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- The Risks to the Inflation Outlook
- 10 Tuesday PM Reads
- Masters in Business: Jack Rivkin
- Digital Journalism and Investing on Charlie Rose
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- 10 Tuesday AM Reads
- Josh’s Citywire Berlin Presentation
- Stocks Headed Higher
| The Risks to the Inflation Outlook Posted: 19 Nov 2014 02:00 AM PST The Risks to the Inflation Outlook
Although inflation is currently low, some commentators fear that continued highly accommodative monetary policy may lead to a surge in inflation. However, projections that account for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the persistent effects of the financial crisis. The Federal Reserve responded to the recent financial crisis and the Great Recession by aggressively cutting the target for its benchmark short-term interest rate, known as the federal funds rate, to near zero. The Fed also began providing information about the probable future path of the short-term interest rate. Known as forward guidance, this policy is fintended to lead to lower long-term yields and therefore stimulate economic activity. Additionally, the Fed has purchased long-term Treasury securities and mortgage-backed securities, leading to a balance sheet that is substantially larger than before the financial crisis. Taylor (2014), among others, argues that these policies are likely to lead to substantially higher inflation. Nevertheless, the inflation rate remains below 2%, the target set by the Federal Open Market Committee (FOMC). This Economic Letter describes results from a model that explicitly accounts for the different dimensions of monetary policy to quantify the risks to the inflation forecast. This analysis suggests that inflation is expected to remain low through the end of 2016, and the uncertainty around the forecast is tilted to the downside, that is, the risk of lower inflation. In particular, the probability of low inflation by the end of 2016 is twice as high as the probability of high inflation—the opposite of historical projections. The analysis also suggests that the risk of high inflation collapsed in 2008 and has remained well below normal since. Importantly, according to the model, there is little evidence that monetary policy constitutes a major source of inflation risk. An empirical macroeconomic model Most empirical macroeconomic models account for monetary policy's effects only through the interest rate channel. This ignores other tools used by the Federal Reserve that can affect the forecast for inflation. Instead, in this study I use the model in Chen, Cúrdia, and Ferrero (2012), which allows for the effects of both interest rate changes and asset purchases. I also add the effects of monetary policy announcements about the future path of the interest rate, called forward guidance. One advantage of this setup is its ability to generate forecasts that account for the fact that the federal funds rate cannot fall below zero. With these features, the model explicitly accounts for all policy tools the Fed has used recently. This is important because it allows a proper interpretation of the risks to the forecast. For example, Cúrdia and Ferrero (2013) show that in this model asset purchases have little effect on inflation. However, they also find substantial uncertainty surrounding those effects, leaning toward projections of higher inflation. This means that asset purchases may have little role in determining the median inflation forecast projection but in principle they can increase the upside risks to inflation. My results using the same model fitted to data since the financial crisis show no evidence that asset purchases have increased the risk of high inflation. The inflation forecast Figure 1
I use data through the third quarter of 2014 to generate forecasts of four-quarter core personal consumption expenditures price inflation, referred to here as inflation, through the fourth quarter of 2016. Figure 1 shows the recent evolution of inflation and these forecasts. The dashed blue line is the median forecast in annualized percentage points. The blue shaded areas represent the 70% and 90% probability ranges of possible forecasts. The vertical grey shaded area shows the quarters for the Great Recession according to the National Bureau of Economic Research (NBER). Figure 1 shows that the median inflation forecast is not expected to return to the FOMC target of 2% until after the end of 2016. The uptick in inflation in the first half of 2014 could lead one to believe inflation is finally on the path back toward its target. However, inflation has shown similar patterns several times before and each time the uptick has never lasted very long. According to this model, we should not see inflation begin to recover more firmly until around the end of 2015. The model explains that persistent effects from the financial crisis are the main reason inflation is expected to remain low for so long. The financial crisis disrupted the credit market, leading to underinvestment and underutilization of resources in the economy. This slowed the economic recovery and pushed inflation down more than 2 percentage points, according to the model. In contrast, the model suggests monetary policy pushed inflation up by 0.8 percentage point. This is expected to fall to zero by the end of 2016. Comparatively speaking, monetary policy appears to be far from causing excessive inflation under present circumstances. Risks to the inflation outlook Figure 1 also shows that the 90% uncertainty around the forecast for the last quarter of 2016 range from less than –0.5 to over 3.8 percentage points. Another way to look at the uncertainty about the forecast is to consider the likelihood that inflation will be within 1 percentage point above or below the 2% FOMC target. This accounts for 54% of the range of probable inflation outcomes by the end of 2016 and about 50% in the long run, according to the model. Considered against the historical experience, this suggests that the level of uncertainty surrounding the forecast is not unusually large. To study the uncertainty around this forecast further, I consider two alternative scenarios: a low inflation scenario in which inflation remains below 1% through the end of 2016; and a high inflation scenario in which inflation climbs