Re: update

Dear Philip,

Seems there’s a break between Mishkin and Kohn that previously wasn’t there.
Markets are thinking Kohn supports a 50 cut and that he and Bernanke are alligned.

Today Bernanke may show whether he leans towards Mishkin, the co academic, or Kohn, more the practitioner.

Meanwhile, another ‘inflation day’ with oil and commodities up, $ down, and headlines like ‘Honda says no recession in US.’

All the best,
Warren

On 27 Feb 2008 09:09:43 +0000, Prof. P. Arestis wrote:
>
> Dear Warren,
>
> Many thanks.
>
> > Do you think Kohn’s speech indicates he’s ready to cut another half point
> > on Mar 18?
>
> I think the simple answer to the question is probably no with a question
> mark. I say this in the sense that before March 18 we will probably hear
> more about Kohn’s views, which may be clearer in terms of whether he is
> ready for another half point reduction. However, in terms of the analysis
> he offered in the piece you kindly sent me I did not see anything that
> suggested half point cut, although there is plenty in the piece to suggest
> that he is in favour of more cuts. I say this in that although he sees
> problems with the real economy he is also mindful of inflation, but he is
> not an ‘inflation nutter’ as some others are. So at this stage I believe he
> will go for a cut but not as much as half point.
>
> What do you think?
>
> Best wishes, Philip

Bloomberg: Fed Sees Rate Low `for a Time’ Then Possible Reversal

Fed Sees Rate Low `for a Time’ Then Possible Reversal (Update1)

by Scott Lanman

Enlarge Image/Details

(Bloomberg) Federal Reserve officials signaled they are prepared to quickly reverse last month’s interest-rate cuts after concluding that borrowing costs need to be kept low for now.

Policy makers cut their 2008 growth forecasts and said that rates should be held down “for a time,” minutes of their Jan. 29-30 meeting showed yesterday. They also called inflation “disappointing,” and some foresaw raising rates, possibly at a “rapid” pace once the economy recovers.

The threat goes beyond remarks by Chairman Ben S. Bernanke, who last week warned that policy will have to be “calibrated” over the next year to meet both inflation and growth objectives.

Yes, the issue is they believe an output gap greater than ‘zero’ is required to bring down inflation over time; so, they can’t afford to let the economy fully recover and grow at an inflationary pace.

So while they don’t want to allow a massive collapse, they also don’t want the output gap to be too narrow to bring down inflation.

This could mean, for example, a GDP growth rate speed limit of between 1% and 2% given current data points of GDP growth and coincident inflation.

That would mean achieving ‘stability’ at current GDP and employment levels rather than a ‘recovery’ to lower unemployment and 2.5%+ GDP.

With inflation expectations considered to be on the verge of elevating, the FOMC now faces elevating risks of both inflation and recession.

Bernanke written testimony

As you know, financial markets in the United States and in a number of other industrialized countries have been under considerable strain since late last summer. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for the economy, have also roiled the financial markets in recent months.

As the concerns of investors increased, money center banks and other large financial institutions have come under significant pressure to take onto their own balance sheets the assets of some of the off-balance-sheet investment vehicles that they had sponsored. Bank balance sheets have swollen further as a consequence of the sharp reduction in investor willingness to buy securitized credits, which has forced banks to retain a substantially higher share of previously committed and new loans in their own portfolios. Banks have also reported large losses, reflecting marked declines in the market prices of mortgages and other assets that they hold. Recently, deterioration in the financial condition of some bond insurers has led some commercial and investment banks to take further markdowns and has added to strains in the financial markets.

This had been expected to cause banks to not be able to lend as before. So far that hasn’t happened. Funds are there for credit-worthy borrowers.

The banking system has been highly profitable in recent years and entered this episode with strong capital positions. Some institutions have responded to their recent losses by raising additional capital. Notwithstanding these positive factors, the unexpected losses and the increased pressure on their balance sheets have prompted banks to become protective of their liquidity and balance sheet capacity and, thus, to become less willing to provide funding to other market participants, including other banks. Banks have also become more restrictive in their lending to firms and households. For example, in the latest Senior Loan Officer Opinion Survey conducted by the Federal Reserve, banks reported having further tightened their lending standards and terms for a broad range of loan types over the past three months. More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth.

