Richard Koo gives a “Post-QE forecast: sunny, cloudy, or stormy?”

Larry Kummer, Editor

12 years ago

Summary: Prosperity, perhaps even survival, in the 21st century might require learning which experts we should listen to. In economics its a short list, if we limit it to people who have understood large aspects of the great recession and the aftermath. Richard Koo certainly deserves to make that short list. Here he tells us what to expect next.

“Post-QE forecast for leading economies:
sunny,cloudy, or stormy?”

Richard Koo, Chief Economist
Nomura Research Institute

25 March 2014

Excerpt

{People} were roiled by Fed Chair Janet Yellen’s first press conference last Wednesday, where she suggested a rate hike could come as soon as next spring. The fact that {people} reacted so much led some in the media to question her communication skills, given her predecessor’s skill in this area.

{People} also appear to have been surprised and disappointed that the supposedly dovish Ms. Yellen indicated the possibility of a tightening of policy. “This wasn’t supposed to happen” seemed to be the general reaction.

Marketsand media unaware that US is in QE trap

Nevertheless, it was easy enough to predict that the Fed would have to move in this direction when it began normalizing policy after years of quantitative easing. The media’s criticism of her dialog and {people’s} complaints about the lack of further accommodation tells us that most of them have yet to realize the US economy has fallen into the QE trap. Their ignorance is of far greater concern, in my view.

{People} and members of the media simply do not understand that an economic recovery in a country that has undertaken QE is going to be very different from a recovery in a country that has not.

First rate hikes could come next Spring

Most of the current brouhaha can be traced to Ms. Yellen’s post-FOMC press conference, where when asked to elaborate on the phrase “considerable time” (“it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends”) she responded “it probably means something on the order of around six months.”

The Fed’s tapering exercise, taking a page from the book of former Chairman Alan Greenspan, who raised rates by 25bp at each FOMC meeting over an extended period from 2004 to 2006, calls for reducing asset pur chases by $10bn at each meeting of the policy-setting committee. If it continues along this path, purchases of new securities would end this autumn.

Six months from then would be next spring, which came as a shock to many market participants who did not expect rates to be raised until the second half of next year at the earliest.

Some also felt the indication of a potentially earlier rate hike was inconsistent with recent economic data, which show an inflation rate (core PCE deflator) of just 1.09% and an economy that is not particularly strong.

Central banks much less tolerant of inflation after QE

What they need to understand is that a central bank that has engaged in QE is far less tolerant of inflation expectations than a bank that has not. The central bank that has conducted only orthodox monetary accommodation can sit back and watch as private loan demand pick s up, driving an economic rebound. Rate hikes need to be considered and implemented — gradually — only after the economy approaches full employment and prices and wages have started to rise.

In this case there is no reason for the central bank or the market s to fear an economic recovery — it can be welcomed with open arms. …

Fed faces arduous journey in normalizing monetary policy

… as I explained in my previous report, it will take an extended period of time for the central banks of the US, Japan, and the UK to wind down their current QE programs because they chose instead to supply funds via the long-term government bond market.

Like the BOJ in 2006, Fed Chair Yellen is trying to keep a step ahead of the market in winding down QE. However, she is likely to face quite an ordeal — not only has the Fed created excess reserves equal to 19 times statutory reserves, versus a maximum multiple of six for the BOJ in 2001–2006, but most of those funds were supplied in the long-term government bond market.

Better dialogue will not help drain excess reserves

Any Fed chair would have to deal with the unpleasant fact that the institution has supplied funds equal to 19 times statutory reserves by purchasing long-term Treasury securities. This is not a problem that can be resolved by better dialog with the market.

In fact, I suspect a key reason why Ms. Yellen’s predecessor was seen as being such a good communicator is that throughout his tenure — at least until May 22, 2013 — he was generally bearing good tidings in the form of more quantitative easing, which of course the market welcomed.

QE at a time of weak private loan demand and a sluggish economy is harmless and will always be welcomed by the market. But when it came time to start winding down this policy, on 22 May last year, Mr. Bernanke’s heralded communication skills failed to prevent a sudden surge in long-term interest rates or corresponding damage to emerging markets and the US housing market. Ms. Yellen acknowledged at her press conference last week that the housing market has yet to regain its earlier momentum since it slowed in response to last summer’s rise in rates.

