A better way to think about capital flows

Summary: International capital flow analysis has suddenly become quite popular again. There are rare instances where this seems to be done well.  But for the most part, the standard take is superficial, lagging, circular, or even backwards.

In my view, the proper way to do this basically ignores the direct effect of flows on domestic asset prices. For example, don’t think of flows into mid-term Treasury bonds being a major source of downward pressure on mid-term yields.  Instead, we should focus on the impact of capital flows on exchange rates, how they feed back into domestic economic variables, and how they in turn influence asset prices. Forex rates can also be a useful signal of relative domestic demand conditions in the countries involved in the flows, which influence trade sector performance even more than exchange rates.

My perspective on this is not new or unique.  It is just an application of the standard bastard Keynesian framework plus a conviction that portfolio balance effects are not dominant, particularly in US fixed income.  The purpose of this post is mostly to remind you of that perspective, which is admittedly incomplete and imperfect, but seems to dominate the trivial approach taken by much of the media and Wall Street.

Many of you may not like this framework, which is fine. But I would encourage you, whatever your preference, not to exclude real-side implications from your analysis of capital flows. If I could get you there, then I would consider this a win.

At this stage of the cycle, the influence of capital flows – or more precisely the global macro fundamentals driving them – seems benign.  The US must accommodate the continued inflow, barring a move to capital account closure, which seems unlikely. But America’s ability to do so does not yet seem stretched.

The more pressing business cycle issue is the achievement of full employment. That is an important achievement socially, but it also means we are probably now entering late cycle, although a recession does not seem imminent.

Blame the Fed…

As you know, I think QE was mostly a harmless distraction. It delivered an interest rate signal that could have been – and ultimately was – provided through more direct means.  QE probably affected the timing but not the magnitude of the equity market rally. And it may have exerted some downward pressure on bond yields in its early applications, but even that was quite transitory.  Later applications had no apparent effect on yields even in the short run.

The dreaded unintended consequences also seem to have been mostly made up, in part by people who had an incentive to overstate the power of QE for good or evil.  Included in these people were Fed officials.  Mechanically, QE was nothing more than the Fed shortening the effective maturity of the federal debt, acting as an agent for the Treasury, which somewhat ironically was going in the opposite direction on its own behalf.

Why would shortening maturity be dangerous? When the Fed tapered, stopped buying, and then started effectively selling down duration, we saw that it wasn’t dangerous. Or perhaps more precisely, we certainly did not see that it was dangerous.

But there is perhaps one unintended consequence of QE that we are still living with.  Proponents of QE have made a strong effort to encourage belief in the so-called portfolio balance effect, which holds that bond prices and yields can be meaningfully affected by marginal manipulations of supply and demand.

There is little actual evidence that the PB effect was very strong over the QE period, during which bond yields generally fell even as the combined influence of the Fed and Treasury provided a massive net increment to the volume of duration that markets had to take down.

But the idea that supply-demand analysis matters seems to have stuck.  And it seems really to be confusing people’s interpretation of the influence of international capital flows on the US markets and economy.

…for confusing Bloomberg and ilk

A month ago, I put up a post about how China is most interesting when misinterpreted backwards. There I pointed out that this fixation with supply and demand encouraged a lot of people – about two years ago – to misinterpret financial instability in China as a likely source of upward pressure on Treasury yields, on the grounds that it would encourage further liquidation of Treasury securities by Chinese reserve managers as they tried to defend the RMB.

Yeah, China melting down financially and the dollar spiking would probably put up US yields. Nice work. Way to follow the big picture.

Yesterday, I noticed a piece on Bloomberg  making the same mistake in a broader geographical context.   There was an accompanying segment on Bloomberg TV, during which one of the interviewers asked a guest economist what Trump could do to encourage foreign holdings of Treasury securities to go back up

The question was a bit silly, because Trump has been pretty clear that he is against “currency manipulation”, which is the main source of adding to those Treasury holdings. But even away from that, why would Trump want foreign holdings of Treasuries to go up? Is that some sort of national objective?

It would be if you wrongly believed that a healthy US bond market depends on the result, which the interviewer apparently does. That piece made me think I might want to write this piece, because the issue is obviously current and because my earlier efforts at weighing in on it have not quite been to my own satisfaction.

And now I see this morning a follow-up piece on Bloomberg reiterating that same argument, as though it were super important or something. In that piece we see this gem:

… U.S. Treasuries have been finding far fewer foreign buyers in recent months — a trend that has so far been offset by higher domestic demand.

