So, that was the US week that was. The August data flow was probably a little better than I reckoned on but was certainly bad (I tend to move more quickly than an economy does).
Indeed, data was bad enough, especially Friday’s employment report, that the tenure of US debate has clearly shifted from worry about poor growth to what can done to avert recession.
There are two key events ahead in this narrative. The first is Obama’s Friday “Jobs speech” in which he is expected to announce limited measures, such as a payroll tax holiday. Although there have been fringe rumblings of a more innovative and grand plan to “jumbo refinance” American housing.
The second event is the FOMC meeting in two a bit weeks and the prospect of further Fed action, currently thought to most likely revolve around “Operation Twist”. The rebalancing of the Fed porfolio from short term to longer term bonds. Presumably thereby also firing up a refinancing boom (most US mortgages are priced off longer term Treasuries).
Neither of these options will solve the underlying issue of too-much-debt (they just make it cheaper) but both potentially help kick the can down the road and perhaps stave off recession if markets react positively, beat down the dollar and fire a new emergingn markets risk rally.
For the FOMC, I reckon that anything short of a full blown round of new asset purchases will have only a passing effect on markets.
A big Obama plan could have a more positive effect so long as, whatever it is, it also weakens the dollar. Otherwise it too is doomed.
How do I reach these rather bold conclusions?
Sell on News had a very important post on the weekend in which he quoted the research of Gauti B. Eggertsson and Benjamin Pugsley:
The mistake of 1937 was in essence a poor communication policy. At the time, President Franklin Delano Roosevelt (FDR), his administration, and the Federal Reserve all offered confusing signals about the objectives of government policy, especially as it related to their goals for inflation. In the first year of his presidency, FDR had vowed to fight the drop in prices and to reflate them back to their pre-depression levels (the reference point was often understood to be the price level in 1926). By every indication, the public believed this commitment. But by 1937, the administration began expressing its alarm over excessive inflation despite the fact that prices had not yet reached their 1926 target. Vague and confusing signals about future policy created pessimistic expectations of future growth and price inflation that fed into both an expected and an actual deflation. We leave it open to question whether this communication was due to a deliberate change in policy or due to confusing signals (see the discussion in Section VII, where we propose two alternative interpretations), but we argue that regardless of the reason, the ultimate effect was a shift in beliefs about future policy. Nominal rigidities helped propagate the shift in beliefs into an output contraction and a collapse in prices.
We show that this propagation mechanism is particularly damaging at zero interest rates by constructing a stylized dynamic stochastic general equilibrium (DSGE) model in which the zero bound on the short-term interest rate is binding due to temporary real shocks that make the natural rate of interest temporarily negative. We simulate this model and show that at zero interest rates, both inflation and output are extremely sensitive to signals about future policy. By “extremely,” we mean that if the public’s beliefs about the probability of a future regime change by only a few percentage points, there are very large effects on inflation and output. This effect is independent of any change in the current short-term interest rate, which we assume remains at zero.
In short, when monetary policy finds itself at the zero bound, it has lost its price signaling efficacy. What is left at that point is only the expectations of price signals. Thus the public discussions had by economic leaders around what those signals should be is the new signal.
To my mind this socialisation of price is compounded further by the compromising of the government risk-free rate with the S&P US downgrade. That’s another price signal compromised (if not yet lost).
FT Alphaville discussed this last week as the emergence of “Jedi Economics”.
So, what importance does this have for us in assessing the stimulus options to come and their potential effects on markets? In a word: everything. A world in which the foundation numbers for modeling risk and return have ceased to exert their traditional force is a world in which investment decisions are based far more upon social judgement. That means the communications of economic leaders are everything.
I can see several important implications flowing from this.
First, the FOMC’s current very public conflict and debate is potentially very damaging to growth.
Second, the economic consequences of the toxic debt-ceiling debate are potentially far more damaging and long lasting than I’d previously thought.
Third, in judging the effect of forthcoming stimulus measures on markets, only a much bigger and more united bazooka is going to have any lasting impact.
Either it’s a full blown QE3 or something of similar magnitude from Obama, or it’s bust as far as I’m concerned.
- Bill Evans: “Substantial falls ahead for house prices” - August 14, 2020
- Andrews is a disaster but Morrison is a catastrophe - August 10, 2020
- US jobs preview - August 7, 2020