Bernanke, King Risk Inflation to Extend Growth Party

Mainstream economists will be increasingly stating that the real GDP ‘speed limit’ is falling or even negative. That is, the non
inflationary growth potential has dropped, and any attempt to support real growth at higher than that ‘non inflationary natural rate’ will only accelerate an already more than problematic inflation rate.

That puts the Fed in the position of either not accommodating the negative supply shocks of food/crude/imported prices or driving up inflation and making things much worse not too far in the future.

And they all believe that once you let the inflation cat out of the bag – expectations elevate- it’s to late and the long struggle to bring it down begins.

So yes, the economy is weak, but they will be thinking that’s the best it can do as demand is still sufficient to support accelerating inflation.

Bernanke, King Risk Inflation to Extend Growth Party

2008-01-03 04:17 (New York)
By Simon Kennedy
(Bloomberg)

Ben S. Bernanke, Mervyn King and fellow central bankers may go on filling up the world economy’s punch bowl in 2008, even at the risk of an inflationary hangover.

Signs that the party is ending for global growth are keeping monetary policy leaning in the same direction at major central banks, with those in the U.K. and Canada likely to join Bernanke’s Federal Reserve in cutting interest rates again. The same conditions may lead the European Central Bank and the Bank of Japan, which shelved plans for raising rates, to remain on hold for months.

“I expect 2008 to mark the beginning of another global liquidity cycle,” says Joachim Fels, Morgan Stanley’s London-based co-chief economist. “More signs of slowdown or even recession are likely to swing the balance towards more aggressive monetary easing in the advanced economies.”

Going against former Fed Chairman William McChesney Martin’s famous central-banker job description — “to take away the punch bowl just when the party gets going” — isn’t an easy call for Bernanke, Bank of England Governor King and other policy makers. Global inflation is the fastest in a decade, say economists at JPMorgan Chase & Co., and easier money policy may accelerate it further.

“Slowing growth and rising inflation will test central bankers to the full,” in 2008, says Nick Kounis, an economist at Fortis Bank NV in Amsterdam.

Hoarding Cash

After growing since 2003 at the fastest rate in three decades, the world economy is being threatened by a surge in credit costs as banks hoard cash and write off losses tied to investments in U.S. mortgages. The Organization for Economic Cooperation and Development in Paris estimates global growth in 2008 will be the weakest since 2003.

In the U.S., the slowdown may turn into recession this year, say economists at Morgan Stanley and Merrill Lynch & Co.

Fed officials signaled yesterday they are now as concerned about a faltering U.S. economy as they are about stability in financial markets. The central bankers anticipated growth that was “somewhat more sluggish” than their previous estimate, according to minutes of the Dec. 11 Federal Open Market Committee.

A contraction in the U.S. would drag down economies worldwide, say Goldman Sachs Group Inc. economists, who have dropped their previous view that the rest of the world can “decouple” from America’s economic ups and downs.

‘Recoupling’

Jim O’Neill, chief economist at Goldman Sachs in London, says that “2008 is the year of recoupling.”

The gloomy outlook may be apparent as central bankers including Bernanke, 54, and ECB President Jean-Claude Trichet, 65, gather Jan. 6-7 for meetings at the Bank for International Settlements in Basel, Switzerland.

“Downside risks to growth will trump their inflation concerns,” says Larry Hatheway, chief economist at UBS AG in London and a former Fed researcher.

After three reductions in the U.S. federal funds rate last year, the Fed begins 2008 with the benchmark at 4.25 percent, the lowest since Bernanke became chairman in 2006.

Easier monetary policy isn’t the only tool central bankers are using to relieve strains in markets. The Fed and counterparts in Europe and Canada last month began auctioning cash to money markets in their biggest coordinated action since just after the 2001 terrorist attacks.

Complementary Medicine

Such operations don’t change “the fact that the central banks still need to cut rates,” says David Brown, chief European economist at Bear Stearns International in London. “It is complementary medicine to improve the situation.”

Economists expect more medicine this year, and investors are demanding it. UBS, Deutsche Bank AG and Dresdner Kleinwort, the most accurate forecasters of U.S. interest rates in 2007, say the benchmark will fall below 4 percent this year. Futures trading suggests a better-than-even chance that will happen before April and investors increased bets yesterday the Fed will cut its key rate by a half-point this month.

The central banks’ choice to help growth will be proven right if economic weakness helps bring inflation down anyway. Global price increases will fade to 2.1 percent this year, the lowest since records began in the early 1970s, as growth slows, according to the OECD.

That outcome is far from guaranteed. In leaning toward easier monetary policy, central banks are accepting the risk that lower rates now may mean higher prices later.

Consumer Prices

U.S. consumer prices in November jumped the most in more than two years, while those in the euro area rose at the fastest pace since May 2001. The Fed’s Open Market Committee said Dec. 11 that “inflation risks remain,” and it will “monitor inflation developments carefully.”

King’s Bank of England, like the Fed, may put aside inflation concerns for now. Its Monetary Policy Committee voted unanimously to cut its benchmark by a quarter-point to 5.5 percent on Dec. 6, an unexpected shift after King, 59, had said two weeks earlier that the price outlook was “less benign.”

Alan Castle, chief U.K. economist at Lehman Brothers Holdings Inc. in London, forecasts that the BOE will cut rates twice more by June, or even go to a half-point reduction as early as February.

Inflation Challenge

At the Bank of Canada, a Bloomberg survey of economists forecasts that Governor David Dodge, 64, in his final decision Jan. 22, will lower the benchmark by another quarter-point after having lopped it to 4.25 percent on Dec. 4. The inflation challenge for Dodge and his successor Mark Carney, 42, is less acute because a surge in the Canadian dollar has restrained prices.

Even the Bank of Japan, whose 0.5 percent benchmark rate is the lowest in the industrial world, may need to cut for the first time since 2001, say economists at Mizuho Securities and Mitsubishi UFJ in Tokyo. While most economists expect the BOJ to remain on hold through the first half of 2008, the bank in December cut its assessment of Japan’s economy for the first time in three years.

The ECB has less room to pare borrowing costs as its own economists predict inflation will accelerate next year and stay above their goal of just below 2 percent. Trichet said last month that some of his colleagues already wanted to impose higher borrowing costs as rising inflation proves more “protracted” than they expected.

European Growth

While that may keep the ECB from lowering its main rate from 4 percent, it won’t lift the rate either, says Jose Luis Alzola, an economist at Citigroup Inc. in London. By the last half of 2008, a “modest rate cut is increasingly probable as growth disappoints,” he adds.

If Bernanke and his counterparts do succeed in dodging recession, they may wind up removing the punch bowl by year’s end, following Martin’s maxim about what central banks have to do as soon as the party “gets going.”

“All central banks are likely to face a sterner global inflation environment,” says Dominic White, an economist at ABN Amro Holding NV in London. By the end of the year, some, including the Fed, ECB and BOJ, “could be forced to tighten policy aggressively as growth recovers,” he says.


U.S. Federal Reserve Meeting Minutes for December 11

U.S. Federal Reserve Meeting Minutes for December 11

2008-01-02 14:06 (New York)

(Bloomberg) Following are the minutes of the Federal Reserve’s Open Market Committee meeting that concluded on December 11.

The Manager of the System Open Market Account reported on recent developments in foreign exchange markets. There were no open market operations in foreign currencies for the System’s account in the period since the previous meeting. The Manager also reported on developments in domestic financial markets and on System open market operations in government securities and federal agency obligations during the period since the previous meeting. By unanimous vote, the Committee ratified these transactions.

The Committee approved a foreign currency swap arrangement with the Swiss National Bank that paralleled the arrangement with the European Central Bank approved during the Committee’s conference call on December 6, 2007. With Mr. Poole dissenting, the Committee voted to direct the Federal Reserve Bank of New York to establish and maintain a reciprocal currency (swap) arrangement for the System Open Market Account with the Swiss National Bank in an amount not to exceed $4 billion. The Committee authorized associated draws of up to the full amount of $4 billion, and the arrangement itself was authorized for a period of up to 180 days unless extended by the FOMC. Mr. Poole dissented because he viewed the swap agreement as unnecessary in light of the size of the Swiss National Bank’s dollar-denominated foreign exchange reserves.