Yeah, I’m guessing that trend where every Treasury security is owned by somebody is probably going to continue indefinitely.

More seriously, just look at the price (i.e. yield). That will tell you the net effect of the relative supply and demand shifts to date. And looking forward, if you think that some hands are stronger than others, in this case, that the foreign hands are the stronger ones, then make the argument.

Link to the real economy

It is easy to pick on sensationalist journalists channeling what they just heard from a trading desk with a one-week horizon, one possibly extending backward. But IMV, there is a serious bit of economics involved here, which I will try to elaborate.  Financial flow reporting that is not directly connected to an analysis of accommodating or motivating real-economy forces is pretty much useless.

This arises from two problems.  First such reporting is backward-looking, along with the inherently ex-post data on which it is based. (All the action on the capital account is ex-ante.)

And second, it has no ability to isolate cause and effect.  To cite the China example, were they selling to defend the RMB, which was weakening in response to financial turbulence? Or had China decided to just to let the RMB appreciate because in a moment of serenity they had decided to move away from their export-driven development strategy?

Same capital flows: largely opposite implications. At the time, about two years ago, the street and media picked the wrong scenario, in part because they were unaware that they even had to make a choice. They fell for analysis of the supply and demand for paper claims, just as they did with QE.

Here is a better way to do it. It is an old story, which I will not try to prove but will just remind you of – before showing some data and drawing some implications for the future.

I could not “prove” this perspetive it if I tried, because it is just the standard, bastard Keynesian view, which is obviously not shared by everybody and is incomplete at best.  Maybe if you reject this story, you could at least be aware that you are doing so, and then give some thought to another story to replace it.

I will start by looking at this through the prism of the bond market, because that links up with “the” interest rate posited in the standard Keynesian set-up.  I will then broaden it out a bit to consider risk assets and the slope of the yield curve, in that odd order, for reasons that will I hope become obvious.  And for simplicity, I will just assume that initial displacement happens overseas, in a country or set of countries I will call “China.”

Flow is not the whole story

The trick here is to focus on the real-economy implications and causes of the capital flows and not just the flows themselves. With that in mind, let’s say – somewhat realistically — that China has “surplus” capital to export to the US.

This could reflect that China is pursuing a savings/investment/export development strategy of the sort that Michael Pettis has described in the Great Rebalancing. In that case, a portion of China’s national savings is being recycled into the US economy, via official capital flows, which put downward pressure on US bond yields, although not for the reason you may assume.

Or it could reflect that China has been trying to move away from that development strategy, but has recently run into some financial market turbulence, which encourages private capital flight out of China, which is partially offset by official sales of Treasury securities, but nevertheless also puts downward pressure on Treasury yields.

To see how this works, you don’t look at China’s official flows, which would give you just a .500 batting average. Nor do you look at just the private flows.  Nor do you look at the total flows, which by virtue of an accounting identity are not going to move much in the short run.

Instead, you look at what is going on in the Chinese financial markets and economy and then imagine how that links up with real-economy developments in the US.  I can imagine some of you thinking by here, man is this guy being obvious. Yeah, I know. Captain Obvious. Very old story. Like I say, I am just reminding you of it.

So briefly, what are the most important things going on here?  I will just list them, as I seem them, in point form:

  • The Chinese economy has “surplus” savings that one way or another are coming to the US. In the first story, these surplus savings arise out of government policy. In the second story, they reflect a failure smoothly to reorient policy, which has let to risk aversion and a desire to save in low-risk financial assets rather than to consume or fund domestic capex.
  • These surplus savings make their way into the US capital market, either as official flows or as private flows. While they are ongoing, they put upward pressure on the dollar, which reduces US exports growth and delivers a disinflationary pulse to the US economy. Both these developments imply downward pressure on US interest rates and therefore bond yields, virtually irrespective of the precise pattern of the capital flows, just so long as they are into dollars.
  • The dollar is directly causal or a direct part of the transmission mechanism, as described above. But it is also a signal. The rising dollar signals that surplus savings in China are a direct image of deficient domestic demand in China, which itself will tend to reduce US exports beyond that implied by the dollar move taken in isolation.
  • In the second story, the stronger dollar also reflects risk-off in China, which may have global contagion effects, which further reinforce the downward pressure on the fundamental or short-term-equilibrium level of interest rates and bond yields in the United States.

