Tag: Federal Reserve

What Are the Economic Impacts of Climate Change?

Strategically, the economic risks relating to the changing climate are one of the most significant challenges we face. But what are the potential long term impacts likely to be? In this Federal Reserve of St. Louis, on the economy blog,  this important subject is explored.

We think there is a need for similar modelling to be done in Australia, as many of the most populated areas are most likely to be impacted.

How might climate change impact the economy over the long term? Some potential impacts include increased mortality, higher demand for electricity and reduced yields for certain crops.

At a recent Dialogue with the Fed presentation, William Emmons, lead economist with the St. Louis Fed’s Center for Household Financial Stability, highlighted research1 that identified geographic “winners and losers” on a county-by-county level across the United States.

Looking out to the year 2090, the findings showed that the St. Louis region could expect a significant impact on its economic activity, Emmons said.

“And if you zoom in and look at our region, [the researchers’] estimates are that we could lose the economic equivalent of 5 to 10 percent of GDP as a result of these effects,” he said, noting that impacts would be gradual.

Interest Rates Are On Their Way Up

Three quick charts which highlight the upward pressure on rates globally. First the T10 US Bond.

Next the average 30-Year US Fixed Mortgage Rate. Again, going higher.

And third, the LIBOR inter-bank rate – a key benchmark which drives interbank funding costs and derivatives pricing.

Marketwatch said:

The London interbank offered rate, known by the acronym Libor, is back on investors’ radar.

Libor reflects what banks charge to borrow dollars from each other and is used as a benchmark for trillions of dollars worth of loans. The rise is nothing like the panic mode of 2008, when soaring Libor reflected a reluctance by banks to lend to each other, reflecting stress in the system and fueled fears of an existential threat to the global banking system.

But the increase is seen tightening financial conditions. Also on the radar is the sharp widening of the spread between Libor and the overnight index swap rate as three-month Libor moved above 2% for the first time since 2008.

“What this means is that rates on more than $350 trillion of debt and derivatives contracts hitched to the U.S. benchmark are on the rise,” said David Rosenberg, chief economist and strategist at Gluskin Sheff, in a Monday note.

“Overleveraged entities will be in for a spot of trouble. We have a situation where half of the investment-grade bond market in the USA is BBB,” he wrote. BBB is the second-lowest investment grade rating by S&P Global Ratings and Fitch Ratings.

In 2016, Libor rose in response to money-market reforms.

The catalyst for the more recent rise, and widening of the Libor-OIS spread, is placed by economists and analysts partly on the U.S. tax legislation signed into law in December. The repatriation of cash held overseas has led to U.S. firms pulling money out of foreign dollar funds, analysts said.

In addition to the suspected return of overseas cash, the financial system is also adjusting to a world of less Federal Reserve-provided liquidity as the central bank unwinds its balance sheet, wrote George Goncalves, head of fixed-income strategy at Nomura, in a late February note.

Meanwhile, analysts will be watching the Libor-OIS spread with the idea that a stubborn widening—and the resulting tightening of financial conditions—could affect the pace of Federal Reserve tightening in the year ahead. Rising Libor in 2016 served to tighten financial conditions, analysts said.

These rising rates spell trouble ahead in an over-leveraged world, and once again underscores that the risks are rising, and that the RBA may have to lift sooner than some expect.You can watch my recent video blog where I discuss these three charts.

The Baby Boom and the U.S. Productivity Slowdown

From The St. Louis Fed On The Economy Blog.

The U.S. economy is currently experiencing a prolonged productivity slowdown, comparable to another slowdown during in the 1970s.

Economists have debated the causes for these slowdowns: The reasons range from the 1970s oil price shock to the 2007-08 financial crisis.

But did the baby boom generation partly cause both periods of slowing productivity growth?

A Demographic Shift

Guillaume Vandenbroucke, an economist at the St. Louis Fed, explored the role of the baby boom generation—specifically, those born in the period of 1946 to 1957 when the birth rate increased by 20 percent—in these slowdowns.

In a recent article in the Regional Economist, he pointed out a demographic shift: Many baby boomers began entering the labor market as young, inexperienced workers during the 1970s, and now they’ve begun retiring after becoming skilled, experienced workers.

“This hypothesis is not to say that the baby boom was entirely responsible for these two episodes of low productivity growth,” the author wrote. “Rather, it is to point out the mechanism through which the baby boom contributed to both.”

