Imagine that US non-farm payrolls were growing by 400k/month (that is how strong the UK labour market is)

My Danske Bank colleague Anders Vestergård Fischer had a fun idea today – he wanted to “translate” the latest UK labour market numbers into something an US audience could understand.

Here is the result of Anders’ back of an envelop calculations – if the US non-farm payrolls were growing as fast as the latest UK employment growth (Q3 2013) then the US economy would be adding 380-400k jobs per month! We haven’t seen job growth like that in the US since the late 1990s. Over the past three months US payrolls have growing around 190k per month.

So what are the explanations for the the UK labour market improvement? The negative spin: Horrible British productive growth. The positive spin: A very healthy combination of monetary easing and fiscal consolidation.

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The (Divisia) money trail – a very bullish UK story

Recently, the data for the UK economy has been very strong, and it is very clear that the UK economy is in recovery. So what is the reason? Well, you guessed it – monetary policy.

I think it is fairly easy to understand this recovery if we follow the money trail. It is a story about how UK households are reducing precautionary cash holdings (in long-term time deposits) because they no longer fear a deflationary scenario for the British economy and, that is due to the shift in UK monetary policy that basically started with the Bank of England’s second round of quantitative easing being initiated in October 2011.

The graphs below I think tells most of the story.

Lets start out with a series for growth of the Divisia Money Supply in the UK.

Divisia Money UK

Take a look at the pick-up in Divisia Money growth from around October 2011 and all through 2012 and 2013.

Historically, UK Divisia Money has been a quite strong leading indicator for UK nominal GDP growth so the sharp pick-up in Divisia Money growth is an indication of a future pick-up in NGDP growth. In fact recently, actual NGDP growth has picked up substantially, and other indicators show that the pick-up is continuing.

If you don’t believe me on the correlation between UK Divisia Money growth and NGDP growth, then take a look at this very informative blog post by Duncan Brown, who has done the econometrics to demonstrate the correlation between Divisia (and Broad) Money and NGDP growth in the UK.

Shifting money

So what caused Divisia Money growth to pick-up like this? Well, as I indicated, above the pick-up has coincided with a major movement of money in the UK economy – from less liquid time deposits to more liquid readably available short-term deposits. The graph below shows this.

Deposits UK

So here is the story as I see it.

In October 2011 (A:QE in the chart), the Bank of England restarts its quantitative easing program in response the escalating euro crisis. The BoE then steps up quantitative easing in both February 2012 (B: QE) and in July 2012 (C: QE). This I believe had two impacts.

First of all, it reduced deflationary fears in the UK economy, and as a result households moved to reduced their precautionary holdings of cash in higher-yielding time deposits. This is the drop in time deposits we are starting to see in the Autumn of 2011.

Second, there is a hot potato effect. As the Bank of England is buying assets, banks and financial institutions’ holdings of cash increase. As liquidity is now readily available to these institutions, they no longer to the same extent as earlier need to get liquidity from the household sector, and therefore they become less willing to accept time deposits than before.

Furthermore, it should be noted that in December 2012, the ECB started its so-called Long-Term Refinancing Operation (LTRO), which also made euro liquidity available to UK financial institutions. This further dramatically helped the liquidity situation for UK financial institutions.

Hence, we are seeing both a push and pull effect on the households’ time deposits. The net result has been a marked drop in time deposits and a similar increase in instant access deposits. I believe it has been equally important that there has been a marked shift in expectations about UK monetary policy with the appointment of Mark Carney in December 2012 (D: Carney).

Mark Carney’s hints – also in December 2012 – that he could favour NGDP targeting also helped send the signal that more monetary easing would be forthcoming if needed, as did the introduction of more clear forward guidance in August 2013 (E: ‘Carney Rule’). In addition to that, the general global easing of monetary conditions on the back of the Federal Reserve’s introduction of the Evans rule in September 2012 and the Bank of Japan’s aggressive measures to hit it new 2% inflation undoubtedly have also helped ease financial conditions in Britain.

