Category Archives: Inflation

A Rescue Plan for the Dollar

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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.

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Friday mid day

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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.

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Updated JGBi Index Ratio Table

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(an interoffice email)

Hi Dave,

If core inflation is finally showing up in Japan that says a lot for world inflation in general!

warren

On Dec 28, 2007 8:12 AM, Dave Vealey wrote:
>
>
>
> With last nights stronger then expected release of core inflation in Japan
> (+0.4% y/y vs. +0.3% expected), January will see linkers pickup another 0.10
> in their index ratio. Prior to last nights release the index ratio was
> expected to be unchanged for the month of Jan.
>
>
>
> DV
>
>

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Calories, Capital, Climate Spur Asian Anxiety

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Higher oil prices mean lower rates from the Fed, and higher inflation rates induced by shortages mean stronger currencies abroad.

Why do I have so much trouble getting aboard this paradigm, and instead keep looking for reversals? Feels a lot like watching the NASDAQ go from 3500 to 5000 a few years ago.

:(

Calories, Capital, Climate Spur Asian Anxiety

2007-12-26 17:51 (New York)
by Andy Mukherjee

(Bloomberg) — The new year may be a challenging one for Asian policy makers.

Year-end U.S. closing stocks for wheat are the lowest in six decades; soybeans in Chicago touched a 34-year peak this week. Palm oil in Malaysia climbed to a record yesterday.

The steeply rising cost of calories may be more than just cyclical, notes Rob Subbaraman, Lehman Brothers Holdings Inc. economist in Hong Kong. Growing use of food crops in biofuels and increasing demand for a protein-rich diet in developing countries may have pushed up prices more permanently.

The wholesale price of pork in China has surged 53 percent in the past year.

“Consumer inflationary expectations may soon rise, feeding into wage growth and core inflation, but we expect Asian central banks to be slow to react, initially due to slowing growth and later because of strong capital inflows,” Subbaraman says.

If the U.S. Federal Reserve continues easing interest rates to combat a housing-led economic slowdown, a surge in capital inflows into Asia may indeed become a stumbling block in managing the inflationary impact of higher commodity prices.

Food and energy account for more than two-fifths of the Chinese consumer-price index, compared with 17 percent for countries such as the U.K., U.S. and Canada, and 25 percent in the euro area, according to UBS AG economist Paul Donovan in London.

As Asian central banks raise interest rates — when the Fed is cutting them — they will invite even more foreign capital into the region. That will cause Asian currencies to appreciate, leading to a loss of competitiveness for the region’s exports.

Carbon Emissions

On the other hand, paring the domestic cost of money prematurely may worsen the inflation challenge.

That isn’t all.

Higher oil prices will also boost the attractiveness of coal as an energy source, delaying any meaningful reduction in carbon emissions in fast-growing Asian nations such as China and India.

As Daniel Gros, director of the Centre for European Policy Studies in Brussels, noted in recent research, the price of coal — relative to crude oil — has been halved since the end of 1999. And per unit of energy produced, coal is a much bigger pollutant than oil or gas.

This doesn’t augur well for the environment.

“Given that China is likely to install over the next decade more new power generation capacity than already exists in all of Europe, this implies that the current level of high oil prices provides incentive to make the Chinese economy even more intensive in carbon than it would otherwise be,” Gros said.

Beijing Olympics

Climate-related issues will be in the spotlight in Asia next year. China’s eagerness to use the Beijing Olympic Games to showcase solutions to its huge environmental challenges will be one of the “big things to watch for” in Asia in 2008, Spire Research and Consulting, a Singapore-based advisory firm, said last week.

Even if China succeeds in reducing air pollution during the Olympics, the improvements may not endure after the sporting event ends on Aug. 24, especially since the underlying economics continue to favor higher coal usage.

A drop in hydrocarbon prices might help check emissions and global warming, Gros noted last week on the Web site of VoxEu.org.

In fact, lower oil prices may also make food costs more stable by lessening the craze for biofuels.

That will leave capital flows as Asia’s No. 1 challenge in 2008. And it won’t be an easy one for policy makers to tackle.

Capital Inflows

Take India’s example.

The $900 billion economy has attracted $100 billion in capital in the 12 months through October, with a third of the money entering the country as overseas borrowings, according to Morgan Stanley economist Chetan Ahya in Singapore.

This has caused the rupee to appreciate more than 12 percent against the dollar this year, knocking off more than three percentage points from India’s inflation index, says Lombard Street Research economist Maya Bhandari in London.

