Year in graphics 2023

As 2023 winds to a close, this post will highlight some graphics about the world we left behind during the year. The New York Times, Bloomberg, FT, The Economist, Goldman Sachs, McKinsey, Visual Capitalist, and World Bank have excellent graphics sections that cover the year in visuals and graphics. 

1. Arguably, the biggest event of the year should be the terrorist attack by Hamas in Israel and the latter’s genocidal bombings of Gaza Strip. The fatalities from the events already make it the deadliest in the region's bloody history, with the vast majority of victims being Palestinians. The global indifference, including within the Arab world, to a genocide of this scale is stunning.

2. On the other big conflict going on in Ukraine, the global opinion has expectedly got more fragmented as the war rages on. After the whole-hearted initial support to Ukraine, many countries outside of Europe no longer see the war as a major threat or concern to them and have positioned themselves as neutral bystanders.

3. Anther big story of the year was the coming of age of large language models in particular and artificial intelligence in general. Sample this

One study found that workers equipped with ChatGPT became 37 percent faster at basic writing and research tasks. The A.I. revolution showed no sign of slowing, either. The first version of GPT, developed in 2018, had 117 million parameters; 2020’s GPT-3 had 175 billion. GPT-4, released this year, has a trillion, according to a report by Semafor.

4. On the climate change side, in keeping with the trend of increasing temperatures and climate volatility, 2023 was the hottest year on record.

1. 

5. It was another year where economists got all forecasts wrong. The Times has an excellent graphic which show how they got it so badly wrong.

6. It’s also in line with how even central banks have got inflation forecasts so badly wrong in recent years (though the Fed did a good job with its 2023 predictions). 

This is a good inflation tracker in the FT.

7. On equity markets, Japan was the standout while China was the laggard.

8. The S&P 500 is up 23% this year, yet 71% of stocks are underperforming the index, underlining the vastly disproportionate reliance on a few technology stocks.

9. Amidst all the turmoil and uncertainties, the year was great for the financial markets.

10. In 2023, inflation started to rapidly trend downwards and is now well within the acceptable range.

11. Accordingly, the US interest rates may have peaked.

12. This represents the dot-plot forward guidance of US FOMC members in their last meeting on December 13, 2023.

13. And bond yields are trending downwards, with 10 year bond yields dropping across the developed countries.

14. Finally, some long-view graphics from Goldman Sachs. If we take the long-view, the global geo-political risk index is not as elevated as is being made out. In fact, even if a take a 20 year perspective, it’s far lower than the peaks.

15. Japanese 10 year bond yields have started to inch up definitively for the first time since perhaps 2006!

16. Amidst all talk of high interest rates, US Treasuries remain below their historical average and look set to decline further in 2024.

17. Finally, the Goldman Sachs folks have an excellent primer on AI.

Weekend reading links

1. Taylor Swift economic multiplier,

For every $100 spent on live performances, an estimated $300 in ancillary local spending is usually created. In contrast, Swifties — fans of Taylor Swift —are shelling out $1,300-$1,500 for the Eras Tour. Over the same period last year, hotel rates in the cities where the Eras Tour is being held increased by an average of 7.2 per cent. Over 300 employment are supported by the approximately $36 million in direct and indirect spending that each Eras show brings to the local economy.

FT has a profile of Swift

Next week, she is set to tie Elvis Presley for the second-highest number of weeks holding the top-selling US album. From there, she trails only The Beatles. For Taylor Swift, 2023 was one of the biggest years for any artist in music history. Earning some $2bn, her utter domination has been compared by industry magazine Billboard to the “fab four” in 1965, or Michael Jackson in 1983. At a time when record executives agonise over how difficult it is to hold listeners’ attention, Swift has come to exist on her own planet. The Federal Reserve noted her tour had bolstered the economy through hotel bookings, with cities such as Chicago and Minneapolis breaking records for hotels rooms occupied during her visits. One sentence towards the end of a song — about making friendship bracelets — boosted sales at craft stores across the US. Several universities, including Harvard, have created classes about her. In Argentina, fans queued on rotation for five months to get as close to the stage as possible for Swift’s concert. For nearly two decades, Swift’s life has been dissected extensively. She narrates every phase, each one packaged into an album with its own sound and aesthetic... 

Early on, she displayed the defiance and ambition that have defined her career. After the success of her 2008 album Fearless, some critics questioned whether she wrote her own lyrics. She wrote her next album, Speak Now, alone, without co-writers. This defiance reared its head again a decade later, when her music catalogue was sold to one of her enemies, Scooter Braun, in a deal financed by private equity groups. Swift slammed the deal as: “very powerful men, using $300mn of other people’s money to purchase, like, the most feminine body of work”. She has spent the past few years painstakingly recording duplicate copies of her first six albums... Before the pandemic, music executives had begun to whisper that Swift was past her peak. Instead, isolation provided a massive boost for her career: she couldn’t stop writing songs, releasing two surprise albums in 2020... Since then, she has entered a supercharged pop-star mode, releasing seven albums in the past three years. In an industry whose executive ranks are dominated by men, Swift’s power has surpassed them all.

