In the continuing series–unsolicited complaints and advice from me to global monetary authorities—see, e.g. 

http://rajakorman.tumblr.com/post/139151237270/tired-of-nirp-try-intervention

http://rajakorman.tumblr.com/post/114124758065/the-fed-never-talks-about-the-dollar-and-other  or

here’s an effort at writing the key exchange rate paragraph from the upcoming G20 statement. I don’t think we’re actually there yet, and I would be very surprised if something like this made it into the statement this coming weekend. At the same time, I think something like this would actually make some sense, with the second half in particular reflecting one of my longstanding bugbears about the way the international monetary and financial system works right now. If, somehow, you have escaped my persistent online buttonholing about this subject, see here.  http://rajakorman.tumblr.com/post/84527845240/on-spillovers-exchange-rates-and-monetary

Anyway, here’s what I would draft if I were a Sherpa. 

“The members of the G20 welcome the inclusion of the renminbi in the IMF’s Special Drawings Rights basket. They urge and commit to further prudent liberalization of China’s capital account and the gradual process of renminbi internationalization in a manner that enhances that global stability.  Members’ central bank reserve portfolios will continue to be modified opportunistically to reflect the renminbi’s inclusion in the SDR as a currency that is freely usable by the official sector. The members acknowledge recent research from the BIS and the IMF on instabilities stemming from the current configuration of the international monetary and financial system and welcome efforts by the IMF to study and  eventually to promote safer cross-border capital flows. Members are aware that there are circumstances in which large, quasi-instantaneous shifts in desired portfolio balances can be self-reinforcing and lead both to substantial divergences from medium-term equilibrium exchange rates and to substantial negative international spillovers. They stand ready to cooperate with each other as appropriate to prevent such disequilibria from destabilizing the global economy”.

Right now, there are two dominant concerns about the international economy that are closely intertwined

The first is the worry that developed market monetary policy is played out, with several major developed market central banks operating benchmark rates at or below the zero lower bound, which in turn has contributed to worries about the health of the banking system under negative interest rate regimes or even with extremely flat yield curves.  My sense is that some of these worries might be overstated as negative rates have existed for a while in Sweden, but the impact on bank equity there is a relatively recent phenomenon.  Nevertheless these worries exist, and can become self-reinforcing, particularly in Europe, where the feedback loops linking bank debt/equity prices, risk aversion among banks, an impaired credit channel, lower economic growth and rising NPLs can be particularly nasty given the absence of fiscal headroom in some countries. The market’s worry seems to be that we have reached a particular point in competitive monetary easing among the major DM  central banks where returns are not only diminishing but might even be negative.

At the same time, there is also a worry that under current circumstances, even as DM central banks engage in competitive monetary easing, the benefits of this are not filtering through in a sustained way to EM. Indeed, the concern in EM is that many CBs might find themselves unable to engage in sufficient monetary easing precisely because the scale of monetary expansion required to restore growth and/or financial stability would weaken their currencies to the point that it might create a financial crisis either at home or abroad. For some emerging markets, the concerns focus on foreign currency debt  that will lead to a tightening of financial conditions; in others  the worry is high inflation passthroughs from exchange rate weakness that limit the ability to cut rates. In the case of China, the biggest and most important EM of all, the worry is more inchoate, with worries that the operation of the trilemma will lead to runaway Renminbi depreciation resulting from capital flight (a term that in the Chinese case includes many flows that in DM would be regarded as portfolio diversification, tax arbitrage or simple asset-liability management). Even among relative optimists who concede that the size of the tradeable sector and the liablity structure of Chinese debt mean that the  weak Renminbi doesn’t hurt China, the concern is that Renminbi weakness can or will spill over into other markets that might be more vulnerable.

In sum, the worries can be captured by the dichotomy that in DM—monetary easing is believed to be ineffective; while in EM it is believed to be impossible.

