Monetary normalization

Ten years after the last financial crisis, most of the big central banks still hold their ultra-loose monetary policies. Even though the ECB seemingly started to taper its QE programme, the money pumps will be on until the end of the year. However, due to base effects (and changing nominal pace of purchases), the ‘tapering’ started more than a year ago by now. The Bank of Japan kept his policy stance so far, although it is questionable how long can they buy assets without jeopardizing the smooth operation of private financial firms or their own solvency. The Fed also switched to a dovish tone lately. Correspondingly, the dollar index went through a mild correction following the Trump-rally in last year’s November and December. One of the reasons might be the fading of the expected policy rate difference between major central banks. Since commodity prices stabilized, inflation returned, and global trade was partly revived, expectations shifted to the upside. Europe might represent an exception, however the weighted 10-year-yield also took part in the global yield rise in the last half a year.

Nowadays the Eurozone still resembles to the international gold-standard system after WWI: fixed exchange rates with balance of payments imbalances. The main issue lies within the solution, governments have to rely solely on internal devaluation by following pro-cyclical policies. The problem with such measurement is its unpopularity, hence can not be held without political turbulences. Realizing the issue, the ECB is constantly trying to inflate the core-economies, while also trying to avoid a debt-deflation spiral in the periphery. Two birds with one stone, we could say. Lowering real debt burden, while they try to restore the balance between economies. Unfortunately, the households of the core do not cheer the measures as they feel the value of their savings eroding.

The strength in the euro and raising core government bond yields are more likely to be due to the favourable result of the French election regarding the unity of the monetary bloc. The insurance premiums (= chance of the Eurozone falling apart * appreciation in national currency) faded, however, the internal imbalances are still present in the system. Given the latter condition, I would be surprised if the ECB would rush with its policy normalization, inflation tolerance will be higher. Negative real rates are still needed and it seems they are here to stay with us.

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Lagging policy

The Trump-administration pledged to cut corporate income tax rates from 35 to 15 percent in the recent days. In accordance with the previous rhetoric of Trump’s campaign and presidency, the measure is also aimed to support international competitiveness and improve external balances by lowering the tax content of American production. After the first hearing, it doesn’t seem to be a bad idea, as the US has the highest official tax rate among OECD member countries. However, if someone would take a look behind the headline numbers the picture would change significantly. On the one hand, when compared to GDP numbers the American corporate tax burden is much lower than in most OECD economies, representing a smaller burden for the overall supply chain. On the other hand, the effective corporate tax rate is 11 percentage point below what the official numbers would suggest.

The differences between official and technical measures originate from various factors. Firstly, American corporation producing for export markets may not bring the profits home, hence spare a round for the taxman, and increase the profit for themselves. Secondly, the share of profits and margins within the headline GDP numbers may differ from country to country, thus examining plain vanilla tax rates does not result an apple-to-apple comparison in the system’s competitiveness. Thirdly, and maybe most importantly, rules of taxation may once again differ between OECD member states. There are several factors, such as accounting for amortization and write-downs, or deferred payments, which can effectively change the base or the temporal flows of public funds.

American corporations already exploiting deduction policies to get a leverage against Uncle Sam. For instance, the companies of S&P 500 are eligible for future deductions around 200 billion dollars, which also appear on their books. Altering the tax rate would change the valuation of such assets, hence create an immediate loss for the firms. However, this loss might be dwarfed by the amount of lower tax obligations in the future. According to the first round calculations, the new tax regime would create a 2-billion-dollar gap on the government account in the next ten years, creating federal debt equal to roughly 12 percent of current economic output. Even though nominal numbers are set to increase, the economy does not have to effectively pay it back in order to build down its debt burden. The other way is to grow it out.

Increasing government deficit would have the same monetary effects as credit expansions created by commercial banks. As in any kind of accounting, the economy also needs a corresponding ‘savings’, or asset side. This may come from the saved tax money, which effectively means that a unilateral social transfer would be replaced by a bilateral agreement (government bond) which would create a ‘tangible’ and marketable asset. The other way is to finance the deficit by involving foreign investors into the equation. However, this would result in deteriorating external balances, exactly the opposite what the current administration is trying to achieve. (Financial and capital accounts = current account)

The two solutions are not mutually exclusive, nor make a difference regarding following policy implications. By issuing new bonds (either financed internally or externally) the quasi-money supply increases, along with money velocity. Given that capacity constraints apply, it would be surprising if the real economy could keep up with this monetary expansion without inflationary pressures. This may help the government finances, however, the Fed would need to tolerate higher inflation.

As a result, if the Fed doesn’t raise rates the dollar would weaken due to low real rates, international investors my demand higher interest rates and sell their treasury holding off. The other way, if the Fed decides to raise the rates to fight inflation, primary fiscal deficit may prevail. Either way, the Treasury department faces a hard time in the long-term for a short-term gain on the peak of the recovery.