More Fed Watching, The Dilemma of August 8

In the post of July 5, After The June Hikes, What Next?, we wrote "unless the second quarter GDP data clearly show a significant slowdown in growth (say below 3%), the balance of risks, in my view, still suggests further 25 basis-point rises in policy rates by the Fed."

In the post of May 25, Inflation, Interest Rates, And Short-Term Market View, we wrote “We may be headed for a period of stagflation, or at least slowing growth and stubborn inflation in the next six months, possibly very slow growth or a mild recession in 2007”.

In the event, the 2^nd quarter GDP growth data came in at 2.5%, apparently lowering the probability of an August hike, but even core inflation, the narrow gauge that the Fed officially touts as its most watched (the so-called personal consumption expenditure minus food and energy), accelerated to 2.9%.

The dollar weakened against the euro, apparently because of the higher probability of a pause in the US and expectations of further hikes in the eurozone. The stock market rallied, also on renewed expectations of a pause, or even an end to the tightening cycle, and the bond market rallied, in part on expectations that a slowdown will, in and of itself, help to cool inflation.

But again, the dollar weakened, the yield curve is noticeably inverted, inflation is stubborn, and consumers, along with the government, are still heavily indebted.

The dilemma the Fed faces is, on the one hand, to what extent to i) recognize real inflation – i.e. the rise in prices of what real human beings actually need, like food, energy, housing, healthcare, and education –, risking what may prove to be a sharp, but healthy, slowdown or recession, and ii) prop up the dollar, or, on the other hand, to prop up the stock market and possibly the real estate market, rolling over, or at least sustaining, the asset price bubble in an attempt to keep consumers feeling good while the government pursues overseas energy wars.

The purported high productivity of the US economy alone is not enough to solve this dilemma. At some point, this productivity must be put to the test in the face of high levels of international competition and the ongoing energy war.

Diffusion and Darkness

(written on July 6, 2005)

It took some ten thousand years for agriculture to spread across the face of Eurasia and about another 1500 to spread to the Americas, as humans emerged from hunting and gathering, mostly like through chance observances of what happened when they dropped seeds in one place or another, leaving the area in the fall and returning in the spring.
When agriculture became consolidated in ancient civilization, nobles and kings pursued hunting as a sport, at times banning all others from pursuing it.

It has taken industrialization some two-hundred fifty years to spread across the face of the globe.
For some years now, people in the early industrialized countries – like retirees who worked all their lives in factories or, more likely, offices – pursue traditional agriculture (gardening) as a sport or hobby.

Now with the emergence of China, India and others as industrial powers, the headstart enjoyed by the early industrialized countries of Europe and their main colonial offspring is being overcome.

It may be the case one day, perhaps soon, that people in the early industrialized countries will pursue industrial enterprises as a hobby or sport, or at least they may attempt to do so for a while, sitting on their wealth.

Through the various stages of hunting & gathering, nomadism, agriculture and industrialization, vestiges, as well as significant groups, representing each stage remain, and in the midst of it all there have been wars, barbarians waiting at the gates, plunging the various civilizations into a dark age.

Europe, for example, has not yet recovered psychologically and spiritually from its two civil wars in the Twentienth Century – and it may never do so for as long as Tietmeyer says "No!".

Of course another dark age is still possible as the early industrialized nations compete with the newly industrialized nations for control over energy resources and with the nations that sit atop the main geological/geographical locations of one of the main such resources still in use today.

A serious world energy summit would be auspicable, but for the moment corporate and nationalist egoism still rules the day. Meanwhile, the barbarians still wait at the gates.

A Foursome On European Monetary Union

I repropose here a series of four articles I wrote just over a year ago on the European economy and European Monetary Union at a time when economic growth was basically flat, as it has been in some European countries, especially Italy, for almost a decade. Most recently, however, the pace of growth seems to have picked up.
Nevertheless, if the US goes into recession towards the latter part of 2006 or into 2007, then we will have a chance to witness a real first test of the robustness of the European economy and monetary union and its energy relationship with Russia, even against the backdrop of the latest flair up in the decades-long war in the eastern Mediterranean (and don't think that this has had no impact on Europe, especially the Mediterranean Europan countries).