What I am describing here is just the IS/LM/BP framework expressed in words rather than charts. I bury this point because I don’t want to come across as an ISLMic fundamentalist. There are other ways to get at this set of results. The only point I would insist on here is that you have to look at the real-economy image of the capital flows.  If you look only at the capital flows, then you will miss the main element of the story.

And of course, the story, as I and others tell it, is symmetrical. If China were successfully to move away from an export-oriented development strategy and/or if the domestic financial market turbulence associated with that effort were to dissipate, then the simple dynamics discussed above would swing into reverse. Again, you will not see this is you obsess over the capital flows in isolation. If you focus on official flows, in particular, then you will systematically get it backwards, just like others did two years ago.

Secondary considerations

So that is the primary consideration, which I think we should focus on first, and perhaps even exclusively.  But there are a couple complications here, which I will mention, just so as not to weaken my case by overstating it.

As I have described it, the composition of those Chinese capital inflows does not matter much so long as they are into dollar assets. To a first approximation, I think that is true, but it is in fairness only to a first approximation.

If the flows were to arise in a serene economic environment, as in the first story, then their private component might more likely be into risk assets than into short-term dollar deposits. Their effect on the exchange rate and US domestic economic conditions would be as described above, and thus favor lower US bond yields.  But in the case of the inflows into dollar risk assets, there would probably be some downward pressure on US risk premia.

Conversely, if the flows were to reflect financial turbulence in China, there would not likely be downward pressure on US risk premia and there might even be some upward pressure.

It is a secondary consideration, but I would not say it is totally irrelevant.  Does this provide a case for looking at the precise distribution of capital flows? I would say it would make being able to predict the composition of the flow a useful skill. But even here, merely looking at inherently ex-post flow data probably would not tell you much useful, except as an historian. The TICS data don’t usually move the market, for example.

Roughly, the same story applies to the term structure.  If the flow of capital from China is being directed into the US bond market via official flows, then there might be a minor net add to the demand for duration in the US.  This might put slight (!) downward pressure on the term premium between say the overnight and five-year maturities. In contrast, private flows motivated by risk aversion in China, might be concentrated in slightly shorter maturities, which means that the term premium might rise slightly (and temporarily!) if these flows were to replace the official flows. But it is  secondary consideration.

So that is it for my lecture, which actually contains nothing new and probably reads a bit more conclusory than you might like.  I am just puking back at you a dumbed down (to my level) version of the bastard Keynesian story, as I understand it.

You can reject it if you want, but just be aware that you are doing so, and maybe come up with an alternative that extends beyond the largely useless errand of looking at capital flow data in isolation.screen-shot-2017-02-14-at-10-06-24-amDollar index is to Feb 10 and financial balance data are to Q3.  The macro flows evolve slowly, and are shown smoothed on the chart. So you need not think that is woefully out of date. New data come in second week of March.

And so?

But with that story in mind, what can we say about the state of the world – or China – as it bears on the US. That is pretty complicated, obviously, but let me boil it down to just a single chart, which might get your head into the county where the right ballpark is.

  • The dollar has been going higher in recent months. This strongly implies that external developments would be a source of downward pressure on US interest rates and domestic demand growth, if they were the main force at work here. There are two caveats to insist on here. First, the dollar move is itself backward looking, although the implications of the move so far, have not yet been fully felt, which I think makes the dollar move practically relevant to some extent even looking forward. Second, the dollar move reflects external as well as domestic forces. To the extent the domestic forces are relevant, we can think of the external forces as providing a partial offset, as evidenced by the dollar move.  In other words, the capital flow story has implied downward pressure on US yields, which you can know roughly without even looking at the capital flow data themselves. It is in the dollar move, roughly.
  • The US has had to accommodate surplus savings from China by running a current account deficit. In earlier periods, such as just prior to the financial crisis, this implied a very large financial deficit in the domestic private sector, because the current account was large and the US fiscal deficit was not. In recent periods, however, the current account deficit has been moderate and the private sector financial deficit has been small and non-dangerous, in part because the fiscal deficit has been high.  (Note to hair shirts: fiscal deficits can be stabilizing. *) I am skipping over a lot of detail here, which was described more fully in this post. But the bottom line, looking at the financial balances data, is that we still seem to be in a sweet spot, in the sense that the private sector financial balance is not dangerously high.  If things utterly blow up in China, then that is a separate discussion.  But America’s ability to accommodate this stuff is not yet apparently dangerously stretched.

