"Kee" Points with Jim Kee, Ph.D.


  • Trade Overshadows Antitrust
  • The Federal Reserve
  • Stage Three
  • European Central Bank
  • Addendum


Trade Overshadows Antitrust

As I write this, markets are selling off because the trade war is back on. Specifically, President Trump announced Friday that tariffs (25%) on Chinese imports ($50bb) were slated for July 6, and China promised retaliatory tariffs. It has escalated from there. But what got my attention was U.S. District Court Judge Richard Leon’s ruling that AT&T could buy Time Warner with no conditions attached (CNBC). There is not a lot of research on the impact of these types of decisions on the overall stock market, but the research that is available (e.g. George Bittlingmayer’s work at the University of Kansas) suggests that it is long-term bullish (good) for stocks.

 

The Federal Reserve

The Federal Reserve raised rates (the benchmark federal funds rate) last week for the 2ndtime this year, with one or two more hikes expected by years’ end. The current rate is 2%, with the Fed targeting 2.5% this year, 3% in 2019, and 3.5% by 2020. The Fed had cut the federal funds rate effectively to zero in 2008, where it remained for 7 years, and then it started raising rates in 2015. That whole situation was unprecedented, which is part of what makes this episode unique from prior episodes. Another part is the fact that, with prior rate hikes, the Fed had been determined to keep inflation under control by raising rates when measures of growth and inflation indicators were getting too strong, or too far from normal. But under the current regime, the Fed wants to “normalize” rates from abnormally low levels, in effect saying “unless inflation numbers are too low, or unless growth number are too low,” we’re going to continue with rate hikes, i.e. rate normalization. That’s what’s different this time around. I’m sure you have all heard enough about the Fed lately, so I’ve put the rest of my thoughts in an addendum below.


Stage Three

Right now we are in kind of a third stage of Federal Reserve policy with respect to the financial crisis. The first stage was the extraordinary asset purchases made by the Fed, which came to be known as quantitative easing. Remember all of the fearmongering that this was going to lead to high inflation? Didn’t happen. The second stage was the tapering (2013) and then ending (2014) of these asset purchases or QE. Remember the fearmongering of market panics and economic decline that was going to follow the end of QE? Didn’t happen. Now we’re in the third stage of bringing interest rates back up to a more normal range, and reducing the Fed’s balance sheet. Expect more fearmongering, but so far so good.


European Central Bank

As for Europe, last Thursday the European Central Bank decided not to raise rates (the “deposit rate”) while laying out plans to wind down its bond-buying (i.e. QE) program by the end of the year. That represents a “soft” versus “hard” taper, whereby the ECB would stop abruptly in September. This was all largely as expected, and I think Mario Draghi’s tenure as head of ECB is aptly summed-up by the Wall Street Journalsubtitle, “Europe’s central bank chief did his best to give political space for reform.” I think the ECB has had some great success in managing the various crisis of the past few years (e.g. debt problems, Brexit, etc.). But there is also something to University of Chicago economist Luigi Zingales’s discussion of Italy, and I think it applies to other countries in the EU as well:


“In many ways, the last few years have been the best possible world for Italy because interest rates were incredibly low, the euro was relatively cheap vis-à-vis the dollar, and oil prices were quite low…if you have to pick the best variables for Italy’s economy, those are the three variables. With this magic combination, we achieved 1.5% GDP growth.”


To me, that expresses well the ongoing need for tax/regulatory reform – just less bureaucracy – not only in Italy but other parts of Europe. However, at 2.1%, Europe’s expected 2018 growth rate (IMF) is still above its longer-term averages, which are in the 1%-2% range depending upon the period.


Addendum: Some Economics of Inflation

Does growth cause inflation? Does the economy “overheat”? I don’t think so. In fact, for a given quantity of money, more output should lead to each dollar buying more goods and services, which is disinflationary. But under modern, fractional reserve banking systems, it gets a little more complicated. Whether growth leads to inflation or not depends upon (1) whether or not the banking system holds excess reserves, which are reserves in excess of required amounts (it does), and (2) whether those excess reserves get loaned out too quickly. The Federal Reserve has more control over excess reserves than it used to because, since 2008, it has had the authority to pay interest on those reserves. This is called Interest on Excess Reserves, or IOER. That allows – orshould allow – the Fed to hold those reserves in place if desired, thus controlling inflation. So growth can be inflationary, but need not be [note: increased banking regulations have also curtailed bank lending].


And what is inflation? It is a rise in allprices, or a decline in the purchasing power of a currency. That’s distinct from a relative price change, or the rise of the price of some specificgood or service relative to another. Confusion occurs when people attach the word inflation to what is really a relative price movement. An example would be the term “wage inflation,” or “housing inflation.” That results in great economy of speech, as people very quickly understand what you mean, i.e. that wages are rising or house prices are rising. But that economy of speech comes at the cost of lost economic understanding, because the distinction between inflation (rise in all prices) versus a relative price movement(rise in some prices) has been lost. And that usually leads to the “cost-push fallacy,” or the notion that a relative price change (e.g. wages) can lead to overall inflation. But think about - If people spend more on wages, or houses, or both (driving up their prices), they have less to spend on other items (driving down their prices). You can only spend more on everything if there is a greater quantity of money to spend! And that all comes back to, or depends upon, how much excess reserves the banking system has, and how much of those excess reserves are being loaned out.