Macro and Markets

While markets have focused attention on China as the primary source of market risk in 2016, Latin America has provided the more significant headlines in recent weeks.  Political turmoil in Brazil has resulted in the resignation of a market-friendly finance minister, and default looms in Venezuela.  But perhaps nowhere in Latin America is more at stake than with the economic revolution now underway in Argentina. As the first non-Peronist president in more than a decade, Mauricio Macri has promised to roll back populist policies of his predecessors and implement market-friendly measures in Argentina. Following his election, his administration moved quickly to lift currency controls, resulting in a substantial devaluation of the official exchange rate, reduced trade taxes, installed a new central bank president, and raised $5 billion in financing from a group of international banks.  He has also promised to settle the country’s decade long legal battle with creditors, normalizing the country’s economic relations and turning Argentina outward. At a time when populism is constraining economic reform across the industrial and emerging world, many in markets see Argentina as a bright spot in the region. Markets have responded quite positively to this big-bang approach. After dropping over 25 percent, the currency has stabilized and a number of banks have raised their recommendation on Argentine assets. Still, the economic challenge is daunting. Diminishing foreign exchange reserves raise uncertainty in Argentina’s ability to defend peso’s value should crises occur (Figure 1). Inflation is rampant, over 25 percent as of October. The expansionist fiscal policy has also created a deficit that private estimates by companies including Goldman Sachs place between 6 and 7 percent. The sharply weaker currency will exacerbate these challenges, at least temporarily, even as it sets the basis for competitiveness in the longer term.  Without much room to maneuver in collecting revenue, Macri’s fiscal consolidation will most likely rely on cutting expenditure, including popular energy subsidies instituted by his predecessors. Finding alternative sources of expenditure cut and revenue increases will be a difficult though critical task. The broader question is whether this time is different, and whether Argentina can break out of its history of populist economic cycles.  While all these measures are necessary, they will be painful and likely induce economic contraction in the short term. Accustomed to years of economic populism, the Argentine people will now need to support policies previously deeply unpopular. Meanwhile, his party lacks a majority in the Argentine congress. Historically, investors would have done well from buying Argentina after default and selling on efforts at normalization. There’s a danger of political and social backlash, and perhaps this is not the end of populism for Argentina. Against a weak global economic backdrop, the country will face challenging fiscal outlook and likely economic contraction. Getting the sequencing and coordination of reforms right will require a delicate balance between economic change and disruption. Macri’s shock therapy is rare in Latin America, and the track record of shock programs (including notably in post-Soviet Eastern Europe) is mixed. A critical question will be his ability to sustain support until reform produces material improvement in growth prospects. Populist pressure could return quickly if the program falters. There is a lot riding on the outcome.   Figure 1 Source: Central Bank of Argentina

