is a good start. In a recent blog post, the Fed’s last chairman, Ben Bernanke, shares his views on the Taylor rule. (2)

References

(1) Taylor, John B. “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy 39 (1993): 195-214. Web.

(2) The blog post can be found at this link: https://www.brookings.edu/blog/ben-bernanke/2015/04/28/the-taylor-rule-a-benchmark-for-monetary-policy/

How Will Trump Affect the Economy?

By William Labasi-Sammartino

Trump’s shocking victory this past Tuesday certainly upset a lot people. Social activists and national security experts were worried about his views on social issues and foreign policy. Economists were also concerned. A group of economic Nobel laureates representing a range of views (from Robert Lucas Jr. and Thomas Sargent to Joseph Stiglitz) had signed an open letter endorsing Hillary Clinton and calling Trump’s proposals “reckless threats”(i). But with the Dow and the S&P in all-time high territory, markets don’t seem to accept the dire predictions that were made during the campaign.

Infrastructure, deregulation, and taxes

During the campaign season, there was a lot of talk about increasing infrastructure spending by both parties. With Republicans being in full control of the White House and Congress, this is the best hope since the Great Recession for increases in infrastructure spending. The supply-side effects can only be assessed when they actually happen, but if we follow Summer’s Secular Stagnation story, increased spending on infrastructure will be beneficial. Boosting investment should raise the neutral rate which has been stuck at about zero for a while. In turn, this could make the Fed’s low interest rate policy much more effective in raising inflation and reducing cyclical unemployment. The surge in long-term bond yields throughout the US and Europe is indicative of this.

Screen Shot 2016-11-13 at 5.35.48 PM.png

Trump’s ambition to lower taxes and simplify the tax code may also answer  some economists’ wish for large-scale fiscal stimulus. His populist message suggests that he won’t only cut for the rich, but for all — thus likely being very costly in terms of a fall in tax revenue. Likewise, the supply-side effects should be positive, but we’ll have to see what actually happens to properly assess their impact on long-term economic growth.

All of this fiscal stimulus will obviously balloon the deficit and the US national debt and worsen the US’s fiscal situation which could lead to more instability down the road and prevent a future administration from acting in the wake of an eventual recession.

Another important part is deregulation. The day after the election, bank stocks soared and outperformed many other sectors. It’s most likely a reaction to the expected deregulation that the Trump administration will take — especially removing the Dodd-Frank bill that increased oversight in the financial sector and heightened controls. Profits are expected to increase as a result.

The Fed 

In all of this, the Fed and other central banks have an important role to play. It might not tolerate Trump’s expansionary fiscal policy so the fiscal multiplier may very well be zero. In reviewing Bernie Sanders’ platform, UC Berkeley economists Christina Romer and David Romer had already described a situation where the Fed would raise interest rates to undo any expansionary fiscal policy.(ii)

Massive demand-side stimulus in an economy closing in on its productive capacity would have one of two effects. First—and most likely—it would lead the Federal Reserve to raise interest rates, offsetting as well as it could the expansionary effects of the stimulus. Output would rise little, and the main effects would be on interest rates and on the composition of output between the components stimulated by the fiscal expansion and the components restrained by higher interest rates. Second, if the Federal Reserve did not respond, the result would be inflation. And if the stimulus were large enough to try to push the economy 10%, 20%, or more above its productive capacity, the inflation would be substantial.

Of course this all depends on the type of rule the Fed is following. Its recent moves towards discretionary policy may however set the precedent for allowing higher inflation. In any case, it’ll welcome the rise in the neutral interest rate as it’ll give them more “breathing room”.

Immigration and international trade

This is where Trump’s policies may do the most damage. Undoing trade agreements that allow for the free flow of capital and goods between borders will cause a huge negative supply shock. Increasing trade barriers will raise the price of consumer goods across the board and make life worse for most Americans — especially for Trump’s voter base. Tighter immigration will have similar effects by raising labour costs and preventing firms from recruiting high-skilled labour. Some economists in the past week have suggested that the odds of stagflation have increased slightly.