Seems that would make them all that much more credit worthy?

The information reviewed at the December meeting indicated that, after the robust gains of the summer, economic activity decelerated significantly in the fourth quarter. Consumption growth slowed, and survey measures of sentiment dropped further. Many readings from the business sector were also softer: Industrial production fell in October, as did orders and shipments of capital goods. Employment gains stepped down during the four months ending in November from their pace earlier in the year.

Yes, they were expecting a ‘rough spot’.

GDP was subsequently revised higher when consumer spending was subsequently released at up 1.2% with the previous month revised up as well from 0.2% to 0.4%.

Headline consumer price inflation moved higher in September and October as energy prices increased significantly; core inflation also rose but remained moderate.

November was even higher.

The slowing in private employment gains was due in large part to the ongoing weakness in the housing market. Employment in residential construction posted its fourth month of sizable declines in November, and employment in housing-related sectors such as finance, real estate, and building-material and garden-supply retailers continued to trend down.

As expected.

Elsewhere, factory jobs declined again, while employment in most serviceproducing industries continued to move up.

A multi-decade trend.

Aggregate hours of production or nonsupervisory workers edged up in October and November. Some indicators from the household survey also suggested softening in the labor market, but the unemployment rate held steady at 4.7 percent through November.

Yes, demographics keeping unemployment low, as the fed expects labor force participation to work its way lower over time. This also keeps the fed’s GDP non inflationary ‘speed limit’ lower than otherwise.

Industrial production fell in October after small increases in the previous two months. The index for motor vehicles and parts fell for the third consecutive month, and the index for construction supplies moved down for the fourth straight month. Materials output also declined in October, with production likely curbed by weak demand from the construction and motor vehicle sectors. Production in high-tech industries, however, increased modestly, and commercial aircraft production registered another solid gain. In November, output appeared to have edged up in manufacturing sectors (with the exception of the motor vehicles sector) for which weekly physical product data were available. After posting notable gains in the summer, real consumer spending was nearly flat in September and October.

Subsequently, November was up big and October was revised up as well.

Spending on goods excluding motor vehicles was little changed on net over that period. Spending on services edged down, reflecting an extraordinarily large drop in securities commissions in September. The most recent readings on weekly chain store sales as well as industry reports and surveys suggested subdued gains in November and an uneven start to the holiday shopping season.

Seems holiday sales muddled through with modest gains meeting low ends of expectations.

Sales of light motor vehicles in November remained close to the pace that had prevailed since the second quarter. Real disposable income was about unchanged in September and October. The Reuters/University of Michigan index of consumer sentiment ticked down further in early December as respondents took a more pessimistic view of the outlook for their personal finances and for business conditions in the year ahead.

In the housing market, new home sales were below their third-quarter pace, and sales of existing homes were flat in October following sharp declines in August and September.

Still down, but signs of bottoming.

These declines likely were exacerbated by the deterioration in nonprime mortgage markets and by the higher interest rates and tighter lending conditions for jumbo loans.

Those have subsequently eased some, last I checked.

Single-family housing starts stepped down again in October after substantial declines in the June-September period. Yet, because of sagging sales, builders made only limited progress in paring down their substantial inventories. Single-family permit issuance continued along the steep downward trajectory that had begun two years earlier, which pointed toward further slowing in homebuilding over the near term. Multifamily starts rebounded in October from an unusually low reading in September, and the level of multifamily starts was near the midpoint of the range in which this series had fluctuated over the past ten years.

Housing remains weak.

Real spending on equipment and software posted a solid increase in the third quarter. In October, however, orders and shipments of nondefense capital goods excluding aircraft declined, suggesting that some deceleration in spending was under way in the fourth quarter. The October decline in orders and shipments was led by weakness in the high-tech sector: Shipments of computers and peripheral equipment declined while the industrial production index for computers was flat; orders and shipments for communications equipment plunged. Some of that weakness may have been attributable to temporary production disruptions stemming from the wildfires in Southern California; cutbacks in demand from large financial institutions affected by market turmoil may have contributed as well. In the transportation equipment category, purchases of medium and heavy trucks changed little, and orders data suggested that sales would remain near their current levels in the coming months. Orders for equipment outside high-tech and transportation rose in October, but shipments were about flat, pointing to a weaker fourth quarter for business spending after two quarters of brisk increases. Some prominent surveys of business conditions remained consistent with modest gains in spending on equipment and software during the fourth quarter, but other surveys were less sanguine. In addition, although the cost of capital was little changed for borrowers in the investment-grade corporate bond market, costs for borrowers in the high-yield corporate bond market were up significantly. In the third quarter, corporate cash flows appeared to have dropped off, leaving firms with diminished internally generated funds for financing investment. Data available through October suggested that nonresidential building activity remained vigorous.

Real nonfarm inventory investment excluding motor vehicles increased slightly faster in the third quarter than in the second quarter. Outside of motor vehicles, the ratio of book-value inventories to sales had ticked up slightly in September but remained near the low end of its range in recent years. Book-value estimates of the inventory investment of manufacturers–the only inventory data available beyond the third quarter– were up in October at about the third-quarter pace. The U.S. international trade deficit narrowed slightly in September as an increase in exports more than offset higher imports. The September gain in exports primarily reflected higher exports of goods; services exports recorded moderate growth. Exports of agricultural products exhibited particularly robust growth, with both higher prices and greater volumes. Exports of industrial supplies and consumer goods also moved up smartly in September. Automotive products exports, in contrast, were flat, and capital goods exports fell, led by a decline in aircraft. The increase in imports primarily reflected higher imports of capital goods, with imports of computers showing particularly strong growth. Imports of automotive products, consumer goods, and services also increased. Imports of petroleum, however, were flat, and imports of industrial supplies fell. Output growth in the advanced foreign economies picked up in the third quarter. In Japan, real output rebounded, led by exports. In the euro area, GDP growth returned to a solid pace in the third quarter on the back of a strong recovery in investment. In Canada and the United Kingdom, output growth moderated but remained robust, as vigorous domestic demand was partly offset by rapid growth of imports. Indicators of fourth-quarter activity in the advanced foreign economies were less robust on net. Confidence indicators had deteriorated in most major economies in the wake of the financial turmoil and remained relatively weak.

Must all be watching CNBC.

In November, the euro-area and U.K. purchasing managers indexes for services were well below their level over the first half of the year; nevertheless they pointed to moderate expansion. Labor market conditions generally remained relatively strong in recent months.

No slack yet. Maybe this Friday’s number will change that.

Incoming data on emerging-market economies were positive on balance. Overall, growth in emerging Asia moderated somewhat in the third quarter from its double-digit pace in the second quarter, but remained strong. Economic growth was also solid in Latin America, largely reflecting stronger-than-expected activit in Mexico.

World demand still ok.

In the United States, headline consumer price inflation increased in September and October from its low rates in the summer as the surge in crude oil prices began to be reflected in retail energy prices. In addition, though the rise in food prices in October was slower than in August and September, it remained above that of core consumer prices. Excluding food and energy, inflation was moderate, although it was up from its low rates in the spring. The pickup in core consumer inflation over this period reflected an acceleration in some prices that were unusually soft last spring, such as those for apparel, prescription drugs, and medical services, as well as nonmarket prices. On a twelve-month-change basis, core consumer price inflation was down noticeably from a year earlier. In October, the producer price index for core intermediate materials moved up only slightly for a second month, and the twelve-month increase in these prices was considerably below that of the year-earlier period. This pattern reflected, in part, a deceleration in the prices of a wide variety of construction materials, such as cement and gypsum, and in the prices of some metal products. In response to rising energy prices, household survey measures of expectations for year-ahead inflation picked up in November and then edged higher in December. Households’ longer-term inflation expectations also edged up in both November and December.

All inflation data has subsequently deteriorated.

