Tag Archives: Inflation

Inflation – clear and present danger?

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Food, fuel, and $/import prices present a triple negative supply shock.

Now gold pushing $900 as LIBOR falls, commercial paper issuance increases, and ‘market function risk’ subsides.

Downside risks to GDP are still not trivial.

Consumer income and desire to spend it may be problematic, and banks and other lenders may further tighten borrowing requirements.

And weaker overseas demand may cool US exports.

Yes, the Fed knows and fears demand MAY weaken, and forecasts lower inflation as a consequence.

But inflation is the clear and present danger, vs an economy that may weaken further

And mainstream economic theory says the cost of bringing down inflation once the inflation cat is out of the bag is far higher than
any near term loss of output incurred in keeping inflation low in the first place.

And the Fed addresses its dual mandate of low inflation and low unemployment with mainstream theory that concludes low inflation is a necessary condition for optimal employment and growth over the long term.

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Fed’s Lockhart: economic outlook

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He is currently leaning towards cuts, but watching carefully for signs of improvements in market functioning and output, and aware of the risks of his inflation forecast being wrong.

Fed’s Lockhart: Economic Outlook

From Atlanta Fed President Dennis P. Lockhart: The Economy in 2008

Looking to 2008, I believe the pivotal question—the central uncertainty—is the extent of current and future spillover from housing and financial markets to the general economy. The dynamics I’m watching—stated simplistically—are the following. First, there’s the effect of dropping house prices on the consumer and in turn on retail sales and other personal expenditures. And second, I’m watching the effect of financial market distress on credit availability and, in turn, on business investment, general business activity, and employment.

Yes, we are all watching that carefully. So far so good, but consumer spending is always subject to change.
I’m watching credit availability, but seems the supply side of credit is never the issue. The price changes some, but quantity is always there at ‘market’ prices that provide desired returns on equity.

Business investment seems to hold up nicely as well, probably due to most investment being for cost cutting rather than expanding output. This makes investment a type of profit center.

Employment is still increasing, more in some fields than others.

And, of course, overall, from the mainstream’s view, demand is more than enough to be driving reasonably high inflation prints.

My base case outlook sees a weak first half of 2008—but one of modest growth—with gradual improvement beginning in the year’s second half and continuing into 2009. This outcome assumes the housing situation doesn’t deteriorate more than expected

Meaning it’s expected to deteriorate some. I’m inclined to think it’s bottomed.

and financial markets stabilize.

They are assuming this and it already seems to have happened. FF/LIBOR is ‘under control.’

A sober assessment of risks must take account of the possibility of protracted financial market instability together with weakening housing prices, volatile and high energy prices, continued dollar depreciation, and elevated inflation measures following from the recent upticks we have seen.

That statement includes both deflationary and inflationary influences – not sure what to make of it.

But he will vote for 50 bp cut in January.

Maybe if the meeting were today, but much can change between now and then.

I’m troubled by the elevated level of inflation. Currently I expect that inflation will moderate in 2008 as projected declines in energy costs have their effect. But the recent upward rebound of oil prices—and the reality that they are set in an unpredictable geopolitical context—may mean my outlook is too optimistic. Nonetheless, I’m basing my working forecast on the view that inflation pressures will abate.

Doesn’t say what the Fed might do, if anything, if inflation doesn’t abate.

To a large extent, my outlook for this year’s economic performance hinges on how financial markets deal with their problems.

He believes the performance of the real economy is a function of the health of financial markets.

I’m not sure that is turning out to be the case.

The coming weeks could be telling. (What does he know). Modern financial markets are an intricate global network of informed trust. Stabilization will proceed from clearing up the information deficit and restoring well-informed trust in counterparties and confidence in the system overall.

To restore market confidence, leading financial firms, I believe, must recognize and disclose losses based on unimpeachable valuation calculations,

Maybe they already have. The penalties for not being ‘honest’ are severe, and it’s hard to see how any public company would try to cover anything like that up.

restore capital and liquidity ratios, and urgently execute the strenuous task of updating risk assessments of scores of counterparties. The good news is that markets can return to orderly functioning and financial institutions can be rehabilitated quickly. With healthy disclosure, facing up to losses, recapitalization, and the resulting clarity, I believe there is hope for this outcome.

May already be happening.

So far only about $50 billion of announced bank losses. Q4 reports will add some to that, when the majority of the remaining losses will be disclosed.

In Aug 1998 $100 billion was lost all at once with no recovery prospects, back when that was a lot of money.

So far this crisis has been mild by historical standards.