Hence, I believe the shift in UK (and global) monetary policy that started in the Autumn of 2011 is the main reason for the shift in the UK households’ behaviour over the past two years.

Monetary policy is highly potent

But you might of course say – isn’t it just money being shifted around? How is that impacting the economy? Well, here the Divisia Money concept helps us. Divisia money uses a form of aggregation of money supply components that takes this into account and weights the components of money according to their usefulness in transactions.

Hence, as short-term deposits are more liquid and hence readably available for transactions (consumption or investments) than  time deposits a shift in cash holdings from time deposits to short-term deposits will cause an increase in the Divisia Money supply. This is exactly what we have seen in the UK over the past two years.

And since as we know that UK Divisia Money growth leads UK NGDP growth, there is good reason to expect this to continue to feed through to higher NGDP growth and higher economic activity in Britain.

Concluding, it seems rather clear that the quantitative easing implemented in 2011-12 in the UK and the change in forward guidance overall has not only increased UK money base growth, but also the much broader measures of money supply growth such as Divisia Money. This demonstrates that monetary policy is highly potent and also that expectations of future monetary policy, which helped caused this basic portfolio readjustment process, works quite well.

“Monetary” analysis based on looking at interest rates would never had uncovered this. However, a traditional monetarist analysis of money and the monetary transmission mechanism, combined with Market Monetarist insights about the importance of expectations, can fully explain why we are now seeing a fairly sharp pick-up in UK growth. Now we just need policy makers to understand this.

—–

Acknowledgements:

I think some acknowledgements are in place here as this blog post has been inspired by the work of a number of other monetarist and monetarists oriented economists and commentators. First of all Britmouse needs thanking for pointing me to the excellent work on the “raid” on UK households’ saving by Sky TV’s economics editor Ed Conway, who himself was inspired by Henderson Economics’ chief economist Simon Ward, who has done excellent work on the dishoarding of money in the UK. My friend professor Anthony Evans also helped altert me to what is going on in UK Divisia Money growth. Anthony himself publishes a similar data series called MA.

Second of course, a thanks to Duncan Brown for his great econometric work on the causality of Divisia Money and NGDP growth in the UK.

And finally, thanks to the godfather of Divisia Money Bill Barnett who nearly single-handledly has pushed the agenda for Divisia Money as an alternative to simple-sum monetary aggregates for decades. In recent years, he has been helped by Josh Hendrickson and Mike Belongia who has done very interesting empirical work on Divisia Money.

For a very recent blog post on Divisia Money, see this excellent piece by JP Koning.

And while you are at it, you might as well buy Bill Barnett’s excellent book “Getting It Wrong” about “how faulty monetary statistics undermine the Fed, the financial system and the economy”.

 

Rules vs central bank superheros

I have a new piece in today’s City AM on central bankers as (pretend) superheros versus rules based monetary policy:

LARRY Summers is out of the race to succeed Ben Bernanke as Fed chair. After months of debate, with politicians and media picking over Summers’s personality and background, the spotlight has returned to Janet Yellen, deputy Fed chairwoman. Is she now a certainty? Or is another monetary superhero about to emerge?

All of this recalls the moment when George Osborne announced that Mark Carney would be governor of the Bank of England. Carney was described by both the chancellor and the media as a superstar. It’s hard to miss the parallel with the hubbub around Gareth Bale’s £85.3m switch to Real Madrid.

But it’s a problem when monetary policy becomes viewed as uniquely dependent on a single “personality”. Central bankers should not be seen as star footballers. At best, they are referees. This is partly a problem of job description. What should the governor do? Should he or she fly about, putting out fires as they erupt in the economy? Or should he or she follow clearly defined monetary policy rules?

Over the past five years, we have grown increasingly used to the idea of the fire-fighting central banker. Even in 1999, Time magazine described Alan Greenspan, Robert Rubin and Summers as “The Committee to Save the World” for their role in the Asian crisis, the Russian crisis and the collapse of long-term capital management. Summers’s reputation nearly landed him the top job at the Fed.

