Vasco Curdia of the San Francisco Federal Reserve Bank writes: To boost economic growth during the financial crisis, the Federal Reserve aggressively cut the target for its benchmark short-term interest rate, known as the federal funds rate, to near zero around the beginning of 2009. Since then the time projected for the rate to return to more normal historical levels has been continually postponed.

To understand the level of the federal funds rate and when it might be normalized it is useful to consider the concept of the natural rate of interest first proposed by Wicksell in 1898 and introduced into modern macroeconomic models by Woodford (2003). The natural rate of interest is the real, or inflation-adjusted, interest rate that is consistent with an economy at full employment and with stable inflation. If the real interest rate is above (below) the natural rate then monetary conditions are tight (loose) and are likely to lead to underutilization (overutilization) of resources and inflation below (above) its target.

Figure 1
Estimated natural rate of interest (annual rate)

Note: Blue shaded areas represent the range of possible estimates with 70% (darker) and 90% (lighter) probability. Gray bar indicates NBER recession dates.

Figure 1 shows that the natural rate declined substantially during the recession and did not start to recover until the end of 2014. Currently, the median estimate is –2.1%, far below its long-run level of about 2.1%. The fall in the natural rate during the recession is explained by low expected productivity growth. With projected low growth, the economy would need less saving and more spending to use resources fully, hence the lower natural rate of interest. During the economic recovery, the natural rate was kept low by weak demand due to a larger propensity to save in the aftermath of the financial crisis.

 

Figure 2
Interest rate gap and output gap

Note: Gray bar indicates NBER recession dates.

The large decline in the natural interest rate early in the recession (shown in Figure 1) may explain why the Federal Reserve lowered the federal funds rate so fast in 2008 even before the output gap became negative. Interest rate rules that ignore the variation of the natural rate over time—like the one proposed in Taylor (1993)—would not prescribe dropping the federal funds rate so quickly, which would lead to even tighter monetary conditions and a more negative output gap. Therefore, while monetary policy was accommodative relative to the Taylor rule, it was not accommodative enough to prevent the interest rate gap from increasing and output from falling below potential, as shown in Figure 2.

This model projects that, based on historical relationships, the future interest rate will return to normal too quickly, leading to persistently underutilized resources and output below potential even after the interest rate gap closes.

Figure 3
Real-time estimates of the natural interest rate

The natural rate of interest is expected to remain below its long-run level for some time. This implies that low interest rates over the next few years are consistent with the most efficient use of resources and stable inflation. The analysis also finds that the output gap is expected to remain negative even after the natural rate is close to its long-run level. Additionally, there is considerable uncertainty about both the short-run dynamics as well as what level should be expected in the longer run. All these considerations reinforce the possibility that interest rate normalization will be very gradual.  Vasco Curdia of the SF Federal Reserve writes

 

Japan is eager to do business with Iran.

J. Berkshire Miller analyzes Japan’s investment interests in Iran:  One of Japan’s key targets is Iran’s potentially lucrative Azadegan oil fields, near the border with Iraq. According to Iranian government estimates, the Azadegan fields could contain over 30 billion barrels of oil in reserve. Tokyo has been interested in working with Tehran to develop the oil fields for the past two decades and at one point, in 1996, had a nearly 75 percent stake in the southern Azadegan fields through Inpex, a Japanese oil company.”

But don’t call it a complete reset just yet.  While Tokyo is looking to increase its investment footprint in Iran, and indeed its presence in the entire Middle East, it will likely tread carefully so as not to upset relations with arguably its most important ally, the United States:

Tokyo remains sensitive to the lingering problems in the relationship between its key ally, the U.S., and Iran, which are not limited to the nuclear issue. During a meeting with Iran’s foreign minister earlier this year, Japan’s foreign minister, Fumio Kishida, expressed concern about longstanding military ties between Iran and North Korea and requested that Iran sever ‘all military cooperation with North Korea.’

Behavioral experts believe that people are more interested in hearing a story about an investment than in assessing its risk.

Behavior Macro reports:  It doesn’t matter how much you explain to clients the centrality of risk management; they obligingly nod, wait for their turn to speak, and say, “Oh, that’s great.  Now, what do you think about the euro here?”

Clients, like traders, crave stories. They want to believe the people they trust with their money are genetically superior, multilingual polymaths. We managers want to believe this about ourselves, too.

But the truth is that in addition to loving stories, we are all hard-wired to be poor risk managers.

Behavioral studies show that we are risk adverse when it comes to losing money, but we take on much more risk when we are trying to “get back to even.” This is referred to as the reflection effect.