Naturally, exporters are complaining.

So why doesn’t India cut domestic interest rates? It can’t do that without the risk of stoking inflation.

Money supply is growing at an annual pace of more than 21 percent in India, compared with the central bank’s target of between 17 percent and 17.5 percent. Inflation has held well below the central bank’s estimate of 5 percent for five straight months partly because of the government’s insistence on not passing the full cost of imported fuel to local consumers. It isn’t yet time for monetary easing in India.

China has it worse. Monetary conditions there remain dangerously loose. And China may be reluctant to do much about the undervalued yuan — the root cause of its record trade surpluses and the attendant liquidity glut — until the Olympics are out of the way.

Asian economies may, to a large extent, be insulated from the subprime mess. Still, 2008 won’t be all fun and games.

(Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.)

–Editors: James Greiff, Ron Rhodes.

To contact the writer of this column:
Andy Mukherjee in Singapore at +65-6212-1591 or
amukherjee@bloomberg.net

To contact the editor responsible for this column:
James Greiff at +1-212-617-5801 or jgreiff@bloomberg.net

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Saudi/Fed teamwork

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Looks like markets are still trading with the assumption that as the Saudis/Russians hike prices the Fed will accommodate with rate cut.

That’s a pretty good incentive for more Saudi/Russian oil price hikes, as if they needed any!

Likewise, the US is a large exporter of grains and foods.

Those prices are now linked to crude via biofuels.

And the new US energy bill just passed with about $36 billion in subsidies for biofuels to help us keep burning up our food for fuel and keeping their prices linked.

This means cpi will continue to trend higher, and drag core up with it as costs get passed through via a variety of channels. In the early 70’s core didn’t go through 3% until cpi went through 6%, for example.

Ultimately everything is made of food and energy, and margins don’t contract forever with softer demand. In fact, much of the private sector is straight cost plus pricing, and govt is insensitive to ‘demand’ and insensitive to the prices of what it buys. And the US govt. indexes compensation and most transfer payments to (headline) cpi.

And while the US may be able to pay it’s rising oil bill with help from its rising export prices for food, much of the rest of the world is on the wrong end of both and will see its real terms of trade continue to deteriorate. Not to mention the likelihood of increased outright starvation as ultra low income people lose their ability to buy enough calories to stay alive as they compete with the more affluent filling up their tanks.

At the Jan 30 meeting I expect the Fed to be looking at accelerating inflation due to rising food/crude, and an economy muddling through with a q4 gdp forecast of 2-3%. Markets will be functioning, banks getting recapitalized, and while there has been a touch of spillover from Wall st. to Main st. the risk of a sudden, catastrophic collapse has to appear greatly diminished.

They have probably learned that the fed funds cuts did little or nothing for ‘market functioning’ and that the TAF brought ff/libor under control by accepting an expanded collateral list from its member banks.

(In fact, the TAF is functionally equiv of expanding the collateral accepted at the discount window, cutting the rate, and removing the stigma as recommended back in August and several times since.)

And they have to know their all important inflation expectations are at the verge of elevating.

They will know demand is strong enough to be driving up cpi, and the discussion will be the appropriate level of demand and the fed funds rate most likely to sustain non inflationary growth.

Their ‘forward looking’ models probably will still use futures prices, and with the contangos in the grains and energy markets, the forecasts will be for moderating prices. But by Jan 30 they will have seen a full 6 months of such forecasts turn out to be incorrect, and 6 months of futures prices not being reliable indicators of future inflation.

Feb ff futures are currently pricing in another 25 cut, indicating market consensus is the Fed still doesn’t care about inflation. Might be the case!

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Strong gdp and high credit losses

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CNBC just had a session on trying to reconcile high gdp with large credit losses. Seems they are now seeing the consumer clipping along at a +2.8% pace for Q4. No need to rehash my ongoing position that most if not all the losses announced in the last 6 months would have little or no effect on aggregate demand. Credit losses hurt demand when the result is a drop in spending. And yes, that happened big time when the subprime crisis took the bid away from would be subprime buyers who no longer qualified to buy a house. That probably took 1% away from gdp, and the subsequent increase in
exports kept gdp pretty much where it was. But that story has been behind us for over a year.

The Fed is not in a good place. They should now know that the TAF operation should have been done in August to keep libor priced where they wanted it. They should know by now losses per se don’t alter aggregate demand, but only rearrange financial assets. The should know the fall off in subprime buyers was offset by exports.

