Tag Archives: CB

The Schroders Economic Viewpoint – Feb 2008

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Interesting in that it totally ignores inflation when predicting CB moves.
Maybe not only the Fed but the rest of the world’s CB’s don’t care about inflation:

Into the valley

One of the characteristics of a recession is a sudden drop off in activity, the point at which a slowdown turns into something more serious. Economists term this a discontinuity or a break in the data and it is this pattern which makes recessions so difficult to spot from simply tracking the daily data releases. There is evidence that we have hit such a point in the US with several indicators taking a tumble over the past month.

True, but these indicators aren’t yet sufficient:

For example, the service sector ISM fell to its lowest level since the last recession in 2001,

The first move of this indicator is very unreliable, and these types of drops have a recent history of getting reversed. The next update will be more meaningful.

consumer confidence reached a 16 year low

Yes, but again, this is not a reliable indicator

and we saw the first fall in payrolls for 4 years as firms trimmed jobs in construction and manufacturing.

Yes, but how quickly they forget the same was said when the August number came out negative, only to be revised to a very respectable positive number a month later.

And the December number was also revised up to a reasonable number from a weak initial report. The February number and revised January number will be out a week from Friday.

Meanwhile, activity in the housing sector remained weak and consumer spending has levelled off. The economy lost momentum at the end of last year with GDP rising just 0.6% at an annualised rate in the fourth quarter.

This could also be revised up soon as exports were higher than anticipated.

It is quite possible that this tipped over into a negative quarter in Q1 this year.

Yes, it’s possible, but this is biased analysis that simply cherry picked the worst possible data.

The Fed has not been slow to respond and cut rates by a further 50 basis points to 3% at its last meeting to bring the cumulative easing to 225 bps in this cycle. Fed chairman Ben Bernanke has shown that he will adopt an activist stance in the face of downside risks to activity, a departure from the gradualist approach of his predecessor Alan Greenspan. Bernanke is a student of the Great Depression in the US

Yes, and he has also expressed risks that existed only due to the gold standard of the time and don’t apply to current floating fx policy.

and so is well aware of the dangers of allowing confidence to slide and the economy falling into a liquidity trap. Sometimes described as pushing on a string, this was also the situation in Japan during the 1990s, where lower interest rates failed to stimulate activity.

Yes, that can happen due to tight fiscal policy. The difference between now/Japan and the gold standard days is that now there are no quantitative supply side constraints on lending. In the US today as with Japan credit is infinitely available to credit worthy borrowers. Today’s constraints come with bank perceptions of credit worthiness, as well as ‘regulatory over reach’ where bank regulators restrict lending. And, for another example, today the treasury can issue unlimited numbers of treasury securities (as did Japan) as rates at or below the CB’s target rates. On a gold standard, treasury borrowing drives up rates as it competes for funds with the private sector, and those funds are limited by the gold standard.

The current situation is not as severe as in these episodes, but does share the essential characteristic that the transmission mechanism from central bank rate cuts to the real economy is impaired and not functioning normally.

Confused as above.

This, of course, is the credit crunch where banks are tightening or withdrawing credit from the economy even as interest rates fall. Evidence of this is found in the continued tightening of lending conditions apparent in the Fed’s senior loan officer survey despite the fall in policy rates (see chart on front page).

Again, very different from gold standard constraints and easily overcome if understood, where the gold standard constraints are only overcome by going off it, as the US did domestically in 1934.

True, however, that employment, growth, and inflation are not functions of interest rates, as is nearly always the case.

It is this headwind which policy makers not just in the US, but also in the Eurozone and UK need to overcome. The problem extends into the markets for securitised debt which have in many cases dried up. In response to this and the weaker near term performance of the economy, we have reduced our forecast for the Fed funds target rate to 2% by May (previously 2.5%).

Regardless of inflation!

These inflation concerns have weighted more heavily in Europe than the US where the Bank of England and ECB continue to voice concern about second round effects from higher commodity prices into wages. Nonetheless, we still see scope for a further easing of policy from both central banks along with the Federal Reserve in coming months as activity weakens (see below for more on the UK and Eurozone).

More generally, our baseline view remains one where global growth slows in 2008 and quells inflation fears in the second half of the year. Our forecasts will be reviewed next month and although we already have a weak profile for US GDP growth we will trim our baseline projections. It is more than likely that the US is now in recession. However, we will still look for a modest recovery in the second half of the year as the housing market stabilises and the economy begins to experience some of the effects of looser fiscal and monetary policy. Nonetheless, growth is expected to remain below trend throughout 2008, so it will feel more like a stabilisation than a recovery. More of an “L” shaped recovery than a “V”.

