Author: admin@hottinger.co.uk

Britain’s new chancellor has quickly gained the nickname “Spreadsheet Phil” with his eye for detail and dull demeanour. A safe and steady pair of hands is just what the UK needs after George Osborne’s tenure. Philip Hammond delivered a commendably dull Autumn Statement against a difficult backdrop.

The statement comes with overwhelming detail. The statement itself (the document, not the speech) runs to 71 pages. This is brief compared with the Office for Budget Responsibility (OBR)’s 271-page Economic and Fiscal Outlook. And this is before the many official supplementary reports and the media over-kill.

However, the key message is that growth will be slower, inflation higher and government borrowing greater than expected in March, as these two charts illustrate.

The first shows the forecast profile of quarterly growth now compared with that in March. Previously, the OBR expected growth to continue at around 0.5%-0.6% a quarter pretty much indefinitely; now, it thinks growth will dip to around 0.25% a quarter in the first half of 2017. Brexiteers have immediately accused the OBR of excessive pessimism but the OBR is more optimistic than independent forecasters and it sets out its reasons in detail in its report.

The second shows that Britain’s public sector borrowing figures are projected to stay higher for longer than previously thought. The deficit this year (FY16-17) will be £68bn rather than £55bn and next year £59bn rather than £39bn. The deterioration comes from three key sources – a) technical changes in ONS statistics, b) policy changes and c) the weaker economy.

The third of those is by far the biggest factor. Taking FY17-18, for example, the technical changes account for £0.4bn of the deterioration, Philip Hammond’s actions for £2.5bn and the economic forecast for £17.2bn. By the way, the £2.5bn “give-away” consists of a large increase in capital spending, a smaller increase in day-to-day departmental spending and a small tax increase.

There were two major talking points. One was the impact of Brexit. The OBR assumes that the UK leaves the EU in April 2019 and that this will mean slower trade growth, a tighter migration regime, lower EU transfers but higher domestic spending (probably not £350m a week to the NHS) and no change in EU-related tax systems (such as VAT). The result is that the level of UK real GDP is 2.3% lower by FY20-21 than it would have been otherwise and that Britain’s public finances will be £10bn worse off in FY17-18 and £15bn a year thereafter.

The other was fiscal rules. George Osborne unveiled three in May 2015: none of them survived 18 months. Philip Hammond introduced another three yesterday. The structural deficit should be below 2% of GDP by FY20-21; net debt as a percent of GDP must fall by FY20-21; welfare and tax credit spending should be not more than £130bn in FY21-22. None of these is especially demanding. The worrying question is whether Mr Hammond has much interest in reducing the UK’s budget deficit to a reasonable level. Perhaps he is not so dull after all.

As Lewis Carroll put it, jam tomorrow and jam yesterday but never jam today. But leaks from Downing Street suggest that Philip Hammond’s Autumn Statement next Wednesday will target the “Jams” today – those just about managing. Measures will include promised increases in income tax allowances (to £12,500 for the basic rate), a freeze in fuel duty, further childcare subsidies and so on. What about the big picture though?

It’s The Economy, Stupid. UK public finances depend heavily upon the health of the economy. Strong growth boost income taxes and VAT while low inflation holds down inflation-linked spending and interest payments.

In the near term, the news is good. The economy grew by a better than expected 0.5% in the third quarter and inflation was back below 1% in October, although the archaic RPI measure was 2%. However, it seems very likely that growth will slow and inflation rise next year. The table shows the Office for Budget Responsibility (OBR) forecast in March versus the average of independent forecasters then and now.

There are two lessons here. First, the OBR tends to be pretty close to the consensus. One benefit of an independent budget think-tank is that the chancellor is no longer tempted to massage the numbers.

Second, the independent forecasters have nearly halved their 2017 growth forecast, slashing it from 2.1% to 1.1% over the past six months. They have also raised their inflation forecast substantially, from 1.8% to 2.7%. Rightly or wrongly – and these are highly uncertain forecasts – the UK decision to leave the EU is the key reason for the changes.

And The Consequence Is … The OBR is sure to forecast higher public sector borrowing figures next week than it did in March. And, unfortunately, the starting point has worsened. In March the then Chancellor, George Osborne, expected a deficit of £72.2bn in 2015-16 and £55.5bn in 2016-17. Well, the outturn for 2015-16 was higher at £76.0bn and the deficit in the first six months of 2016-17 is only £2.3bn lower than a year earlier.