The implication, as I see it, is that there remains room for Treasury yields to move higher, as US domestic influences dominate the external influence, which is already largely in US financial asset prices. And from a financial balances perspective, we do not yet appear to be at end-cycle for the US.  The low unemployment rate signals we are late cycle, but that is a separate discussion, and recession does not yet quite seem imminent.

Obviously, we can debate about all of that. I am not in the table pounding mood these days. But the point of this post is just to remind you that you can’t really squeeze much out of the capital flow data taken in isolation. And the way those data are described by the media and much of Wall Street is pretty much a complete waste of time and in many cases just demonstrably flat wrong or even backwards.

* In my view, a larger fiscal deficit is neither required nor a good idea in the current environment. But the fact that the deficit is now moderately large and not likely to contract is probably bullish a continuation of the economic expansion in the short to near intermediate term, i.e., out to, say, two years.

Other people’s stuff — Feb 17

Here is a list of stuff I have read and found interesting.  It goes from new to old in descending order. I am not sure yet if I will ever trim the old. Will see how this does.

Thanks to Dario Perkins, I see that Stephen Williamson of New Monetarist Economics has a new post assessing the efficacy of QE and the likely effects of the Fed’s plan to unwind it.  He makes roughly the points I have, although with greater rigor and in the context of formal models, and concludes as follows: So, in conclusion, I think Bernanke’s arguments are weak. It’s hard to make a case that QE is a big deal, or that stopping the Fed’s reinvestment policy is risky or harmful – indeed it might improve economic welfare. Further, if one thinks that QE is accommodative, and that we can measure accommodation by the average maturity of the Fed’s asset portfolio, or by the ratio of interest-bearing Fed liabilities to GDP, then withdrawal of accommodation has been underway for some time. I am not inclined to argue, obviously. I would put more emphasis on the idea that it does nothing than that it might “gum up” the financial system. But it is a pretty minor point relative to the ballyhoo that has been made over this largely benign/pointless policy effort.  As you know, I think a big part of the emphasis the Fed placed on QE had to do with being unwilling to concede that the zero bound binds. I am guessing Williamson might disagree with me on the actual role of the zero bound, but that is separate, I guess.

Paul Krugman has no problem with fake-balance centrism and its accompanying false equivalence. Here he describes the facts around Putin’s interference in the US election, Trump Administration complicity in that, and the failure of GOP members of Congress to defend the interests of their own country. He will be accused of being shrill by those whose main interest is self-regard. Whatevs. The pice is quite informative. Recently, consensus seems to have been creeping toward we the shrill. So unfair to The Man in the Low Castle.

Bless you, Barry RithholtzMy heart sank when I read the open of this article because it had the usual pointless whine about “partisan politics.” If you don’t name names or parties, then what is the point? It is like complaining about the weather or democracy or free will. But then Ritholtz names names and gets specific. He does it in a bipartisan way, but he specifically mentions who to blame for what.  In my view, it is only by holding the parties to account for specific failures, without false equivalence, that the media can exert some actual oversight. This was such a breath of fresh air compared to the lazy, self-serving above-it-all nothing we usually get from fake-balance centrists. Bravo!

Via Economist’s View, Uneasy Money has a nice piece explaining how difficult it is to identify currency manipulation with protection.  He goes over some of the economic conditions that need be in place for the mapping to be valid.  I have no quibble with the piece, and I assume he is doing the world a service by unmasking the “monetary policy entrepreneur” into whom he laces.  (That concept, I think from Krugman, is very fun.)  I would add, though, that this whole discussion is arguably beside the point from a welfare perspective. The welfare gains associated with importing low-priced stuff do not rise and fall based on the source of the low pricing.  I suspect people have forgotten about this, again (pet peeve warning) because they fall for the essence in this case, as is others.  Is Germany currency manipulating or not? Wrong question.

Talking Points Memo reports that the Tea Party is re-engaging to stiffen the spines of conservatives in Congress, particularly their Freedom Caucus within the GOP. They plan to hold a rally in support of the repeal of Obamacare.  Please do this! Please be very clear that you own it. The more specific you can be about your intentions and the quicker you carry them out, the better. Perhaps that is an odd thing to say. Shouldn’t a nice liberal want to protect his programs more than to punish his political opponents? Yeah, probably. But I am not a nice liberal, and I think the stakes are higher here than Obamacare. Get thyself uninsured! Do it now!!

