Expectations and Monetary Policy

Monetary policy has been in unchartered territory since the global financial crisis of 2007-2008. Interest rates in the Group of Seven (G7) countries have been cut by the central banks to zero or near zero since 2008 and have remained at that level until now. Besides the lowest level of interest rates, G7 central banks have engaged in massive financial asset and government bond purchases to continue to increase money supply at the zero bound while rescuing financial institutions which were impacted adversely by the crisis.

New regulations have been put into place with the intent of preventing future such crises and to ensure the solvency of financial institutions should a crisis occur again. Stress tests of systemically important financial institutions have concluded that the financial institutions are better prepared for any future crisis.

In spite of extraordinarily accommodative monetary policy and new regulatory regimes to contain the possibility of crises again, economic recovery has been slow and gross domestic product (GDP) growth rates have been, at best, moderate and, at worst, modest with low potential growth rates.

The Japanese economy remains mired in low or recessionary growth, continuing to be in an economic condition that began with the lost decade of the 1990s when its real estate bubble burst. It is now feared that, absent unconventional monetary policies, looking forward, the other G7 countries could face the same fate as Japan.

It has been argued that the interest rate sensitivity of G7 economies has gone down because of the large service sectors in G7 countries which are less sensitive to interest rate changes compared to agricultural and industrial sectors. It is unclear if the G7 economies are more sensitive to interest rates when interest rates are on the rise during monetary tightening than they are during monetary easing. In the United States consumer spending on durable goods and on residential fixed investment after the crisis has also been found to have become less sensitive to decreasing interest rates because consumers have withheld spending to make their debt-to-income ratios better. The question arises, however, as to why ever lower interest rates are being expected by market participants before investment and consumer spending can fully recover? Expectations could provide an answer.

Though the conduct of monetary policy has been discounted as a reason for muted interest rate sensitivity of the economy since 1984 in the United States, it must be remembered that the expectation of preemptive easing before economic downturns and especially during crises and preemptive tightening to avert higher levels of inflation has become the norm since the coming of the Greenspan Fed in 1987. Market participants expect the central bank to keep cutting interest rates until recovery indicators surface and, therefore, consumers hold back spending on big ticket items such as durable goods and residential fixed investment, and businesses hold back on capital spending waiting for lower interest rates. Likewise, as inflation begins to rise, with the expectation that the central bank will raise interest rates, market participants will borrow and spend before rates rise further.

Monetary policy response and, in particular, central bank signaling of the health of the economy, therefore, plays a critical role in setting and managing the expectations of consumers and businesses.

To Brexit or Not to Brexit

The word “Brexit”, a portmanteau of the words “Britain” and “Exit”, refers to the possible exit of the United Kingdom (U.K) from the 28-member European Union (EU). The British people will vote on June 23rd in a referendum to decide if Britain should remain in the EU or leave it. The referendum attains special importance because of the current economic problems in the eurozone. To be evaluated by the voters, therefore, before voting, is the impact of Brexit on the U.K, and more broadly the impact of Brexit on the EU and the western bloc of countries in Europe.

Britain always had an uneasy relationship with continental Europe. Not part of the Treaty of Rome in 1957 which formed the European Economic Community (EEC) and after its applications to join the EEC were vetoed by France’s Charles de Gaulle, Britain eventually joined the EEC in 1973. Yet, the U.K has profound reservations about giving up its currency, the pound sterling, which it equates with its sovereignty, and adopt the euro.

Sovereignty has been, in fact, a key negotiating point between Britain and the EU for continued membership of Britain in the bloc: the U.K wanted supersession of a vote in the British parliament over any EU legislation and regulations. The EU agreed to such a special status for Britain where the non-commitment of the U.K to further political integration into the EU (or to ever closer union) will be incorporated into the Treaties governing the Union.