I’m not convinced of either of the above, but to the extent that markets believe either one or both of these things, the answer is obvious to me. The way to make monetary easing effective in DM and possible in EM is for DM to focus its monetary easing efforts not on interest rates, but on exchange rates directly. In other words, instead of using negative interest rates to try to get the exchange rate channel to work (the channel that partisans of NIRP believe to be most effective anyway), resort to directly to unsterilized foreign exchange intervention to weaken DM currencies against EM currencies, specifically the Renminbi, which has become the anchor EM currency. Such a move would represent a happy congruence of interests—it would ease DM monetary policies via CB balance sheet expansion, only such expansion would be focused on the acquisition of foreign assets, rather than domestic assets (at a point when people looking at 10 year Treasuries, Bunds or JGBs are questioning the value of such expansion).  At the same time it would alleviate worries stemming from the market’s focus on China’s monthly reserve drawdowns as participants (mistakenly in my view) gauge the pace of PboC foreign asset drawdown as being more problematic for Chinese financial stability than the pace of PboC domestic asset expansion.  The dollars that Chinese banks and corporations are buying wouldn’t come from the PboC; they would come from the Fed (same applies to Yen from the BoJ and Euros from the ECB). As I’ve said before, the excuse to do so is pretty straightforward—the inclusion of the Renminbi in the SDR basket can serve as justification for its inclusion in G7 reserve portfolios and such an excuse would also salve Chinese dignity.  And insofar as it represents intervention by the US and other DMs to strengthen the renminbi rather than Chinese intervention to weaken it (or prevent such strengthening) it can also be spun positively before Congress.

The impact of such moves on market confidence would be profound, in my view, precisely because this would help negate the narratives of inefficacy and uncoordinated policies that animate much of the sentiment in the market these days.  Someday, maybe we can even get DM fiscal policy to help out, but in the meantime, this seems to me like a pretty good place to start.

This post follows on a recent poll I held on whether the Pax Americana since 1945 was a net subsidy from or to the US. For what it’s worth, the poll (with 76 respondents) came out 55% -45% in favor of the idea that the Pax Americana was a US subsidy to the rest of world. This is my view as well, and I’m surprised it was as close as it was. About 18 hours into the poll, I actually realized that a more interesting (and in my view, truer) formulation might have been that the Pax Americana (at least since 1990) is a subsidy from the US working class to global capital and to the labor aristocracy in the emerging markets (I’m using labor aristocracy loosely, but here’s a useful link http://richardjohnbr.blogspot.com/2011/06/what-was-aristocracy-of-labour.html ). This view obviously reflects Branko Milanovic’s great work on the narrowing of cross-national (specifically DM vs. China) inequality, alongside the rise in within-DM inequality.

One of the many fascinating things about Milanovic’s work is that it suggests a huge contrast between two ages of globalization that are frequently compared with each other—the first, between 1870-1914, and the second, between 1990-2015.  

Although the first period, before the Great War, saw an increase in within-country inequality within the developed world, it also saw huge improvements in living standards for developed world (DM—to stay with the financial world’s conventions) working classes alongside an increase in the divergence between mass living standards in the DM and in their colonial empires on the other (EM for shorthand, though the term is obviously anachronistic). I’m going to chicken out of the debate on whether levels of colonial immiseration actually increased in absolute terms in this period (or just relative to DM), focusing instead on just what was happening in W. Europe, where the evidence on real improvements seems more clearcut (and which was also arguably the bigger driver of the global divergence). But the real point of this is political–this improvement in mass living standards (notwithstanding widening inequality) contributed to the sense of a national identity that existed alongside the rise of class identity that grew with industrialization. These material phenomena together help to explain developments such as the rise of revisionist socialism, tacit working class support for empire and above all, the so-called puzzle of August 1914, when socialist parties across Europe supported their national governments at the start of war. 

Contrast these material and economic developments in that first age of globalization with material and economic developments in the second age of globalization that we are living through right now.  In this phase of globalization, pace Milanovic, inequality within DM has begun to widen even as there begun a convergence of East Asian and DM working class living standards. The gains of globalization are accruing to working classes in EM (China above all) rather than to the working class in the developed world. China now looks like Western Europe/US in the Belle Epoque/Gilded Age in that we are seeing a rise in inequality, but in the context of a rise in living standards as well.