The Institute for Fiscal Studies does a thorough job analysing Britain’s public finances and thinks the deficit will be £60.5bn in 2016-17 falling to £47.3bn in 2017-18. That looks optimistic to us, which just goes to illustrate Mr Hammond’s difficult balancing act.

Likely Outturn. Look out for three aspects of the Autumn Statement. The first is a sense of medium term direction. His predecessor had an addictive urge to meddle and micro-manage. Mr Hammond may take the opportunity to set out a more sober, medium term view. Some sign of sensible fiscal rules would be welcome.

The second is a moderate boost for the economy now. Extra infrastructure spending would be better than tax cuts but this is difficult to do because many projects have little immediate impact

The third is keeping some budgetary firepower for March. The UK economy remains in reasonable shape, so it makes sense to avoid big measures now in case they are needed in the March 2017 budget statement.

After the Brexit vote in the UK and Donald Trump’s win in the US, the Italian referendum and the French election are in the spotlight. We can ignore the French election for now but Italy’s referendum on 4th December is rapidly approaching.

The past twenty polls all show the No vote will win. True, the polls were wrong about Brexit and Trump but only because they under-estimated the extent of the protest vote. After last week’s US election, it seems likely to us that PM Renzi will lose the referendum and it is time to think about what happens next.

It will mean broadly no change for the Italian political system but Matteo Renzi is likely to resign as prime minister. Although he has furiously back-tracked, he has unwisely made the referendum a vote of confidence in his leadership. Maybe there is a slight chance he stays but we doubt it.

Thus, President Mattarella will face a choice between early elections – next due March 2018 – or a technocratic government. He is likely to choose the latter, led by either Pier Carlo Padoan or Enrico Letta.

Nothing to see here then, you might think, but you would be wrong. First, there is no guarantee that a technocratic government would last. If the No vote is sufficiently decisive (say 55% to 45%), then the outcry for new elections could become irresistible.

Second, even without early elections, it would only delay matters by some fifteen months. Note that the ruling Democratic Party is the only major party in the Italian parliament which is actively pro-euro. The next most popular parties – the Five Star Movement and the Northern League – wish to pull Italy out of the euro. And the latest polls show support for Democratic at 33% and Five Star Movement at 31%.

Third, before Trump’s win, it was plausible that the protest parties could win power in March 2018 and start the process of leaving the euro, thanks to weak growth, banking system problems and a refugee crisis. The dramatic US election result last week has reinforced the argument. Austria’s presidential election, the same day as Italy’s referendum, is yet another wild card.

The smart money is shifting the same way. The chart shows the spread between ten year Italian and German government bonds: this has widened out to 180 bps this morning from 115 bps three months ago. Another indicator is Italian central bank balances with the eurosystem. These show that €132bn has flowed out of Italy over the past year.

Neither indicator is anywhere near the panic levels of the Eurozone debt crisis in 2012 but both show rising concern. We would get seriously concerned if the BTP/bund spread climbed above 300 bps. For now, investors should avoid Italian assets.

In the early hours of Wednesday morning, Donald Trump became the 45th President of the United States. In a longer post than usual, here is our immediate reaction.

The Result. Mr Trump won the electoral college by an estimated 306-232 but lost the popular vote by 59.9m to 59.7m. The Republicans also held on to power in the Senate (52 seats to 48) and the House (238 to 193). However, Senate legislation often requires 60 votes so do not expect Washington gridlock to cease.

Local Politics. With effect from 20th January, the US will have a real estate tycoon and reality TV star with no experience of public office as its president. He will also be the oldest first time president in US history at 70 years old. At first sight, it does not look promising.

However, there are a couple of historical parallels. The first is Dwight Eisenhower, US president 1953 to 1961, who also had never held public office, although he had run an army. The second is Ronald Reagan (1981 to 1989) who was 69 when he was first elected, also came from a showbiz background and held right-of-centre views. Both are held in high esteem in US history.

But Trump comes to office after a bitter and divisive electoral battle, which his acceptance speech acknowledged – “it is time for us to come together … I pledge to every citizen of our land that I will be president for all Americans”. Also, he is on bad terms with most of the Republican establishment. Many refused to endorse him or even vote for him.

And, like most presidents, he will find it difficult to get stuff done. As one example, he cannot fire Janet Yellen as chair of the Federal Reserve, no matter how much he wishes to do so. He will have to wait for her term to expire on 31st January 2018.

