2008-01-21 Update

Major themes intact:

  • weak economy
  • higher prices

Weakness:

US demand soft but supported by exports.

US export strength resulting from non resident ‘desires’ to reduce the rate of accumulation of $US net financial assets. This driving force is ideologically entrenched and not likely to reverse in the next several months.

In previous posts, I suggested the world is ‘leveraged’ to the US demand for $700 billion per year in net imports, as determined by the non resident desire to accumulate 700 billion in $US net financial assets.

US net imports were something over 2% of rest of world GDP, and the investment to support that demand as it grew was probably worth another 1% or more of world GDP.

The shift from an increasing to decreasing US trade deficit is a negative demand shock to rest of world economies.

This comes at a time when most nations have decreasing government budget deficits as a percent of their GDP, also reducing demand.

The shift away from the rest of world accumulation of $US financial assets should continue. Much of it came from foreign CB’s. And now, with Tsy Sec Paulson threatening to call any CB that buys $US a ‘currency manipulator’, it is unlikely the desire to accumulate $US financial assets will reverse sufficiently to stop the increase in US exports. I’m sure, for example, Japan would already have bought $US in substantial size if not for the US ‘weak dollar’ policy.

All else equal, increasing exports is a decrease in the standard of living (exports are a real cost, imports a benefit), so Americans will be continuing to work but consuming less, as higher prices slow incomes, and output goes to non residents.

I also expect a quick fiscal package that will add about 1% to US GDP for a few quarters, further supporting a ‘muddling through’ of US GDP.

Additional fiscal proposals will be coming forward and likely to be passed by Congress. It’s an election year and Congress doesn’t connect fiscal policy with inflation, and the Fed probably doesn’t either, as they consider it strictly a monetary phenomena as a point of rhetoric.

Higher Prices:

Higher prices world wide are coming from both increased competition for resources and imperfect competition in the production and distribution of crude oil. In particular, the Saudis, and maybe the Russians as well, are acting as swing producer. They simply set price and let output adjust to demand conditions.

So the question is how high they will set price. President Bush recently visited the Saudis asking for lower prices, and perhaps the recent drop in prices can be attributed to those meetings. But the current dip in prices may also be speculators reducing positions, which creates short term dips in price, which the Saudis slowly follow down with their posted prices to disguise the fact they are price setters, before resuming their price hikes.

At current prices, Saudi production has actually been slowly increasing, indicating demand is firm at current prices and the Saudis are free to continue raising them as long as desired.

The current US fiscal proposals are designed to help people pay the higher energy prices, further supporting demand for Saudi oil.

They may also be realizing that if they spend their increased income on US goods and services, US GDP is sustained and real terms of trade shift towards the oil producers.

Conclusion:

  • The real economy muddling through
  • Inflation pressures continuing

A word on the financial sector’s continuing interruptions:

With floating exchange rates and countercyclical tax structures we won’t see the old fixed exchange rate types of real sector collapses.

The Eurozone banking sector is the exception, and remains vulnerable to systemic failure, as they don’t have credible deposit insurance in place, and, in fact, the one institution that can readily ‘write the check’ (the ECB) is specifically prohibited by treaty from doing so.

Today, in most major economies, fiscal balances move to substantial, demand supporting deficits with an increase in unemployment of only a few percentage points. Note the US is already proactively adding 1% to the budget deficit with unemployment rising only 0.3% at the last initial observation in December. In fact, fiscal relaxation is being undertaken to relieve financial sector stress, and not stress in the real economy.

Food and energy have had near triple digit increases over the last year or so. Even if they level off, or fall modestly, the cost pressures will continue to move through the economy for several quarters, and can keep core inflation prices above Fed comfort zones for a considerable period of time.

Fiscal measures to support GDP will add to the perception of inflationary pressures.

The popular press is starting to discuss how inflation is hurting working people. For example, I just saw Glen Beck note that with inflation at 4.1% for 07 real wages fell for the first time in a long time, and he proclaimed inflation the bigger fundamental threat than the weakening economy.

I also discussed the mortgage market with a small but national mortgage banker. He’s down 50% year over year, but said the absolute declines leveled off in October, including California. He also pointed out one of my old trade ideas is back – when discounts on pools become excessive to current market rates, buy discounted pools of mortgages and then pay mortgage bankers enough of that discount to be able refinance the individual loans at below market rates.


