Comments on Bernanke speech

Although economic growth slowed in the fourth quarter of last year from the third quarter’s rapid clip, it seems nonetheless, as best we can tell, to have continued at a moderate pace.

Q4 GDP seen as ‘moderate’ – that is substantially better than initial expectations of several weeks ago.

Recently, however, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced.

They initially said this for Q3 and for Q4.

Notably, the demand for housing seems to have weakened further, in part reflecting the ongoing problems in mortgage markets.

Maybe, but even if so, housing is now a much smaller influence on GDP.

In addition, a number of factors, including higher oil prices,

Yes, this slows consumer spending on other items, but oil producers have that extra income to spend, and if they continue to do so, GDP will hold up and exports will remain strong.

lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008.

The fed has little if any evidence those last two things alter consumer spending.

Financial conditions continue to pose a downside risk to the outlook for growth.

Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future. On the whole, despite improvements in some areas, the financial situation remains fragile, and many funding markets remain impaired. Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses.

Yes, his main concern is on the supply side of credit. With a floating fx/non convertible currency, there is a very low probability. Even Japan with all its financial sector problems was never credit constrained.

Debilitating credit supply constraints are byproducts of convertible currency/fixed fx regimes gone bad, like in the US in the 1930s, Mexico in 1994, Russia in 1998, and Argentina in 2001.

I expect that financial-market participants–and, of course, the Committee–will be paying particular attention to developments in the housing market, in part because of the potential for spillovers from housing to other sectors of the economy.

A second consequential risk to the growth outlook concerns the performance of the labor market. Last week’s report on labor-market conditions in December was disappointing, as it showed an increase of 0.3 percentage point in the unemployment rate and a decline in private payroll employment. Heretofore, the labor market has been a source of stability in the macroeconomic situation, with relatively steady gains in wage and salary income providing households the wherewithal to support moderate growth in real consumption spending. It would be a mistake to read too much into any one report.

Right, best to wait for the revisions. November was revised to a decent up number, and October was OK as well. And today’s claims numbers indicate not much changed in December.

However, should the labor market deteriorate, the risks to consumer spending would rise.

Yes, if..

Even as the outlook for real activity has weakened,

Yes, the outlook has always been weakening over the last six months, while the actual numbers subsequently come in better than expected. Seems outlooks are not proving reliable.

there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well.

Interesting that he mentions upward pressure on core – must be in their forecast. It took them a long time to get core to moderate, and even in August they did not cut as upward risks remained.

Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored,

They have very little information on this. They only know when they become unglued, and then it is too late.

and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future.

Meaning once they go, it is too late.

Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

The fed has no credibility here. Markets ignore this, and the financial press does not even report it.

Monetary policy has responded proactively to evolving conditions. As you know, the Committee cut its target for the federal funds rate by 50 basis points at its September meeting and by 25 basis points each at the October and December meetings. In total, therefore, we have brought the funds rate down by a percentage point from its level just before financial strains emerged. The Federal Reserve took these actions to help offset the restraint imposed by the tightening of credit conditions and the weakening of the housing market. However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary.

Reads a bit defensive to me.

The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.

This was to come out at 1PM, instead it was released at noon.

This seems they meant to send a signal that they are ready to go 50.

It may take another 0.3% core CPI number, low claims numbers, and further tightening of the FF/LIBOR spread to get them to think twice about not cutting.

Their fixed fx paradigm supply side fears elevates their perception of the downside risks.


♥

January 2008 update

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.

Bernanke, King Risk Inflation to Extend Growth Party

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.


Friday mid day

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.


Calories, Capital, Climate Spur Asian Anxiety

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

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

:(

Calories, Capital, Climate Spur Asian Anxiety

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

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

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

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

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

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

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

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

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

Carbon Emissions

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

That isn’t all.

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

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

This doesn’t augur well for the environment.

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

Beijing Olympics

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

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

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

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

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

Capital Inflows

Take India’s example.

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

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

Naturally, exporters are complaining.

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

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

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

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

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

–Editors: James Greiff, Ron Rhodes.

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

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


it’s about price, not quantity

It’s about price, not quantity.

CB’s don’t alter net reserve positions – they ‘offset operating factors’ and set interest rates.

Fed to redeem $14.02 bln of bill holdings Dec. 27

Thu Dec 20, 2007 11:20am EST

NEW YORK, Dec 20 (Reuters) – The U.S. Federal Reserve said on Thursday it will redeem the full amount of maturing Treasury bill holdings, amounting to $14.02 billion on Dec. 27.

The redemption, a move to drain liquidity from the banking system, will take place via the Federal Reserve’s System Open Market Account or SOMA.