Average hourly earnings increased faster in November than in the previous two months. Over the twelve months that ended in November, however, this wage measure rose a bit more slowly than over the previous twelve months. At its October meeting, the FOMC lowered its target for the federal funds rate 25 basis points, to 4« percent. The Board of Governors also approved a 25 basis point decrease in the discount rate, to 5 percent, leaving the gap between the federal funds rate target and the discount rate at 50 basis points.

This shows a lack of understanding of monetary operations and reserve accounting. Otherwise, they would set the discount rate at or below the Fed Funds rate.

The Committee’s statement noted that, while economic growth was solid in the third quarter and strains in financial markets had eased somewhat on balance,

Interesting! They recognized strains have eased.

the pace of economic expansion would likely slow in the near term, partly reflecting the intensification of the housing correction. The Committee indicated that its action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should promote moderate growth over time.

Again, forestall effects from ‘disruptions’ in financial markets.

Readings on core inflation had improved modestly during the year, but the statement noted that recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.

They have done exactly that.

In this context, the Committee judged that some inflation risks remained and indicated that it would continue to monitor inflation developments carefully.

Markets think this means monitor with no intention to act?

The Committee also judged that, after this action, the upside risks to inflation roughly balanced the downside risks to growth.

Subsequently, the upside risks to inflation have increased dramatically. Growth seems to be at least at the levels they anticipated, especially with December being revised up.

The Committee said that it would continue to assess the effects of financial and other developments on economic prospects and would act as needed to foster price stability and sustainable economic growth.

They claim to believe low inflation is a necessary condition for optimal long term growth and employment.

The Committee’s action at its October meeting was largely expected by market participants, although the assessment that the upside risks to inflation balanced the downside risks to growth was not fully anticipated and apparently led investors to revise up slightly the expected path for policy.

February Fed Funds are, again, pricing another cut.

During the intermeeting period, the release of the FOMC minutes and associated summary of economic projections, as well as various data releases, elicited only modest market reaction. In contrast, markets were buffeted by concerns about the potential adverse effects on credit availability and economic growth of sizable losses at large financial institutions and of financial market strains in general. Market participants marked down their expected path for policy substantially, and by the time of the December meeting, investors were virtually certain of a rate cut. Two-year Treasury yields fell on net over the intermeeting period by an amount about in line with revisions to policy expectations. Ten-year Treasury yields also declined, but less than shorter-term yields. The steepening of the yield curve was due mostly to sharply lower short- and intermediate-term forward rates, consistent with investors’ apparently more pessimistic outlook for economic growth. TIPS yields fell less than their nominal counterparts, implying modest declines in inflation compensation both at the five-year and longer horizons.

After showing some signs of improvement in late September and October, conditions in financial markets worsened over the intermeeting period.

Seems they have since eased, especially FF/LIBOR.

Heightened worries about counterparty credit risk, balance sheet constraints, and liquidity pressures affected interbank funding markets and commercial paper markets, where spreads over risk-free rates rose to levels that were, in some cases, higher than those seen in August. Strains in those markets were exacerbated by concerns related to year-end pressures. In longer-term corporate markets, both investment- and speculative-grade credit spreads widened considerably; issuance slowed but remained strong. In housing finance, subprime mortgage markets stayed virtually shut, and spreads on jumbo loans apparently widened further. Spreads on conforming mortgage products also widened after reports of losses and reduced capital ratios at the housingrelated government-sponsored enterprises. Broadbased equity indexes were volatile and ended the period down noticeably.

Up for the year, but down from the highs. And nonfinancial did far better.

Financial stocks were especially hard hit, dropping substantially more than the broad indexes. Similar stresses were evident in the financial markets of major foreign economies. The tradeweighted foreign exchange value of the dollar against major currencies moved up, on balance, over the intermeeting period.

Since moved down.

Debt in the domestic nonfinancial sector was estimated to be increasing somewhat more slowly in the fourth quarter than in the third quarter. Nonfinancial business debt continued to expand strongly, supported by solid bond issuance and by a small rebound in the issuance of commercial paper.

Real economy functioning though housing weak.

Bank loans outstanding also continued to rise rapidly.

Absorbing CP.

Household mortgage debt was expected to expand at a reduced rate in the fourth quarter, reflecting softer home prices and declining home sales, as well as a tightening in credit conditions for some borrowers. Nonmortgage consumer credit in the fourth quarter appeared to be expanding at a moderate pace. In November, M2 growth picked up slightly from its October rate.

Interesting they care about that.

While liquid deposits continued to grow slowly, heightened demand for safety and liquidity appeared to boost holdings of retail money market mutual funds. Small time deposits continued to expand, likely in part due to high rates offered by some depository institutions to attract retail deposits. Currency outstanding was about flat in November. In the forecast prepared for this meeting, the staff revised down its estimate of growth in aggregate economic activity in the fourth quarter. Although thirdquarter real GDP was revised up sharply, most available indicators of activity in the fourth quarter were more downbeat than had previously been expected. Faster inventory investment contributed importantly to the upward revision to third-quarter real GDP, but part of that upswing was expected to be unwound in the fourth quarter. The available data for domestic final sales also suggested a weaker fourth quarter than had been anticipated. In particular, real personal consumption expenditures had been about unchanged in September and October, and the contraction in singlefamily construction had intensified. Providing a bit of an offset to these factors, however, was further improvement in the external sector.

Q4 subsequently revised up.

The staff also marked down its projection for the rise in real GDP over the remainder of the forecast period. Real GDP was anticipated to increase at a rate noticeably below its potential in 2008. Conditions in financial markets had deteriorated over the intermeeting period and were expected to impose more restraint on residential construction as well as consumer and business spending in 2008 than previously expected.

They have eased some since the TAFs over year end were implemented.

In addition, compared with the previous forecast, higher oil prices and lower real income were expected to weigh on the pace of real activity throughout 2008 and 2009.

Interesting that they are now expecting higher oil prices going forward.

By 2009, however, the staff projected that the drag from those factors would lessen and that an improvement in mortgage credit availability would lead to a gradual recovery in the housing market. Accordingly, economic activity was expected to increase at its potential rate in 2009. The external sector was projected to continue to suppor domestic economic activity throughout the forecast period. Reflecting upward revisions to previously published data, the forecast for core PCE price inflation for 2007 was a bit higher than in the preceding forecast; core inflation was projected to hold steady during 2008 as the indirect effects of higher energy prices on prices of core consumer goods and services were offset by the slight easing of resource pressures and the expected deceleration in the prices of nonfuel imported goods.

Projecting declining nonfuel import prices?

The forecast for headline PCE inflation anticipated that retail energy prices would rise sharply in the first quarter of 2008 and that food price inflation would outpace core price inflation in the beginning of the year. As pressures from these sources lessened over the remainder of 2008 and in 2009,

Wonder why they think pressures would drop as that’s when they think their 100 bp of easing kicks in?

both core and headline price inflation were projected to edge down, and headline inflation was expected to moderate to a pace slightly below core inflation.

Subsequently, fuel and food have gone back through their highs.

Delinquency rates on credit card loans, auto loans, and other forms of consumer credit, while still moderate, had increased somewhat, particularly in areas hard hit by house price declines and mortgage defaults. Past and prospective losses appeared to be spurring lenders to tighten further the terms on new extensions of credit, not just in the troubled markets for nonconforming mortgages but, in some cases, for other forms of credit as well. In addition, participants noted that some intermediaries were facing balance sheet pressures and could become constrained by concerns about rating-agency or regulatory capital requirements. Among other factors, banks were experiencing unanticipated growth in loans as a result of continuing illiquidity in the market for leveraged loans, persisting problems in the commercial paper market that had sparked draws on back-up lines of credit, and more recently, consolidation of assets of off-balance-sheet affiliates onto banks’ balance sheets.

Concerns about credit risk and the pressures on banks’ balance sheet capacity appeared to be contributing to diminished liquidity in interbank markets and to a pronounced widening in term spreads for periods extending through year-end.

Subsequently, FF/LIBOR narrowed with the TAFs and now the passing of year end.

A number of participants noted some potential for the Federal Reserve’s new Term Auction Facility and accompanying actions by other central banks to ameliorate pressures in term funding markets.