Read the rest here.

It is time to stop worrying about austerity – also in the UK

I have a piece in City AM today on the impact of fiscal austerity in the UK:

FIVE years ago, nearly every macroeconomist agreed that central banks determined aggregate demand (total spending in the economy), and that fiscal stimulus was therefore unnecessary to lift depressed economies. Conversely, fiscal austerity was seen as irrelevant at best for overall growth; any impact of austerity on demand can be offset by the right monetary policy – though tax cuts could, of course, boost aggregate supply.

But the age-old discussion about the relation of fiscal policy to growth has resurfaced. Keynesian economists – including Òscar Jordà and Alan M Taylor in a paper just released by the National Bureau of Economic Research – claim that government austerity is to blame for lacklustre UK growth since 2010.

There are technical issues with the paper that make Taylor and Jordà’s precise numbers hard to evaluate. And as the economist David B Smith has noted, the important question of fiscal sustainability is not even addressed. But the more fundamental issue in the whole debate is the idea of “monetary offset”.

Read the rest here.

Prediction markets and UK monetary policy

I have long argued that central banks should utilise prediction markets for macroeconomic forecasting and for the implementation of monetary policy.

In today’s edition of the UK business daily City AM I have an oped on this topic and about how the Bank of England should have a closer look at prediction markets. See here:

IN HIS first major speech since becoming governor of the Bank of England, Mark Carney is today likely to defend a policy that has come to be described as the “Carney rule”. Also known as forward guidance, the rule effectively promises that interest rates will stay at present levels until unemployment drops below 7 per cent, so long as the Bank’s inflation forecast does not top 2.5 per cent.
 
This kind of forward guidance is welcome news for the financial markets. We will now at least have some sort of map to navigate monetary policy, instead of relying on insinuations from the lips of the wise men on the Monetary Policy Committee (MPC).
 
But this still leaves markets at the mercy of the Bank of England’s internal forecasters, whose credibility can certainly be questioned. The Bank doesn’t need to be biased to consistently predict that it will hit its inflation target, for example (though what institution would forecast that it will fail?). Even with the best incentives, it cannot possibly bring together all the private knowledge spread across investors, firms and households.
 
It is this inability of elite central planners to gather such a wide source of information that led even committed Marxist GA Cohen to agree that markets may be necessary for a rational economic system. No individual, however intelligent, can know enough about the economy to make a really reliable prediction about it.
 
And it’s not just the dragging-together of information from thousands of different sources that makes market predictions more accurate than those made by small elite groups. Investors betting in markets have skin in the game; they have an extremely strong incentive to get their bets right, since they will lose money for bad (inaccurate) bets and win money for good (accurate) ones.
Read the rest of the piece here.
 
And Mark Carney is lucky that he now in fact has a prediction market to look at. This is from a press release from the Adam Smith Institute:

Today we’ve launched two betting markets to try to use the ‘wisdom of crowds’ to beat government economic forecasters….The Bank of England’s economic forecasts have been wrong again and again. To counter this, the free market Adam Smith Institute is today (Wednesday 28th August) launching two betting markets where members of the public can bet on UK inflation and unemployment rates, taking the government’s experts on at their own game. The markets are designed to aggregate individual predictions about the economy’s prospects to use the ‘wisdom of crowds’ to beat the predictions of government experts.

The launch coincides with Mark Carney’s first major speech as governor of the Bank of England and follows his announcement earlier this month that the Bank will consider both inflation and unemployment when deciding monetary policy.
Read more here.
 
It will extremely interesting to follow how this prediction market will work and it will obviously be very interesting to see how it will impact the monetary policy debate in the UK. My hope certainly is that it will help the case for market-driven monetary policy implementation and also help “police” the Bank of England’s forecasts.
 