The problem was the FOMC- as demonstrated by their speeches and actions- did not have an adequate working understanding of monetary operations and reserve accounting back in August, and by limiting the current TAFs to $20 billion it seems they still don’t even understand that it’s about price, and not quantity. Too many members of the FOMC
are mostly likely in a fixed exchange rate paradigm, with its fix exchange rate/gold standard fractional reserve banking system that drove us into the great depression. With fixed exchange rates it’s a ‘loanable funds’ world. Banks are ‘reserve constrained.’ Reserves and consequently ‘money supply’ are issues. Government solvency is an issue.

With today’s floating exchange rate regime none of that is applicable. The causation is ‘loans create deposits AND reserves,’ and bank capital is endogenous. There are no ‘imbalances’ as all current conditions are ‘priced’ in the fx market, including ANY sized trade gap, budget deficit, or rate of inflation.

The recession risk today is from a lack of effective demand. There are lots of ways this can happen- sudden drop in govt spending, sudden tax increase, consumers change ‘savings desires’ and cut back spending, sudden drop in exports, etc.- and in any case the govt can instantly fill in the gap with net spending to sustain demand at any level it desires. Yes, there will be inflation consequences, distribution consequences, but no govt. solvency consequences.

So yes, there is always the possibility of a recession. And domestic demand (without exports) has been moderating as the falling govt budget acts to reduce aggregate demand. But the rearranging of financial assets in this ‘great repricing of risk’ doesn’t necessarily reduce aggregate demand.

Meanwhile, the Saudis, as swing producer, keep raising the price of crude, and so far with no fall off in the demand for their crude at current prices, so they are incented to keep right on hiking. And they may even recognize that by spending their new found revenues on real goods and services (note the new mid east infrastructure projects in progress) they keep the world economy afloat and can keep hiking prices indefinitely.

And food is linked to fuel via biofuels, and as we continue to burn up every larger chunks of our food supply for fuel prices will keep rising.

The $US is probably stable to firm at current levels vs the non commodity currencies, as portfolio shifts have run their course, and these shifts have driven the $ down to levels where there are ‘real buyers’ as evidenced by rapidly growing exports.

Back to the Fed – they have cut 100 bp into the triple negative supply shock of food, crude, and the $/imported prices, due to blind fear of ‘market functioning’ that turned out to need nothing more than an open market operation with expanded acceptable bank collateral (the TAF program). If they had done that immediately (they had more than one outsider and insider recommend it) and fed funds/libor spreads and other ‘financial conditions’ moderated, would they have cut?

There has been no sign of ‘spillover’ into gdp from the great repricing of risk, food and crude have driven their various inflation measures to very uncomfortable levels,and they now believe they have ‘cooked in’ 100 bp of inflationary easing into the economy that works with about a one year lag.

Merry Christmas!

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Re: Is $700 billion a big number

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(an email and an article)

On Dec 23, 2007 5:37 PM, Russell Huntley wrote:
>
>
>
> For a very bearish take on the credit crisis, see: Crisis may make 1929 look
> a ‘walk in the park’. The article includes a $700 billion loss estimate from
> the head of credit at Barclays capital:
>
> Goldman Sachs caused shock last month when it predicted that total crunch
> losses would reach $500bn,

Yes, could be. Rearranging of financial assets.

leading to a $2 trillion contraction in lending
> as bank multiples kick into reverse.

I don’t see this as a consequence. Bank lending will go in reverse only if there are no profitable loans to be made.

With floating exchange rates, bank capital in endogenous and will respond to returns on equity.

This already seems humdrum.
>
> “Our counterparties are telling us that losses may reach $700bn,” says Rob
> McAdie, head of credit at Barclays Capital. Where will it end? The big banks
> face a further $200bn of defaults in commercial property. On it goes.

Been less than 100 billion so far. Maybe they are talking cumulatively over the next five years?

>
> UPDATE: My main interest in this article was the quote from Barclays
> Capital. There has been a growing agreement that the mortgage credit crisis
> would result in losses of perhaps $400B to $500B; this is the first estimate
> I’ve seen significantly above that number.
>
> I noted last week that a $1+ trillion mortgage loss number is possible if it
> becomes socially acceptable for the middle class to walk away from their
> upside down mortgages.

Historically, people just don’t walk out onto the streets. They are personally liable for the payments regardless of current equity positions, and incomes are still strong, nationally broader surveys show home prices still up a tad ear over year.

Yes, some condo flippers and speculators will walk. But demand from that source has already gone to zero – did so over a yar ago, so that doesn’t alter aggregate demand from this point.