Here goes.

mercoledì, 01 giugno 2005

1. Something Has To Give

Sandwiched between the competitive forces converging upon them from Asia and across the Atlantic, the Europeans paint themselves into a corner with contradictory economic and social policies. The French rejection of the proposed EU constitution, itself absurd as far as Constitutional documents ought to go, is an expression of utter confusion as how to lead and act in the face of demographic and social stagnation while major portions of the rest of the world industrialize, erasing the two-century or so headstart that the Europeans had.

Now there are reports of German leaders talking about trashing the euro as a failed experiment, acknowledging growth and inflation differentials across eurozone countries.

Something has to give and perhaps competitive devaluations are a less worse solution than contradiction and utter confusion, than subliminal slow decline, unperceptible to the majority of citizens because blinded by the spectacle posed to them by the two-headed monster, i.e. the contrived spectacle of petty party politics.

Many energetic, talented good-willed people would have given their hearts and souls, while still in their precious youth, to forming new economically and culturally creative enterprises on European soil.

But in the event they didn't.

Because the two-headed monster, affectionately known as Teitmeyer, said, "No".

venerdì, 03 giugno 2005

2. Something Has To Give II: future of euro

Italian labour minister Roberto Maroni added his voice to figures in Europe casting doubt on the utility of the euro going forward.

While actual scrapping of the euro is unlikely, these latest statements are tantamount to acknowledgment, at least to some extent, that the structural rigidities of the European economy are unsustainable.

The question is: will this acknowledgment spread to more senior figures among the ruling classes in Europe?

I'm going to ask Tietmeyer. And I bet you I know what Tietmeyer will say.

Tietmeyer will say, "No!"

martedì, 07 giugno 2005

3. Another Useless Mouth

European Central Bank governor Trichet says Europe needs reforms to grow.

Thanks.

His and other useless mouths of overpaid bureaucrats have been uttering this and similar platitudes in various European countries for some fifteen years now.

Europe does not need another several years of the same useless mouths repeating platitudes like "Europe needs reforms to grow".

Europe needs a dynamic, creative, courageous, forward-looking ruling class that talks less and actually implements reforms.

But even this is easy to say.

And Tietmeyer still says, "No!".

mercoledì, 22 giugno 2005

4. The Real Meaning of European Monetary Union

The recent back and forth between Chirac and Blair, Shroeder and Blair only serves to confirm what we already knew about monetary union in Europe back in 1997.

Back then we wrote ... "The purpose of monetary union in Europe is to give the ruling classes of Europe more time to manage some of the underlying fundamental moral and economic problems. There is no question of resolving them as a result of EMU, but just to give more time to manage them in the hope that some solution may evolve, assuming of course that the ruling classes even pose themselves the question or attempt to actually resolve them. History shows that this is not a given."

Indeed, politicians can be great actors, building merely their own careers and leaving it at that.

In the meantime, the best creative energies of millions of wide-eyed young people have been sapped away.

And Tietmeyer still says "No!".

More On Gold And The Global Economy

You asked me to review the article Why Gold Will Break All Records (http://www.egoli.com.au, weekly feature).

Overall the article has merit because it gives a balanced view between some of the fundamentals that may be underlying the bull market in gold and the speculative element (the emergence of ETFs).

From the point of view of a speculative investor, there are indeed strong fundamental arguments in favor of a long-term bull run in gold, but it remains a bet that could go either way.

From the point of view of an economist, the "gold is gold is gold" argument doesn't convince. Sometimes a piece of wood or a sheet of paper or a ceramic shard is worth more than gold, and sometimes other metals are worth more than gold.