2. Scott Galloway makes some powerful points in his weekly posts. Sample this one reposted from 2020

This country was built by titans of industry even wealthier than billionaires today — Vanderbilt, Rockefeller, Carnegie, and J.P. Morgan. But 1 in 11 steel workers didn’t need to die for bridges and skyscrapers to happen. We are a country that rewards genius. Yet no one person needs to hold enough cash to end homelessness ($20 billion), eradicate malaria worldwide ($90 billion), and have enough left over for 700,000 teachers’ salaries. Bezos makes the average Amazon employee’s salary in 10 seconds. This paints us as a feudal state and not a democracy... Steve Jobs, Donald Trump, and Jeff Bezos have 13 kids by 6 women. One denied his blood under oath to avoid child-support payments, another mocks the disabled, and the third steals from school districts (demand tax/budget cuts) to cling to power and wealth. We need a generation of men who emerge from this crisis with a commitment to being better fathers, husbands, and citizens.

3. FMCG majors are seeing decline in rural retail demand and signatures of rural stress on the back of erratic monsoon and other factors. More here. 

4. Katie Martin has a very good article explaining the various factors contributing to heightened financial market risks and uncertainty about Federal Reserve's monetary policy decisions. The surge in equity markets and steep fall in bond yields following Jay Powell's press meet on December 13 have increased market risks and made the timing of the Fed's rate cut critical. The Fed risks being led by the markets and jumping the gun, thereby running the risk of both further inflating the bubbles and also reversing the inflation trend.

5. Pakistan has one of the lowest tax to GDP ratios.

6. Paul Krugman points to how economists got their prediction so wrong about inflation and the economy. We should not be surprised by this, but instead should be surprised as to why we still expect economists to get predictions right. They have rarely got predictions right. He writes

As recently as March, the Federal Reserve committee that sets monetary policy projected that we’d end this year with 4.5 percent unemployment and with core inflation, the Fed’s preferred measure, running at 3.6 percent. Last week, the same group projected year-end unemployment of only 3.8 percent and core inflation at only 3.2 percent. But actually the news is even better, because that last number is inflation for the year as a whole; over the six months ending in October, core inflation was running at 2.5 percent, and most analysts I follow believe that when November data comes in this week, it will show inflation down to around 2 percent, which is the Fed’s long-run target.

Krugman had consistently been in the team transitory camp. 

Economists who argued that the inflation surge of 2021-22 was transitory, driven by disruptions caused by the Covid pandemic and Russia’s invasion of Ukraine, appear to have been right — but those disruptions were bigger and longer lasting than almost anyone realized, so “transitory” ended up meaning years rather than months. What happened in 2023 was that the economy finally worked out its postpandemic kinks, with, for example, supply chain issues and the mismatch between job openings and unemployed workers getting resolved.

See also Tyler Cowen here. 

7. Executive compensation fact of the day

From 1978 to 2022, US CEO pay based on realised remuneration grew by 1,209 per cent, adjusting for inflation. This was well above the 932 per cent growth in the S&P 500 in the same period, and the 465 per cent rise in incomes in the top 0.1 per cent of earners. The median US worker’s annual remuneration rose by a puny 15.3 per cent.

8. Excellent set of graphics to explain the challenges associated with the conversion of office buildings to residential units in the aftermath of the pandemic-induced relocation of people away from large and associated lowering of demand for office spaces. 

The deep interior of the modern office building, which is perfectly useful for windowless meetings and supply closets, is now largely useless for apartment living... The exterior window system on a building like this would need to be replaced at major expense, because these windows don’t actually open. These buildings have far more elevators than an apartment of the same size would want (adding either more expense in conversion or more wasted space). And in many downtown markets, a modern building like this is worth more per square foot in office rents than in apartment rents... As offices, these buildings can also rent 100 percent (or even more) of their total square footage, according to the quirky math of commercial real estate. That’s because some companies rent entire floors, but also because office tenants — unlike apartment renters — typically pay additional rent for shared building spaces beyond their suites. To convert any of these properties to apartments, you’d have to add common corridors, bike storage, lounges, a gym — features that take up space but don’t collect rent (at least, not explicitly). In a typical residential building, only 80 to 85 percent of all square footage is considered rentable. That makes conversions particularly unappealing to many office owners.

9. The English Premier League dominates broadcast revenue takeaways.

When Norwich City finished in last place in the 2021-22 Premier League, they earned more broadcast revenue for their league appearances than Bayern Munich, AC Milan or Paris St Germain, the German, Italian and French champions. The Premier League’s pulling power is so great that across the whole of Europe only Barcelona and Real Madrid made more money from televised league games than England’s bottom-ranked team, with the result that the biggest clubs on the continent now increasingly find themselves outbid on transfers not only by fellow giants but also by Premier League minnows.

10. The Tesla-Swedish unions face-off is a litmus test for Europe. Without getting lost in its nitty gritties, this is essentially about whether the Europeans will allow a central aspect of one of the most important features of their economic system, the collective bargaining between owners and labour, to give way when faced with onslaught from buccaneering US capitalism.