♥

Re: meltdown?

(an interoffice email)

> … He’s here w/me now & also is very concerned over the entire
> spectrum, especially all the 5/1 ARM’s & 2nd mgtg paper most
> refinancing this year. Ie: orginally good credits, now not. A ton of
> 5/1 Arm paper was done w/ escalations up 40/50% payment wise.

Presumably the borrowers qualified at the time based on the higher payments?

And I see refi’s ratcheting up nicely. Unemployment is about the same, incomes are up, so most borrowers should qualify for refis,
apart from the ones that slipped by with substandard credit in the first place?

> Guess w/these Insurance Cos being downgraded tomorrow will be BLACK Tuesday.
> So, how do we fix a crisis of CONFIDENCE? BB isn’t too convincing these days.

The risk is mark to market risk if there is forced selling by investors that must have rated credits and were relying on the insurance to comply with their ratings criteria.

Forced selling is disruptive for sure- sellers lose, buyers gain as prices go lower than economic and/or recovery value.

Not much the Fed or Congress can do apart from bailing out the bond holders by taking over some piece of the insurance, and operationally it’s hard to see them doing that on a timely basis. But it would ‘cost’ the govt. a relatively small amount of $ to do that, as first loss would still be the shareholders of the ins. companies, and the govt could insure maybe only 95% of the rest, limiting default losses for bond holders to 5 pts max, for example.

As before, none of this directly alters the real economy, apart from psychological effects that might slow demand for a while. This much like the crash of 87- large financial losses but the real economy muddled through until the Bush tax hikes…

All the best!

warren

Big think: Q and A’s

Response to questions from big think.

Is fiscal responsibility essential to creating a stronger, more prosperous nation, or is the matter overhyped?

Worse, the matter is totally confused. By identity, government budget deficits = ‘non-government’ accumulation of financial assets denominated in that currency.

That means net savings desires of the non-government sectors can only be accommodated by the government’s fiscal balance. (Deficit to add financial assets; surplus to reduce financial assets.)

Therefore, if government deficit spending is insufficient to satisfy the total net savings desires of the non-government sectors, the evidence is unemployment and excess capacity in general, which is also known as a lack of aggregate demand.


There are a plethora of reasons for Americans to work later in life today. It is difficult to live off of Social Security benefits alone, we are living longer and 401(k) plans are far less reliable than traditional retirement plans. So do older members of our society get a fair shot when it comes to employment? What about younger workers? Does youth and inexperience repel employers?

Employers attempt to maximize their profits. That means ‘hiring off the top.’ In other words, they try to hire the best first, and the seemingly less attractive workers get hired last.


What is the most exciting thing going on in business today?

The combination of weak demand, due to world budget deficits being too small, and rising prices of food and fuel, due to the Saudis acting as the swing producer (they are a monopoly supplier at the margin), is creating a highly disruptive ‘stagflation’ condition much like the 70’s.


Where is capitalism failing today?

Capitalism is functioning within the given institutional structure, which includes tax laws, labor laws, govt. spending decisions, contract law, etc.

What needs to change in the system?

The system changes continually with changes in the application of the institutional structure and with the advancement of knowledge on how to use any given structure.

Currently, we have a floating exchange rate system in place, which is capable of sustaining full employment and price stability. This is a major advancement over the previous gold standard, which necessarily resulted in periodic recessions and depressions and allocated real resources to the production and accumulation of gold.

However, we continue to fail to recognize how to sustain sufficient demand for full employment and we fail to utilize techniques of government spending that will promote price stability; so, the promise of floating exchange rates has yet to be realized.


Everyone deserves a fair price for their work,

As a matter of ‘game theory’ if a person has to work to eat and survive, but business only has to hire if it determines it can sufficiently profit by adding employees, it is an ‘unfair game’ biased against workers, and we should expect real wages to stagnate over time.

And this is exactly what we observe.

but should there be caps on CEO salaries?

The corporate structure is part of the general institutional structure, which is producing the seemingly higher than necessary CEO salaries. Simple caps would have other consequences.

More fundamental changes to the institutional structure are needed to put incentives in place for alternative distributions of incomes.