The Federal Reserve today delivered exactly what was expected: a liftoff in interest rates from the zero lower bound, coupled with strong assurances that the future rise in interest rates will be moderate. Markets reacted hardly at all to the statement and Janet Yellen’s press conference, beyond a bit of short covering, by and large seeing the decision as a comforting first step towards normalization at a time of significant global tensions. In sum: The Fed raised the target for the fed funds rate to 0.25 to 0.5 percent, increased the discount rate (the primary credit rate) to 1 percent, slightly revised downward its economic outlook, and released a statement that was comfortably dovish. The participants’ projection for interest rates (“the dots”) suggests perhaps 100 basis points in rate hikes in 2016 and that rates will remain below 3.25 percent through 2018. There also was an implementation note that built on previous releases and explained how the new target will be reached through payment of interest on excess reserves and repo facilities that reflects the detailed preparation that went into the decision and should provide confidence that market liquidity will be smoothly managed. The overall message was that monetary policy will remain extremely accommodative and supportive of a continued economic expansion in the United States. Four broad challenges await though if the Fed is to sustain this optimism. You can’t communicate what you don’t know. The Fed has done a poor job communicating this year, contributing to market volatility and at least temporarily weakening its credibility. In September, for example, within a few days the Fed’s statement, Janet Yellen’s press conference and her speech at the University of Massachusetts arguably provided three different messages about the risks (including importantly international risks) and conditions for liftoff. Adding to the confusion at that time was the perception that the Board was divided on the timing of liftoff, divisions that may well persist with the change in voting members in 2016. But the more fundamental point in the Fed’s defense is that at a time of economic uncertainty, it is hard to credibly precommit to a certain policy path when you are explicitly data dependent. And yet an accommodative policy depends importantly on credible forward guidance on policy. Traditional macroeconomic relationships (e.g., labor market measures and the Phillips curve) have over-predicted inflation in recent years, and there is a substantial debate over whether this represents a temporary or more persistent failure of the models. The current positive pricing in markets reflects a belief that the inflation will remain muted. It doesn’t require an inflation spike, only some evidence that such relationships again have predictive power, to create significant market volatility. A high risk of market turbulence.  It is easy to argue that markets in 2016 will face higher policy and geopolitical risks than they have for some time: China, emerging markets, and populism and anti-union pressures in Europe to name a few. As many have noted, the beginning of Fed normalization at a time when the European Central Bank (ECB) and Bank of Japan are still easing introduces a period of policy asynchronization that traditionally is associated with greater market volatility, especially for exchange rates. Emerging markets remain a central concern. There is growing concern about growth and financial fragility risks in emerging markets, against which continuing capital outflows creates an additional global uncertainty.  The Fed has made clear in recent months that international uncertainties have weighed on their decision making (though expressing confidence that those shocks would have a lessening effect on U.S. activity over time), and Janet Yellen’s press conference comments emphasized her commitment to communicate carefully their plans to avoid spillovers to other markets. I do not believe that there is a credible argument that the Fed has under-accounted for these external risks. Still, this may be the major uncertainty for the outlook. End of an era?  Since the start of the Great Recession, monetary policy has carried most of the burden of support for economic activity. Now that is coming to an end, reflecting not only the Fed’s decision but also a growing skepticism about the power that successive rounds of quantitative easing programs have on industrial economies. An increase in interest rates does provide some scope for rates to be lowered in the face of future adverse shocks, but the benefit of returning to zero is limited. One does not have to fully subscribe to secular stagnation theories to believe that fiscal and structural policies will need to take more responsibility for growth in the period ahead.

There are reports this morning that House and Senate legislators have included language authorizing U.S. support for International Monetary Fund (IMF) reform in the $1.1 trillion spending package funding the government for the rest of FY16.  If this language reaches the president’s desk and is signed into law, it would be an important achievement and a positive reflection on the perseverance of U.S Treasury officials and congressional leaders to get this deal done. The package—first agreed to by the Obama administration in 2010—changes voting shares and governance for the institution at a critical time, bolstering the IMF’s credibility and its ability to play a lead firefighting role at times of crisis.  Failure to pass the legislation had become a substantial irritant for U.S. influence internationally, and resolving this is a win for good global economic governance. The price the administration paid included a commitment to seek to eliminate the “Systemic Exemption”, the rule that since 2010 has allowed lending even when there was a risk that the debt was unsustainable, and that was used to support loans for the periphery countries of Europe.  I have supported the rule, which recognizes the inevitable risk involved in these large scale programs where there are broad systemic effects, but giving up the rule is a small price to pay to get IMF reform passed. Should a global crisis threaten in the future, the IMF may again need to bend their rules to respond effectively. That discussion now will begin with a clean sheet of paper, and Congress will need to be informed. The administration also has promised to report to the Congress ahead of any vote supporting a large lending program.  While these commitments add an extra layer of process, I agree with others that requiring clear explanations before and after the use of such a policy can strengthen the legitimacy of such policy decisions. The idea for this trade--IMF reform for the Systemic Exemption--originates with John Taylor, and I gave it a strong endorsement when I testified before the Senate Foreign Relations Committee earlier this year. Quietly, as a footnote to the broader budget deal, good policy is being made.