Pascal Blanqué opened the conversation with Janet Yellen by asking about the disconnect in the economy between stronger growth with low unemployment and little wage pressure and inflation.

Does the investment community understand what is going on?

THE MYSTERY OF LOW INFLATION

Ms. Yellen responded that she is also surprised by this, but that wages are starting to rise a little. US regions bthat have seen the largest fall in unemployment are experiencing more rapid wage increases. The Phillips curve the relationship between labour market slack and wages is still valid, although not very strong. Slow productivity growth is one reason firms may not be bidding strongly for labour by paying more, and there is little upward pressure on inflation.

It remains to be seen whether the slight rise in inflation in the US to about 2% will be sustained, she said. Labour market participation is slacker in the US than one would expect from the 3.8% unemployment rate. While prime-age worker participation has risen a lot, it is not back to pre-crisis levels.

HAS THE PHILLIPS CURVE DISAPPEARED? 

Unemployment is below structural unemployment, but inflation is still far below its target. The Phillips curve is flat, but has it disappeared?
• If it has disappeared, the Fed can look for lower unemployment without any risk of higher inflation. Interest rates can stay low for long and “normalisation” is not that necessary;
• If the Phillips curve has not disappeared, there is a pending risk for inflation to resurface, but how soon and how strong? In that case, normalisation and interest rate hikes have to be pursued.

So, What’s up?
• Observation #1: Inflation expectations are anchored to low levels.
• Observation #2: Inflation is now a function of long-term expected inflation and not a function of past inflation.
• Observation #3: The Phillips curve is a relation between unemployment and inflation (as in the 1960s) and not a relation between unemployment and inflation changes. 

Why such a situation?
• Explanation #1: High central bank credibility. For the past 20 years, and especially in the past 10 years, central banks did well in controlling inflation. The nature of the Phillips curve has therefore changed. It is sustainable as long as wages remain under control.
• Explanation #2: Another reason for the flat Phillips curve is that the jobs created are low skilled with low wages and little impact on inflation, which is probably not sustainable.

LOWER PRODUCTIVITY MEANS LOWER GROWTH

Turning to potential growth, Ms. Yellen stated that expectations remain low. The US has been averaging 2.25% for years while unemployment was falling, which indicates that potential growth that would require a stable unemployment rate is running under 2.25%. She estimates that future growth will be around 1.75% and stay at that level, despite hopes for a boost from the digital revolution and innovations such as artificial intelligence.

In the US one factor that is lowering productivity growth is the levelling off of educational attainment, which had been rising rapidly. Investment spending and factor productivity have also been weak, with the US economy becoming less dynamic for reasons that are not clear. It is possible that productivity growth will pick up, as it did in the late 90s, but she would not count on it.

Mr. Blanqué interjected that there are various schools of thought on this, from the “Gordon School”, which borrows from the secular stagnation theory, to those who think there will be an acceleration thanks to the digital revolution. Others say that it is a useless question due to problems of measurement.

Ms. Yellen agreed on measurement. For example, some digital innovations have changed our lives but are not accounted for in GDP growth. However, there has always been mismeasurement of productivity and it has not increased enough to explain the slow-down. Mr. Blanqué responded that this is a problem for longterm investors, who must extrapolate figures from trends in the labour force and the stock of capital or similar indicators.

Looking over the years after the financial crisis, Ms. Yellen pointed out that productivity growth was running between 0-0.5%  and has risen to only about 1%. The US tax reform will raise investment spending, but productivity will likely grow by just fractions of a percent, less than what people may be hoping for.

« Investment spending and factor productivity growth have been weak. Part of that is a mystery, but part of it looks like a decline in dynamism in the US economy. That, in some ways, is also mystery. »  

Janet L. Yellen

« Investment spending and factor  productivity growth have been weak. Part of that is a mystery, but part of it looks like a decline in dynamism in the US economy. That, in some ways, is also mystery. »  

Janet L. Yellen

ARE WE APPROACHING THE NEUTRAL INTEREST RATE?