It's one thing to reject unreasonable demands of unions, but altogether different thing to openly oppose the right of their workers to unionise. It's a sad state of affairs that companies like Tesla and Big Tech can get away by taking a view that they'll not allow their workers to unionise not only in the US but globally too. Where are the liberals in this debate?

11. Fascinating story about Secunda mines-to-refining complex of South African chemical company Sasol, which alone emits more carbon dioxide than Portugal, and is now under pressure to decarbonise faster than originally planned. Sasol is the country's largest taxpayer and also claims to account for 5% of South Africa's GDP. 

Sasol, which is listed in New York as well as Johannesburg with a market value of about $7.6bn, produces one-third of South Africa’s fuel, exports speciality chemicals worldwide, and employs more than 30,000 people. Secunda drives about 40 per cent of its earnings. Now two South African institutional investors, Old Mutual and Ninety One, which together own about 5 per cent of Sasol, have openly revolted over its emissions-reduction timetable — breaking with a tradition of quiet shareholder engagement in the country. Environmental protesters stormed Sasol’s annual general meeting last month, forcing it to abandon proceedings. Shareholders have questioned Sasol’s ability to meet its goal of cutting emissions by 30 per cent by 2030 and, beyond that, of reaching net zero by 2050. The acid test will be whether Secunda can decarbonise, or if it will ultimately have to shut down.

12. Novo Nordisk Foundation as an alternative to shareholder corporations.

The Novo Nordisk Foundation is the controlling shareholder of Danish drugmaker Novo Nordisk, currently Europe’s most valuable company thanks to soaring sales of weight loss and diabetes drugs Wegovy and Ozempic. The foundation holds 77 per cent of Novo’s voting rights and 28.1 per cent of its shares... Thanks largely to Wegovy and Ozempic, the foundation’s assets under management have risen 300 per cent in the past 10 years... Foundation ownership is common in Denmark: brewer Carlsberg and shipping company Maersk are also partly owned by foundations. In Novo Nordisk’s case, thanks to the success of GLP-1s, its owner is now bigger than the Bill & Melinda Gates Foundation or the Wellcome Trust, the two other powerhouses of medical research funding and philanthropy. In the past 10 years in particular, the money Novo Nordisk pays to it in dividends and through share buybacks has soared, rising about 180 per cent over the period to DKr14.2bn ($2.1bn) last year. As of the end of last year, the foundation had DKr805bn or $116bn of assets... 

One of its aims is to try to tackle the root causes of obesity and diabetes. It also funds research on stem cell science and climate change and gives to humanitarian causes, such as providing shelters and essential medicines to Ukraine... The foundation is funding a Center for Basic Metabolic Research, a collaboration with the genomics-focused Broad Institute in Boston, and has set up a Centre for Childhood Health that aims to promote healthy weight for children. In parts of India and east Africa, it is teaching healthcare professionals to improve the prevention and treatment of noncommunicable diseases like diabetes. It recently opened its first office in Delhi... Many of the foundation’s aims have long time horizons. Last year, it launched reNEW, the Novo Nordisk Foundation Center for Stem Cell Medicine, supporting research in Denmark, Australia and the Netherlands.

13. Toby Nangle points to new research that raises more questions about the equity risk premium, the higher returns demanded by equity holders compared to bondholders. While instances of bonds outperforming equities over long periods are not uncommon elsewhere in developed world, the equity risk premium has generally been accepted to hold in the US. 

Edward McQuarrie, an emeritus marketing professor, has spent the past seven years taking a closer look at US exceptionalism. His conclusion, published in the Financial Analyst Journal this month, is that the data is dud. Building on bond figures assembled by financial historian Richard Sylla, McQuarrie conducted city-by-city searches of digitised archives for details of dividends and share counts to expand the American historical financial record. The result is a new resource containing more than three times as many stocks and five times as many bonds. His account captures many more failures, reducing survivorship bias, and a stunningly different long-term story. The impact of survivorship is no small detail... the new historical record still favours equities, but less so. 

This downward re-evaluation of old American financial returns has form. In 2002, Research Affiliates founder Rob Arnott co-authored a paper with Peter Bernstein concluding that the historical average equity risk premium was about half of what most investors believed and stood at only 2.4 percentage points a year. The quantum of stocks’ median outperformance over long-term holding periods is roughly halved again in the new data. And the incidence of equity underperformance over fifteen-year holding periods more than triple.

14. Finally, an FT article points to research by Allianz Research which finds that a 

Allianz Research has disaggregated the 9 percentage point drop in America’s quarterly annualised inflation since the second quarter of 2022 using regression analysis. It finds 5.5pp of the drop was indeed driven by supply-chain snags simply unwinding. But it also attributes 2.7pp to the Federal Reserve’s signalling, which helped to re-anchor inflation expectations. Another 2.2pp comes from the impact of higher rates squeezing demand, which was needed to counteract the inflationary impact of supportive fiscal policy and labour shortages. Maxime Darmet, Allianz’s senior US economist, said without the Fed’s actions and its tough words, quarterly annualised inflation would be 6.1 per cent in the fourth quarter of this year compared with the previous three months, instead of 0.7 per cent.

