MacroScope

A week before emerging-market turmoil, a prescient exchange on just how much the Fed cares

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The last seven days has been a glaring example of fallout from the cross-border carry trade. That’s the sort of trade, well known in currency markets, where investors borrow funds in low-rate countries and invest them in higher-rate ones. Some $4 trillion is estimated to have flooded into emerging markets since the 2008 financial crisis to profit off the ultra accommodate policies of the U.S. Federal Reserve, Bank of Japan, European Central Bank and the Bank of England. Now that central banks in developed economies are looking to reverse course and eventually raise rates, that carry trade is unraveling fast, resulting in the brutal sell-off in emerging markets such as Turkey and Argentina over the last week.

The Fed’s decision on Wednesday to keep cutting its stimulus effectively ignores the turmoil in such developing countries. And while the Fed may well be right not to overreact, it makes one wonder just how much attention major central banks pay to the carry trade and its global effects — and it brings to mind a prescient exchange between some of the brightest lights of western economics, just a week before emerging markets were to run off the rails.

On January 16, minutes before Ben Bernanke took the stage for his last public comments as Fed chairman, the Brookings Institution in Washington held a panel discussion featuring former BoE Deputy Governor Paul Tucker, Harvard University professor Martin Feldstein and San Francisco Fed President John Williams. They were asked about the global effects of U.S. monetary policy:

Williams:

“These countries have been affected, no question, affected in a major and important ways by these flows and have adapted their policies and their approaches to better insulate them from some of those effects… That said, at the end of the day, we live in a modern and global financial system.. Monetary policy in the U.S. obviously has effects outside the U.S. and we need to study those, we need to understand those, and we need to coordinate or communicate more effectively with our colleagues around the world.”

Feldstein:

“The only thing I would add is that the Fed doesn’t take those effects on other countries into account.”

Will rounding cents bring euro zone down?

The 18-country euro zone has had a rough ride in the past 6 years, and even with the glimmers of good news reaching the darkest corners of the debt crisis, the European Central Bank has been anything but ready to sound a crisis-over siren.

Right after ECB President Mario Draghi warned against undue optimism, the central bank has identified a new threat to the common currency’s integrity – rounding up or down small change.

Belgium plans to allow retailers to round 1 and 2-cent coins to the closest five cents, in a similar fashion as Finland and the Netherlands already do. But the ECB had harsh words against such going-it-alone moves, published in a legal opinion published on its Internet site.

Hollande’s moment of truth

This afternoon, French President Francois Hollande will expand upon his New Year announcement that French companies who agree to hire more workers could pay lower labour taxes in return and find themselves less tied up in red tape. Unemployment is running near to 12 percent and Hollande’s vow to get it falling by the end of 2013 fell short.

Unfortunately, the announcement has been eclipsed by his threat of legal action after a French magazine reported he was having an affair with an actress. France tends to overlook its politicians’ peccadilloes but with the economy in a hole, Hollande risks facing the charge that he should be focusing squarely on that.

To complicate matters his partner, Valerie Trierweiler, has been admitted to hospital following the reports. She will stay there for a number of days yet.
Given this is one of only two news conferences that Hollande has promised to give each year it’s hard to see how he can avoid it being hijacked by his personal life. As boxing promoter Don King was fond of saying: there are two chances, slim and none and Slim just left town.

New face at the ECB

The European Central Bank held a steady course at its first policy meeting of the year but flagged up the twin threats of rising short-term money market rates and the possibility of a “worsening” outlook for inflation – i.e. deflation.

The former presumably could warrant a further splurge of cheap liquidity for the bank, the latter a rate cut. But only if deflation really takes hold could QE even be considered.
Sabine Lautenschlaeger, the Bundesbank number two poised to take Joerg Asmussen’s seat on the executive board, breaks cover today, testifying to a European Parliament committee. A regulation specialist, little is known about her monetary policy stance though one presumes she tends to the hawkish.

Iran and the EU announced on Sunday that a deal between Tehran and six major powers intended to pave the way to a solution to a long standoff over its nuclear ambitions will come into force on Jan. 20. Thereafter, negotiations will begin on a final settlement. Brent crude has fallen in response. It’s early days but if oil falls significantly this year, that will factor into fears about deflation taking hold in Europe.