Perhaps the most important pointer will be how he builds the White House team. The three key posts are Treasury Secretary, Secretary of State and White House Chief of Staff. If he gets those right, then things may look up.

Global Politics. The two big losers could be Europe and Mexico. Trump’s America First agenda will mean the US is reluctant to guarantee European security via NATO. However, there is an argument that Trump would not want to look weak, for example, if Russia moves troops to Lithuania’s border. Expect Vladimir Putin to test his resolve at an early date.

We shall also see whether Trump follows through on his promise to build a wall and to re-negotiate the NAFTA free trade agreement. If so, then Mexico’s future for the next four years looks fraught. On all three issues – NATO, NAFTA and the wall – the reality in the White House may be different to the words on the campaign trail.

However, Donald Trump ran for the presidency on an anti-trade, anti-immigration and anti-climate change platform. All of these are bad for the rest of the world and we assume that he will at least try to keep his word.

Another key issue is whether Donald Trump’s angry populist style gains traction elsewhere. After Brexit and Trump, it is an obvious thought that Marine le Pen could now have a serious shot at the French presidency in April 2017.

The Economy. The big shift will be the mix of fiscal and monetary policies. While policy pledges were scarce, Donald Trump promised extra infrastructure and defence spending. With echoes of Reagan, he is also keen on tax reform and corporate tax cuts. The consequence will be a higher budget deficit and hence a tighter monetary policy to prevent over-heating.

The impact on growth of the Trump agenda may be roughly neutral – a boost from public spending but a drag from less trade and immigration. However, there is likely to be upward pressure on inflation from less immigration (restricting the supply of workers in a tight labour market) and more government spending (boosting an economy near full capacity).

The Markets. The initial reaction to Trump’s win looks about right – equities, Treasury yields and the dollar all up. Corporate America should gain from infrastructure spending and tax reform (but will be squeezed by higher labour costs); US Treasury yields may rise due to higher inflation and a larger budget deficit; and the US dollar will strengthen due to the looser fiscal, tighter monetary policy mix.

We expect these trends to continue but a key uncertainty is the FOMC meeting on 14th December. There has been talk that the Fed might postpone its 25 bps rate hike. For now, we think it will go ahead and, significantly, the Fed Funds future shows an 82% probability of a rate increases.

Word of the Day (with thanks to The Economist) – Snollygoster. The OED defines snollygoster as a shrewd unprincipled person, esp. a politician. You can decide whether Donald Trump is a snollygoster.

The markets have worried about China’s debt load for some time but are they right to do so?

The Case for the Prosecution. Last month, the BIS, the central bankers’ bank, updated its four early warning indicators of banking crises: two were flashing red and another amber. The BIS is especially keen on the “credit gap” – the percentage spread between actual and trend credit-to-GDP – as a crisis leading indicator. It reckons that a reading over 10% is a cause for concern: China’s gap was 30.1% in March.

There is no doubt that China’s private sector debt has risen rapidly. The credit-to-GDP ratio has increased by roughly 60 percentage points over the past five years. An IMF study found that, in 38 out of 43 global instances where the ratio grew by more than 30 percentage points, the result was a financial crisis, much slower growth or both.

The argument is that excessive credit growth reduces the efficiency of capital spending and hurts corporate profits and asset quality. This in turn prompts an increase in defaults and non-performing loans.

The Defence. However, all may not be lost. First, China is engaging in massive economic and social change, one consequence of which is slower growth. Thus, the IMF’s narrative is correct but may not mean a financial crisis is due.

Second, China’s overall debt burden (including government debt) was 255% of GDP in March which was below that of five of the G7 – Canada, France, Italy, Japan and the UK. In other words, the debt ratio is nothing unusual, although it is high by emerging markets standards.

Third, since China’s public debt ratio is modest, the government has room to act in the event of a corporate debt crisis, taking private sector bad debts onto the public balance sheet, much as the advanced nations did in 2008-09.

Fourth, there is a problem of definition. Much of the increase in debt belongs to state-owned enterprises (SOEs), which might be better classified as local government debt. Thus, one would not expect the usual dynamics outlined above to apply. This does not deny that many SOEs are in trouble – there have been at least five major SOE near-defaults since 2014 – but the analysis should be different.