Productivity 101

One measure of productivity is labor productivity, which can be measured as gross domestic product (GDP) per worker. By this measure, the growth of labor productivity was low in the 1970s. Between 1980 and 2000, this growth accelerated, but then has slowed since 2000.

“It is interesting to note that the current state of low labor productivity growth is comparable to that of the 1970s and that it results from a decline that started before the 2007 recession,” Vandenbroucke wrote.

How does a worker’s age affect an individual’s productivity? According to economic theory, young workers have relatively low human capital; as they grow older, they accumulate human capital, Vandenbroucke wrote.

“Human capital is what makes a worker productive: The more human capital, the more output a worker produces in a day’s work,” the author wrote.

The Demographic Link

Vandenbroucke gave an example of how this simple idea could affect overall productivity. His example looked at a world in which there are only young and old workers. Each young worker produces one unit of a good, while the older worker—who has more human capital—can produce two goods. If there were 50 young workers and 50 old workers in this simple economy, the total number of goods produced would be by 150, which gives labor productivity of 1.5 goods per worker.

Now, suppose the demographics changed, with this economy having 75 young workers and 25 old workers. Overall output would be only 125 goods. Therefore, labor productivity would be 1.25.

“Thus, the increased proportion of young workers reduces labor productivity as we measure it via output per worker,” he wrote. “The mechanism just described is exactly how the baby boom may have affected the growth rate of U.S. labor productivity.”

The Link between Boomers and Productivity Growth

Vandenbroucke then compared the growth rate of GDP per worker (labor productivity) with the share of the population 23 to 33 years old, which he used as a proxy for young workers.

This measure of young workers began steadily increasing in the late 1960s before peaking circa 1980, which represented the time when baby boomers entered the labor force.

Looking at these variables from 1955 to 2014, he found the two lines move mostly in opposite directions (the share of young people growing as labor productivity growth declined) except in the 2000s.

(To see these trends, see the Regional Economist article, “Boomers Have Played a Role in Changes in Productivity.”)

“The correlation between the two lines is, indeed, –37 percent,” Vandenbroucke wrote.1

The share of the population who were 23 to 33 years old began to increase in the late 2000s, which can be viewed as the result of baby boomers retiring and making the working-age population younger.

“This trend is noticeably less pronounced, however, during the 2000s than it was during the 1970s,” the author wrote. “Thus, the mechanism discussed here is likely to be a stronger contributor to the 1970s slowdown than to the current one.”

Conclusion

If this theory is correct, it may be that the productivity of individual workers did not change at all during the 1970s, but that the change in the composition of the workforce caused the productivity slowdown, he wrote.

“In a way, therefore, there is nothing to be fixed via government programs,” Vandenbroucke wrote. “Productivity slows down because of the changing composition of the labor force, and that results from births that took place at least 20 years before.”

Notes and References

1 A correlation of 100 percent means a perfect positive relationship, zero percent means no relationship and -100 percent means a perfect negative relationship.

Why Are Banks Shuttering Branches?

From The St. Louis Fed On The Economy Blog

On Feb. 6, the Wall Street Journal published a startling statistic: Between June 2016 and June 2017, more than 1,700 U.S. bank branches were closed, the largest 12-month decline on record.1

Structural Shift

That large drop, while surprising, is part of a trend in net branch closures that began in 2009. It follows a profound structural shift in the number and size of independent U.S. banking headquarters, or charters, over the past three decades.

In 1980, nearly 20,000 commercial banks and thrifts with more than 42,000 branches were operating in the nation. Since then, the number of bank and thrift headquarters has steadily declined.

The reasons for the decline in charters and branches are varied. Regarding charters, the passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act in 1994 played a significant role in their decline. Banks operating in more than one state took advantage of the opportunity to consolidate individual state charters into one entity and convert the remaining banks into branches. Almost all states opted in to a provision in the law permitting interstate branching, which led to a steady increase in branches.

Trend Reversal

Even before the number of charters declined, however, the number of branches grew steadily throughout the 1980s, 1990s and early 2000s. It peaked in 2009, when the trend reversed, as seen in the figure below.

Since 2009, the number of commercial bank and thrift branches has shrunk nearly 10 percent, or just over 1 percent per year.

The initial wave of closings can be attributed to a wave of mergers and failed bank acquisitions following the financial crisis. There was an immediate opportunity to reduce cost through the shuttering of inefficient office locations. Branch closings were also influenced by earnings pressure from low interest rates and rising regulatory costs.

More recently, changing consumer preferences and improvements in financial technology have further spurred the reduction in branches. Customers increasingly use ATMs, online banking and mobile apps to conduct routine banking business, meaning banks can close less profitable branches without sacrificing market share.