By analogy with the European experience, it seems plausible that China experiences not just social stresses, but also a surprising (to skeptical observers) rise in systemic resilience, as was the case in August 1914 in Europe. Conversely, even as elite/working class fortunes become more closely tied in the case of China or other “successful” EMs, Milanovic’s work suggests that they becoming more divergent in the case of the DMs. If so, the problems of interest group aggregation at a national level in DMs become much more problematic  now as they rely on party structures and a legacy of of elite-working class linkages that were forged during the dawn of DM mass politics in happier economic times, first in the run-up to 1914 and in a modified form between 1945-73. To make a point that’s been made before, it is this disjunction between elite and mass interests within single Western countries  that brings us the Tea Party  and other attempts to “emigrate in time rather than space” to use Ryszard Kapuscinski’s wonderful phrase.

I’m jumping all over the place here, but a related area of inquiry is to what extent the contours of this age of globalization follow from the necessary compromises made to keep Western democratic capitalism sustainable (I.e., both relatively democratic and relatively capitalist) after 1945. Did the development of the DM capitalist welfare state put sufficient pressure on profitability that capacity expansion overseas (in the EM) became essential to maintain profitability? That is the essence of the Robert Brenner argument here. http://www.sscnet.ucla.edu/issr/cstch/papers/BrennerCrisisTodayOctober2009.pdf

But the destination of DM capital exports now is also an interesting contrast with the first age of globalization. Many EM states are stronger than their pre-colonial counterparts, and judging from the FDI statistics, capital-export driven capacity expansion has been the most intense in the strongest states. –China now, as compared to the China of the Boxer Rebellion era, e.g. This is likely because capital in our era has gravitated to strong states with an indigenous “steel frame” (the phrase used to describe the Indian Civil Service of the Raj) of bureaucratic and technocratic governance, precisely because it was unthinkable to return to direct colonial experiments that provided such governance.. But the strength of such a steel frame would necessarily reflect grounding in the local polity and local legitimacy that was far stronger than what a comprador bourgeoise would have enjoyed. And such legitimacy would be greatest precisely in countries that  are enjoying a period of economic development that looks like Europe in the Belle Epoque. 

If I’m right, the argument is that this age of globalization could do for national cohesion and identity across class lines in successful EM ( China, above all) precisely what the last period of globalization that ended in 1914 did for national cohesion in Western Europe and the US.  The obverse is that the economic consequences of this age of globailization contribute to an unwinding of national cohesion in DM, precisely because the beneficiaries of globalization (all of finance Twitter, most of my TL, bicoastal white collar Americans –or the European equivalent– engaged in symbolic manipulation) have more shared economic interests with c. 400 million people in China or India than they do with a majority of their own conationals. 

For those who’ve followed thus far—the reward is one of the most beautiful passages I’ve ever read—it comes from Chapter 13 of F. Scott Fitzgerald’s Tender is the Night.

“See that little stream — we could walk to it in two minutes. It took the British a month to walk to it — a whole empire walking very slowly, dying in front and pushing forward behind. And another empire walked very slowly backward a few inches a day, leaving the dead like a million bloody rugs. No Europeans will ever do that again in this generation.”

“Why, they’ve only just quit over in Turkey,” said Abe. “And in Morocco —”

“That’s different. This western-front business couldn’t be done again, not for a long time. The young men think they could do it but they couldn’t. They could fight the first Marne again but not this. This took religion and years of plenty and tremendous sureties and the exact relation that existed between the classes. The Russians and Italians weren’t any good on this front. You had to have a whole-souled sentimental equipment going back further than you could remember. You had to remember Christmas, and postcards of the Crown Prince and his fiancée, and little cafés in Valence and beer gardens in Unter den Linden and weddings at the mairie, and going to the Derby, and your grandfather’s whiskers.”

“General Grant invented this kind of battle at Petersburg in sixty- five.”

“No, he didn’t — he just invented mass butchery. This kind of battle was invented by Lewis Carroll and Jules Verne and whoever wrote Undine, and country deacons bowling and marraines in Marseilles and girls seduced in the back lanes of Wurtemburg and Westphalia. Why, this was a love battle — there was a century of middle-class love spent here. This was the last love battle.”

To me, this is an extraordinarily evocative distillation of the social and economic forces that made Europe in that period (and the forces that may be at work in other parts of the world right now).This was the passage that got me about 90% of the way through a Ph.D in European history, and the first paper I wrote in graduate school was about the peacetime experience of conscription of German Social Democrats in the Empire.  But the reason I mention it here is also because of the peculiarly American twist that Fitzgerald brings to it—he refers to a “century of middle-class love.” Of course, he was unable to bring himself to say  “working class.”