Five, the government has already recognised the problem and taken action. It has reduced coal and steel capacity, identified and tackled “zombie” companies, announced SOE reforms, improved local government finances and encouraged debt-for-equity swaps.

And, six, China has been here before. In 1997 about a quarter of SOE loans were non-performing. This prompted the government to step in with a rescue plan worth over 30% of GDP over the next decade.

The Verdict. China’s debt mountain is clearly a problem. But there are good reasons to think the position as not as bad as some analysts make out. Investors should keep this on the risk register and monitor closely. Meanwhile, the chances of a Chinese recession are slim and Asia-Pacific ex-Japan remains one of our favoured equity regions.

Nearly four months after the UK voted to leave the EU, it is time to take stock.

Politics – Fog lifting slowly. We do not claim any great political insight but the fog is slowly lifting. Since the Conservative party conference, the mood has shifted in favour of a “hard Brexit”. The prime minister has apparently decided the control of immigration should outweigh staying in the EU single market. However, parliament has asserted its authority and will debate Article 50 before the UK triggers the exit process by end-March next year.

Economics – Heavy cloud, no thunderstorms. In theory, the Brexit vote should mean weaker growth compared with not leaving the EU. We shall never actually know because we cannot run an alternative universe where there is no Brexit.

Just to complicate matters, the UK economy was slowing anyway prior to the EU referendum vote but, on the other hand, the Bank of England eased monetary policy on 4th August and the Chancellor, Philip Hammond, may loosen fiscal policy on 23rd November.

Leaving all that aside, the latest surveys show the UK economy is indeed below par compared with the past five years. We have looked at 18 business surveys for an up-to-date reading across the economy. Three are exceptionally weak, none are exceptionally strong, the rest are evenly split around the mean. In other words, timely growth data shows some weakness but nothing disastrous.

Turning to inflation, Tuesday’s numbers showed a jump in headline inflation to 1.0% and core inflation to 1.5% in September. The rising trend is mainly due to a firmer oil price and a weaker pound. The former has nothing to do with Brexit but the latter certainly does.

Sterling’s fall will continue to feed through into retail prices for some time such that inflation will head for 2.5% or 3% in a year’s time. We recommend you buy your Marmite now!

Markets – Mixed sunshine and clouds. The truest Brexit barometer is probably the pound, which has fallen some 15% in trade-weighted terms since 23rd June. The first roughly 10% came immediately after the vote as the markets re-assessed Britain’s prospects; recent weakness has reflected the rising chances of a hard Brexit. For now, we expect sterling to reflect the shifting chances of hard and soft Brexit.

UK equities have rallied in sterling terms but the gains are illusory. In any other major currency, they are down year to date. The large cap FTSE 100 has profited especially from its high weighting of oil companies and commodity producers and roughly 75% of profits being generated overseas. In the absence of a recession (which we do not expect) the market may slog higher.

Finally, the 10yr gilt yield has risen by around 60 bps since mid-August to just over 1.1% today. This largely reflects global markets – the 10yr Treasury yield has risen 40 bps – but also the additional negatives of a weak pound and possible fiscal easing ahead. We cannot claim that gilts are great value when inflation is heading for 3% but, with short rates anchored close to zero, there may not be much further upside for yields.

You may think that the UK Brexit vote was the biggest event risk of 2016 but, in our opinion, you could be wrong. We are much more worried about the constitutional referendum in Italy on Sunday 4th December, more so than a Trump win or a Fed rate hike.

Why so? Well, Brexit is turning out to be a local affair and will also be something of a slow burner. It may be some while before Article 50 is invoked and, even then, negotiations are sure to drag on. In contrast, a No vote in Italy could be the start of withdrawal from the euro and, stretching the imagination a bit, lead to the fracturing of the European Union.

The reforms being sought are the most sweeping since the second world war and seek to diminish the size and power of the Senate so that the government can govern. In recent times, Italian governments have been short-lived and achieved little.

However, prime minister Matteo Renzi has taken two risks. First, he has turned the poll into a personal popularity contest in saying he will resign if the outcome is No. Second, as David Cameron found out, referenda tend to become hijacked by off-topic issues. In theory, constitutional reform looks sensible but the poll could turn into a protest vote, thanks to weak growth, a troubled banking sector and a migration crisis in southern Italy.

In addition, the referendum may galvanise vested interests which benefit from the status quo. Big business groups such as Confindustria are in favour so it is likely that trades unions will be against. Latest opinion polls show the outcome is too close to call.