Uneven Changes

The reduction in offices has not been uniform. According to the Federal Deposit Insurance Corp., less than one-fifth of banks reported a net decline in offices between 2012 and 2017, and slightly more than one-fifth reported an increase in offices.

Just 15 percent of community banks reported branch office closures between 2012 and 2017. And though closures outnumber them, new branches continue to be opened. It’s also important to note that deposits continue to grow—especially at community banks—even as the number of institutions and branches decline.

The Industry of the Future

It seems inevitable that this long-term trend in branch closings will continue as consumer preferences evolve and financial technology becomes further ingrained in credit and payment services.

Although it is unlikely that the U.S. will end up resembling other countries with relatively few bank charters, it seems certain that consumers and businesses will increasingly access services with technology, no matter the size or location of bank offices. This change creates opportunities as well as operational risks that will need to be managed by banks and regulators alike.

US Debt Will Grow, But It’s Mostly Government Borrowing

Moody’s says a possible $975 billion increase in U.S. government debt for fiscal 2018 would leave Q3-2018’s outstanding federal debt up by 5.9% annually. As of Q3-2017, federal debt outstanding grew by $597
billion, or 3.8%, from a year earlier.

Into the indefinite future, federal debt is likely to materially outrun each of the other broad components of U.S. nonfinancial-sector debt. Because of non-federal debt’s relatively slow growth, the private and public debt of the U.S.’ nonfinancial sectors may grow no faster than 4.3% annually during the year ended Q3-2018 to a record $50.77 trillion. For the year-ended Q3-2017, this most comprehensive estimate of U.S. nonfinancial-sector debt rose by 3.8% to $48.64 trillion.

Though expectations of faster growth for total nonfinancial-sector debt complements forecasts of higher short- and long-term interest rates for 2018, the quickening of total nonfinancial-sector debt growth may not be enough to sustain the 10-year Treasury yield above the 2.85% average that the Blue Chip consensus recently predicted for 2018.

The projected growth of nonfinancial-sector debt looks manageable from a historical perspective. For one thing, 2018’s projected percent increase by debt lags far behind the 9.1% average annual advance by U.S. nonfinancial sector debt from the five-years-ended 2007. Back then, unsustainably rapid growth for total nonfinancial-sector debt and 2003-2007’s 2.1% annualized rate of core PCE price index inflation supplied a 4.4% average for the 10-year Treasury yield of the five-years-ended 2007. By contrast, the 10-year Treasury yield’s moving five-year average sagged to 2.2% during the span-ended September 2017 as the accompanying five-year average annualized growth rates descended to 4.4% for nonfinancial-sector debt and 1.5% for core PCE price index inflation.

Westpac Says The Fed May Lift Rates Faster And Higher Than Markets Currently Expect

From Business Insider.

Now here’s an interesting paragraph from the minutes of the US Federal Reserve’s January FOMC meeting released on Wednesday.

Many participants noted that financial conditions had eased significantly over the intermeeting period; these participants generally viewed the economic effects of the decline in the dollar and the rise in equity prices as more than offsetting the effects of the increase in nominal Treasury yields.

So we know the question you’re asking — what are “financial conditions” and why is this interesting?

According to the St Louis Fed, financial conditions indices “summarise different financial indicators and, because they measure financial stress, can serve as a barometer of the health of financial markets”.

Using short and long-term bond yields, credit spreads, the value of the US dollar and stock market valuations, it attempts to measure the degree of stress in financial markets.

What the minutes conveyed in January was despite a lift in longer-dated bond yields, strength in stocks and decline in the US dollar suggest that financial conditions still improved.

So why is that important?

According to Elliot Clarke, economist at Westpac, it suggests the Fed may need to hike rates more aggressively than markets currently anticipate.

“That financial conditions have eased at a time when the FOMC is tightening policy will grant confidence that downside risks associated with further gradual rate increases and quantitative tightening are negligible,” he says.

“More to the point, this implies that risks to the FOMC rate view, and Westpac’s, are arguably to the upside.”

Adding to those risks, and even with the correction in US stocks seen after the January FOMC meeting was held, Elliot says in February “we have seen a further significant increase in government spending and signs of stronger wages”.

He also says the stronger-than-expected consumer price inflation in January — also released after the FOMC meeting was held — “will have also given the FOMC greater cause for confidence that inflation disappointment is behind them and that the risks are instead skewed to inflation at or moderately above target”.