Have a great holiday and all the best for 2016.

This post falls in the category of a) things that are so obvious that someone must have written about it, only I haven’t come across it and I don’t know the literature b) so interesting/provocative that if noone has done it , I better get it out there. If it’s a) let me know—I’d like to find out.

Anyway, people who’ve been reading my blog or following me on Twitter probably know that I’m quite perplexed by what I see as one persistent tendency in American politics/ideology. This the coexistence (in the same people’s heads) of the idea that American domestic public policy should be run on the basis of dog-eat-dog winner-take-all competition, alongside the idea that American foreign policy should be run on the basis of idealistic altruism. 

I’ve dealt with this schematically here (the US policy quadrant) https://twitter.com/RajaKorman/status/389132368914550784 and in my blogpost here http://rajakorman.tumblr.com/post/84927622370/the-chicago-school-and-foreign-policy-story-of-a which expresses wonderment that the Chicago school’s vision of Homo Oeconomicus, applied as a critique of US domestic public policy in the Great Society years was never applied to American foreign policy.

Anyway, what all of this perplexity comes down to is my difficulty in reconciling the dominant ideology of our domestic political economy—that Men are selfish–with the dominant ideology of our foreign policy—that Americans are good. In thinking more about this, I went back to one of the founding documents of American political philosophy—the Federalist Papers, especially Federalist 51 (by either Hamilton or Madison). The document sets out America’s political architecture as a response to a problem rooted inherently in human nature.

“Ambition must be made to counteract ambition. The interest of the man must be connected with the constitutional rights of the place. It may be a reflection on human nature, that such devices should be necessary to control the abuses of government. But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary…… This policy of supplying, by opposite and rival interests, the defect of better motives, might be traced through the whole system of human affairs, private as well as public.”

If this were a doctrine applied to foreign policy, it would read like Metternich or Castlereagh as a theory of the balance of powers. And indeed the entire intellectual (and practical) architecture of American domestic politics is based on the idea that self-interest is such a dominant force that it can only be curtailed by harnessing and dissipating it, rather than concentrating it in the hands of an overweening sovereign. Why then does this mistrust of human nature and the associated fear of such a sovereign have such a limited echo in a foreign policy predicated on the idea that an all-powerful America can be a force for global good? There are, of course,  two towering thinkers and practitioners who have taken a more “Federalist 51″ view of foreign policy–Kissinger and Kennan–but it is in large part such a skeptical view of human nature that accounts for the combination of admiration and mistrust with which they continue to be viewed across the political spectrum. 

The simplest answer (which might well make it the right answer) is hypocrisy. But that’s not the most interesting answer, not to mention that the depth and breadth of conviction about America’s exceptionalism as a benevolent global power suggests that the contradiction described above reflects  mass delusion rather than hypocrisy. 

Insofar as the vision of human nature embodied in Federalist 51 owes to Calvin, the answer I propose (which I think of as more interesting) is grounded in Max Weber’s thesis on the transformation of Calvinist theology into the Protestant ethic. At the heart of Weber’s Protestant Ethic is the idea that the existential anxiety inherent in the idea of inherently fallen human nature predestined for damnation was resolved by the conviction (and the spur) that worldly success was a sign of Grace and redemption from the Fall. 

Transposed to the arena of foreign policy, I wonder if it is possible that Americans treat both the country’s success and the seeming perfection of its political institutions (tAmericans view the Constitution as a document of Cartesian excellence) as a sign of redemption or election. Assured, thus of the Grace that informs our intentions, we find it possible to embark on foreign crusades even as our ideology of fallen nature makes us suspicious of domestic ones. It is this transference that makes it possible for us to reconcile a domestic public policy based on irredeemable nature, with a foreign policy that sees ourselves as a force for global redemption. 

I like think I’ve resolved something (elegantly, I hope) to my own satisfaction here.  Apologies are, of course, due to scholars in several fields–Protestant theology, Weberian sociology, and the histories of American political thought and American foreign policy, to name just the most obvious ones, for all the errors in here. That said, any blogpost that allows me to cherrypick the three thinkers I venerate most (on largely superficial acquaintance) –Hume, Hamilton and Weber– to explore a minor hobbyhorse is a trifecta for me. 

