The Great Debate

The Federal Reserve's "Operation Twist" has set the literary- and musical-allusion juices flowing.  It is all about the Fed selling or not rolling over short-term debt and buying long-term bonds instead in order to keep borrowing costs low.

But that is frightfully dull for economists, analysts and reporters trying to get attention for their work. So, so far we have heard:

-- "Let's Twist Again", a reference to the 1960's Chubby Checker record about the dance craze . Problem is that the second line is "Like we did last summer", and the Fed did nothing of the sort, launching plain old quantative easing instead.

-- Twisted Sister might be a contender, but the heavy metal band's big hit "We're Not Going To Take It" probably better descibes market reaction to euro zone debt-crisis policy.

-- "Twist and Shout",  a reference to the rock song covered by The Beatles, among, others.  This is better. "Well, shake it up, baby, now" could indeed be the clarion call from financial markets for the Fed to so something, almost anything. But "Come on and twist a little closer, now, and let me know that you're mine" might be going a little far.

Retirement investors have struggled with a Jekyll and Hyde economy these past two years, where Dr. Jekyll lives very well on Wall Street while Mr. Hyde runs roughshod over a terrified Main Street.

On Main Street, the jobless rate tops 9 percent and 14 million residential mortgages are underwater – a figure Deutsche Bank thinks will hit 25 million, or 48 percent of all home loans, before the housing bust ends.

On Main Street, the economy hasn't respond to ultra-accommodative monetary policy. Near-zero interest rates don't matter because because there's so little demand for credit to hire people or to buy post-bubble real estate.

The European Central Bank is off and running with its tightening cycle -- raising by 25 basis points last week and talking in tongues enough to persuade markets that another hike is coming by July.  At the same time, the Fed -- despite some hawkish comments recently about QE -- isn't seen actually tightening for some time. Next year, actually.

Bank of America-Merrill Lynch is now wondering whether there is something wrong with this. " Surely one of these central banks is heading to a painful policy mistake? " it says.

Key to the question is the fact that U.S. and euro zone economics are not as far apart normally as one might think. Take growth, where there is a 0.6 positive correlation between the two across business cycles. Or inflation. The correlation there is even greater at a positive 0.75 over a whole economic cycle.

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.

Ultra-low interest rates and massive liquidity injections have acted like a painkiller, stabilising the U.S. economy and preventing it from going into shock. But they have not cured the underlying problem of over-extended households and an economy dependent on increasing consumer indebtedness as its main source of growth.

The result is a highly uneven recovery. While many parts of the manufacturing and the service sectors are rebounding strongly, those most dependent on credit, particularly housing and autos, and others associated with them such as home furnishing remain depressed.

Low rates have largely solved the cash flow problem, at least for households that have remained in employment. But household balance sheets are still undergoing what is likely to be a long and painful period of adjustment that will continue to act as a drag on credit-driven spending for several more years.

Could the first increases in  short-term U.S. interest rates come much earlier than most forecasters expect, perhaps as soon as September or November 2010?

Past experience suggests rates begin to rise about 30-35  months after the trough in the manufacturing cycle (as measured by capacity utilisation rates).

In the last four expansions, before this one, rates started rising 27 months, 48 months, 33 months and 31 months after  capacity utilization had hit its low point.

– John Kemp is a Reuters columnist. The views expressed are his own. –

Commodity prices exhibit a strong cyclical component — though it can be masked when producers are carrying a lot of excess capacity.

The attached chart shows the real price of various commodity baskets (Jan 1980=100) overlaid by U.S. interest rates (discount rate, later funds target), and the business cycle (NBER Business Cycle Dating Committee).

– John Kemp is a Reuters columnist. The views expressed are his own. —

Plotting an exit strategy and shrinking the Federal Reserve’s balance sheet has become a hot topic as policymakers try to underscore their commitment to price stability and markets ponder the risk of inflation.

But micro-managing the reserve base is a curiously inadequate way to respond to medium-term concerns about inflation. Interest rates (the cost of credit) and supervision (leverage) are broader, more appropriate tools.

– John Kemp is a Reuters columnist. The views expressed are his own –

Unable to rely on the wounded consumer, the outlook for U.S. growth in the next three years depends on business investment and exports to take up the slack when stimulus programmes wind down.
Ultra-low interest rates will help. But with the economy struggling to work off a huge overhang of unused real estate assets, and not much sign of investment elsewhere, investment spending is set to remain sluggish, condemning the economy to a weak recovery in the medium term.

Federal Reserve Chairman Ben Bernanke and other senior U.S. officials have already warned the rest of the world can no longer rely on over-indebted U.S. consumers as the principal source of global growth. There is no choice but to rely on investment and exports to take up more of the burden.

-David Kuo, Director at the financial website The Motley Fool. The opinions expressed are his own.-

Go on. Admit it. You didn’t see it coming, did you? You never thought a member of the G20 nations would dare to break ranks and raise interest rates this soon.

But Australia has done just that. The Central Bank of Australia has increased the cost of borrowing by 0.25 percent to 3.25 percent. It is doing what it thinks is right for the country regardless of what the rest may think. Now, Asian countries, keen to avert another bubble, may follow Australia’s lead and ratchet up interest rates before long.