Gold is as much a fiat measure of value as paper currencies or as electronic accounting systems: it is valuable because people view it as valuable; there is no "intrinsic" value in gold or in anything for that matter. And while it might be conceivable that the gold price would determine the allocation of resources for, say, big energy infrastructure investments around the world, it could be as, more, or less practicable in comparison to any other system – even war – depending on its design and its enforceability. In the case of war as the determinant of the allocation of investment in international energy infrastructure, I think there may be commodities other than gold which are more valuable. Nonetheless, they could still conceivably be priced in gold, but then the focus of the war effort may shift to seizing the sources of gold, not energy. I think the global human community is facing a different problem. Perhaps we should design our "monetary" system based on units of energy.

A few quibbles. The article states that "more and more imports have flooded into the US while fewer exports have left its shores": not true. The volume of US exports is at all time highs and the US is the number one exporting nation. The problem is that it is also the number one importing nation to the tune of an around 7% trade deficit measured against GDP.

Also, I reiterate a point on inflation. The flood of Chinese imports has kept inflation down in terms of incidental consumer goods, those which account for most of the official CPI, but US inflation of domestic assets and services, like housing, healthcare and education, has been sky-rocketing, and little effective has been done to address it; the current cycle of interest rate rises may arguably be timid and may prove to be like shaking a stick at a tidal wave: credit and prices of non-exportables are out of control, though of course this is to some extent related to international linkages.

Nonetheless, the competitiveness of US manufacturing, both in high-tech fields and possibly also in lower rungs of the technology chain once again in the future, as well as the overall productivity of the US economy, cannot be easily dismissed. On the other hand, however, these real and potential strengths may be nullified by some of the recent blunders in domestic economic policy (too easy credit for too long, for example, leading to the gross misallocation of resources, both human and material, flooding out real, productive investment domestically, not to mention the social implications of a debt-burdened, fast-declining middle class) and domestic and international energy policy, in no small way contributing to the current global political tensions and the depletion of country's fiscal reserves, among other things.

In short, the US economy is operating on an unsustainable consumption and energy model, a significant contributor to the several imbalances in the global economy and the tension in the global political community. One offshoot of this situation may be a speculative bull run in gold prices as fiat currency systems lose their credibility as instruments for determining the peaceable allocation of resources around the globe. The speculator will focus on the former, the economist, perhaps, on the latter.

On Proper Monetary Policy

Investments must stand on their own merits and not fly high on overdoses of money supply.

Governor Kohn Indicates Higher Interest Rates, Lower Real Estate Prices

Today the Vice Chairman of the Federal Reserve Board, Donald L. Kohn, offered remarks at the European Economics and Financial Centre Seminar, House of Commons, London, England, entitled Reflections on Globalization and Policies.

http://www.federalreserve.gov/boarddocs/speeches/2006/20060706/default.htm

As is often the case, the language is hard to decipher for a non-economist, but my take is that the Governor is indicating higher interest rates and lower real estate prices going forward, highlighting

in my view, asset prices on the one hand, and the dollar, inflation and interest rates, on the other.

Here are quotes from his remarks mentioning these variables (the bold type is mine).

1) Mention Of Asset Prices

a) "Various asset markets have experienced rather sharp fluctuations in prices in recent decades, some of which have threatened disruption in the United States and have contributed to sluggish growth elsewhere, as in Japan following the real estate boom and bust; we certainly cannot rule out the possibility of further sharp asset price movements as product prices and spending adjust."

b) "Sound public policies ... can contribute by facilitating needed adjustments in spending, production, and relative prices and by taking steps to foster strong, flexible product and financial markets that are resilient to more abrupt changes in asset prices and spending patterns, cushioning the effect of any such fluctuations on output and product prices."

c) "By ensuring that financial institutions are adequately capitalized and are managing risks well, and are in general well prepared to deal with major changes in asset prices, they are in a better position to weather any necessary changes in policy settings.”

2) The Dollar, Inflation, And Interest Rates

a) "Continued strong demand for dollar assets will be critical to keeping that unwinding smooth and not disruptive."

b) "The lesson from the 1970s, however, is that an unchecked or permanent increase in inflation would only feedback adversely on demand for dollars. Such an unmooring of the anchor of price stability could only elevate the odds on abrupt changes in interest rates and asset prices, instability in the US economy, and disorder in global adjustments."