As such, Elliot says the tone of the January minutes points to gradual rate rises from the Fed, mirroring what was seen last year.

However, the risk to this view, he says, is for more and faster hikes in the years ahead.

“In these circumstances, a continued ‘gradual’ increase in the fed funds rate through 2018 and 2019 — implying five hikes in total — is still the best base case,” he says.

“However, a careful eye will need to remain on financial conditions.

“Should they continue to move in the opposite direction to policy, a more concerted effort by the FOMC may prove necessary to keep the economy on an even footing.”

Federal Reserve restricts Wells’ growth

Responding to recent and widespread consumer abuses and other compliance breakdowns by Wells Fargo, the Federal Reserve Board on Friday announced that it would restrict the growth of the firm until it sufficiently improves its governance and controls. Concurrently with the Board’s action, Wells Fargo will replace three current board members by April and a fourth board member by the end of the year.

In addition to the growth restriction, the Board’s consent cease and desist order with Wells Fargo requires the firm to improve its governance and risk management processes, including strengthening the effectiveness of oversight by its board of directors. Until the firm makes sufficient improvements, it will be restricted from growing any larger than its total asset size as of the end of 2017. The Board required each current director to sign the cease and desist order.

“We cannot tolerate pervasive and persistent misconduct at any bank and the consumers harmed by Wells Fargo expect that robust and comprehensive reforms will be put in place to make certain that the abuses do not occur again,” Chair Janet L. Yellen said. “The enforcement action we are taking today will ensure that Wells Fargo will not expand until it is able to do so safely and with the protections needed to manage all of its risks and protect its customers.”

In recent years, Wells Fargo pursued a business strategy that prioritized its overall growth without ensuring appropriate management of all key risks. The firm did not have an effective firm-wide risk management framework in place that covered all key risks. This prevented the proper escalation of serious compliance breakdowns to the board of directors.

The Board’s action will restrict Wells Fargo’s growth until its governance and risk management sufficiently improves but will not require the firm to cease current activities, including accepting customer deposits or making consumer loans.

Emphasizing the need for improved director oversight of the firm, the Board has sent letters to each current Wells Fargo board member confirming that the firm’s board of directors, during the period of compliance breakdowns, did not meet supervisory expectations. Letters were also sent to former Chairman and Chief Executive Officer John Stumpf and past lead independent director Stephen Sanger stating that their performance in those roles, in particular, did not meet the Federal Reserve’s expectations.

Greenspan Warns Of Rates Rises

Alan Greenspan, the former Fed Chair, speaking on Wednesday on Bloomberg Television said “there are two bubbles: We have a stock market bubble, and we have a bond market bubble”.

This at a time when US stock indexes remain near record highs and as the yields on government notes and bonds hover not far from historic lows.

As the Fed continues to tighten monetary policy, interest rates are expected to move up in coming years.

At the end of the day, the bond market bubble will eventually be the critical issue, but for the short term it’s not too bad

But we’re working, obviously, toward a major increase in long-term interest rates, and that has a very important impact, as you know, on the whole structure of the economy.

What’s behind the bubble? Well the fact, that, essentially, we’re beginning to run an ever-larger government deficit.

Greenspan said. As a share of GDP, “debt has been rising very significantly” and “we’re just not paying enough attention to that.”

“Irrational exuberance” is back!

Fed Holds, But Signals More Rises Ahead

The Fed held their target range but confirmed its intent to lift rates ahead at Yellen’s last meeting as head. The bank signalled that it would push ahead on its monetary policy tightening path as economic activity has been rising at a solid rate, while inflation remained low but is expected to “move up” in the coming months. Most analysts suggest 2-3 hikes this year. The T10 bond yield continues to rise and is highest since 2014. Expect rates to go higher, putting more pressure on international funding costs.

Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Gains in employment, household spending, and business fixed investment have been solid, and the unemployment rate has stayed low. On a 12-month basis, both overall inflation and inflation for items other than food and energy have continued to run below 2 percent. Market-based measures of inflation compensation have increased in recent months but remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12‑month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1-1/4 to 1‑1/2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

How Fiscal Realities Intersect with Monetary Policy

From the St. Louis Fed On The Economy Blog.

How are government deficits financed, and what are the implications for monetary policy and inflation?

The deficit is defined as the difference between expenditures (including the interest paid on debt) and revenues. If the difference is negative, we get a surplus.

Between 1955 and 2007, the deficit of the U.S. federal government averaged about 1.9 percent of gross domestic product (GDP). In the decade since, the deficit averaged about 5.3 percent of GDP. Roughly two-thirds of this increase is attributable to larger expenditures.