Via Economist’s View, Brad Setser highlights that the prospect of a big dollar rally in response to the border adjustment tax has sparked a debate about whether that might lead to global financial instability. One source of this, for example, might be currency mismatch in EMG balance sheets. The optimists point out that the dollar makes large moves all the time. But Setser retorts that there is a difference between a mean-reversion of the dollar, which partly explains its recent move off the low, and a surge to a record new high. I am not competent to weigh in on this debate, or on what seems to be a widely accepted premise within it: that the border adjustment tax is indeed protectionist and that the protection will not actually be delivered but will be vented through the exchange markets, which will deliver up to a 25% dollar appreciation. Huge if true.

Feldstein, Halstead and Mankiw make the case for a carbon tax with revenues paid back to citizens in the form of “dividends.”  The tax increase is offset by a social credit, not a reduction of marginal tax rates. Unemployed and liberal, I love it.  Send money soon. They claim this can win support across the political spectrum, including from “populists” who want income redistribution in line with Trump’s stated objective.  I am glad they said stated.  They claim it could justify repealing the Clean Air Act outright. I wonder if the Clean Air Act regulates anything but carbon. It would be hard to argue with less and more effective regulation.

Mark Thoma claims that Trump may radically change and politicize the Fed to the point where it is not recognizable, as an independent technocracy. That seems like a big deal if true, and it strikes me as the sort of thing the American political process is not likely to focus on. By the time we do, it may be too late.  Governors add up over time.

A typically bizarro discussion of QE

Tim Duy and Jim Bullard are concerned that the Fed’s approach to balance sheet policy may prevent the yield curve from behaving somehow properly, by holding down long yields even as the Fed raises short rates.

So let me get this straight. The Fed is adding default-free rates duration to the market by not reinvesting maturing bonds at the same maturity as their existing portfolio. Janet Yellen claims this alone is worth about +15 bps on the 10-year UST yield in 2017.  And the Treasury is adding much more duration to the market by running a reasonably healthy deficit, one that seems likely to quicken.

Meanwhile, the stock of government duration held outside the Fed has seldom been higher, nominally or relative to GDP.

But a dearth of duration – i.e. QE the effect – is why bond yields are being held down. Got it. Science!

I preferred Tim’s earlier piece in which he argued the QE unwind was not a big deal because the odds were that the Fed would calibrate it correctly. I would add — and did add — that QE does not have much effect on bond yields anyway, beyond the signaling which can be managed, and the knee-jerk reactions, which are demonstrably temporary.

It is just my opinion, but as a rule I would steer away from the premise that there is truth in the Fed’s pronouncements around these subjects that has to be incorporated into our world view. Things are clearer if you just identify it as bullshit, as Tim did so wonderfully while assessing former Fed Governor Warsh’s comments. Warsh is not the only one to fib.

Fair point by Jared Bernstein

He says that the US is probably not at full employment. And he presents some decent evidence in favor of that.

I have argued that it is important for issues like fiscal and trade policy that the US is now effectively near full employment and — more to the point — that the US has escaped liquidity trap, at least for now, which is the relevant horizon in this case.

The possibility that the US is not at full employment has implications for monetary policy.  At the margin, it strengthens the case for being dovish, something I am not inclined to fight because a) I might be slightly off in my guess that we are at full employment and b) I think an overshoot of 2% inflation would be wise in the late cycle.

BUT, because the unemployment rate has fallen, the Fed is quite sensibly no longer trying to deliver as much stimulus and as quick a decline in the unemployment rate as is possible. It follows from this that policy innovations elsewhere * that lead (mainly) to a rise of aggregate demand (without having other merits) will systematically be offset by the Fed.  This is a point of simple logic and is not model dependent. The model or models driving the Fed’s behavior may be wrong, but that is a separate discussion.

Take a look at this chart from Jared Bernstein making the point that we are not quite yet at full employment. On his own premise, we are 8/9 the way to what he wants.  For the purposes of assessing the full derivative of policy innovations away from monetary policy, that is close enough, practically speaking.


* We can put this in a different way.  Bernstein wants the Fed’s objective for demand growth to be higher than the Fed occasionally  lets on and others advise for the Fed. I share Bernstein’s view on that. But once we accept that the Fed has AN objective, regardless of what it is, the fact that we are away from liquidity trap and somewhere near the objective for employment, dominates this — in terms of the full derivative implications of policy innovations away from monetary policy.  It seems to me that people have trouble with this fairly basic point. It is a rather dumb time rather dumb timing now to be dreaming up fiscal stimulus, worrying about trade drag or figuring out a way to get credit growth going. 


