Posted by on July 1, 2017 9:08 pm
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Categories: Bank of Japan Business central bank Central Banks China ECB Economy ETC FED Financial economics Global Economy Inflation Inflation targeting International Monetary Fund Macroeconomics Monetary Policy money Output Gap Phillips curve Real interest rate recovery unemployment US Federal Reserve Yield Curve

It has been a trying time for the world’s central bankers, who for decades have been used to the “high finance” community’s adulation, derived from the deliverance of policy wrapped in so much opacity, gibberish and contradictions, that neither the central bankers, nor the markets, had any idea what was going on (see the Greenspan tenure), or dared to admit it was all meaningless drivel, resulting in phases during which the market was on “autopilot” and culminating with a bubble and subsequent crash, “rescued” by an even greater asset bubble and even greater crash, etc.

However, after generations of largely uncontested and unquestioned monetary policy where only the occasional “tinfoil” fringe blog dared to say that central banker emperors are not only naked and clueless but are also the cause of the world’s biggest problems, more and more voices are emerging to both challenge the prevailing monetary religious dogma, as well as daring to do something unprecedented: tell the truth.

One example was Bank of America’s chief strategist, Michael Harnett, who on Friday confirmed what we had been saying for years, that  “central banks have exacerbated inequality via Wall St inflation & Main St deflation” and that the Fed failed in its mission to make the poor richer, instead its destructive policies have made the top 1% wealthier beyond its wildest dreams, and have been directly responsible for such political outcomes as “Brexit” and “Trump.”

Then there was the WSJ, which on the front page, led with a headline that would have been anathema for “established” (i.e. sycophantic) financial journalism as recently as a few years ago:

“Are Central Bankers Twisted Geniuses Or Bumbling Ex-Academics” the WSJ blasted on its front page, with James Mackintosh writing the following:

Are central bankers twisted geniuses manipulating the markets in order to meet their inflation goals? Or are they bumbling ex-academics whose ramblings are overinterpreted by investors besotted with their brilliance?

After last week’s “communication” debacle, and as a result of the unprecedented ongoing collapse in the yield curve and plunge in inflation expectations at a time when central banks are coordinatively hawkish resulting in ever more deflationary market outcomes, increasingly more observers have become convinced that “bumbling academics” is the correct answer.

Which brings us to the latest note by Deutsche Bank’s Dominic Konstam, who dares to go so far as to stake his team’s credibility in “fighting the Fed”saying that “If we are right, then [central banks] will be wrong” and adds that “we are biased towards a view that central bankers are not as powerful as they think they are in terms of delivering to their economic ‘targets”. Structural forces are more important.”

And so, the sellside mutiny against the Fed has officially begun, nearly 9 years after we first said that the Fed’s response to the financial crisis was the biggest financial mistake in the Fed’s 100+ years of existence. Of course, DB’s phrasing is somewhat more contained – for now – but the moment has come and gone: the Fed “emperor”, in this case Yellen, has been called out for being naked and this nobody can afford to ignore it any longer.

Below we present some of the key highlights from Konstam’s latest note, “Fumbling in the Dark?” which we are confident will be copied and immitated in the coming days, and may, in retrospect, have the same impact on the prevailing religious dogma involving monetary policy as Martin Luther’s 95 theses.

There is every possibility that global central banks have a good handle on the pulse of the global economy and know what they are doing. There is also every possibility that they don’t. The key will lie in the  adjustment process for risk assets, particularly equities as well as the data. And as we demonstrate below precisely because of the manner in which risk assets have performed since 2013, investors should not be complacent.

We think the apparent shift towards a more hawkish policy stance from the likes of Draghi as well as some of the smaller central banks needs to be viewed in terms of the complexity surrounding the Fed’s own normalization process. Inflation has disappointed and curve resteepening from last summer with a rise in inflation expectations has been reversed to various degrees. The fear is that all else equal more may follow. We think this is more about talking up the outlook than having any exceptional insight into the future.