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Re: RBA – 86% OIS odds of a hike in March

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(an interoffice email)

Looks familiar – the CB forecasting inflation falling from higher and higher levels as it move up rather than down as originally forecast.

———- Forwarded message ———-
From: Milo
Date: 2008/2/14
Subject: This Picture says it all, I recon – 86% OIS odds of a hike in March
To: Warren Mosler, Karim

Core inflation and successive RBA forecast tracks

The RBA has come to grips with Australia’s stark inflation reality. Inflation forecasts have been revised up significantly (see Figure 1), the RBA will deliver

more rate hikes and domestic demand will eventually slow. At the moment, forecasters are grappling with how high the terminal cash rate will be. Is it

7.5%, 8.0% or higher?

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2008-01-21 Update

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Major themes intact:

  • weak economy
  • higher prices

Weakness:

US demand soft but supported by exports.

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

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

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

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

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

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

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

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

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

Higher Prices:

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

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

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

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

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

Conclusion:

  • The real economy muddling through
  • Inflation pressures continuing

A word on the financial sector’s continuing interruptions:

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

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

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

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

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

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

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

♥

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Why I expect US exports to continue to be very strong..

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The desire to accumulate $US financial assets has been diminished for at least the following reasons:

  1. Treasury policy – Paulson is actively pushing both a strong yuan and threatening any other CB that buys $US with the label of ‘currency manipulator.’ CB’s had been perhaps the largest source of $US financial assets accumulation and are now limited to compounding of interest.
  2. US foreign policy is probably driving CB’s in less than friendly nations to diversify their reserves away from $US financial assets.
  3. Fed policy has the appearance of a ‘beggar thy neighbor’/’inflate your way out of debt’ policy, as the Fed aggressively cuts rates in the face of inflation not seen in 25 years.

This all sets in motion a downward pricing of the $US as non residents sell them to each other at lower and lower prices in this effort to lower their rate of accumulation of $US financial assets. But these financial assets can only ‘go away’ when they get spent or invested in the US, when US prices are low enough to cause this to happen. The rapid rise in exports and accelerated non resident buying of US real estate and other assets is anecdotal evidence this is taking place as theory predicts.

This is a very large cyclical force that should continue to drive rapidly rising exports for perhaps a year or more. Weak foreign economies should have little effect on this process, as that weakness doesn’t reduce the desire of portfolio managers to shift out of $US financial assets.

This is also highly inflationary for the US. This buying by non residents both drives down the $US and drives up the prices of US exports, now rising at a 7% clip last I checked.

The desired shift is probably well over $1 trillion which means exports will increase by a good part of that to facilitate this transfer.

This can sustain US GDP in the face of falling domestic demand, which will stay relatively low until housing picks up. Employment will remain reasonably good, but standards of living fall as we produce as much, but export more and consume less. We get paid to work but can buy less due to high prices, with our remaining production exported to those wishing to reduce their accumulated $US financial assets.

We’ve been talking about this possibility about a long time, but seems our trade negotiators have finally got their wish.

Meanwhile, Saudis continue to act the swing producer. In fact, they told Bush today they have 2 million bpd capacity in reserve, and that markets are well supplied. At their price, of course.

Probably have been some year end allocations out of crude by pension funds as with the price hikes they would need to sell some to keep the same ‘weight’ in their portfolios. That should be ending soon.

And I agree with Karim, the Fed is not likely to act on inflation until core starts to rise or their measures of inflation expectations start to rise, despite the fact that mainstream theory clearly says if any of that happens it’s too late. Seems to me the senior FOMC members are putting their jobs on the line by taking that kind of systemic risk, which their own theory tells them is far higher than the risk of any lost output from a .

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If it isn’t inflation, what is it?

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What we used to call an ‘inflation day’ –

  • $ down/oil up
  • Gold through 900- if nothing else, it’s an inflation expectation indicator (not that they cause anything, just reflect it)
  • Other metals up
  • Grains going parabolic
  • Stocks up

also,

  • Export driven growth means demand coming from and output going to non residents, rather than retail sales and other domestic consumption.
  • Changes of portfolio currency preferences away from the $US are driving the dollar down to low enough levels where non residents buy here to use up some of their $US financial assets.
  • Japan/mof (and others) would probably like to buy $ to keep the yen from rising and hurting their exports, but Paulson has warned the world CB’s that this makes them ‘currency manipulators’ and subject to criticism.