Bernanke sees the above as stemming from the supply side – bank’s becoming ‘protective’ of their balance sheets and rationing credit.

I see it, at the macro level, as banks being prudent in trying to lend only to people who can pay it back at spreads that compensate them for perceived risks.

In part as the result of the developments in financial markets, the outlook for the economy has worsened in recent months, and the downside risks to growth have increased.

Not sure if this means things have gotten worse since the last meeting – probably not.

To date, the largest economic effects of the financial turmoil appear to have been on the housing market, which, as you know, has deteriorated significantly over the past two years or so. The virtual shutdown of the subprime mortgage market and a widening of spreads on jumbo mortgage loans have further reduced the demand for housing, while foreclosures are adding to the already-elevated inventory of unsold homes. Further cuts in homebuilding and in related activities are likely.

Not much spillover yet.

Conditions in the labor market have also softened. Payroll employment, after increasing about 95,000 per month on average in the fourth quarter, declined by an estimated 17,000 jobs in January.

He must know January is subject to revision in a couple of weeks.

Employment in the construction and manufacturing sectors has continued to fall, while the pace of job gains in the services industries has slowed. The softer labor market, together with factors including higher energy prices, lower equity prices, and declining home values, seem likely to weigh on consumer spending in the near term.

Forward looking only? Seems he doesn’t think the consumer has already cut back all that much.

On the other hand, growth in U.S. exports should continue to provide some offset to the softening in domestic demand, and the recently approved fiscal package should help to support household and business spending during the second half of this year and into the first part of next year.

This could mean the Fed forecasts are for stronger growth now that the fiscal bill has been signed.

On the inflation front, a key development over the past year has been the steep run-up in the price of oil. Last year, food prices also increased exceptionally rapidly by recent standards, and the foreign exchange value of the dollar weakened.

The three negative supply shocks.

All told, over the four quarters of 2007, the price index for personal consumption expenditures (PCE) increased 3.4 percent, up from 1.9 percent during 2006. Excluding the prices of food and energy, PCE price inflation ran at a 2.1 percent rate in 2007, down a bit from 2006.

Doesn’t mention the recent acceleration of core PCE over the last several months.

To date, inflation expectations appear to have remained reasonably well anchored,

Only ‘reasonably’.

but any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future.

Indicating that if they do elevate, it’s too late. Most of the FOMC agrees with this.

Accordingly, in the months ahead we will be closely monitoring inflation expectations and the inflation situation more generally.

To address these developments, the Federal Reserve has moved in two main areas. To help relieve the pressures in the interbank markets, the Federal Reserve–among other actions–recently introduced a term auction facility (TAF), through which prespecified amounts of discount window credit can be auctioned to eligible borrowers, and we have been working closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.
In the area of monetary policy, the Federal Open Market Committee (FOMC) has moved aggressively, cutting its target for the federal funds rate by a total of 225 basis points since September, including 125 basis points during January alone. As the FOMC noted in its most recent post-meeting statement, the intent of these actions is to help promote moderate growth over time and to mitigate the risks to economic activity.

Promote moderate growth over time. With inflation where it is, they can’t promote robust growth or full-employment. They need a positive output gap to bring inflation down to their long-term objectives.

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability and, in particular, whether the policy actions taken thus far are having their intended effects.

Doesn’t sound like there’s another cut coming? The ‘stance’ is the real rate, and without inflation coming down, keeping the stance constant doesn’t mean cutting rates.

Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation, as well as the risks to that forecast.

As follows:

At present, my baseline outlook involves a period of sluggish growth,

It would have to get worse for a change in stance.

followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt.

Somewhat stronger – can’t get too strong and close the output gap.

At the same time, overall consumer price inflation should moderate from its recent rates, and the public’s longer-term inflation expectations should remain reasonably well anchored.

Headline CPI expected to flatten, but doesn’t mention core, which is probably projected to rise as it catches up to headline.

Although the baseline outlook envisions an improving picture, it is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

Barring a major deterioration in the growth outlook from ‘sluggish’ by the next meeting seems rates may be on hold.