Monetary policy - the false precision of the 2% target and its capture by financial markets

As the year winds down, it's becoming clear that inflation is trending downwards. This has in turn posed inevitable questions to central bankers. Is the downward trend definitive and sufficient enough to merit rate cuts? And if so when should the rate cuts begin? And once they begin there would be questions about the pace and extent of cuts. These questions will all acquire great significance in 2024, as much as questions about how many more rate rises that central bankers faced in the first half of 2023.

From hindsight, it's now clear that the central banks under-estimated the inflation impulses that emerged from the combination of pandemic and Ukraine war induced supply shocks and the demand resilience/spurts from the massive pandemic fiscal stimuluses and post-pandemic revenge spending. They went along with those group of economists who believed that the spike in inflation would be transitory and would reverse on its own once the shocks receded. But as we know now, the stimulatory effects more than offset the contractionary supply-side forces. The shocks while temporary had sowed seeds of a wage-price spiral. Complementary trends like the reduction in labour market participants (the Great Resignation etc, even if they were temporary as it appears) amplified the spiral.

Once inflation continued to surge and hopes of any immediate reversal receded, the US Federal Reserve Open Market Committee (FOMC) started raising rates from mid-March 2022 and immediately signalled six more increased during the year. And it undertook 11 consecutive rate rises over 16 months till late-July 2023 when it signalled pause. It included four increases by 75 basis points and two of 50 basis points. The rates rose from the 0-0.25% band to 5.25-5.50% band, the highest since 2001. 

While the Fed was clearly behind the curve in responding to the rising inflation, it made up with an impressive display of resolve with its rapid response since March 2022. Therefore, as Larry Summers has commented, if there's a soft landing, the Fed should take all the credit for its decisive, rapid, and large enough rate increases by 5 percentage points. Summers has described the Fed's actions "in the two years after 2021 were a less than 1 per cent probability set of actions relative to what the market expected". 

It now faces the challenge of not falling behind the curve in cutting rates. 

But while it seems to have got right the decision to call the rates have peaked, there's a strong argument that its forward guidance on this count may have gone too far prematurely. Mohammed El Erian made the point that the Fed's dovish remarks in the latest FOMC may be leading it down a slippery slope of shaping market expectations that favour accommodation.

The more the Fed gives in to investor expectations for sizeable and early rate cuts in 2024 — including getting closer to the six cuts priced in for next year — the more the markets will press for an even more dovish policy stance. If investors price in additional rate cuts, it is harder for the Fed to pursue its mandate without a big market reaction. The Fed’s divergence with the market will prove hard to fix quickly while its policy divergence with the Bank of England and European Central Bank will widen. The more this continues, the greater the risks to economic wellbeing and financial stability.

In fact, there are already signs of heightened expectations among market participants. Following Jerome Powell’s last FOMC press meet on December 13, the markets have surged and bond yields have dived.

Analysts and investors scrambled to catch up, pencilling in rate cuts earlier than they had previously predicted, and in much greater number. Subsequent efforts by Fed officials to cool market exuberance have had little impact. Swaps markets show some investors are looking for six quarter-point rate cuts next year, against guidance from the Fed for a potential three. Such market measures are not perfect, and could mean that most investors are anticipating two or three cuts but a smattering of hedging for extreme outcomes is bending the median out of line… Since those pronouncements from the Fed, yields have lurched lower, sinking well under 4 per cent and blasting through many of Wall Street analysts’ forecasts for where they might end 2024. The impact fanned out across other major government bond markets and sent stocks motoring higher. “What the Fed delivered in terms of message was not a big shock. The market reaction was more of a shock,” said Vincent Mortier, chief investment officer at Amundi, Europe’s largest asset manager… Days after Powell’s comments Goldman Sachs, which had already set a target of 4,700 for the S&P 500 for the end of 2024, raised that forecast to 5,100, seven per cent above prevailing levels.

In this context, Summers questions the wisdom of forward guidance and says that it's a case of transparency gone too far with monetary policy communications.

I think the Fed has done itself considerable damage by putting as much emphasis on forward guidance and transparency as it has. I [prefer] the Volcker/Greenspan approach, which is to recognise that the Fed is a little bit like the Delphic oracles. People regarded them as omniscient and omnipotent, but they were in fact neither. So the oracles kept their pronouncements vague and oracular, not concrete and specific, because it was impossible to be concrete and specific without being wrong frequently and undercutting credibility. So I think that the Fed has had a problematic approach to financial communications. 