This is an explicit weak $ policy that is probably altering CB portfolio preferences and inducing price pressures on our imports.

The Fed is sending signals it’s fine with this kind of inflation at least as long as they are forecasting the risk of weaker domestic demand as a result (somehow) of financial concerns. And because they analyze the risks as if we had a fixed exchange rate they see the risks of supply side credit issues as those of the great depression of the 1930’s. Doesn’t happen with today’s floating fx.

Don’t know when/if the Fed ‘figures it out’ but the curve can go from wherever it is to seriously negative should the Fed hike aggressively to ‘get ahead of the inflation curve.’

The inflation is coming from non monetary sources – monopolist pricing in oil, biofuels linking food to fuel, portfolio shifts out of $US due to US political rhetoric and apparent Fed policy of inflating your way out of debt without concern for the value of the currency. Enough to scare any portfolio manager out of $US risk.

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Re: US Libor GC Spreads comment

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(an interoffice email)

Good report, thanks!

On Jan 4, 2008 10:41 AM, Pat Doyle wrote:
>
>
>
> Pre- August 2007 GC US Treasury’s repo averaged Libor less 17 across the
> curve. In early August and again in early December the spread between GC
> and Libor hit it’s wides in excess of 150bps for 3m repo and 180bps for
> 1mos.
>
>
>
> Today’s Spreads:
>
> 1m = L -46.5
>
> 3m = L – 77
>
> 6m = L – 82
>
>
>
> This recent narrowing of the spread is primarily a result of the TAF
> program and CB intervention but may also be attributed to continuing
> writedowns of assets. There is plenty of cash in the short term markets and
> now some of this cash is going out the curve helping to narrow Libor
> spreads. The problem banks continue to have is that their balance sheet size
> and composition is adversely affecting their capital ratios. Banks and
> Dealers remain very cautious about adding risk assets to their balance
> sheets. Bids are defensive as dealers are demanding higher rents (return
> for risk) for balance sheet. Dislocations still exist, for example it may
> make no sense from a credit perspective but AAA CMBS on open repo trades at
> FF’s + 75, while IG Corp trades FF’s + 40, even NON IG Corps trade tighter
> than AAA CMBS. The more assets are either sold or otherwise liquidated off
> of the balance sheets and the more transparent the balance sheet
> compositions become, then the quicker the markets will stabilize
>
>
>
> GRAPH OF 1 MONTH LIBOR VS. 1 MONTH UST GC
>
>

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

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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.

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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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Roubini blog

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Roubini totally doesn’t get it.

The point of CB intervention is to keep interest rates at their target rates, not to provide funds for lending, as described in previous posts.

This plan will succeed at doing that, best I can tell.

It’s all about price, not quantity.

That’s all a CB can do.

Also, insolvency matters to the real economy only as it reduces aggregate demand.

The largest current risk to aggregate demand in my estimation is the media frightening businesses and consumers from spending.

That’s always a risk to a monetary economy where the government isn’t standing by to net spend when demand sags. When government does that there is little or no risk of negative growth or unemployment as we currently define it.

Nouriel Roubini | Dec 12, 2007

Given the worsening of the global liquidity and credit crunch – with a variety of short term interbank Libor spreads relative to policy rates and relative to government bonds of same maturity being even higher recently than at the peak of the crisis in August – it is no surprise that central banks were really desperate to do something.

The announcement today of coordinated liquidity injections by FED, ECB, BoE, BoC, SNB is however too little too late and it will fail to resolve the liquidity and credit crunch for the same reasons why hundreds of billions of dollars of liquidity injections by these central banks – and some easing of policy rates by Fed, BoC and BoE – has totally and miserably failed to resolve this crunch in the last five months. What was announced today are band-aid palliative that will not address the core causes of this most severe liquidity and credit crunch.

There has some heated debate in recent weeks on whether the liquidity crunch is due to:

  1. short-term year end liquidity needs (the “Turn”);
  1. a more persistent liquidity risk premium;
  1. a rise on counterparty risk and broader perceived credit problems of counterparties; i.e. serious problems of insolvency rather than illiquidity alone.
  1. a more general increase in risk aversion due to severe credit problems and information asymmetries (risk aversion due to uncertainty about the size of the financial losses and uncertainty on who is holding the toxic waste of RMBS, CDOs and other ABS products);
  1. the failure of the monetary transmission mechanism in a financial system where most financial institutions are now non-bank and thus do not have direct access to the central banks’ liquidity or lender of last resort support.