What might be the implications of a No vote? One, increased political uncertainty. Having staked so much on this vote, Mr Renzi is likely to resign. There could then be a stop-gap technocratic government until new elections in 2018. If electoral reforms passed earlier this year are also struck down by the Constitutional Court, then Italian politics will be in big trouble.

Two, slow growth and high deficits.  The government downgraded its growth forecast yesterday to just 0.8% in 2016 and 1% in 2017 which in turn implies a higher budget deficit than previously thought and less room for fiscal stimulus.

Three, wider bond spreads and weaker equity prices. The spread between ten year BTPs and bunds is currently 133 bps, up from an August low of 113 bps and reflecting some political risk. During the eurozone sovereign debt crisis, the spread peaked at over 500 bps so the markets are not under stress at these levels but that could change in the event of a No vote.

However, the equity market has under-performed this year. It is down 22.6% year-to-date compared with a decline of 6.9% in the FTSE Eurotop 100 index. Partly this is due to Italy’s banking woes but we think it may also reflect political risk. European equities are relatively cheap but investors should be wary of the Italian market for now.

Ever since interest rates hit zero, central banks have been forced to use unconventional measures. This has usually taken the form of forward guidance plus asset purchases such that unconventional monetary policy has become conventional. However, earlier this summer, Bank of Japan governor Haruhiko Kuroda called for a “comprehensive assessment” of the bank’s monetary policy. The result was published yesterday.

The Key Points. The new framework consists of two parts, which the BoJ described in classic central bank-speak as an “inflation-overshooting commitment” and “yield curve control”. In plain English, the BoJ will not just aim to hit its 2% inflation target but exceed it and it will control not only short rates but also long rates. Both are bold moves.

The practical implications are: 1) the BoJ’s short-term policy rate is unchanged at minus 0.1%; 2) the BoJ will aim to keep the 10yr JGB yield around zero; 3) it thinks that this implies JGB purchases of “more or less” ¥80trn a year, close to the present pace; 4) it will continue this policy until inflation “stays above the target in a stable manner”; 5) it will reduce purchases of longer-dated JGBs beyond 10yr maturities (to help banks); and 6) it will amend its ETF purchases (to correct the Nikkei versus Topix distortion).

Deliberately Irresponsible Policy. The inflation over-shooting part of the new policy follows work by US academics. Michael Woodford of Columbia University presented a persuasive paper at the Jackson Hole conference in 2012, arguing that unconventional policies would only work if the general public thought the central bank was being reckless. Paul Krugman has endorsed the idea. The BoJ is the first central bank brave enough (or desperate enough) to see whether Woodford is right.

Quantitative Easing Revisited. In our view, QE has three problems. First, the bank does not know how much to do (because the precise impact is unknown); second, there are unintended consequences; and, third, it may be difficult to unwind.

The new BoJ policy addresses the first point directly. Central banks usually measure the impact of asset purchases in terms of how far bond yields fall. The BoJ is reversing the logic in targeting the 10yr JGB yield and saying it will buy enough bonds to achieve this. Policy should be more precise.

In the process, it mitigates the second problem in that the collateral damage of asset price inflation will be limited. Unfortunately, it does little to deal with the third but, given the rapid expansion of the BoJ balance sheet (see chart), better control of JGB purchases will be welcome.

Conclusion. There will be no need to forecast Japanese interest rates in future: they will be roughly zero out to ten year maturities. The market reaction of higher equity prices and a stronger yen was probably about right and may continue. And will the BoJ achieve 2% inflation? Well, it has given itself a fighting chance.

The ECB met last week; the Bank of England and the Swiss National Bank met today; the Federal Reserve and the Bank of Japan meet next week. Central bankers just can’t stay out of the limelight and the message is that (limited) monetary policy divergence is making a come-back.

Will The Fed Raise? Its chair, Janet Yellen, has left the markets in no doubt – the case for a rate increase has strengthened. However, the committee is divided. Just this week, an influential governor, Lael Brainard, set out four reasons not to move soon – low inflation, labour market slack, a muted recovery in wage growth and weak demand from abroad. The judgment is fine – moderate growth and price inflation on the one hand versus a low jobless rate and gradually rising wage inflation on the other. Our view, a commonly-held one, is that the FOMC will remain on hold in September but raise rates by 25 basis points in December.

