The Federal Reserve’s search for stability

April 11, 2014

Stability is a fleeting concept at my house. Three children, two working parents and a set of interesting relatives make chaos our normal state. But over the years, we’ve gotten used to the volatility and have stopped pining for calmer times.

By contrast, the Federal Reserve has projected itself as a source of stability since its founding. From its Corinthian columns to its Discount Window, the organization aims to promote "the impression of dignity and strength, in harmony with the power and purpose of the institution."

The Fed may have to work a little harder in the coming months to maintain stability inside and outside of its walls. Last week, Governor Jeremy Stein announced his intention to leave the Fed Board in May. The departure is significant for a couple of reasons.

First, Stein has contributed importantly to thinking about how central banks can sustain financial stability while pursuing their formal mandates. Substantial amounts of reserves have been introduced into the financial system since 2009, but asset prices could become inflated as the funds look for a home. By keeping interest rates at very low levels, central banks aim to promote more risk-taking … just not too much.

Armies of analysts in the official sector are scanning the horizon for signs of trouble. To date, no major markets seem to be out of hand, although the pricing of risk has become thinner and thinner. In the U.S. high-yield bond market, for example, spreads are well down, and issuance has boomed.

Prior to the financial crisis, central banks kept a studied distance from asset bubbles, finding them difficult to diagnose and remote from “the real economy.” That thinking has clearly changed. Former Fed Chair Ben Bernanke proposed the use of macro-prudential tools like bank supervision and regulation to lean against financial excess. This week’s announcement of higher capital requirements for large U.S. banks is a step in this direction.

This sounds promising in theory, but the track record of supervisors in identifying trouble spots and cleaning them up is mixed at best. Responsibility for this mission in the United States is now vested in the Financial Stability Oversight Council, a group with 10 members that does not appear overly nimble. And tougher rules can create unintended consequences. Higher capital requirements, for example, are sure to drive more activity into less-regulated areas of the financial system.

In light of all this, Stein suggested that traditional monetary policy might be more effective at heading off financial excess. Such a strategy, he observed, “gets in all the cracks” to curb risk appetites wherever they might be offside. The downside is that using a blunt instrument like interest rates could quash desirable as well as undesirable activity and hamper progress toward inflation and employment goals. However the debate is ultimately resolved, Stein did a very good job of raising the key issues, and the Fed will certainly miss his intellect.

Second, Stein’s transition back to academe could leave the Fed with just three sitting governors out of the seven that should be in place. The candidacies of Stanley Fisher and Lael Brainard have passed to the full Senate, but no date has yet been set for a confirmation vote. Congress has been extraordinarily slow to act on presidential appointments over the past decade, and with many members deeply engaged in the midterm election process, analysts do not see an impending increase in urgency.

Operating at full capacity has been very much the exception and not the rule recently for the Fed. Running short-handed is a burden; serving on the Board involves much more than voting on monetary policy every six weeks. There is a business to run, consultations to undertake and research to conduct. Further, some official matters require the assent of five governors, which in recent times has often meant unanimity.

To promote full employment on the Board of Governors, policy-makers should have a fresh look at the recruitment process and compensation for members. While stated terms are 14 years, actual service averages well under half that. Prospective governors should be asked to commit for somewhat longer than the two years Stein will serve. The confirmation process itself discourages candidates, who can find themselves in limbo for long periods before finally taking their seats.

Embarrassingly, the Fed chair earns just over $200,000 yearly, a paltry sum when compared to the earnings of peers in other countries with much smaller levels of gross domestic product (GDP). Others around the Board table earn $181,500, a fraction of what they might command in the private sector.

With the aid of a very capable staff, Janet Yellen, Jerome Powell and Daniel Tarullo may have to soldier on as best they can. They’ll hope that nothing comes before them that requires five votes and that reinforcements arrive soon. And they’ll pray that chaos takes a couple of months off.

