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Wednesday, January 10, 2024

A Non-Forecast 2024 Outlook

Since I am not in the forecasting game, I not on top of what the consensus views are. I also no longer pay attention to others’ Year Ahead Forecasts (which tend to be produced in December and long forgotten by February — people seem to produce them solely because it’s traditional). However, I wrapped up my “central banks as banks” article sequence, and I am now going to catch up on some charts to see where we stand. For brevity, I am just looking at a handful of American charts; I could possibly do some comments on other markets later. As a spoiler, I am repeating what I have been saying for at least a year.

The chart above for me is the most important summary of the state of the U.S. dollar fixed income market. The 5-year Treasury is trading massively through the overnight rate. As I have noted before, this only makes sense if one thinks there is a good near-run recession risk. (Please note that I am agnostic on that possibility.) In the absence of a recession, I can accept a story that the Fed might be satisfied with where things stand, and might do a few tactical rate cuts to balance out potential risks. But the pricing is beyond that.

One could try selling some theory about risk premia. For some reason, within a few quarters of the worst bond market carnage since 1994, bond market investors suddenly decided that the duration risk premium should be negative. I am somewhat unconvinced, nor does it make any difference to how one should view the market.

Although it has stopped trending higher, the prime age (25-54 year old) employment-to-population ratio is still at respectable levels when compared to recent history. The employment-to-population ratio moved a lot due to structural changes in the work force, but those lost steam by the 1990 start date of the chart. By cutting out the low and high age cohorts out of the working age population, this measure is less affected by the aging population. (The working age employment ratio has been depressed by the increasing weight of retired oldsters in the 55-65 year old bracket.) It is hard to look at the above chart and say that tight labour markets are a thing of the past — the usual tendency is for tightening until derailed by a recession.

I remain of the view that if one wants to be long duration at these levels, you need to find a story about faltering investment cashiering the business cycle.

Transitory Debate, Again

The demise of Twitter as a useful source of information has been personally annoying. To the extent that any economic debates made it onto my timeline, it was mainstream economists dunking on MMT/heterodox economists for allegedly being wrong about inflation being transitory. Since I am not greatly interested in bad faith attacks on MMT, I largely skipped over those discussions to look at the cat videos.

There were two articles on this (and related) topics.

At this point, I have little idea what points are attempted to be scored on this debate. I think the only interesting bits are about the alleged mechanisms that stopped inflation — since those mechanisms are still in play.

  • One argument was that the U.S. needed a recession/rise in unemployment (that was somehow not a recession) to tame inflation. (This was not the case.) This was the Larry Summers view, until he flip-flopped to whatever he is droning on about now.

  • Another argument was that inflation would only turn around once the real Fed Funds rate was heavily positive. I have forgotten who was pushing that story, and since it was not a long form article, not easy to discuss.  (Interestingly, it did appear to be a minority opinion — which raises questions about how seriously mainstream economists take their own models.)

The lack of a recession to tame unemployment pops up in the two pieces above. Skanda also discusses the effect of interest rates. However, my main observation is the Calvinball-esque nature of neoclassicals claiming victory for the alleged effect of interest rates.

Neoclassicals are very quick to condescend to anyone who doesn’t use mathematical models in macro. But what do neoclassical models say about interest rates? They say that real interest rates matter (nominal rates less inflation).

Well, let’s look at that.

The top panel shows the evolution of the real Fed Funds rate, where I deflate by core CPI to get the “real” rate. Below that, we see the core CPI rate itself. Core CPI did a double peak in Q1 and Q3 of 2022. When we look at the real Fed Funds rate, it was still quite negative. Unless r* was zooming around like a toddler overdosed on chocolate cake, the real policy rate was still in accommodative territory. However, rather than dwell on this inconvenient fact, the standard tactic seems to be quoting the change in the nominal rate and then claiming that this means that interest rates “worked.” (I am in the camp that rapid increases in the nominal policy rate will whack the economy — but I am basing that on heterodox arguments.)

The bottom panel perhaps offers a way of wiggling out of this problem. One could argue that we should not look at the real policy rate, rather we need to look at the discounted path of real interest rates (and to be fair, that is how the models work, although this is typically ignored in discussing central bank policy). The quoted yield (“real yield” or “indexed yield”) on inflation-linked bonds is precisely that (assuming risk neutrality). The quoted yields did rise. The argument whether this was enough to “cause” inflation to drop remains unclear. It also raises the issue whether this implies that if the discounted real interest rates in early-/mid-2022 were enough to cause inflation to reverse, why will inflation not rapidly rocket to deflation since we are at similar levels? (We can then get into non-falsifiable theories about inflation expectations and/or the inflation risk premium that allows movements in these non-measurable values to explain any possible outcome.)

Going forward, this is probably the most important angle for Fed watching — if they are not sure what the “neutral rate” is, how exactly are they supposed to set the policy rate (beyond vibes)? I do not spend a whole lot of time parsing Fed statements, but I believe that Powell is somewhat frustrated with the answers he is getting to that question. But we need to look beyond his opinions and ask how the Fed personnel more broadly are looking at this (and whether it makes any sense).

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(c) Brian Romanchuk 2024

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