Turning to the notion of a neutral, equilibrium rate of interest, Ms. Yellen, underlined that it is an important concept, since it helps define for the markets and for the central banks whether a monetary policy is accommodative or restrictive. The Fed has made this a central part of its communication with the markets. It is now forecasting a move over the next year toward a neutral stance. Then, if the economy continues to grow with falling unemployment it will move to a mildly restrictive stance to ease some of the labour market slack, she said.

Members of the Federal Open Market Committee write down what they think the neutral rate is – at the moment between 2.75-3%. There are methods for estimating it, but different methods can lead to different conclusions, she warned, and there is a great deal of inherent uncertainty.

In the US there have been seven increases in the funds rate, so it is getting closer to the neutral rate. However, indices of financial conditions suggest not much more tightening of monetary policy. For example, the slowing of job gains normally seen as the rate approaches neutral is not apparent in the US. So there are a number of uncertainties and it is important for market participants not to be misled by numbers that are being mentioned by analysts, including those of the Fed. “Only time will tell”, she cautioned.

DO TRADITIONAL RULES STILL APPLY?

Following up, Mr. Blanqué asked whether rules are still useful. Ms. Yellen explained the Fed does not set monetary policy according to any mechanical rules. This would be impossible in any case, since most rules rely on estimates of unknown parameters. For example, estimates of the natural rate of interest in the long run have come way down, so if you mechanically apply a rule like the Taylor Rule you would fare badly, she warned. However, there are principles embodied in most rules that are worthwhile and do characterise the behaviour of the Fed.

Almost every rule would say that when there is an upside inflation surprise the Fed should raise real interest rates by more than inflation. That is called the Taylor Principle and it characterises the Fed’s behaviour. The other thing you can rely on is that upside inflation surprises or downside unemployment surprises will lead to a tighter policy than is projected.

Going forward, behaviour may become more rule-like than it has been since the financial crisis, continued Ms. Yellen. After the crisis if you had followed the Taylor Rule or most other rules, you would have taken interest rates into highly-negative territory, which is impossible. The FOMC had to follow a completely different strategy, based on asset purchases and holding short rates at very low levels for a very long time (“lower-for-longer”). Market participants could not have known that the Fed would do this, based on past experience in normal times.

« Market participants should not to be misled by neutral interest rate levels being mentioned by analysts, including those in the Fed. There is a sense of, yes, it’s low, maybe it’s 3 or under, but only time will tell. »  

Janet L. Yellen

« Market participants should not to be misled by neutral interest rate levels being mentioned by analysts, including those in the Fed. There is a sense of, yes, it’s low, maybe it’s 3 or under, but only time will tell. »  

Janet L. Yellen

NO MORE FORWARD GUIDANCE BUT LOOK AT PROJECTIONS

Those were abnormal times, Ms. Yellen emphasized, so the Fed tried to signal that by giving forward guidance and becoming more explicit. Forward guidance by a central bank articulates more clearly to markets the expectations for future policy. Throughout the post- crisis period the FOMC wanted to help market participants understand what was likely, but not to lock themselves into absolute commitments.

In the current environment there is less need for forward guidance. However, the FOMC’s projections, while not necessarily representing committee consensus, have good information for market participants on the underlying parameters like the equilibrium-level interest rate or the natural rate of unemployment.

THE FED WILL RESIST “FISCAL DOMINANCE”

Responding the Mr. Blanqué’s question whether there is growing temptation for governments to directly monetise deficits, Ms. Yellen responded that this is one of the reasons to assure the independence of central banks. The Fed should focus on Congressional mandates such as price stability and raising employment. She is confident that it will remain independent and resist pressures to keep interest rates low to help fiscal policy.

Concerning the rising fear of “fiscal dominance”, it could be a concern, said Ms. Yellen, if deficits are not on a sustainable path. This is becoming a problem in the US and some other countries. The recent fiscal stimulus in the US, coupled with an ageing population and rising healthcare costs, threatens to raise the debt-to-GDP ratio going forward.