Some Thoughts on World Trade

Significant growth in world trade over the past three decades has done much to shape the contours of the global economy. The future trend of world trade likely will be driven by a different set of forces compared with those that underpinned trade flows during this 30-year period.

The financial crisis after the collapse of Lehman Brothers in 2008 led to a collapse of world trade, followed by modest recovery.

Growth in trade may struggle to return to the double-digit level often seen in the last 20 years. The International Monetary Fund projects world economic growth of 3.8% in the next five years – an entire percentage point lower than the 4.8% pace recorded during the five years ended 2007. Slower demand for imports translates directly into slower growth of trade.

Further, nations are likely to focus on protecting domestic industry and employment in an environment of decelerating growth, and inertia in trade negotiations would not be surprising. Analysis of the data published by Global Trade Alert indicates that protectionist measures imposed by the Group of 20 have risen in the last five years. (See our March 14 weekly commentary for details on trade negotiations.)

Looking at exports from a country-specific perspective, the Chinese economic model is undergoing a transformation, with less focus on exports and more on domestic consumption. A young labor force and a low-wage environment propelled the country to grab the largest share of world exports. Higher wages and the aging of China’s population will reduce its comparative advantage in the years ahead. China’s share of total exports could establish a plateau soon.

In the longer term, China will need a new source of advantage to retain its current edge in exports. It faces a great deal of competition: India, the Middle East and Sub-Saharan Africa are labor-rich and have the potential to take market share going forward. The ability of these countries to educate their young labor forces to enable production of sophisticated goods and services will guide their places in the global economy.

Demographics may change the relative positions of exporters and importers over time. Industrialized economies will confront the challenge of aging populations, particularly in Japan and Europe. Technology and immigration are potential sources for rejuvenating growth in these economies. From this perspective, the United States should fare better than others. It is the favored destination of workers from around the world and attracts scores seeking higher education. Furthermore, the U.S economy is the breeding ground for entrepreneurship, another source of comparative advantage.

The combination of cyclical and secular shifts has always driven trade patterns and will do so to a great degree in the future. As these shifts take place, economies that innovate more and are more balanced between domestic and foreign consumption will fare best. All of this suggests that if China cannot develop a consumer class, it may not be able to sustain its recent growth rates.

Greece Goes Back to Market

In ancient times, Greek city-states had central gathering places called agoras. There, people would meet, debate events of the day and transact with one another.

Today, what used to go on in the agoras happens in online blogs and electronic portals. But whatever the medium, the government of Greece made quite a splash in the modern financial agora this week by issuing its first new batch of public debt since its bailout in 2010. This represents a significant milestone, but it raises as many questions as it answers.

To be sure, Greece has made tremendous progress in getting its national budget under better control. Overall, the annual deficit as a percent of GDP is about one-fifth the size it was four years ago. Excluding interest costs, Greece actually finds itself with a “primary” surplus. This has come at a tremendous economic cost: real GDP has fallen by almost 20% since 2009.

Private-sector creditors were the subject of a significant restructuring in 2012, with many losing three-quarters of their principal. One would think that very recent memory would lead investors to swear off Greek debt for a very long time.

Yet this week’s offering was more than six times oversubscribed. The yield on the 5-year issue was less than 5%. This led some to trumpet the success of austerity and the prospect of much better times ahead for the Greeks.

It’s tempting to embrace these conclusions, but they may be premature. Sovereign debt issues from all over Europe have been very popular in recent months, thanks partly to capital flows from emerging markets. Those monies could certainly return to emerging markets in time. Very low inflation across Europe has also enhanced the attraction of fixed-income assets there, but the European Central Bank hopes to reverse that trend soon.

And Greece still has hard fiscal work to do; its debt remains at about 175% of GDP, which is likely not sustainable. Access to debt markets is better than the alternative, but debt reductions are more what the country should pursue.

So a cynic could certainly wonder: “What were investors thinking?” Is this an example of hubris or a paean to fiscal discipline? Only an oracle can answer these questions.

© Northern Trust.

© Northern Trust

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