Turkish troubles

Ask investors about their minimum criteria when putting money into a country and rule of law comes pretty high. That’s one of the reasons why Turkey’s corruption scandal, and the reaction of the government in ousting hundreds of police officers, is so serious. The lira touched a record low on Thursday.

Today, parliament’s justice commission will debate a draft law reforming the High Council of Judges and Prosecutors, which makes judicial appointments. Critics of the bill say it will give the justice minister significant influence over appointments, describing it as anti-constitutional and undermining the separation of powers.

Prime Minister Tayyip Erdogan’s ruling party is slipping in the opinion polls although it remains comfortably ahead of its opponents. Erdogan finishes an Asian tour today with a visit to Malaysia.

ECB’s Draghi gives Germans “perverse” lesson

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When Mario Draghi, the president of the European Central Bank, told Der Spiegel magazine at the end of last year that “there was this perverse Angst” in Germany that things were turning bad, he caused an outcry in  German media, already suspicious of his policies. What had perhaps slipped by Draghi is that the English word perverse can also mean kinky in German.

Was his outburst really helpful, a German journalist queried during the monthly press conference on Thursday, and the Italian tried to set the record straight.

Scrambling for the right sheet of paper, he started: “First of all, … if I can find the actual definition of perverse in English I’d be very glad, but as usual … anyway there is a difference between perverse and perverted.” The whole room burst into laughter.

ECB rate cut expectations to be left deflated

Euro zone inflation has dropped to just 0.8 percent and the core measure is lower still – at 0.7 percent it has fallen pretty consistently over the last year.

Nonetheless, the European Central Bank is likely to sit tight at its policy meeting today. The Bank of England’s rate setters are also meeting but facing a very different set of problems.

It’s probably too early for any dramatic moves but the ECB may well be pushed into easing policy if inflation refuses to pick up and/or the banks clam up ahead of this year’s health tests. Today, Mario Draghi is likely to reaffirm its readiness to act.

That sinking feeling

Euro zone inflation, or deflation, is the focus of the moment.

Germany’s HICP rate fell to 1.2 percent last month, Italy’s hit 0.6 percent and Spain’s just 0.3 in December (not to mention Greece’s -2.9 percent). Today we get the figure for the euro zone as a whole. Forecasts for it to hold at 0.9 percent may now look a little toppy.

It’s too early for any dramatic moves but the European Central Bank, which has a policy meeting on Thursday, may well be pushed into easing policy if inflation refuses to pick up and/or the banks clam up ahead of this year’s health tests.

A shock fall in euro inflation to 0.7 percent prompted an interest rate cut to 0.25 percent in November followed by a chorus of denials that deflation was a threat. ECB chief Mario Draghi adhered to that last week but added that he and his colleagues had to make sure inflation didn’t get stuck in the “danger zone” below one percent.

Banking union … timber not steel

A day after she was sworn in for a third term and a day before she attends an EU summit in Brussels, Chancellor Angela Merkel delivers a speech in the Bundestag lower house. She will then head to Paris in the evening for a meeting with French President Francois Hollande. That bilateral could be the moment that the seal is set on banking union, in time for the Thursday/Friday EU leaders summit.

In parallel, the bloc’s 28 finance ministers will meet in Brussels to try and finalise a common position on the detail. “For the acceptance of the euro on financial markets, the banking union is very important,” Merkel said on Tuesday.

For the markets, it will be impossible to look beyond today’s Federal Reserve policy decision which might, or might not, start the process of slowing the pace of money-printing which has been churning out $85 billion a month. But banking union is hugely important too.
Euro zone finance ministers made progress overnight, essentially agreeing the blueprint Reuters reported exclusively over the weekend.

Decision day for Kiev … and Moscow

Decision day for Ukrainian President Viktor Yanukovich as he heads to the Kremlin seeking a financial lifeline while demonstrators in Kiev gather again to demand he steps down.

Vladimir Putin seems set to agree a loan deal, and possibly offer Ukraine a discount on the Russian natural gas.
It seemed he was the only game in town after an EU commissioner said the bloc was suspending talks on a trade agreement with Kiev. But yesterday, European Union foreign ministers said the door remained open, which in a way makes Yanukovich’s predicament harder.

Does Russia really need this? Politically yes, but economically? Ukraine is seeking help to cover an external funding gap of $17 billion next year and is in no position to pay for its gas.