Archive for the ‘Monetary Policy’ Category
After having been blissfully unaware of any economic and market news since the end of March I am back in Boston, and it’s time for me to get back into the game. I’m still in the process of catching up, but here’s what I think the key developments over the last few months were:
1. The market hit a (temporary) bottom in early March. The Dow Jones is back at around 9,550, roughly 45% above its March 9 low of 6,547.05. Similarly, the S&P500 is somewhere north of 50% above its March low. At the same time, 30 year Treasury yields are back in the neighborhood of 4.35% after having hit a bottom at 2.55% in late December 2008.
2. Both Chrysler and GM declared bankruptcy; the two firms emerged from bankruptcy after no more than a few weeks each. In addition to the troubled automakers there were 84 bank failures in 2009 through August, a full 63 of which occurred in between the end of April and now. 24 of those bankruptcies occurred in July, another 15 in August.
3. The US economy seems to recover, albeit slowly. Unemployment stands at 9.4% but negative GDP growth slowed to -1.0% over the second quarter and durable goods orders were up. Re-appointed Fed Chairman Ben Bernanke suggested in his speech last week that we have the worst behind us in this “most severe financial crisis since the Great Depression.”
But do we really? Is the rally in the stock markets actually sustainable, especially without analogous interest rate increases? What happens if the dollar crashes? What if inflation picks up? The futures markets do not seem particularly worried at the moment: implied probability has the Fed Funds rate steady at 0.25% through the end of 2009 and then suggests and increase to 1.0% towards the end of the first quarter of 2010, suggesting steady progress on the course towards economic recovery.
My own conclusion at this point is simple: I’m at a loss. I don’t see what should justify a stock market rally of the magnitude that we have seen. I do see optimism that isn’t based on any real data (if you disagree please let us know!), and I believe that there’s a systemic problem lurking in the financial system that we prefer to ignore: all the money that has been printed over the course of the last year. When you look at the US monetary base and the level of excess reserves of depository institutions, the picture doesn’t look much different from seven months ago when I first wrote about it.
Bernanke suggested last week that “the continuing provision of liquidity and a tightening of the regulatory framework are key” to keep financial markets functioning properly. It’s blatantly obvious that the provision of liquidity remains a top priority of the Fed at the moment, and our monetary base and excess reserves are still at levels that are barely different from the end of 2008 when the crisis was in full swing. Looking at these charts doesn’t make me confident that we have the worst behind us. Or maybe we do, and what we are looking at is a systemic change in the financial system. What do you think?
The title says it all: my next blog post will likely be up in August 2009, thanks to a four month sabbatical. Hopefully by the time I return from Southeast Asia / New Zealand / Fiji, the various Fed & Treasury efforts will be having a lasting – positive – effect on the economy. Regardless of if things will look better or worse, I am going to be back with charts and commentary on Wall Street and DC in the summer. In the meantime, feel free to continue to leave comments on my previous posts (they’ve been a huge source of value-add so far, thanks to all who contributed!); I look forward to picking up where we left off later this year.
Over the last few months we’ve seen a drastic increase in bank reserves. As I’ve pointed out on previous occasions, banks are soaking up the liquidity provided by the Fed’s various programs and the credit crunch continues. But what’s the reason? Is it that banks are unwilling to lend in the current environment, trying to cap their losses? JPMorgan recently argued that it’s not the supply of credit that has collapsed, but the demand for it – consumers are hunkering down and have lost their appetite for spending; businesses that suffer from weak demand don’t require as much credit as they do in prosperous times; and hedge funds have grown weary of leverage. It’s a bit of a chicken and egg problem, but what do you think: is the credit crunch driven by the lack of supply or the lack of demand?
The money multiplier is money stock M2 (money & close substitutes for money) over monetary base M0.
This is a visual addendum to my earlier post about inflation vs. deflation and the quantity theory of money. As a reminder, Friedman postulates that inflation is caused by an increase in the money supply; the quantity theory of money in its simple form states that the amount of money in an economy multiplied by its velocity equals the real value of goods in the economy times the price level, or M*V = P*Q. So an increase in the money supply, ceteris paribus, should result in an increase in price levels.
As I noted last month, the US monetary base has recently seen drastic increases. We haven’t seen rising inflation, though, because all the additional money that the Fed has been printing is getting soaked up by banks upping their reserves. FT Alphaville’s Stacey-Marie Ishmael posted an impressive chart yesterday showing this decrease in the velocity of money.
You can find the original here. And if you’re sifting through the FT Alphaville archives, also take a look at the hyperinflation scenario that Morgan Stanley sees as a (not highly likely, but realistic) possibility.