The severe financial crunch is likely due to all of the factors above; but the measures announced today can only partly deal with the first of the two explanations above of the crunch and will do nothing to address the other causes of the crunch. These measures will not be successful for a variety of reasons.

First, you cannot use monetary policy to resolve credit and insolvency problems in the economy; and most of the crunch is due not just to illiquidity but rather to serious credit and solvency problems of many economic agents (households, mortgage borrowers, subprime, near prime and prime mortgage lenders, homebuilders, highly leveraged and distressed financial institutions, weak corporate sector firms).

Second, monetary injections cannot resolve the information asymmetries and generalized uncertainty of a financial system where financial globalization and securitization have led to lack of transparency and greater opacity of financial markets; these asymmetric information problems that generate lack of trust and confidence and significant counterparty risk cannot be resolved with monetary policy.

Third, the US is at this point headed towards a recession regardless of what the Fed does as the build-up of real and financial problems (worst housing recession ever, oil at $90, a severe credit crunch, falling capex spending by the corporate sector, a saving-less and debt burdened consumer buffeted by ten separate negative shocks) in the economy make a recession unavoidable at this point; similarly other economies are also now headed towards a hard landing as the US real and financial mess lead to significant contagion and recoupling.

Thus, to mitigate the effects of an unavoidable US recession and global economic slump the Fed and other central banks should be cutting rates much more aggressively. The 25bps cut by the Fed yesterday is puny relative to what is needed; 25bps by BoE and BoC does not even start to deal with the increase in nominal and real borrowing rates that the sharp spike in Libor rates (the true cost of short term capital for the private sector) has induced.

And the ECB decision not to cut policy rates – and deluding itself that it may be able to raise them once the alleged “temporary” credit crunch is gone – is dangerous and ensures a sharp slowdown in a Eurozone where deflating housing bubbles, oil at $90 and a strong Euro are already sharply slowing down growth. Central banks should have announced today a coordinated 50bps reduction in their policy rates as a way to signal that they are serious about avoiding a global hard landing. Instead the Fed yesterday gave a paltry 25bps with a neutral bias rather than the necessary easing bias.

Fourth, the actions by the Fed today provide more liquidity to a greater variety of institutions but, as the Fed announced, these institutions are only “depository” institutions, i.e. only banks. The severe liquidity and credit problems affect today a financial market dominated by non-bank that do not have direct access to the liquidity support of the Fed; these include: broker dealers and investment banks that do not have a commercial bank arm; money market funds; hedge funds; mortgage lenders that do not take deposit; SIVs, conduits and other off-balance sheet special purpose vehicles; states and local governments funds (Florida, Orange County, etc.).

All these non-bank institutions do not have direct access to the Fed and other central banks liquidity support and they are now at risk of a liquidity run as their liabilities are short term while many of their assets are longer term and illiquid; so the risk of something equivalent to a bank run for non-bank financial institutions is now rising. And there is no chance that depository institutions will re-lend to these to these non-banks the funds borrowed by central banks as these banks have severe liquidity problems themselves and they do not trust their non-bank counterparties. So now monetary policy is totally impotent with dealing with the liquidity problems and the risks of runs on liquid liabilities of a large fraction of the financial system (in a world where these non-bank financial institutions play a larger role in financial markets than non-banks).

And let us be clear: the Federal Reserve Act striclty forbids the Fed from lending to non-depository institutions apart from very emergency situations that would require a complex and cumbersome approval process and the provision of high quality collateral. And the Fed has never – in its history – used this procedure and lent money to non-depository institutions.

Fifth, as discussed before on this blog, this is the first real crisis of financial globalization and securitization; it will take years of major policy, regulatory and supervisors reform to clean up this disaster and create a sounder global financial system; monetary policy cannot resolve years of reckless behavior by regulators and supervisors that were asleep at the wheel while the credit excesses of the last few years were taking place. Now the US hard landing and global sharp slowdown is unavoidable and monetary policy – if aggressive enough with much greater and rapid reduction in policy rates – may only be able to affect how long and protracted this hard landing will be.

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