And that doesn’t include losses in CRE, corporate
> debt and the decrease in household net worth.

Different things, but again, the key to GDP is whether demand will hold up, including exports.

And probably half of aggregate demand comes directly or indirectly from the government. Don’t see that going negative. And AMT tax just cut fifty billion for 2008 will help demand marginally.

>
> The S&L crisis was $160B, so even adjusting for inflation, the current
> crisis is much worse than the S&L crisis (see page 13 of this GAO document).

That was net government losses? Shareholders/investors lost a lot more?

And a $1 trillion per day move in the world equity values happens all the time.

Q4 GPD being revised up to the 2% range. This has happened every quarter for quite a while.

Yes, it can all fall apart, but it hasn’t happened yet. And while there are risks to demand, negative GDP is far from obvious. Those predicting recessions mainly use yield curve correlations with past cycles and things like that.

Interesting that the one thing that is ‘real’ and currently happening is ‘inflation’, which the fed doesn’t seem to care about. And it won’t stop until crude stops climbing.

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2007-12-21 US Economic Releases

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2007-12-21 Personal Income

Personal Income (Nov)

Survey 0.5%
Actual 0.4%
Prior 0.2%
Revised n/a

OK number.

2007-12-21 Personal Spending

Personal Spending (Nov)

Survey 0.7%
Actual 1.1%
Prior 0.2%
Revised 0.4%

Nice bounce back from a low number also revised up. Makes the two month average about 0.75%. This will cause further upward revisions of Q4 GDP.

2007-12-21 PCE Deflator YoY

PCE Deflator YoY (Nov)

Survey 3.4%
Actual 3.6%
Prior 2.9%
Revised 3.0%

Back to my favorite quote from September, ‘If the fed doesn’t care about inflation, why should I?’

Wonder what it takes for the fed to care?

2007-12-21 PCE Core MoM

PCE Core MoM (Nov)

Survey 0.2%
Actual 0.2%
Prior 0.2%
Revised n/a

2007-12-21 PCE Core YoY

PCE Core YoY (Nov)

Survey 2.0%
Actual 2.2%
Prior 1.9%
Revised 2.0%

Core at or though fed’s upper bound.

2007-12-21-u-of-michigan-confidence.gif

U. of Michigan Confidence (Dec F)

Survey 74.5
Actual 75.5
Prior 74.5
Revised 2.0%

People still watching CNBC.

2007-12-21 Inflation Expecations - 1 Year Ahead

Inflation Expectations – 1 Year Ahead

Survey n/a
Actual 3.4%
Prior 3.2%
Revised n/a

One of the fed’s indicators – don’t like this action as they think once it elevates it’s too late.

2007-12-21 Inflation Expecations - 5 Years Ahead

Inflation Expectations – 5 Years Ahead

Survey n/a
Actual 3.1%
Prior 2.8%
Revised n/a

As above – once it elevates it’s too late.

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The Trillion Dollar Day

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The Trillion Dollar Day

Yesterday, $1.048 trillion dollars was printed out of thin air, which gave the globe its first Trillion Dollar Day.

Everyday, all government spending is ‘printed out of thin air’, and all payments to the government ‘vanish into thin air’.

However, there were no net payments yesterday for all practical purposes.

$506 bb was injected by the ECB into European Banks,

The uninformed language continues with ‘injected’ implying net funds ‘forced in’ somehow.

All that happened was the ECB offered funds at a lower interest rate to replace funds available from the ECB at higher interest rates. This has no effect on aggregate demand.

$518 bb was earmarked as an addon to the USA federal spending for 2008

Federal deficit spending does increase net financial assets of the ‘non government’ sectors. That is more properly called ‘injecting’ funds, as government exchanges credit balances for real goods and services (buy things), thereby adding to aggregate demand.

plus, $24 bb was taken by banks from other central banks to shore up reserves.

Not what happened. It was all about substituting one maturity for another.

Most importantly, 3 month Libor and Euro Dollar rates declined by only 15 – 20 basis points. The markets expected these rates to decline more as a sign of greater liquidity. The European and USA markets sold off over night and this morning in reaction to stubbornly high short-term rates.

When the CB’s fully understand their own reserve accounting and monetary operations, they will offer unlimited funds at or just over their target rates and maturities and also have a bid for funds at or just under their target.

An anonymous person from the ECB told Bloomberg this morning that the $518 bb was the single greatest injection of emergency lending in central bank history

Probably. Interesting thing to remember for trivial pursuits.

and that it was a climatic effort to free up inter-bank lending.