The two most successful bits of financial communications in the last generation, I would argue, were both of an entirely non-dot-plot or forward guidance variety. They were Mario Draghi’s statements about “whatever it takes”, and Bob Rubin’s “the strong dollar is in the national interest”, both of which qualified as general and oracular. So I would be endeavouring to not constrain myself substantially with any set of predictions or attempt to lay out my reaction function, because I would recognise that events would come in ways that I wouldn’t anticipate, and that I would run the risk of trouble. Another way to say it is: forward guidance is a bit of a fool’s game. The market doesn’t especially believe it and the Fed feels constrained by it down the road. 

But on the issue of Fed falling behind the curve in combatting inflation, academic and outside critics may be discounting the real-time practical challenges faced by central bankers as they were forced to respond to the emerging inflation trends. Sam Fleming in FT has a good interview of Charles Goodhart, where he highlights the problems faced by central banks in responding quickly to the rising inflation in 2021.

In Bank of England policymaker Jonathan Haskel’s excellent speech he says that they had to wait until December 2021 because they feared that there would be a massive increase in unemployment when the workers came flooding back after the furlough. And Federal Reserve chair Jay Powell makes much the same argument... Haskel’s work on this uses the modelling that former Fed chair Ben Bernanke and former IMF chief economist Olivier Blanchard developed — transposing it to the UK. It says there was an initial burst of inflation during the spring and summer of 2021, and that was from energy prices and shortages, and that the labour story kind of picks up later. And so it was reasonable of them to say this is transitory...

They didn’t see that Covid had itself reduced the likelihood of a large return of labour. And they didn’t see that the underlying trend was strongly against a significant increase in the labour force... the decisions they made in the summer of 2021 that they could hold interest rates at very low levels. It was in the second half of 2021 that inflation really began to get going quite rapidly and well before the Ukraine attack by Russia... I think that Blanchard and Bernanke, and Haskel and his colleagues overstate the supply side shortage argument. It’s my guess that quite a lot of what they attribute to shortages actually is much more attributable to the fiscal expansions that were occurring at more or less the same time.

Goodhart also questions the central bank's dot-plot forward guidance,

With the dot plots is this what they would like to happen? What they think will happen? Do you estimate future interest rates depending on how you think your colleagues are going to vote or do you estimate the future interest rates on what you think ought to happen? Exactly what do they represent? It’s not really clear. 

Goodhart makes a point on short-term inflation trends.

There’s absolutely no doubt that inflation got exaggerated by the supply shocks, oil and particularly gas in Europe and the UK, which America didn’t suffer to anything like the same extent. So when that reverses, you’re bound to get quite a sharp decline. But the underlying core and labour market inflation has not yet got down to the target level. My expectation is that 2024 will look very nice because we’re having a reversal of the upsurge in energy prices. And if, as I think is quite possible, there is some kind of truce in the Ukraine war, energy prices might come down even further. And I think 2024 will look good. I think the central banks will declare victory and at some point will start lowering nominal interest rates. My concern is the catch-up argument. The desire of households to restore living standards to what they were earlier, will mean that particularly if interest rates do go down, the labour market will remain tighter than is consistent with underlying target inflation. So 2025 will actually see some reversal, with inflation going up again, maybe even towards the end of 2024...

The concern about catch-up is cumulative. It’s not just ‘did we misestimate inflation now?’ It’s a question of ‘how far have our living standards fallen, compared to a reasonably recent past, which we thought in some sense was normal?’ So it’s a cumulative decline in living standards that I think is crucial. You’ve only got to look at what the striking doctors and nurses, railwaymen and so on say now, to realise it’s cumulative. Moreover, UK real living standards have been further reduced by the fact that effective tax rates have been increased in the meantime by keeping the thresholds constant. So if you take real post-tax living standards, many, particularly in the public sector, are suffering a considerable cumulative reduction in their standard of living. I would argue that the actual variable that [Haskel et al] use to model catch-up is not, in my view, sufficient or satisfactory...

It’s a very difficult period for central banks. If headline inflation gets down to or below 2 per cent, as is perfectly possible during the course of 2024, and unemployment is rising, and you have got general elections coming along so politicians are unhappy if you don’t cut interest rates, I think the pressure on central banks during 2024 to cut nominal interest rates will be overwhelming. And I would understand entirely if they do so. I think my only comment would be that if and when — and I think it’s a question of when rather than if — inflation then starts rising again towards the very end of 2024 or into 2025, as the reduction in energy prices itself falls out of the headline CPI, they’ve got to be ready to reverse tracks again.

Given all these some thoughts:

1. I'm a bit surprised by the debates on inflation revolving so tightly around the 2% target. As has been well documented, the 2% target is not based on any objective scientific principles and owes its current importance to Ben Bernanke's decision in 2012 to make it the stated inflation target. This has since taken the nature of something sacrosanct. Not even the problems with deflation last decade appears to have shaken this 2% inflation target. 

As economies were stuck with deflation and the zero lower bound in interest rates, Olivier Blanchard had led a small group of influential economists to question the wisdom of the 2% inflation target and suggested instead that it be raised to 4%. The IMF too expressed its sympathy with this view. In fact, in August 2020, in a small concession, the FOMC adopted a flexible average inflation targeting (FAIT) regime wherein the objective means achieving an inflation target (the same 2%) which is average over time. It implied that if the inflation was running persistently below the target, the FOMC will aim at an inflation moderately above the target for some time to return to the target of 2%. But now with inflation declining and debates raging on when to start cutting rates, the 2% inflation target appears to have resurfaced with a vengeance. 