Some potential? More evidence of the lack of understanding of reserve accounting and monetary operations.

Participants recognized, however, that uncertainties about values of mortgage-related assets and related losses, and consequently strains in financial markets, could persist for quite some time. Some participants cited more-positive aspects of recent financial developments. A number of large financial intermediaries had been able to raise substantial amounts of new capital. Moreover, credit losses and asset write-downs at regional and community banks had generally been modest; these institutions typically were not facing balance sheet pressures and reportedly had not tightened lending standards appreciably, except for those on real estate loans. And, although spreads on corporate bonds had widened over the intermeeting period, especially for speculative-grade issues, the cost of credit to most nonfinancial firms remained relatively low; nonfinancial firms outside of the real estate and construction sectors generally reported that credit conditions, while somewhat tighter, were not restricting planned investment spending; and consumer credit remained readily available for most households. Nonetheless, participants agreed that heightened financial stress posed increased downside risks to growth and

In their discussion of the economic situation and outlook, participants generally noted that incoming information pointed to a somewhat weaker outlook for spending than at the time of the October meeting. The decline in housing had steepened, and consumer outlays appeared to be softening more than anticipated, perhaps indicating some spillover from the housing correction to other components of spending. These developments, together with renewed strains in financial markets, suggested that growth in late 2007 and during 2008 was likely to be somewhat more sluggish than participants had indicated in their October projections.

Again, December subsequently revised up.

Still, looking further ahead, participants continued to expect that, aided by an easing in the stance of monetary policy, economic growth would gradually recover as weakness in the housing sector abated and financial conditions improved, allowing the economy to expand at about its trend rate in 2009. Participants thought that recent increases in energy prices likely would boost headline inflation temporarily, but with futures prices pointing to a gradual decline in oil prices

Still using futures prices!

and with pressures on resource utilization seen as likely to ease a bit, most participants continued to anticipate some moderation in core and especially headline inflation over the next few years.

Seems to not talk about cutting rates into a negative supply shock of food and fuel was discussed?

Participants discussed in detail the resurgence of stresses in financial markets in November. The renewed stresses reflected evidence that the performance of mortgage-related assets was deteriorating further, potentially increasing the losses that were being borne in part by a number of major financial firms, including money-center banks, housing-related governmentsponsored enterprises, investment banks, and financial guarantors. Moreover, participants recognized that some lenders might be exposed to additional losses: made the outlook for the economy considerably more uncertain. Participants noted the marked deceleration in consumer spending in the national data. Real personal consumption expenditures had shown essentially no growth in September and October, suggesting that tighter credit conditions, higher gasoline prices, and the continuing housing correction might be restraining growth in real consumer spending. Retailers reported weaker results in many regions of the country, but in some, retailers saw solid growth. Job growth rebounded somewhat in October and November, and participants expected continuing gains in employment and income to support rising consumer spending, though they anticipated slower growth of jobs, income, and spending than in recent years. However, consumer confidence recently had dropped by a sizable amount, leading some participants to voice concerns that household spending might increase less than currently anticipated.

Recent data and anecdotal information indicated that the housing sector was weaker than participants had expected at the time of the Committee’s previous meeting.

OK, that is news to me.

I had thought the weakness was in line with expectations.

In light of elevated inventories of unsold homes and the higher cost and reduced availability of nonconforming mortgage loans, participants agreed that the housing correction was likely to be both deeper and more prolonged than they had anticipated in October. Moreover, rising foreclosures and the resulting increase in the supply of homes for sale could put additional downward pressure on prices, leading to a greater decline in household wealth and potentially to further disruptions in the financial markets.

Indicators of capital investment for the nation as a whole suggested solid but appreciably less rapid growth in business fixed investment during the fourth quarter than the third. Participants reported that firms in some regions and industries had indicated they would scale back capital spending, while contacts in other parts of the country or industries reported no such change. Similarly, business sentiment had deteriorated in many parts of the country, but in other areas firms remained cautiously optimistic. Anecdotal evidence generally suggested that inventories were not out of line with desired levels. Even so, participants expected that inventory accumulation would slow from its elevated third-quarter pace. Several participants remarked that, participants also noted the deterioration in the secondary market for commercial real estate loans and the possible effects of that development, should it persist, on building activity. The available data showed strong growth abroad and solid gains in U.S. exports. Participants noted that rising foreign demand was benefiting U.S. producers of manufactured goods and agricultural products, in particular. Exports were unlikely to continue growing at the robust rate reported for the third quarter, but participants anticipated that the combination of the weaker dollar and still-strong, though perhaps less-rapid, growth abroad would mean continued firm growth in U.S. exports. Several participants observed, however, that strong growth in foreign economies and U.S. exports might not persist if global financial conditions were to deteriorate further.

Seems they were putting a negative bias on everything.

Probably watching CNBC a lot.

Recent readings on inflation generally were seen as slightly less favorable than in earlier months, partly due to upward revisions to previously published data. Moreover, earlier increases in energy and food prices likely would imply higher headline inflation in the next few months, and past declines in the dollar would put upward pressure on import prices. Some participants said that higher input costs and rising prices of imports were leading more firms to seek price increases for goods and services. However, few business contacts had reported unusually large wage increases. Downward revisions to earlier compensation data, along with the latest readings on compensation and productivity, indicated only moderate pressure on unit labor costs. With futures prices pointing to a gradual decline in oil prices

Again, futures prices are getting into their models and their thinking. They fail to recognized the difference between perishable and nonperishable commodities in regards the information discounted by future prices.

and with an anticipation of some easing of pressures on resource utilization, participants generally continued to see core PCE inflation as likely to trend down a bit over the next few years, as in their October projections, and headline inflation as likely to slow more substantially from its currently elevated level. Nonetheless, participants remained concerned about upside risks to inflation stemming from elevated prices of energy and non-energy commodities; some also cited the weaker dollar. Participants agreed that continued stable inflation expectations would be essential to achieving and sustaining a downward trend to inflation, that wellanchored expectations couldn’t be taken for granted,

OK, that is inline with main stream thought.

and that policymakers would need to continue to watch inflation expectations closely.

Mainstream theory says that when expectations elevate it is too late – the inflation cat is out of the bag.

softening in the outlook for economic growth warranted an easing of the stance of policy at this meeting. In view of the further tightening of credit and deterioration of financial market conditions, the stance of monetary policy now appeared to be somewhat restrictive.

Mainstream economics would counter that it should be restrictive with inflation as high as it is.

And that if demand is strong enough to drive up prices, it is too high.

Moreover, the downside risks to the expansion, resulting particularly from the weakening of the housing sector and the deterioration in credit market conditions, had risen. In these circumstances, policy easing would help foster maximum sustainable growth and provide some additional insurance against risks.

Only if they are not concerned about inflation.

At the same time, members noted that policy had already been eased by 75 basis points and that the effects of those actions on the real economy would be evident only with a lag. And some data, including readings on the labor market, suggested that the economy retained forward momentum. Members generally saw overall inflation as likely to be lower next year, and core inflation as likely to be stable, even if policy were eased somewhat at this meeting;

Seems they were not at all concerned about inflation.

but they judged that some inflation pressures and risks remained, including pressures from elevated commodity and energy prices and the possibility of upward drift in the public’s expectations of inflation. Weighing these considerations, nearly all members judged that a 25 basis point reduction in the Committee’s target for the federal funds rate would be appropriate at this meeting. Although members agreed that the stance of policy should be eased, they also recognized that the situation was quite fluid and the economic outlook unusually uncertain. Financial stresses could increase further, intensifying the contraction in housing markets and restraining other forms of spending. Some members noted the risk of an unfavorable feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit; such an adverse development could require a substantial further easing of policy.

Yes, if that happens and the inflation outlook continues to not be a concern.

Members also recognized that financial market conditions might improve more rapidly than members expected, in which case a reversal of some of the rate cuts might become appropriate.

Financial market conditions have improved, but downside risks to growth remain and the inflation outlook has deteriorated.

