from MacroScope:
India’s central bank battles alone in inflation struggle
What more does India's central bank have to do? Last week data showed March inflation rising to almost 9 percent on an annual basis. More importantly, core inflation is above 7 percent for the first time in 3 years meaning demand-side pressures are rising fast. And that's despite the Reserve Bank of India raising interest rates eight times since last March.
The inflation data comes just after a quarterly HSBC report based on purchasing managers indexes showed that inflation in India seemed impervious to monetary policy tightening.
The truth, is the inflation-fighting central bank has little backup from the government which remains stubbornly in spending mode. Its foot-dragging on reform and foreign investment contributes towards keeping food price inflation high. This year's fiscal deficit target is 4.8 percent of GDP and even this is seen as optimistic.
"What India really needs is to have domestic demand slowing down quite rapidly but the government is not prepared to risk that,"says Claire Dissaux, investment strategist at Millenium Global in London.
The RBI has repeatedly said it shouldn't have to do all the heavy lifting. But lack of support from the government means the central bank will have to put up rates another 100 bps this year, analysts reckon.
Of course India is not alone in this bind though it is the most extreme example of lax fiscal policy being counterbalanced by tight monetary policy. Brazilian interest rates are among the highest in the developing world at 11.75 percent and that is down to loose fiscal policy, a lot of it "quasi-fiscal spending" via the state development bank BNDES, research house Capital Economics says.
Brazil's central bank suggested recently that fiscal tightening of one percent of GDP would have the same impact as 125 bps of interest rate hikes.
Markets make prisoner of the Fed
“Market participants should not direct policy,” Kansas City Fed President Thomas Hoenig warned listeners at a town hall meeting in Lincoln, Nebraska, back in August. Unfortunately that is precisely what is now happening.
Hoenig noted that Wall Street’s clamour for cheap money was not disinterested: “Of course the market wants zero rates to continue indefinitely … they are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.”
Now the same pressure groups want the Fed to launch a second round of asset purchases so they can sell U.S. Treasury bonds to the central bank (in effect back to the federal government) at inflated prices.
A new round of securities purchases provides investors with an exit strategy from what might otherwise be a dangerous bubble in the bond market. Every bubble needs a “greater fool” prepared to pay a higher price for the asset to keep the bubble inflating. In this case, the guaranteed sucker is the Fed itself.
Meanwhile quantitative easing (QE) has pushed up the value of all the risk assets institutions and investors hold, giving the market a highly desirable insurance policy.
Set aside the question of whether the Fed should socialise investors’ risks and losses in this way. Set aside also the issue of moral hazard — whether by bailing out investors the Fed will encourage more excessive risk-taking behaviour in future. Most officials admit recent actions have increased moral hazard but believe it is a problem to be solved in the long term by appropriate supervision.
The immediate policy question is whether the prospective QE programme is contributing to stability in the financial markets and an environment likely to encourage more long-term investment by businesses and job creation. In other words, is QE succeeding in its own terms, meeting the objectives set by the central banks themselves? There are several reasons to be extremely doubtful.
The trade of QE causing intense inflation harming primarily the poor and further QE to keep the S&P alive is a hard choice.
The Poor, rationing between food and fuel, now reaching to the lower middle class, which Mr. Bernanke when addressing food & fuel doesn’t consider as real inflation conflicting with Europe’s measurements; or propping up the S&P and Dow by maintaining a cheap dollar and pushing exports.
Unfortunately his positive arguments for QE is weakened by the Large corporate entities going rapidly offshore to avoid paying American Corporate taxes. It’s tough when your chosen constituents stick it up your rear.
There is no such thing as inflation
In 1987, UK Prime Minister Margaret Thatcher whipped up a firestorm of criticism from her opponents on the left when she told a magazine reporter that “there is no such thing as society”, only individual men and women, and families.
The interpretation of those comments remains fiercely controversial. From the context it is not certain the prime minister was clear what she was trying to say.
But according to one interpretation the prime minister was encouraging her listeners to look beyond the impersonal aggregate of “society” to the individuals behind it.