Is it fair to lay off workers when your own salary is worth tens of millions of dollars.

At the macro level, with sufficient aggregate demand to ensure full employment, efficiency increases total output. Therefore layoffs without production cuts potentially benefit the entire population.

However to get that outcome, the current institutional structure has to be adjusted to include the necessary incentives.

Or, does the market require high salaries to retain the highest quality leaders and the lifestyle they must lead in their high risk jobs?

No. The reason for the high CEO salaries is a function of the corporate structure that includes the legal arrangements between shareholders, board of directors, and management. It is the resulting interaction that will continue to push up CEO salaries.


Is war the biggest growth economy? It pours unknown amounts of wealth from around the world into technology, man power and manufacturing as well as using up, or destroying a great deal of natural resources.

Again, this is the result of institutional structure which is currently providing the incentives that give us the observed results.

And the situation is actually much worse than described above.

Current tax and other elements of fiscal policy are supporting biofuels. The result is that we are directly and indirectly burning up our food supply for fuel. This is already creating food shortages which have the potential to kill more people than were killed in World War II over the next few years.

How many people have an income either directly or indirectly derived from armed conflict? Since the industries that profit from the various aspects of war have become so vast and dependent on world wide struggles, will they ever let the world create peace?

First, biofuels will kill tens of millions over the next few years if nothing is done to stop that process. That is far higher than any of the current wars.

Second, the lack of understanding of the application of fiscal policy to ensure full employment and price stability is contributing to
regional conflicts.

Third, profiting from war is an example of how institutional structure functions channel economic resources. The outcomes are a function of the structure.


Are you worried about America’s economy?

Yes, I see weaker demand, supported by rising exports that diminish demand in the rest of the world, while inflation accelerates due to imperfect competition in the production of crude oil.


♥

ECB reiterates rate hike warning

ECB reiterates rate hike warning

FRANKFURT(AFP): The European Central Bank (ECB) reiterated Thursday a strong warning about eurozone inflation, calling for price and wage moderation and suggesting it would raise interest rates if necessary.

A monthly ECB bulletin said it was “absolutely essential” that long-term inflation be avoided, underscoring that the bank “remains prepared to act pre-emptively so that second-round effects” do not materialise. Such effects include further consumer price increases and excessive pay increases. The ECB said inflation pressure “has been fully confirmed” after eurozone consumer prices rose by 3.1 percent in December, the biggest increase in six-and-a-half years.

The report was released a day after Yves Mersch, Luxembourg central bank chief and a member of the ECB board, spoke in an interview of “factors that mitigate inflation risks” and suggested the ECB should “be cautious” amid widespread economic uncertainty. That was taken to mean the bank could lower its main lending rate, currently at 4.0 percent, causing the euro to fall below $1.46 on foreign exchange markets.

Like ECB president Jean-Claude Trichet on Wednesday, the bulletin confirmed the bank’s economic outlook: “That of real GDP (gross domestic product) growth broadly in line with trend potential” of around two percent. But it acknowledged that this projection was subject to high uncertainty owing to the US housing crisis and its unknown final effect on the global economy.

Wording of the bulletin matched that of a press conference by Trichet on January 10, when the bank left its key interest rate unchanged. Among other threats to the economy, the ECB pointed Thursday to persistently high prices for oil and other commodities. While acknowledging growth risks, the bank has stressed concern about rising prices and said that keeping inflation expectations under control was its “highest priority,” suggesting it was more inclined to raise interest rates than to lower them.

Many economists have cast doubt on such a possibility however since the US Federal Reserve and Bank of England have begun a cycle of interest rate cuts.

Faced with such scepticism, Trichet raised his tone last week, saying the bank would not tolerate an upward spiral in consumer prices and wages, a message in part to trade unions gearing up for pay talks.

Faced with drops in purchasing power, labour representatives have become particularly militant in Germany, the biggest eurozone economy. The ECB has raised its rates eight times since an increase cycle began in December 2005, with the benchmark lending rate rising from two to four percent.

An additional hike was expected in September but rates remained on hold owing to the US subprime mortgage market crisis.


♥

2008-01-18 US Economic Releases

2008-01-18 Leading Indicators

Leading Indicators (Dec)

Survey -0.1%
Actual -0.2%
Prior -0.4%
Revised n/a

Down some, but not terrible.