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Not that anyone asked me, but here’s what I would say in September if I were the Fed. I also think such an outcome (essentially, a one and done for a while, or a hovercraft liftoff) would be better for most markets than a hold that then leaves people guessing about when liftoff actually occurs, rather than shifting their attention to the pace and altitude of rate hikes in this cycle.

The Federal Reserve has decided to raise the target interest rate from a range of 0-25 bps to 25-50 bps.

This measure recognizes the significant recovery in the US economy and its emergence from the Global Financial Crisis that began in 2008

This rate increase follows other elements of the normalization of the Federal Reserve’s monetary posture, including the end of Large Scale Asset Purchases

The Federal Reserve is increasingly confident that it is on track towards reaching its mandate of full employment, but considerable uncertainties remain as to when it will reach its inflation mandate, operationally defined as an long-term annual rate of PCE inflation close to, but not in excess of 2.0%.  The Federal Reserve is also uncertain that attainment of its full employment target will necessarily lead to the the attainment of its inflation target, with the potential for very significant lags between attainment of the employment target and attainment of the inflation target.

These uncertainties stem from the interaction of international and financial developments as well as dynamics within US labor markets, which, together suggest that the 2.0% inflation target will be achieved later than previously believed, and may, over the two-year horizon, be subject to downside risks.

Internationally, the presence of large amounts of global slack in tradeable goods markets owing to the interaction of a slow speed of recovery in Europe;  a massive supply-side response in global commodities markets; a slowing China; and recessionary conditions in other significant portions of the emerging markets will exercise a disinflationary or deflationary impact on the tradeable goods sector in the US. Such disinflationary pressures in the US tradeable goods sector will not only exert downward pressures on measures of aggregate inflation but will also likely serve to moderate wage demands in those segments of the US economy that are currently experiencing a tightening of labor markets.

Among the supply-side responses in global commodity markets, the most critical from the point of the US employment and inflation outlook is the development of unconventional shale oil production in the US. This development has led to a substantial decrease in US trade and current account deficits, with the effect that for any given level of consumption growth in the US, the US has a lower external financing requirement than it would have had in prior economic cycles over the last four decades. In a context of asynchronous global recovery, this will increase appreciation pressures on the US dollar on a broad trade-weighted basis.

A stronger dollar will tighten monetary conditions for the US economy with each 10% appreciation of the US dollar having a growth and inflation impact that is roughly commensurate to a 1% increase in the Fed Funds rate. On this basis, the appreciation of the real broad trade-weighted dollar over the last year has already had tightening impact roughly equivalent to a 100 bps rise in the Fed Funds rate.

Estimations of the impact of the dollar’s rise on US growth are complicated to a considerable extent by the international role of the dollar. While most G10 countries experience domestic currency weakness and dollar strength as an unequivocal easing of financial conditions, there are portions of the emerging markets universe where foreign exchange asset-liability mismatches (particularly in the corporate sector) can mean the negative financial effects of dollar strength outweigh the positive impact on net exports. While the Federal Reserve will continue to make policy solely on the basis of its domestic mandates for inflation and employment, it recognizes additional downside risks to the US growth and inflation outlook that may stem from the impact of dollar strength on global growth.

Beyond the financial tightening that may proceed from the appreciation of the dollar exchange rate, and the associated trade and financial consequences in the US and in the rest of the world, additional tightening may be felt as securities acquired during the program of Large Scale Asset Purchases mature over the course of 2016 and 2017. Accordingly, the Federal Reserve is conscious of the potential for a tightening of financial conditions that proceeds from factors independent of movements in the Fed Funds rate.

Given the considerable progress in the US economy since December 2008, the Federal Reserve believes that a further step towards the normalization of monetary policy as embodied by a rise in the Fed Funds rate from the zero-lower-nominal bound is warranted. At the same time, the Federal Reserve believes that the risks of undue haste in further removal of monetary accommodation via the Fed Funds rate significantly exceed any inflationary risks that may stem from a more judicious pace of rate hikes that is cognizant of domestic, international and financial developments.