 
 
 
 

Mark Carney’s tiny step in the right direction

I have an oped in UK’s City AM on Bank of England’s new forward guidance regime. Yes, I am disappointed…

ALMOST everyone will be disappointed by governor Mark Carney’s announcement yesterday. Those hoping the Bank of England would announce more monetary easing will feel let down. And while those of us hoping for strictly rules-based policy do have something to be happy about, Carney needed to go much further.

The Bank has now spelled out its own version of the Federal Reserve’s Evans Rule. The “Carney Rule”, as we might call it, implies that the Bank will commit itself to maintaining interest rates at the present level as long as unemployment is above 7 per cent, and the Bank’s inflation forecast is below 2.5 per cent….

Read more here

PS Mark Carney tightened monetary policy yesterday. Just look at the pound (it strengthened) and the UK stock market (it dropped). So those who fear that inflation is about to get out of control in the UK are very wrong.

Mark Carney please listen to “Reform”

The UK think tank Reform has good advice for Bank of England governor Mark Carney. This is from Reform’s latest publication “Kick-starting growth” (I stole it from it from Britmouse):

“The upshot is that ideal Bank policy should pin the two or three year forecast of inflation at 2 per cent, unless there are extenuating factors. Figure 6 shows that monetary policy performed exceptionally well on that score prior to the recession.

However, when the financial crisis hit the Bank was slow to respond, with the two-year inflation forecast dropping to just 0.3 per cent in 2009. That, coupled with the huge fall in nominal output, indicates a need to massively loosen monetary policy, which the Bank eventually did when it dropped its interest rate to 0.5 per cent and implemented a programme of quantitative easing.

Those actions have often been represented as constituting extremely loose monetary policy but the persistently low inflation forecasts tell a different story. In fact, monetary policy has been tight by the Bank’s own measures, with forecast inflation well below target throughout much of the recession. The low forecast path looks even worse in light of the series of external shocks to the CPI, such as VAT and tuition fees, detailed previously. Bearing in mind the large, positive shocks to the CPI, the forecast path shows even tighter policy, which suggests the Bank may have been focussing on inflation concerns to the exclusion of growth.

As Milton Friedman famously remarked, “Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.” The UK’s low interest rates are not a signal that policy is easy, but rather a sign that nominal growth expectations are low. That problem can largely be laid at the feet of monetary policy.”

It hardly gets more Market Monetarist than this and we can only hope that Carney have read the Reform report ahead of tomorrow’s crucial and long-awaited announcement of BoE’s new “strategy”. I doubt we will get an announcement of an NGDP targeting regime, but we might get the announcement of a Evans rule style monetary policy in the UK. That would be NGDP targeting ultra light.

Even though I am not too optimistic about major regime change in UK monetary policy I must on the other hand say that there is no country in the world where Market Monetarists ideas have had such a big impact on the intellectual debate as in the UK – particularly among the UK think tanks. That makes me optimistic that UK monetary policy in the coming years will move even closer to the Market Monetarist ideal – even if Carney disappoint us all tomorrow.

HT Mike Bird

Indian superstar economists, Egyptian (not so liberal!) dictators, the Great Deceleration and Taliban banking regulation – Some more unfocused musings

While the vacation is over for the Christensen family I have decided to continue with my unfocused musings. I am not sure how much I will do of this kind of thing in the future, but it means that I will write a bit more about other things than just monetary issues. My blog will still primarily be about money, but my readers seem to be happy that I venture into other areas as well from time to time. So that is what I will do.

Two elderly Indian economists and the most interesting debate in economics today

In recent weeks an very interesting war of words has been playing out between the two giants of Indian economic thinking – Jagdish Bhagwati and Amartya Sen. While I don’t really think that they two giants have been behaving themselves in a gentlemanly fashion the debate it is nonetheless an extremely interesting and the topic the are debate – how to increase the growth potential of the Indian economy – is highly relevant not only for India but also for other Emerging Markets that seem to have entered a “Great Deceleration” (see below).