Bernanke preview

If inflation is now above Bernanke’s comfort zone, as per Yellen who has been more dovish than Bermanke, and above their long-term target of maybe 2%, it can only be brought down by maintaining an output gap greater than zero under the mainstream theory they all subscribe to.

Particularly with the negative supply shocks of food, crude, and import/export prices persisting. And with energy prices (headline CPI) now showing up in core prices, also as per Yellen, inflation expectations are showing signs of coming unglued.

And the fiscal package has likely increased the Fed’s growth forecasts (smaller output gap) for Q2, Q3, and Q4.

The Fed believes a zero output gap means about a 4.75% unemployment rate.

That means the Fed wants to keep the economy from deteriorating and unemployment from rising, but it also doesn’t want unemployment falling to 4.75% which would mean it would have to act (rate hikes) to get it back up to something over 5% to meet long-term inflation targets.

So while Bernanke can say he stands by to do everything necessary to avoid a financial collapse, he also can’t allow the output gap to go to zero.


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Stagflation

Yes, the below analysis has also been the Fed’s position, up until this week’s speeches.

It’s been about a crude/food/$ negative supply shock, supported by Saudis/Russians acting as swing producer and biofuels linking crude prices to food prices.

The fed has called the price hikes relative value stories that they don’t want turning into an inflation story. They feel they have room to cut rates as long as expectations stay well anchored, which includes wage demands but other things as well.

Yellen the dove, along with the hawks, now saying inflation expectations are showing signs of elevating, and saying energy costs are being passed through to core inflation is a departure from previous Fed rhetoric and may signal they are at or near their limits regarding ff cuts (data dependent, of course).

Also, Bernanke pushing Congress and the President to add to the deficit could also be a sign he is reaching his inflation tolerance regarding lowering the FF rate. The mainstream belief is that inflation is a function of monetary policy, not fiscal policy.

Now with the ECB perhaps throwing in the towel on inflation as well, look at how the commodities are responding. ‘Cost push inflation’ is ripping, and the perception is the CB’s around the world will act to sustain demand, including pushing for larger fiscal deficits.

Difficult to explain why so many have stagflation on the brain It is difficult to explain why so many folks still have stagflation or inflation on the brain just because wheat prices have soared to new highs. We have to distinguish between relative and absolute pricing. Not only that, but unlike the 1970s, the current ‘inflation’ backdrop is much more narrowly confined. The key is the labor market. And here we have a 4-quarter growth rate in unit labor costs of a mere 1% in 4Q (a three-year low), which compares to 4% heading into the 2001 downturn. In other words, as far as the labor market is concerned, inflation is less of a threat to the economy than it was at this same stage of the cycle seven years ago. In fact, heading into the 1990 recession, the trend in ULC was also 4% – the Fed sliced the funds rate from almost 10% to 3% that cycle, for crying out loud. In fact, scouring more than 50 years’ worth of data, at no time in the past has the year-to-year trend in unit labor costs been as low as it is today heading into an official recession. Make no mistake, deflation is going to emerge as the next major macro theme.


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Tax cuts, oil prices, and gasoline consumption

Oil prices jump after Bush, Congress reach agreement on economic stimulus plan

by John Wilen

Oil futures jumped more than $2 a barrel Thursday after the Bush administration and Congressional leaders agreed to an economic stimulus plan that will give most Americans tax rebates of $600 to $1,200, or even more if they have kids.

With Bernanke’s blessings and with the mainstream seeing demand already strong enough to be driving prices well above the Fed’s comfort zone, the response is no surprise. Gold shot up as well as other commodities, and the $ fell.

Prices were already higher after the government reported a drop in heating oil supplies and as investors anticipated a stimulus plan. But futures took off, posting their largest gains in over three weeks, on word that an agreement had been reached.

“What’s boosting us up today is a little economic optimism because people are going to get a little free money,” said Phil Flynn, an analyst at Alaron Trading Corp., in Chicago.

Yes, and a turnaround in housing probably is underway as well.

Light, sweet crude for March delivery rose $2.42 to settle at $89.41 a barrel on the New York Mercantile Exchange.

(SNIP)

The high prices may be having an impact on consumer behavior. Demand for gasoline fell last week by 152,000 barrels, though demand over the past four weeks _ which included the busy holiday travel period _ rose by 1.1 percent over the same period last year.