When I first got into FX in 1997, one of the first things I learned was “The Fed never talks about the Dollar; only theTreasury talks about the Dollar.” I absorbed this piece of wisdom and parroted it, and remarked on the rare occasions when this rule was breached (usually by Ben Bernanke in a speech, but as far as I can recall, never in an FOMC statement). Over the last couple of days, since the Fed press conference, I’ve been thinking more about this rule and I’ve come to the following conclusions below, but most importantly, this rule makes no sense at all

I’m not sure but this division of “verbal labor” probably originated during Bretton Woods 1, when exchange rates were fixed, capital accounts were relatively closed and re- or devaluations were discussed in a transatlantic + Japan version of Eurogroup all-nighters. (Incidentally, Paul Volcker and Toyoo Gyohten’s book Changing Fortunes is great on this).

In an era of floating exchange rates and open capital accounts, this rule makes a lot less sense. Capital is mobile and exchange rates respond to interest rate differentials (and expectations of changes in rate differentials) more than to just about anything else. Yes, I know FX prediction is far from perfect, but there’s a reason people pay up for overnight vol ahead of central bank meetings or unemployment days.

Most modern central banks do not have exchange rate targets in their mandate; instead they have inflation targets and in the case of the Fed, an employment target as well. The exchange rate is an important variable that determines the ability of a central bank to reach one (or both) targets in its mandate. The exchange rate is not a target, but it is a tool, which can make it an intermediate “target,” in much the same way that loan spreads are, for example. Yet noone has ever said to me, “the Fed never talks about loans spreads, only the Comptoller of the Currency and the FDIC do.”

The importance of the exchange rate as tool or “intermediate target” (and I’m going to use them as synonyms) will depend on how large the external sector of any given economy is, but it has some degree of importance everywhere. This includes the US, for all of the protestations that the US is a largely closed economy (which is true, but probably less true than many think—more below). Indeed, things may have changed, but among Investment Banks that have financial conditions indices for the US, the exchange rate is typically in the top three variables. Ask your sell-side coverage to tell you about the weight of the Dollar in their proprietary FCIs.

In any economy that has a tradeable sector (which I think of is comprising not just its export sector but also its import substitutable sector), the exchange rate will play a part in determining growth conditions, employment conditions and consequently, the inflation outlook. The currency composition of assets and liabilities (and flows stemming therefrom) will play a role in determining asset valuations, leading to wealth effects. Both these facts are true of the US. The exchange rate may matter less in the US than in Canada, but it will  nonetheless matter.

It is also probably the case that what we think about as tradeable encompasses a larger group of things than before. The girding of the globe by cheap fiber-optic cable in the early 2000s has made some portion of hitherto nontradeable services tradeable—accountancy, legal services, back office sectors of financial intermediation, medical diagnostics, design, programming, animation (take a look at the credits of Nick Jr. cartoons next time you’re watching).

Under these circumstances, what matters is not just national slack but global slack in tradeables because that will moderate (or exacerbate) the extent to which national slack impinges on inflationary pressures.

Accordingly, I would argue that NAIRU is not a static thing, but it can move around. It moves around in response to domestic variables such as the participation rate, but also should move around in response to the size of the tradeable sector (exports and import substitutables as laid out above); the amount of global slack; and critically, the exchange rate—which will determine the extent to which (and the price at which) a country can import from or add to global slack.

One interesting thing in the newest dots on a chart (our secular equivalent of heads on a pin) is the 2017 dots show the unemployment rate at or below NAIRU, but show Fed Funds below the long run equilibrium Fed Funds rate. This might be because the Fed expects downward pressure on prices as U6 continuing to drop, but could also reflect some ability to import disinflation from the level of global slack.  Interestingly, a move to push the Fed to a single inflation mandate under these circumstances (if I’m right) could lead to policy being looser than it would be under a national full employment mandate.

Anyway, the big point in all this is the Fed should, in my view, be talking about the Dollar a lot more. It should not be a shock when it does, but rather a normal practice. For an institution that prides itself on transparency, the least transparent thing about it is its view on the interaction between the exchange rate and domestic growth and inflation conditions. That’s just ridiculous and needs to change.