Yeah but



Yeah but,  if you compare Trompe’s numbers among likely voters with past presidents’ numbers among all respondents, then Trompe is worse by a narrower margin. See important discussion on Twitter from yesterday for details.

A good fake-balance centrist needs to see the nuance in all situations.  Let’s not “hype” this constitutional collapse.

I retract every mean thing I said about MMT


You may dislike the robotic and conclusory way they express themselves. You may think they try to evade the public sector budget constraint with sneaky semantics.  You may dislike how they invent a quirky unconventional definition of “saving” and then slag others for using the concept conventionally.

But they don’t do stupid shit like this. And they correctly express horror at it.

The US is Greece. Christ.


Screen Shot 2017-02-17 at 9.23.18 AM.png

So to my brothers and sisters in MMT, to everything there is a season.

To everything (turn, turn, turn)
There is a season (turn, turn, turn)
And a time to every purpose, under heaven

Bloomberg editorial on Fed ticks boxes

It goes pretty far down the usual list when making the case for the Fed to raise the funds rate at the next meeting:

  • Opens by overstating the rate of inflation.
  • Confuses “normal” and “neutral” and with what they remember rates having been on average a long time ago.
  • Uses the word “swollen” to describe the Fed’s balance sheet.
  • Concludes by fretting about a surge of inflation.

I think it could have been improved if it had thrown in that the Fed is encouraging an equity bubble and acting politically to help the GOP retain the House and Senate in 2018.  I would have worked “bloated” in there.  But from the perspective of mischaracterizing what the Fed is up to, I would have to say this editorial covers about 2/3 of the usual bases. Not too shabby!

I have no idea if the Fed goes in March. At some point soon, the Fed will want to contain growth to trend, because we are at full employment, or thereabouts, I think.  But that is separate.  In terms of regurgitating mindless bromides, Bloomberg remains on its game here.

Inflation scare 31

Federal Reserve Vice-chair Stanley Fischer tries to calm down the Bloomberg airhead here by insisting that we do not have high inflation and that we are “moving toward” 2% inflation, which is a desirable outcome.

I have learned not to take Stan Fischer at his word.  Here, for example, is a passage from his most recent speech, as channeled (favorably) by Tim Duy’s Fed Watch:

One important but underappreciated aspect of the SEP is that its projections are based on each individual’s assessment of appropriate monetary policy. Each FOMC participant writes down what he or she regards as the appropriate path for policy. They do not write down what they expect the Committee to do. Yet the public often misinterprets the interest rate paths we write down as a projection of the Committee’s policy path or a commitment to a particular path.

Really, Stan, you are going to draw a distinction between what the FOMC members write down as their best guess for rates under optimal policy and what they actually project optimal rates policy might be?  You sound like a medieval Catholic.  Maybe Talmudic scholarship and Jesuitical sophistry have a common root. *  Who knows?

What chaps my ass is that these guys come out with nonsense like this and then complain that the pubwic just wefuses to understand us. Boo frickin hoo. I want my mommy.

And then the consensus Fed watcher jumps on and says, so true. Stupid public! Can’t even understand the Fed, which is so crystal clear.

But in this case, I think Stan is onto something.  The guys at the Fed probably have roughly the same spreadsheet that economists at JP Morgan very competently run, which allows them to relate the individual price detail in the CPI and PPI reports to an estimate of the core PCE deflator for the same month. A friend at JPM tells me they have guessed to their clients 0.35%. I bet that is pretty close, so I will just pencil it in for January, in the chart below.screen-shot-2017-02-16-at-9-57-53-amI have just a couple quick points about the chart. First, the left panel is meant to show that the Fed has been chronically undershooting its objective this entire expansion, not to mention the period just before. This is true for the core, shown, and true also for the headline, although that is not shown.

The purpose of this left panel is not to imply that the Fed needs to make-up for bygones, although I am not against that personally. Their stated objective is to deliver a 2% average inflation rate over time, looking forward only. Ok, so get on it! Capping inflation at 2% at the top of the cycle would not be consistent with that objective, as I have pointed out so many times that I won’t even provide the link.

Second, boring! Macro Shitposts on Twitter calls the January price data 3.7 adjusted Brentwood Hellos from the mean. So good. Follow that man. But the firm (implied) core PCE “print” for January follows some low ones in December and especially November. So the rising trend in the 12-month trailing is pretty gentle.

