Are the Fed’s interest rate projections credible?

At the FOMC meeting on September 19 and 20, members charted the central bank’s so-called dot plot of expected rates for the years out to 2020, involving one interest rate hike in 2017, three in 2018, two in 2019 and only one in 2020, leading to an end figure of 2.875% vs. 1.125% currently. These figures published by the Fed are generally extreme, as the US central bank endeavors to influence investors’ expectations to suit its own narrative. Continue reading

The Fed normalizes its monetary policy but is not optimistic

As expected, the Federal Reserve has decided to start the process of reducing the size of its balance sheet. It will start next month in October. Details of the operation were presented in June and are available on a post send earlier today.

During her press conference, Janet Yellen has clearly announced the hierarchy between the two instruments the Fed can use to manage its monetary policy. The main instrument remains the fed fund interest rate. In “normal” time, this is the instrument that must be used by the FOMC to manage its monetary policy. The purchases of assets could become again an instrument for the Fed if the situation is exceptional. The interest rate is the rule and the assets’ purchase is the exception. But it was a relevant question as the current level of the fed fund is too low to have a strong impact on the economic activity in the case of a negative shock. A quantitative adjustment could be necessary. Janet Yellen sees a kind of complementarity between the two and the two instruments must remain in the central banker toolbox.  Continue reading

The US Federal Reserve in unknown territory

Written with Aline Goupil-Raguénès

During today’s meeting, the probability is high that the Federal Reserve will decide to reduce the size of its balance sheet.
This latter started to increase at the end of 2008, first when the Fed was a provider of liquidity to the banking sector, and second when the US central bank started to purchase assets on a large scale. Few figures will give the scale of the transformation; in 2007 on average the size of the balance sheet was USD 830bn, it is now close to USD 4 500bn. As percentage of GDP the change is impressive from 5.7% on average in 2007 to 23% during the second quarter of this year.
Many questions are associated with this new step in the normalization of the US monetary policy. That’s the reason of this post and of the attached detailed document which is more technical but also more precise on the way it will work. Continue reading

Wind will blow strongly on the Fed

Stan Fisher the Fed’s vice president has decided to resign at mid-October for personal reasons. This will dramatically changed the internal equilibrium of the Fed’s board. Until now, three seats were vacant but there were 4 members appointed by Barack Obama. Their mandates are going at least beyond 2020 for all of them. The numerical advantage could lead to a statu quo and the possibility for Janet Yellen to remain president of the board.
With Fischer’s resignation the balance changes with now 4 seats that are unoccupied. On these 4, one has already been appointed by Donald Trump. Randal Quarles a private banker will replace Daniel Tarullo but he has yet to be confirmed by the Congress.
Who will be the next three? And who will be the next Fed’s president? Before Fischer’s resignation it could have been Yellen but we cannot expect this conclusion now.

4 types of risks
1 – If the Fed’s members appointments mimic what’s happening in the current Trump administration we can expect that many of these vacant seats will remain vacant. In many ministers, many jobs with high responsibility have not been filled yet. It would be problematic for the monetary policy management and the credibility of the US central bank.
2 – Will the next president be an economist as it is the rule? Jimmy Carter in 1978 named a non economist and it was a nightmare.
3 – There is not a lot of talented economists who claim for the job. It’s annoying for the quality of the board, the monetary policy management and the prospects for the US economy.
4 – With this new equilibrium and a Congress with a republican majority there is a risk on the independence of the Fed. Many reports from the republican side have asked for a Fed following a monetary policy rule (a Taylor rule type). Following such a rule would limit the capacity of judgement of the US central bank and its independence as it will have to follow the rule.

Fischer’s resignation can be a game changer on monetary policy at a moment where the US economic policy is just monetary policy.

“Whatever it takes” Five years later

Five years ago, Mario Draghi made remarks in London that have changed the world.
When he spoke in London on July the 26th 2012, the Euro area was in its deepest recession since WWII* and two important countries, Italy and Spain, were following a non sustainable trajectory that can be described as a deep recession with high real interest rates.

These problems came from the European decision to follow austerity policies. These latter dramatically reduced domestic demand but without having a strong impact on public finance. So the main question for Italy and Spain was the date of their exit from the Euro area; not if but when.
An exit from these two countries would have led to a collapse of the Eurozone. This would have destabilised the world economy.

Five years ago, in London, Mario Draghi did three things

First he said that the Euro Area was a political construction. It was the result of countries' will to live together. It has worked. The area has been in peace since WWII. This is the most important point for Europe. The euro currency is just a technical commitment. An important one but not more than that.

The second point is the following: if the currency is just a technical mean to improve the way the Euro area political framework works then it has to continue. The collapse of the Eurozone (after an exit from Italy or Spain or another country) would have been a source of political instability in Europe and probably the end of most European institutions.
The role of the ECB was to save the Eurozone by avoiding a collapse of its currency.
The famous sentence "whatever it takes" (the whole sentence is "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.") explains this new mission.
After this sentence the ECB became the lender of last resort that a monetary construction needs. Until this moment the central bank had never played this role. It's a fracture in the European institutional framework.
In a situation where governments didn't know what to do, the ECB became the leader under the auspice of Mario Draghi.

The third point came few days later at the ECB monetary policy meeting with the creation of the OMT which allows the ECB to buy assets (public debt) mainly in Italy and Spain. This was enough to reduce tensions on these two countries. Later in 2012 and after in 2013 the interest rate spreads with Germany decreased dramatically. This was the end of the main divergence within the Euro area.

The ECB has been a game changer by avoiding the collapse of the European construction. Since then, economic policy leader is the central bank under the impulse of Mario Draghi. Progressively the fiscal policy has converged to a neutral stance. The Eurozone economic policy is now done in Frankfurt more than in Brussels.
The QE strategy was consistent with this new ECB framework. It had to create the necessary impulse that would provoke the recovery. It has worked with all the instruments used in this non orthodox monetary
The European Central Bank has been the channel for a smooth adjustment in the most important financial crisis since WWII.
Its job is now almost over as the growth recovery is now strong. It just have to keep its accommodative monetary policy in order to ease the needed political adjustment. The next step of the Eurozone institutional construction is political. It's time for government to take the relay.
We will forget a lot of ECB presidents, past and future, but Mario Draghi will remain as the one who save the European construction.

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* The Euro Area has started in January 1999, but if we look at the economic situation of constituant countries since WWII none of them has had such a recession.