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Weekly Economic Commentary
Northern Trust
By Carl Tannenbaum, Asha Bangalore
November 16, 2012


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- The focus on the fiscal cliff cannot be overstated.


- It is very hard for the world’s central banks to set rules governing monetary policy.


- The troika charged with addressing Greece has some internal disagreement.
I had the good fortune of spending most of this week at our offices in London and Amsterdam. With the exception of some travel travails (involving planes, trains, and automobiles), the trip was a great success. The conversations were illuminating.

Partners and clients there were keenly focused on the current US budget negotiations, which began in earnest almost immediately after the voting concluded on November 6. The urgency is being driven by the fast approach of Federal tax and spending changes that form our fiscal cliff. And if the number of headlines, position papers, and pledges of cooperation emerging from Washington are any indication, our leadership has been spurred to action.

There are certainly skeptics on both sides of the ocean. If past is prologue, the intransigence of the past four years is not a good harbinger. And political commentators have observed that both sides might stand to reap strategic gains from taking us over the cliff.

But we think this time could be different. Here’s why.

- At a high level, the election didn’t change the composition of the Congress very much. But it appears that the fringes on each side are smaller, or at least less vocal. Visits with analysts in Washington immediately after the election gave me a sense that there is increased willingness to engage, as opposed to standing on absolutes.


- The difference in the two sides on tax policy seems to have narrowed since the height of the Presidential campaign. There is consensus that current tax rates should be extended for households earning less than $250,000; the debate surrounds those earning more than that.

Weekly Economic Commentary 11/16/12 Chart 1

As shown in the chart above, top earners represent a small fraction of the tax-paying populous, but they account for a significant portion of the country’s adjusted gross income. Upper income taxpayers also make greater use of deductions. There seems to be a willingness on each side to look at the crossover between tax rates and deductions in an attempt to sustain Federal revenue; even Glen Hubbard, who advised Governor Romney, offered support for some compromise.


- Each side recognizes the long-term impact that entitlement spending will have on the Federal budget, on debt sustainability, and on American competitiveness. Picking up on recommendations made by last year’s Simpson-Bowles commission, the two sides are exchanging good thoughts on reducing the nation’s long-term liabilities.


- Markets are clearly threatening the parties with revolt if nothing is done. Equity trading has struggled since the election, with the fiscal cliff often blamed for bearishness. A looming debt downgrade provides the prospect of additional negative reinforcement.


We certainly do not think that structural reform of the US tax code or medical system will emerge from lame duck negotiations. Those will take a bit more time and careful thought. But we do think that the two sides will do more than simply tiding the budget over for a few months.

Despite the fog that enveloped both England and Holland last week, my flight ultimately arrived at its destination. I am hopeful that a US budget resolution will soon emerge from the political mist, late but nonetheless welcome.

Central Bank Guidelines: Clear or Cloudy?

Central banks around the world are grappling with how best to express their policy objectives to investors. Their hope is that doing so will provide a discipline around decisions and make their actions more predictable and transparent. But no one has yet hit on the optimal formula.

It’s been more than 50 years since Milton Friedman first proposed his version of a monetary policy rule, calling for central banks to seek steady growth in the money supply…and nothing else. Based on economic history to that point, this simple formula promised to produce solid growth with limited inflation.

But almost from the first, implementing this regime encountered practical realities. How should money be defined? The answer to this question has become considerably more difficult in the last generation. What should an appropriate target be, and over what time frame should it be measured? Should it be a point, or a range? And should corrective action be taken immediately if actual behavior varies from what is desired?

The dimensions of this challenge have multiplied geometrically as central banks add mandates. In the US, the goal of achieving maximum sustainable employment was added to the Fed’s plate in the late 1970s, and monetary authorities around the world have become increasingly involved in the quest for financial stability.

Even in places like the UK and the Eurozone, which have adopted seemingly simple inflation targets, these devices do not seem to be the call to action that some think they should be.

Weekly Economic Commentary 11/16/12 Chart 2

Federal Reserve Vice Chair Janet Yellen picked up on the theme this week, offering a talk entitled “Evolution and Revolution in Central Bank Communications.” It traces the trail from secrecy to transparency that monetary authorities have blazed in the last generation, and offers thoughts on current issues facing the Fed. Should there be a formal target for employment conditions as a complement to the one adopted for inflation earlier this year? And should targets be ceilings, or central tendencies?

The minutes of last month’s Federal Open Market Committee meeting certainly seem to suggest that the group might replace date-based guidance with language that links policy to specific macro variables. More discussion is forthcoming, but the current “low for long” promise might be rephrased in coming months.
Given that targets are hard to define, and not always strictly adhered to, the question arises as to whether they are of any use. Our view is that they do have important value, but that they shouldn’t be given more credit than they deserve.

Decision rules are a distinct improvement over the mystery that used to shroud central bank policy, and they provide at least a framework that makes decision-making more understandable. But given the uncertainty surrounding economic measurement and cause-and-effect relationships between policy changes and outcomes, discretion in enforcement is a must.

Seeking the Right Grecian Formula

Mario Draghi, the head of the European Central Bank (ECB), unveiled a new euro note at the last press conference with pictures of Europa from Greek mythology. Admittedly, the design choice was undertaken a while ago, but it does carry an implicit message that Greece is unlikely to leave the eurozone in the next few months.

The Greek economic crisis has taken on a new dimension and now includes a spat between two of the three inspectors of the so-called troika (European Union, European Central Bank, and International Monetary Fund). At the heart of the dispute between the IMF and EU is whether Greece should be given time until 2020 or 2022 to reduce its public debt to 120% of GDP from the most recent predicted peak of 182% in 2013.

The issue at hand is deeper than the time span involved to reduce the debt burden of Greece. The IMF strongly believes that without another round of debt restructuring, Greek sovereign debt cannot be reduced to the desired level in the next ten years. More importantly, this time around both private sector creditors and official creditors would need to take a haircut, unlike the spring 2012 debt reduction program which involved only the private sector taking a hit.

Weekly Economic Commentary 11/16/12 Chart 3

 

For example, Germany would have to write down Greek debt on its books, incur a significant loss, and face challenges in balancing its own budget. Likewise, all official holders of Greek sovereign debt including the ECB would have to follow suit. The IMF’s insistence is tied to the credibility of the debt-reduction plan. The EU is of the opinion that stretching the time frame for debt reduction to 2022 would allow the Greek economy to recover and enable it to meet its debt obligations.

In the meanwhile, of utmost importance to Greece is the next tranche of €31.5 billion aid package. A decision about this support will be made on November 20. Athens has managed to tide itself over by raising short-term funds in the market with the helping hand of the European Central Bank. The public airing of differences between the IMF and EU led to unsettled market conditions, with the euro losing ground and trading around $1.28 on the day of the dispute, a level last seen in September.

The nature of the likely settlement of the EU/IMF row remains fuzzy. Lurking in the background is whether official sector involvement in Greek sovereign debt restructuring will provide disincentives to other indebted members of the Eurozone undertaking reforms and fiscal consolidation. The drama continues.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

 

(c) Northern Trust

www.northerntrust.com


 

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