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(a casual email exchange)

>   
>   On 8/24/08, Russell wrote:
>   
>   I found this an interesting read. Roach argues that economies and the US
>   economy has generally been built on a consumption binge.
>   

Right, consumption is the whole point of working.

Some of the output is consumed, some ‘invested’ for future consumption to be greater than otherwise, but it’s all consumption based. There’s no other point.

>   
>   And the reason why it happened was that the consumption was not based on
>   income, but instead since 1999 is has been based on appreciating asset values
>   and easy access to credit.
>   

The budget surpluses of the late 1990s removed that much income and financial equity (net financial assets) from the non govt sectors.

The only way the economy could continue was accelerating non govt debt. Private sector domestic credit expansion was around 7% of gdp by 2000 before it collapsed due to lack of income and financial equity to support that kind of credit structure.

1% interest rates didn’t turn it around. It was the tax cuts/spending increases/larger govt. deficit that turned it in 03. And as that tail wind was allowed to blow out it all slowed down right up to today. There was a small burst due to the private sector deficit spending due to the sub prime fraud, where lender’s equity fraudulently got spent on houses.

And, again, it was the fiscal package that supported gdp in q2 and q3, along with exports, which resulted from foreign cb’s cutting their accumulation of $US financial assets.

>   
>   Sees a slower global commodity market in the next couple of years as ASIA GDP
>   slows as a result of a slowdown in US consumption.
>   

Consumption will slowdown if agg demand isn’t supported by govts as they all implement demand draining tax advantaged savings incentives (pension funds, ira’s, ins reserves, etc.) that require deficit spending for some other entities sustain demand.

And govt deficits are the only ones that are independently sustainable. Non govt entities have limits they hit periodically.

>   
>   
>   
>    The key question going forward is whether an adaptive and
>   
>    increasingly interrelated global system learns the tough lessons
>   
>    of this macro upheaval. At the heart of this self-appraisal must
>   
>    be a greater awareness of the consequences of striving for
>   
>    open-ended economic growth. The US couldn’t hit its growth
>   
>    target the old fashioned way by relying on internal income
>   
>    generation, so it turned to a new asset- and debt-dependent
>   
>    growth model. Export dependent Developing Asia took its
>   
>    saving-led growth model to excess: Unwilling or unable to
>   
>    stimulate internal private consumption, surplus capital was
>   
>    recycled into infrastructure and dollar-based assets – in effect,
>   
>    forcing super-competitive currencies and exports to become
>   
>    the sustenance of a new development recipe.
>   
>   

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[written on Sunday]

While not a problem in the US for the Fed to do this and more (in fact it should be standard operating procedure), the eurozone has self imposed treaty issues that make it very problematic.

If there are defaults its the national governments that will probably be called on to repay the ECB for any losses, but given the national governments didn’t approve the transactions the result will be chaotic at best.

Without bank defaults it will probably all muddle through indefinitely.

As before, the systemic risk is in the eurozone.

Valve repair tomorrow, going to try to smuggle in a knife under my gown to even the odds…

Bank borrowing from ECB is out of control

by Ambrose Evans-Pritchard

The European Central Bank has issued the clearest warning to date that it cannot serve as a perpetual crutch for lenders caught off-guard by the severity of the credit crunch.

Not Wellink, the Dutch central bank chief and a major figure on the ECB council, said that banks were becoming addicted to the liquidity window in Frankfurt and were putting the authorities in an invidious position.

“There is a limit how long you can do this. There is a point where you take over the market,” he told Het Finacieele Dagblad, the Dutch financial daily.

“If we see banks becoming very dependent on central banks, then we must push them to tap other sources of funding,” he said.

While he did not name the chief culprits, there are growing concerns about the scale of ECB borrowing by small Spanish lenders and ‘cajas’ with heavy exposed to the country’s property crash. Dutch banks have also been hungry clients at the ECB window.

One ECB source told The Daily Telegraph that over-reliance on the ECB funds has become an increasingly bitter issue at the bank because the policy amounts to a covert bail-out of lenders in southern Europe.

“Nobody dares pinpoint the country involved because as soon as we do it will cause a market reaction and lead to a meltdown for the banks,” said the source.

This “soft bail-out” is largely underwritten by German and North European taxpayers, though it is occurring in a surreptitious way. It has become a neuralgic issue for the increasingly tense politics of EMU.