2008-01-18 U. of Michigan Confidence

U. of Michigan Confidence (Jan P)

Survey 74.5
Actual 80.5
Prior 75.5
Revised n/a

Up, but not great – not yet the stuff of recession.


2008-01-18 U. of Michigan Confidence TABLE

U. of Michigan Confidence TABLE

Note how high the current levels are – no recession there.

It’s expectations that are weak – the CNBC effect.

And inflation expectations remain higher than the fed’s comfort level.


♥

Lacker speech (edited)

NOTE: Particularly the last 3 paragraphs on inflation, as he has always been hawkish:

Remarks by Jeffrey M. Lacker President, Federal Reserve Bank of Richmond
The Economic Outlook for 2008 Risk Management Association Richmond, Virginia

January 18, 2008

Home prices increased significantly during the long boom, particularly in local markets with restricted supply. Existing home prices increased about 90 percent between 1995 and 2005 for the nation as a whole. In the Washington, D.C., market, prices increased 148 percent from 1995 to 2005 and rose another 11 percent in 2006. Here in Richmond, prices climbed by 85 percent over the same 10-year period and increased by another 12 percent in 2006. Of course, rapid increases in real quality-adjusted prices are not indefinitely sustainable for any asset, and in the case of housing, potential buyers eventually get priced out of the market. In many markets, prices changed course quickly, but in others, prices have continued to increase. Average prices for the nation as a whole fell in the third quarter of 2007 by 0.4 percent, which is the first national price decline since 1994. And in formerly hot markets, the declines have been larger, with prices falling over 5 percent in San Diego, for example. Prices also have fallen significantly in areas with weak regional economies, like Michigan and northern Ohio. Richmond has avoided an outright decline in prices, although appreciation has slowed significantly, with third-quarter growth of just less than 1 percent.

(snip)

Against this back-drop, the Federal Reserve introduced a new mechanism for providing term funding to financial institutions. The Term Auction Facility, or TAF, makes 28-day loans of a predetermined total amount at a rate set by auction. These loans are otherwise similar to discount window loans made by a bank’s regional Reserve Bank against collateral posted with that Reserve Bank. Since these auctions began, near the end of December, spreads on interbank term loans have fallen significantly, although they still remain elevated by historical standards. It will be difficult to determine the extent to which the TAF contributed to this easing of rates in the term funding market, since the counterfactual will never be observed. An earlier instance of elevation in term spreads, peaking in early September, abated without such action by the Fed.

As one would expect, revised assessments of mortgage lending risk have resulted in a tightening of credit standards. Many lenders are requiring larger down payments, and mortgage rate spreads have increased significantly for riskier borrowers and riskier products. Mortgage rates have come down since December the rate on conventional 30-year fixed-rate mortgages has fallen about 50 basis points. And even though the spread between jumbo and conforming mortgages has widened a bit, jumbo rates have also eased in recent weeks, coming down about 30 basis points. Spreads on investment-grade corporate bonds have widened over the last month, but still, the level of yields on such debt has fallen. On the other hand, interest rates on high-yield debt and commercial mortgage-backed securities moved up in the last half of 2007, and have increased further since the beginning of the year. The strong differentiation in the response of lending spreads across borrower classes suggests that increasing spreads have been driven mainly by changing risk assessments rather than bank funding pressures. Higher risk spreads and generally tighter lending terms will tend to restrict spending in the near term. But the fall in short- and long-term Treasury rates over the last few months has offset the upward movement in higher spreads for a wide range of borrowers. The net effect has been lower rates for all but the highest risk borrowers.

The economic outlook for 2008 has worsened in response to the developments of the last six months, and the recent flow of data has heightened the downside risks. The housing sector has been and will continue to be affected by the tightening we’ve seen in lending standards. Home construction is unlikely to bottom out this year, and I expect housing investment to continue to be a drag on growth through at least year-end. Business investment has contributed positively to growth over the last year, but I expect it to grow less robustly than in 2007, since some firms may see a higher cost of capital and some firms may face a decline in the demand for their products. Exports are likely to remain a source of strength next year, however, as a weaker dollar and relatively healthy economies overseas support demand for U.S. goods and services. Accordingly, I expect the trade deficit to continue to narrow, providing modest support to real GDP growth.

