Kotok: Complete Report from Dubai

Report from Dubai
David R. Kotok
March 26, 2013



The slides used at the Global Interdependence Center conference in Dubai on March 26, 2013, are now posted under the “Special Reports” section on Cumberland’s website. Here is the link. The guide to the slides follows.

Slide 1 is the asset side of the Federal Reserve (Fed) balance sheet. Notice that the size of the Fed’s balance sheet has grown from slightly over $900 billion before Lehman-AIG to approximately $3.2 trillion. The Fed continues to increase assets pursuant to its current policy.

Slide 2 is the liability side of the Fed’s balance sheet. The key to that slide is the green section labeled “Currency in Circulation,” which totals approximately $1 trillion. The red component is the excess reserves deposited at the Fed through the US banking system.

Slides 3 and 4 come from a 2013 special paper entitled “Crunch Time: Fiscal Crises in the Role of Monetary Policy,” by Greenlaw, Hamilton, Hooper, and Mishkin. We have used the slides that the writers placed in their paper. Those slides show the projected peaking of the Fed’s balance sheet at about $3.5 trillion and the gradual decline through 2020. The color codes match those of the slides we showed of the Fed’s current balance sheet, so viewers can track them more easily.

In slide 4, you can see that, according to the authors’ projections, by 2020 the Fed’s mortgage backed paper will also have shrunk. The Fed will have permitted the excess reserve liability to run off as it reduces the asset side. Thus slides three and four depict that in 2020 the Fed’s balance sheet size will be approximately $1.7 trillion. The holdings on the asset side will be Treasuries, and the liabilities will be currency in circulation. These are just projections that may or may not occur. The authors of the paper made assumptions on future Fed policy that would result in a successful exit strategy.

Slide 5 lays out some simple assumptions to help us project the answer to the question: When will the unemployment rate hit 6.5 percent?

Slide 6 is a table that was designed by Cumberland’s Chief Monetary Economist, Dr. Robert Eisenbeis. Dr. Eisenbeis used historical data in order to translate estimates of GDP growth into job-creation rates. The table projects job growth for both high- and low-confidence intervals.

Slide 7 shows how much time it would take for the unemployment rate to fall to 6.5 percent, depending on GDP growth rate (vertical axis) and certain baseline assumptions. The estimates range from 2015 to 2017.

Slide 8 shows the number of jobs the US economy needs to produce per month in order to hit a 6.5 percent unemployment rate. This too is an estimate based on a lot of assumptions.

Slide 9 shows the U3, U4, U5, and U6 unemployment rate measures and the definition of each. The Fed has selected the U3 unemployment rate for its 6.5 percent target. The parallel structure of these curves derives from the fact that these measures of unemployment are built one upon the next.

The results of disaggregating this data and drilling into it in detail are depicted in slide 10. Here the large green band shows the percentage of the labor force that is part-time workers who want full-time work. In other words, about four percent of the labor force consists of part-time workers who want full-time work and cannot find it. That is what is different about the current economic cycle, and this particular composition issue is not addressed by the Fed’s 6.5 percent target. Think about what this means. The labor force in the US comprises approximately 135 million people. Five to six million people fall into this category of part-time workers who cannot find full-time work. That is a huge overhang not addressed by the Fed’s policy of targeting 6.5 percent on the U3 measure of unemployment.

On slide 11 you see a Beveridge curve, named for economist William Beveridge. The curve tells you about the regime change that took place between the previous expansion, from December 2001 to November 2007 (shown in blue), and the present expansion (shown in green). The ’07-’09 recession is shown in red. The curve is created by taking the job vacancy rate and dividing it by the U3 unemployment rate.

Beveridge curves tell you a lot about expansions and recessions and how difficult it is for recovery to take place in the labor force. Clearly, the recession was a regime change, according to these Beveridge curve calculations. The U3 unemployment rate is used in the curves on this slide. When you use the U6 unemployment rate, which the Fed is not doing, you find that the regime shift was actually much greater.

Slide 12 tracks the Phillips curve, or inverse relationship between the unemployment rate and inflation rate. The concept was introduced to me by Thomas Synnott, a colleague at the National Business Economic Issues Council (NBEIC). Synnott uses the tracking system shown, with monthly data points. He describes it as an “under-damped oscillatory system.” The idea is to show the difference in shifts in duration, slope, and composition of the Phillips curve. One can see the pre-crisis levels in blue, the shift during the crisis in red, and the current green expansion period, through February 2013. The Fed’s target is marked with an “X.” Clearly there is a large gap between the current situation, in February 2013, and the Fed’s targets of 6.5 percent for the U3 unemployment rate and 2.5 percent for the inflation rate. Again, if we were to use the U6 in this curve instead of the U3, the gaps would be much more extreme.

Slide 13 lists the total assets of the major central banks. Those are the Federal Reserve, European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank. We have added the Swiss National Bank since Switzerland now practices a policy maintaining a pegged floor in the exchange rate between the Swiss franc and the euro. Essentially, these central banks started pre-crisis with about $3.5 trillion in total assets, in US dollar terms. Their assets now exceed $10 trillion and are growing. We have broken out the individual central banks for tracking purposes.

Slides 14 and 15 show the assets and liabilities of the European Central Bank. Slides 16 and 17 show the assets and liabilities of the Bank of England. Slides 18 and 19 show the assets and liabilities of the Swiss National Bank.

Slides 20 and 21 depict the assets and liabilities of the Bank of Japan. Note that Japan is the only major country that has experienced extraction from quantitative easing. That happened in 2006. At the time, the Japanese quarter-end extraction shocked world markets quite seriously. This is the only case in modern history where a large extraction at quarter-end occurred. We have noted it for both the assets side and liabilities side in slides 20 and 21.

The conclusion of our remarks in Dubai outlined the various factors that world markets and economies confront as this immense expansion of central bank balance sheets, along with massive liquidity injections, runs its course. We do not know how long this game of monetary quantitative easing will continue in the world. We do not know when it will stabilize. We do not know what will happen after that period, and we do not know how extraction will occur. What we do know is that world monetary affairs have never been in a situation like this before.


David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

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