Real demand up for the month year over year.

Looking forward to see how a ‘nimble’ Fed responds.


Re: Will the cure be worse than the disease?

(an interoffice email)

> the only problem i have with Meltzer is that is the consensus view now,
> that inflation is a foregone conclusion-i think long term that may be
> right (long term paper currency devaluation) but you could easily
> correct commodity and energy prices if you have a reduction of
> speculator and investor demand (ie see 1970s chart of gold and crude
> oil-there years in which the price of those commodities corrected
> viciously in a long term up trend). Specs of today in a mark to market
> world i dont believe are immune from short term negative commodity
> marks…

Agreed.

Two things (as Reagan would say):

  1. Crude probably stays high as Saudis are selling 9 million bpd at current prices. no reason to cut price unless demand fall off and forces them to hit bids rather than getting offers lifted. And world inventories are relatively low so it would be hard to get a sell off from physical inventory liquidation. More likely for other commodities to underperform crude in a spec sell off. Might even be happening now. (And biofuels like crude and food costs.)
  1. Even if crude/food/import and export prices level off or even go down some, they are so far ahead of core CPI increases that core can continue to go up for several quarters to close the gap. And the Fed thinks that can dislodge expectations so can’t afford to let it happen.
  1. world employment/income seems to be holding up, so actual nominal demand for consumption of resources shouldn’t collapse without some major positive supplied side shock.

Meltzer is wrong as IMHO not much is a function of interest rates; so, he’s ‘blaming’ the wrong entity for ‘inflation’. But his story is the mainstream story; so, i expect a lot more of same.


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Fed comments

The Fed is aware rate cuts don’t do much for near term financial disruptions. For example, the FF/LIBOR spread was first addressed with FF cuts, but little or nothing changed until the TAF was introduced to address and normalize that spread.

Along the same lines, Bernanke has recently met with the President and Congress to coordinate a fiscal package, and today’s cuts were preceded by Paulson talking about what Treasury is doing for the financial crisis.

The Fed knows they pay an inflation price for each cut, but also believe they need to get the current financial crisis behind them first, and then address any residual inflation issue. Nor does Congress want to go into the election with a weak economy.

The incentives are in place for a credible fiscal package.

And with core inflation indicators now moving up, the Fed would very much like this rate cut, along with the pending fiscal package, to ‘work’ and be the last one needed.


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I’ve been wrong on the Fed

> Hi
>
> You’ve been looking for this kind of financial trouble for a bit over in Europe. Good call Warren.
>
> Bobby.
>

Thanks, yes, I called it from mid 2006 – weakness due to deficit too small to support the credit structure, but inflation racing up as food/fuel rise due to Saudis acting the swing producer and biofuels burning up our food supply.

My error was in thinking the inflation would keep the fed from cutting. Been totally wrong on that!

Never would have thought a CB would act this way in the face of a triple negative supply shock – food/fuel/importand export prices all ratcheting up.

And looks like another 50 cut or maybe even 75 or 100 on Jan 30 even as core inflation goes through their ‘comfort zone,’ and Bernanke’s pushing Congress to hike the deficit! Never imagined the Fed would be keen to send a strong ‘we don’t care about inflation’ message, regardless of GDP in the short run. Goes against every aspect of mainstream monetary theory. But they sure are doing it!

And still no major weakness in the real economy, apart from some possible weakness late December if exports fell off. That won’t be out for a while.

All I can come with are three things:

  1. They’ve been misusing futures prices for oil and food to predict inflation will fall.
  2. They are afraid of fixed exchange rate/gold standard types of monetary collapses, even though we have a floating exchange rate policy, where that doesn’t happen and for all practical purposes can’t happen with floating fx.
  3. They are relying on their forecasts for weakness to bring down inflation when it’s coming from a combination of producer price
    setting, biofuels, and Paulson’s weak $ policy chasing foreign central banks away from $US financial assets.

And yes, watch out for a system wide failure of the payments system in the Eurozone if deposit insurance gets tested by a major bank failure.

Also, the $US remains fundamentally strong, but Paulson and to some degree the Fed are scaring investors away from $US financial assets, including US and other pension funds, which keeps the $ cheap enough to drive increasing US exports.

warren


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