Deflation is a dangerous distraction
– John Kemp is a Reuters columnist. The views expressed are his own –
LONDON, Nov 24 (Reuters) – For the second time in less than a decade, the spectre of deflation is stalking western economies and filling acres of newsprint. But the focus on deflation is based on a misreading of history and risks diverting attention from more pressing problems.
First time around, the mistaken focus on falling prices caused the Federal Reserve to leave interest rates too low too long in 2002-2004, fuelling the surge in U.S. real estate and subprime loans that now threatens to overwhelm the global banking system.
This time, the obsessive focus on deflation threatens to become a distraction from the real problem confronting policymakers: how to stabilise output, employment and home values, rather than worry about marginal and largely theoretical declines in consumer prices that have little impact on the business cycle.
DEFLATION AND ITS DISCONTENTS
There is a fairly widespread consensus among economists and policymakers that the appropriate target for monetary policy is “price stability”.
Like inflation, deflation is problematic because genuine price signals may be lost amid the noise. But there are at least four reasons why economists are especially concerned about a generalised, sustained fall in prices:
Biofuels run into trouble
– John Kemp is a Reuters columnist. The opinions expressed are his own – Despite a promising start, the U.S. experiment with renewable fuels is facing a serious challenge next year. Falling gasoline consumption, lower pump prices and contradictions within the federal government program are intensifying existing pressures on ethanol distillers and farmers already struggling to cope with over-capacity and collapsing margins.
ETHANOL ENTHUSIASM
Between 2000 and 2007, production of fuel ethanol quadrupled from 1.6 billion to 6.5 billion gallons, and the industry is on course to distill a record 9.3 billion gallons in 2008.
Ethanol production is not really economic at oil prices below about $60-70 per barrel (prices of grains and fats for ethanol conversion and processing costs are too high relative to oil). So the original boost to ethanol came from its use as an oxygenating additive in reformulated gasoline, rather than as fuel in its own right, when a number of states banned the use of MTBE.
As oil prices breached $50 in late 2004 and continued to climb steadily higher over the next four years, ethanol’s properties as a fuel suddenly became more attractive. Blenders began to use ethanol as a cheaper (partial) substitute for conventional oil-derived blendstocks in making gasoline.
Prompted by national security concerns and encouraged by lobbyists for the farm sector, U.S. legislators tried to accelerate the use of ethanol by mandating a minimum ethanol content for all gasoline produced or imported into the United States.
The centerpiece of the government’s intervention is the Renewable Fuel Standard (RFS) which sets a steadily increasing minimum volume of ethanol that must be blended into the nationwide gasoline supply each year.
quote: For $100 the auto Industry can make any vehicle a Flex Fuel Vehicle capable of running on Gasoline or any blend of ethanol..
the flex fuel sensor for a GM costs $500, the larger needed injectors cause worse atomization, and less accurate fuel air mixtures. GM gets away with this because it lets the vechile get %20 worse fuel economy. They trade these MPG costs to other vechiles to stay under the cafe cap.
G20 summit shows lack of resolve
–John Kemp is a Reuters columnist. The opinions expressed are his own–
The G20 summit must be considered a disappointing failure, even by the relatively low expectations set for the event. Leaders produced a long agenda of further studies, reports and work, but failed to provide a clear direction or tackle even the most fundamental decisions.
On the key issues, leaders displayed a worrying irresolution. Without unambiguous instructions from the top, discussions between finance ministers and officials will prove protracted and risk getting bogged down in detail. Negotiations between officials can fill in the details; they cannot make the kind of fundamental choices about strategic direction that leaders avoided at the weekend.