The main story in the forecast, though, remains household spending, which accounts for 70 percent of GDP. Consumer spending held up quite well up until the end of last year, having grown at over 3 percent in real terms during the three months ending in November. Higher energy prices and falling home prices are cited often as factors that could dampen consumer spending, and these are legitimate concerns. In addition, we could see more moderate growth in household income in the year ahead. Job growth slowed somewhat over the course of 2007, and in December employment was reported to have expanded by a meager 18,000 jobs, with the unemployment rate rising by three-tenths of a percentage point to 5 percent. Payroll employment is a fairly choppy series from month to month, however, and over the last three months payrolls grew by 97,000 jobs per month, on average. So while employment has certainly decelerated over the last 12 months, I continue to expect moderate job growth in 2008. With wage gains outpacing inflation now, and thus real incomes continuing to expand, I believe the most likely scenario is for reasonably solid income growth next year that will support some gains in consumer spending.

Putting it all together, I expect growth to be very weak for several more months, but to improve toward the end of this year. Clearly, the most cogent risks to the growth outlook are on the downside. With the strains in housing persisting, a substantial slowdown in business spending could raise the odds of a recession. This risk would be heightened if December’s job market weakness proved persistent, pulling down prospects for personal income and household spending. Nevertheless, I believe the most likely outcome is for growth to continue and to improve. I should note that m baseline outlook does not depend on an overly sanguine view of financial market conditions, which are, after all, a significant source of uncertainty right now. Much remains to be learned about the magnitude of ultimate losses in various mortgage market segments and on various related securities. Episodes of turmoil could recur in response to new information. But I believe that financial market participants will find ways to work through problems as the year progresses. Financial intermediaries will re-adjust balance sheets and continue to replenish capital as needed, and investors’ desire for transparency will help shape the next generation of financial innovations.

Risks are not limited to the outlook for real economic growth. Inflation has stepped up recently. As measured by the 12-month change in the PCE price index, inflation was 3.5 percent ending in June 2006. That measure of inflation fell to 1.8 percent in August 2007. Similarly, core inflation, which omits volatile food and energy prices, was 2.5 percent in August 2006, and then declined to 1.8 percent in August 2007. Those declines were heartening, and when the financial market turmoil intensified in August the improving inflation picture allowed even an inflation hawk to endorse an easier monetary policy stance. Since then, however, the inflation picture has deteriorated. From August through November, the overall PCE price index rose at a 4.8 percent annual rate, and the core index rose at a 2.9 percent rate. Judging by the closely related consumer price index, the numbers for December will not be any better. Now these numbers do display transitory swings, so I wouldn’t extrapolate them forward indefinitely. Still, I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we’ve seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right this time.

The Fed has responded to the slowing economy with a cumulative reduction in the federal funds rate of 100 basis points. A slowing economy requires a lower real interest rate because it means softer relative demand for resources now compared to the future. And the current downside risks mean that further slowing, and thus further easing, is quite possible. But inflation also presents risks. Throughout the period since 2005, when inflation rose, eased off, then rose again, longer-term inflation expectations have remained fairly stable. If energy and food prices continue to push overall inflation above core inflation, then this higher overall trend could work its way into expectations, further complicating monetary policy in 2008.

1This is a revised and expanded version of a speech I gave to the Charlotte Chamber of Commerce on December 19, 2007. I am grateful to Roy Webb for help in preparing this speech.

2Edward M. Gramlich, Subprime Mortgages: America’s latest Boom and Bust, Urban Institute Press, Washington D.C., 2007.


Fed’s Fisher

Doesn’t get any more hawkish than this.

Well worth a quick read.

Richard W. Fisher
Challenges for Monetary Policy in a Globalized Economy
Remarks before the Global Interdependence Center
Philadelphia, Pennsylvania
January 17, 2008

Thank you, Charlie [Plosser]. I am grateful for the invitation to speak to the Global Interdependence Center.