A sticking point for the U.K in Prime Minister David Cameron’s negotiations with the EU has been the in-work benefits for EU migrants to Britain. While Britain wanted a ban on these benefits, what was agreed upon at the end was the idea of an emergency brake where a member state could apply to the European Commission for permission to suspend benefit payments if they were placing too much burden on the social services of a member state. It was agreed that such an emergency brake can last for 7 years. Likewise, on child benefits to children of EU migrants, instead of a total ban as Britain wanted, it was agreed that the payments would be indexed to what the migrants would get in their home countries and that the change will be phased in for existing claimants from 2020.

Even though Mr Cameron has negotiated the above changes in Britain’s relationship with the EU, those who want Britain out of the EU – the Brexiteers – see as benefits the annual net contribution of about $12 billion to the EU budget that the U.K will no longer have to make and flexibility in not having to conform to EU regulations, particularly in product and labor markets and over the free movement of people across borders.

The Brexiteers have a lot of precedence on their side. Over long periods of time, gross domestic product (GDP) per capita has risen steadily and it did not much deviate from this underlying trend even during shocks to the British economy such as joining the EEC in 1973 or leaving the Exchange Rate Mechanism (ERM) in 1992. Only war and the mistake of contractionary monetary policy during the Great Depression have affected this long term trend in the growth of GDP per capita. So, the Brexiteers argue that as in the past, exiting from the EU should not cause a dent in the long term growth of the U.K. It can also be argued, therefore, that staying in the EU will not likewise harm Britain given the underlying trend in Britain’s long term growth rate. So, at a minimum, on balance, staying is no better or worse than leaving. Then why leave but to be politically quixotic?

Looking to the future, however, arguments for staying in the EU are stronger. The much larger U.K trade with the closer EU countries than with the far away countries of the Anglosphere or the emerging markets will most certainly be negatively impacted in the short run until Britain has in place new trade deals to at least compensate for the access it had to the common EU market. The pound sterling could be under severe pressure to depreciate against the currencies of Britain’s biggest trading partners in Europe, that is primarily against the euro. It is unclear at this point how long it will take to make the new trade deals. Moreover, the City of London’s de facto role as Europe’s financial center will also be challenged in the short run.

British voters on June 23rd must ask themselves if the short term risks are worth taking by leaving the EU than by being a part of it and reforming it to make the Union work for the U.K and the rest of Europe.

The Future of the Chinese Economy

China is on everyone’s mind, particularly because of its economy and the increased interdependence between the rest of the world and China. After roaring growth since Deng Xiaoping initiated the policy of reform and opening up in 1978, China’s economy began slowing down to an annual rate of gross domestic product (GDP) growth target of between 6.5% and 7% in 2016. The longest period of vigorous and continuous economic growth with the exception of a hiccup in 1989 and 1990 seems to have come to an end in 2015 when China recorded an annual real GDP growth rate of 6.9% meeting its growth target of around 7% for the year.

The next 5 year plan, China’s thirteenth, from 2016-2020 has set as its objective China’s climb up the value chain. China wants to engage in what it calls “supply side restructuring” aimed at boosting economic growth to double the standard of living, as measured by per capita income, by 2020 and to eliminate poverty which is defined as living on an annual income of $354 or less a year.

“Supply side” is a term intended to distinguish the new policies from traditional demand side policies of easy money and a higher fiscal deficit to boost economic activity. Important among the supply side policies is the reduction of overcapacity in state-owned coal and steel industries which will displace about four million workers, or about 0.5% of China’s workforce, from their jobs. The government is setting up a special fund to assist those who remain unemployed after the restructuring. More restructuring of the bloated state-owned enterprise sector is needed where some firms are consolidated and some are allowed to fail which will create more unemployment, so the government is starting small to see how it works and to monitor the public’s response.

Investment in infrastructure will continue with the proposed building of 50 new airports and thousands of miles of roads and railroads as millions of people will be shifted from low-productivity agricultural areas to dozens of new cities. The proposed One Belt, One Road initiative to open up China to other countries in Central Asia and Asia and perhaps Europe with a network of ports, railroads, and highways linking China to these other parts of the Asian continent and the world could also provide an opportunity to export some of China’s excess industrial capacity.