The distinction between aggregates and individual components is something the Federal Reserve should bear in mind as officials mull whether to launch a new round of asset purchases to keep inflation from falling further and stimulate the recovery.
Because in some sense there is no such thing as inflation, only a collection of price rises for individual items, some rising faster and some slower.
It is clear price increases do have a structural component. Policymakers and economists distinguish between a general rise in the level of prices (“inflation”) and relative price increases for individual items (Adam Smith’s “invisible hand” guiding the reallocation of scarce resources).
But in an economy characterized by uneven spare capacity, with bottlenecks in some areas and unused capacity in others, excess demand and inflationary pressures may not show up evenly. Even as all prices rise (inflation), price rises are likely to be largest in those parts of the system with the worst bottlenecks, while increases in areas suffering significant under-employment of resources lag behind.
In purely mathematical terms, inflation is relativistic, and thus dependent upon reference frame. When conventional pundits characterize an economy as “inflationary”, they are also making the simultaneous implicit statement that the value of currency is being deflated. Hence, inflating prices is, in relativistic terms, the same as deflating cash. What conventional pundits call “inflation” is, in absolute terms, a perturbation of the commodity value / cash value ratio in the positive direction. What is now needed is a new function which recognizes the sector-related variance in the commodity value/cash value ratio. Then, intelligent stimulus policies which are sector-specific could be designed.
The wrong sort of inflation
Chairman Ben Bernanke’s Fed is beset by demons of its own design.
Terrified by memories of the 1930s and Japan’s more recent experience in 1990s and 2000s, the academics who now dominate the Federal Open Market Committee display a hyperactive compulsion to tinker with monetary policy in a bid to solve all the problems besetting the U.S. economy.
But if inflation is always and everywhere a monetary phenomenon, as Milton Friedman argued, Fed policy has a smaller role in solving real-economy problems such as a gaping trade deficit, moribund housing market, sluggish growth and joblessness.
Expectations of another substantial round of quantitative easing (QE2) have gone too far for the Fed to pull back now. The Fed must press ahead or risk a massive, disorderly correction across all asset classes (bonds, equities, commodities and currencies).
But once the trigger is pulled members of the FOMC should resist the temptation to tweak further and give the normal cyclical processes of recovery and structural reforms time to work.
HUBRIS
Never before has the Fed had so much theoretical firepower at senior level.
Mr Hoenig is correct. QE caused the misallocation and waste of trillions of dollars. Most of it just increased speculation in the stock market, and prevented the market from correcting itself. It artificially inflated stock prices while increasing unemployment and reducing demand. It created an increased disconnect between the value of the real economy and the price of stocks. Further QE will further increase that disconnect. Sooner or later, that disconnect will correct itself. The longer the FED prevents the correction, the worse it will be when it happens.
The real economy suffers from a lack of demand. QE has devalued the US dollar in real terms and that increases the cost of products, further reducing the purchasing power of consumers in the largest consumer economy in the world. That reduces demand. It does not increase it. Reduced demand means businesses must lay off workers or shut down their businesses. That increases unemployment and reduces demand even further.
If that wasn’t bad enough, the FED has borrowed trillions of dollars to deflate the currency and that money must be repaid. And that is only the money that was borrowed “on the books”. Who really knows how much “off the book” money the FED has spent for “unnofficial” QE and government bailouts. The FED refuses to be audited.
Instead of all that money being available to grow the economy and increase employment in the future, it will have to be used to repay the debt. That means QE will slow the private sectors ability to regrow the economy and may even force it into recession.
If that wasn’t bad enough, we have the Government adding massive new entitlement programs we can’t afford and thousands of burdensome new laws that business will have to comply with. Not only does that force businesses to waste employee time and resources complying with thousands of new laws, it also reduces business efficiency and competitiveness in a global economy, increases the cost of doing business, increases government enforcement costs, and increases economic uncertainty. It’s hardly surprising businesses are reluctant to hire new workers under those conditions.
QE1 was a dismal failure in terms of the real economy. Now the FED wants to repeat it and make the problem a trillion dollars worse? It didn’t work on the real economy the first time. We can’t afford to repeat
Bernanke’s failure again.
