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Monthly Archives: February 2008

An across-board commodity run

Jim Hamilton is worried about a broad based inflation (see chart), “If it were just a few commodities moving, I wouldn’t be concerned, as any of these prices can be quite sensitive to small disruptions in supply. But we are clearly looking at an aggregate phenomenon here, and it seems unreasonable to suppose that the phenomenon has nothing to do with choices by the Fed”.

He is also suspicious about the effectiveness of the Fed’s rate cuts, “In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good.”

Finally, he hopes Bernanke has “checked out the net that’s supposed to catch him if he falls”.

(click to enlarge, each price was normalized at 100 for January 1)


Allan Meltzer on current monetary policy

Allan Meltzer thinks the Fed reverted to its mistaken behavior in the 70s by being "a handmaiden heholden to political and market players".  I appreciate Meltzer's concern and thinks he's absolutely right to remind us the peril of central bank's tendency to treat inflation as second order to unemployment.  But his criticism to Bernanke seems to me a bit unfair. Bernanke Fed is certainly vigilant on inflation, in my view. The aggressive rate cuts are not indication of Bernanke being dovish on inflation, rather it reflects his view that the current recession could be very severe so it warrants a risk management approach.

That '70s Show

February 28, 2008; WSJ

Is the Federal Reserve an independent monetary authority or a handmaiden beholden to political and market players? Has it reverted to its mistaken behavior in the 1970s? Recent actions and public commitments, including Fed Chairman Ben Bernanke's testimony to Congress yesterday — where he warned of a steeper decline and suggested that more rate cuts lie ahead — leave little doubt on both counts.

An independent central bank is supposed to maintain the value of the currency and prevent inflation. In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten.

People soon recognized that avoiding possible recession overwhelmed any concern about inflation. Many concluded that inflation would increase over time and that the Fed would do little more than talk. Prices and wages fell very little in recessions. The result was inflation and stagnant growth: stagflation.

It's beginning to happen again. Unlike the response of wages and prices in the low inflation 1990s, expectations of rising inflation now delay or stop price and wage adjustment, inhibiting growth.

One lesson of the inflationary 1970s: A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public's complaints about inflation. Instead of paying the relatively small cost of a possible recession, the public pays the much larger cost of sustained inflation and a deeper recession. And enduring the deeper recession is the only way to convince the public that the Fed has at last decided to slow inflation.

Economic forecasts are not very accurate; still, the International Monetary Fund, the Congressional Budget Office and even the Federal Reserve do not forecast recession in 2008. The Fed thinks that the unemployment rate may rise to 5.3%, below the postwar average. In any event, it cannot do much to change economic activity or unemployment experienced in the next few months, and the Fed anticipates stronger growth in the second half of the year. Why the haste to cut interest rates drastically?

The freezing up of short-term financial markets called for more borrowing. The Fed's response was creative and correct. It recognized that its responsibility as lender of last resort required bold action to maintain the payments system; and it delivered.

But the rush to bring real short-term interest rates to negative values is an unseemly and dangerous response to pressures from Wall Street, Congress and the administration. The Federal Reserve became "independent" in 1913 so that it could resist pressures of that kind. And in the postwar years, although it often failed to do so, it was expected to safeguard the purchasing power of our money and maintain economic growth.

For Wall Street, the pressure for lower interest rates is based on a hope that bond and mortgage yields will decline and their losses will be limited. Often long-term rates fall when the Fed lowers short-term rates — and since bond and mortgage prices rise when their rates fall, the losses of investors in these instruments will be reduced. For Congress and the administration, there is a need to show "concern" by doing something in an election year. These are not the concerns that should influence an independent central bank.

Surely Mr. Bernanke and his colleagues remember what happened in the 1970s. They console themselves with the belief that they will respond to any inflation that occurs by promptly raising interest rates. That repeats the commitments made repeatedly in the 1970s, which the Fed was unwilling to keep. The blunt fact is that there is rarely a popular time to raise interest rates. And with the growing streak of populism in the country, it will become more difficult.