While Bhagwati has been arguing in favour of a free market model Sen seems to want a more “Scandinavian” development model for India with bigger government involvement in the economy. I think my readers know that I tend to agree with Bhagwati here and in that regard I will also remind the readers that the high level of income AND the high level of equality in Scandinavia were created during a period where all of the Scandinavian countries had rather small public sectors. In fact until the mid-1960s the role of government in Scandinavia was more limited than even in the US at the same time.

Anyway, I would recommend to anybody interested in economic development to follow the Bhagwati-Sen debate.
Nupur Acharya has a good summery of the debate so and provides some useful links. See here.

By the way this is Bhagwati’s new book – co-authored with Arvind Panagariya.

Bhagwati

The Economics of Superstar Economists

Both Bhagwati and Sen are what we call Superstar economists. Other superstar economists are people like Tyler Cowen and Paul Krugman. Often these economists are also bloggers. I could also mention Nouriel Roubini as a superstar economist.

I have been thinking about this concept for a while  and have come to the conclusion that superstar economists is the real deal and are extremely important in today’s public debate about economics. They may or may not be academics, but the important feature is that they have an extremely high public profile and are very well-paid for sharing their views on everything – even on topics they do not necessarily have much real professional insight about (yes, Krugman comes to mind).

In 1981 Sherwin Rosen wrote an extremely interesting article on the topic of The Economic of Superstars. Rosen’s thesis is that superstars – whether in sports, cultural, media or the economics profession for that matter earn a disproportional high income relative to their skills. While, economists or actors with skills just moderately below the superstar level earn significantly less than the superstars.

I think this phenomenon is increasingly important in the economics profession. That is not to say that there has not been economic superstars before – Cassel and Keynes surely were superstars of their time and so was Milton Friedman, but I doubt that they were able to make the same kind of money that Paul Krugman is today.  What do you think?

The Great Deceleration – 50% structural, 50% monetary

The front page of The Economist rarely disappoints. This week is no exception. The front page headline (on the European edition) is “The Great Deceleration” and it is about the slowdown in the BRIC economies.

I think the headline is very suiting for a trend playing out in the global economy today – the fact that many or actually most Emerging Markets economies are loosing speed – decelerating. While the signs of continued recovery in the developed economies particularly the US and Japan are clear.

The Economist rightly asks the question whether the slowdown is temporary or more permanent. The answer from The Economist is that it is a bit of both. And I agree.

There is no doubt that particularly monetary tightening in China is an extremely important factor in the continued slowdown in Emerging Markets growth – and as I have argued before China’s role as monetary superpower is rather important.

However, it is also clear that many Emerging Markets are facing structural headwinds – such as negative demographics (China, Russia and most of the rest of Central and Eastern Europe), renewed “Regime Uncertainty” (Egypt, Turkey and partly South Africa) and old well-known structural problems (for example the protectionism of India and Brazil).  Maybe it would be an idea for policy makers in Emerging Markets to read Bhagwati and Panagariya’s new book or even better Hernando de Soto’s “The Mystery of Capital – Why Capitalism Triumphs in the West and Fails Everywhere Else”

Egypt – so much for “liberal dictators”

While vacationing I wrote a bit Hayek’s concept of the “liberal dictator” and how that relates to events in Egypt (see here and here). While I certainly think that the concept a liberal dictatorship is oxymoronic to say the least I do acknowledge that there are examples in history of dictators pursuing classical liberal economic reforms – Pinochet in Chile is probably the best known example – but in general I think the idea that a man in uniform ever are going to push through liberal reforms is pretty far-fetched. That is certainly also the impression one gets by following events in Egypt. Just see this from AFP:

With tensions already running high three weeks after the military ousted president Mohamed Morsi, General Abdel Fattah al-Sisi’s call for demonstrations raises the prospect of further deadly violence.

…Sisi made his unprecedented move in a speech broadcast live on state television.

