Will the Fed Cut Again?
Usually, I don't indulge on Fed watching here at this blog but since global central banks at this delicate point in time cannot exactly be treated within the realms of black box analysis (and no they can't!) the proper analysis of what is going on within Europe and the Eurozone, where I usually situate my analyses, critically depend on what happens in the US come next Fed meeting. You see, with the EUR/USD flirting with figures around 1.43-1.44 and a US economy where the economic news flows continue send to out bad signs the Eurozone has now become (one of) the center piece(s) for the test of de-coupling in the sense that one of the really big questions in connection with the global economy at this point in time is for how long and indeed whether in fact the ECB can hold or go north in an environment where the Fed walks the opposite direction? (The same question could of course be asked in connection to Japan and the BOJ but at this point I think this is even more unrealistic).
In many ways, the recent release on the US trade balance gave us the first signs that thing might be about to change in the global economy and thus also in connection to the global imbalances. Not surprisingly, Brad Setser (and Macro Man too) was all over this and according to Brad the release made for some very grim reading indeed; the main point is this ...
The net outflow in August – from a combination of foreign investors reducing their claims on the US and Americans adding to their claims on the world – was around $160b. Most of that -- $140b – came from the private sector, but the official sector also reduced its claims on the US. The total monthly outflow works out to a bit more than 1% of US GDP. Annualized, that is a 12% of GDP outflow. To put a 12% of GDP outflow in context, it is roughly the magnitude of the private outflow from Argentina in 2001, at the peak of its crisis.
Throw in the United States roughly $70b a month current account deficit and there is a $200b – or 1.5% of GDP monthly, and more like 18% of GDP annualized – gap between the net flows in the August data and the flows needed to sustain the current equilibrium. There is no way to spin that kind of outflow as a positive.
Of course, this spells trouble for the Dollar in the sense that the only way this 'gap' can be filled is by definition for the Dollar to fall. Yet as I have argued time and time again there is a little more to it than the traditional 'the US is going down' story and really the international structure of capital flows are much more symbiotic. However, this does raise some very interesting and essentially immediate questions ...
- Where is the capital going? Clearly, if people are selling US denominated assets they have to pool that liquidity elsewhere in the sense that the books has to balance one way or the other; this begs the question of where all the money is going The recent perkiness of the Euro tells a part of the story but clearly China is also under much pressure at the moment to widen the band for Yuan appreciation. Also, India seems to be sucking up a lot of capital at the moment. At this point it is difficult to say which ties intimately to the next point.
- Are we re-balancing? Remember that this question entails much more than whether the US deficit is about to correct (i.e. narrow) and in reality we need to ask ourselves whether importers will turn into exporters and vice versa. At this point, I would argue that Brazil as a single nation would be best equipped to swing into a deficit in the short run. China is much more complicated although its strong ties with the US in bilateral terms mean that the Yuan might be able to take up some slack. I doubt however, that China itself is going to rebalance in any sense of the word. As for the Eurozone a lot of faith seems to be attributed to this but I don't buy it, and this is in fact is what this post is implicitly all about. In general terms the Eurozone aggregate external balance is likely to be stuck in a very modest surplus moving towards a balance and perhaps a small deficit. As for Japan, well I don't think I need to say much here but merely to note that Japan is completely dependant on exports at this point. Moreover, the interesting thing will be whether Japanese authorities are going to intervene if the Yen appreciates too much. My guess is that they will if and when the Yen approaches 100 per Dollar.
As such, and in order to approach an answer to the question of where the capital is flowing then my guess would be the Eurozone (where the ECB of course is now stuck in a bind), India, Turkey and of course Eastern Europe where capital still seems to be pouring in although the edifice is seriously wobbly. Brazil should also be watched here. Yet, I don't really have any hard data on my hands here so I am pending Setser here. Lastly and in close connection to notion of re-balancing and de-coupling we need to ask ourselves for how long and far this current process of adjustment can go on and if you believe that the process will continue you need to begin speculating where the money is going to flow or perhaps better yet, look! One thing seems certaint in the sense that in stead of talking about de-coupling from the US we should perhaps rather be talking about re-coupling in the sense that it now seems as if many of the big emerging markets are being treated as much more mature investment (or is this just because of too much liquidity chasing too little yield?) targets than to actually merit calling them 'emerging' markets, I mean; emerging from what? China is still the big question mark for me in this sense and I am not sure Yuan appreciation is a magic wand of re-balancing although of course and as always time will tell.