DOES FISCAL DOMINANCE REPRESENT A RISK IN TERMS OF CREDIBILITY?

It is not wise to stoke doubts about the central bank’s reaction function. The theme of “fiscal dominance” (the sustainability of debt as the central bank’s target) is growing because interest rates remain ultra-low in some countries despite the economic recovery. If real or perceived as such, it would lower the credibility of the Central Bank, and the perception of its independence.

There are several questions around this:
Q1: Does the level of the debt constrain economic policy? Yes; fiscal and tax austerity in Europe are the best (or worst) examples of that.
Q2: Has it changed the mission of the central banks? No; the Fed still has several objectives while the ECB still has one: price stability, i.e. the internal value of the euro.
Q3: Can we consider some central banks to have low rates only to restore solvency of indebted agents? No; they need to preserve their neutrality and independence.
Q4: Can the ECB be potentially suspected to have entered into fiscal dominance? Does it represent a risk? Yes; interest rates are abnormally low compared to growth or potential growth. Negative rates are quite unusual, and especially at this stage of the cycle.
Q5: Is the suspicion that the ECB is under fiscal dominance correct? No; like the BOJ, the ECB is looking for inflation and unlike the Fed, it considers it is too early to restore leeway, since the Eurozone economy may be far from the end of cycle.

ASSET PRICES AND FINANCIAL STABILITY ARE NOT ASSURED

Turning to asset prices, Ms. Yellen said that price stability is well defined in most countries that have inflation targets, including the US, but that this does not include asset prices. Financial stability is something the FOMC spends a lot of time on, and there is an avid debate about whether monetary policy should take financial stability conditions into account. The first line of defence should be financial regulation and macro-prudential policies, she said. These include making sure that there is more capital and liquidity in the banking system and monitoring of leverage and maturity transformation.

Ms. Yellen continued that the long period of stable macro-economic performance prior to the financial crisis may have bred excessive risk-taking and undermined financial stability. The absence of good supervision and regulation was an important part of that. Low interest rates can also induce reach-for-yield behaviour, underestimating credit risks and liquidity risks. Some of that has happened after the crisis.

Commenting on the stock market, Ms. Yellen said that there may be a “new normal” of lower interest rates than in the past, with an equilibrium short-rate closer to 1% than 2%. If that is the case, then price-earnings ratios in the stock market may justifiably be higher on a long-run basis.

IS THE US STOCK MARKET OVERVALUED?

The US stock market is supposed to be at risk, because it is regarded by many investors as being highly overvalued. However, the high value is partially justified by the strength of economic activity, the lack of inflation, the return of profits, the tax measures, and the still accommodative monetary policy. The US stock market is not overvalued. As a consequence, EPS consensus is still very strong: 20% in 2018, and 11% in 2019-2020 (versus 8%-8.5% in Europe in 2018- 2020).
The key question is whether the appreciation is purely cyclical or structural. While the US stock market followed the balance sheet of the Fed for the past five years, it then appreciated strongly with the election of Donald Trump and his tax measures, despite the announced reduction in the balance sheet of the Fed. The gap between equities and the balance sheet seems to be vertiginous at present. For it to remain sustainable, we need strong growth and as well as potential growth to soon rise further. We also need long-term productivity to finally take off and future profits to continue to be at least as strong as they are at present.
This is a big challenge. Even if the valuation is not extreme or abnormal, its sustainability is questionable, so, in that sense, the market remains at risk.

THE NEED TO MANAGE LIQUIDITY

On liquidity, Mr. Blanqué posited that broker dealers now hold much smaller inventories of assets, particularly corporate bonds, than they did before the financial crisis. Under stressed conditions market liquidity may not be sufficient. This creates a risk, particularly if there is a shock such as a shift in risk premiums or a sudden increase in selling activity that prompts funds to liquidate corporate bonds. If widespread, then liquidity could be impaired, creating fire sale conditions with systemic risk and contagion. Ms. Yellen added that there has been a lot of focus on regulation impairing liquidity. The US has tried to diminish the reliance of the financial system on wholesale funding, penalising short-term funding of large inventories of liquid assets because they may pose a risk to financial stability. This can be an unintended side-effect of that kind of regulation. However, it is important to remember to take both sides of the regulatory agenda into account and, on balance, the regulations have lowered leverage and made the financial sector safer.