While the gradual restructuring of the heavy industry-based ‘old China’ economy and continued investment in infrastructure and housing is meant to prevent a hard landing of the Chinese economy, the key policies are targeted to stimulate innovation through research and development including by lowering tax rates for high-technology firms. China’s value-added tax will also be extended to the service sector. Financial reforms will bring China closer to a market economy by eliminating limits on interest rates that banks can pay on deposits and charge on loans.

An important part of the reform process will be to deal with the outsize debts of the state-owned enterprises and the excess debts of local governments. China will be able to deal with these potential bad debts by transferring them to the central government in Beijing because government debt is very low – around 17% of GDP – at this time.

In the big picture, China’s productivity or output per worker will have to rise to achieve higher GDP growth in the new economic structure. Overtime, beyond the next five years, a large part of the GDP growth will be borne by consumption and low-end to high-end services as spending on infrastructure, housing, and industrial capacity bottoms out. Productivity will increase through automation especially as the working-age population declines through 2030. However, this increase in productivity will require upgrading the skills of the workforce to offset the need for large scale unemployment in the short to medium terms.

Productivity and innovation are the two key requirements for China to become a developed, high-income country by 2030. As more of the population becomes involved in the innovation sector and productivity rises through high-end manufacturing where China is no longer assembling parts but is designing and manufacturing from scratch aided by increased automation, the displacement of the workforce due to automation will be partly offset by the retiring workers because China’s working age population has peaked. In this context, a key reform is the establishment of a robust social safety net to assist the retiring and displaced workers.

Contrary to fears of a hard landing, execution of reforms, as China has done so far, and not short term monetary and fiscal policies, can relatively smoothly transition China into a high-income developed country by 2030.

Why is Inflation So Low?

Inflation, contrary to Milton Friedman, is after all a real and not a monetary phenomenon.

The intersection of the aggregate demand (AD) and aggregate supply (AS) curves determines the price level. Change in the price level or inflation, therefore, is dependent on the shifts in the AD and AS curves. Economic slowdown in China due to its structural transformation from a manufacturing and exports-based economy to a consumption and services-based economy and the slow economic recovery in Europe after the 2007-2008 financial crisis have considerably reduced the pricing power of businesses. With aggregate demand falling globally during the Great Recession due to the financial crisis, the aggregate demand curve has shifted to the left, lowering the price level, causing disinflation. Excess supply of commodities because of competition for market share among commodity suppliers has caused a steep decline in commodity prices worldwide, putting greater downward pressure on the overall price level.

Central banks of the Group of Seven (G7) countries, whose currencies command the most market share in international trade, have lowered interest rates to zero or near-zero level to revive their economies. At the zero bound they also engaged in buying massive quantities of bonds, known as Quantitative Easing (QE), to inject cash into the economy, and in the process grew their balance sheets enormously.

To spur investment and growth central banks not only lowered short-term interest rates but also long term rates by buying long bonds and other long term financial assets on a large scale. Such an increase in money supply should theoretically cause inflation by raising prices because more money chases the same amount of goods and services available in an economy when the cash is not used for real investment. In fact, even though central banks increased the money supply, the money is sitting as excess reserves in the central bank accounts of the banks and is not circulating in the real, non-financial sector of the economy to cause inflation (various financial asset prices could be inflated instead).

The G7 countries are in a ‘liquidity trap’ – the cash is not being used for raising real investment because financial institutions, in a low (zero nominal interest) rate environment, prefer hoarding cash instead of lending out the money for real investment when the aggregate demand is low. The more the money supply at zero or near-zero nominal rate of interest, the more the cash hoarding and inflation in the financial sector leading to bubbles in the financial markets. This is made worse when, for example, the Federal Reserve in the United States is paying interest on excess reserves (IOER) creating an incentive for banks not to lend out the excess reserves.

In the absence of targeted fiscal incentives to raise real investment, the G7 countries are operating well below their potential growth rates causing low inflation. The eurozone and Japan have now opted for negative interest rates to flush the hoarded cash out of the central bank accounts of banks into the real economy to ignite real investment, employment, aggregate demand, growth and hence, inflation. This, however, cannot be done by the central banks alone. Fiscal incentives and perhaps even higher public spending are necessary if – instead of higher public spending from government tax receipts or budget deficits – monetary policy refuses to be even more unconventional by directly lending to targeted industries in the economy to raise real investment, employment, aggregate demand, growth and hence, inflation.