Markets trapped between euphoria and despair
“Don’t panic!” was good advice provided by Lance-Corporal Jones to his commanding officer in the 1970s BBC comedy series “Dad’s Army”. Perhaps it should now be directed to central banks and increasingly jittery investors.
The last six months have witnessed a rollercoaster as markets and policymakers have alternated between euphoric optimism and crashing pessimism with bewildering speed.
Many seem convinced the world’s major economies are poised on either the brink of liquidity-induced inflation; a renewed descent into recession and deflation; or perhaps both at different times, with near-term disinflation is followed by an upsurge in inflation later.
But what if policymakers and investors are overestimating the likelihood of extreme outcomes? Past experience suggests outcomes are much more likely to fall somewhere in the middle, as the economy “muddles through”; the likelihood of extreme outcomes being realised is actually very small.
U-SHAPED FORECAST DISTRIBUTIONS
The best example of the increasingly binary outlook shared by policymakers and investors is a chart buried in the Bank of England’s May “Inflation Report” (Chart 5.13) which shows the Bank thinks it is much more likely inflation in 2012 and 2013 will be very low (<1.5 percent) or very high (>2.5 percent) than a moderate level near the target (1.5-2.5 percent).
Rather than a bell-curve shaped distribution (in which expected outcomes cluster around the middle) the Bank’s inflation forecast is U-shaped, with extreme outcomes dominating more moderate ones.
Maybe we could find an “Economic Octopus Profit” as good as the world cup octopus. Then we could flip a coin as to who gets it; Ben Bernanke or Larry Summers?
Inflation or Deflation, why settle for just one?
If you are trying to decide whether to fret about inflation or deflation, don’t bother: you may just get both.
Yes, in the spirit of these austere times, it is a two for one offer; deflation comes first, followed by an almighty inflation after central banks press the “go nuclear” button on the quantitative easing machine.
It seems clear that, at least in the near term, the stars are aligned for deflation. Rather than lancing a massive debt bubble, policy-makers have added to it and the intense pressure to clean balance sheets has spread from corporations and households to nations.
As in 1937 in the U.S. or 1997 in Japan, a move to budget austerity has taken hold in large swaths of the global economy, adding to the intense downward pressure already being generated by very large unused economic capacity.
If neither banks nor governments are willing and able to stoke demand then prices will fall, and as we have seen, absent an outside shock this is a cycle which feeds on itself.
Consumers and businesses will pay down debts that are becoming heavier as money becomes more valuable and they will delay purchases as prices fall.
Of course in a system in which the government can create money at will, deflation should theoretically be an easy problem to solve; central banks can, in Chairman Bernanke’s famous image, simply drop money from helicopters.
Deflation is a far closer threat than inflation in the current economic climate
You can print money almost at will, but with unemployment figures sky-high (and not higher because the discouraged not count as unemployed) what is the “rational” decision – spend the easy money – may be overruled by a more urgent need -hoard as much money as possible in prevention of future unemployment.
Second, even if people would start spending that money, excess demand will not take place until production capacity is at full utilization which, by definition does not happen under conditions of high unemployment and depressed demand.
Keynesians used to say about monetary policy that you can pull a cart with a cord but not push a cart with it…
Pretty bad environment and not likely to change for a long while.
Economy volatility a hurdle for stocks
Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.
Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.
It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War-Two period.
This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.
The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.
Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.
What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States — currently in the 14-15 neighborhood — have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.
Good article, and I enjoyed reading the comments posted by CrisisMaven, Kina and Story_Burn.
Tightening underway, Fed a passenger
A tightening in financial conditions is under way but its principal architect won’t be the Federal Reserve.
Far from it, the Fed will be pinned down by powerful disinflationary, perhaps even deflationary, forces, making it very unlikely to be willing to raise interest rates any time soon.
Instead the tightening is coming from Asia, where China is fighting a local battle against rampant lending, and from investors all over the world, as one by one they realize that lending to governments isn’t always so risk-free.
These two forces will form a vise around still riskier assets like stocks, especially in the United States, as companies face weak conditions at home in combination with tightening from markets.