The persistence of the 2% inflation target may be a reflection of the hankering of the markets and policy makers to get back to the economic conditions of the last two decades and the belief that ultra-low rates, low inflation, high growth rates, and booming financial markets can all co-exist together. This goldilocks state of the world economy may have been an exception and we may now be seeing a reversion to the norm. There are several factors pointing to the normalisation of inflation trends - end of the China effect and globalisation on inflation, rising protectionism, increased labour market tightness, rising geopolitical uncertainties especially from the new Cold War etc. 

2. Also surprising is the absence of financial market stability considerations in the debates on monetary policy actions despite all the convulsions of the last four years. The commentary on monetary policy response to inflationary trends continue to be dominated by the macroeconomic indicators - labour markets, consumer sentiments, goods and services output etc. Where do the financial market conditions fit into the objective functions of central banks? Even as inflation rate declines and other macroeconomic indicators point to a cooling economy, how does the Fed view the resurgent financial markets which appear to be clearly irrationally exuberant? Where does it fit in the Fed's objective function on rate setting? 

This will become even more important as the rate cuts start. The markets having internalised the ultra-low rates as the norm will invariably demand a return to those levels. Assuming inflation remains range bound or even falls to below the 2% target, the pressure will mount on the Fed to keep cutting below what's required and to levels that will engender financial instability. The over-leveraged governments and policy makers too will favour such rate cuts. In the circumstances, where does the Fed draw the line on what's an acceptable interest rate? 

It's therefore important that the Federal Reserve factor in financial market conditions in its monetary policy decisions also because a likely soft economic landing coupled with the ongoing frenzy on new technologies like artificial intelligence may be creating the conditions for further increases to an already heavily over-priced equity markets. The financial markets may have internalised expectations that the Fed will not allow major convulsions in the run up to the 2024 elections and will lose no opportunity to pressure the Fed before every FOMC meeting next year to be a bit more accommodative than it would otherwise have been.

It's ironical that Fed may have become even more beholden to financial market signals despite all the events of the last couple of years and the volatility surrounding them. 

3. The point here is that the Fed’s decision on rate cuts should not be premised on the 2% inflation target which was decided in a period of low inflation rates, but a slightly higher inflation rate consistent with a return to more normal inflation rates. Further, especially given the extent of influence that financial markets appear to exercise over Fed decisions, it may be time to think about the possibility of explicitly factoring in some range-bound parameters of financial market conditions in the Fed’s rate setting decisions. 

4. There is a strong case that the most important factor for Fed to consider while deciding when to cut rates may be the financial market conditions. The wealth effect from rising equity markets and cheaper lending from falling bond yields risks fuelling inflation. In other words, the financial market conditions may drive the reversal of the current declining inflation trend. 

5. There are other problems with forward guidance than the one highlighted by Summers. For one, uncertainty may have some virtues. The former Fed Governor Donald Kohn has argued that through its forward guidance the Fed may be communicating more certitude to the markets than may be appropriate.

Mr. Kohn believes that some of the ways the Fed now communicates to markets—by way of its “dot plot” of interest-rate projections, as well as its other forecasts—have come to be viewed as more certain than they are. He believes the Fed, both in the presentation of these views and in the remarks of officials, has reinforced the certainty of its outlook, even when officials already know much about the future is unknowable. The Fed’s quarterly forecasts should be aligned with “the rhetoric of uncertainty and data dependency and the true state of economic knowledge,” Mr. Kohn said. The Fed should stop summarizing key projections with medians, and portray the amount of uncertainty the Fed has around its various forecasts.

There may be merit in asymmetric ignorance of monetary policy in disciplining the financial markets and ensuring that investors exercise vigilance and due-diligence in their investment decisions. Forward guidance appears to be getting blunted in an age where expectations are baked in that central banks will backstop equity markets. For example, “it took months of persuasion for investors to get the message from monetary policymakers that rates would stay high, particularly after a clutch of US regional bank failures, only for market rates to collapse shortly after the message from central banks had been absorbed.”

Besides, markets have an asymmetric tendency to overshoot its expectations when faced with signals of good news and quickly price them in (the surge in equity markets and drop in bond yields following Powell’s press conference is the latest example), even as it under-estimates negative signals. And this asymmetry is further exacerbated by the market tendency to respond even more positively in relief when an anticipated negative news does not materialise. I have blogged here on the psychology of financial markets and here on the overshooting forward guidance and good news.

Reforming the sovereign credit rating agencies

The Ministry of Finance, Government of India has published an excellent and much needed examination of the methodologies adopted by sovereign rating agencies. It's a rare example of India taking the lead in setting the agenda for a debate on a critical part of the plumbing of the international financial market system. 