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The subprime mess

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On Jan 5, 2008 9:40 PM, Steve Martyak wrote:
> http://www.autodogmatic.com/index.php/sst/2007/02/02/subprime_credit_crunch_could_trigger_col
>
>
> also….
>
> 9/4/2006
> Cover of Business Week: How Toxic Is Your Mortgage? :.
>
> The option ARM is “like the neutron bomb,” says George McCarthy, a housing
> economist at New York’s Ford Foundation. “It’s going to kill all the people
> but leave the houses standing.”
>
> Some people saw it all coming….
>

The subprime setback actually hit about 18 months ago. Investors stopped funding new loans, and would be buyers were were no longer able to buy, thereby reducing demand. Housing fell and has been down for a long time. There are signs it bottomed October/November but maybe not.

I wrote about it then as well, and have been forecasting the slowdown since I noted the fed’s financial obligations ratio was at levels in March 2006 that indicated the credit expansion had to slow as private debt would not be able to increase sufficiently to sustain former levels of GDP growth. And that the reason was the tailwind from the 2003 federal deficits was winding down. as the deficit fell below 2% of GDP, and it was no longer enough to support the credit structure.

Also, while pension funds were still adding to demand with their commodity allocations, that had stopped accelerating as well and
wouldn’t be as strong a factor.

Lastly, I noted exports should pick up some, but I didn’t think enough to sustain growth.

I underestimated export strength, and while GDP hasn’t been stellar as before, it’s been a bit higher than i expected as exports boomed.

That was my first ‘major theme’ – slowing demand.

The second major theme was rising prices – Saudis acting the swing producer and setting price. This was interrupted when Goldman changed their commodity index in aug 06 triggering a massive liquidation as pension funds rebalanced, and oil prices fell from near 80 to about 50, pushed down a second time at year end by Goldman (and AIG as well this time) doing it again. As the liquidation subsided the Saudis were again in control and prices have marched up ever since, and with Putin gaining control of Russian pricing we now have to ‘price setters’ who can act a swing producers and simply set price at any level they want as long as net demand holds up. So far demand has been more than holding up, so it doesn’t seem we are anywhere near the limits of how high they can hike prices.

Saudi production for December should be out tomorrow. It indicates how much demand there is at current prices. If it’s up that means they have lots of room to hike prices further. Only if their production falls are they in danger of losing control on the downside. And I estimate it would have to fall below 7 million bpd for that to happen. It has been running closer to 9 million.

What I have missed is the fed’s response to all this.

I thought the inflation trend would keep them from cutting, as they had previously been strict adherents to the notion that price
stability is a necessary condition for optimal employment and growth.

This is how they fulfilled their ‘dual mandate’ of full employment and price stability, as dictated by ‘law’ and as per their regular reports to congress.

The theory is that if the fed acts to keep inflation low and stable markets will function to optimize employment and growth, and keep long term interest rates low.

What happened back in September is they became preoccupied with ‘market functioning’ which they see as a necessary condition for low inflation to be translated into optimal employment and growth.

What was revealed was the FOMC’s lack of understanding of not only market functioning outside of the fed, but a lack of understanding of their own monetary operations, reserve accounting, and the operation of their member bank interbank markets and pricing mechanisms.

In short, the Fed still isn’t fully aware that ‘it’s about price (interest rates), not quantity (‘money supply, whatever that may be)’.

(Note they are still limiting the size of the TAF operation using an auction methodology rather than simply setting a yield and letting quantity float)

The first clue to this knowledge shortfall was the 2003 change to put the discount rate higher than the fed funds rate, and make the discount rate a ‘penalty rate.’ This made no sense at all, as i wrote back then.

The discount rate is not and can not be a source of ‘market discipline’ and all the change did was create an ‘unstable equilibrium’ condition in the fed funds market. (They can’t keep the system ‘net borrowed’ as before) it all works fine during ‘normal’ periods but when the tree is shaken the NY Fed has it’s hands full keeping the funds rate on target, as we’ve seen for the last 6 months
or so.

While much of this FOMC wasn’t around in 2002-2003, several members were.

Back to September 2007. The FOMC was concerned enough about ‘market functioning’ to act, They saw credit spreads widening, and in particular the fed funds/libor spread was troubling as it indicated their own member banks were pricing each other’s risk at higher levels than the FOMC wanted. If they had a clear, working knowledge of monetary ops and reserve accounting, they would have recognized that either the discount window could be ‘opened’ by cutting the rate to the fed funds rate, removing the ‘stigma’ of using it, and expanding the eligible collateral. (Alternatively, the current TAF is functionally the same thing, and could have been implemented in September as well.)

Instead, they cut the fed funds rate 50 bp, and left the discount rate above it, along with the stigma. and this did little or nothing for the FF/LIBOR spread and for market functioning in general.