Will The Bank of Japan Ease? There is a strong case for further Bank of Japan easing – inflation is currently minus 0.4% versus a target of 2% – but the question is how. The BoJ embarked on an aggressive programme of asset purchases in April 2013 and resorted to negative interest rates in January this year. Neither has been a great success, partly because the government has not fired the other two arrows of Abenomics with any conviction. At next week’s meeting, BoJ boss Haruhiko Kuroda may present the results of a “comprehensive assessment” of past policies. We expect some easing measures but are unsure in what form.

And the ECB? Stuck in neutral for now. Ever since his “whatever it takes” pledge in 2012, Mario Draghi’s ECB has been on a mission to ease. However, despite the shock of Brexit, the eurozone central bank was relaxed about the economic outlook and its policy stance at the past two meetings. The ECB staff forecast barely changed last week and Mr Draghi was in no hurry to act.

What Do The Markets Think? Central banks drive markets and so market expectations of future policy moves do matter but the markets do not appear to expect much. Monetary policy is not much about interest rates these days but, for what it is worth, three month money market futures imply an increase of about 10 bps in US rates, no change in euro rates and a 10 bps decline in Japanese rates over the next six months.

Two year government yields may be more useful in that they are sensitive to both interest rates and asset purchases. Since end-June, US yields have picked up by 17 bps, pretty much endorsing one rate increase, but JGB and bund yields have barely moved.

The conclusion is that the Fed is set to hike and the BoJ to ease but none of the G3 central banks look like taking drastic action.

With a thousand apologies for writing about a crowded topic, we take stock of the UK economy nearly twelve weeks after Britain voted to leave the EU.

Too early to say. In 1972 the Chinese premier, Zhou Enlai, famously said it was too early to say what was the impact of the French Revolution of 1789. It should not take so long to get a sense of Brexit’s impact but ideally one would wait until 26th January 2017, when the fourth quarter GDP statistics will be released, giving two full quarters of information. Just 81 days after Brexit, with little hard data available, it is too early to say much that is sensible.

Unreliable evidence. However, the markets are impatient and so we have pulled together 18 timely indicators, mainly surveys, under four headings – whole economy, consumer spending, investment intentions and exports. Taking the period since January 2011, the bad news is that thirteen measures are below their post-2011 average versus only five above.

However, the UK economy has been slowing since late 2014 so perhaps it is fairer to look at the latest numbers versus the second quarter average. On this basis, seven indicators are stronger but eleven are weaker. Notably, using both methods, investment intentions have worsened but export orders have improved, as one would have expected.

This is not a Lehman moment. The financial crisis and recession in 2008-09 was the worst in over 80 years. Brexit is not even close in its severity. The chart shows that the UK economy is back to the early 2010s, not the 1930s, although this is with the help of reduced political uncertainty, a weaker pound and Bank of England easing.

Depends upon the deal. Moving from the near term to the longer term, much will depend upon the eventual terms on which the UK leaves the EU and what trade deals can be struck. However, since government policy currently amounts to “Brexit means Brexit”, we have very few clues.

We’ll never know. And, of course, the rarely-mentioned truth is that we shall never know just how much leaving the EU will affect the UK economy. It would be nice to run two parallel universes, one where Britain votes to Remain and another where the vote is Leave, so that we can compare the two. Sadly, this is not possible outside of science fiction. However, one respected economic historian, Prof Nick Crafts of Warwick University, reckons that UK membership of the EU has added 10% to UK GDP.

Likely outturn – lost output, slower growth. However, given near-term uncertainty and longer-term damage to trade and inward foreign investment, the UK economy is set to lose some relative output over the next couple of years. On some mild but reasonable assumptions, output could be nearly 1% lower by end-2017 than if Remain had won. Farther ahead, our best guess is that long-term growth might be say 1/4% a year weaker (or 2.5% over a decade).

The most important speech at Jackson Hole last week was given by Janet Yellen but the most interesting by Christopher Sims, a Princeton economics professor. His topic was dry – fiscal policy, monetary policy and central bank independence – but he made it searingly relevant to the global economy’s current woes. Here is a summary.

Are central banks truly independent? In theory, yes but in practice, not really. The idea is that central banks should be insulated from short-run political forces and charged with controlling inflation. However, some fiscal policy moves can force the hand of central banks and every monetary policy action has fiscal consequences.