“Next Friday, all honourable Egyptians must take to the street to give me a mandate and command to end terrorism and violence,” said the general, wearing dark sunglasses as he addressed a military graduation ceremony near Alexandria.

You can judge for yourself, but I am pretty skeptical that this is going to lead to anything good – and certainly not to (classical) liberal reforms.

Just take a look at this guy – is that the picture of a reformer? I think not.

Dictator

Banking regulation and the Taliban

Vince Cable undoubtedly is one of the most outspoken and colourful ministers in the UK government. This is what he earlier this week had to say in an interview with Finance Times about Bank of England and banking regulation:

“One of the anxieties in the business community is that the so called ‘capital Taliban’ in the Bank of England are imposing restrictions which at this delicate stage of recovery actually make it more difficult for companies to operate and expand.”

While one can certainly question Mr. Cable’s wording it is hard to disagree that the aggressive tightening of capital requirements by the Bank of England is hampering UK growth. Or rather if one looks at tighter capital requirements on banks then it is effectively an tax on production of “private” money. In that sense tighter capital requirements are counteracting the effects of the quantitative easing undertaken by the BoE. Said in another way – the tight capital requirements the more quantitative easing is needed to hit the BoE’s nominal targets.

That is not to say that there are not arguments for tighter capital requirements particularly if one fears that banks that get into trouble in the future “automatically” will be bailed out by the taxpayers and the system so to speak is prone to moral hazard. Hence, higher capital requirements in that since is a “second best” to a strict no-bailout regime.

However, the tightening of capital requirements clearly is badly timed given the stile very fragile recovery in the UK economy. Therefore, I think that the Bank of England – if it wants to go ahead with tightening capital requirements – should link this the performance of the UK economy. Hence, the BoE should pre-annonce that mandatory capital and liquidity ratios for UK banks and financial institutions in general will dependent on the level of nominal GDP. So as the economy recovers capital and liquidity ratios are gradually increased and if there is a new setback in economy capital and liquidity ratios will automatically be reduced. This would put banking regulation in sync with the broader monetary policy objectives in the UK.

 

Unfocused vacation musings on money – part 1

It is vacation time for the Christensen family. We are in the Christensen vacation home in Skåne (Southern Sweden) and my blogging might reflect that.

There are really a lot of things going on the in world and I would love to write a lot about it all, but there is not enough time. But here are a few observations about recent global events from a monetary perspective.

Egyptian Regime Uncertainty

I am not getting myself into commenting too much on what is going on in Egypt other than I fundamentally is quite upbeat on the Egyptian economy, which I easily could see growth 7-8% y/y in real terms in the next 1-2 decade (with the right reforms!)

Remember the Egyptian population is going from 80 to 90 million within the next decade and the labour will be growing by more than 1% a year in the same period (as far as I remember). With the right reforms that is a major growth boost. So Egypt is a major positive long-term supply side story – short-term it is a major negative supply side story.

What we have in Egypt is of course a spike in what Robert Higgs calls Regime Uncertainty. That is a negative supply shock. The Egyptian central bank should of course allow that to feed through to higher prices – don’t fight a supply shock with monetary policy. There is a lot to say about how Egyptian monetary policy should be different, but monetary policy surely is not Egypt’s biggest problem. If you want to understand Egypt’s problem I think you should read “Why Nations Fail”.

I earlier wrote a post on the implications of recent Turkish political unrest from an AD/AS perspective. I think that post easily could be copy-pasted to understand the economics of the Egyptian crisis.

A Polish deflationary monetary policy blunder

I have followed the Polish economy closely for well over a decade and I love the country. However, recently I have got quite frustrated with particularly the Polish central bank. Yesterday the Polish central bank (NBP) cut its key policy rate by 25bp. No surprise there, but the NBP also (wrongly) said it was the last rate cut in the rate cutting cycle.