Therefore, Hey Fed, don’t just do something, stand there!  Rather than screw it up by over-reacting to the still-too-shallow rise, and then find yourself back in liquidity trap, having to lie about the most exotic of remedies, just let this run a bit.

I think they will. My forecast is they don’t overreact, which is slightly different from saying they follow the path implied by futures.  That comes across in Fischer’s video with the Bloomberg airhead. On this I am willing to believe Fischer.  FWIW, I think Fed guys generally do a pretty good job, even if they way they describe what they are doing totally stretches credulity.

* The real issue here, as I see it, is that the case for providing rates guidance evaporates once the Fed escapes the logic of liquidity trap. The timing of the coming and going of formal rates guidance is perfectly consistent with that interpretation. Or perhaps I should say, that that interpretation has been tightly subjected to falsification and has survived. But the Fed is locked into providing dots because of inertia, I guess. The way they get around this is to downplay their importance, which is totally fair. But the way they do this is so bizarre and in Fischer’s case involves ridiculous sophistry.  You may want to argue the minutia with me about this. No if you really read what he is saying….  Fine, I am often wrong. But would you cut that argument that slack if it were not offered by an official at the Federal Reserve, which can ruin your day, your week, your quarter, and your year? Don’t fall for Stockholm Syndrome.

Things I wish they had taught me

When I was young, I had trouble with the intuition of statistics and econometrics. One thing that really screwed me up was the error term. That is a pretty big thing to be screwed up by. Managing it is like all of econometrics. Without the error term, all you have is accounting identities and pure theory.

My problem was I thought the world generated errors. * I was not aware that the error referred to us, not it.  You can imagine how not knowing that would have been a handicap.

Another thing that bothered me was how we calculated the standard error. Why did we have to add up the squared deviations and then take the root of that? It is not like that is a super-obvious thing to do. Right? Why not just look at the mean absolute error?  That is way more intuitive.

Within the normal distribution, the formula that describes the standard error maps directly to the share of the probability found within the standard error. In other words, the distribution is logically prior to the calculation of standard deviation or error. It is not like we start with “the” standard and then go looking for some place to apply it. It is the OPPOSITE. I wish they had told me that.


This came to mind when I saw this excellent tweet from this wonderfully snarky tweeter. He too must work with people who remain every bit as dumb as I was and perhaps still am.

How many times a week do you see guys report a 1 in 400 years event? Hell, things that are unlikely to have happened in the entire history of the universe are fairly common in the minds of innumerate Wall Street analysts.  It seems most concentrated in currencies, for some reason. Wow that move in Swissy was 14 sigma.

* Particle physics might bail me out on this, but that is no excuse.  We all know what I mean here, not about physics, but about not understanding human ignorance. Sad.


Yellen on the balance sheet


In my view, this Bloomberg piece describing Yellen’s take on the balance sheet is pretty good. The journalist seems to know his subject matter, which is rare when the subject is QE.  For example, he does say “massive balance sheet”, which is a bit sensationalist. But he does not say “massive stimulus”, which is far more important. *  Nice.

I have just one thought to add to it, which I steal from a fellow who was commenting critically on one of the several pieces I have written on QE.  He pointed out that the Fed does not want to use QE as a “marginal” tool of monetary policy.

They made great fanfare of QE on the way in, because they welcomed the stimulative effects of people assigning great significance to QE.

But on the way out, they want to be much quieter and understated, because they don’t want to risk a bigger tightening of financial conditions than the one they are trying to calibrate.

Somewhat separately, I assume for political reasons, they don’t want to start explicitly selling and then have to stop or reverse course.  It is this latter consideration, I think, that most strongly inclines them not to want to use QE as a “marginal” tool.

I think that commenter made a good point, although I am putting it to my own use here. The issue is not so much that QE is super-potent (it is not) or that removing it is dangerous, beyond a likely knee-jerk reaction that can be managed and made temporary by telegraphing ahead and then messaging on the day of the event and afterward.

Rather, to repeat,  once they start, they want to be in a position to continue.  THAT is why they want to have rates at a high enough level that they can be cut meaningfully enough to provide real stimulus before moving on the balance sheet.

My one add to the article would be to emphasize that. As I read it, the Fed’s story is not quite coherent without it.

* Also, the world “massive” occurs only in the headline, which the journalist probably did not write and may not have endorsed.



