Category Archives: Interest Rates

King Says U.K. Inflation May Match Fastest Pace in a Decade

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States the issues clearly:

King Says U.K. Inflation May Match Fastest Pace in a Decade

(Bloomberg) Bank of England Governor Mervyn King said inflation may match the fastest pace in at least a decade this year and require an explanation to the Treasury, a sign that policy makers have limited scope to cut interest rates.

“It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the chancellor,” King said in a speech today. “To put it bluntly, this year we are probably facing a period of above-target inflation and a marked slowing in growth.”

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Fed comments

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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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Meltdown?, continued..

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Weakness:

  • Equity markets still heading down.
  • Commodity markets anticipate slowing demand.
  • Credit markets anticipate additional rate cuts.

First, a word on the bond insurers:

A Fed rate cut won’t address the risk that an insurer failure could trigger panic selling by bond holders that require AAA ratings to hold their bonds.

The Fed could offer to provide supplemental insurance to investors holding the bonds for a fee (maybe a point), and discount the strike of the put a few points as well. The insurer would continue in first loss position. This would allow investors to ‘pay the price’ to the Fed if they want to keep the AAA rating. Additionally the Fed would take measures to make sure this doesn’t happen again.

Second, commodity markets:

Story today that OPEC still sees demand increasing 1.3 million bpd, even with a slowdown. Not good. Means they retain pricing power.

The unknown is whether they agreed to cut prices in response to the Bush visit.

Third, equities:

Dupont earnings way above expectations on world demand, and price increases on their cost side were more than passed through.

And bank earnings off but all still in positive territory for Q4, indicating losses during what is likely the largest quarter for writeoffs were less than earnings. I’ve seen worse…

Equity markets relatively flat from yesterday, earning look good, particularly ex financial writedowns, as core earnings of the financials look OK as well.

One of the problems with equities continues to be shareholder vulnerability to converts and other dilutions as corporate structure/law rewards management for this kind of recapitalization. This shifts wealth from existing shareholder to new shareholders.

Initial claims estimated at 325,000 for Thursday. If so, I still don’t see much damage to the real economy. Q4 may sink or swim on December export numbers that will be released in February.

The jobless recovery ends with a full employment recession?
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I’ve been wrong on the Fed

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> 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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ECB reiterates rate hike warning

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ECB reiterates rate hike warning

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

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

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

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

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

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

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

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

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

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Bernanke

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Fed/Bernanke probably concerned about core CPI going so high and making ‘popular’ headlines and is worried about cutting 50 into the triple negative supply shock of food/fuel/import-export prices.

And with today’s claims number showing, there may not be as much slack in the labor markets as the last unemployment number indicated. The fed has been counting on slack in the labor markets to keep wage demands in check and not transmitting headline inflation to core inflation via higher wages.

And now that core has in fact started to move, he’s pushing for a fiscal package (which goes against the mainstream grain/fiscal responsibility, etc.) as an alternative to future rate cuts which carry, in mainstream theory, an inflation price.

He would very much like the planned January 30 cut to be the last one needed. He doesn’t want to be the next Miller or the next Volcker.

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Re: Bernanke

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(email)

On 11 Jan 2008 11:17:34 +0000, Prof. P. Arestis wrote:
>   Dear Warren,
>
>   Many thanks. Some good comments below.
>
>   The paragraph that I think is of some importance is this:
>
> >  The Committee will, of course, be carefully evaluating incoming
> >  information bearing on the economic outlook. Based on that evaluation,
> >  and consistent with our dual mandate, we stand ready to take
> >  substantive additional action as needed to support growth and to
> >  provide adequate insurance against downside risks.
>
>   If I am not wrong this is the first time for Bernanke that the word
>   inflation does not appear explicitly in his relevant statement. But also
>   there is no mention of anything relevant that might capture their motto
>   that winning the battle against inflation is both necessary and sufficient
>   for their dual mandate.
>
>   Are the economic beliefs of BB changing, I wonder? I rather doubt it but
>   see what you think.

Dear Philip,

I see this is all part of the Bernanke conumdrum.

Implied is that their forecasts call for falling inflation and well anchored expectations, which can only mean continued modest wage increases.

They believe inflation expectations operate through two channels-accelerated purchases and wage demands.

Their forecasts use futures prices of non perishable commodities including food and energy. They don’t seem to realize the
‘backwardation’ term structure of futures prices (spot prices higher than forward prices) is how futures markets express shortages.

Instead, the Fed models use the futures prices as forecasts of where prices will be in the future.

So a term structure for the primary components of CPI that is screaming ‘shortage’ is being read for purposes of monetary policy as a deflation forecast.

Bernanke also fears convertible currency/fixed fx implosions which are far more severe than non convertible currency/floating fx slumps. Even in Japan, for example, there was never a credit supply side constraint – credit worthy borrowers were always able to borrow (and at very low rates) in spite of a near total systemic bank failure. And the payments system continued to function. Contrast that with the collapse in Argentina, Russia, Mexico, and the US in the 30’s which were under fixed fx and gold standard regimes.

It’s like someone with a diesel engine worrying about the fuel blowing up. It can’t. Gasoline explodes, diesel doesn’t. But someone who’s studied automobile explosions when fuel tanks ruptured in collisions, and doesn’t understand the fundamental difference, might be unduly worried about an explosion with his diesel car.

More losses today, but none that directly diminish aggregate demand or alter the supply side availability of credit.

And while the world does seem to be slowing down some, as expected, the call on Saudi oil continues at about 9 million bpd,
so the twin themes of moderating demand and rising food/fuel/import prices remains.

I also expect core CPI to continue to slowly rise for an extended period of time even if food/fuel prices stay at current levels as
these are passed through via the cost structure with a lag.