Federal Debt Expansion

Deficits are financed by issuing debt. Since 2007, the federal debt in the hands of the public has grown at an average annual rate of 11 percent.1 As a share of GDP, it went from about 30 percent in 2007 to almost 64 percent as of the end of fiscal year 2017.2

According to the Financial Accounts of the United States, about 40 percent of this debt expansion was absorbed by foreigners, mostly in Japan and China.3

Before Congress approved the tax cut package in December, deficits and the debt were expected to grow significantly over the next decade.4 The new tax plan is expected to add further to the deficit. Though estimates of how much have varied widely, the most recent put the increase in the deficit over the next 10 years at about 10 percent.5,6

What Can Monetary Policy Do?

By influencing interest rates, the Fed can affect the servicing cost of debt. The current path of monetary policy normalization will imply generally higher interest rates, which will add to the deficit and require the Treasury to issue even more debt, raise taxes or reduce expenditures.

Federal revenues are supplemented by Federal Reserve remittances. These have been unusually large in recent years, about 0.5 percent of GDP, due to the Fed’s large balance sheet. Monetary policy normalization contributes to the expected increase in the deficit, since remittances are expected to decline to historical levels as the Fed’s balance sheet contracts.

The burden of debt can also be alleviated with higher inflation. This is not unprecedented in the United States. For example, after World War II, high inflation was used to finance part of the accumulated debt.7 Arguably, in the post-Paul Volcker era, the Fed has enjoyed increased independence and has not been very accommodative to the Treasury.

Inflation Becoming a Fiscal Phenomenon

However, as government debt has increasingly become more widely used as an exchange medium in large-value transactions (either directly or indirectly as collateral), the control of the “money” supply has shifted away from the Fed. In other words, the more cash, bank reserves and Treasuries resemble each other, the more inflation depends on the growth rate of total government liabilities and less on the specific components controlled by the Fed (i.e., the monetary base).

Thus, inflation becomes more of a fiscal phenomenon. Traditional monetary policy tools, such as swapping reserves for Treasuries, may be less effective in controlling it.

Though government debt has expanded significantly in recent years and is expected to continue growing, inflation and inflation expectations have not diverged far away from the Fed’s target of 2 percent annually. The likely reason is that demand for government liabilities has kept pace with the growth of the supply.

In this sense, during and after the financial crisis of 2007-08, there was a big appetite for U.S.-dollar denominated safe assets. As mentioned at the beginning of this post, 40 percent of the debt increase since the crisis has been absorbed by foreigners.

The high demand for U.S. Treasuries may continue or may reverse. If taste for U.S. debt declines, the projected deficits (with their associated debt expansion) may imply an increase, potentially significant, in inflation in the long run.

In this last scenario, the Fed would face a difficult challenge if facing a strong-headed Treasury and Congress that refuse to lower the deficit in the long run. Increasing interest rates—as during the Volcker disinflation, but now in an era of liquid government debt—may only exacerbate the deficit problems and do little to lower inflation.

Notes and References

1 The official figures of “Debt in the hands of the public” include holdings by the Federal Reserve Banks. I have netted those out since we are looking at the consolidated government budget.

2 The U.S. government’s fiscal year begins Oct. 1 and ends Sept. 30 of the subsequent year and is designated by the year in which it ends.

3 Martin, Fernando. “Who Holds the U.S. Public Debt?” Federal Reserve Bank of St. Louis On the Economy Blog, May 11, 2015.

4 Martin, Fernando M. “Making Ends Meet on the Federal Budget: Outlook and Challenges.” The Regional Economist, Third Quarter 2017, pp. 16-17.

5 For example, see Jackson, Herb. “Deficit could hit $1 trillion in 2018, and that’s before the full impact of tax cuts,” USA Today, Dec. 20, 2017; and The Associated Press. “The Latest: Estimate says tax bill adds $1.46T to deficit.” Dec. 15, 2017.

6 The Joint Committee on Taxation, the Senate’s official scorekeeper, estimates the deficit increase at about $1.5 trillion; the committee’s macroeconomic analysis of the “Tax Cuts and Jobs Act” is available here (JCX-61-17).

7 Postwar inflation (1946-1948) is estimated to have resulted in a repudiation of debt worth about 40 percent of output. See Ohanian, Lee E. The Macroeconomic Effects of War Finance in the United States: Taxes, Inflation, and Deficit Finance. New York, N.Y., and London: Garland Publishing, 1998.