As the title says, this one is just for fun: a chart of the price of CDS on 10 year US Treasuries from April 2008 through January 27. The CDS priced at 68 bps today, after having hit a record high of 75 bps in the first week of December. According to FT Alphaville, the same contract trades around 2 (!) bps points in normal times. I should mention that the concept of CDS on US sovereign debt is somewhat flawed in my opinion (Who buys these things? Do people really think their counterparty will be around to honor the CDS if the US defaults? Isn’t the market too thinly traded for prices to be meaningful?), but their development is still interesting to watch. The chart below includes annotations on a few major Wall Street and Main Street events.
If you’re interested in commentary, I recommend the recent pieces by Greg Ip, Dean Baker and Felix Salmon for further reading. And if you have any thoughts on how sensible or flawed the notion of CDS on US Treasuries is, post a comment and let us know!
As I’ve been asking colleagues and friends what topics they’d like me to address here, I got a number of interesting nominations: from a closer look at the Iceland debacle over economic damage control to the question of what needs to happen for things to finally get better. I plan on spending time on all of the above in the very near term, but the one topic that currently occupies me is closely related to the previous posts – at least in substance, if not geographically.
I believe that inflationary tendencies are a significant concern for the US over the medium term. The same holds true for Europe, but the stakes are different. Not only does Europe have to worry about its economic future, but the economic union also has its common currency to look after. Starting last fall, talk of the EU’s Economic and Monetary Union (EMU) potentially falling victim to the financial crisis began to surface as European spread levels came to indicate that the currency union should not be taken for granted. In addition to widening spread levels, prediction markets are trading futures on the likelihood of at least on Eurozone member leaving the currency union by the end of 2010, and the prices indicate a likelihood of more than 20% of such an event occurring, with prior highs of more than 30%.
To take a step back from prediction markets or bond market realities (i.e. spread levels) and understand the macro mechanism behind what we’re seeing, I once again revert to textbook simplicity – what are the advantages and disadvantages of a currency union?
Primary advantages of a currency union per Harvard economists Robert J. Barro and Alberto Alesino:
(1) diminished transaction costs for goods & financial services (scalable with the number of member countries)
(2) peripheral members “import” the inflation rate of the anchor country (or anchor countries, in this case Germany and France which account for 45% of the Eurozone’s population and 52% or $4.4 trillion of the Eurozone’s $8.4 trillion combined GDP in 2006)
Primary disadvantages of a currency union:
(1) loss of flexibility in monetary policy, especially for peripheral members
(2) loss of seigniorage revenue unless elaborate currency union treaties are in place
(3) import of inflation rate for peripheral nations does not necessarily translate to price stability
What makes the Euro vulnerable to the current crisis is that it is an EMU product only by name – while the fifteen nations of the Eurozone are bound by a common currency and interest rates are set by the the European Central Bank, the union is a monetary union only and not an economic union. The impact of and responses to the global financial crisis vary from country to country, and quite drastically – yet all Eurozone members are subject to the ECB’s interest rate policy. As inflation expectations and the strength of individual countries’ banking systems diverge, we may come to a point where the advantages of sovereign monetary policy may outweigh the disadvantage of increased transaction costs.
William Buiter recently articulated a different view in the Financial Times, as picked up by Yves Smith at Naked Capitalism on January 15. Buiter suggests that “a eurozone country defaulting and leaving the euro is close to an unthinkable event.” What do you think?
I’m deliberately being simplistic and reducing the inflation/deflation debate to the monetarist framework; I think it’s useful as a starting point in order to get a grasp of the facts – and I like scary graphs. So take a look at the St. Louis Fed statistics regarding currency in circulation and monetary base: despite abundant talk of the Fed printing money, currency in circulation on an absolute level has not increased that drastically over the last few months. Sure, the slope of the curve or pace of increase has accelerated a lot, but from an absolute perspective things don’t look too bad:
Unfortunately, the above graph only shows currency in circulation, or the amount of currency available to consumers. The picture looks very different when you look at the US monetary base (i.e. Fed reserves and the reserves of commercial banks at the Fed): the monetary base has more than doubled over the course of 2008.
Hard to argue that this looks like it should spell inflation. Why haven’t we seen any of it so far? The answer is simple: banks have increased their excess reserves and are too scared of what may come to lend to the consumer. The graph below shows the missing link between monetary base expansion and the growth (or lack thereof) in the volume of currency in circulation, namely bank reserves in excess of Fed requirements.
The above charts suggest that we are currently seeing deflation concerns because banks are increasing their excess reserves faster than the Fed is expanding the monetary base; in other words, all the additional money printed by the Fed is getting soaked up by banks and the consumer is seeing decelerating inflation. This trend is bound to reverse suddenly and drastically once credit thaws, though. At that point do you think the Fed will be able to drain excess cash from the system fast enough to prevent massive inflation?