The Committee agreed that the statement to be released after this meeting should indicate that economic growth appeared to be slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending, and that strains in financial markets had increased. The characterization of the inflation situation could be largely unchanged from that of the previous meeting.

I did not think so then and certainly not any more.

Members agreed that the resurgence of financial stresses in November had increased uncertainty about the outlook. Given the In the Committee’s discussion of monetary policy for the intermeeting period, members judged that the sof unlike residential real estate, commercial and industrial real estate activity remained solid in their Districts. But heightened uncertainty, the Committee decided to refrain from providing an explicit assessment of the balance of risks. The Committee agreed on the need to remain exceptionally alert to economic and financial developments and their effects on the outlook, and members would be prepared to adjust the stance of monetary policy if prospects for economic growth or inflation were to worsen.

The risks to growth are still very real, and inflation risks are increasing.

If they continue to not care about inflation, another cut is likely. Seems to me the inflation outlook has gone from bad to worse, and by now they should realize the futures prices are not a reliable indicator of food and fuel prices in the future.

They might also realize that after seeing their GDP forecasts revised up for the last few quarters, there are risks to the upside as well as the downside.

At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: ?The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with reducing the federal funds rate to an average of around 4¬ percent.?

The vote encompassed approval of the statement below to be released at 2:15 p.m.: ?The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4¬ percent. Incoming information suggests that economi growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time. Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. Votes for this action: Messrs. Bernanke, Geithner, Evans, Hoenig, Kohn, Kroszner, Mishkin, Poole, and Warsh. Votes against this action: Mr. Rosengren. Mr. Rosengren dissented because he regarded the weakness in the incoming economic data and in the outlook for the economy as warranting a more aggressive policy response. In his view, the combination of a deteriorating housing sector, slowing consumer and business spending, high energy prices, and illfunctioning financial markets suggested heightened risk of continued economic weakness. In light of that possibility a more decisive policy response was called for to minimize that risk. In any case, he felt that wellanchored inflation expectations and the Committee’s ability to reverse course on policy would limit the inflation risks of a larger easing move, should the economy instead prove significantly stronger than anticipated. It was agreed that the next meeting of the Committee would be held on Tuesday-Wednesday, January 29-30, 2008. The meeting adjourned at 1:15 p.m.


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2008-01-02 US Economic Releases

RPX Composite 28dy Index (Oct)

Survey n/a
Actual 258.86
Prior 259.22
Revised n/a

2008-01-02 RPX Composite 28dy Index

RPX Composite 28dy Index YoY (Oct)

Survey n/a
Actual -3.4295
Prior -2.4848
Revised n/a

Metropolitan housing prices remain very weak.


2008-01-02 ISM Manufacturing

ISM Manufacturing (Dec)

Survey 50.5
Actual 47.7
Prior 50.8
Revised n/a

On the weak side – mainly new orders.

Employment ok.


2008-01-02 ISM Prices Paid

ISM Prices Paid (Dec)

Survey 65.0
Actual 68.0
Prior 67.5
Revised n/a

No weakness here!


2008-01-02 Construction Spending MoM

Construction Spending MoM (Nov)

Survey -0.4%
Actual 0.1%
Prior -0.8%
Revised -0.4%

Stronger than expected; may have bottomed.


2008-01-02 ABC Consumer Confidence

ABC Consumer Confidence (Dec 30)

Survey n/a
Actual -20
Prior -23
Revised n/a

Moderately less negative.


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A very British bubble for Mr Brown

A very British bubble for Mr Brown

Leader
Sunday December 16 2007
The Observer

The buzz words in the world of finance these days are ‘moral hazard’. That is economist-speak for what happens when people who have engaged in risky business and fallen foul of market forces are let off the hook. It is the recognition that when you give dodgy lenders and borrowers an inch, they recklessly gamble for another mile.

When the City started to feel the ‘credit crunch’ over the summer, the Bank of England at first took a tough line on moral hazard. But it subsequently changed its mind. It rescued Northern Rock.

It rescued the depositors. Hardly a moral hazard issue. The shareholders still stand to lose if the assets don’t have the hoped for cash flows over time.

Last week it joined a coordinated action with US, Canadian and European central banks to provide easy credit to any institution that can’t borrow elsewhere.

Sort of, the CB’s job is to administer policy interest rates. And, again, there is nothing yet to indicate shareholders are getting baled out.

That was the right course of action. The banking sector may be in a mess of its own making – it over-exposed itself to US sub-prime mortgages – but the danger to the wider economy of a prolonged cash drought is too big to ignore.

What is a ‘cash drought’???

But even if last week’s intervention gets the wheels of global finance moving again,

Whatever that means. GDP seems to be muddling through as before.

the danger will not have receded. That is because high street lenders have no reason to pass central bank largesse onto their customers. Ordinary people will still find it hard to borrow and will still pay more than before to service their debts.

Haven’t seen any evidence of that, apart from would be subprime borrowers who perhaps never should have had access to funds anyway.

Since Britons are some of the most indebted people in the world, that puts us in a particularly vulnerable position. Per capita, Britons borrow more than twice as much as other Europeans. The average family pays 18 per cent of disposable income servicing debt. If the world economy slumps, the bailiffs will knock at British doors first.

More confused rhetoric. Aggregate demand is about spending. The risk to output and employment remains a slump in spending.

It might not come to that. The best case scenario envisages a mild downturn, consumers turning more prudent, demand dipping and inflation falling, which would free the Bank of England to cut interest rates and re-energise the economy for a prompt comeback.

No evidence cutting rates adds to demand in a meaningful way. It takes a strong dose of fiscal for that or for the non resident sector to start spending its hoard of pounds in the UK.

But in the worst case scenario, the credit crunch turns into a consumer recession.

If it results in a cut in aggregate demand, which it might, but somehow this discussion does not get into that connection.

House prices fall dramatically. People feel much poorer and stop spending.

OK, there is a possible channel, but it is a weak argument. Seems to take a cut in income for spending to fall.

Small businesses can’t get credit and fold.

Could happen, but if consumers spend at the remaining businesses that do not fold and employment and income stays constant, GDP stays pretty much the same.

But high fuel and commodity prices keep inflation high. Unemployment rises

When that happens, it is trouble for GDP, but he skirts around the channels that might lead to a loss of income, spending, and employment.

and millions of people default on their debts. Boom turns to bust.

Right, and the policy response can be an immediate fiscal measure that sustains demand and prevents that from happening.

The problem is with ‘high inflation’ and an inherent fear of government deficits; policy makers may not want to go that route.

The government can hope for the best, but it must prepare for the worst.

Fallout shelters?

That means talking to banks, regulators and debt relief charities to work out ways to help people at risk of insolvency.

Actually, bankruptcy is a means of sustaining demand. Past debts are gone and earned income goes toward spending and often spending beyond current income via new debt.

They must look first at reform of Individual Voluntary Arrangements. These are debt restructuring packages that fall short of personal bankruptcy declarations. In theory, they allow people to consolidate and write off some of their debt, paying the rest in installments.

This could hurt demand unless the installment payments get spend by the recipients.

There is no debtors prison over there anymore, last I heard?

But in practice they are sometimes scarcely more generous than credit card balance transfer deals, with large arrangement fees and tricky small print. There is emerging evidence they have been mis-sold to desperate debtors.

In theory, individuals can also negotiate debt relief directly with banks. But that requires the pairing of a financially literate, assertive consumer with a generous-hearted lender – not the most common combination. The government and banks should already be planning their strategy to make impartial brokering of such deals easier.

But the first hurdle on the way to easing a private debt crisis is political. Gordon Brown has constructed a mythology of himself as the alchemist Chancellor who eliminated the cycle of boom-and-bust from Britain’s economy. To stay consistent with that line, he has to pretend that Britain is well insulated from financial turbulence originating in the US.

Banning CNBC would help out a lot!

That simply isn’t true. The excessive level of consumer borrowing in recent years is a very British bubble and the government can deny it no longer. If the bubble bursts, we will face a kind of moral hazard very different from the one calculated by central banks when bailing out the City. It is the hazard of millions of people falling into penury.