The latest data from the Bank of Spain shows that the country’s banks have increased their ECB borrowing to a record €49.6bn (£39bn). A number have been issuing mortgage securities for the sole purpose of drawing funds from Frankfurt.

These banks are heavily reliant on short-term and medium funding from the capital markets. This spigot of credit is now almost entirely closed, making it very hard to roll over loans as they expire.

The ECB has accepted a very wide range of mortgage collateral from the start of the credit crunch. This is a key reason why the eurozone has so far avoided a major crisis along the lines of Bear Stearns or Northern Rock.

While this policy buys time, it leaves the ECB holding large amounts of questionable debt and may be storing up problems for later.

The practice is also skirts legality and risks setting off a political storm. The Maastricht treaty prohibits long-term taxpayer support of this kind for the EMU banking system.

Few officials thought this problem would arise. It was widely presumed that the capital markets would recover quickly, allowing distressed lenders to return to normal sources of funding. Instead, the credit crunch has worsened in Europe.

Not to miss out, Nationwide recently announced that it was setting up operations in Ireland, partly in order to be able to take advantage of ECB liquidity if necessary. Any bank can tap ECB funds if they have a registered branch in the eurozone, although collateral must be denominated in euros.

Jean-Pierre Roth, head of the Swiss National Bank, complained this week that lenders were getting into the habit of shopping for funds from those authorities that offer the best terms. The practice is playing havoc monetary policy.

“What we should avoid is some kind of arbitrage by banks, which say they are going to go to central bank X, instead of central bank Y, because conditions are more attractive,” he said.

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Seems Paulson is still blocking foreign CBs from accumulating USD financial assets. This is a negative for the USD and a negative for US real terms of trade.

It does support US exports and reduces the need to add to domestic demand, even as US consumption remains low.

Yuan Rises Most in 3 Weeks After Paulson Calls for Appreciation

by Kim Kyoungwha and Belinda Cao

(Bloomberg) The yuan climbed by the most in three weeks after U.S. Treasury Secretary Henry Paulson urged China to let its currency appreciate to curb inflation and deter Congress from introducing trade penalties. Bonds gained.

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Highlights:

 
 
Article snip:

BoE Cuts Growth Forecasts, Jobless Climbs (Bloomberg) The BoE cut its forecast for U.K. economic growth and held out the prospect of lower interest rates as unemployment rose the most in almost 16 years in July. Governor Mervyn King said the inflation rate will fall below the 2 % target in two years if policy makers keep the benchmark interest rate at 5 %.

But not if they cut is the implication as well.

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I could fix this in twenty minutes…

Money Market `Plagued’ by Libor That Fed Can’t Reduce

by Gavin Finch

(Bloomberg) A year after central banks started to pump trillions of dollars into the financial system to end a seizure in credit markets caused by subprime mortgages, cash is about as tight as it’s ever been.

The U.S. market for commercial paper, or short-term IOUs, backed by assets such as mortgages has shrunk 40 percent from its peak in July 2007. The amount borrowed in pounds between banks in the U.K. fell by 70 percent in June from a record in February 2007. The European Central Bank received $100 billion of bids for the $25 billion it offered to financial institutions on July 29, the most since the sales began in December.

Efforts by the Federal Reserve, ECB and Swiss National Bank to shore up the world’s biggest banks and promote lending have had limited success.

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Highlights:

 
 
 
Article snip:

ECB Leaves Interest Rates at Seven-Year High to Fight Inflation (Bloomberg) - The ECBkept interest rates at a seven-year high to fight inflation even as evidence of an economic slump mounts. ECB policy makers meeting in Frankfurt left the benchmark lending rate at 4.25 %, as predicted by all 60 economists in a Bloomberg News survey. The bank, which raised rates last month, will wait until the second quarter of next year to cut borrowing costs, a separate survey shows. The ECB is concerned that the fastest inflation in 16 years will help unions push through demands for higher wages and prompt companies to lift prices. At the same time, record energy costs and the stronger euro are strangling growth. Economic confidence dropped the most since the Sept. 11 terrorist attacks in July and Europe’s manufacturing and service industries contracted for a second month. ECB President Jean-Claude Trichet will hold a press conference 2:30 p.m. to explain today’s decision.

Same as UK, less costly to address inflation now rather than support growth and address inflation later if it gets worse.

It’s been said in the US that the Fed needs to firm up the economy first, and then address inflation. To most Central Bankers this makes no sense, as they use weakness to bring inflation down.