Following on the Matt Klein, Paul Krugman thing on currencies and forwards, thought I could formalize some circumstances in which carry trades SHOULD work due to macroeconomic fundamentals, and not just momentum, etc. I suspect this is not new, but still might be useful . Basically, I think there are at least four separate sets of circumstances in which high rate currencies should justifiably outperform their forwards (other things being equal).

a) If a country is undergoing significant improvements in tradeable sector productivity and the call on resources closes the output gap, interest rates will go up, but the improvement in tradeable sector productivity will lead to a rise in the equilibrium exchange rate. In such an instance, the currency will not depreciate as much as priced into the forward. This might well require governmental action to ensure that foreign capital inflows encouraged by the higher interest rates are directed to the tradable sector. See http://rajakorman.tumblr.com/post/102531405985/niip-sustainability-and-the-case-for-capital 

b) If a country has just undergone or is currently undergoing a recent transition to inflation-targeting and central bank independence, it is likely that term premia will remain high in the yield curve. As time goes on, and central bank independence is established, gains in central banking credibility will erode the term premium, allowing the currency to outperform the forward price that reflected such high term premia.

c) Somewhat akin to a) in terms of the effects on the equilibrium exchange rate, a long-lasting shift in global terms of trade is also likely to allow a country’s exchange rate to outperform its forward. However, unlike a) this will reverse as the terms of trade shock reverses. 

d) A fiscal devaluation that leaves the aggregate fiscal stance (and consequently monetary policy) unchanged but changes the effective exchange rate for the tradeable versus the non-tradeable sector will also allow  a currency to outperform its forward.

I think one result of this is that a) and b) are particularly likely to apply to EM currencies rather than G10 currencies, precisely because EM is more likely to be in a phase of both institutional and productivity catchup.  So I’m not sure of the literature on this, but I strongly suspect EM carry will outperform G10 carry, since structural shifts in equilibrium exchange rates are less common inside a group of countries at a similar level of development. 

2. Wage rises in Germany that allow incomes to catchup to past German labor productivity gains.

I’ve said a lot of this before in a more long-winded way elsewhere on this blog but tried to tighten it up. Presumably, this is all obvious, but still…. 

1. Macroeconomic sustainability can be gauged by the current level of inflation and the current level of current account balance and Net International Investment Position (NIIP).  This is because domestic constraints on supply that might be inflationary can be eased by imports that widen current account deficits.

2. Over the course of a business cycle it is important to maintain NIIP at a sustainable level rather than permit a trend increase or decrease in NIIP.

3. This means getting the balance of tradeable vs. non-tradeable investment right over the cycle.

4. This in turn means that for purposes of targeting both axes of sustainability (inflation and NIIP), central banks need control of both short term interest rates and the exchange rate.

5. The reason for central bank control of the exchange rate is behavioral–an episode of exchange rate appreciation driven by a cyclically appropriate interest rate rise is more likely to lead to nontradeable rather than tradeable investments as agents typically do not assume that the future path of exchange rate will follow the depreciation embedded in the forward curve.

6. An excess of non-tradeable investment during a period of currency appreciation and widening current account deficits reduces the economy’s ability to benefit from subsequent exchange rate depreciation, and consequently fails to smooth the NIIP over the cycle.

 7. This suggests that NIIP sustainability requires that a central bank be able to control both components of domestic monetary conditions–interest rates and the exchange rate.

8. Since the “trilemma” postulate holds that a country can control either the exchange rate or short-term interest rates with a completely open capital account, this suggests that some kind of capital controls might be necessary for a central bank to target broad macroeconomic sustainability.  

9. Two forms of capital controls that might be particularly helpful are: a) forcing foreign investment in countries with large negative NIIPs exclusively into the tradeable sector (thus helping the cause of current account smoothing or NIIP sustainability described above or b) forcing foreign investment to take the form of equity rather than debt, so that even if misdirected, it is lower in the capital structure and associated liabilities (dividends) depend on the business cycle of the recipient of capital inflows rather than on the business cycle of the source of the inflow.

10. Although it is undoubtedly true that capital controls distort investment allocation questions, the real question is whether capital controls are more or less distortionary than unrestricted cross-border flows. The above argument (and recent experience) suggests there are sound reasons to believe that intelligently-framed capital controls are more supportive of macreconomic sustainability than completely open capital accounts.