Mickey levy

The Fed, ECB, BoJ and BoE: Objectives and Challenges Mickey . D. Levy Blenheim Capital Management 32nd Annual Monetary and Trade Conference Global Interdependence Center Philadelphia, Pennsylvania April 16, 2014

Monetary Policy Objectives and Challenges • The US Fed has a dual mandate—low inflation and high employment— while the ECB, BoJ and BoE have single inflation mandates • Since the US financial crisis, economic recoveries have been slow with lingering high unemployment and with the exception of Japan, inflation has been below target • All CBs have been pursuing unconventional monetary policies and are under intense pressures to achieve broader government objectives • Presently, what should be the appropriate policy response for each CB? • Fed: proceed toward quick monetary policy normalization; ECB: implement QE to replace LTRO; BoE: hike rates and normalize policy; BoJ: under the Abe Administration’s direction, likely to enhance QQE

Low Inflation: Underlying Conditions • Inflation in the US, Eurozone and Japan have generally converged toward 1%, below desired 2% long‐run targets • Core inflation in the UK has recently receded below 2%

• CBs are forecasting inflation to rise to 2% • Economic and financial conditions underlying those forecasts vary: • US: economy mostly normal but high unemployment; improved balance sheets; many earlier economic and financial imbalances reduced • Eurozone: early stage of recovery following deep recessions and financial crises; clearing up excesses and imbalances is painful; addressing banking reform • Japan: economy growing but uncertainties abound; trying to reverse two decades of malaise but big obstacles to reform; large fiscal drag • UK: strength in economy exceeding expectations boosting confidence; inflation near target

Clarifying a Misperception about Deflation • Policymakers assert that low inflation or actual deflation is necessarily harmful to economic performance • This assertion is not correct • If source is insufficient demand and expectations of deflation become embedded and deter consumption and investment, it may reinforce weak aggregate demand (Japan) • If deflation or low inflation do not have negative feedback on expectations and aggregate demand, then not harmful ‐Low inflation may reflect technological innovations or positive productivity shocks that contribute to economic growth (US) ‐Low inflation may reflect necessary wage or price adjustments (Europe)

Observations about Low Inflation and Aggregate Demand, US and Eurozone • US: nominal GDP growth (4%+) comfortably above potential growth and accelerating • Real economic performance strengthening: monetary stimulus, improving balance sheets, diminishing headwinds and fiscal drag • Deflation probability minimal; rising inflation almost certain, upside risks

• Eurozone: soft nominal GDP growth below potential; downward wage and price adjustments following unsustainable excesses • Moderate growth, but early stage of recovery with necessary adjustments and inhibitions constraining expansion • Outlook: sustained low inflation, possibility of temporary deflation • However, rising confidence dispels concerns about negative feedback loop

Trends in Nominal GDP Growth

US PCE Deflators: Changes in Relative Prices

Japan: No Nominal GDP Growth since 1991

Observations about Low Inflation and Aggregate Demand, Japan and UK • Japan: nominal GDP now growing above potential, following two decades of no growth and insufficient demand ‐Real growth OK, but substantial uncertainty and fiscal headwinds; lack of necessary long‐run reforms ‐Outlook: positive CPI inflation but difficult to sustain 2% objective (excluding impact of VAT tax hike) ‐Concern: rising inflation reduces real purchasing power, but inflationary expectations lag, undercutting propensity to spend • UK: strengthening economic performance and high confidence • ‐Consumer spending, housing and business investment strengthening ‐Outlook: continued strong growth, rising inflation

US: The Need to Normalize Monetary Policy • Economy moving back to normal; unemployment declining cyclically, but noncyclical factors (demographics, govt policies, etc.) inhibit jobs • Fed’s policies generating significant distortions and pose significant long‐ run risks while not helping economy much • Low inflation reflects in part declining prices of some goods due to technological innovations, internationalization of labor and goods markets • Maintaining negative or zero real Federal funds rate until economy reaches full employment would add to distortions and long‐run risks • Rising real interest rates reflecting healthy growth do not inhibit economic recovery or expansion (1983, mid‐1990s) • Fed should accelerate monetary policy normalization: establish strategy for unwinding balance sheet and rate hikes

Eurozone: The Need to Maintain Growth • The ECB forecasts sustained moderate economic growth and lower unemployment, as well as inflation rising to 2% • Financial risks have abated, current account imbalances have narrowed, most governments’ primary budgets are in balance and bank recapitalization has begun

• However, the ECB’s balance sheet is shrinking as banks pay back LTRO loans and bank lending continues to decline • Eurozone nominal GDP growth is barely at real potential, consistent with long‐run price stability (zero inflation) • Replacing the ECB’s LTRO loans to banks with a QE program of purchasing EU sovereign debt would be consistent with the ECB’s inflation mandate • This monetary policy should be accompanied by needed economic reforms and long‐run fiscal austerity focusing on spending cuts

Central Bank Assets: Growth since 2007Q4

Japan: The BoJ Cannot Do It Alone • Following two decades of on‐and‐off deflation and recession resulting from insufficient demand and misguided policies, sustained growth requires a combination of confidence‐building and pro‐growth reforms • BoJ’s QQE and an associated depreciated yen (and higher Nikkei) temporarily boosted confidence but cannot sustain healthy growth ‐The lower yen has had only a modest impact on exports and business

investment, and a one‐time impact on profits

• VAT tax hike poses significant fiscal drag and uncertainty • Significant economic, labor and regulatory reforms are necessary to generate sustained healthy growth • More monetary easing would provide little lasting effect, but the BoJ seems likely to carry out orders from the Abe Administration and enhance QQE