In other words, this is not an issue that can be dealt with via better communications with the market. Far from it. …

Forecast for post-QE world: day after day of dark, low-lying clouds

The Fed’s decision to emphasize its willingness to stay ahead of the curve on inflation and keep long-term rates from climbing out of control signifies a reduced likelihood of a sharp acceleration of US inflation. In effect, the central bank has demonstrated its intention to nip any inflation in the bud.

With the Fed acting in this way, the most likely scenario for the US economy going forward is one in which the economy ekes out a hesitant recovery against the backdrop of constant concerns at the Fed and in the markets about a surge in long-term interest rates. Such an outcome is unlikely to lead to significant inflation.

This is the world of the QE trap. It is the price that must be paid when a nation conducts quantitative easing }by buying} long-term bonds.

The “new normal” awaiting an economy where the central bank has implemented QE is day after day of dark, low-hanging clouds with no sunny skies. While this is clearly preferable to the storms that followed Lehman’s failure, we face the prospect of a world weighed down by worry instead of sunny skies and a quickly rebounding economy (which would be the case by now without the QE).

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About Koo’s pasts forecasts

Most Americans knew 4 big things at the start of this recession, things confidently explained by our experts. Richard Koo, economist for Nomura, told us that time would prove all of 4 wrong.

Our banks were the strongest they had ever been on the eve of a recession. Unlike Japan’s before their 1989 crash.
We were free-market capitalists. Any banks that proved weak would be closed (as we did during the S&L crisis). Unlike Japan, that propped up their banks (becoming zombie banks).
We were smart. If the recession was deep, we would stabilize the economy with wise public spending, repairing and building our infrastructure (as FDR did during the depression). Unlike Japan, who channeled stimulus funds to politically powerful interests, wasting vast fortunes on large train stations in villages and bridges to nowhere.
Our economy was resilient and adaptable, so any recession would be brief and followed by a strong recovery (the “V”). Unlike Japan, where the crash ushered in a 20 year (and counting) period of economic stagnation. The economy slumped every time the fiscal stimulus was slowed (either through higher taxes or spending cuts).

So far Koo is 4 for 4.

Much of our financial system collapsed. Large banks, investment banks, AIG (a weird hybrid), and the government-sponsored enterprises (Fannie Mae and Freddie Mac), and many smaller banks.
We boldly closed small S&L’s during the 1990s. But when politically powerful banks tottered, our government politely asked how many billions would they like — on the easiest possible terms, at low rates, combined with a wide range of additional subsidies from the Fed.
We’ve spent — and continue to spend — tens of billions on fiscal stimulus. Some provides valuable support for the unemployed. Some has gone to the States, so that they can continue their feckless spending. Some has gone into visible infrastructure work (e.g., roads). Most of the rest has left behind little but public debt.
Since 2010 real US GDP has grown at an average of 2.2% per year. The first quarter is estimated to have grown more slowly than that, perhaps more slowly than the ~1.9% of 2013. That’s better than stagnation, aided by massive fiscal and monetary stimulus (zero rates and QE).

I suggest we listen to him.

About the author

Richard C. Koo is Chief Economist of the Nomura Research Institute, providing economic analysis to Nomura Securities, the leading securities house in Japan, and its clients. Consistently voted as one of the most reliable economists by Japanese capital and financial market participants for nearly a decade, he has also advised prime ministers on how to deal with Japan’s economic and banking problems. He is also the only non-Japanese member of the Defense Strategy Study Conference of the Japan Ministry of Defense.

Prior to joining Nomura, he was an economist with the Federal Reserve Bank of New York, and was a Doctoral Fellow of the Board of Governors of the Federal Reserve System. {source}

Some works by Richard Koo:

“‘Plan B’ for the Global Financial Crisis“, presentation at the Center for Strategic and International Studies, 22 October 2008 — Here is a PDF of his slides.
Interview of Koo by Kate Welling, Welling @ Weeden, 11 September 2009
“Financial markets rocked by ‘Obama shock’”, Richard Koo (Chief Economist), Nomura Research Institute, 26 January 2010 (on Scribd)
“The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005″, April 2010 (on Scribd)
“Whither the patchy US recovery”, 20 April 2010 (on Scribd)
The Holy Grail of Macroeconomics, Revised Edition: Lessons from Japans Great Recession (2009)