We have been arguing the Fed (but also some other central banks) have bemoaned the flattening and shifting lower of the Phillips curve but remain hopeful that it will reverse. The “explanation” partly lies in the hope that there are non linearities in the relationship and wage inflation can suddenly kick up and/ or NAIRU may be being mis-estimated and so once we find NAIRU, the Phillips curve will “recover”. Equally important is a central bank self-justification that inflation targeting reinforces the Phillips curve. As the ECB has recently argued the existence of the Phillips curve relationship makes central bank policy easier in that it allows for a closer control of inflation outcomes implying less output gap sacrifices. Inflation expectations can be rapidly brought under control, when inflation is rising too much; and on the downside, falling inflation expectations can be pre-emptively stabilized allowing for more effective monetary policy through avoiding the classic liquidity trap (real rates are allowed to fall). The  fact that the central banks have had a poor record in reaching their inflation target is therefore of great concern in that it maybe undermining the Phillips curve. Therefore emphasizing that inflation is alive and well, perhaps even threatening to raise the inflation target as the IMF has suggested is a rationale reaction to the evidence to date.

While the Fed’s grand, and hopefully final Phillips curve experiment will soon be over (spoiler alert: it will be an epic disaster), the market is far more interested by a different offshoot of Fed policy: the Fed’s support and levitation of risk assets, and what happens now that all central bankers are seemingly warning investors to take profits as equities are “overvalued.” Here is Konstam:

The Fed also continues to be wary around the solid performance of risk assets which, in part thanks to the dollar, allowed for easier monetary conditions overall (FCI). Monetary tightening is supposed to tighten financial conditions and if it doesn’t, presumably there is a case for either more tightening or something to dampen FCI with the view that otherwise imbalances might develop that could threaten the longer term growth and inflation outlook. Easier FCI therefore is a foil to being more alert to inflation risk as and when (or if and when?) the Phillips curve kicks in.

* * * 

Whether or not the Fed needs to tighten financial conditions is the key question. Someone like Dudley clearly thinks it’s a good idea and Yellen while not explicitly targeting financial conditions, implicitly may have sympathy. And very obviously in late December 2015, when the Fed started to hike, only to call a year’s time out after the China mini crisis, that was all about financial conditions tightening too much .

We think there is a perfectly reasonable equilibrium where the Fed ignores financial conditions and tolerates further positive performance in equities in particular, with the weaker dollar, that ultimately allows for a better balanced recovery via stronger productivity. This would materialize in terms of our empirical models via a higher Tobin’s Q (ratio of equity market value to replacement cost value) that raises the investment rate and real investment growth which in turn raises the capital labor ratio and therefore productivity growth. It is the richness of equities that will encourage corporates to invest rather than  buyback their own stock or even others’. The buyback machine is a natural equity response to QE in that it is an “equity QE” side effect as equities look too cheap versus rates.

From a practical standpoint, Konstam focuses, as he traditionally has, on how future economic events will impact (reflexively) the term premium, inflation breakevens and the equity – and thus the Fed’s – response, a topic which BofA expanded on last week in “The Paint May Be Drying, But The Wall Is About To Crumble”: BofA Explains What The Market Is Missing.” Here he finds something interesting: the fate of stock prices may be far more closely tied to the BOJ than the ECB, or Fed:

[our model] highlights the relative importance of BoJ purchases to Fed and ECB. For a 100 bn in annualized purchases of each, the BoJ has been associated with a 15 bps decline in term premium, almost twice the impact of either the Fed or the ECB. While the market is rightly concerned about the extent and timing of ECB taper, the BoJ is potentially much more important to the rate outlook as it was in the middle of last year.

We, for one, can’t wait for the S&P to tremble and soar with every hiccup by Kuroda. And while DB does not reach a specific conclusion, suffice to predict that the Fed is now on a wrong path, it does highlight just how schizophrenic the central bankers have become in a time when they are forced to one thing, and then its opposite in hopes of achieving the same outcome:

Deutsche also points out the schizophrenic nature of the Fed’s “reaction function” if such a thing can even be said to exist any more, and why policy error is now virtually assured:

Ironically, in other times, central banks might have been expected to talk about more accommodation not less in the face of flatter yield curves and lower inflation expectations. In talking up inflation and talking down accommodation we think they hope to achieve the same result. It is a very different script which is understandable but not necessarily proven to succeed. It falls into the same category of thought that higher rates stimulate growth not lower rates and reflects complex models around the role of forward guidance and the formation of (inflation) expectations. It is understandable also why many investors lament an impending “policy error” as a result.

It is understandable. What isn’t understandable, however, is why the S&P remains just a few points away from its all time highs now that one bank after another has started to point out that the emperor has been naked all along.

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