Given the central role played by credit ratings in determining cost of capital for sovereigns, its reform should be one of the most important priorities for global financial market reform. This assumes greater significance in the context of the climate change financing agenda on channeling private capital to developing countries.  

The basic argument is that the rating functions of rating agencies rely disproportionately on qualitative measures of sovereign risk that are in turn drawn from data sources whose methodologies are both questionable and biased. They are doubly distorted - their bias under-estimates the sovereign risks of western countries and over-estimates that of the developing countries. This amplifies the cost of capital for developing countries. 

Avinash Persaud has highlighted this over-estimation problem with financial markets in general by pointing to the striking difference between FX futures cost and the actual FX depreciation experienced by developing countries compared to their developed counterparts. The cost of FX hedging considerably overstates the actual risk, thereby resulting in large overpayments by developing countries. It amounted to an average of 4.65 percentage points for a sample of developing countries on their historical five year forward FX rates. This overpayment of scarce capital should be seen as a market-driven subsidy from the developing country governments to western private financial institutions. 

The paper informs that sovereign ratings are defined by the agencies themselves as forward looking assessments of the "ability" and "willingness" of countries to repay their debts. But its analysis finds that they place a disproportionate emphasis on "willingness to pay", drawing on qualitative indicators. Given the subjectivity associated with such "willingness" to pay assessments, the paper argues that developing countries pay a "perception" premium instead of a "risk" premium in their sovereign borrowings.

It does an excellent job of unpacking the blackboxes of each rating agency, to the extent possible given the opacity surrounding them. It exposes the likely failings and problems with the qualitative measures, and asymmetricities in their application to developed and developing countries. What comes out is not very edifying. 

The summary of the paper is,

Our review of the credit rating methodologies reveals that there is considerable reliance on qualitative variables to capture ‘willingness to pay’. The enormous degree of opaqueness in the methodology makes it challenging to quantify the impact of qualitative factors on credit ratings. The significant presence of qualitative factors in credit rating methodologies also gives rise to bandwagon effects and cognitive biases amply reflected in various studies, generating concerns about the credibility of credit ratings. From our quantitative analysis, we find that over half the credit rating is determined by the qualitative component. Institutional Quality, proxied mostly by the World Bank’s Worldwide Governance Indicators (WGIs), emerges as the foremost determinant of a developing economy’s credit rating, which presents a problem since these metrics tend to be non-transparent, perception-based, and derived from a small group of experts, and cannot represent the “willingness to pay” of the sovereign. Their effect on the ratings is non-trivial since it implies that to earn a credit rating upgrade, developing economies must demonstrate progress along arbitrary indicators while simultaneously contending with the discriminations the ratings tend to carry. 

Reform in the credit rating process is the need of the hour. As the rated sovereign is obligated to be completely transparent, establishing symmetry of obligations warrants that the rating agencies make their processes transparent and avoid employing untenable judgements. Enhanced transparency in credit rating may compel the use of hard data and likely result in credit rating upgrades for a good number of sovereigns... Reforming the sovereign rating process will correctly reflect the default risk of developing economies, saving them billions in funding costs.

The paper uses the example of India as a case study and does an econometric modelling to assess the degree of correlation between fiscal performance, external debt variables, monetary variables, national income, and governance impact ratings. The first four capture the "ability" to pay and the last reflects "willingness" to pay. 

We can infer that better governance, a healthy fiscal position, and low external liabilities emerge as the most important determinants of India’s rating... We observe that the composite governance indicator has the largest and statistically significant coefficient of 15.85 within our specification. To put it another way, the composite governance indicator explains approximately 68 per cent of our assigned rating (the governance coefficient divided by the sum of all absolute coefficients). Further, in terms of sensitivities, the assigned credit rating to India is most sensitive to changes in the governance parameter. For a 0.74 unit change in the average WGI score, India stands a chance to be upgraded from BBB- to BBB. Such a high sensitivity to the governance indicator implies that they are granted a far higher than specified weightage in the methodology documents published by the rating agencies... the influence of the composite governance indicator and perceived institutional strength surpasses the collective influence of all other macroeconomic fundamentals when it comes to the chances of earning India and other developing economies an upgrade. The effect is non-trivial because it implies that to earn a credit rating upgrade; developing economies need to demonstrate progress along arbitrary indicators, which are also criticised for being constructed from a set of several one-size-fits-all perception-based surveys.

These calculations vary widely with the likely ratings and rating changes that can be inferred from the models disclosed by the rating agencies themselves. These variations can be explained only in terms of subjective assessments in the rating agencies calculations. The paper could have gone one step more and made an assessment of the likely additional interest payment made by India due to this "perception" premium. 

I'm inclined to believe that apart from the cognitive biases discussed in the paper, the reliance on qualitative factors betrays some laziness on the part of rating agencies. It appears as an excuse to cover up for inadequate diligence on the macroeconomic side. In the absence of standardised and good quality measures of macroeconomic data and forecasts, rating agencies ought to be exploring proxies, innovative methodologies, and look at more granular data to evaluate sovereign credit worthiness. However, a rating methodology that relies on this approach cannot use the standardised and simplified templates that agencies currently deploy. Instead, sovereign ratings will have to be a bespoke exercise anchored around some basic principles and a common objective function. 