Say what? Poland is likely to have deflation before then end of the year and real GDP growth is well-below trend-growth. Not to talk about NGDP growth, which has been slowing significantly. I am not sure the NBP chief Marek Belka realises, but it did not ease money policy yesterday. It tightened monetary policy.

When a central bank tells the markets it will cut interest rates (or expand the money base) less than the markets have been expecting then it is effectively monetary tightening. That was what the NBP did yesterday – pure and simply. Now ask yourself whether that is the right medicine for an economy heading for deflation soon. To me it is a deflationary monetary policy blunder. (I will not even say what I think of the recent FX intervention to prop up the Polish zloty).

A confident Kuroda should not be complacent

This morning Bank of Japan governor Kuroda had press conference on monetary and economic developments in Japan. I didn’t read up on the details – I am on vacation after all – but it seems like Mr. Kuroda was quite confident that what he is doing is working. I agree, but I would also tell Mr. Kuroda that he at best is only half way there. Inflation expectations are still way below his 2% inflation target so his policies are not yet credible enough to declare victory yet. So let me say it again – more work on communication is needed.

Carney’s long and variable leads (I would have hoped)

Mark Carney has only been Bank of England governor since Monday, but it is tempting to say that he is already delivering results. The macroeconomic data released this week for the UK economy have all been positive surprises and it looks like a recovery is underway in the British economy. So why am I saying that Carney is already delivering results? Well because monetary policy is working with long and variable leads as Scott Sumner likes to tell us. There is a wide expectation in the markets that Carney will “try to do something” to ease UK monetary policy and that in itself is monetary easing (this is the reverse of the Polish story above).

However, my story is unfortunately a lot less rosy. The fact is that the market is not totally sure that Carney will be able to convince his colleagues on the Monetary Policy Committee to do the right thing (NGDP targeting) and judging from the markets a major change in policy is not priced in. So Carney shouldn’t really take credit for the better than expected UK numbers – at least not a lot of credit. So there is still no excuse for not doing the right thing. Get to work on an NGDP level target right now.

Summertime reading…

I hope to be able to do some reading while on vacation – at least I brought a lot of books (yes, one of them is about Karl Marx). Take a look…

Vacation books

PS It is 4th of July today. The US declaration of independence is surely something to celebrate and here in the small city of Skyrup in Skåne our neighbour always fly the Stars and Stripes on July 4th so we won’t forget. I like that.

If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

Among ‘internet Austrians’ there is an idea that there is gigantic bubble in the global bond markets and when this bubble bursts then the world will come to an end (again…).

The people who have these ideas are mostly people who never really studied any economics and who get most of their views on economics from reading more or less conspiratorial “Austrian” school websites. Just try to ask them and they will tell you they never have read any economic textbooks and most of them did not even read Austrian classics as “Human Action”. So in that sense why should we worry about these views?

And why blog about it? Well, because it is not only internet Austrians who have these ideas. Unfortunately many central bankers seem to have the same kind of views.

Just have a look at this from the the Guardian:

A key Bank of England policymaker has warned of the risks to global financial stability when “the biggest bond bubble in history” bursts.

In a wide-ranging testimony to MPs, Andy Haldane, Bank of England director of financial stability, admitted the central bank’s new financial policy committee is taking too long to force banks to hold more capital and appeared to criticise the bank’s culture under outgoing governor Sir Mervyn King.Haldane told the Treasury select committee that the bursting of the bond bubble – created by central banks forcing down bond yields by pumping electronic money into the economy – was a risk “I feel acutely right now”.

He also said banks have now put the threat of cyber attacks on the top of their the worry-list, replacing the long-running eurozone crisis.

“You can see why the financial sector would be a particularly good target for someone wanting to wreak havoc through the cyber route,” Haldane said.

But he described bond markets as the main risk to financial stability. “If I were to single out what for me would be biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally.” he said. There had been “shades of that” in recent weeks as government bond yields have edged higher amid talk that central banks, particularly the US Federal Reserve, will start to reduce its stimulus.

“Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history,” Haldane said. “We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted.”