Why is Monetary Policy Appearing Impotent in Restoring Growth and Raising Inflation?

The financial crisis of 2007-2008 has seen an unprecedented monetary policy response across the world to prevent what was feared could be a depression. The U.S Federal Reserve (Fed), Bank of England (BoE), Bank of Japan (BoJ), and the European Central Bank (ECB) slashed interest rates to zero or close to zero, engaged in quantitative easing by purchasing government bonds to increase money supply, and BoJ and ECB have now deployed negative interest rates to spur investment, growth and inflation. As a consequence, the reserves held by banks at their central banks have ballooned into trillions of dollars, yen and euros without those funds circulating in their economies and in the global economy as real investment.

Global growth is continuing to slow and commodity prices are at their bottom especially because China is executing a structural transformation of its economy from one of real investment and exports to consumption and services. India, despite strong growth, is taking further measures to ensure that monetary policy easing is indeed transmitted to the economy to raise real investment to create jobs and more growth.

Such extraordinary monetary expansion not achieving the desired goals of growth and inflation in the global economy is leading central bankers to conclude that monetary policy alone cannot be expected to achieve those goals and that fiscal and structural policies are necessary. But the question of why such a monetary expansion has proved to be ineffective begs to be examined.

Many of the G20 countries are exercising caution in deploying expansionary fiscal policy to produce growth. Many of them, with the exception of a few such as Germany, already have high debt-to-GDP ratios and are being, therefore, careful to borrow more. Structural reforms such as setting and meeting fiscal targets; trade liberalization, that is, lifting restrictions on imports and exports; removing price controls and state subsidies; encouraging more investment (for example, by encouraging foreign direct investment, FDI, and foreign institutional investment, FII, flows); and improving governance and fighting corruption are being put into place to create a favorable climate for real investment. But these take time. So, it is necessary to think out of the box about the fiscal and monetary policy mix that is necessary to attain the goals of restoring growth and producing inflation.

Growth to get out of the Great Depression came because of government public works and World War II, not because of monetary policy. However, nothing precludes monetary policy from supporting fiscal incentives to provide targeted money supply to increase real investment in specific sectors and industries in an economy. China has achieved historic growth rates doing precisely that: the People’s Bank of China (PBOC) supplied money for initiatives targeted by government planners. Monetary, fiscal and structural policies in China have executed industrial policy.

There has been an outright rejection of monetary policy executing industrial policy in the United States and in the Group of Seven countries (G7) in general because doing so goes against the grain of the economic orthodoxy of free market capitalism. Banks have been bailed out during the 2007-2008 financial crisis with the central banks engaging in industrial policy in the financial sector but it has been left to the financial markets to figure out where and when in the real sector to invest and how much (the U.S government had to bail out General Motors using tax payer money and not the Fed despite the Federal Reserve Act allowing it to do so). The result is poor monetary policy transmission. The monetary expansion instead is being used by corporations to raise money in the markets through the issuance of corporate bonds, raise venture capital for start-ups based on outlandish evaluations, for appreciating stock values, and by using stock buybacks with declining revenues and earnings (profits) to boost stock prices. Also, cost cutting in an environment of declining revenues is boosting stock prices. Stock prices are ceasing to be truly reflective of corporate performance. In this scenario it is doubtful when the global economy will fully recover to healthy growth.

It is time to dispense with economic orthodoxy and let monetary policy do industrial policy around the world by supporting prudent fiscal and structural policies.

Trade and Economic Development

There has been a backlash against international trade in developed countries and developing countries alike since the radical trade liberalization policies of the 1990s. Developed countries lost jobs in manufacturing and services to developing countries and the benefits of free trade have not been equitably distributed within countries leading to rising income inequality. Moreover, trade liberalization was not conditioned on sound environmental and labor policies in developing countries resulting in the export of negative externalities to the developing world from the developed countries. Developed economies, in particular United States, became consumers of goods and services produced in developing countries, leading to large trade deficits and government indebtedness in developed economies with the exception of export-oriented countries such as Germany and Japan. China became the hub of global manufacturing, while India turned into an exporter of information technology services.