She said that US authorities are most worried about liquidity, fire sale, and contagion risks when you have funds like ETFs that offer daily or rapid redemption but illiquid long-term assets. Under stress such funds can try to sell illiquid assets, lowering their value and provoking a price drop and contagion across funds, and eventually throughout the financial sector.

So the SEC has written rules on liquidity management of funds, recommending swing pricing or other techniques to make sure the penalties for liquidating a fund fall on first movers and are not shifted to others in the fund. Authorities also concerned that some hedge funds are using too much leverage, including derivatives to create synthetic leverage. There is insufficient information and disclosure to be able to evaluate whether or not these are significant risks.

« When you say ‘financial crisis’ let me say ‘disruption’. Our hope is that, because we have stronger regulations and a safer financial system, a disruption would not trigger a fullblown financial crisis of the type we have seen. »  

Janet L. Yellen

« When you say ‘financial crisis’ let me say ‘disruption’. Our hope is that, because we have stronger regulations and a safer financial system, a disruption would not trigger a fullblown financial crisis of the type we have seen. »  

Janet L. Yellen

THE PARADOX OF LIQUIDITY

Do not confuse macro liquidity coming from accommodative monetary policies with market liquidity, which determines the capacity to sell in normal conditions. The former is quite high, while the latter is reduced. This is the “paradox of liquidity”.

There are several aspects to this:
•The more the positions are consensual and liquidity is low, the greater the risk of collapse.
• When liquidity declines, prices become less indicative since they move away from their fundamentals.
• Contagion and volatility risks tend to increase, while less liquid markets lose some of their shock absorption capacity.
• Lower liquidity means greater handling capacity.
• Low micro liquidity may be more risky than excess macro liquidity.

For traditional assets market liquidity is assessed in terms of four dimensions:
• Market depth or the ability to conduct large transactions without causing significant price changes.
• The narrowness of the bid-offer spread.
• The speed of execution.
• Price resilience, or the ability of a market to return to prevailing price levels before a period of turbulence. Overall, liquidity of portfolios is one of the the major worries at present.

WE ARE BETTER PREPARED FOR A FUTURE CRISIS

Overall, the world would be better placed to deal with another financial crisis, stated Ms. Yellen. The banking system is safer with more and better-quality capital and more liquidity. In the US there is resolution planning for the largest firms and better tools to resolve systemic financial institutions. Standardised derivatives are being centrally cleared, and those that are not have higher margin requirements. The monitoring system for financial stability risks has also been improved.

On what could trigger a crisis, she theorized that it could be trade policy or overvaluation of assets. It is easy to envision shocks that could lead to higher risk premiums, increases in long-term rates, or increases in the low credit spreads in debt instruments. Perhaps some of these risks are being underestimated, and if there were a significant upward movement in rates that could trigger changes in asset valuation. “I hope that potential shocks would not create a financial crisis, but obviously there are risks”, she warned.

WILL WE MOVE TOWARDS A “DEBT TRAP”?

In OECD countries, public debt ratios are very high as the ageing of the population accelerates, leading to higher public spending on pensions and health care. What are the possible scenarios?

• A massive reform or cut of pensions and health care, which will improve the metrics, but can give another boost for populist parties and extreme parties.
• A significant rise in the tax burden which would curb potential growth (as in Italy) and real growth (as in peripheral countries during the austerity period).
• Strong pressure on monetary policy, with the risk of fiscal dominance. Low rates for even longer, and a continued increase in the size of central banks balance sheets through QE programmes, which could lead to a financial crisis.
• The continued rise in public debt ratios leading to a sharp rise in interest rates unless there is a drop in private debt (crowding- out effect).