Rising incomes can sustain rising debt indefinitely. It is up to the banks to make loans to people who can service them; otherwise, their shareholders lose. That is the market discipline, not short term bank funding issues.


Crisis may make 1929 look a ‘walk in the park’

Crisis may make 1929 look a ‘walk in the park’

Telegraph
by Ambrose Evans-Pritchard

As central banks continue to splash their cash over the system, so far to little effect, Ambrose Evans-Pritchard argues that things risk spiralling out of their control

Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas.
Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.

It’s about price, not quantity (net funds are not altered), and the CB actions have helped set ‘policy rates’ at desired levels.

That is all the CBs can do, apart from altering the absolute level of rates, which, by their own research, does little or nothing and with considerable lags.

Not to say changing rates isn’t disruptive as it shifts nominal income/wealth between borrowers and savers of all sorts.

As the credit paralysis stretches through its fifth month, a chorus of economists has begun to warn that the world’s central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions.

“Liquidity doesn’t do anything in this situation,” says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression.

The last major, international fixed exchange rate/gold standard implosion. Other since – ERM, Mexico, Russia, Argentina – have been ‘contained’ to the fixed fx regions.

“It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue,” she adds.

The critical issue at the macro policy level is what it is all doing to the aggregate demand that sustains output, employment, and growth. So far so good on that front, but it remains vulnerable, especially given the state of knowledge of macro economics and fiscal/monetary policy around the globe.

Lenders are hoarding the cash, shunning peers as if all were sub-prime lepers. Spreads on three-month Euribor and Libor – the interbank rates used to price contracts and Club Med mortgages – are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.

The CB can readily peg Fed Funds vs. LIBOR at any spread they wish to target.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster.

Seems they pretty much did before year end. Spreads are narrower now and presumably at CB targets.

“The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are
allowing the money markets to dictate policy. We are long past worrying about moral hazard,” he says.

They have allowed ‘markets’ to dictate as the entire FOMC and others have revealed a troubling lack of monetary operations and reserve accounting.

“They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don’t think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park,” he adds.

Hard to do with floating exchange rates, but not impossible if they try hard enough!

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. “We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other,” he says.

Seems a lack of understanding of the ‘suppy side’ of money/credit is pervasive and gives rise to all kinds of ‘uncertainties’ (AKA – fears, as in being scared to an extreme).

New York’s Federal Reserve chief Tim Geithner echoed the words, warning of an “adverse self-reinforcing dynamic”, banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Banks can only own what the government puts on their ‘legal list’, and banks can issue government insured deposits, which is government funding, in order to fund government approved assets.

Functionally, there is no difference between issuing government insured deposits to fund their legal assets and using the discount window to do the same. The only difference may be the price of the funds, and the fed controls that as a matter of policy.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.

Section 13 (3) allows the Fed to take emergency action when banks become “unwilling or very reluctant to provide credit”. A vote by five governors can – in “exigent circumstances” – authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.

The government already does this. They already determine legal bank assets, capital requirements, and via various government agencies and association advance government guaranteed loans of all types.

This is business as usual – all presumably for public purpose.

Get over it!!!

Yet still the central banks shrink from seriously grasping the rate-cut nettle. Understandably so. They are caught between the Scylla of the debt crunch and the Charybdis of inflation. It is not yet certain which is the more powerful force.

Yes, as they cling to the belief that ‘inflation’ is a ‘strong’ function of interest rates, while it is an oil monopolist or two and a government induced and supported link from crude to food via biofuels that are driving up CPI and inflation in general.

America’s headline CPI screamed to 4.3 per cent in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.

CPI might also be headed higher if crude continues its advance.

This has eerie echoes of Japan in late-1990, when inflation rose to 4 per cent on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country’s financial system tipped into the abyss.

As I recall, it was a tax hike that hurt GDP.

Yes, the world economies are vulnerable to a drop in GDP growth, but the financial press seems to have the reasoning totally confused.


♥

2007-12-31 US Economic Releases

2007-12-31 Existing Home Sales

Existing Home Sales (Nov)

Survey 4.97M
Actual 5.00M
Prior 4.97M
Revised 4.98K

2007-12-31 Existing Home Sales MoM

Existing Home Sales MoM (Nov)

Survey 0.0%
Actual 0.4%
Prior -1.2%
Revised -1.0%

Could be bottoming. Affordability is up nicely, employment is reasonably strong, income holding up nicely. And on a per capita basis, housing is at forty year lows.


2007-12-31 NAPM-Milwaukee

NAPM-Milwaukee (Dec)

Survey n/a
Actual 62.0
Prior 60.0
Revised n/a

2007-12-31 NAPM-Milwaukee TABLE

NAPM-Milwaukee TABLE

Table looks solid, and prices are still up quite a bit.


♥

China – Passing higher food prices to Asia

It makes political sense to use export taxes as a form of a domestic subsidy for basic necessities, and from a macro economic
point of view, it a good way to express the political desire as well.

A negative is this will give domestic producers an incentive to ‘cheat’ to avoid the tax. Enforcement costs depend on they type of borders, etc.

It also puts downward pressure on the currency, though very modestly in this case, as it now takes more fx to buy the same products.

China – Passing higher food prices to Asia

Barclays Capital Research
by Wai Ho Leong

Tax on food grain exports comes shortly after subsidies removed.

In a further attempt to rein in food price inflation, China will introduce a one-year tax on grain exports beginning in January 2008. This will require exporters of 57 types of food grains to pay temporary taxes of 5-25%. Exporters of wheat, rye, barley and oats will be required to pay a 20% tax, while exporters of corn, rice and soy beans will have to pay 5%. Soaring food prices (+18% Y/Y in November), which have a 33% weight in the CPI, drove inflation to an 11-year high of 6.9% in November. The tax applies only to basic food grains. Other agricultural and processed products are not included, reflecting the government’s continued emphasis on promoting higher-value-added agricultural exports.

This latest administrative measure comes less than two weeks after China scrapped a 13% rebate on 84 types of exported food grains on 18 December. Prices have been rising, even though government reserves of corn and wheat were opened up earlier this year to meet domestic demand. The administrative measures taken in China will compound these pressures further, particularly in North Asian countries.


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A Rescue Plan for the Dollar

A Rescue Plan for the Dollar

By Ronald McKinnon and Steve H. Hanke
The Wall Street Journal, December 27, 2007

Central banks ended the year with a spectacular injection of liquidity to lubricate the economy. On Dec. 18, the European Central Bank alone pumped $502 billion — 130% of Switzerland’s annual GDP — into the credit markets.

Misleading. It’s about price, not quantity. For all practical purposes, no net euros are involved.

I have yet to read anything by anyone in the financial press that shows a working knowledge of monetary operations and reserve accounting.

The central bankers also signaled that they will continue pumping “as long as necessary.” This delivered plenty of seasonal cheer to bankers who will be able to sweep dud loans and related impaired assets under the rug — temporarily.

Nor does this sweep anything under any rug. Banks continue to own the same assets and have the same risks of default on their loans. And, as always, the central bank, as monopoly supplier of net reserves, sets the cost of funds for the banking system.

The causation is ‘loans create deposits’, and lending is not reserve constrained. The CB sets the interest rate – the price of funding – but quantity of loans advanced grows endogenously as a function of demand at the given interest rate by credit worthy borrowers.

But the injection of all this liquidity coincided with a spat of troubling inflation news.

At least he didn’t say ’caused’.

On a year-over-year basis, the consumer-price and producer-price indexes for November jumped to 4.3% and 7.2%, respectively. Even the Federal Reserve’s favorite backward-looking inflation gauge — the so-called core price index for personal consumption expenditures — has increased by 2.2% over the year, piercing the Fed’s 2% inflation ceiling.

Yes!

Contrary to what the inflation doves have been telling us, inflation and inflation expectations are not well contained. The dollar’s sinking exchange value signaled long ago that monetary policy was too loose, and that inflation would eventually rear its ugly head.

The fed either does not agree or does not care. Hard to say which.