In their view that means the Fed wants to get the economy strong enough to then weaken it.

The Fed majority sees it differently.

They agree with the above.

However, for the last year they have been forecasting lower inflation and lower growth were willing to take the chance that supporting growth would not result in higher inflation.

Now, a year later, the FOMC is faced with higher inflation and more growth than the UK and Eurozone, and systemic ‘market functioning’ risk remains.

The FOMC continues to give the latter priority as they struggle with fundamental liquidity issues that stem from a continuing lack of understanding of monetary operations.

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(an email exchange)

>   
>   
>   On Wed, Aug 6, 2008 at 12:25 AM, Prof. P. Arestis wrote:
>   
>   Dear Warren,
>   
>   Just received the piece below. The situation over here is getting
>   worse but pretty much as expected.
>   
>   Recession signalled by key indicators of British economy
>   
>   
>   Best wishes, Philip
>   

Dear Philip,

Yes, seems tight fiscal has finally taken its toll and is now reversing the ugly way - falling revenues and rising transfer payments.

Without support from government deficit spending, consumer debt increases sufficient to support modest growth are unsustainable.

And with a foreign monopolist setting crude oil prices ‘inflation’ will persist until there is a large enough supply response,

It’s the BoE’s choice which to respond to, though ironically changing interest rates is for the most part ceremonial.

All the best,
Warren

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Karim writes:

• CATERPILLAR SEES ECB CUTTING RATES AT LEAST 25BP BEFORE YR END
• CATERPILLAR SEES NO SIGN OF RECOVERY IN NORTH AMERICAN HOUSING
• CATERPILLAR ASSUMES AT LEAST ONE MORE RATE CUT LATER THIS YR
• CATERPILLAR SEES ‘DIFFICULT’ FOR ECONOMY TO AVOID A RECESSION
• CATERPILLAR SEES OIL PRICE AVG ABOUT 16% HIGHER IN LAST HALF
• CATERPILLAR SAYS 2Q SALES/REVENUE UP 30% OUTSIDE NORTH AMERICA
• Caterpillar Net Rises 34% as Asia, Mideast Building Lift Sales
• Caterpillar Reports All-Time Record Quarter Driven by Strong Growth Outside North America

Right, weak domestic demand for sure. But note the last few lines that represent the booming exports even though domestic economies around the world are slowing.

That’s what happens when they spend their accumulated hoard of USD here and spend less at home as they try to get rid of their USD hoards. This doesn’t stop until their holdings of USD fall to desired levels.

I still see continued domestic weakness with GDP muddling through due to exports and government spending.

And ever higher prices pouring in through the import/export channel.


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Interesting how reports of higher inflation have often meant stronger currencies in the short run due to higher anticipated rates from the CB.

Inflation, however, by definition means the currency buys less of most everything; therefore, inflation and a weakening currency are one and the same.

But it can take a long time for markets to discount this.

Emerging-Market Currency Rally Dies as Inflation Hits

by Lukanyo Mnyanda and Lester Pimentel

(Bloomberg) The five-year rally in emerging- market currencies is coming to an end as central banks from South Korea to Turkey struggle to contain inflation, say DWS Investments and Morgan Stanley.

The 26 developing-country currencies tracked by Bloomberg returned an average 0.86 percent in the past three months, down from 1.63 percent in the first quarter, 8.2 percent for all of 2007, and 30 percent annually since 2003. For the first time in seven years, investors are less bullish on emerging-market stocks than on U.S. equities, a Merrill Lynch & Co. survey showed last week.

Confidence in the Indian rupee is weakening after inflation accelerated at the fastest pace in 13 years, stoked by soaring food and energy prices. South Korea’s won will drop this year by the most since 2000, while Turkey’s lira will reverse its biggest gain since at least 1972, the median estimates of strategists surveyed by Bloomberg show.

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Too Big to Fail?

by Peter S Goodman

Using public money to spare Fannie and Freddie would increase the public debt, which now exceeds $9.4 trillion. The United States has been financing itself by leaning heavily on foreigners, particularly China, Japan and the oil-rich nations of the Persian Gulf.

This is ridiculous, of course. The US, like any nation with its own non-convertible currency, is best thought of as spending first, and then borrowing and/or collecting taxes.

Were they to become worried that the United States might not be able to pay up, that would force the Treasury to offer higher rates of interest for its next tranche of bonds.