A SENSE OF HISTORY
The summit has been bedeviled by comparisons with the Bretton Woods conference in 1944. Intended as a rhetorical device to restore confidence by suggesting governments were taking bold action in an unprecedented spirit of agreement, the ghost of Bretton Woods has raised impossible expectations and distracted both leaders and officials from the real issues facing the global financial system:
(1) The three-week conference at Bretton Woods was the culmination of more than two years of detailed work at official level and more than a decade studying the issues. There was substantial prior agreement about the problem (poorly coordinated monetary and fiscal policies, leading to payment imbalances and protectionism) and the solution (a gold-exchange system, with multilateral surveillance of national policies, and national reserves supplemented by IMF drawing facilities on a conditional basis).
The system was buttressed by a new multilateral development bank to help fund infrastructure and post-war reconstruction, and later by the General Agreement on Tariffs and Trade (GATT) to prevent a slide back into protectionism.
“But too many proposals in the document are either irrelevant or reveal a disinclination to challenge the status quo.”
True enough, Mr Kemp. But have you ever been to a G-7, G-8, G-20, IMF, World Bank etc. meeting where this did NOT apply?
Quantitative easing has begun
– John Kemp is a Reuters columnist. The views expressed are his own –
Quietly, without fanfare, the Federal Reserve has turned on the printing presses. The central bank is flooding the market with enough excess liquidity to refloat the banking system — and hopes to generate an upturn in both economic activity and inflation in the next 12-18 months to prevent the economy falling into a prolonged slump.
Since the banking crisis intensified in September, the Fed has been rapidly expanding the credit side of its balance sheet, providing an ever-increasing array of facilities to support the financial system (repos, term auction credit, primary discount credit, broker-dealer credit, commercial paper funding, money market mutual fund liquidity and term securities lending).
Total credit extended by the central bank has surged from an average of $885 billion in the week ending August 27 to $2.198 trillion in the week ending November 12. Credit extensions surged another $142 billion last week alone — mostly in form of increased term auction credit (+$114 billion) and other miscellaneous credits the central bank does not break out (+$41 billion).
Until fairly recently, the expansion on the asset side of the Fed’s balance sheet was matched by increased non-bank liabilities, mostly in the form of higher balances deposited by the US Treasury into its regular and special supplementary financing accounts at the central bank.
Since the Treasury was borrowing this money in the open market by issuing cash management bills, the impact of the Fed’s balance sheet expansion was being fully sterilized.
The Fed was providing liquidity in the narrow sense (helping commercial banks cover short-term funding problems arising from illiquid assets on their books) but not in the broader sense of inflating the money supply (money in circulation plus vault cash plus reserve balances).
Quantitative easing whereby newly printed notes are handed over to banks in the expectation that bank lending will be revived does nothing to solve the main problem of banking namely defaulting borrowers. The fiscal solution to defaulting borrowers involves giving an annual $1500 housing benefit to all United States citizens in reduction of their toxic bank overdrafts where appropriate, these toxic debts will then cease to be toxic.
TARP and Fed facilities unravel
–John Kemp is a Reuters columnist. The opinions expressed are his own–
LONDON (Reuters) – Experience shows financial crises escalate very rapidly, and need a swift and decisive response from policymakers to break the cycle of panic. Time to reflect, craft thoughtful policies and consider long-term consequences is a luxury policymakers generally don’t have.
But the problem with bold ad hoc responses is they often have unintended consequences. Individual policy actions may prove inconsistent with one another, fail to achieve objectives, and store up larger problems for the longer term.
Developments over the last week suggest the U.S rescue program has fallen into just this trap and is now rapidly unraveling.
The twin pillars of the rescue program are the multiplicity of liquidity and lending programs being offered by the Federal Reserve and the Treasury’s Troubled Asset Relief Program (TARP).
Both programs are now in deep trouble. In fact the various rescue packages risk becoming a textbook example of how poorly designed programs can fail to achieve their objectives.
LIQUIDITY EVERYWHERE BUT MAIN STREET
In fact it’s not clear what the bailout package was intended to do. The Administration spent months in blissful denial (‘strong fundamentals’ and all that) then upon slowly noticing the symptoms of the sickness — not the causes — cobbled something together in a panic. The current effort is akin to handing out tissues in a pneumonia ward and wondering why none of the patients is getting better.