above 3% by the end of 2016. The model currently assigns nearly twice as much probability to the low inflation scenario at 30% than to the high inflation scenario at 16%. Historically, we tend to see the opposite: the high inflation scenario is typically much more likely than the low inflation one. The model assigns whether inflation will be high or low depending on the uncertainty around whether headwinds induced by the financial crisis are expected to persist. If these headwinds last longer than expected, then inflation is more likely to remain low due to continuing underutilization of resources. If instead those headwinds turn out to be easing faster than expected, then inflation will revert back to normal more quickly and possibly overshoot its intended target. The difference in inflation outcomes between the high inflation scenario and the baseline median forecast is almost exclusively accounted for by the effects associated with the financial crisis. The contribution of monetary policy to the inflation outcomes is identical in the baseline projection and the high inflation scenario. The same applies to the low inflation scenario. This means that this model finds little evidence that monetary policy is adding to the risks to the inflation outlook. The explanation for this surprising result is that the estimates for the policy rule imply that monetary policy has a strong stabilizing role. This means that departures from systematic monetary policy are expected to be temporary, and if they led to increased inflation or real activity they would trigger higher interest rates in the future, mitigating the effects of discretionary policy. Evolution of the risks over time Figure 2
To understand how the composition of risks to the inflation outlook has evolved since the beginning of the financial crisis, I compute the probability of the low and high inflation scenarios at one-year and two-year horizons at the end of different data subsamples. Figure 2 shows the evolution of those probabilities as of the end date of each subsample, shown on the horizontal axis. The top panel shows the probability of the low inflation scenario, while the lower panel shows the probability of the high inflation scenario. The thin blue lines are the probability for each scenario looking ahead one year. The thick red lines show the probability for two years ahead. The vertical grey shaded areas show the Great Recession. The top panel of the figure shows that the probability of observing inflation below 1% at the one-year horizon fell in early 2014 but came back up in the third quarter. The probability of low inflation at the two-year horizon has been substantially more stable, remaining just above 30%. This is considerably less than its peak during the recession but is still substantially above the model projection of 19% probability for the long run. The bottom panel of the figure shows that the risk of inflation being above 3%—the high inflation scenario—at the one- and two-year horizons fell substantially with the financial crisis and subsequent recession. The probability of this scenario one year ahead has never recovered and remains near 1%. On the other hand, the probability of high inflation two years ahead bottomed out at about 2% in the recession but has since recovered to the 10–13% range. This is still well below the probability of high inflation historically, which is 31%. The difference between the probabilities of high and low inflation at the one- and two-year horizons suggests that some of the factors pushing inflation projections down are transitory, because inflation projections are lower at the one-year horizon than at the two-year horizon. The fact that the one-year-ahead probability of high inflation has remained low for so long also suggests that, since the recession, the model projects a quicker return to more normal inflation levels than what is consistent with incoming data. This could mean that the risks to the inflation outlook may remain tilted to the downside longer than what this model currently projects. Overall, Figure 2 shows that the odds of inflation being outside the 1–3% range have remained relatively stable in the past three years, especially when predicting two years out. This contrasts with Bauer and Christensen (2014), who found that those odds have fallen since 2011, using data from financial contracts. Conclusion Overall, this Letter suggests that inflation is not expected to surge in the near future. According to this model, the risks to the inflation outlook remain tilted to the downside. The financial crisis disrupted the credit market, leading to lower investment and underutilization of resources in the economy, causing slower growth, which in turn put downward pressure on inflation. My analysis suggests that these effects from the crisis explain a substantial part of the outlook for inflation. Monetary policy has played a stabilizing role in the recent past, preventing inflation from falling further below its 2% target. Moreover, the analysis suggests that monetary policy is not contributing to the risk of inflation being above the median projection in the near future. The risk of high inflation in the next one to two years remains very low by historical standards. The analysis suggests that the factors keeping inflation low are expected to be transitory. However, differences between projected and realized inflation in the recent past suggest that those factors may in reality be more persistent than implied by the model. ~~~ Vasco Cúrdia is a senior economist in the Economic Research Department of the Federal Reserve Bank of San Francisco. FRBSF Economic Letter 2014-34 November 17, 2014
References Bauer, Michael D., and Jens H.E. Christensen. 2014. "Financial Market Outlook for Inflation." FRBSF Economic Letter 2014-14 (May 12). Chen, Han, Vasco Cúrdia, and Andrea Ferrero. 2012. "The Macroeconomic Effects of Large-Scale Asset Purchase Programs." The Economic Journal 122, pp. 289–315. Cúrdia, Vasco, and Andrea Ferrero. 2013. "How Stimulatory Are Large-Scale Asset Purchases?" FRBSF Economic Letter 2013-22 (August 12). Taylor, John B. 2014. "The Role of Policy in the Great Recession and the Weak Recovery." American Economic Review: Papers & Proceedings 104, pp. 61–66. |
| Posted: 18 Nov 2014 02:00 PM PST My afternoon train reads:
What are you reading?