Also ridiculous. Japan had total debt of 150% of GDP, 7% annual deficits, and were downgraded below Botswana, and they sold their 3 month bills at about 0.0001% and 10 year securities at yields well below 1% while the BOJ voted to keep rates at 0%. (Nor did their currency collapse.)

The CB sets the rate by voice vote.

And that would increase the interest rates that Americans must pay for houses and cars, putting a drag on economic growth.

As above.

For one thing, this argument goes, taxpayers — who now confront plunging house prices, a drop on Wall Street and soaring costs for food and fuel — will ultimately pay the costs. To finance a bailout, the government can either pull more money from citizens directly,

Yes, taxing takes money directly, and it’s contradictionary.

But when the government sells securities they merely provide interest bearing financial assets (treasury securities) for non-interest bearing financial assets (bank deposits at the Fed). Net financial assets and nominal wealth are unchanged.

or the Fed can print more money — a step that encourages further inflation.

This is inapplicable.

There is no distinction between ‘printing money’ and some/any other way government spends.

The term ‘printing money’ refers to convertible currency regimes only, where there is a ratio of bill printed to reserves backing that convertible currency.

Skip to next paragraph “They are going to raise the cost of living for every American,”

True, that’s going up!

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Bloomberg News Video Clip

Maybe, but…

It will be tough for the USD index to move up without the CBs and monetary authorities buying it, and that means crossing Paulson and accepting being labeled a ‘currency manipulator’ and ‘outlaw.’

And the higher crude prices mean USD spent on imports increase and unless spending on US domestic assets, goods, and services goes up by that much those unspent USD need to be/are ’saved’ by non-residents and the USD goes to a level that reflects their current desire to accumulate them.

A rising USD is evidence that the foreign sector wants the extra USDs and are fighting over them. A falling dollar is evidence of the reverse.

Also, if they don’t like the other currencies any more than they like the USD, the currencies can remain relatively stable as the excess USDs are all spent on US exports and US domestic assets. The evidence of this is rising/accelerating US exports and export prices and support for US assets which can include real estate and equities. Note the falling USD has made US equities that much cheaper for non-USD based investors.

This is all part of the same adjustment process, which includes ‘inflation’ as all the pieces described above support higher prices for goods and services both in the US and elsewhere.

And the ‘inflation channel’ also is part of the adjustment of the trade gap. I use the extreme example (hopefully it’s only an extreme example) of prices adjusting upward until coffee is $60 billion a cup, in which case the trade gap of $60 billion per month is only one cup of coffee. In other words, higher prices work to bring down the ‘real’ trade gap.

So they are all working together -trade, fx, prices- within current institutional arrangements (including CBs not wanting to be labeled outlaws and currency manipulators vs the desire to support their exporters, etc) as they always and continuously do to adjust desired to actual ’savings’ of financial assets, and sustain all the indifference levels.

A turning point if the level of the USD is sufficiently low to drive the US exports and asset sales to non residents needed to keep their residual accumulation of USD to their desired levels.

And with crude prices still rising, it seems likely to me that more USD are being credited to ‘their’ accounts than they currently wish to cling to at current exchange rates, so more downward pressure on the USD would not surprise me. Along with the associated increase in US exports and higher prices in general.

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Bank deputy chief warns of market trouble to come

by Ben Russell, Political Correspondent and Sean O’Grady

Britain is facing the risk of renewed turmoil in the financial markets, the new deputy governor of the Bank of England warned yesterday.

Professor Charlie Bean, the deputy governor for monetary policy and a former chief economist at the Bank, raised the prospect of a slowing global economy triggering a new round of problems with corporate loans and said that the impact of the credit squeeze could be greater than Bank projections.

Yes, but unlike the Eurozone, the BoE is permitted to ‘write the check’ as in the treasury.

National solvency is not an issue in the UK as it is in the Eurozone when weakness is addressed.

He told members of the Commons Treasury Select Committee that Britain faced “major conflicting risks” threatening the Government’s inflation target from the problems of a slowing economy and rising commodity prices.

Yes, the twin themes of weakness and inflation.

In a memorandum to the committee, Professor Bean warned that the “dislocation” in the financial markets “probably has further to run, especially if a slowing economy here and abroad generates a second round of write-downs, this time associated with corporate loans. Moreover, the impact of the tightening in the terms of availability of credit could prove greater than is embodied in the central case in our most recent set of projections”.