(NON ECON INTRO SNIPPED)

You’d be hard pressed to find an economist or market operator in this city or anywhere else on the planet who is not concerned about waning U.S. economic growth. Some analysts and commentators sound like Chicken Littles. Others are less excitable, but are nevertheless assuming a defensive crouch. Most are mindful of recent developments in employment patterns, uneven retail sales and downward shifts in shipping, rail and trucking indexes, industrial activity, business capex plans, credit card payables, purchasing manager activity and other carefully watched indicators. These stresses follow on the severe housing downturn and the liquidity bind. There is an increasingly insistent drumbeat urging the Fed not only to not impose contractionary policy on a weakening economy, but indeed to get “ahead of the curve” through further monetary accommodation.

Chairman Bernanke spoke last week and made it clear that the FOMC stands “ready to take substantive action needed to support growth and provide insurance against downside risks,” adding that “additional policy easing may well be necessary.” In short, he made clear that the FOMC does not intend to just squat and wait should economic data and sound risk management signal that monetary accommodation is required.

It needs to be underscored that being proactive and not passive in doing our job does not mean that we will abandon prudent decisionmaking. We are the central bank of the United States, the bellwether economy of the world. Our job is not to bail out imprudent decisionmakers or errant bankers, nor is it to directly support the stock market or to somehow make whole those money managers, financial engineers and real estate speculators who got it wrong. And it most definitely is not to err on the side of Wall Street at the expense of Main Street.

In fact, to benefit Main Street, we have a duty to maintain a financial system that enables American capitalism to do its magic. To this end, we have recently taken steps designed to circumvent
bottlenecks in interbank lending—steps that include changing the operation of our discount window and opening a new term auction facility. This facility has provided $70 billion in funds in roughly a
month and will soon provide another $30 billion, and perhaps even more over time if needed.

In setting broader monetary policy and the fed funds target rate, the Fed operates under a dual mandate. We are charged by Congress with creating the monetary conditions for sustainable, noninflationary employment growth. Put more simply, our mandate is to grow employment and to contain inflation. Unstable prices are incompatible with sustainable job growth. Some critics worry that we have forgotten that axiom. We haven’t.

Let me give you my personal view.

In discharging our dual mandate, we must be mindful that short-term fixes often lead to long-term problems. The Fed occupies a unique place in the pantheon of government institutions. It was deliberately designed to be calm and steady, untainted by the passion of the moment and immune to political exigency and influence. Because monetary policy’s effects spread into the economy slowly and accumulate over time, having an itchy trigger finger with monetary policy risks shooting everyone in the foot. Our policy mandate must be discharged with careful and deliberate aim.

In the attention-deficit world of television and Internet commentary, where so-called “instant analysis”—an oxymoron if there ever was one—makes headlines, it is easy to understand why one might think that the effect of a change in the fed funds rate would immediately alter the dynamic of the economy. To be sure, movement in the fed funds rate, or even no movement at all, may have an immediate psychological effect and influence expectations for future monetary policy action. But the act of changing or not changing the fed funds target rate, in and of itself, has no immediate effect on the economy. Like a good single malt whiskey, the ameliorating or stimulating influence kicks in only with a lag.

The lag time necessary for inflation to respond to policy is especially long. As a policymaker discharging our dual mandate, I am always mindful that in providing the monetary conditions for employment growth, we must not also sow the seeds of inflation that will eventually choke off the very employment growth we seek to encourage. You do not have to be an inflation “hawk” to recognize that would be a Faustian bargain.

Those of you who follow my speeches—probably a very small number of you with way too much time on your hands—will recall that I like neither the term “hawk” nor “dove.” I like to think that all FOMC
members are best metaphorically described in ornithological terms as “owls”—wise women and men seeking to achieve the right balance in carrying out our dual mandate. To be owlish, and to avoid the
imbalance of emphasis that gave rise to needed harsh discipline imposed by the Volcker FOMC, one has to bear in mind that the seeds of inflation, once planted, can lie fallow for some time, then suddenly burst through the economic topsoil like kudzu, requiring a near-toxic dose of countermeasures to overcome.

In the pre-Volcker era, the Fed had a less-than-admirable record of keeping inflation at bay. But over the past few decades, we have done well enough to both contain inflation and engender growth that far outpaced other advanced economies for a sustained period with only a smattering of short recessions. In short, the Fed has delivered on its mandate.

