How monetary policy entrenches secular stagnation

Editor’s note: The original title of this piece was “Secular stagnation and policy rate normalization in the English-speaking G7”. But as I wrote it, I changed it to focus on ‘policy choices’. Read and you will see why.

Recent statements by monetary authorities in Canada, the United States and the United Kingdom tell us rate hikes are possible in all three countries this year. This trio of English-speaking G7 nations is at a different phase of the monetary policy cycle than Europe or Japan. The implications are unclear though.

So before I get into the actual statements, let me put a marker down on the asset implications. As a former credit guy, I am looking at this through the lens of the convergence to zero trade that I called out two and a half years ago. At that time, low nominal GDP growth meant curve flattening that favoured long-lived government bonds in the big five English-speaking countries, Australia, New Zealand, the UK, the US, and Canada. These bonds had the biggest appreciation potential from curve flattening due to low growth and falling long-term rates.

But while the yield curve is still flattening now, I think it’s more questionable whether that trade still makes sense. So far, it has done, as policy tightening hasn’t been transmitted across the curve evenly. For example, in the US, over the past year, 3-month rates have jumped 74 basis points, while 2-year rates have increased less, 59 basis points, and 10-year rates even less, 46. I have taken this as a sign of the market’s anticipating continued secular stagnation. But, I believe that weak nominal growth is a policy choice in large part, rather than a destiny. Here’s why.

We have seen weak nominal growth in Japan for decades. And my last post yesterday showed scepticism that Abenomics would break that pattern. But are we all turning Japanese? Or is what has happened in Japan in part about policy choices – on interest rates, on immigration, and on fiscal policy?

For example, where would Japan be now if it didn’t treat the deficit as a policy target which needed to be decreased before Japan reached full employment? You remember the 1997 take hike? That could have been the first critical error, which was very hard to undo. But it has been followed by more such policy flip-flops.

Now, in terms of statements, I talked about New York Fed President Bill Dudley’s desire to normalize yesterday. But Pedro da Costa’s take on Dudley is worth reading because he sees Dudley signalling that the Fed sees full employment more as a threat to inflation than an opportunity for the economy. Here’s the key passage:

“If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation,” Dudley said. “Then the risk would be that we would have to slam on the brakes and the next stop would be a recession.”

This is what is known in economic circles as ‘Phillips Curve’ thinking, based on the 1958 empirical work of economist William Phillips. Phillips observed that, empirically speaking, inflation tended to rise when employment fell. Eventually economists came to see the two as a trade-off and have been working ever since to create models to express the hypothesized trade-off relationship.

Now what Dudley was implicitly saying is that he wants to tune Fed policy in order to make sure a small cadre of people stays unemployed so that inflation doesn’t take off. That’s because he thinks that, at low levels of unemployment, inflation will rise so much that the Fed will have to react violently. And so it makes sense to prevent that from happening by raising rates sooner rather than later.

That’s a policy choice, folks. Dudley is saying lower inflation is better than higher inflation. And he is also saying in no uncertain terms that he prefers some people be unemployed because their lack of employment will weaken wage-earners’ bargaining power and keep inflation lower. It’s choices like this – when nominal growth is already low – that entrench low growth. And that’s why the yield curve is flattening.

In the UK, I warned yesterday that we should expect policy rate normalization to begin soon – given the higher levels of inflation there. The Bank of England’s Andy Haldane gave a speech today confirming this, saying:

Provided the data are still on track, I do think that beginning the process of withdrawing some of the incremental stimulus provided last August would be prudent moving into the second half of the year. As and when the MPC begins this process of normalising monetary policy, it will be a sign of the economy itself having begun to normalise.

And while he was careful to note that “none of this is to suggest that the risks of a Brexit break have disappeared”, he was still talking about rate hikes.

And in Canada, the rate hike train is approaching the station too.

The central bank’s next decision on July 12 is now a toss up, with traders assigning a 50 per cent chance of an increase. Before Governor Stephen Poloz and his top deputy Carolyn Wilkins talked openly about the prospect of raising rates, odds were close to zero for a July hike and investors hadn’t priced in a full 25 basis point increase until the end of 2018.

Conclusion: The jury is still out on whether robust economic growth is possible. Central bank officials in all three Anglo-Saxon G7 countries are talking about raising rates. But with yield curves flattening in response, markets seem to be betting against a breakout in growth to the upside.

I believe we will have an answer on growth before the year is out. Either markets will follow the central banks and yield curves will steepen on the back of growth prospects or the central banks will dial back their rhetoric about monetary tightening.

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