Agreed. And while ‘writing the check’ can readily address these issues with no risk to government solvency, it will also support the higher prices he next discusses:

He said that increasing oil and other commodity price rises would lead to higher inflation becoming “embedded in the economy”, warning that people might seek to offset price increases by making higher wage demands. He said: “There is no doubt that the UK economy presently faces the most challenging set of circumstances since at least the early 1990s and probably earlier.”

Professor Bean said oil prices could continue to rise for another two years and cautioned that Britain faced the danger of a pay-price spiral if workers tried to compensate by pushing up wages. He said: “It certainly poses a significant challenge. There is no doubt about that at all. It may be a relatively unlikely event but it could be particularly unfortunate if it happened, if households and businesses start losing faith in the idea that inflation will stay low, round about the target, they start building it into their pay and prices and inflation becomes much more embedded into the system… Provided pay growth remains subdued, the current pick-up in inflation will be temporary.”

Living standards, the deputy governor stressed, will inevitably be lower because of the global inflation in commodity prices.

Agreed. It’s all about real terms of trade, which have also been declining rapidly in the US as evidenced by the drop in growth of GDP and the drop in non-oil trade deficit.

My guess is the most likely political response in the US and the UK is proactive deficit spending from the treasury to address the weakness and higher interest rates to address the inflation.

Unfortunately the deficit spending that supports domestic demand will also support crude consumption (as well as housing) and ‘monetize’ the ever higher crude prices being set by the Saudis, thereby supporting ‘inflation’ in general.

And this will trigger ever higher interest rates from the Central Bank as inflation trends even higher.

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Karim writes:

FRB-5 stories since Sunday trying to dampen rate hike expectations seems like a coordinated plant: Page 1 of WSJ today, FT article today citing ’senior officials’, Market News piece from Beckner from yesterday, Washington Post article yesterday from Novak, and Blinder editorial in New York times on Sunday. Also Lacker was unusually tame yesterday in his remarks on inflation expectations.

Yes, agreed.

In fact, it can be said that this entire cycle has witnessed subdued inflation responses from top CBs. There is probably no precedent for the Fed cutting aggressively into the food/fuel negative supply shocks.

‘SOME’ have suggested this is a baby boomer phenomena - short sighted aversion to ‘pain’ by a bunch of spoiled kids more than willing to eat their seed corn seems to crop up everywhere. Nothing gets addressed until it gets bad enough to be a major crisis. Energy, biofuels, environment, Iran, weak levies, etc. etc. and now inflation.

It does seem to explain a lot.

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(an interoffice email)

>
>   On Tue, Jun 17, 2008 at 7:58 AM, DV wrote:
>
>   Mervyn King was required this morning to write a letter to the
>   Chancellor explaining why inflation was greater then 3% in the UK
>   (released this morning at 3.2% vs. 3% previously). The letter follows
>   and was taken as dovish by the markets as it seemed to have more
>   emphasis on the weakening economy then additional upside inflation
>   risks.
>
>   DV
>

Letter to the Chancellor

The CPI inflation rate for May, to be published at 9:30 am tomorrow by the Office for National Statistics, is 3.1%. That is more than one percentage point above our target of 2%. Under the terms of the remit you have given us, I am, therefore, writing an open letter to you today on behalf of the Monetary Policy Committee. As requested by the National Statistician, in order to avoid conflict with the release of the official statistic, in this case the CPI, the Bank of England will publish this open letter at 10:30am.

Our remit specifies that an open letter should explain why inflation has moved away from the target, the period within which we expect inflation to return to the target, the policy action that the Committee is taking to deal with it, and how this approach meets the Government’s monetary policy objectives.

Why has inflation moved away from the target?
Inflation has risen sharply this year, from 2.1% in December to 3.3% in May. That rise can be accounted for by large and, until recently, unanticipated increases in the prices of food, fuel, gas and electricity. These components alone account for 1.1 percentage points of the 1.2 percentage points increase in the CPI inflation rate since last December. Those sharp price changes reflect developments in the global balance of demand and supply for food and energy.

In the year to May:

• world agricultural prices increased by 60% and UK retail food prices by 8%.
• oil prices rose by more than 80% to average USD123 a barrel and UK retail fuel prices increased by 20%.
• wholesale gas prices increased by 160% and UK household electricity and gas bills by around 10%.

The global nature of these price changes is evident in inflation rates not only in the UK but also overseas, although the timing of their impact on consumer prices differs across countries. In May, HICP inflation in the euro area was 3.7% and US CPI inflation was 4.2%. As described in our May Inflation Report, inflation is likely to rise significantly further above the 2% target in the next six months or so.