To be sure, we have been profoundly impacted by the shifting economic dynamics that have complicated our efforts to continue delivering on our mandate. I need not try to convince members and supporters of the Global Interdependence Center that we are living in a globalized world. Increasingly, globalization is blurring economic boundaries. On the inflation front, for example, we have extensive economic playbooks that tell us how to treat the wage–price spiral or cost-push forces in a closed economy. In a closed environment, one would ordinarily expect that a weakening economy would lead, in turn, to a diminution in price pressures. But we have less experience with prescribing policy in an open economy where demand-pull forces come from beyond our borders—such as the burgeoning demand for commodities and food from rapidly growing and newly consequential economies like China, India, Latin America and the countries liberated from the oppression of Soviet communism. These faraway places play an ever-increasing role in determining prices here at home.

Writing in last Sunday’s New York Times, Ben Stein noted this and that the Fed does not have much power to influence the price of oil.[1] He is right. And for that matter, we can’t do much about the external demand impacting the price of food—which, by the way, carries twice the weight of energy in the consumer basket of personal consumption expenditures. But the dynamics of production and demand among the new participants in the global economy nonetheless impact us in different ways at different times. As these new participants joined the global economy, they provided significant tailwinds, helping us grow by providing cost savings, new sources of productivity enhancement and new sources of demand, helping fatten both the top line and bottom line of our businesses while also holding down inflation. Under such conditions, the Fed could operate with a more accommodative monetary policy than what might have been appropriate in a closed economy, without putting upward pressure on inflation. And that is what the Fed did, although some argue—with the benefit of hindsight—it did so for too long.

I think it is now clear that the winds have shifted. The growing appetite for raw inputs from the new participants in the global economy represents an inflationary headwind that is unlikely to soon abate. The so-called “income elasticity of demand” for energy is 1.2 across a wide range of countries, which is a fancy way of saying that economic theory should lead one to conclude that the demand for energy in, say, China, for example, would begin to grow faster than China’s income growth, which continues to increase at a rapid rate. Put more simply, income growth in China and India and elsewhere, even if it slows from its torrid pace, is likely to continue raising demand for food and energy. There is a risk that upward price pressures will continue to affect American producers and consumers of energy and food products and a continuing danger that overall inflation expectations will drift upward as a result.

If I am correct, then the situation today is the flip side of the 1990s and early 2000s: In delivering on our mandate to be monetary policy “owls,” we will have to err on the side of running tighter policy than would otherwise be justified if we wish to limit upward inflation pressures.

I mentioned single malt whiskey earlier to describe the effective time lags of monetary policy. I realize it is only lunchtime, but let’s return to the economics liquor cabinet for a moment. Inflation is like absinthe. The narcotic allure of inflation is a dangerous thing. It might seem like the remedy to bail out a government or a bad book of business and forget your troubles. Yet our experience in the past has taught us only too well that inflation is a dangerous elixir that ultimately proves debilitating for businesses, consumers, investors—including those foreign investors who have lately come to the aid of some large balance sheets here—and especially for the poor, the elderly and people on fixed incomes. It even inculcates bad financial behavioral patterns in the young by encouraging spending rather than investment and saving. Inflation is bad for Main Street and Wall Street and even for Sesame Street.

Yet we central bankers also traverse Lombard Street, and we know from Walter Bagehot that in times of crisis, liquidity is key. As a voter on the FOMC this year, I stand ready to take substantive action to support growth and provide insurance against downside risk, as long as inflation expectations remain contained.

You will note the operative qualifying words there were “as long as inflation expectations remain contained.” Each of us looks to different indicators for a sense of inflation’s direction. Some peruse markets for signs of shifting expectations, looking, say, to the yield on Treasury Inflation-Protected Securities, or TIPS, or to the spread between yields in the forward markets between TIPS and nominal Treasuries at different points of the yield curve or all along the entire curve. Personally, as a former market operator, I am wary of relying on Treasury spot or futures indicators during a flight to quality or at times when liquidity is at a premium, as investors may have other preoccupations that trump or distort conventional inflation concerns.

Others look to surveys of consumers and professional forecasters, like those conducted by the University of Michigan and the Philadelphia Fed. The latest, the University of Michigan survey, released in December, is forecasting headline Consumer Price Index (CPI) inflation of 3.4 percent, which is hardly comforting. The Philadelphia Fed survey, released last November, provides a more palatable forecast of 2.4 percent for the next four quarters; yet if you plot that survey against actual headline inflation obtained for the last four years, it has more often than not underestimated inflation’s true path.