The Fed's recent behavior is in sharp contrast to the European Central Bank. The ECB keeps its eye on both objectives, growth and low inflation. It doesn't shift back and forth from one to the other. The Fed should do the same. In the 1970s, because the Fed shifted from one goal to the other and back again, it achieved neither. Both inflation and unemployment rose on average, then fell together in the 1980s — after the Fed controlled inflation.

After 1985, Fed policy kept inflation and unemployment low. The result was 20 years of growth, and three of the longest peacetime expansions punctuated by short recessions.

We should not throw this policy away. Federal Reserve independence is a valuable right which should not be discarded. The Fed should insist on its obligation to prevent inflation and sustain growth, not sacrificing inflation to lower unemployment before the election.

Mr. Meltzer is a professor at Carnegie Mellon and the author of the forthcoming "A History of the Federal Reserve."

Common feature of recent financial crises

Martin Wolf had a wonderful piece on FT, where he summarizes common feature of all recent crises:

All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado. This generates low real interest rates and a widening current account deficit. Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.

Symptom or disease?

Dani Rodrik wrote a quite provocative piece on FT today, “We must curb international flows of capital“. Bill Easterly’s response makes a lot sense to me:

To say that there are crises because of international capital flows is not very meaningful; it is like saying there are recessions because of GDP. Dani and Arvind do not adequately address two big issues on capital flows:

(1) what are the benefits of capital flows? Usually, a voluntary movement of capital signifies a reallocation from a low-return investment to a high-return investment. This raises the rate of return to investment overall, which is usually considered to be a good thing.

(2) To what extent are international capital flow crises the symptom or the disease? They are oftentimes the symptom, so trying to control them to treat macroeconomic imbalances is like treating fevers with ice-baths. Better to confront the underlying imbalances, as Dani and Arvind sensibly recommend in the second half of their column.

No Stagflation

Richard Berner of Morgan Stanley argues convincingly that current fear of stagflation is overblown. He thinks slack of the economy will eventually bring inflation down but it will take some time. So be patient.

Vicious circle in the economy

I learnt the theory of vicious circle in economic development, the situation where people are trapped in poverty and can’t get out of it. It’s hard to imagine the phrase being applied to a rich country like United States. Well, here we go: when US consumers and investors get too complacent with credit and risk, this is what they got.

Housing Cycle Is Caught in Vicious Circle


Economists have a term to describe what it means when things keep going from bad to worse: negative-feedback loop. One day’s problems create a broad set of behaviors that only make the problems worse.


Consider housing. As home prices fall, more families see the values of their homes decline to less than the amount of money they have to pay back on their mortgages. That gives them an incentive to walk away from their mortgages and leave their homes empty, which puts more downward pressure on home prices, drawing more households into the loop.

Housing turmoil, in turn, causes consumers to pull back, hurting the broader economy, which puts more downward pressure on home prices. Banks, worried about mortgages going bad, tighten lending standards, shutting some new buyers out of the market and further depressing home prices.

Negative-feedback loops can be pernicious when an economy depends heavily on borrowed money. Total outstanding household debt rose to $13.6 trillion by the third quarter of 2007 from $7.2 trillion at the beginning of 2001 — a 10% annual growth rate. Mortgage borrowing more than doubled in this stretch. One out of every seven dollars of disposable income earned by Americans now goes toward paying down debt — near a record.

Corporate borrowing was modest for most of the decade, then started rising at double-digit rates in 2006 and 2007, amid a wave of private-equity buyouts and debt-financed share buybacks. Meantime, Wall Street juices returns by making investments with borrowed money.

Yale economist John Geanakoplos’s concept of the leverage cycle shows how negative-feedback loops are driving today’s economy. When times are good, credit is ample, causing the economy to heat up. When the cycle shifts, lenders tighten standards and become more demanding about the collateral they hold, feeding into the negative-feedback loops hitting the economy.

He says shifts in this cycle can happen suddenly, catching investors and policy makers off guard. “When the world seems more uncertain, everyone wants a lot of collateral and the economy goes from highly leveraged to no leverage very quickly,” he says.

“When things go bad, people have to sell assets to raise collateral,” says Gregg Berman, co-head of the risk management unit of RiskMetrics Group. Selling reduces the value of the very assets borrowers have used as collateral against loans — such as homes. “The more leverage is built into the system, the more the cascade effect is magnified,” Mr. Berman says.