Free trade has been driven by David Ricardo’s principle of comparative advantage which states that countries export goods and services where they have comparative advantage and import the rest even though they are capable of self-sufficiently producing all goods and services in autarky. The supply chain or value chain has now become global with the introduction of the principle of technological competitive advantage: developed economies are now focused on excelling in innovation while outsourcing all the work that does not require innovation such as low-end manufacturing and parts assembly, and technical programming work in information technology to low wage countries around the world, shifting those jobs from developed countries to developing countries permanently leading to job dislocations and increased pressure on the welfare systems in developed countries. Important development needs such as superior infrastructure, sanitation and beautification which characterize the developed world are not being met in the developing countries. Except in the case of China where the government has made it its objective to climb up the value chain and grow from a low income country to a middle income country, development of developing countries is not happening because of free trade because important sectors such as infrastructure and sanitation continue to remain status quo. Then what should trade policy be to ensure job losses at the lower end of the value chain do not occur in developed countries and developing countries rise up the development value chain? Autarky may provide the answer.

Since the rise of the mercantilist East India Company in 1600, the multinational corporation is now commonplace. Global companies such as the East India Company and imperialism by the governments of countries to which corporations such as East India Company belonged traded in raw materials and finished goods especially after the Industrial Revolution: for example, cotton was imported from India and finished cloth was exported back to India from Britain. India was not efficient in the production of cloth because it lacked the mechanization of the mills of Britain. In a regime of autarky, India could have been self-sufficient in cloth if only it had the British technology of textile mills. Britain could also have been self-sufficient in cloth by importing Indian cotton and both countries could have been better off. Assuming labor productivity in both the countries is the same, abundance of labor in India would produce cloth cheaper than in Britain. There would be a price difference between the two countries for the same cloth, but cloth would not be exported or imported by either country. It is important to reiterate here that the precondition for such a state of autarky in both countries is the initial sharing of textile mill technology by Britain with India. Both British-owned and Indian-owned textile mills would operate in the Indian market and the technology of textile mills could be improved just as likely by Indian companies as by British companies.

Such a model of autarky is, in fact, true in today’s pharmaceutical market where licenses to produce some drugs are given by patent-owning developed country companies to companies in developing countries. Drug prices are lower as a result in developing countries such as India for the same drugs. Both the technology sharing country and the technology receiving country would be better off and, as with cloth, it is just as likely that new drugs could be invented over time by developing countries as by developed countries.

For trade to produce economic development, therefore, it is important that global corporations which innovate must, in a model of autarky, produce for the markets of various countries in those countries by sharing technology and by employing the labor of those countries and importing natural resources which the countries lack for the production. This model does not export jobs but creates jobs locally in the various countries. Same products will have different prices in different countries and there will be more competition in the marketplace both to innovate and to produce leading to robust economies.

Today’s Ricardian model of international trade does not lead to development as efficiently as is necessary. A global-local model of quasi-autarky with open technology transfer and trade in natural resources will lead to more efficient economic development.

Can Artificial Intelligence in Finance Overcome Herd Behavior?

Artificial intelligence (AI), using evolutionary computing and deep learning techniques, is beginning to be used for trading stocks, commodities, currencies and bonds. The idea is to keep trading rational by having a computer program decide on which trades to engage in so that human emotion is kept out of the process.

John Maynard Keynes, in the aftermath of the Great Depression, had coined the term “animal spirits” to describe human emotion in the financial markets. Since the Great Depression of 1929-39 in the United States – which began with the stock market crash on Black Tuesday, October 29, 1929 after stock prices started falling around September 4, 1929 – many financial crises struck the U.S and world economies: the Black Monday, October 19, 1987 crash, the bursting of the technology bubble in 2000, and the housing bubble in 2007-2008 are all examples of the action of animal spirits in finance. Human emotion not only leads to financial panics and crashes out of fear but also causes bubbles to form because of euphoria. While Keynesianism, or expansionary fiscal policy, became the standard doctrine of economic policy to recover from the Great Depression, nearly a century later, a radical monetary policy experiment of negative interest rates is underway to deal with the Great Recession of 2007-2008 and the subsequent economic recovery that began in 2009.

