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PolicyWatch
The bargaining problem*
1
By Carlos B. Cavalcanti @ ResearchGate
November 2017
At its October 30-November 1 meeting, the Federal Open Market
Committee (FOMC) left its benchmark interest rate unchanged in the
1.0% to 1.25% range, while signaling the possibility of raising it at the next
meeting (December 13-14). The meeting also confirmed its strategy for
shrinking the Fed’s US$ 4.5 trillion balance-sheet by rolling over the
principal amount of payments from the Fed’s holdings of Treasury securities
maturing during each calendar month that exceed $6 billion, as well as
reinvesting agency mortgage-backed securities in the amount of principal
payments holdings of agency debt and agency mortgage-back securities that
exceed $4 billion. The market’s response to the outcome of the meeting was
swift: yields on Treasury securities dropped and the trade-weighted U.S.
dollar index rose (Figures 1 and 2). Also in line with these decisions, the
market for Federal-funds futures contracts, where traders wager on the path
of policy rates, assigned a 98% chance of another increase in interest rates
before the end of the year.
* Comments are welcome. Email: ccavalcanti@1818alumniwbg.org.
2.65
2.70
2.75
2.80
2.85
2.90
2.95
3.00
Figure 1: Yields on 30 yr nominal securities,
September-November 2017 (%)
Is the dollar's resurgence likely to last? An answer to this question is
important for determining the future path of crude oil and other
commodities exports priced in dollars, and will be influenced by the
prospects of the tax reform bill currently being considered by the U.S.
Congress and the Fed’s new chair’s ability to implement the strategy already
outlined for shrinking the Fed’s $4.5 trillion portfolio. Crude oil prices, after
a gradual increase in prices above the $50 threshold, flattened out at end-
October as the market appeared to raise doubts about the sustainability of
the current economic recovery (Figure 3). Similarly, the proposed tax reform
bill, aims at sharply reducing the corporate tax rates, as well as simplifying
the individual income tax,
2
is facing headwinds now that the draft bill also
includes a repeal of the health insurance mandate under the Affordable
Health Care Act. An agreement on this bill is bound by the budget framework
approved by Congress in late October. This framework provides scope for
$1.5 trillion in tax reductions over a ten-year period, while the proposals
being considered by the Republican leadership in Congress adds at present
to more than this budgeted amount. Although it is beyond this newsletter’s
scope to opine on the outcome of Congressional deliberations, it is
noteworthy that deliberations on this tax-overhaul proposal have coincided
with the flattening in the stock market index (Figure 4).
2
The draft legislation changes, among other features, limits on the home mortgage-interest deduction, caps
on state and local tax deductions and ceilings on property tax deductions. Also, key contrasts between the
draft House and the Senate bills include the timing of a cut to the corporate-tax rate, the number of
individual tax brackets, the details of international tax rules and the particulars of estate-tax changes.
116.6000
118.6000
120.6000
122.6000
124.6000
126.6000
128.6000
130.6000
Figure 2: U.S. Trade Weighted Dollar Index,
January-November 2017
This newsletter focuses primarily on the future path of Fed
policies. This path is contingent on accurately judging where the US real
GDP growth stands relative to its long term potential – the so-called the real
GDP gap.
3
Real GDP growth in the 1st three quarter of 2017 reached 2.4%,
placing the current real GDP gap at its smallest size over the last 17 years
3
This potential real GDP growth is estimated as the trend real GDP growth, which is the decomposition of
the time series long-run conditional expectation of real GDP growth. This decomposition is done after all
forecastable momentum has died out (and any deterministic drift is subtracted). This decomposition
provides a reliable estimate of the output gap as long as it is based on accurate forecasts over short and
medium term horizons.
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2017-11-13
Figure 3: WTI Crude Oil prices, September-November
2017 ($ per barrel)
21500.00
22000.00
22500.00
23000.00
23500.00
24000.00
Figure 4: Dow Jones Industrial Average Index,
September-November 2017
(Figure 5).
4
When the gap narrows, and eventually disappears, real GDP
expands above its long term potential, raising inflationary pressures. While
many analyst agree that not pursuing the Fed’s announced portfolio
shrinkage risks engendering another crisis, there is a trade-off in how to
implement it to best calibrate the growth momentum. This challenge
highlights the importance of deftly managing the next steps of the Fed’s
strategy. A similar situation was aptly described in John Nash’s 1950 article
‘The bargaining problem.’ In that article, the bargainer fails to agree on an
efficient solution, and ends up with nothing by demanding everything for
himself.
5
Resolving the dilemma of how fast to proceed on the Fed’s
portfolio shrinkage pivots on daily decision on the Fed’s holdings of U.S.
Treasury securities. The latest information shows a sharp decline in the Fed’s
holding following the latest FOMC meeting (Figure 6). However, since that
meeting the market has been sending mixed signals about its demand for
Treasury securities. While yields on 30-year Treasury securities moved
4
Real Gross Domestic Product (GDP) growth increased by 3.0% in the third quarter of 2017, according to
the Commerce Department’s ‘advance’ estimate – approximately the same rate as in the previous quarter.
The final and complete real GDP estimate will be released on November 29th, 2017.