In short, the Fed, along with many other observers, knows that debt-based spending in the United States, both private and government, cannot continue. One way out, the Fed hopes, is that investment and consumption demand will pick up in the rest of the world, allowing US exports to increase, by virtue of the productivity and saving in the corporate sector, and that US domestic demand will slow, in part through a downward correction in real estate prices (stock prices may come down, but most likely will continue to fluctuate and even drift upwards since the corporate sector is not so heavily indebted and is highly productive), while at the same time foreigners remain willing to hold US debt paper by virtue of competitive US interest rates.

In his remarks, the Governor is obviously addressing these variables from a long-term point of view. But he also states elsewhere in these same remarks that the long-run consists of series of short-runs. So, in my view, these remarks are further evidence that we can expect at least two or three more rate hikes by the Fed in the next three or four meetings, and that the downward pressure on the real estate market will continue, perhaps with some abrupt drops in several regions of the country in the next six to eighteen months, even as economic growth slows to a pace more in line with real productivity growth, and no longer inflated by excessive debt-based spending.

After The June Hikes, What Next?

Any doubts during the interim between the previous two FOMC meetings about what the Fed might do were resolved by what appears to have been a coordinated series of hawkish statements by various Board members in the remaining weeks before the late-June meeting, making the result a foregone conclusion, sending stock markets into a tailspin and buoying the dollar, staying afloat at the lower end of its current 1.25-1.29 range against the euro, even as long-term rates surged ahead to the 5.20 level and beyond.

Buy The Rumor, Sell The Fact

In the event, the Fed once again raised policy rates one one-quarter of a point, and the markets reacted with a stock market rally, firmer bond prices, sending the long-term rate back down to around 5.12, while the dollar shot back down to the upper part of its current range against the euro. I interpret this as the stock market with a dovish interpretation of the FOMC statement explaining the policy action, profit-taking on the bond market and, perhaps most significantly, caution on the part of currency market participants concerned about the twin deficits in case of a pause at the next meeting or meetings.

In the most recent days, however, stock markets are back in the red, at least in Europe with the US slowed by a holiday-shortened week, the long-term rate has inched back up to around 5.15%, while the dollar is in the middle part of its range against the euro.

For some months now, the Fed has clearly indicated that policy going forward will be data dependent. Now, in this blog I have already addressed the issue of the quality of the inflation data, and GDP data for the second quarter has not been released yet, though the Fed certainly has a more up-to-date picture than most other market participants. In the end, the stock market enthusiasm may prove to be pre-mature, or perhaps the move up has been more profit-taking on short positions rather than expectations of faster corporate earnings growth going forward based on fundamentals.

In the United States, some are seriously concerned about the possibility of higher inflation combined with not only a slowdown, but even a recession, perhaps prompted by excessive tightening by the Fed, but more so because of the weight of excess debt. Others argue, on the other hand, that despite the high debt levels (both private and government, reflected in the gaping trade deficit), the situation is under control by virtue of the high productivity of the US economy and so the expectation that the debt can be overcome in the medium/long-term through growth, with some slowdown now, followed by renewed acceleration later.

So the Fed must do a tight-rope walk at high altitude, seeking a balance between maintaining the value of the dollar in the face of high levels of debt supported to a large extent by foreign purchases of treasury securities, on the one hand, and economic growth on the other, equally in the face of high levels of debt supported, however, by what probably still is the most productive, or at least the most efficient, economic system in the world in terms of the production and distribution of goods and services.

Depending on the second quarter GDP data, then, and indications that the Fed may have at mid-third quarter, the monetary authority may indeed risk a pause at the FOMC meeting scheduled for August 8 when many people are on vacation. But it may also prove to be too risky, in the face of real inflation, especially at a time when currency markets are relatively thin.

So, once again, unless the second quarter GDP data clearly show a significant slowdown in growth (say below 3%), the balance of risks, in my view, still suggests further 25 basis-point rises in policy rates by the Fed.