All the best,

Warren

>
>  Best wishes,
>
>  Philip

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Plosser the hawk on the tape

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This is the most hawkish Fed pres:

GLADWYNE, PENNSYLVANIA (Thomson Financial) – The head of the Philly Fed, Charles Plosser, today raised the possibility of a stagflation threat to the US economy.

“Although I am expecting slow economic growth for several quarters, we should not rely on slow growth to reduce inflation,” the Philadelphia Federal Reserve Bank president warned in a speech here. “Indeed, the 1970s should be a sufficient reminder that slow growth and falling inflation do not necessarily go hand in hand.” Plosser, who has a vote on the rate-setting Federal Open Market Committee this year, warned that he is getting increasingly worried about inflation. “Recent data suggest that inflation is becoming more broad-based,” he said, “And recent increases do not appear to be solely related to the rise in energy prices. Consequently I see more worrisome signs of underlying price pressures.” Plosser also used today’s speech to draw a clear line between what the Fed should do to stabilize the economy and what it should do to stabilize financial markets.

He believes the Fed’s three rate cuts will take time to work through the economy and that in the meantime growth will slow.

“Since monetary policy’s effects on the economy occur with a lag, there is little monetary policy can do today to change economic activity in the first half of 2008.” In the meantime, “we will get some bad economic numbers from various sectors of the economy in the coming months,” he added.

But beyond the immediate short term, Plosser was more optimistic. He reckons the economy will “improve appreciably by the third and fourth quarters of 2008, and that is when any monetary policy action today will begin to have noticeable effects.” On the credit market front, the Fed’s new Term Auction Facility (TAF) program should help stabilize financial markets and provide liquidity when the interbank lending markets “are under stress and not functioning smoothly,” he added.

Plosser said early evidence suggests the first two 20 bln usd auctions were successful. Two more have been scheduled later this month.

The key point, he said, is that “the TAF did not change the stance of monetary policy. The Fed actually withdrew funds through open market operations as it injected term liquidity through the TAF.” Plosser was already known as one of the inflation “hawks” among the regional Fed bank presidents. His analysis confirms a preference for avoiding further rate cuts and the risk of further inflation as long as financial markets problems do not pose a danger to the rest of the economy.

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Re: fiscal response

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On 04 Jan 2008 22:29:03 +0000, Prof. P. Arestis wrote:
> Dear Warren,
>
> Many thanks.
>
> This is all interesting. The sentence that caught my eye is this: “A fiscal

> package is being discussed to day by Bernanke, Paulson, and Bush. That

> would also reduce the odds of a Fed cut”. This would indeed reduce the odds
> of a rate cut. But would Bernanke accept such a proposition when he
> believes passionately that crowding-out in fiscl policy is very much the
> order of the fiscal day? I am curious to see the result of this discussion.

Dear Philip,

Very good point!

Warren

>
> Best wishes,
>
> Philip
>

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January 2008 update

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The following sums up the mainstream approach:

Low inflation is a NECESSARY condition for optimal long term growth and employment.

There is not trade off. If a CB acts to support near term output, and allows inflation to rise, the longer term cost to output of bringing down that inflation is far higher than any near term gains in output.

The evidence of excessive demand is prices. So the way the mainstream sees it, currently demand is sufficiently high to support today’s prices of fuel, food, gold, and other commodities, as well as CPI in general.

In the first instance, price increases are ‘relative value stories.’ The negative supply shocks of food, fuel, and import prices are shifts in relative value, and not inflation. However, should the Fed ‘accommodate’ those price increases, and allow inflation expectations to elevate and other prices to ‘catch up,’ the Fed has allowed a ‘relative value story’ to become an ‘inflation story.’

Therefore, to optimize long term employment and growth, the Fed needs only to conduct a monetary policy that targets low inflation, and let markets function to optimize long term employment and growth.

There’s the rub. The Fed has been concerned about ‘market functioning.’ The mainstream understanding assumes markets are
‘functioning’ (and competitive, but that’s another story). If markets are not functioning there is no channel to translate low inflation to optimal growth and employment.

Hence the Fed concern for ‘market functioning.’ Unfortunately, there isn’t much in the literature to help them. There’s nothing, for example, that tells them what transactions volumes, bid/offer spreads, credit spreads, etc. are evidence of sufficient ‘market functioning.’ Nor do they have studies on which markets need to function to support long term output and growth. For example, are the leveraged buyout markets, CMO and other derivative markets supportive of optimal growth? And what about markets such as the sub prime markets that added to demand for housing, but may be unsustainable as borrowers can’t support payment demands? And meaning all they did was get housing subsidized by investor’s shareholder equity.

On Sept 18 the Fed cut rates 50 basis points citing risks to ‘market functioning.’ Given the above, this was a logical concern,
particularly given the lack of experience with financial markets of the FOMC members.

In the latest minutes, a different story seems to be emerging. Markets are now pricing in rate cuts based on the risks of a weakening economy per se.

While it is generally agreed that markets are now functioning (there are bid/offer spreads, and sufficient trading is taking place to
support the economy at modest levels of real growth) the concern now is that higher prices for fuel, food, and imports, higher credit thresholds, falling home prices, and a host of other non ‘market functioning’ issues, might reduce growth and employment to recession levels.

This view has no support in mainstream economic theory. As above, mainstream math- and lots of it- concludes that any level of demand that is driving inflation higher is too much demand for optimal long term growth and employment. If that means recession in the near term, so be it. The alternative is perhaps a bit more short term growth, but at the risk of accelerating inflation which will cost far more to bring under control than any possible short term gains. As Fed Governor Kohn stated, “We learned that lesson in the 70’s and we’re not going to make that mistake again.”

To be continued.

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