Should have been done long ago. CB’s main job as single supplier of net reserves is setting rates.

They also said it was all that they could do (for now).

It’s not all that they can do. Operationally, it’s simply debits and credits, for the most part totally offsetting with no net funds involved, not that it matters for the ECB anyway.

Here is my take on ECB efforts as I have discussed with members of our firm. Some bank(s) and/or investment bank(s) most likely have sustained huge market to market losses that they must bring onto their balance sheets soon, which are causing them and others who fear losses from counter parties in our $500 trillion plus derivatives market. My suspicion is that these losses include derivative losses that are not directly related to subprime.

OK. Point?

I also think that the FED and Central Banks have suspected the above since August 2007, which caused them to reverse course from fighting inflation to supply liquidity to save the banking and financial system.

Seems to be the mainstream view right now?

I also do not have much faith in central banks and government authorities ability to manage a widespread financial crisis because THEY created this crisis with their lose money and lax regulatory practices that have been rampant since 2002.

Point?

There is also evidence that USA government spending and deficits are much larger than actually reported since 2002. I have found reports from numerous ex-GOA officials and current GOA staff that have come clean with our BUDGET. Former government officials are now reporting that TSY SEC O’Neil was fired because he wanted to right the ship at GOA and report true numbers in his reports to Congress and the American public.

If they were larger than reporter and added more aggregate demand than appears on the surface, they are responsible for sustaining growth and employment.

Below is a take on this from John Williams. John also publishes the CPI using pre-1982 methods that show annualized CPI running 3-4% higher than reported under current methods.

I recall that debate and the results seemed very reasonable at the time. Can’t remember all the details now.

Here are adjusted Budget numbers for 2006-2007.

The results summarized in the following table show that the GAAP-based deficit, including the annual change in the net present value of unfunded liabilities for Social Security and Medicare narrowed to $1.2 trillion in 2007 from $4.6 trillion in 2006. The reported reduction in the deficit, however, was due to a one-time legislative-related accounting change in Medicare Part B that likely will be reversed, and, in any event, needs to be viewed on a consistent year-to-year accounting basis.

On a consistent basis, year-to-year, I estimate the 2007 deficit at $5.6 trillion, or worse, based on the government’s explanation of the process and cost estimates.

What matters from the macro level is the fiscal balance that adds/subtracts from the current year aggregate demand. This was learned the hard way in 1937 when, if I recall correctly, tax revenue from the new social security program was put in a trust fund and not counted as federal revenue for purposes of reporting fiscal balance and funds available for federal spending. The result was a fiscal shock/drop in demand that upped unemployment to 19% after having come down close to 10%.

From Note 22 of the financial statements, under “SMI Part B Physician Update Factor:”

“The projected Part B expenditure growth reflected in the accompanying 2007 Statement of Social Insurance is significantly reduced as a result of the structure of physician payment updates under current law. In the absence of legislation, this structure would result in multiple years of significant reductions in physician payments, totaling an estimated 41 percent over the next 9 years. Reductions of this magnitude are not feasible and are very unlikely to occur fully in practice. For example, Congress has overridden scheduled negative updates for each of the last 5 years in practice. However, since these reductions are required in the future under the current-law payment system, they are reflected in the accompanying 2007 State of Social Insurance as required under GAAP. Consequently, the projected actuarial present values of Part B expenditure shown in the accompanying 2007 Statement of Social Insurance is likely understated (my emphasis).”

Since this was handled differently in last year’s accounting, the change reduced the reported relative deficit. The difference would be $4.4 trillion, per the government, if physician payment updates were set at zero. I used that estimate, tentatively, for the estimates of consistent year-to-year reporting, but such likely will be updated in the full analysis that follows in the December SGS.

With Social Security and Medicare liabilities ignored, the GAAP deficits for 2007 and 2006 were $275.5 billion and $449.5 billion, respectively. Those numbers contrast with the otherwise formal and accounting-gimmicked cash-based deficits of $168.8 billion (2007) and $248.2 billion (2006).

Yes, net government spending may increase over time and may lead to higher rates of reported inflation, but solvency is not the issue.

These ‘deficit terrorists’ totally miss the point; fore, if they did ‘get it’ they would be doing the work and projecting future inflation rates, not just deficit levels.

Furthermore, they ignore the demand drains, like pension fund contributions, IRA’s, insurance reserves, corporate reserves, etc. that also grow geometrically and help ‘explain’ how government can deficit spend as much as it does without excess demand driving nominal growth to hyper inflationary levels.