“The Federal Reserve Open Market Trading Desk will continue to evaluate the need for the use of other tools, including further
Treasury bill redemptions, reverse repurchase agreements and Treasury bill sales,” the Fed said in a statement on the New York Fed’s Web site. (Reporting by John Parry; Editing by James Dalgleish)


Libor rates & spreads: down in GBP & EUR, stable in US

Thanks, Dave, my thought are the Fed will also ‘do what it takes’ which means setting price and letting quantity for term funding float.

The ECB doing 500 billion without ‘monetary consequences’ beyond lowering the term rates should have been no surprise to anyone who understands monetary ops, and confirmation of same for those central bankers who may have needed it demonstrated.


Libor rates; no surprises, most of them are down, especially in longer expiries (3mth+) -see table below-. GBP3m -18bp helped by yesterday’s auction. EUR 3m -4.75bp and probably more tomorrow.

Libor spreads.- In 3mth -spot- rates, sharp declines in EUR (-6bp to 78bp) and GBP (-14bp to 76bp) while the US spread remains fairly stable at 80.3bp (-1bp).

It seems the BoE and ECB have taken bolder actions to provide liquidity (see this morning’s message on the ECB LTRO). Let’s see the results of the 1st $20bn TAF later today.

19-Dec
Libor Rate
18-Dec
Libor Rate
Change in
% Points
18-Dec
Libor
17-Dec
Libor
Change in
% Points
USD Overnight 4.34500% 4.40000% -0.05500% 4.40000% 4.41750% -0.01750%
USD 1 Week 4.38875% 4.38625% 0.00250% 4.38625% 4.36375% 0.02250%
USD 3 Month 4.91000% 4.92625% -0.01625% 4.92625% 4.94125% -0.01500%
USD 12 Month 4.41750% 4.47188% -0.05438% 4.47188% 4.51875% -0.04687%
EUR Overnight 3.86125% 3.82750% 0.03375% 3.82750% 3.98875% -0.16125%
EUR 1 Week 4.01000% 4.01625% -0.00625% 4.01625% 4.06625% -0.05000%
EUR 3 Month 4.80125% 4.84875% -0.04750% 4.84875% 4.94688% -0.09813%
EUR 12 Month 4.80250% 4.80750% -0.00500% 4.80750% 4.88313% -0.07563%
GBP Overnight 5.58750% 5.59750% -0.01000% 5.59750% 5.59750% 0.00000%
GBP 1 Week 5.61125% 5.63250% -0.02125% 5.63250% 5.64125% -0.00875%
GBP 3 Month 6.20563% 6.38625% -0.18062% 6.38625% 6.43125% -0.04500%
GBP 12 Month 5.88000% 5.94500% -0.06500% 5.94500% 5.96375% -0.01875%

Re: liquidity or insolvency–does it matter?

(email with Randall Wray)

On Dec 15, 2007 9:05 PM, Wray, Randall wrote:
> By ________
>
> This time the magic isn’t working.
>
> Why not? Because the problem with the markets isn’t just a lack of liquidity – there’s also a fundamental problem of solvency.
>
> Let me explain the difference with a hypothetical example.
>
> Suppose that there’s a nasty rumor about the First Bank of Pottersville: people say that the bank made a huge loan to the president’s brother-in-law, who squandered the money on a failed business venture.
>
> Even if the rumor is false, it can break the bank. If everyone, believing that the bank is about to go bust, demands their money out at the same time, the bank would have to raise cash by selling off assets at fire-sale prices – and it may indeed go bust even though it didn’t really make that bum loan.
>
> And because loss of confidence can be a self-fulfilling prophecy, even depositors who don’t believe the rumor would join in the bank run, trying to get their money out while they can.

If there wasn’t credible deposit insurance.

>
> But the Fed can come to the rescue. If the rumor is false, the bank has enough assets to cover its debts; all it lacks is liquidity – the ability to raise cash on short notice. And the Fed can solve that problem by giving the bank a temporary loan, tiding it over until things calm down.

Yes.

> Matters are very different, however, if the rumor is true: the bank really did make a big bad loan. Then the problem isn’t how to restore confidence; it’s how to deal with the fact that the bank is really, truly insolvent, that is, busted.

Fed closes the bank, declares it insolvent, ‘sells’ the assets, and transfers the liabilities to another bank, sometimes along with a check if shareholder’s equity wasn’t enough to cover the losses, and life goes on. Just like the S and L crisis.

>
> My story about a basically sound bank beset by a crisis of confidence, which can be rescued with a temporary loan from the Fed, is more or less what happened to the financial system as a whole in 1998. Russia’s default led to the collapse of the giant hedge fund Long Term Capital Management, and for a few weeks there was panic in the markets.
>
> But when all was said and done, not that much money had been lost; a temporary expansion of credit by the Fed gave everyone time to regain their nerve, and the crisis soon passed.

More was lost then than now, at least so far. 100 billion was lost immediately due to the Russian default and more subsequently. So far announced losses have been less than that, and ‘inflation adjusted’ losses would have to be at least 200 billion to begin to match the first day of the 1998 crisis (August 17).

