Aug 1, 2017 - backed securities in agency mortgage-backed securities and of ... the Fed's holding of Treasury securities has continued to increase, albeit.
PolicyWatch A Minsky Trap?1,2 By Carlos B. Cavalcanti @ ResearchGate August 2017 At the Federal Open Market Committee’s (FOMC) meeting on July 25-26, 2017, participants voted unanimously to leave their benchmark rate unchanged--a decision that was widely anticipated. The discussions shifted, therefore, to how fast to proceed with the planned reduction in the Fed’s portfolio. Officials were divided over when balance-sheet normalization should begin. Some FOMC members expressed concerns about moving too aggressively with removing recession-era support systems, while others were of the view that normalization should begin immediately. For the time being, the Committee will maintain its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgagebacked securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. As a result, the balance sheet normalization program was postponed once again, and since that meeting the Fed’s holding of Treasury securities has continued to increase, albeit slightly more slowly (Figure 1). Figure 1: U.S. Treasury Securities Held by the Fed, Oct. 2016-Aug. 2017 ($ Million) 2,466,000 2,465,500 2,465,000 2,464,500 2,464,000 2,463,500 2,463,000 2,462,500 2,462,000 2,461,500 2,461,000
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Comments are welcome. Report Number: 10.13140/RG.2.2.32049.68969.
It was indicative that the Fed acknowledged in its July policy statement that “inflation measures have declined" and are now "running below 2%,” rather than that inflation had “recently declined” and was “somewhat below 2%”, as it noted in the June policy statement. The choice of words suggests that the Fed now views low inflation as more entrenched and less transitory. The consequence is that the dollar continued on its downward slide and yields on Treasury long-term securities fell in a spontaneous reaction to the realization that easy-money policies will be around for a while (Figures 2 and 3). As this view becomes more established, the CME group lowered the chances that the Fed will raise its benchmark interest rate once again by end-2017 to 38%, down from the 54% chance wagered earlier. Figure 2: US Trade Weighted Dollar Index, January-August 2017 131.0000 129.0000 127.0000 125.0000 123.0000 121.0000 119.0000
Figure 3: Yields on 30 yr nominal securities, March-August 2017 (%) 3.3 3.2 3.1 3 2.9 2.8 2.7 2.6 2.5 3/1/2017
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Did the Fed's minor revision in its policy statement signal a collective rethink about the structural forces restraining inflation? The last Newsletter (July 2017) listed three forces stifling inflation: (i) the increase in the elasticity of the global supply curve, fundamentally altering the concept of excess supply in labor and product markets;3 (ii) the after-effects of balance-sheet recessions, which have weakened the demand side of most major economies; and (iii) the fact that central banks have limited tools to cope with the moving target of what can be called a ‘non-stationary liquidity trap.’ This Newsletter (August 2017) highlights how the consumer (CPI) and the producer (PPI) price indexes appear to be moving in sync on a downward path (Figure 4). Since the PPI is a leading indicator for price changes at the CPI-level, it is signaling sluggishness in aggregate demand.4 Figure 4: Annual Producer & Consumer Price Indexes, 2017 (%) 2.9
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Nowhere is this increase in the elasticity of supply more visible than in the crude oil market, where oil shale productions has become similar to manufacturing, rather than the usual commodity business. It has been able to spend more than its own cash flows by securing financing to raise production. 4 The only sign the PPI cannot capture is a change in imported prices. 3
The results of the second quarter real GDP growth rate ‘advanced’ estimate added to the uncertainty in understanding what is driving real GDP growth, employment and inflation. Although the headline figures for second quarter real GDP growth were higher, printing at 2.6%, growth in the first six months of the year was around the average for the last two years - 2%.5 What was notable in the ‘advance’ estimates was that net international trade continued a modest improvement from the last quarter, contributing 0.18 percentage point to the overall 2.6% expansion.6 These developments were further complemented by recent news of an uptick in export prices, which increased by almost 0.5% in July alone due to the good performance in nonagriculture exports (Figure 5). This unanticipated development raises a dilemma for the Fed because any changes in monetary policy are bound to have spillover effects on the exchange rate. Figure 5: Import & Export Price Indexes, 2015-2017 (%) 1.5 1 0.5
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Source: Bureau of Labor Statistics
Adding to the difficulties in steering monetary policy was the fact that the price index for gross domestic purchase increased by only 0.8% in the second quarter of 2017, compared to the 2.6% increase in the first quarter.7 This conundrum appears to reflect a disconnect between output, These estimates reflect the result of the annual update of the national and product account (NIPA) in conjunction with the advance estimate of the GDP for 2017. This update covers from the first quarter of 2014 through the first quarter 2017. Also, while the real GDP growth rate in the second quarter reflected the positive contribution from personal consumption expenditure (PCE), advancing at a 2.8%, compared to 1.9% gain in the first quarter, spending on home building and improvements fell in the second quarter by the most since 2010, providing headwinds for broader economic growth. 6 Although trade had been a drag on annual growth over the last three years, the turnaround suggests any headwinds from a strong U.S. dollar might be subsiding. 7 Also, it was reported that disposable personable income increased by only 3.5% in the second quarter of 2017, compared to 5.1% in the first quarter 5
unit labor costs and productivity growth.8 While output continues on a upward trend, this trend is not being matched by either the growth in labor productivity or in unit labor costs (Figure 6). These incongruent trends could reflect the fact that employers are accumulating more workers without adding enough productivity-enhancing capital. This is the so-called Minky Trap, where firms usually rely on existing cash flows to meet interest payments while rolling over other debt obligations. If cash flows improve, boosting profits, debt can be paid off, otherwise the options are to either continuing to rollover the existing debt or to liquidate some (or all) of their assets, expecting that the sale of these assets (tangible and intangible) can meet these obligations. Although firms that fall into this second scenario can, under easy money policies, survive for a while, they lock in capital and labor, and operate at lower productivity levels, holding back the rest of the economy. The recent evidence appears to support this ‘Minsky trap’ hypotheses, where labor productivity growth is lower than output growth, as firms chose to recruit more workers than invest in productivity-enhancing capital.9 Figure 6: Labor market indicators from the nonfarm business sector - 2015-2017 (% change from corresponding quarter in the previous year) 4.5 4.0
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the latest jobs report, total nonfarm payroll employment increased by 209 thousand in July, down from 231 thousand in June. This increase allowed the labor force participation rate to rise slightly to 62.9%, up from 62.8% in the previous month. 9 This concern is important because as the population ages it means that the workforce begins to stagnate and, in the absence of new immigration, shrink. Growth increasingly relies on productivity improvements, therefore.
Conclusion. The information available thus far places even more importance on the Fed’s view about inflation and its decision on when to proceed with the balance sheet normalization. Although the FOMC expects that economic conditions will evolve in a manner that will warrant gradual increases in the Federal-funds rate, it appears that it is likely to remain, for some time, below levels that are expected to prevail in the longer run. The chances this Newsletter is assigning are: September 19-20 – unlikely, December 12-13 – probable, next year – possible. The actual path of the Federal-funds rate will depend actions to normalize the Fed’s portfolio, and will be contingent on inflation picking-up again.
