OECD Chief Economist: It’s Time To “Temper The Frothiness” In Markets
My argument for having the first interest rate rise has very little to do with the inflation target. It has a lot to do with unproductive use of resources in asset markets and so that’s my story, not the one that is the argument for the inflation target
Catherine Mann, the chief economist at the Organisation for Economic Co-operation and Development, is concerned the Fed is “crying wolf,” always threatening a rate hike but not moving.
The Fed’s inaction is fueling unproductive moves in asset markets, Mann said.
She thought the Federal Reserve should have hiked rates in September. Ahead of the Federal Open Market Committee decision that comes Wednesday, Mann now wants the central bank to increase interest rates as soon as possible. Mann doesn’t think the U.S. economy is in danger of overheating, instead she is focused on asset markets, including the U.S. Treasury market.
Mann, a former Fed staffer and economics professor at Brandeis University, joined the OECD last October.
The following is her interview with MarketWatch, edited for clarity.
MarketWatch: New York Fed President William Dudley said the key question for the Fed is how the global weakness would impact the U.S. economy. If he asked you how it would, what would you say?
Mann: What perhaps he is making reference to, of course, is the developments of the summer time with regard to China and with regard to China trade and China financial turbulence. Those were put forward as being important contributors to the Federal Reserve choosing to not move in September. And so you know that the OECD put forward in our interim economic outlook a discussion about the timing of the Federal Reserve’s first move, and we argued that even though there was turbulence from China and even though there was some concerns about global trade, that it was still appropriate to move in September because it wasn’t so much about the timing of the liftoff that mattered, what mattered for U.S. economic activity and global economic activity, as well as all the financial stuff, really was about the trajectory. So we argued that September would have been a good idea because it would have put behind us and behind the emerging markets and behind the markets, the timing of the first move. That is not Monday-morning-quarterbacking because we actually said that we thought they should have moved.
You’ve got the market participants with the shortest horizon having the greatest incentive to do what they want to do for six weeks at a time. That is not productive activity.
But if we just look at China turbulence and trade issues with China these two small things — that are small for the United States — they are important for the global economy, and of course, the global economy is relevant to the United States. So that’s the kind of twist that I think [the Fed] did clearly put on it back in September.
Now going forward, we continue to have uncertainty about global trade, about the magnitude of global trade — it is quite low compared to global GDP— but this is something that the U.S. economy has been dealing with for a while. That is not new. Commodity prices? Again this is not new. We’ve been dealing with this for a while.
What is a new dimension between September and October is, that unfortunately, there is a lot of speculative capital that had been repositioning itself all summer for the expectation of a September hike. Now, since that didn’t happen, all that capital starts running back to where it was before, creating some problems in emerging markets with basically the most speculative money going for six weeks more of higher yields. So that is the unfortunate new aspect, I think, of where the global economy is. And that, again, would suggest that the best thing to do is to take the first move off the table by doing it, and then being very clear about the shallow slope of the trajectory of interest rates going forward.
MarketWatch: How can the Fed raise rates when inflation is not on horizon?
Mann: I go back to a paper that Ben Bernanke gave at the Jackson Hole conference in 2012 where he set out in really very clear terms about the pros and cons of quantitative easing, which of course we were still in the process of doing at the time. The pros were you want to lower interest rates, reduce the slope of the yield curve, get the credit channel moving, use the wealth effect to bolster consumption and business investment. The cons were, what would we need to know when it was time to kind of take the foot off the accelerator, and it had to do with disruptions in the Treasury market and it had to do with a change in the nature of asset markets.
So when I look at the Treasury market functioning, I see some problems there, with liquidity, some spiking. So, some disruptions or malbehavior in the Treasury market, I see as one indicator, that even though the objectives of inflation and unemployment have not been reached. The second indicator that was outlined in the Bernanke speech was concerns about what was going on in asset markets — housing markets but also in equity markets. And I think what we can look at the housing market [and say it] is back on track, not really recovered completely, that is of course related to the bank situation and attitudes toward risk and some of the new regulatory requirements.
But if you look at the equity markets and you look at what is supporting equity prices — how much of that support is coming from real economic activity versus from using stock buybacks, using cash on balance sheet for stock buybacks, or mergers and acquisitions, to reduced competition in the marketplace. These are the sort of stories that if there were a small increase in interest rates, you would temper some of that frothiness. Is this really a thing you want to be going on in asset markets? Is this really representative of the kind of asset-market activity that is supportive of the foundations for more robust growth in the U.S. economy? The answer has to be no. And so a small change in interest rates would temper some of that activity in the asset markets. So I go back to the Bernanke speech — it was a cost-benefit speech, and I look at those two elements and I say: well, the cost-benefit equation has shifted.