A good example is Brazil in the 1980s where increases in official rates to reduce inflation actually had the opposite effect. The reason was that interest payments were a large part of public finances. Thus, when the central bank raised rates, it also increased the budget deficit and boosted demand. Monetary tightening caused fiscal loosening and was thus self-defeating. Hence, central bank independence depends upon interest payments being a small part of public spending.

Do large central bank balance sheets matter? Yes, they do because quantitative easing has created a risk mismatch between assets and liabilities. The liabilities (e.g. currency, bank reserves) are short duration but the assets (e.g. government bonds) are long duration, thus putting the central bank in danger of technical insolvency if it raises interest rates. Of course, a central bank should never go bust because it can “print money” to cover losses but the loss of confidence and the financial dislocation could be badly damaging.

Why has monetary policy failed to create 2% inflation? Partly because it is tough for central banks to push interest rates much below zero but also because, at low inflation rates, effective monetary policy requires fiscal expansion to accompany interest rate cuts.

It is understandable that politicians worry about high budget deficits and debt-to-GDP ratios and that electorates suspect that today’s budget deficit is tomorrow’s tax increase. However, in Europe and Japan, tight fiscal policy has offset easy monetary policy and condemned their economies to prolonged low growth, low inflation. In the US, there has been less emphasis on budget cuts and the US economy has performed a little better.

Is fiscal deficit finance a better idea? Possibly but it requires deficits specifically aimed at generating inflation. The deficits must be seen as financed by future inflation, not future tax hikes or spending cuts.

With government bond yields at record lows and a pressing need for more roads, railways, bridges and so on, the idea of “infrastructure bonds” to pay for these projects is attractive. However, this will only work if the authorities make clear that part of the purpose is to raise inflation and that it will not cut back on existing spending to “pay” for the infrastructure.

Implications. Christopher Sims’ thoughtful speech has several important consequences. First, monetary policy and fiscal policy have to work together. At present, they don’t. Second, Japan and continental Europe will continue to experience low growth and inflation, which in turn suggests zero or negative short rates for some time. Third, Sims’ analysis justifies gradual and limited interest rate increases in the US. Fourth, easy monetary policy will support global equity markets but do little to boost them further. Much the same applies to government bond markets.

According to the old blues song, Stormy Monday, “the eagle flies on Friday”. However, this Friday the markets worry whether Fed chair Janet Yellen will prove a dove or a hawk when she speaks at the Jackson Hole conference at 3pm London time.

Fed governors are divided in private and in public and over the short and longer term. The July 27 minutes showed that, behind closed doors, there was agreement that uncertainties relating to May’s weak payrolls report and June’s UK Brexit vote had diminished. However, there was a three-way split over the looming interest rate increase. One was keen to raise rates immediately; others thought a move would “soon be warranted”; two preferred to wait for evidence that inflation would rise to 2% on a sustained basis.

Meanwhile, over the past couple of weeks there has been a very public debate with speeches from Bill Dudley (New York Fed), Stanley Fischer (deputy chair) and John Williams (San Francisco Fed) plus a Brookings blog from Ben Bernanke (ex-chair). Dudley warned that markets were mispricing (i.e. under-estimating) Fed rate rise risks while Fischer believes the US economy is “close to meeting its targets” of full employment and price stability. Both messages had a hawkish tone.

In contrast, an article in the Washington Post and Ben Bernanke’s blog suggest that the Fed’s strategic thinking is moving in a more dovish direction. The table below (taken from Bernanke’s piece) shows that Fed long-run forecasts for growth, unemployment and interest rates have been falling. Comparing the latest projections with those made four years ago, long-run growth is expected to be half a percent slower and the ultimate destination of the Fed’s policy rate 125 bps lower. Meanwhile, John Williams was proposing among other things that the Fed’s inflation target be raised to 3% from 2%, which would have the consequence of reducing the urgency to increase interest rates.

Thus, we appear to have an FOMC which is becoming more hawkish in the near term but more dovish in the long term.

The crucial question, though, is the timing and size of the next Fed rate increase. Our best guess is a 25 bps rise in December. Some commentators have taken the Fischer and Dudley comments as indicating a September rate hike but that looks unlikely. The evidence is not yet compelling and the temptation to wait is attractive. It would be a brave Fed which raised interest rates on 2nd November, six days before the US presidential election … which leaves 14th December.

As for Janet Yellen’s speech today, she is unlikely to signal an imminent interest rate increase but will keep a December rise in play, thus averting “Stormy Monday” for now.