This, of course, hasn’t bothered the mercantilists in Washington, who have rejoiced as the dollar has shed almost 30% of its value against the euro over the past five years. For them, a maxi-revaluation of the Chinese renminbi against the dollar, and an unpegging of other currencies linked to the dollar, would be the ultimate prize.

Mercantilism is a fixed fx policy/notion, designed to build fx reserves. Under the gold standard it was a policy designed to accumulate gold, for example. With the current floating fx policy, it is inapplicable.

As the mercantilists see it, a decimated dollar would work wonders for the U.S. trade deficit. This is bad economics and even worse politics. In open economies, ongoing trade imbalances are all about net saving propensities,

Yes!!!

not changes in exchange rates. Large trade deficits have been around since the 1980s without being discernibly affected by fluctuations in the dollar’s exchange rate.

So what should be done? It’s time for the Bush administration to put some teeth in its “strong” dollar rhetoric by encouraging a coordinated, joint intervention by leading central banks to strengthen and put a floor under the U.S. dollar — as they have in the past during occasional bouts of undue dollar weakness. A stronger, more stable dollar will ensure that it retains its pre-eminent position as the world’s reserve, intervention and invoicing currency.

Why do we care about that?

It will also provide an anchor for inflation expectations, something the Fed is anxiously searching for.

Ah yes, the all important inflation expectations.

Mainstream models are relative value stories. The ‘price’ is only a numeraire; so, there is nothing to explain why any one particular ‘price level’ comes from or goes to, apart from expectations theory.

They don’t recognize the currency itself is a public monopoly and that ultimately the price level is a function of prices paid by the government when it spends. (See ‘Soft Currency Economics‘)

The current weakness in the dollar is cyclical. The housing downturn prompted the Fed to cut interest rates on dollar assets by a full percentage point since August — perhaps too much. Normally, the dollar would recover when growth picks up again and monetary policy tightens. But foreign-exchange markets — like those for common stocks and house prices — can suffer from irrational exuberance and bandwagon effects that lead to overshooting. This is precisely why the dollar has been under siege.

Seems to me it is portfolio shifts away from the $US. While these are limited, today’s portfolios are larger than ever and can take quite a while to run their course.

If the U.S. government truly believes that a strong stable dollar is sustainable in the long run, it should intervene in the near term to strengthen the dollar.

Borrow euros and spend them on $US??? Not my first choice!

But there’s a catch. Under the normal operation of the world dollar standard which has prevailed since 1945, the U.S. government maintains open capital markets and generally remains passive in foreign-exchange markets, while other governments intervene more or less often to influence their exchange rates.

True, though I would not call that a ‘catch’.

Today, outside of a few countries in Eastern Europe linked to the euro, countries in Asia, Latin America, and much of Africa and the Middle East use the dollar as their common intervention or “key” currency. Thus they avoid targeting their exchange rates at cross purposes and minimize political acrimony. For example, if the Korean central bank dampened its currency’s appreciation by buying yen and selling won, the higher yen would greatly upset the Japanese who are already on the cusp of deflation — and they would be even more upset if China also intervened in yen.

True.

Instead, the dollar should be kept as the common intervention currency by other countries, and it would be unwise and perhaps futile for the U.S. to intervene unilaterally against one or more foreign currencies to support the dollar. This would run counter to the accepted modus operandi of the post-World War II dollar standard, a standard that has been a great boon to the U.S. and world economies.

‘Should’??? I like my reason better – borrow fx to sell more often than not sets you up for a serious blow up down the road.

The timing for joint intervention couldn’t be better. America’s most important trading partners have expressed angst over the dollar’s decline. The president of the European Central Bank (ECB), Jean Claude Trichet, has expressed concern about the “brutal” movements in the dollar-euro exchange rate.

Yes, but the ECB is categorically against buying $US, as building $US reserves would be taken as the $US ‘backing’ the euro. This is ideologically unacceptable. The euro is conceived to be a ‘stand alone’ currency to ultimately serve as the world’s currency, not the other way around.

Japan’s new Prime Minister, Yasuo Fukuda, has worried in public about the rising yen pushing Japan back into deflation.

Yes, but it is still relatively weak and in the middle of its multi-year range verses the $US.

The surge in the Canadian “petro dollar” is upsetting manufacturers in Ontario and Quebec. OPEC is studying the possibility of invoicing oil in something other than the dollar.

In a market economy, the currency you ‘invoice’ in is of no consequence. What counts are portfolio choices.

And China’s premier, Wen Jiabao, recently complained that the falling dollar was inflicting big losses on the massive credits China has extended to the U.S.

Propaganda. Its inflation that evidences real losses.

If the ECB, the Bank of Japan, the Bank of Canada, the Bank of England and so on, were to take the initiative, the U.S. would be wise to cooperate. Joint intervention on this scale would avoid intervening at cross-purposes. Also, official interventions are much more effective when all the relevant central banks are involved because markets receive a much stronger signal that national governments have made a credible commitment.

And this all assumes the fed cares about inflation. It might not. It might be a ‘beggar thy neighbor’ policy where the fed is trying to steal aggregate demand from abroad and help the financial sector inflate its way out of debt.

That is what the markets are assuming when they price in another 75 in Fed Funds cuts over the next few quarters. The January fed meeting will be telling.

While they probably do ultimately care about inflation, they have yet to take any action to show it. And markets will not believe talk, just action.

This brings us to China, and all the misplaced concern over its exchange rate. Given the need to make a strong-dollar policy credible, it is perverse to bash the one country that has done the most to prevent a dollar free fall. China’s massive interventions to buy dollars have curbed a sharp dollar depreciation against the renminbi;

Yes, as part of their plan to be the world’s slaves – they work and produce, and we consume.

they have also filled America’s savings deficiency and financed its trade deficit.

That statement has the causation backwards.

It is US domestic credit expansion that funds China’s desires to accumulate $US financial assets and thereby support their exporters.

As the renminbi’s exchange rate is the linchpin for a raft of other Asian currencies, a sharp appreciation of the renminbi would put tremendous upward pressure on all the others — including Korea, Japan, Thailand and even India. Forcing China into a major renminbi appreciation would usher in another bout of dollar weakness and further unhinge inflation expectations in the U.S. It would also send a deflationary impulse abroad and destabilize the international financial system.

Yes, that’s a possibility.

Most of the world’s government reaction functions are everything but sustaining domestic demand.

China, with its huge foreign-exchange reserves (over $1.4 trillion), has another important role to play. Once the major industrial countries with convertible currencies — led by the ECB — agree to put a floor under the dollar, emerging markets with the largest dollar holdings — China and Saudi Arabia — must agree not to “diversify” into other convertible currencies such as the euro. Absent this agreement, the required interventions by, say, the ECB would be massive, throwing the strategy into question.

Politically, this is a non starter. The ECB has ideological issues, and the largest oil producers are ideologically at war with the US.

Cooperation is a win-win situation: The gross overvaluations of European currencies would be mitigated, large holders of dollar assets would be spared capital losses, and the U.S. would escape an inflationary conflagration associated with general dollar devaluation.

Not if the Saudis/Russians continue to hike prices, with biofuels causing food to follow as well. Inflation will continue to climb until crude prices subside for a considerable period of time.

For China to agree to all of this, however, the U.S. (and EU) must support a true strong-dollar policy — by ending counterproductive China bashing.

Mr. McKinnon is professor emeritus of economics at Stanford University and a senior fellow at the Stanford Institute for Economic Policy Research. Mr. Hanke is a professor of applied economics at Johns Hopkins University and a senior fellow at the Cato Institute.


Perspective

Perspective

by Steve Hanke

US Mercantilist Machismo, China replaces Japan

The United States has recorded a trade deficit in each year since 1975.

That is a good thing – exports are real costs, imports benefits.

This is not surprising because savings in the US have been less than investment.

This is a tautology from the above misconceived notion and of no casual consequence.

The trade deficit can be reduced by some combination of lower government consumption, lower private consumption

Yes, if we get less net goods and services from non residents, our trade deficit goes down, as does our real terms of trade and our standard of living.

Real terms of trade are the real goods and services you export versus the real goods and services you import.

