Mickey Levy - Bank of America

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Mickey Levy - Bank of America

  1. 1. Fiscal and Monetary Policy “Worst Practices”Treasury & Risk Management Amid UncertaintyMickey D. LevyChief EconomistBank of America Treasury & Risks 17th Annual Alexander Hamilton Best Practices Summit New York, NY October 1, 2012
  2. 2. Monetary and Fiscal Policy “Worst Practices”• The namesake of today’s event—Treasury & Risk’s Alexander Hamilton Best Practices Summit & Award program—the first Secretary of the Treasury and the architect of the First Bank of the United States, as well as an advocate of federal debt “if not excessive”, would be aghast at today’s fiscal and monetary policies and would demand instant and radical reform• Separately and combined, US fiscal and monetary policies are inconsistent with long-run healthy economic performance and involve risks that are potentially destructive to financial markets and the economy• Today I will discuss the current thrusts of monetary and fiscal policies, their intentions, their influences and costs, and the risks they may involve• The short-term and political priorities of macroeconomic policymakers make our strategic decision making very difficult2
  3. 3. Fiscal Policy: Undisciplined, Unsustainable and Costly• US deficit spending is one of the highest in the world in last four years; and stock of debt has doubled to over 80 percent of GDP since 2007 • Under reasonable assumptions, high deficits will persist and debt will grow; the fiscal shortfall is multiples larger when unfunded liabilities are included• In addition to the mounting debt, critically important for economic performance is what the spending is for• A high and rising share of spending is for transfer payments, income support and medical programs, and a small and shrinking share is for investment and activities that explicitly add to productive capacity • The rising debt and allocation of national resources to current consumption is effectively “borrowing” from future standards of living • This reflects the national priorities of the government and its citizens3
  4. 4. Fiscal Policy (con’t)• The current structure of taxes violates best practice rules of efficiency, fairness and simplicity • Result: costly; source of “dead weight economic losses”, economic and financial distortions, uncertainty; also resentment and loss of credibility• There are large political obstacles to reform• General observations: • The US is a very wealthy nation that can afford to support incomes of the needy and elderly, but the current spending programs are highly inefficient and wasteful • Long-run budget imbalance too large to close through tax increases • Eventual fiscal compromise will involve some cuts/restructuring of entitlements and higher taxes • Achieving compromise will require effective leadership • The economic and financial benefits of achieving fiscal policy sustainability are substantial 4
  5. 5. The Fiscal Cliff: Playing the Probabilities• Temporary tax cuts and spending increases, if allowed to expire, would impose significant “fiscal restrictiveness” in early 2013• Neither political party wants it to occur, so it won’t• Select tax and spending provisions will be allowed to expire and others will be extended • The result will be moderate tax increases and spending cuts • Likely tax increases: payroll taxes, business expensing rules, marginal rates on highest income • Likely spending cuts: extended unemployment compensation• Businesses and households already anticipate changes and are adjusting behavior, such that negative economic impact in early 2013 will be muted, and growth will be sustained• Extremely low probability that Congressional non-action will result in large tax increases and spending cuts that generate recession • But lack of leadership may result in low probability high-cost outcome 5
  6. 6. The Fed’s Unprecedented Monetary Policy: Will it Work?• Fed’s QE has flooded financial system with excess liquidity ($1.5 trillion in excess reserves) and lowered interest rates• QEIII’s purchases of MBS and forward guidance on low interest rates designed to stimulate demand and create jobs • Presumes high unemployment is cyclical• Many steps between monetary stimulus and job creation • Lower bond yields and higher asset prices, along with weaker currency, are primary channels• Constraints on economic and jobs recovery remain: • Demand and production inhibited by household deleveraging; bottlenecks in mortgage markets; heightened uncertainties (fiscal, Europe) • Employment inhibited by labor market characteristics, government downsizing, business uncertainties, globalization/skills mismatches6
  7. 7. Turbo-Charged Monetary Policy: Risks• Distorts financial markets, boosts asset prices, encourages risk-taking and neutralizes market discipline• Risks to current policies • Economy and/or employment do not respond positively • Lower US dollar/higher commodity prices boost inflation (and suppress real disposable income) • Abrupt shift in market expectations, despite moderate inflation • Loss in credibility of monetary and fiscal policymakers/credit downgrade • Risk of generating new bubble• Eventually, Fed must end MBS purchases and change forward guidance • Artificially low interest rates eventually must adjust to reflect economic and inflation fundamentals7
  8. 8. The Unhealthy Monetary-Fiscal Policy Nexus• The Fed’s massive purchases of government debt (Treasuries plus agencies) and MBS entwines monetary policy with fiscal and credit policies • Fed is largest holder of US Treasury debt, and dominant owner of long- dated securities • Blurs concept of government’s “publicly-held debt”• Fed’s debt monetization exceedingly unhealthy: • Fed’s “printing press” designed to inflate, suppresses interest rates and subsidizes/reduces government’s debt service costs • Mounting budget costs of interest rates may influence Fed’s policies (i.e., on when to exit) • Heightened influence of fiscal/budget on inflationary expectations• Fed relinquishes independence to fiscal policy with unknown consequences• MBS purchases involve Fed in credit policies; monetary bailout of GSEs?8
  9. 9. US: Moderate Growth, High Unemployment• Low probability of recession• Consumer spending constrained by deleveraging, mortgage problems, balance sheet adjustments• Housing: positive trend with upside potential• Exports: critical risk amid slowing global growth• Business investment soft, adversely affected by uncertainties• High unemployment: is it simply “cyclical” or something more?• My hunch: growth will improve gradually, but weak labor markets reflect challenges that will not be resolved quickly• Outlying risks: fiscal policy follies9
  10. 10. Treasury Risk Management Amid Policy Uncertainties• Economic growth is moderate, probability of recession is low, and inflation presently is tame, but remember, monetary and fiscal policies are both unprecedented and unsustainable • Remember, unsustainable trends eventually end • Both fiscal and monetary policies involve significant risks• The Fed’s monetary policy is purposely distorting markets, keeping interest rates artificially low and neutralizing “market discipline”• History shows that markets may take a long time to recognize fundamental imbalances, but once price inconsistencies are acknowledged, market price adjustments may be rapid and jarring10

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