Riskier assets sold off last week after the Fed raised the discount rate it charges banks by 25 basis points, a move some argued was a sign that actual rate hikes could come sooner than expected.
This was a good example of getting the right result for the wrong reasons.
Core consumer prices, excluding food and energy, fell in January for the first time since 1982, driven by falling rents and car prices and cheaper clothing. Energy costs drove overall inflation higher, but those prices, which are set by global demand, do not pose the kind of sustained inflationary threat the Fed will meet with rate hikes.
Sovereign risk? What sovereign risk? Is there still a country called Greece? I thought they have all melt together into one country called EuroZone. Unlike US or UK, Greece cannot even print its own money. At least the Chinese can print more money if they wanted. But why would they? They still have US$2Trillion of foreign currency reserve. Where is the sovereign risk? I do not get it.
Fed audit push gives impetus to gold rally
(James Saft is a Reuters columnist. The opinions expressed are his own)
Auditing the Federal Reserve may or may not be a good idea, but one thing seems pretty sure: just discussing it seriously will tend to drive the price of gold higher.
The U.S. House of Representatives Financial Services Committee last week voted to approve an amendment that would bring about an audit of the Fed, its monetary policy and lending programs, since when gold has gone its merry way higher, hitting an all-time high of $1,174 per ounce on Monday.
The amendment, a provision to a broader financial services reform bill that is still under consideration, was co-sponsored by Republican Representative Ron Paul, author of the book “End the Fed,” and the man least likely to be found chairing a panel at Jackson Hole or Davos.
The Fed, understandably, hates the idea, saying it will compromise its hard-won independence, the administration loathes it, and really it will almost certainly never become effective in a recognizable form.
Even so, and even interpreting the vote as a populist cry of the heart against Washington and Wall Street, the fact that it has gotten this far will cause some serious people without an ideological dog in the Federal Reserve fight to buy a bit of gold, which is really a sort of anti-currency, as a hedge against increased political influence in the process of making monetary policy.
Undoubtedly many people who think keeping the Fed on a short leash attached to an elected body is a good thing also think the Federal Reserve should have been much less aggressive in creating money and risking inflation. History shows that the risks are actually skewed the other way: tighter political control of central banks more often means more inflation and a higher risk of a debased currency.
The Dollar has to stabilise sooner or later, otherwise the asset bubbles in Asia countries and the “gold bubble” will get bigger. Once the Dollar appreciates, the bubbles will burst and hurt the economy of these countries.Those who invest in Gold will lose heavily too.China is trying very hard to control the bubble in stock market and real estate. If USD does not stop the decline, it’s very hard for China to succeed.
Look out for emerging markets inflation
(James Saft is a Reuters columnist. The opinions expressed are his own)
Emerging markets could be the first to suffer destabilizing inflation, courtesy of a strong economic rebound, a weak dollar and extremely loose monetary policy in the developed world.
Inflation, in faster growing emerging markets, was not high on the list of worries even months ago, but the speed and strength of the rebound and red-hot asset markets in some places show that it may be a rising threat.
“The surprise could be that inflation in emerging markets really takes off,” Amer Bisat of hedge fund Traxis Partners said on Tuesday at a Euromoney foreign exchange conference in New York.
It is not yet a central case, but should price pressures in countries like China, Korea and Brazil take hold, it will leave policy makers in a bind and would roil financial markets.
Interest rate hikes might only attract more hot capital and may be only partially effective. Rising currencies can be self-fulfilling and higher interest rates in emerging markets make carry trades — borrowing in dollars, for example, and reinvesting in something like Korean won — all the more attractive.
Other methods of stemming currency appreciation, which stokes inflation, may also become more popular; Brazil in October imposed a 2 percent tax on foreign inflows into equities and fixed-income instruments designed to keep the real from appreciating too quickly.
The problem is that China is too big. Inflation in the cities will have a ripple effect on the rural areas. When the cost of real estate escalates in cities, the manufacturing cost increases, the farmers will have to pay more for products and services originate in cities.
This will cause the rich-poor gap to widen between city-folks, and rural folks.