>
> In August, the Fed tried again to do what it did in 1998, and at first it seemed to work. But then the crisis of confidence came back, worse than ever. And the reason is that this time the financial system – both banks and, probably even more important, nonbank financial institutions – made a lot of loans that are likely to go very, very bad.

Same in 1998. It ended only when it was announced Deutsche Bank was buying Banker’s Trust and seemed the next day it all started ‘flowing’ again.

>
> It’s easy to get lost in the details of subprime mortgages, resets, collateralized debt obligations, and so on. But there are two important facts that may give you a sense of just how big the problem is.
>
> First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.

Incomes are sufficient to support the current prices. That’s why they haven’t gone down that much yet and are still up year over year. Earnings from export industries are helping a lot so far.

>
> Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.

Yes, there was a large drop in aggregate demand when borrowers could no longer buy homes, and that was over a year ago. That was a real effect, and if exports had not stepped in to carry the ball, GDP would not have been sustained at current levels.

>
> As home prices come back down to earth, many of these borrowers will find themselves with negative equity – owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

‘Often’? There will be some losses, but so far they have not been sufficient to somehow reduce aggregate demand more than exports are adding to demand. Yes, that may change, but it hasn’t yet. Q4 GDP forecasts were just revised up 2% for example.

>
> And the numbers are huge. The financial blog Calculated Risk, using data from First American CoreLogic, estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.

Not likely if income holds up. That’s why the fed said it was watching labor markets closely.

And government tax receipts seem OK through November, which is a pretty good coincident indicator incomes are holding up.

>
> That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

Enough money funds in particular have decided to not get involved in anyting but treasury securities, driving those rates down. That will sort itself out as investors in those funds put their money directly in banks ans other investments paing more than the funds are now earning, but that will take a while.

>
> How will it all end?

This goes on forever – I’ve been watching it for 35 years – no end in sight!

> Markets won’t start functioning normally until investors are
> reasonably sure that they know where the bodies – I mean, the bad
> debts – are buried. And that probably won’t happen until house prices
> have finished falling and financial institutions have come clean about
> all their losses.

And by then it’s too late to invest and all assets prices returned to ‘normal’ – that’s how markets seem to work.

> All of this will probably take years.
>
> Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed.

Right, only a fiscal response can restore aggregate demand, and no one is in favor of that at the moment. A baby step will be repealing the AMT and not ‘paying for it’ which may happen.

Meanwhile, given the inflationary bias due to food, crude, and import and export prices in genera, a fiscal boost will be higly controversial as well.


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UK Inflation expectations rise

Sends a chill up the spine of any red blooded mainstream central banker!

Inflation expectations rise

Thu Dec 13, 2007 9:37am GMT – Britons’ expectations of future inflation rose to hit a series high of 3.0 percent in November, well above the actual rate of inflation, a survey by the Bank of England showed on Thursday.

The central bank’s quarterly survey showed median expectations for the rate of inflation over the coming year picked up from 2.7 percent in August to its highest level since the survey began in 1999.

The survey also showed people’s perception of the current rate of inflation rose to a series high of 3.2 percent, from 2.8 percent in August. The latest official figures showed inflation at 2.1 percent in October, just above the central bank’s 2.0 percent target.

The figures may hamper the Bank of England’s ability to cut interest rates much further, after lowering borrowing costs by 25 basis points to 5.5 percent last week.

Money markets are pricing in three more quarter point cuts before the end of 2008.

Policymakers, who had access to the survey before last week’s rate cut, have expressed concern that inflation expectations have not fallen even though headline inflation has come back to near target.

Inflation hit a series high of 3.1 percent in March.

Expectations of inflation can become self-fulfilling as people are encouraged to demand higher wages, potentially fueling a wage-price spiral.

(c) Reuters2007All rights reserved


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GC Tsy changes post announcment

I’m mainly interested in LIBOR over the turn as an indicator or how the new international facility is doing.

Also watching to see when higher oil means higher inflation and higher rates, vs. higher oil currently meaning econ weakness and lower rates. Maybe next week after this weeks inflation numbers are out.

GC has lost some of it’s flight to quality bid on term repos. The market is higher across terms as a result of the treasury announcement. Expectations of future rate cuts have not been priced out of the market I will follow up shortly with an AGCY and MBS runs.

GC TSY Last Night Now Change
O/N 4.60 4.23 -0.37
1wk 4.12 4.12 0
2wk 4.03 3.95 -0.08
3wk 3.7 3.75 0.05
1mo 3.7 3.76 0.06
2mo 3.68 3.74 0.06
3mo 3.63 3.71 0.08
6mo 3.62 3.67 0.05
9mo 3.52 3.56 0.04
1yr 3.42 3.46 0.04

* 1wk – 2wk seasonal add need “window dressing” balance sheets


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