The brow of a central banker considering further accommodation furrows further when looking at the inflation measures that form the basis for Main Street’s inflationary expectations—the CPI and the Personal Consumption Expenditures (PCE) deflator. On a 12-month basis, the most recent CPI, released yesterday, was running at a rate of 4.1 percent. The last PCE deflator, released in December, was 3.6 percent. The Trimmed Mean PCE Deflator, which the Dallas Fed tracks in an effort to eliminate “noise from signal” and as a basis for projecting inflation, is no longer trending downward. Even the so-called “Core PCE,” which I personally consider least useful because it eliminates food and energy prices, is rising rather than declining.

Of course, what matters most is the future direction of inflation, not the past. In the course of preparing for each FOMC meeting, I regularly consult directly with some 30-plus CEOs to develop a sense of future business activity, including cost and pricing developments. I have found this rigorous exercise to be extremely helpful in placing our staff’s econometric analysis in context as I have prepared for FOMC meetings in the past, and I will be listening especially carefully to these business operators’ reports on inflation-related developments as I prepare for upcoming FOMC meetings.

In my view, the degree of substantive action to support economic growth and insure against downside risk will be conditioned by what we see coming down the inflation pike. To deliver on its dual mandate, the Fed must keep one ear cocked toward signs that inflationary expectations are drifting upward as we execute additional monetary measures.

Let me bring this home to Philadelphia. In 1748, Benjamin Franklin wrote an “Advice to a Young Tradesman.” In it, he speaks in the language of the day of the concepts of opportunity cost and of the power of compound interest—pretty precocious stuff for those times. Of the money supply, he wrote that “the more there is of it, the more it produces [at] every turning, so that the profits rise quicker and quicker.” Yet he also warns in earthy terms of the dangers of being too prolific. “He that kills a breeding sow,” Franklin warned, “destroys all her offspring to the thousandth generation. He that murders a crown [the currency of the day], destroys all that it might have produced….”

The late Dame Mary Douglas was no Ben Franklin. Nor was she a Philadelphian. She was a brilliant British economic anthropologist who wrote a pathbreaking book titled Purity and Danger. In it, she wrote something that Franklin or Stephen Girard or any good central banker since the onset of time has understood implicitly: “Money can only perform its role of intensifying economic interaction if the public has faith in it. If that faith is shaken, the currency is useless.”

Like Charlie and my other colleagues, I have every desire to use monetary policy to intensify economic interaction, to keep breeding jobs and growing our economy, so that we might keep America strong to the thousandth generation. I have no intention of being party to any action that might shake faith in the dollar. The challenge to monetary policy, as I see it, is to achieve the growth part of our mandate in the short term and get “ahead of the curve” without shaking faith in the currency over the long term.

I know that the GIC has other things on its mind than just monetary policy. So let me stop there and answer any questions you might have.

About the Author

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas.


2008-01-18 EU Highlights

With the US Fed cutting aggressively, and now a reasonably large US fiscal package a near certainty, the mainstream will see increase in US demand as further support for world prices.

They have no economic theory to support this.

In fact, mainstream theory would more likely be inclined to call this policy subversive, as it sees inflation as the primary risk to optimal long term growth and employment. And they see the real costs (in terms of lost output) to bring down inflation, once allowed to elevate, as far higher than any possible near term gains from adding to demand in the short run.

Highlights:

EU’s Almunia Says Inflation ‘Is on the Rise’ Due to Oil Prices
ECB’s Weber Doesn’t Expect Inflation Far Below Ceiling in 2009
Liebscher Sees Prices Easing by Year-End
ECB Says Banks Expect Funds Squeeze in Coming Months
Trichet discounts productivity gain
German Economy on a Solid Foundation in 2008: Finance Minister
French Growth to Be About 2.25% in 2008, Sarkozy Spokesman Says
Spain House Price Inflation Slowed to 4.8% in Fourth Quarter
Spanish Mortgage Lending Growth Decelerates to 15% in 2007
Portugal’s Dos Santos Says Slowdown May Be Worse Than Forecast

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