Collective euphoria and fear are what behavioral economists call ‘herd behavior’ among financial market participants. Herd behavior is the tendency of individuals to mimic the rational or irrational actions of others, though independently they may not necessarily make the same choice. Social pressure of conformity and the belief that a large group cannot be wrong lead to herd behavior. The tech bubble in the late 1990s was formed because venture capitalists invested in startups with unsound business models because everybody was doing the same. That bubble burst in 2000. The housing bubble from 2002-2007 happened because of unsound lending practices to boost the housing market, again because everybody was doing the same. The housing crisis was worse because the government also tacitly encouraged such behavior with policies to promote housing ownership among the population.

It is clear that automated trading systems (ATS) could neither contain the euphoria nor stanch the fear during the 2007-2008 stock market collapses. Then, the question arises if the new generation of AI-ATS can prevent euphoria and fear from taking hold. Can AI-ATS learn in real time that the market mood is euphoric or is besieged by fear by discerning a pattern in current data when compared to past data and neither act in euphoria nor out of fear? Or will AI-ATS choose to ride the euphoria, sense a turning point in the market at the top and then exit to maximize the trading profits for its human owners? Will there be euphoria and fear at all if a majority of trades in the market are performed by AI-ATS and human beings are out of the picture? Moreover, if AI-ATS are available not just to institutional investors but to a majority of retail, day-to-day investors, will market returns, by the law of averages, come down because the trading opportunities are arbitraged out quicker than when human traders are engaged?

AI-ATS are still new and their inventors are quite thoughtfully keeping them discreet to preserve the competitive advantage of their clients. The proliferation of AI-ATS to replace human traders has some ways to go. If AI-ATS agents become common place, it is indeed likely that the financial markets could be less volatile and more stable. But that is yet to be seen.

Will the Reserve Bank of India Further Cut the Policy Rate?

India currently is a goldilocks economy and the envy of the rest of the world. The Indian economy expanded 7.3 percent year-on-year in the last three months of 2015, slowing from an upwardly revised 7.7 percent growth in the previous quarter but in line with market expectations. Consumer prices increased 5.18 percent year-on-year in February of 2016, lower than 5.69 percent in January and below market expectations of 5.6 percent. More importantly, since the Reserve Bank of India (RBI) and the Ministry of Finance agreed in February 2015 to institute an inflation target of 4 percent increase in the Consumer Price Index (CPI) plus or minus 2 percent, inflation has hewed to the target range of 2-6%. In 2013, the CPI replaced the wholesale price index (WPI) as a main measure of inflation. Then, to spur growth even more, will the RBI cut the policy rate again, as seems to be the expectation of the Indian government, after cutting the repo rate four times by a total of 1.25 percent in 2015 to 6.75%?

The governor of the independent central bank – RBI – Raghuram Rajan, has laid out his conditions to the Indian government about what it will take for him to further lower the policy rate to support investment and, hence, growth. This was before Finance Minister Arun Jaitley presented his budget for fiscal year 2016-17 to the parliament. Rajan’s message was that India needs structural reforms that raise government spending in some areas to boost growth while holding back spending in other areas to keep the budget deficit under control. Fiscal rectitude, inflation control, reducing subsidies on fuel and food, increase in spending on infrastructure and other government programs such as swach bharath and Digital India, and making it easier to do business in India for attracting capital inflows to make programs such as Make in India successful would, according to Rajan, indeed be a recipe for sustained growth of the Indian economy where less expensive capital from the central bank can be put to productive use.

In the budget Jaitley delivered what Rajan wanted, at least partially but in important areas: India’s fiscal deficit will stick to the target of 3.9% for FY 2016-17 and to 3.5% for the following year. The Indian budget has increased infrastructure spending, reduced subsidies on oil (convenient given the current low oil prices. Reducing agricultural subsidies would be politically difficult.), allocated funding for swach bharath and has tweaked tax and investment policies to make it attractive for foreigners to invest in infrastructure, Digital India and Make in India initiatives.