Translated in trading, this means we tend to harvest profits too early, and tend to let our losers run. This is where the famous “I’ll sell it when it gets back to where I bought it” comes from. The reflection effect generates negative payoff asymmetries.

One of the most important risk management tools is doing the opposite: Generating positive payoff asymmetries in your trading. Risking one to make three. Risking two to make five. This is what good traders do, even if they claim their P&L comes from superior intellect. And, of course, if a trade breaks your way, you can use trailing stops and/or other techniques to improve your payoff asymmetries even further.

So, what one really needs to do is set up trades so that winners run and losers are dumped quickly.

Think about the math. If you are risking one to make a minimum of three, and your ideas are right 50% of the time, you will be doing very well. In fact, your batting average could be far less than 50% and you’d still make money. If you regularly take profits quickly, as “everyone’s” would have us do, your batting average needs to be far higher.

Anything that appeals to our instincts to take profits quickly is likely to make us worse traders, not better. And trading is hard enough as it is.

This may seem obvious, but if it were that obvious, no one would ever again say, “You can never go broke taking a profit.” Ever.

Central Banks have been dictating economic policy world wide for a decade.  is it time to shift gears?

Larry Elliot writes:  Turn those machines back on. So demands the unscrupulous banker, Mortimer Duke, when he finds he and his brother Randolph have been ruined by their speculative scam in the film Trading Places. Having lost all his money betting wrongly on orange juice futures, Mortimer demands that trading be restarted so that he can win it back.

It’s not known whether Christine Lagarde is a secret fan of John Landis movies. As a French citizen, François Truffaut might be more her taste. There is, though, more than a hint of Trading Places about the advice being handed out by Lagarde’s International Monetary Fund to global policymakers.

To Europe and Japan, the message is to print some more money. Keep those machines turned on, in other words. To the US and the UK, there was a warning that raising interest – something central banks in both countries are contemplating – could have nasty spillover effects around the rest of the world. Think long and hard before turning those machines off because you may have to turn them back on again before very long, Lagarde is saying, because the big risk to the global economy is not that six years of unprecedented stimulus has caused inflation but that the recovery is faltering.  Should We Minimize the Role of Central Banks

Global finance leaders believe China will weather its slowing growth and manage a successful transition from an export to a consumer economy despite a huge buildup of internal debt in the world’s second largest economy.

The International Monetary Fund believes the Chinese economy will grow 6.8 per cent this year and 6.3 per cent in 2016, slower than recent levels but still enough to keep driving global economic growth when other positives have largely disappeared.

French Finance Minister Michel Sapin is among the optimists, along with Britain’s George Osborne and IMF chief Christine Lagarde.

China’s Deputy Central Bank Governor, Yi Gang, was keen to reassure his peers at this week’s IMF meetings in Lima, saying a recent devaluation was a one-off and that China’s economy was stable.

Yet cracks are already appearing in China, an economy whose red-hot growth of almost 10 per cent a year for 30 years fueled a commodity super-cycle that in 2008 pushed oil prices as high as $145 a barrel, and inflated demand for iron ore and edible oils, as well as industrial goods from advanced economies like Germany.

It is not just China that is a risk – although it is by far the biggest one to the relatively rosy IMF forecasts of global economic growth of 3.1 per cent this year and 3.6 per cent in 2016.

In Germany exports to China, Brazil and Russia account for 3.4 per cent of gross domestic product, according to investment bank Barclays, a risk for Europe’s largest economy. China alone accounts for 10 per cent of Germany’s auto exports.

A sharp drop in German exports  in August, which fell at their fastest pace since the 2009 financial crisis, is likely to be related to the fall in trade in Asia, Barclays said. Industrial production and factory orders also declined.

“Because of China’s weight in global production and trade, and because of the high commodity intensity of its production and demand, China’s recession is the one that matters most for the global economy,” Citi’s chief economist Willem Buiter has warned.

The IMF Global Financial Stability report said that over-borrowing by Chinese companies was equivalent to a quarter of gross domestic product.

While China’s August stock market crash and sudden devaluation rattled global markets, it may have just been a foretaste of things to come if China does not address its huge debt problems.

“Direct financial spillovers include a possibly adverse impact on the asset quality of at least $800 billion of cross-border bank exposures,” the IMF report said.

It calculates that if a tightly wound credit cycle in emerging economies, including China, unwinds with rising corporate default rates, aggregate global output could be as much as 2.4 per cent lower by 2017 relative to the IMF’s baseline forecast.

“China still has policy buffers to absorb financial shocks, including a relatively strong public sector balance sheet, but over-reliance on these buffers could exacerbate existing vulnerabilities,” the IMF said.