Maybe Bloomberg should stick with providing pricing, data and market wrap

This guy seems to think he has found some simple inconsistency between the Fed’s view on rates (which is that they go up, by the way) and their take on fiscal policy.

But this is very easily resolved by a recognition that the Fed has last mover advantage and believes the economy to be out of liquidity trap, at least for now, which is the relevant horizon in this case.  I have written about this issue extensively, most directly recently here.

screen-shot-2017-02-15-at-7-55-33-amThe Fed’s perspective on this, which I share, is model-dependent and could be wrong.  In some regard, it is almost certainly wrong. Moreover, the Fed often fibs. So if a journalist or economist wanted to investigate those issues, then by all means. Nobody has a monopoly on truth, especially in macro, IMV.

But to imply that this is simply a matter of self-evident logical inconsistency with probably a little hypocrisy thrown in for good measure is just wrong.  You either believe the last-mover advantage is relevant here or you don’t. You can just ignore the issue, which is absolutely central to Yellen’s view here.

Because of it, I changed  my own view on fiscal about two years ago, so for me at least, it is not about politics. * I would give Yellen the benefit of the doubt relevant there.

Separately, that is a great title for a news story on the Fed, in 2011 and 2012 and 2013 and 2014 and 2015 and 2016 and 2017….

* I make no pretense of being unbiased politically. But some things are really just technical, although controversial just the same.

Small creditors give huge endorsement of Trump, apparently

Bloomberg, as often, has the story, which is “great” if they do say so themselves.


All Treasuries are owned by somebody, so if the bigger creditors are selling, then the smaller creditors are buying. Those smaller investors must really love Trump!

Yes, I know, the net effect is measured with the price. * That is actually my point. Here is the price, expressed as yield.

10-year Treasury Yield


The yield is up (price down) a bit since the election. Before the mass marches, that was supposed to be a good thing. But with Presidente Trompe’s net approval rating now at -15, Bloomberg TV is asking, what does Trump have to do to get foreign holdings of Treasuries back up?  I guess the answer would be encourage “more currency manipulation” by foreign central banks.  But I thought we disliked that?

They have an economist on TV segment who starts off by saying very confidently four misleading things:

  • Bond yields are determined by supply and demand.
  • “Surely”, the reflation trade will require a capital reallocation away from fixed income.
  • To lock the reflation trade and reallocation in, we will need actual fiscal stimulus.
  • If the US pays more for credit, then everyone else will have to.

As I see it, the first claim is trivially true, but in context leaves the impression that you can predict Treasury yields by looking at the pattern of capital flows, which you cannot.  **  I would forgive the economist for that one, because the lawyer was leading the witness really badly there. It looks like he was just yessing her.

The second one is untrue because all securities are owned by someone.

The third is untrue by virtue of the second being untrue. If there is fiscal stimulus, then there will necessarily be an allocation toward Treasuries, because the deficit will be larger and the stock of debt will be higher than otherwise.

And fourth, bond yields in the major overseas economies will be determined by local conditions, particularly at the short and medium-term conditions. To the extent their long ends get dragged higher, that is probably pro-growth for them. In fairness to the economist, he did not imply otherwise on the latter point.

I don’t think there is much risk that I under-hate Presidente Trompe. But this need to torture asset prices until they confess he is great or — now — not so great, makes no sense to me.  What would eliminating constitutional restraint on presidential power be worth to the SPUs?  Is your guess +12% or -97%? I figure IG CDX comes in 7 bps if we round up all the muslims? That seems a bizarre way to speak of these things.

Less politically, people really need to get over their fascination with the pattern of capital flows.  The ex-ante net flow, almost irrespective of how comprised, is what matters, in my view. The patter of flows is interesting and relevant, but probably quite secondary.

Also, we need to get over looking at this capital flow stuff as generally “good” or “bad.” And not to be too overawed by accounting identities, a little logical consistency here might be nice too.  You can’t be against currency manipulation and mourn the loss of foreign holdings of USTs.

I will have more, hopefully less conclusory, stuff on this later. For now, I would rank that Bloomberg take up with misinterpreting China backwards.

* The yield has a small effect on the market value of Treasury securities, which will always be held. And the yield measures the incentive that must be given to investors secure the result.

** Some analysts can apparently get an insight into what yield change might be required by looking at ex-ante supply/demand imbalances, on the grounds that they must close ex-post. But looking at ex-post data flow is not that.