5
John Nash was one of the winners of the 1994 Noble prize in economics for his pioneering work on game
theory, including the 1950 article ‘The Bargaining Problem’ published in the April 1950 edition of the
Journal of the Econometric Society (Volume 18, number 2).
y = 5600.7+316.7x
R² = 0.99
6000.0
8000.0
10000.0
12000.0
14000.0
16000.0
18000.0
1981'
1982'
1983'
1984'
1985'
1986'
1987'
1988'
1989'
1990'
1991'
1992'
1993'
1994'
1995'
1996'
1997'
1998'
1999'
2000'
2001'
2002'
2003'
2004'
2005'
2006'
2007'
2008'
2009'
2010'
2011'
2012'
2013'
2014'
2015'
2016'
2017'
Figure 5: Real GDP, 1981-2017 (% Change)
downwards following a 2.96% peak on October 26 (Figure 7), the spread
between short-term (2 year) and long-term (10 year) Treasury securities has
been falling, with this spread reaching 0.65 percentage point on November
15 – the lowest level in a decade. The concern is that the flattening of the
yield curve could lead to its inversion, where short-term rates move higher
than long-term ones. These inversions have preceded every recession since
1955.
2,459,000
2,460,000
2,461,000
2,462,000
2,463,000
2,464,000
2,465,000
2,466,000
Figure 6: U.S. Treasury Secrities Held by the Fed,
August-November 2017 ($ Million)
0.67
0.72
0.77
0.82
0.87
0.92
0.97
1.02
7/7/2017 8/7/2017 9/7/2017 10/7/2017 11/7/2017
Figure 7: Spread Between 10-year and two-year Treasury
Securities, July-November 2017 (%)
This information is important because although the Federal Reserve
has lifted its key interest rate several times this year, pushing up short-term
interest rates, low inflation has held long-term yields down. Meanwhile,
demand from foreign investors looking for higher returns than available in
Europe and Japan has also held down yields on longer term bonds. These
market signals are puzzling because the economy appears to be
strengthening, rather than weakening. The Federal Reserve Bank of
Atlanta's real-time tracker forecasts that GDP is on the path to grow by an
annualized 3.3% in the fourth quarter of 2017.
One of the challenges in placing bids for Treasury securities is
accurately forecasting the trends in the price indexes (Figure 8). The
Consumer Price Index (CPI) unexpectedly dropped earlier this year despite
solid economic growth and labor market indicators. While the core personal
consumption expenditure (PCE) price index (the Fed’s favorite gauge of
inflation) rose by 1.7% at an annual rate in the third quarter 2017, this was a
notable recovery from the slowdown experienced over the spring and
summer of 2017, and the PCE is still running below the 1.9% pace recorded
in the first quarter of the year and under the Fed’s own 2.0% target. One
factor contributing to this outcome was the improvement in the US’ terms of
trade, which has helped hold back external pressures on domestic prices
(Figure 9). Providentially, by the time the December FOMC meeting takes
place, information on the October PCE and November CPI will be available.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Jan' Feb' Mar' Apr' May' Jun' Jul' Ago' Sept' Oct' Nov' Dec' Jan' Feb' Mar' Apr.' May' Jun' Jul' Aug' Sept' Oct'
Figure 8: Consumer Price Index (CPI) and Personal
Consumption Expenditure (PCE) Price Index, 2016-2017
CPI PCE
Conclusion. The challenge facing the next Fed Chair will be to pursue the
strategy already announced for shrinking the Fed’s portfolio, despite tepid
wage and inflation growth.
6
While the interest rate hike scheduled for the
December 12-13 meeting is already fully priced in by the market, the weak
reading of the Consumer Price Index for October (released on November 15)
has lowered the market’s confidence that this strategy will be fully
implemented in 2018.
7
Did the recent growth spurt reflected faster potential
output growth, leading to a permanent upward shift in growth, or was it a
transitory increase that pushed the economy up against its own financial
constraints? The US’ Net International Investor Position continues to
decline (Figure 10), with more recent figures on the increase in fiscal deficit-
to-GDP ratio to 3.1% in the fiscal year ending on October 31, 2017 likely to
have further weaken the situation.
8
Understandably, the public debt-to-GDP
ratio is forecasted by the Congressional Budget Office to increase (under
their baseline scenario) to 80% of GDP by 2020 (Figure 11).
6
The next Fed chair will come into his new position in February 2018.
7
The provision of liquidity by the Fed has been made more important by regulations introduced in the
aftermath of the global financial crisis (2008-2009) that limit the role that financial institutions in
providing liquidity by being market-makers (i.e.. purchasing bonds, even if at lower prices).
8
The government recorded a $62 billion deficit in the fiscal year ending on October 31, 2017, according to
the by-partisan Congressional Budget Office (CBO). This amount is about $17 billion more than the shortfall
recorded in the same month last year. Shifts in the timing of payments affected the deficits in both years; if
not for those shifts, the deficit in October 2017 would have been $19 billion larger than it was in
October 2016.
99.000
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101.000
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102.000
102.500
103.000
103.500
104.000
Figure 9: US GDP Terms of Trade Index,
2014-2017 (Quarterly)
Source: Bureau of Economic Analysis.
Source: Congressional Budget Office.
-$9,000,000.00
-$8,000,000.00
-$7,000,000.00
-$6,000,000.00
-$5,000,000.00
-$4,000,000.00
-$3,000,000.00
-$2,000,000.00
-$1,000,000.00
$0.00
2010 2011 2012 2013 2014 2015 2016
Figure 10: US Net International Investment Position,
2010-2016 (US $ Million)
60.0
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2011-04-01
2011-08-01
2011-12-01
2012-04-01
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2012-12-01
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Figure 11: Federal Public Debt-to-GDP ratio, 2011-20 (%)