As should readily clear this ties in quite well with my initial question surrounding the Fed's next decision. The latest Fed watch from Tim Duy (courtesy of Mark Thoma) leaves us with little confidence in terms of a strong call.
Bottom line: The flow of recent data, outside of housing, in my opinion does not suggest an immediate need for additional easing. I continue to believe that the external accounts are beginning to drive a structural shift in the US economy that is not fully appreciated by many. At the same time, this is another close call, and market participants could very well be 50-50 again on Halloween.
With today's data suggesting that the labour market conditions might suffer further the barometer is inching ever so more in the favor of a further cut but I am far too modest to be making any kind of concrete call. What I can see however from my desk here in Europe is that the EUR/USD is likely to stay in 1.43-1.44 territory for the foreseeable future, I can also see that Eastern Europe where many countries, as you will remember, are pegged to that Euro on helium is in a substantial risk of running into a nice bout of Christmas trouble, finally; I am looking at a European central bank which is still trying to play the situation as an attempt to strike the ultimate balance but alas this is a strategy which could very well end up badly once calls are made and the cards have to come on the table. It is in this immediate light that I am awaiting the Fed decision with much interest since depending on the move and the rhetoric the rubber band might end up being stretched even further than it already is. There is also of course a flip side of this coin and thus all my talk about why central bankers in the G3 might be more reluctant to look south than north, yes you guessed it; inflation. The Economist had an illuminating article recently on this topic and as such we really should be watching those structural inflation pressures (or headline if you will);
AS oil touched $88 a barrel on Tuesday October 16th, the temptation was to seek an explanation in geopolitical events. Many cited a potential incursion by Turkish soldiers into northern Iraq. Some believed gold’s rise to a new 27-year high was driven by the same factor.
But the commodities market is being affected by a lot more than just events in the Middle East. Raw materials prices are seeing widespread gains. Talk of a “supercycle” is in the air. As of October 15th, copper, lead, soyabeans, wheat, cotton, coffee, cocoa and cattle feed were all showing double-digit percentage gains on the year.
Perhaps, it is as the Economist lays it out in the sense that the credit crunch/financial market turmoil itself has prompted investors to pool money into commodities as proxy for a flight to safety. Yet, I am more inclined to another explanation which, at least in part, also needs to be considered. In this way and by no means is this new we also need to look at the effect of this idea that the global economy is 're-coupling' in the sense that those large 'emerging' economies are proxies for a solid upward tick in global commodity prices. In close connection, you have the ever recurring talk about the China effect and its potential reversal. The always readable IPEZone had an interesting contribution up just a few days ago ...
For the longest time, many commentators noted that China exported deflation by taking advantage of labor, environmental, and currency arbitrage (i.e., an artificially weak yuan). Those days may be coming to a close, however, as raw materials prices rise. Ironically, Chinese demand for these raw materials is likely a large driving factor behind these price rises. Labor prices are going up as well as workers are unable to make ends meet by working at lower wages while the cost of foodstuffs [:- )] rises.
Lastly and as a sort of conclusion on inflation I am sure the econsphere's designated inflation hawk Stefan Karlsson without a doubt will hammer down again and again the risk of rising inflation is very real. I largely agree but I am just not sure that traditional central bank remedies will be exactly what the doctors should prescribe; at least the trade-off epitomized by the ghost of stagflation seems set to potentially become a very hot potato.
Ok, I think that I will finish off now. Sorry that I am not able to answer the question which started this whole writ of mine but given even higher minds' hedging galore I hope that you can forgive me. IF pressed (and now I am going to do this anyway) I think that the Fed will hold; boring ain't it?