Absolute Return letter for the month of October 2016, titled, “The New Normal, Mk. II.”
- Q3 2016 hedge fund letters
- Q2 2016 hedge fund letters
- Q1 2016 hedge fund letters
“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.” — Ronald Reagan
I spent much of August in Texas. An extraordinary bunch of people, those Texans. Exceptionally friendly and much less reserved than the sorts of people you typically run into in London or New York – and I have to give them some credit; they must be made of something quite special. How else do you work outside in 42 degree temperatures (107 Fahrenheit) as I saw quite a few do? Simply too much for a pale Northern European. No wonder Texans have a love affair with air conditioning.
[drizzle]I was also reminded of the fact that the Olympics are much more fun to watch when you don’t have to set the alarm for 3 o’clock in the morning, but, most importantly, I learned that life can still be quite enjoyable, even if you miss an important statement from the Fed.
On the 15th August, John Williams, President of the San Francisco Federal Reserve Bank, rattled the world of Fed watchers when he stated that:
“Central banks and governments around the world must be able to adapt policy to changing economic circumstances. The time has come to critically reassess prevailing policy frameworks.”1
In the conservative world of central bankers, this was at least a seven on the Richter scale, and I could possibly only have missed it because I was intoxicated by the extraordinary success of the British and Danish athletes in Rio. Shame on me.
Ever since the brutal war against inflation, fought first and foremost by Paul Volker in the late 1970s and early 1980s when he was Chairman of the Federal Reserve Bank, central bankers have emphasised inflation targeting when conducting monetary policy, and 2% has become the widely accepted target – at least in most developed countries. John Williams is now questioning whether we have come to the end of the road as far as that policy is concerned.
What did John Williams actually say?
In the opinion of John Williams, central banks should consider changing the practice of 2% inflation targeting, as the New Normal continues to change the economic landscape in front of us.
Central bankers work with something they call natural (aka neutral) interest rates. It is when prevailing interest rates are neither accommodative nor contractionary. In other words, the overall economy is in perfect balance. Let’s call that level of interest rates r*.
The challenge facing central bankers today, according to John Williams, is that r* is extraordinarily low, and he argues that if we are ever to move on from the New Normal and the mess left behind by the Global Financial Crisis, we need to find ways to raise r*.
One implication of a low r* is that monetary policy loses much of its potency. In particular, when the economy is weak and needs a boost from lower policy rates, there is only so much central banks can do, because there is a limit to how low interest rates can go.
In his paper, John Williams actually provides estimates on r* for the US, Canada, the UK and the Eurozone (chart 1) and, as you can see, it has been declining steadily for the past 35 years, but the decline has gained momentum since 2000.
New Normal
Furthermore, he argues that it is a mistake to assume that central bank policy has always been the same, and that it should always be the same. When circumstances change, central bank policy should change accordingly, he says.
At this point, I should probably point out that his paper has not been universally endorsed by other central bankers. Bill Dudley and Stanley Fisher have both made less than enthusiastic comments, and Janet Yellen wasn’t exactly complimentary either when commenting on John Williams’ thoughts in Jackson Hole, so it is far from certain that his ideas will be implemented.
According to John Williams, the main culprits behind the low and falling r* are the usual suspects – adverse demographics, slowing productivity growth and the global savings glut. Hence it is no surprise that he suggests a much more active and counter-cyclical use of fiscal policy going forward, but his suggestion as to how monetary policy could be changed to raise r* is what caught my attention.
So what monetary policy changes did he suggest? In fact, he suggested two possible options:
- Raise the inflation target to 4%, which would almost certainly drive interest rates up, making monetary policy more effective along the way; or
- Drop inflation targeting altogether, and replace it with a nominal GDP target. The biggest advantage of such a change is probably the built-in protection against debt deflation.
Both would imply such a radical change to the modus operandi of the entire central banking system that they deserve more than just a passing comment.
Why John Williams could possibly be wrong
The New Normal, the secular stagnation, or whatever you prefer to call the post-crisis environment of low economic growth, low inflation and exceeding low – even negative – interest rates, is no longer a peripheral economic concept. After years of firing on only four or five of its eight cylinders, the global economy is in danger of falling into the trap of persistently low economic growth, which is increasingly recognised by investors.
One very simple way to measure the extraordinary level of pessimism, as far as economic growth is concerned, is to look at yield curves across the world. If investors weren’t so downbeat, those yield curves would be a lot steeper than they are at present, so there is absolutely no question; investors are very glum when looking into the future.
Is it possible that we are all wrong, though? Could GDP growth in fact be higher than we all think it is? In order to answer that question, I need to re-visit a very basic economic identity, which I have used many times before:
Let’s divide the economy into the Old Economy and the New Economy. The Old Economy is everything our parents used to do – in other words, how the economy used to work prior to the digital age. The New Economy is all the stuff made possible by the internet and digitalisation – e-commerce, digital currencies, smartphones, 3D printing, etc., and the argument put forward by a growing number of researchers is that the true growth rate of the economy is understated because much of the growth in the New Economy is not captured by the way we calculate GDP.
The argument goes as follows: The guidelines provided by the OECD (which are used by most countries) re the price-deflators used when calculating GDP growth in industries where output needs to be quality-adjusted every year, are not far-reaching enough. Take the communications and information industry, where quality has certainly improved in recent years, whereas prices have fallen steeply (chart 2).
The statisticians in charge of calculating GDP will then apply a price-deflator, which is supposed to the make the necessary quality adjustment. So far, so good, but many online products (such as Google Maps and Facebook) are given away for free nowadays, the value of which is not at all included when calculating GDP.
All this has led to a rather fierce debate amongst researchers. Do we actually calculate GDP correctly? Let’s look at a recent research paper from UK-based Redburn, which concludes precisely what I suspect, i.e. that actual GDP growth is underestimated. Redburn uses Vodafone – a global leader in the provision of mobile phone services – as an example. Not surprisingly, Vodafone’s average revenues per user have fallen like a stone more recently. That said, data usage has done exactly the opposite, growing by approximately 35% year-on-year in recent quarters (chart 3).
Using a very traditional approach to calculating Vodafone’s contribution to GDP growth, you would multiply revenues and volume (i.e. data usage), and you would find that falling prices have largely offset the increase in usage – and that is even after the Office for National Statistics have applied their OECD ‘approved’ price-deflator. In other words – Vodafone hasn’t added much to economic growth in recent years, or so the numbers would suggest.
Now, I suggest you try to explain to your teenage daughter or your swanky brother-in-law that mobile phone services today do not offer much better value than they did a handful of years ago. Why else would millions of people walk around every day glued to their mobile phone?
See the full PDF below.
[/drizzle]