I must admit that I am somewhat shocked by Haldane’s comments as it seems like Haldane actually thinks that monetary easing is the cause that global bond yields are low. The Bank of England later said it was not the view of the BoE, but Haldane’s “personal” views.

If Haldane ever studied Milton Friedman it did not have an lasting impact on his thinking. Milton Friedman of course told us that low bond yields is not an result of easy monetary policy, but rather a result of excessively TIGHT monetary policy. Hence, if monetary conditions are tight then inflation and growth expectations are low and as a consequence bond yields will also be low.

Hence, Milton Friedman would not be surprised that Japanese and US bond yields have risen recently on the back of monetary easing being implemented in the US and Japan.

In fact the development in global fixed income markets over the past five years is a very strong illustration that Friedman was right – and why Haldane’s fears are misguided. Just take a look at the graph below – it is 10-year US Treasury bond yields.

10y UST

(If you think you saw this graph before then you are right – you saw it here).

If Haldane is right then we should have seen bond yields decrease following the announcement of monetary easing. However, the graph shows that the opposite have happened.

Hence, the announcement of TAP and the dollar swaps lines in early 2009 was followed by an significant INCREASE in US (and global) bond yields. Similarly the pre-announcement of ‘QE2′ in August 2010 also led to an increase in bond yields.

And finally the latest sell-off in the global fixed income markets have coincided with monetary easing from the fed (the Evans rule) and the Bank of Japan (‘Abenomics’)

If you think there is a bond bubble

then blame the ECB’s rate hikes in 2011

Looking at US 10-year yields over the past five years we have had three major “down-legs”. The first down-leg followed the collapse of Lehman Brothers in October 2008. The second down-leg played out in the first half of 2010 following the hike in Federal Reserve’s discount rate in February 2010 and the People Bank of China’s increase in the reserve requirement in January 2010.

However, the biggest down-leg in US 10-year bond  yields followed the ECB’s two rate hikes of 2011 (April and July). Believe it or not, but the ECB was “able” to reduce US 10-bond yields more than the collapse of Lehman Brothers did.

Hence, if there is a ‘bubble’ in the global fixed income markets it has not been caused by monetary easing. No if anything it is a result of excessively tight monetary conditions.

In fact it is completely absurd to think that global bond yields are low as a result of central bank ‘manipulation’. Global bond yields are low because investors and households fear for the future – fears of low growth and deflationary tendencies. Global bond yields are low because monetary policy have been excessive tight.

Rejoice! Yields are rising

Unlike Andy Haldane I do not fear that day the bond ‘bubble’ (it is not a bubble!) will burst. In fact I look forward to the day US bond yields (and UK bond yields for that matter) once again are back to 5%. Because that would mean that investors and households again would believe that we are not heading for deflation and would once again believe that we could have ‘normal’ GDP growth.

And unlike Haldane I don’t believe that higher bond yields would lead to financial armageddon and I don’t believe that Japan will default if Japanese bond yield where to rise to 3 or 4%. Banks and countries do not go belly up when growth takes off. In fact the day US bond yields once again is back around 5% we can safely conclude that the Great Recession has come to an end.

Concluding, there is no ‘bond bubble’ and Andy Haldane should not have sleepless nights over it. The Bank of England did not cause UK yields to drop – or rather maybe it did, but only because monetary policy has been too tight rather than too easy.

PS I never heard any of these ‘bubble mongers’ explain why Japanese property prices and equity prices have been trending downward for nearly two decades despite interest rates being basically at zero in Japan.

PPS the graph above also shows that “Operation Twist” in 2011 failed to increase growth and inflation expectations. Any Market Monetarists would of course have told you that “Operation Twist” would fail as it did nothing to increase the money base or increase the expectation for future money base expansion.

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Related posts:

When US 30-year yields hit 5% the Great Recession will be over
Confused central banks and the need for an autopilot
Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)
Tight money = low yields – also during the Great Recession

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