Global recession has begun
— John Kemp is a Reuters columnist. The opinions expressed are his own –
LONDON (Reuters) – Yesterday’s bleak reports on the state of U.S and European manufacturing confirmed that a global recession has already begun.
The Institute of Supply Management (ISM)’s composite business activity indicator plunged for the second month to 38.9 – far below the 50-point threshold dividing expanding activity from a contraction, and the lowest level since September 1982 (see chart https://customers.reuters.com/d/graphics/US_ISM1108.gif).
The 11-point plunge in the index over the last three months (August-October) has been equaled on only four occasions since 1945 (1949-50, 1959-60, 1974 and 1980-81).
It dispels any remaining doubt that the United States has already entered recession – which the National Bureau of Economic Research (NBER) defines as “a significant decline in economic activity, spread across the economy, lasting more than a few months”.
The economy has been in trouble for more than a year. Manufacturing output peaked in July 2007 and had fallen 2.3 percent by August 2008 according to estimates published by the Federal Reserve. Private sector jobs peaked in November and were down 0.7 percent by August.
Repeat claims for unemployment insurance had risen almost 1 million over this period, and the number of people in desperate poverty receiving help under the federal government’s Aid to Families with Dependent Children (food stamp) program surged almost 2.5 million.
My worry is where these trillions of dollars being pumped into the financial markets coming from? I’m sure it wasn’t just sat in the ‘rainy day’ box.
Commodities and the Great Conundrum
– John Kemp is a Reuters columnist. The views expressed are his own –
By John Kemp
LONDON (Reuters) – By driving up long-term real interest rates, the forthcoming flood of U.S Treasury borrowing threatens to crowd out the amount of capital for investing in other asset classes, creating a much tougher environment for commodity prices over the next two to three years.
Like many other asset classes, commodity prices have benefited from an influx of funds in recent years driven by three related factors:
(1) The long-term downtrend in inflation, greater macroeconomic stability, and heightened confidence in fiscal and monetary policy since the early 1980s have resulted in a steady reduction in both nominal and inflation-adjusted interest rates. Real rates are down from +8.0 percent in 1984 and +4.5 percent at the start of 1995 to -0.5 percent in H1 2008, or +1.5 percent if rising food and energy costs are excluded (see chart https://customers.reuters.com/d/graphics/US_RLINT1108.gif).
As real returns on benchmark government bonds have shrunk, investors have shifted into higher risk asset classes (equities, hedge funds, private equity and commodities) in search of better returns.
(2) Current account surpluses from China’s export-related boom and OPEC’s torrent of petrodollar revenues have been smoothly recycled back into debt markets, private equity, hedge funds and other instruments in North America and Western Europe.
Replace tax with inflation? that’ll mean that the billionaires are effectively being taxed the same rate as the minimum wagers – This will just push more people below the poverty line, creating an even bigger drain on society. Sure, if you think that is a good policy, go for it.
TARP, bonuses, dividends and Waxman’s letter
–John Kemp is a Reuters columnist. The views expressed are his own–
By John Kemp
LONDON (Reuters) – The bitter political divisions between middle America and Wall Street on display when the House of Representatives first rejected the Emergency Economic Stabilization Act last month look set to be re-opened in even more dramatic form in the remaining months of the year.
Rep Henry Waxman, chairman of the powerful House Committee on Oversight and Government Reform, on Tuesday sent identical letters to the chief executives of nine major banks receiving $125 billion of capital injections under the Troubled Assets Relief Program (TARP) demanding details of total bonus payments for 2006, 2007 and 2008 (see http://oversight.house.gov/documents/20081028142314.pdf).
The issue of bonuses and dividend payouts from banks that accepted the TARP injection looks set to become highly charged.