The May Report set out three main reasons for this:

• The increase in oil prices will continue to pass through to the costs faced businesses.
• Rising wholesale gas prices are expected to lead utility companies to announce further tariff increases. There is considerable uncertainty about their size and timing.
• The depreciation of sterling, which has fallen some 12% since its peak last July, has boosted the prices of imports and will add to the pressure on consumer prices.

The Committee’s central projection, described in its May Inflation Report, was for CPI inflation to rise to over 3 1/2%% later this year. But in the past month, oil prices have risen by about 15% and wholesale gas futures prices for the coming winter have increased by a similar amount. As things stand, inflation is likely to rise sharply in the second half of the year, to above 4%. I must stress, however, that there are considerable uncertainties, in both directions, around this, and any such projection is particularly sensitive to changes in domestic gas and electricity charges.

There are good reasons to expect the period of above-target inflation we are experiencing now to be temporary. We are seeing a change in commodity, energy and import prices relative to the prices of other goods and services. Although this clearly raises the price level, it is not the same as continuing inflation.

There is not a generalised rise in prices and wages caused by rapid growth in the amount of money spent in the economy. In contrast to past episodes of rising inflation, money spending is increasing at a normal rate. In the year to 2008 Q1, it rose by 5 1/2%, in line with the average rate of increase since 1997 - a period in which inflation has been low and stable. Moreover, in recent months the growth rate of the broad money supply has eased and credit conditions have tightened. This will restrain the growth of money spending in the future.

Over what period does the MPC expect inflation to return to the target?
It is possible that commodity prices will rise further in the coming months - oil prices have now been rising for four years. But in the absence of further unexpected increases in oil and commodity prices, inflation should peak around the end of the year and begin to fall back towards the 2% target. Nevertheless, each monthly rise in food, energy and import prices will, by pushing up the overall price level, affect the official twelve-month measure of inflation for a year. So CPI inflation is likely to remain markedly above the target until well into 2009.

I expect, therefore, that this will be the first of a sequence of open letters over the next year or so. The remit for the Monetary Policy Committee states that:

“The framework takes into account that any economy at some point can suffer from external events or temporary difficulties, often beyond its control. The framework is based on the recognition that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output”.

The Committee believes that, if Bank Rate were set to bring inflation back to the target within the next 12 months, the result would be unnecessary volatility in output and employment. So the MPC is aiming to return inflation to the 2% target within its normal forecast horizon of around two years, when the present sharp rises in energy and food prices will have dropped out of the CPI inflation rate. Nevertheless, the Committee is concerned about the present and prospective period of above-target inflation. It is crucial that prices other than those of commodities, energy and imports do not start to rise at a faster rate.

That would happen if those making decisions about prices and pay began to expect higher inflation in the future and acted on that. It could also happen if employees respond to the loss of real spending power that results from higher commodity prices by bidding for more substantial pay increases. Pay growth has remained moderate. But surveys indicate that higher inflation has already had an impact on the public’s expectations of inflation. For that reason, the Committee believes that, to return inflation to the target, it will be necessary for economic growth to slow this year.

A slowdown is already in train. Moreover, as described in the Committee’s May Inflation Report, the prospective squeeze on real incomes associated with higher inflation, together with the reduced availability of credit, is likely to lead to a further slowing in activity this year. This will reduce pressure on the supply capacity of the economy and dampen increases in prices and wages. What policy action are we taking? Since December, Bank Rate has been reduced three times, to stand at 5%. When setting Bank Rate the Committee has faced a balancing act between two risks. On the upside, the risk that above-target inflation could persist explains why the Committee has not responded more aggressively to signs that the economy is slowing. On the downside, the risk is that the slowdown could be so sharp that inflation did not just return to the target but was pulled below. This explains why Bank Rate has been reduced at a time when inflation is above the target.

The MPC will discuss at its July meeting the implications of the latest inflation and other economic data for the balance of these risks. That analysis will be described in the minutes, published two weeks later, and a fully updated forecast will be presented in the August Inflation Report. The path of Bank Rate that will be necessary to meet the 2% target is uncertain. The MPC will continue to make its judgement about the appropriate level of Bank Rate month by month.