In economics, it is better to receive (real goods and services) than to give.

or lower private domestic investment.

We could (and would if ‘profitable’) ‘borrow to invest’ domestically (loans ‘create’ deposits, not applicable/no such thing as ‘borrowing from abroad’ etc.)

But said, domestic borrowing decreases ‘savings’ equal to the increased domestic investment (accounting identity). So, the trade gap would remain the same if we invested more or less via domestic funding.

So, his above statement is a tautology of no casual interest.

But you wouldn’t know it from listening to the rhetoric of Washington’s politicians and special interest groups. Many of them are intent on displaying their mercantilist machismo. This is unfortunate. A reduction of the trade deficit should not even be a primary objective of federal policy. Never mind. Washington seems to thrive on counter-productive trade “wars” that damage both the US and its trading partners.

Almost sounds like he gets it! But don’t get your hopes up..

From the early 1970s until 1995, Japan was an enemy. The mercantilists in Washington asserted that unfair Japanese trading practices caused the US trade deficit and that the US bilateral trade deficit with Japan could be reduced if the yen appreciated against the dollar.

Washington even tried to convince Tokyo that an ever-appreciating yen would be good for Japan. Unfortunately, the Japanese
complied and the yen appreciated, moving from 360 to the greenback in 1971 to 80 in 1995. In April 1995, Secretary of the Treasury Robert Rubin belatedly realized that the yen’s great appreciation was causing the Japanese economy to sink into a deflationary quagmire.

Actually, it was the fiscal surplus they allowed from 1987-1992 that drained net yen income and financial assets that removed support for the yen credit structure and ended the expansion.

In consequence, the US stopped arm-twisting the Japanese government about the value of the yen and Secretary Rubin began to evoke his now-famous strong-dollar mantra. But while this policy switch was welcomed, it was too late. Even today, Japan continues to suffer from the mess created by the yen’s appreciation.

The mess was created by the surplus and repeated attempts to reduce the following countercyclical deficits. Only when the deficit was left alone and grew to 7% of GDP a few years ago did the economy finally get the net income and financial assets it needed to recover. Only to be undermined recently by a political blunder regarding building codes. Japan should do better in 2008, as that obstacle is overcome.

As Japan’s economy stagnated, its contribution to the increasing US trade deficit declined, falling from its 1991 peak of almost 60% to about 11%.

Sad to see that happens. Now Americans have to build the cars here as their new factories are now in the US.

While Japan’s contribution declined, China’s surged from slightly more than 9% in 1990 to almost 28% last year.

Yes, they have workers willing to consume fewer calories than those in Japan.

With these trends, the Chinese yuan replaced the Japanese yen as the mercantilists’ whipping boy. Interestingly, the combined Japanese–Chinese contribution has actually declined from its 1991 peak of over 70% to only 39% last year. This hasn’t stopped the mercantilists from claiming that the Chinese yuan is grossly undervalued, and that this creates unfair Chinese competition and a US bilateral trade deficit with China.

The unfair part is their workers are willing to work for a lot less real consumption and become the world’s slaves via net exports.

And we don’t know how to sustain our own domestic demand via internal policy; so, our politicians blame the foreigners.

I was introduced to the Chinese currency controversy five years ago when I appeared as a witness before the US Senate Banking Committee on May 1, 2002. The purpose of those hearings was to determine, among other things, whether China was manipulating its exchange rate.

All state currencies are public monopolies, and value is a function of various fiscal/monetary policies. So in that sense, all currencies are necessarily ‘manipulated’ as all monopolists are inherently ‘price setters’.

So, this entire point is moot, though far from mute.

United States law requires the US Treasury Department, in consultation with the International Monetary Fund, to report biyearly as to whether countries – like China – are gaining an “unfair” competitive advantage in international trade by
manipulating their currencies.

Clearly no understanding that exports are real costs, and imports are real benefits. The entire worlds seems backwards on this.

The US Treasury failed to name China a currency manipulator back in May 2002, and it hasn’t done so since then. This isn’t too surprising since the term “currency manipulation” is hard to define and, therefore, is not an operational concept that can be used for economic analysis. The US Treasury acknowledged this fact in reports to the US Congress in 2005. But this fact has not stopped politicians and special interest groups in the United States, and elsewhere, from asserting that China manipulates the yuan.

Yes, to keep their wages low so they can produce, and we can consume.

Protectionists from both political parties in the US have threatened to impose tariffs on imported Chinese goods if Beijing does not dramatically appreciate the yuan. These protectionists even claim that China would be much better off if it allowed the yuan to become stronger vis-à-vis the US dollar.

They would – it would lower their net exports, a real benefit at the macro level.

Percenta

This is not the first time US special interests have made assertions in the name of helping China. During his first term, Franklin D. Roosevelt delivered on a promise to do something to help silver producers. Using the authority granted by the Thomas Amendment of 1933 and the Silver Purchase Act of 1934, the Roosevelt Administration bought silver.

Can’t think of a better way to help a producer!

This, in addition to bullish rumors about US silver policies, helped push the price of silver up by 128% (calculated as
an annual average) in the 1932-35 period.

(It has gone up more here in the last three years without the government buying any.)

Bizarre arguments contributed mightily to the agitation for high silver prices. One centered on China and the fact that it was on the silver standard. Silver interests asserted that higher silver prices—which would bring with them an appreciation in the yuan—would benefit the Chinese by increasing their purchasing power.

Yes – whoever is long silver wins when the price goes up.

As a special committee of the US Senate reported in 1932, “silver is the measure of their wealth and purchasing power; it serves as a reserve, their bank account. This is wealth that enables such peoples to purchase our exports.”

Things didn’t work according to Washington’s scenario. As the dollar price of silver and of the yuan shot up, China was thrown into the jaws of depression and deflation. In the 1932-34 period, gross domestic product fell by 26% and wholesale prices in the capital city, Nanjing, fell by 20%.

In an attempt to secure relief from the economic hardships imposed by US silver policies, China sought modifications in the US
Treasury’s silver purchase program.

They didn’t know how to sustain domestic demand. They needed to float the currency, offer a public service job at a non disruptive wage to anyone willing and able to work, and leave the overnight risk free rate at 0%. (See ‘Full Employment and Price Stability‘.)

But its pleas fell on deaf ears.

Maybe ears with different special interests?

After many evasive replies, the Roosevelt Administration finally indicated on October 12, 1934 that it was merely carrying out a policy mandated by the US Congress. Realizing that all hope was lost, China was forced to effectively abandon the silver standard on October 14, 1934, though an official statement was postponed until November 3, 1935.

About the same time the US abandoned the gold standard domestically for much the same reason.

This spelled the beginning of the end for Chiang Kaishek’s Nationalist government.

He let unemployment go too high out of ignorance of how to sustain domestic demand. A common story throughout history.

History doesn’t have to repeat itself. Foreign politicians should stop bashing the Chinese about the yuan’s exchange rate. This would allow the Chinese to focus on important currency and trade issues: making the yuan fully convertible, respecting intellectual property rights and meeting accepted health and safety standards for their exports.

Why do we want to encourage anything that reduces their net exports???
(rhetorical question)

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C.


♥

Friday mid day

Food, crude, metals up, dollar down, inflation up all over the world, well beyond CB ‘comfort levels.’

Nov new home sales continue weak, though there are probably fewer ‘desirable’ new homes priced to sell, and with starts are down the new supply will continue to be low for a while.

The December Chicago pmi was a bit higher than expected, probably due to export industries. Price index still high though off a touch from Nov highs.

So again it’s high inflation and soft gdp.

Markets continue to think the Fed doesn’t care about any level of inflation and subsequently discount larger rate cuts.

Mainstream theory says if inflation is rising demand is too high, no matter what level of gdp that happens to corresponds with. And by accommodating the headline cpi increases with low real interest rates, the theory says the Fed is losing it’s fight (and maybe its desire) to keep a relative value story from turning into an inflation story. This is also hurting long term output and employment, as low inflation is a necessary condition for optimal growth and employment long term.

A January fed funds cut with food and energy still rising and the $ still low will likely bring out a torrent of mainstream objections.