This was followed by two more 25 cuts and libor was still trading at 9% over year end until they finally came up with the TAF which immediately brought ff/libor down. It didn’t come all the way down to where the fed wanted it because the limited the size of the TAFs to $20 billion, again hard evidence of a shortfall in their understanding of monetary ops.

Simple textbook analysis shows it’s about price and not quantity. Charles Goodhart has over 65 volumes to read on this, and the first half of Basil Moore’s 1988 ‘Horizontalists and Verticalsists’ is a good review as well.

The ECB’s actions indicate they understand it. Their ‘TAF’ operation set the interest rate and let the banks do all they wanted, and over 500 billion euro cleared that day. And, of course- goes without saying- none of the ‘quantity needles’ moved at all.

In fact, some in the financial press have been noting that with all the ‘pumping in of liquidity’ around the world various monetary
aggregates have generally remained as before.

Rather than go into more detail about monetary ops, and why the CB’s have no effect on quantities, suffice to say for this post that the Fed still doesn’t get it, but maybe they are getting closer.

So back to the point.

Major themes are:

  • Weakness due to low govt budget deficit
  • Inflation due to monopolists/price setters hiking price

And more recently, the Fed cutting interest rates due to ‘market functioning’ in a mistaken notion that ff cuts would address that issue, followed by the TAF which did address the issue. The latest announced tafs are to be 30 billion, up from 20, but still short of the understanding that it’s about price, not quantity.

The last four months have also given the markets the impression that the Fed in actual fact cares not at all about inflation, and will only talk about it, but at the end of the day will act to support growth and employment.

Markets acknowledge that market functioning has been substantially improved, with risk repriced at wider spreads.

However, GDP prospects remain subdued, with a rising number of economists raising the odds of negative real growth.

While this has been the forecast for several quarters, and so far each quarter has seen substantial upward revisions from the initial forecasts, nonetheless the lower forecasts for Q1 have to be taken seriously, as that’s all we have.

I am in the dwindling camp that the Fed does care about inflation, and particularly the risk of inflation expectations elevating which would be considered the ultimate Central Bank blunder. All you hear from FOMC members is ‘yes, we let that happen in the 70’s, and we’re not going to let that happen again’.

And once ‘markets are functioning’ low inflation can again be translated via market forces into optimal employment and growth, thereby meeting the dual mandate.

i can’t even imagine a Fed chairman addressing congress with the reverse – ‘by keeping the economy at full employment market forces will keep inflation and long term interest rates low’.

Congress does not want inflation. Inflation will cost them their jobs. Voters hate inflation. They call it the govt robbing their
savings. Govt confiscation of their wealth. They start looking to the Ron Paul’s who advocate return to the gold standard.

That’s why low inflation is in the Fed’s mandate.

And the Fed also knows they are facing a triple negative supply shock of fuel, food, and import prices/weak $.

While they can’t control fuel prices, what they see there job as is keeping it all a relative value story and not ‘monetizing it into an
inflation story’ which means to them not accommodating it with low real rates that elevate inflation expectations, followed by
accelerating inflation.

There is no other way to see if based on their models. Deep down all their models are relative value models, with no source of the ‘price level.’ ‘Money’ is a numeraire that expresses the relative values. The current price level is there as a consequence of history, and will stay at that level only if ‘inflation expectations are well anchored.’ The ‘expectations operator’ is the only source of the price level in their models.

(See ‘Mandatory Readings‘ for how it all actually works.)

They also know that food/fuel prices are a leading cause of elevated inflation expectations.

In their world, this means that if demand is high enough to drive up CPI it’s simply too high and they need to not accommodate it with low real rates, but instead lean against that wind with higher real rates, or risk letting the inflation cat out of the bag and face a long, expensive, multi year battle to get it back in.

They knew this at the Sept 18 meeting when they cut 50, and twice after that with the following 25 cuts, all as ‘insurance to forestall’ the possible shutdown of ‘market functioning’.

And they knew and saw the price of this insurance – falling dollar, rising food, fuel, and import prices, and CPI soaring past 4% year over year.

To me these cuts in the face of the negative supply shocks define the level of fear, uncertainty, and panic of the FOMC.

It’s perhaps something like the fear felt by a new pilot accidentally flying into a thunderstorm in his first flight in an unfamiliar plane without an instructor or a manual.

The FOCM feared a total collapse of the financial structure. The possibility GDP going to 0 as the economy ‘froze.’ Better to do
something to buy some time, pay whatever inflation price that may follow, than do nothing.

The attitude has been there are two issues- recession due to market failure and inflation.

The response has been to address the ‘crisis’ first, then regroup and address the inflation issue.

And hopefully inflation expectations are well enough anchored to avoid disaster on the inflation front.

So now with the TAF’s ‘working’ (duh…) and market functions restored (even commercial paper is expanding again) the question is what they will do next.