Marijuana Very Low Toxicity |
| Masters in Business: Jack Rivkin Posted: 18 Nov 2014 09:30 AM PST In this week's "Masters in Business" podcast, I speak with Jack Rivkin, former head of research at Lehman Brothers, former chief investment officer at Neuberger Berman and now CIO at Altegris. Rivkin tells the story of joining Lehman Brothers when its equity research department was ranked dead-last in the institutional investor rankings. Within three years, he took the company from worst to first in those rankings, which include metrics such as client approval, revenue and influence. The results were so startling that Lehman Brothers became the subject of a Harvard Business School case study. The methods Rivkin used – tracking precise metrics, diverse hiring, cross promotion and offsite retreats – have become fairly standard today but were unusual for their time. For his success, Rivkin was fired by Dick Fuld, the chief executive officer. Several years later as CIO of Neuberger Berman, Rivkin was reunited with Fuld when Lehman acquired Neuberger. You can download the podcast here or on iTunes, or stream it at SoundCloud. All of our prior podcasts are available on Apple iTunes. Next week, we speak with Robert Shiller, a Yale University professor of economics and Nobel Prize laureate.
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| Digital Journalism and Investing on Charlie Rose Posted: 18 Nov 2014 08:00 AM PST On "Charlie Rose," a conversation digital journalism and its affect on financial investing. We are joined by Josh Brown, CEO of Ritholtz Asset Management; Joe Weisenthal of Bloomberg News; Felix Salmon, senior editor at Fusion; and Megan Murphy of Fast FT.
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| Posted: 18 Nov 2014 06:30 AM PST Welcome to Turnaround Tuesday, which on my calendar follows Merger Monday. And train reads:
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| Posted: 18 Nov 2014 06:30 AM PST Welcome to Turnaround Tuesday, which on my calendar follows Merger Monday. And train reads:
Continues here |
| Josh’s Citywire Berlin Presentation Posted: 18 Nov 2014 06:00 AM PST |
| Posted: 18 Nov 2014 03:00 AM PST Stocks Headed Higher
We open this commentary with a link to the October 31 policy statement of the Government Pension Investment Fund of Japan. Any serious investor who has not read it is invited to go to this link right now. Simply put, one of the G4 has made its position clear with great transparency. The Pension Fund of Japan is going to raise its allocation to stocks, both domestically and internationally. It is going to reduce its allocation to government bonds denominated in its own currency. Internally, that means selling JGBs and buying an ETF that comprises 400 stocks. Meanwhile, the Bank of Japan will maintain a policy of very low interest rates so that the reallocation does not disrupt Japanese financial markets. For Japanese investors this is very bullish. Japanese stocks are headed higher – maybe a lot higher. The recent recession news means that this policy will be in place even longer and more robustly than expected just one week ago. The other three in the G4 include the United Kingdom, where there is no interest-rate policy change (still stimulative) and where the focus of central bank policy is to acquire British pound-denominated government debt at a forecasted rate. The Bank of England will not buy stocks, nor will it acquire foreign-denominated debt. Also in the G4 is the US. Our Federal Reserve has reached the end of tapering and is engaged in a rolling replacement of maturing assets. The Fed holds only US government securities. It has shifted the maturity of its holdings over the last 6 years. Its assets are now at duration of about 5.5 years. They were near 2 years at the start of the financial crisis. If one compares total available marketable federal debt and the Fed's holdings, the conclusion is that any increase in holdings now might actually be disruptive to markets since the Fed holds so much already. We believe the Fed is done with QE unless there is some truly global calamity. Since the onset of the financial crisis, the Fed has quintupled its holdings and tripled their duration. It will take years to unwind the cumulative effects of QE1, QE2, and QE3. The Fed is now expected to take most of the coming year to refine its working programs and tools and then