It's understandable that making the entire rating process quantitative, objective, and public may not serve the purpose. After all, if everything is made public then the only differentiator between different rating agencies would be the parameters included and their respective weights. You don't need a professional agency to do such evaluations. 

It has to be acknowledged that there's a fundamental information asymmetry problem with sovereign ratings. Unlike corporates who are regulated, sovereigns are not accountable to disclose their accounts in a standardised format. Apart from publicly available documents and certain disclosures made to the IMF, there are no independently evaluated data on current national macroeconomic indicators. There are wide variations in quality of this data across countries and quality is questionable especially in low income countries. This is unlikely to change. In the circumstances, it may be necessary to settle for second best strategies. 

Historical data on macroeconomic indicators (specifically the variances in important economic, fiscal, monetary, currency, and external parameters) and risk incidence episodes (high inflation periods, sovereign defaults, policy induced shocks etc) may be good practical second-best measures of a country's capability and willingness to repay its debts. They rely on the only two reliable measures - variances of macroeconomic indicators (measures macroeconomic stability) and repayment track record. This should be complemented with some subjective assessment, based on a commonly applied set of principles, of the country's economic prospects given the likely global economic conditions. The rating agency could then be held accountable for that subjective assessment. 

This approach should be no worse than the outcomes from the current rating approach. The history of corporate credit ratings is replete with countless examples of extremely embarrassing defaults even immediately after investment rating endorsements. After all, the objective is a comparative measure to assesses the relative credit worthiness across countries. Shedding inherently biased and secondary (for credit worthiness assessment) measures on institutions and governance and qualitative assessments should not detract from the basic comparative evaluation objective of any sovereign ratings exercise. In any case, in an inherently complicated exercise, adding too many parameters, and that too deeply subjective ones, ends up only amplifying the noise and detracting from credibility. 

In the circumstances, I propose the following steps as a leadership agenda for Government of India:

1. Refine the methodology used in the paper based on a rigorous enough peer-review. The GoI could then support a credible research institution in the country use this methodology to calculate and make available the variations between the ratings given by the agencies and that calculated using this method, the magnitude of the "perception" premium in terms of cost of capital, and the additional debt service burden incurred by the country. This database should be updated on a continuing basis and should strive to become a reference source for debates on rating agency reform. 

This research agenda could be expanded to build on the work of Avinash Persaud and create a historical data depository for all countries on their market priced sovereign bond yields, foreign exchange futures, credit default swaps etc and their actual realised rates. This database could be updated continuously and form an area of high-value policy research. There are several examples of such databases like that on cross-border capital flows, cross-border tax evasion etc. and those maintained by various UN and other international agencies on a variety of sectors. Finally, the sovereign rating reform research agenda could expand into a wider research agenda of reforms to the seriously flawed process of corporate credit ratings. 

2. Posit the outlines of an alternative ratings methodology focused on parameters of macroeconomic stability and track record of risk incidence, with a principles-based assessment of economic prospects. Prepare a draft concept paper, have it circulated widely internationally to solicit feedback, organise a conference, and have it introduced as a reform agenda in multilateral fora. Have this included as a top priority item in the the Government of India’s international diplomacy agenda. Pursue it actively and diligently with a 3-5 year timeframe for change. 

3. Formulate a narrative around the imperative for change to the ratings methodology. The climate finance agenda could provide the most appropriate and current anchor. The need to attract large volumes of private capital to developing countries is widely acknowledged as being central to any meaningful efforts to address climate change. It's also becoming clear that cost of capital is the biggest deterrent to attracting such capital. And as we have seen above, the prevailing sovereign ratings with their "perception" premia impose a prohibitive additional cost on borrowings by developing countries. The need for reform becomes clear and important.  

4. Identify an institution to host standards management guidance and regulation of rating agencies. This institution could cover the wider area of corporate ratings too. The BIS sets the agenda on the harmonisation and continuous calibration of banking sector risk parameters and the OECD provides the forum for international negotiations on tax avoidance practices of multinational corporations through its Base Erosion and Profit Shifting (BEPS) initiative. The IMF or another multilateral institution could be encouraged to take the lead on reforming the rating agencies. In fact, in the context of the wider corporate credit ratings, the IMF has already written about the need for a global regulatory mechanism for credit rating agencies and outlined some principles for such ratings.

One more item that should be on the agenda for the Government of India in its financial market shaping efforts should be to champion reforms to the international arbitration system on inter-state dispute settlements. As I blogged here and here, it subordinates sovereign law, elevates contractual obligations beyond even sovereign law, and is heavily biased towards multinational corporations and against developing country governments. India could put forth an objective and neutral framework for international arbitration to replace the current one-sided mechanism. UNCITRAL should be encouraged to take the lead on reforming the international arbitration process. India could put forth its agenda and demonstrate genuine global leadership in pushing forward both these issues.