The February 2nd Sixth Bi-monthly Monetary Policy Statement of 2015-16 says “[g]oing forward, under the assumption of a normal monsoon and the current level of international crude oil prices and exchange rates, inflation is expected to be inertial and be around 5 per cent by the end of fiscal 2016-17.” There is, however, some uncertainty that could affect this forecast if the assumption does not hold true.

The RBI may wait to ensure that the monsoon season is normal, assuming approximately status quo conditions on crude oil prices and exchange rates, before cutting rates again. Therefore, the policy rate may not be cut until August 2016, until after the coming of the monsoon.

Should the U.S. Federal Reserve Continue to Raise Rates?

The divergence between the large economies of the world cannot be more apparent than it is now. United States and India are growing. Japan, Brazil, Russia and South Africa are shrinking.

Europe is stagnating, with a few countries such as Ireland and Germany showing confident growth, while the rest of the countries in the euro area and the European Union are eking out only modest increases in their gross domestic product (GDP) threatened by deflation and burdened by high unemployment.

China is in the midst of an economic restructuring to a consumer and services driven economy rather than the real investment, manufacturing and export oriented economy it has been for the past 30 years. This reorientation of the Chinese economy is slowing growth in a manner commensurate with the new structure even as it is facing the rising risk of high indebtedness in its corporate sector which is a mix of the state owned enterprises (SOE) it wants to reform and private firms. China wants to try all the macroeconomic policy measures of monetary policy, fiscal policy and structural change to reach its growth and per capita income targets between now and 2020. This is a strong reassurance to the financial markets about the future of the Chinese economy though the world must get used to the fact that China’s growth looking forward, as the country reforms to a more market-oriented economy, will never be near its growth in the past decades.

As the largest open economy in the world, the focus is on the United States and its currency – the dollar. U.S. unemployment is at full employment and growth is still below potential, hovering between 2 and 2.5 percent annually, but healthy including in 2016 forecasts. U.S. central bank, the Federal Reserve (the Fed), has begun, very gradually, raising the rate at which its member banks borrow funds from each other overnight from their federal reserve accounts – the federal funds rate – at its December 2015 meeting. The idea is to preemptively manage inflation to hew to the central bank’s target of 2% in the medium term without hurting growth.

The domestic debate in the U.S., given the turmoil in the rest of the global economy primarily because of the China slowdown (albeit still at a high enough growth rate) and European stagnation, is whether the Federal Reserve should continue to raise rates in policy divergence with other central banks of the world which are all cutting interest rates.

Salutary growth in the U.S. has strengthened the dollar against other currencies, cheapening U.S. imports and making U.S. exports expensive for other countries. U.S. net exports (the difference between exports and imports), however, are only a small component of the GDP. Most of U.S. output comes from domestic consumption. Therefore, as long as the domestic U.S economy is doing well, global economic conditions should not affect how U.S economic policy is made. This numerical fact nixes any worries about the effects of the rest of the global economy on the U.S.

Those who are suggesting that the Fed should stop raising rates for the rest of 2016 because of the market turmoil with which the year began, despite its causes elsewhere in the world, are pointing to the decline in corporate earnings since the third quarter of 2015. In fact, the financial markets have reduced the probability that the Fed will raise rates in 2016 to negligible. And, not only that, they are looking warily at the prospect of a recession in the U.S. because of what is known as an earnings recession which is defined as two consecutive quarters of decline in corporate earnings. J.P. Morgan’s Qualitative Macro Index (QMI) which measures business conditions shows “a cycle that remains in contraction (weak and decelerating) over the coming months.” Such recession talk is questioning the ability of the Fed to be potent in its response should a recession materialize because the federal funds rate is already so low around 0.25 percent. There is speculation if the Fed would go the way of the Bank of Japan and the European Central Bank by implementing negative interest rates.