MarketWatch: You’ve said you were worried that the Fed was crying wolf, saying they would hike rates and never doing it.
Mann: You’ve got the market participants with the shortest horizon having the greatest incentive to do what they want to do for six weeks at a time. That is not productive activity, whether it be in emerging markets or in the U.S. marketplace, these are not productive investments. Eliminating the incentive to engage in that kind of activity seems to me to be a good idea. We know that 25 basis points is not going to do that much, on the margin, to affect business decisions on whether to undertake real investment or not.
MarketWatch: My sense is that you are not worried about the U.S. economy slowing.
Mann: We have to be concerned about the U.S. economy, but I guess my view is that, for the U.S. economy, again, the 25-basis-point first move is not nearly as important as the trajectory. Uncertainty is a big issue. So getting one element of uncertainty off the table, I think is what we ought to be looking at here.
MarketWatch: Some worry that without the Fed’s support, the whole thing falls down
Mann: I think there is a possibility that you will see some equity market correction, but since I see a fair underpinning of where we are in equity right now is based on some of these not-really conducive to real economic activity anyway — stock buybacks, the mergers and acquisitions – taking a little bit of the top off of that is not something that is going to negatively affect the economy. There would be a proportion of the population that would have less capital gains — but they’ve been enjoying very big capital gains, and it is a narrow segment of the population. And for firms, for those who are in the equity markets, the bulk of them have a lot of ammunition to work with on their own balance sheets, so 25 basis points is not going to make a difference to them.
MarketWatch: Do you think Fed Chairwoman Janet Yellen and her allies are worried about asset prices? It is not something they talk about much.
Mann: These are very smart people, and I am sure it is part of the overall thought process that’s done around the table.
MarketWatch: Wanted to ask about low productivity in the U.S. and around the world.
Mann: The three things that we look at when we try to understand low productivity growth is the pace of innovation, characteristics of the labor force and investment. We’ve already told a story about how little real investment there has been in the global economy over the last seven years. It is particularly bad in Europe. The U.S. is not nearly as bad as Europe.
Business fixed investment is only 7% or so above where we were at the previous peak of the business cycle on average across the OECD, and about 5% actually in the U.S. In other time periods and other business cycles, by this point in time we would be 20% or in some cases 40% [above]. So we’ve had a recovery, but it is much less robust than in other time periods. So that is one reason for the low productivity growth.
The second reason for low productivity growth is that although there is plenty of innovation out there, there is very little diffusion of innovation from frontier companies to the average company in countries. Now different countries have different reasons for it, but one of it does go back to investment again. It costs money to invest in new technologies, and if you don’t think that there is going to be any return because you don’t think there is going to be market for your product, then you are not going to undertake the investment, and so overall the innovation that is out there doesn’t diffuse to the average company, and so on average you have much lower productivity growth than you would have.
One of the things we’ve observed is that there is a fair degree of skill mismatch in the marketplace. And we base this on the adult skills data, and the U.S. is not as bad as some other economies in terms of the skill mismatch, but what we find is that there are workers who are kind of sitting in firms that are not being paid for the skills that they have, they are actually over-skilled, and the firms don’t pay them what they are worth, so that is part of the reason for the wage stagnation. But there are negative consequences for productivity growth if you have mismatched labor. So a lot of this low productivity growth and the low potential output that we see is sort of a negative feedback loop between investment innovation diffusion and skill mismatch.
Everything is sort of hunkered down in this relatively slow-growth situation. You end up with people who are over-skilled for their jobs, and companies are not going to pay them for their extra skills.
It is a low-level equilibrium that we are trapped in, and the real issue is how we’re going to get out of it. I don’t have the answer to that question. There is a high-level equilibrium which has higher investment, creates more jobs, creates more consumption which expands the market which ratifies the investment that has been undertaken. You have to get the animal spirits to move toward the high-level equilibrium.
MarketWatch: It is hard to believe the U.S. economy could overheat in this environment.
Mann: That’s true. I think it is hard to argue that it is overheating, but my argument for having the first interest rate rise has very little to do with the inflation target. It has a lot to do with unproductive use of resources in asset markets and so that’s my story, not the one that is the argument for the inflation target.