It should go without saying that protectionism will be horrible for emerging markets since their economies rely heavily on international trade.

Uncertainty of a Trump presidency

The onset of uncertainty from a Trump administration may also cause  instability throughout the system. The positive market reaction so far indicates that investors are suggesting that Trump may turn out to be a traditional GOP supply-sider and therefore seems to be quite different from Brexit where we saw investors rush to bonds and dump the pound. Only time will tell what policies investors are expecting will actually materialize. It’s safe to say that the complete Republican takeover will bring an end to the gridlock that has plagued Congress in the last years.

References

i. http://www.nobellaureatesforclinton.us/economics/

ii.  Romer, Christina D., and David H. Romer. Senator Sanders’s Proposed Policies and Economic Growth. Institute for New Economic Thinking, 25 Feb. 2016. Web. 11 Nov. 2016. <https://ineteconomics.org/uploads/general/romer-and-romer-evaluation-of-friedman1.pdf&gt;.

Reims Economic Society: World Economy

By William Labasi-Sammartino, Reims Economic Society

Welcome to a new writing series from the Reims Economic Society! The Sundial has kindly given us a platform to write articles every now and then. We will provide a commentary on world economic affairs and also review ongoing discussions in the financial press and the economic blogosphere. We will shortly post a list of blogs and pages we highly recommend you read before coming here (some honest humility right here). To serve as an introductory post, we’ll discuss the current state of the world economy.

Today’s combination of low growth, low inflation, low interest rates, low labour participation, etc. has led some to call this the Age of Secular Stagnation or of Sclerotic Growth. The average annual growth rate during the 80s and 90s was 3.1 and 3.2% respectively. Since 2005, it’s been at a meagre 1.6%. This is especially alarming considering that countries hit by the Great Recession should have shown catch-up growth rates. In the graph below, we see the enduring gap between potential and actual output for the U.S. Notice how other countries don’t seem to be returning to trend either. Other major economies such as Japan and Europe have not seen nearly the same amount of growth as the U.S.

econ1

As a result, many commentators have come out with different explanations.

 

Secular Stagnation : a story of high saving and low investment

So-called secular stagnation has become one of the most popular — well, at least, it’s gotten the most attention. Larry Summers has led a group of economists who have argued that there is a chronic deficit in aggregate demand around the globe and that the Great Recession has only made matters worse. Summers points to global monetary policy which seems to being unable to reboot spending and low interest rates as being suggestive of a worldwide drop in demand to invest. Instead, there has been a rise in savings. All of this puts downward pressure on the natural rate of interest. Critically, even if  economic conditions return to what they were before the crisis, monetary policy will be unable to reach the required interest rate which coincides with full employment. Hence, full employment may be elusive.

econ2

The graph shows an undeniable truth to Summers’ story : the natural equilibrium rate of interest has fallen. The last decade’s low inflation and low nominal income growth has been indicative that even if central banks target near-zero interest rates, it will have limited stimulative effect.

Stuck in a liquidity trap?Paul Krugman, on the other hand, has advocated for nearly a decade that we have entered a period of “liquidity trap economics”. The idea of the liquidity trap was notably developed in Keynes’ General Theory where it is said that monetary policy is ineffective when a central bank’s main instrument, the short-term nominal interest rate, has hit the zero lower bound (ZLB). The U.S. was in such a situation from 2008 to December of last year. Krugman has repeatedly argued in his NYT column that monetary policy is ineffective in such circumstances and that governments should therefore not solely rely on their central banks to get growth going again. Thus only expansive fiscal policy will manage to increase demand. As much as Krugman’s push for reigniting interest in an old-school Keynesian approach to macroeconomic policy has attracted a lot of  attention, a long list of economists have argued that central banks still have a lot of “ammo” left. This issue will be covered in future articles ; however, it is worth mentioning now that the quantitative easing (QE) programs that the Federal Reserve, the Bank of England, Bank of Japan, and now the European Central Bank have undertaken are a testament to this view. Even if there is a lot of talk about monetary policy being powerless at the ZLB, this claim remains highly disputed.