How does this approach meet the Government’s monetary policy objectives?
Over the past decade, inflation has been low and stable. Volatility in commodity, energy and import prices means that inflation will now be less stable but it does not mean that inflation will persist at a higher rate. The Committee will maintain price stability by ensuring that the rise in inflation is temporary and that it returns to the 2% target. In the short term, this commitment should give those setting prices and wages some confidence that inflation will be close to the target in the future. That will minimise the slowdown in economic activity that will be necessary to ensure that inflation does fall back. In the longer term, price stability, as our remit states, is “a precondition for high and stable levls of growth and employment”.

We have seen in the past how the need to reduce inflation from persistently high levels has required prolonged periods of subdued economic growth. The resulting instability in our economy deterred investment and contributed to poor economic performance over a longer period. The Monetary Policy Committee remains determined to set interest rates at the level required to bring inflation back to the 2% target, and I welcome the opportunity to explain our thinking in this open letter.

I am copying this letter to the Chairman of the Treasury Committee, through which we are accountable to Parliament, and will place it on the Bank of England’s website for public dissemination.

Thanks, seems the risk of crude rising continuously due to demand continues to be downplayed by the world’s central bankers even though it has been the case for several years, so they continue to pursue policies that in their models are designed to at least support demand.

I continue to suggest mainstream history will not be kind to them.

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Dollar Index vs US Exports

Right - seems to me the dollar will fall until it’s at a level where the trade gap goes to about zero. So even though exports are way up and the trade gap down, there could be a lot more to go.

A nation can only run a trade deficit to the extent non-residents (governments and private sector agents) desire to net accumulate its financial assets (or buy its domestic assets such as real estate).

Seems to me Paulson, Bush, and Bernanke have successfully kept the world’s CBs, monetary authorities, and portfolio managers from actively accumulating USD financial assets.

Doesn’t seem like jawboning is going to alter foreign ’savings desires’ apart from short term trading responses.

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Maybe the weak USD is causing him to have second thoughts on preventing CBs and monetary authorities from accumulating USDs to keep their currencies low and support their exporters?

Ending dollar peg won’t solve Gulf inflation: Paulson

by David Lawder

(Reuters) U.S. Treasury Secretary Henry Paulson said on Saturday the dollar peg for currencies in the Middle East had served those countries well and any changes to the peg would be a sovereign matter.

Paulson, on a visit to Saudi Arabia, Qatar and the United Arab Emirates, also told a news conference the current level of oil prices were a burden on economies and consumers around the world.

Asked about the dollar peg, Paulson said:

“That is a sovereign decision … The dollar peg, I think, has served this country (Saudi Arabia) and this region well.”

Paulson earlier met Saudi Finance Minister Ibrahim al-Assaf to discuss a range of issues including the oil market, the U.S. and Saudi economies and issues related to foreign exchange.

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Mainstream economics says:

Get inflation right and that ‘automatically’ optimizes long-term growth and employment.

Adding to demand with a negative supply shock turns a ‘relative value story’ into an ‘inflation story.’

The ECB is following mainstream theory, while the Fed is not.

why?

The Fed sees looming systemic, deflationary tail risk at the door. At least up to now.

The panic of 1907 and the early 1930s deflationary collapse (both previous examples given by the Fed) were gold standard events.

With a gold standard (and/or other fixed rate regimes) there are direct supply side constraints on the reserve currency. Interest rates are market determined, and during a credit crunch rates spike higher ‘automatically.’ Even the treasury must fund itself and faces the same supply side constraints, thereby limiting fiscal responses. This continues in today’s fixed fx currencies.

With floating fx/non-convertible currency there are inherent no direct supply side constraints on bank lending, deposit creation, and credit in general. Any constraints are on the demand side, including financial capital where constraints are also on the demand side. The CB necessarily directly sets rates, not market forces, and government spending is not constrained by taxing, borrowing, etc., hence fiscal packages are subject only to political choice.

Today’s risks are much the same as previous financial crisis type risks like 1987 and 1998, where the government and its agencies have the open option of ‘writing the check’ as desired, with inflation the price to pay, not government solvency as with fixed fx regimes.

Just like the 1970s, the Saudis are acting the swing producer and setting price and letting quantity they pump adjust. This is also necessarily the case when one is single supplier at the margin with excess capacity. The alternative of pumping flat out and hitting bids in the spot market is not a functional option for any monopolist. Only price setting is.

Russia is also a monopoly supplier at the margin and probably is also acting as a swing producer. So crude prices go to where the higher of the two set them.