Individual banks might be acting rationally when demanding more or better collateral. Trouble is, when every lender does this at once, it becomes self-destructive, triggering shock waves that threaten the banks themselves.

The trick for policy makers is to break the loop. “A macroeconomic downturn tends to diminish the value of many forms of collateral…reinforcing the propagation of the adverse-feedback loop,” Federal Reserve Governor Frederic Mishkin said in a January speech. Aggressive Fed interest-rate cuts help by reducing the cost of all of this borrowing.

The psychology of risk aversion behind these negative loops is hard to alter once it sets in. That is why breaking the chain this time could be harder than anyone expected.

Diverging performance not justified

The author of below wsj article seemed to suggest stock relative to bond is overvalued. I agree current equity market could be overvalued, if you take into consideration of potential earnings declines in a recession environment. But what I do not see is why stock and bond should go in tandem with each other, especially when bond market is in a temporary shock or panic.

Mind the Gap Between Stocks And Bonds


The stock market is peppier than the credit market. One of them might be in denial.

The Dow Jones Industrial Average has fallen about 8% since credit problems first started bubbling up last June, but has rebounded lately as investors bet on a recovery in the second half.


The credit market's pain, meanwhile, has been far deeper and is getting worse. Markit's CDX investment grade index, which tracks the cost of insurance against investment-grade corporate defaults, has swollen more than 330% since June. Spreads on leveraged loans, which are made to companies with junk ratings, are at their worst levels of the crisis, having widened by about 184% since June, according to the Standard & Poor's/LSTA Leveraged Loan Index.

Swap spreads, another measure of risk aversion in credit markets, are pointing in the same direction. Swap spreads are essentially a measure of the difference between buying a safe government bond and making a riskier loan to a bank. The gap widens when lenders are pulling in their horns.

For example, the 10-year swap spread — the gap between 10-year Treasury yields and market rates derived from the London interbank offered rate — has ballooned above three-quarters of a percentage point, what Michael Darda, chief economist at MKM Partners, calls "crisis" territory. The spread hit that level last July and November, heralding credit-market meltdowns and, a little later, stock-market swoons.

That chain of events may not unfold again this time, Mr. Darda suggests, saying stock prices already reflect fairly dismal credit conditions. The Federal Reserve has flooded the system with money, and a viable bond-insurance rescue plan could shrink spreads and improve credit conditions.

The trouble is that neither the Fed nor would-be bond-insurance rescuers can magically make lenders feel giddy about lending money again. Big bubbles tend to end badly, take time to unwind, and claim a lot of victims. That applies to credit bubbles, too.

The credit market could be ringing false alarms. But it could also be foreshadowing more damage yet to come in stocks.

Is China’s Consumption Fire Burning?

This Economist article tries to convince you that Chinese domestic consumption is well on an expansionary path. I agree that the importance of export to China's fast GDP growth has been somewhat exaggerated (as shown in the left side of the graph below), but I remain suspicious (as in right side of the graph) that Chinese real consumption had changed much. The large portion of the nominal change in retail sales, in my view, came from 6.5% inflation last year. Consumption habavior is closely related to underlying economic structure and can only change gradually. So every time you see such a dramatic increase, you want to think twice, no matter what deflator you are using.  In fact, the last dramatic increase was in 2003, and that happens to be the year when Chinese inflation jumped to 3.2% from -0.4% in the previous year.
From Mao to the mall

Feb 14th 2008
From The Economist print edition

Amid all the global gloom, the good news is that China is turning into a nation of spenders, as well as sellers

THE past year has seen a lively debate among economists about China's rapid economic growth. Some, such as Brad Setser from the Council on Foreign Relations, believe that exports have been the main generator; others, like UBS's Jonathan Anderson and The Economist, think that domestic demand—spending on roads and railways, cars and clothes, and the like—has been the driving force. Just now, a lot turns on this argument: both how badly China's economy could be hurt by an American recession and also the extent to which Chinese spending could help to prop up the rest of the world economy. Some new figures suggest Chinese demand is rising strongly enough to help offset the increasing weakness in China's export markets. That could be good news for the world at large.