Contrary to J.P. Morgan’s concerns, Federal Reserve Bank of Atlanta’s GDPNow forecast for the second quarter of 2016 for the U.S. is at a moderate 2.5 percent annual rate (as of June 3rd) and the Federal Reserve Bank of Atlanta’s GDP-based recession indicator index is at 10 percent which indicates that the U.S economy is still in an expansionary phase. According to the recession indicator index, U.S economy cannot be considered to have entered a recession unless the index rises above 67 percent.

The mere fear among some analysts that the current expansion has entered its seventh year to prompt a recession is unfounded. Further, as of May 2016 the core consumer price index (CPI) inflation rate is 2.2% and as of April 2016 the core personal consumption expenditures (PCE) inflation rate – the preferred inflation measure of the Fed – is 1.6%. Both core CPI and core PCE measures of inflation are near the Fed’s 2% target which bolsters the case for continuing to gradually raise the federal funds rate. The current U.S unemployment rate is 4.7%. To reach the pre-recession low of 4.4%, unemployment still has room to fall 0.3% which could be inflationary.

The U.S. Federal Reserve should continue to raise the federal funds rate, except if growth slows significantly, very gradually to normalize monetary policy conditions and it may raise the rate, if not at the March 2016 meeting, at the June 2016 meeting.

Responsible Investment

International trade, climate change and the 2007-2008 financial crisis are forever changing the landscape of investing. As advocated by free market economists such as Milton Friedman, the notion that the purpose of the firm is to maximize profit – its bottom line, irrespective of any negative impacts of the firm’s activities on the environment and society – has come under severe scrutiny over the past decade.

Negative externalities in the operation of a firm, which are many, have not thus far been factored into the cost of production of goods and services and hence into their prices. Impacts such as pollution, climate change, exploitation of labor in the global supply chain, and adverse consequences of a firm’s operations to employee and people’s health and safety have largely been dealt with in the judicial system, with the cost of such litigation eventually finding its way into prices.

There have been no attempts until the turn of the century to prevent the harmful consequences of the activities of the firm, to deal with them ex ante rather than ex post through the legal process, because the financial markets did not punish such behavior. In fact, risky financial market behavior in investing was encouraged by the government in the name of not interfering with financial innovation leading to the housing crisis in the United States and the consequent Great Recession that is still reverberating around the world. The financial crisis has put the spotlight on corporate governance and on the ability of financial institutions to weather economic downturns and any crises caused by their actions so that tax payers do not foot the bill of rescuing systemically important financial institutions and real sector corporations while also enduring loss of livelihoods, homes and jobs as a result of such crises.

The systemic negative consequences of the activities of the firm have spurred change to take the approach of strengthening the triple bottom line rather than merely the single bottom line of profit: corporate sustainability is now beginning to mean operating at the intersection of the economy, environment and society. Now more corporations are publishing annual corporate citizenship or sustainability reports along with their annual financial reports. The movement is toward publishing integrated annual reports of corporate finance and sustainability because the ability of public corporations to raise capital in the financial markets is increasingly becoming dependent on the triple bottom line. Moreover, the triple bottom line will determine the market capitalization of firms.

Investing in firms, public and private, is beginning to incorporate the medium and long term sustainability (or Environment, Society, Governance – ESG) performance of corporations along with the short term because of the financial materiality of ESG issues in strategic planning. Some examples are the financial impacts of the Deep Water Horizon Spill on BP and the Libor scandal on Barclays. “Responsible investment,” says the United Nations supported Principles for Responsible Investment (UNPRI), “requires investors and companies to take a wider view, taking into account the full spectrum of risks and opportunities facing them, in order to allocate capital in a manner that is aligned with the short and long-term interests of their clients and beneficiaries. This analysis should inform asset allocation, stock selection, portfolio construction, shareholder engagement and voting.”

The six UNPRI principles for responsible investment that UNPRI signatories adopt are:

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Widespread adoption of responsible investing is a first step toward financial and corporate sustainability to achieve the Quadruple Bottom Line (QBL) of incorporating the future vis-a-vis the environment, social and governance actions in the present.