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Libor Settings, Eur, and UK leading the way lower…

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Currency TERM Today Monday Friday Thursday Wednesday Tuesday
USD ON 4.40 4.4175 4.3025 4.30 4.34 4.4325
  1M 4.94875 4.965 4.99625 5.0275 5.1025 5.20375
  3M 4.92625 4.94125 4.96625 4.99063 5.057 5.11125
EUR ON 3.8275 3.98875 3.85875 4.04625 4.055 4.05
  1M 4.58813 4.92375 4.93375 4.935 4.945 4.9225
  3M 4.84875 4.94688 4.94688 4.94938 4.9525 4.92688
GBP ON 5.5975 5.5975 5.600 5.60875 5.685 5.7000
  1M 6.49125 6.54125 6.5925 6.60375 6.74625 6.73875
  3M 6.38625 6.43125 6.49625 6.51375 6.62688 6.625

Seems coordinated – move working as expected.

The sizes should be unlimited- it’s about price and not quantity – the size of the operations doesn’t alter net reserve balances.

All they are doing/can do is offering a lower cost option to member banks, not additional funding.

Bank lending is not constrained by reserve availability in any case, just the price of reserves.

Bank lending is constrained by regulation regarding ‘legal’ assets and bank judgement of creditworthiness and willingness to risk shareholder value.

The Fed’s $ lines to the ECB allows the ECB to lower the cost of $ funding for it’s member banks. To the extent they are in the $ libor basket that move serves to help the Fed target $ libor rates.

Regarding the $:

As per previous posts, when a eurozone bank’s $ assets lose value, they are ‘short’ the $, and cover that short by selling euros to buy $.

The ECB also gets short $ if it borrows them to spend. So far that hasn’t been reported. There has been no reported ECB intervention in the fx markets, nor is any expected.

When the ECB borrows $ to lend to eurozone banks it is acting as broker and not getting short $ per se. It is helping the eurozone banks to avoid forced sales/$ losses of $ assets due to funding issues. If the assets go bad via defaults and $ are lost that short will then get covered as above.

‘Borrowing $ to spend’ is ‘getting short the $’ regardless of what entity does it. So the reduction in credit growth due to sub prime borrowers no longer being able to borrow to spend was ‘deflationary’ and eliminated a source of $ weakness.

The non resident sector is, however, going the other way as they are increasing imports from the US and reducing their deflationary practice of selling in the US and not spending their incomes.

Portfolio shifts- both by domestics and foreigners- out of the $ driven by management decision (not trade flows) drive down the currency to the point where buyers are found. The latest shift seems to have moved the $ down to where the the real buyers have come in due to ppp (purchasing power parity) issues, which means that in order to get out of the $ positions the international fund managers had to drive the price down sufficiently to find buyers who wanted $ US to
purchase US domestic production.

These are ‘real buyers’ who are attracted by the low prices of real goods and services created by the portfolio managers dumping their $ holdings. They are selling their euros, pounds, etc. to obtain $US to buy ‘cheap’ real goods, services, real estate, and other $US denominated assets.

Given the tight US fiscal policy and lack of sub prime ‘short sellers’ borrowing to purchase (as above), these buyers can create a bottom for the $ that could be sustained and exacerbated by some of those managers (and super models) who previously went short ‘changing their minds’ and reallocated back to the $US.

Seems US equity managers are vulnerable to getting caught in this prolonged short squeeze as well.

It’s been brought to my attention that over the last several years equity allocations us pension funds- private, state, corporate, etc – have been gravitating to ever larger allocations to non US equities, and are now perhaps 65% non US.

This is probably a result of the under performance of the US sector, and once underway the portfolios are sufficiently large to create a large, macro, ‘bid/offer’ spread. The macro bid side for the trillions that were shifted/reallocated over the last several years was low enough to find buyers for this shift out of both the $ and the US equities to the other currencies. And the shift from $ to real assets also added to agg demand and was an inflationary bias for the $US.

Bottom line – changing portfolio ‘desires’ were accommodated by these portfolios selling at low enough prices to attract ‘real buyers’ which is the macro ‘bid’ side of ‘the market.’

When portfolio desires swing back towards now ‘cheap’ $US assets and these desires accelerate as these assets over perform they only way they can be met in full is to have prices adjust to the ‘macro offered side’ where real goods and services, assets, etc. are reallocated the other direction by that same price discovery process.

more later!

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