Mainstream theory has not yet publicly addressed this kind of negative supply shock.

One option is to match the domestic inflation rates to the price hikes to try to avoid declining real terms of trade.

This is both politically impossible, and it can quickly lead to accelerating inflation.

We have two choices, neither particularly attractive:

1. Watch our real terms of trade continue to collapse as crude prices are continuously hiked.
2. Try to inflate to moderate the drop in real terms of trade.

Ironically, we will chose the later as we did in the 1970s because inflation is not a function of interest rates in the direction CBs subscribe to.

Increasing nominal rates increases inflation via the cost and demand channels.

Costs of holding inventory and investment rise with rate hikes.

Governments are net payers of interest to the non-government sectors; so, rate hikes also increase government spending on interest to support incomes in the non-government sectors.

Good luck to us!

(an email exchange)

>
>   On Mon, Apr 21, 2008 at 9:55 AM, Russell wrote:
>
>   Fannie and Freddie now back 82% of all mortgages in the U.S.,
>   up from only 46% in the second quarter of 2007. If they need
>   a bailout – could be a trillion dollars –

Funds are already advanced to the homeowners which supports demand.

A ‘bailout’ would only be an accounting entry between the government’s account and the agency’s account - no effect on aggregate demand.

>   the USA may lose its AAA credit rating.

Like Japan did. Just another sign of incompetance by the ratings agency if it happens.

Looks functionally the same as direct lending to the banks vs their mortgage-backed securities.

Don’t know why they are taking this indirect route. Maybe because the Fed is also doing a security lending facility vs direct lending, and the BOE doesn’t want to show them up by doing it right as a gesture of solidarity.

Like everyone in Spain talking with a lisp when pronouncing the ’s’ sound because the king did way back.

Gets stranger by the day.

Treasury and Bank to publish mortgage remedy

by Chris Giles

The government and Bank of England’s plan to unblock mortgage markets will be published today, but its broad outline began to emerge shortly after Mervyn King, Bank governor, met the heads of the main British banks a month ago.

Unlike other European countries, which wanted to change accounting rules to increase the value of mortgage-backed securities on banks’ books, the British authorities have aimed to acquire these assets at a price higher than the current market values but lower than the price that reflects the fundamental risk of default.

Because they reckon a gap between the two prices exists, the intention is to ease the liquidity strains on banks without the taxpayer adopting much extra risk or buying assets that are fundamentally under water.

With Treasury approval, the Bank of England is to swap mortgage-backed securities for government paper for a year, with an understanding that these year-long swaps will be extended for a further two years.

The programme will act as a new Bank of England facility by which banks will be given short-dated and highly liquid Treasury bills with maturities of one year or less. The Bank will accept mortgage-backed securities and other asset-backed securities in exchange. So arrangements will not be counted as new government debt by public sector books.

Ed says:

Warren,

Isn’t it also true that the US export boom is less a result of the weaker dollar, so much as it is the cause? Foreigners using the trade surplus dollars they were previously content to save, are now spending them, and the shopping list is sizable. In this sense, all the dollars we have been exporting for years are coming home to roost, and that explains a good chunk of the inflation we are seeing.

Ed

I agree the cause is foreigners switching as a sector from wanting to accumulate USD to not wanting to accumulate them, and therefore spending them.

However, I see the market forces working as follows:

The first desire is ‘not to save’ which drives the USD down either until the $ is somehow low enough where they want to save it again, which doesn’t make sense to me, or until the USD is low enough for them to spend them here, which makes a bit more sense to me.

And the other force is the decreased desire to export to us which is evidenced by higher import prices.

Last, this is all inflationary, and inflation is the other channel for getting rid of a trade gap.

For an extreme example, if there is sufficient inflation for the minimum wage to go to $60 billion per hour, the real trade gap is suddenly down to only an hour of labor, though still nominally at 60 billion.

The combination of rising net exports, falling imports, and inflation are all working together right now to digest the sudden shift from CBs and monetary authorities away from buying USD financial assets.

Fiscal adjustment checks start going out in a couple of weeks.

Rest of govt. spending going up as well.

GDP should muddle through and inflation continue to accelerate.

It may dawn on the Fed that the weak dollar is hurting the financial sector as the consumer is being squeezed by food/energy prices and therefore having trouble making loan payments. That’s the price of sticky wages, at least this time around.

Foreign CBs have no option regarding world currency stability but to try to put pressure on the Fed to stop cutting.