It is going to be hard for the banks and Treasury to explain why so much taxpayer funding needs to go in through the front door, only for it to flow out again as staff bonuses and dividend payments to ordinary shareholders. Bonus and dividend payments could quickly absorb all the TARP capital funding.
The issue of responsibility for the credit crisis will intensify during the quarterly dividend and annual bonus payout period in Dec-Feb, just when a new administration will be taking office and Democrats are likely to extend their control over both houses of Congress.
The employees and executives with contracts to be paid bonuses are unsecured creditors, are they not? Why should they get paid before anyone else?
The Fed as lender of first and only resort
John Kemp is a Reuters columnist. The opinions expressed are his own.
LONDON (Reuters) – The Federal Reserve has unveiled a dizzying array of new lending and liquidity support facilities over the last six weeks, but the diminishing law of marginal returns already looks to have set in. Each new lending and liquidity facility announced by the Fed is providing a smaller boost to confidence than the last.
The market is increasingly focused on how the Treasury and the Fed will fund the ever-expanding array of facilities, and the huge overhang of very short-term paper that needs to be rolled over into longer-term securities in a market that already looks queasy about the forthcoming flood of notes. Rather than multiplying the number of acronymned facilities further, restoring confidence now rests on solving two issues.
First, the market needs to see buyers for all this new Treasury paper that will have to be issued in the coming year.
The government is under pressure to line up support from overseas central banks and other institutional investors to continue supporting the market by absorbing a large share of the new issuance that will be required.
A much higher share may need to be in the form of Treasury Inflation Protected Securities (TIPS) to reassure buyers the government will not seek to inflate its way out of the problem.
Additional commitments on exchange-rate stability may also need to be given, at least implicity, to solicit strong foreign participation.
The financial crisis is “spinning out of control” not because “Authorities are behind” but because the top messed with the shelter of the bottom. It’s one thing to hike prices with low interest rates on luxury items, but it’s quite another to cause price bubbles on homes and food.
If you think the Govt is responsible for bailing any of you out, think again. We are not responsible for your mess. Step up to the plate and take your wild swings George, I’m tired of watching this game, I’m going home.
A crisis of solvency?
(John Kemp is a Reuters columnist. The opinions expressed are his own)
LONDON (Reuters) – Despite Fed assurances that the worst of the crisis has passed, and the banking system has been successfully “saved”, credit conditions are actually getting much worse, not better, for even mid-grade corporate borrowers.
Credit spreads have continued to flare out in recent sessions. Spreads for seasoned Baa-rated corporate issuers over U.S. Treasuries have widened from 337 basis points on Sep. 10 to 486 on Oct. 10 and 560 on Oct. 22.
Some of this may reflect an increased liquidity premium for the most desirable on-the-run U.S. Treasuries in the current environment — and a similar illiquidity discount for mid-grade corporate paper that may not be easy to value or trade at present.
But it also reflects growing fears about default.
Corporate earnings are clearly deteriorating. Fitch has already warned that default rates are rising — with $25 billion of U.S. high-yield bonds defaulting in Jan-Sep 2008 compared with just $3.5 billion in the whole of 2007. Default rates look set to surge in the remainder of the year and throughout 2009 as the economy slows.
Equity injections into the U.S. banking system (up to $250 billion) and purchases of troubled assets (up to $450 billion from the remaining Troubled Asset Relief Program funds) will help strengthen bank balance sheets.
We should plan to restructure our withered manufacturing base rather than depending on borrowed spending by the consumer.
This is a very well written article. I will be recommending it to many people.
However, I have to say, I am seeing a lot of similarities between your arguments and the arguments of the French politicians written about in A. D. White’s “Fiat Money Inflation in France” (http://mises.org/books/inflationinfranc e.pdf). Obviously the situation is different, but the justification for the recommended policies is shockingly similar. I would think that that similarity was enough for one to consider the long term consequences of policies that provide “an immediate boost to output and employment.”