begin a gradual program of rate normalization. Our guesstimate of the Fed's policy interest rate one year from today is somewhere close to 0.5%, a slight increase from the present range of 0.0% to 0.25%. Even the structure of that forthcoming policy rate is still a subject of discussion. The Fed will not buy stocks. Nor will it buy foreign-denominated assets. Let's get to the last of the G4. The European Central Bank remains an enigma. It has yet to formulate a policy that is credible or understandable. It demonstrates internal division. And it looks at the economic landscape of the Eurozone and sees inflation near zero and growth elusive. The ECB cannot even find a way to buy government debt, let alone other assets. It has not resolved how to deal with the credit structures of some of its weaker banks and member countries. All we know is that the ECB says it wants to expand its holdings of assets to three trillion euros. Details remain to be seen, let alone implemented. And the policy interest rate is negative, marginally disruptive, and cannot go any lower, by the ECB's own admission. For financial markets the next year is easy to forecast. All four central banks will keep their short-term policy interest rates below 1%. Their GDP-weighted average will be below 0.5%. Their risk-free benchmark government bond rate will also remain quite low. Note that in the Eurozone the market differentiates between risk-free, as in Germany, and higher-risk, as in Greece. There is a risk hierarchy in the Eurozone. Note that the US offers the highest G4 bond rate, at less than 2.5% on 10-year risk-free debt. Also note that Japan has raised the allocation that can be used to purchase US Treasury notes. In this present global scenario, it is hard to see the US ten-year treasury yield much higher. It is also hard to see other US dollar-denominated high-grade bond interest rates rising a lot under this scenario, even if the US economy gains some strength. Corporate borrowers are really flush with cash. And also note that the amount of cash they hold outside the US in foreign subsidiaries of US corporations ($2.1 trillion) now exceeds their internal US dollar holdings of cash ($1.9 trillion). (Hat tip to Capitol Economics.) Were Congress to pass repatriation tax relief as it did in 2004, the amount of transfer into the US would be huge. Capitol Economics notes that the 2004 legislation resulted in about 3% of GDP being repatriated in that one-year window and that most of it was used "to fund dividend payouts and share buybacks rather than boost investments." The latest estimate is that a repatriation tax relief bill would have four times the impact today than it did in 2004. Imagine the cash flow into an infrastructure-rebuilding program for America if Congress were to allow it through repatriation tax relief funding. But hope is not a strategy, and politicians maintain their despicable reputations for reasons that the rest of us understand only too well. They would rather fight for years over a pipeline than rebuild all the roads, bridges, schools, etc. in our country. So let's summarize. One of the G4 is acting bullishly for US stocks and for US bonds as well as bullishly for its own markets. Another is trying to figure out how to be more stimulative. A third is maintaining its stimulative policy at a predictable pace. And the fourth is at neutral. We maintain our bullish stance on equities. We are using a $130 earnings estimate for the S&P 500 Index in 2015. That is the center point of a range of 123 to 137. We may be a little high at $130 but not by very much if the US economy continues its gradual, low inflation growth track. Our end of decade target for the S&P 500 Index is a range between 2600 and 3000. Several years ago we projected that the S&P would reach 2000. That is becoming an ancient milestone. Cumberland remains fully invested in our US ETF strategy. Our other ETF strategies (we have four of them) are nearly fully invested. We use each of these four strategies in separate account management only. Our bond strategies keep some hedges in place or are using a barbell. Why? We expect that the very low interest-rate period is coming to an end over the next year or two. We do not know when, nor is it easy to forecast that timing. ~~~ David R. Kotok, Chairman and Chief Investment Officer |
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