It is certainly true that China's current-account surplus rose to a record 10% of its GDP last year, which means that it produced a lot more than it consumed and so relied on foreigners to buy the excess. But it is the change in a country's trade surplus, not its absolute size, which matters for GDP growth. The increase in net exports (exports minus imports) has never been the main source of China's growth. It contributed two to three percentage points to annual GDP growth between 2005 and 2007, whereas domestic demand (consumption and investment) added eight to nine percentage points. But the latest figures show that exports have become even less important as a driver of growth. The World Bank's latest China Quarterly Update suggests that net exports contributed only 0.4 percentage points to GDP growth in the year to the fourth quarter of 2007 (see left-hand chart). Overall GDP growth slowed only modestly (to 11.2%) because of faster growth in domestic demand, which contributed an impressive 10.8 percentage points.

The significance of all this is that although China's headline GDP growth is widely tipped to slow to 9-10% in 2008, if a bigger chunk of this growth comes from domestic consumption and investment, then in absolute dollar terms China could well contribute more to global demand this year than in 2007.

Dragonomics, a Beijing-based economics-research firm, forecasts that the contribution of net exports to GDP growth will actually fall to zero during 2008, but this will be partly offset by strong growth in investment and consumption. After growing by an average of $80 billion during each of the past three years, China's trade surplus is likely to remain more or less flat this year. Export growth fell from 28% in the year to the first quarter of 2007 to 22% by the fourth quarter because of weaker American demand and the impact of a stronger yuan.

Meanwhile import growth surged from 18% to 26% on the back of strong industrial and consumer demand. In other words, Chinese imports are now growing faster than exports. China's trade surplus widened by only 12% (in dollar terms) over the year to the fourth quarter, compared with an increase of almost 90% in the first half of last year. This was partly due to higher oil prices that increased the value of imports, but even in inflation-adjusted volume terms the surplus stopped growing in the latter part of last year.

Not only did more of China's growth come from domestic demand late last year, but there were also signs of a “rebalancing” of the economy from investment towards consumption. Using figures from China's National Bureau of Statistics, Mark Williams, an economist at Capital Economics, a London-based research firm, calculates that in 2007 consumption accounted for a bigger slice of GDP growth than investment for the first time in seven years. Government restraints on bank lending caused investment growth to slow slightly, whereas consumer spending picked up. The often-quoted monthly figures on fixed-asset investment still show annual growth of over 20%, but these figures are misleading. Measured on the same national-accounts basis as GDP, to exclude property and land sales, real investment rose by a more modest 11% in the year to the fourth quarter, less than the growth in real consumption.

China's consumer-spending data are notoriously murky. The annual rate of growth in retail sales has surged from 13% in early 2006 to 20% in December of last year (see right-hand chart). Some sceptics argue that this increase is mainly due to a rise in inflation. However, the consumer-price index is not the appropriate deflator because it gives a much higher weight to food (the main source of the recent surge in inflation) than the share of food in total retail sales. Frank Gong, an economist at JPMorgan, argues that using a more appropriate deflator, real spending has clearly accelerated, especially on household goods. One important stimulus is that last year real urban disposable income per head rose faster than GDP for the first time in five years. This should help to keep consumption growing rapidly in 2008.

A growth rate in China driven more by consumption than by exports and investment is exactly what the American government has been demanding for several years. Indeed, it might be hoped that if China's trade surplus stops expanding and consumer demand plays a bigger role in growth, international trade tensions should subside. The snag is that even if net exports were no longer contributing to China's growth, its trade surpluses with America and Europe would continue to loom embarrassingly large. And, says Mr Williams, as Chinese exporters move into higher-value products, they will become more of a threat to Western producers.

In 2008 China will probably suffer its first slowdown in growth for seven years. But strong domestic demand should mean that an American recession would not bring the Chinese economy to a screeching halt. Indeed, to the extent that the economy was starting to overheat, a slowdown will be welcomed by Chinese policymakers. And if almost all of the slowdown comes from net exports, while domestic spending remains robust, then the whole world can cheer, too.