 

Other significant headwinds

Another prominent position points to the supply-side in the sense that there is too much regulation which is holding down the world economy. Along with others, John Cochrane has espoused this view on his blog and in a string of articles. He claims that the low productivity growth has resulted in the real economy growing at below trend levels. He points to the excessive amount of regulation, complicated tax schemes, poor public schools, and policies promoting closed borders as the main culprits.

Particularly, but not exclusively to the US, urban centres may be over regulated. Combine unbearable zoning laws and construction regulations with slow population growth, cities can’t deliver the innovative and job growth that is necessary to keep the economy on trend. Increased regulation restricts the supply of housing thus leading to higher real estate prices which in turn hinders population growth and increases inequality.

Robert Gordon has famously been pessimistic on American productivity growth. He suggests that the IT-technology boom was a singular event and that we should settle for stagnation in technological progress. Furthermore, low population growth, rising inequality, and a poor education system all contribute to the current state of the US economy.

These reasons should not be ignored since important structural factors tend to matter much more in determining an economy’s long run performance.

Other narratives involve the astonishing growth in public and private debt around the world. Kenneth Rogoff has laid out this debt overhang hypothesis in a couple of (in)famous[i] papers in 2010[ii] and 2012[iii] where he argues that excessive amounts of debt can cause economies to grow at a considerably lower rate. Reinhart, Reinhart, and Rogoff (2012)[iv] shows that countries that demonstrate debt to GDP ratios above 90% experience, on average, 1.2% lower annual growth.

Who’s right? 

There has been a lot of debate around this issue since the world economy’s low growth has been quite puzzling. There seems to be a tentative consensus that many structural factors in industrialized economies are in need of reform in some way. Even Larry Summers has recently pointed to the US’ unfavourable climate for infrastructure development in a recent article for the Boston Globe[v]. The same can be said about housing regulation. Several commentators of different political stripes have found similar conclusions (see here[vi], here[vii], and here[viii]). A likely scenario is that supply-side issues will be resolved on a case-by-case basis after sufficient formal evidence is presented.

Demand-side and by extension short-run issues are, conversely, a bit more complicated. Being subject to elegant and elaborate macroeconomic theories, short-run economic policy has always been strongly debated and highly polarizing. This is why monetary and fiscal policy in the current world economy will be further discussed in future posts.

References

All time series come from the Federal Reserve Bank of St. Louis :

GDPPOT

GDPC1

CLVMEURSCAB1GQEU28

JPNNGDP

JPNGDPDEFAISMEI

CLVMNACSCAB1GQUK

INTGSTJPM193N

DTB3

INTGSBDEM193N

INTGSBGBM193N

Graphics are author’s calculations.

[i] http://www.bloomberg.com/news/articles/2013-04-18/faq-reinhart-rogoff-and-the-excel-error-that-changed-history

[ii] Carmen M. Reinhart & Kenneth S. Rogoff, 2010. “Growth in a Time of Debt,” American Economic Review, American Economic Association, vol. 100(2), pages 573-78, May.

[iii]Public Debt Overhangs: Advanced-Economy Episodes since 1800” (with Carmen M. Reinhart and Vincent R. Reinhart), Journal of Economic Perspectives, Vol. 26, No. 3, Summer 2012

[iv] Carmen M. Reinhart & Vincent R. Reinhart & Kenneth S. Rogoff, 2012.”Debt Overhangs: Past and Present,” NBER Working Papers 18015, National Bureau of Economic Research, Inc.

[v] https://www.bostonglobe.com/opinion/2016/05/25/lesson-infrastructure-from-anderson-bridge-fiasco/uKS6xQZxFBF0fZd2EuT06K/story.html

[vi] https://www.whitehouse.gov/sites/default/files/page/files/20151120_barriers_shared_growth_land_use_regulation_and_economic_rents.pdf

[vii] http://www.nytimes.com/2015/11/30/opinion/inequality-and-the-city.html?_r=0

[viii] Glaeser, Edward L. and Joseph Gyourko. “The Impact Of Building Restrictions On Housing Affordability,” FRB New York – Economic Policy Review, 2003, v9(2,Jun), 21-39.