They may decide markets are still too fragile to risk not cutting, as priced in by Feb fed funds futures, and risk a relapse into market dysfunction. Recent history suggests that’s what they would do if the Jan meeting were today.

But it isn’t today, and a lot of data will come out in the next few weeks. Both market functioning data and economic data.

Yes, the economy may weaken, and may go into recession, but with inflation on the rise, that’s the ‘non inflationary speed limit’ and the Fed would see cutting rates to support demand as accomplishing nothing for the real economy, but only increasing inflation and risking elevated inflation expectations. The see real growth as supply side constrained, and their job is keeping demand balanced at a non inflationary level.

But that assumes markets continue to function, and the supply side of credit doesn’t shut down and send GDP to zero in a financial panic.

With a good working knowledge of monetary ops and reserve accounting, and banking in general that fear would vanish, as the FOMC would know what indicators to watch and what buttons to push to safely fly the plane.

Without that knowledge another FF cut is a lot more likely.

more later…

warren

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Payrolls

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On Jan 4, 2008 10:43 AM, Mike wrote:

> Warren, right now economic sectors in stock mkt are pricing in a severe
> recession-your call on no recession is extremely out of consensus now-I
> think that mkt has overdone the recession theme short term…

Agreed!

We may get to 0 or negative growth for a quarter or so, but probably not due to financial sector losses, ‘market functioning’ issues, or housing related issues.

More likely if it happens it will be a fall off in exports or something like that.

Also, the Fed can’t talk about it, but it knows it’s way behind the inflation curve due to fears of ‘market functioning.’ Their concern now turns to the ‘insurance premium’ they paid- food, fuel, $/import prices.

ISM service just came out- solid number.

Orders and employment strong, prices strong.

And in today’s employment number service sector jobs expanded faster than the rest fell, so q4 remains ok at 2% or so, and q1 still looks up.

I still see GDP muddling through (assuming exports hold up), and upward price pressures continuing indefinately as Saudis/Russians keep hiking.

Saudi production numbers due out for Dec any day. That’s the best indicator we have for whether demand is holding up at current prices.

warren
> Mike

Yes, a weak number for sure, though probably as expected by those originally looking for negative growth for the entire quarter.

And only a few months ago a negative employment number was revised to a strong up number.

And unemployment is also a lagging indicator, reflecting the weakness of several months ago.

Service sector added 93,000, other sectors lost, so employment continues its multi year shift.

And, however weak demand may have been, from the Fed’s point of view it was still strong enough to further drive up food/fuel/import prices.

3 mo libor down again and now about 75 bps lower than August in absolute terms, and spread to ff falling and way down from the wides, cp starting to expand, and most everything indicating market functioning returning and financial conditions easing..

The Fed views this as an ‘ease’ the same way it viewed the reverse as a ‘tightening’ when it cut 50.

Even write down announcements have subsided with less than 100 billion in write offs announced so far. In 1998, for example, $100 billion was lost the first day due to the Russian default, with no prospect of recoveries. That’s probably equiv to a 300b initial loss today.

Also heard this statement on CNBC: current oil prices mean $4 gasoline at the pump, and that will cut into consumer spending so the Fed has to cut rates to keep us out of recession.

That’s exactly what the Fed doesn’t want to happen- they call that monetizing a negative supply shock and turning a relative value story into an inflation story.

With the return of ‘market functioning’ the risks to growth change dramatically for the Fed.

They are now far less concerned about ‘the financial system shutting down’ and instead can now get back to their more familiar discussion of the long term relation between inflation and growth when making their decisions.

A fiscal package is being discussed to day by Bernanke, Paulson, and Bush. That would also reduce the odds of a Fed cut.

With their belief that fiscal is for the economy and monetary policy for inflation, the mainstream might prefer to see a fiscal response to support gdp rather than an inflation inducing rate cut to support growth.

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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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Bernanke, King Risk Inflation to Extend Growth Party

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

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

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

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

Bernanke, King Risk Inflation to Extend Growth Party

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

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

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

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

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

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

Hoarding Cash

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

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

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

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

‘Recoupling’

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

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

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

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

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

Complementary Medicine

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

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

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

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

Consumer Prices

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

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

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

Inflation Challenge

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

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

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

European Growth

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

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

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

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A very British bubble for Mr Brown

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A very British bubble for Mr Brown

Leader
Sunday December 16 2007
The Observer

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

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

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

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

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

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

What is a ‘cash drought’???

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

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

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

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

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

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

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

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

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

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

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

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

Small businesses can’t get credit and fold.

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

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

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

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

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

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

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

Fallout shelters?

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

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

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

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

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

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

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

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

Banning CNBC would help out a lot!

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

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

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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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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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