Is the Fed Getting Cornered and a Bird's Eye View
[Update added below: Markets are moving at a blistering pace]
[Update 2 added below: Mark Thoma refers to my post and an interesting comment follow in the comments section]
If you want doom and gloom about the current environment in financial markets and 'Fed bashing' you probably don't want to sniff much around this space. I usually try to refrain from these kinds of rants since they rarely bring anything useful to the debate even if they are exceptionally effective in shaping the general market discourse. However, you cannot make the seas go back and it does seem as if we are slowly but surely getting closer to some kind of crunch time whatever that is. On the face of it equity markets do not seem to be sending this message. On the back of the Fed recent measure to combat the liquidity and solvency crisis equity markets rallied to reflect the new measures. And what was those measured again? Well IHT (linked above) provides a good overview.
The Federal Reserve, increasingly convinced that the United States is sliding into recession, is now taking on the role of lender of last resort to subdue the deepening global credit crisis. Impelled to take extraordinary measures for the second time in less than a week, the Fed moved Tuesday to let the biggest investment banks on Wall Street borrow up to $200 billion in U.S. Treasury securities in exchange for hard-to-sell mortgage-backed securities as collateral. And the Fed made clear that it was prepared to do more as needed, even as analysts questioned the wisdom of such steps.
The move, which was coordinated with central banks in Europe and Canada, came on the heels of two similar actions on Friday, in which the Fed offered up to $200 billion in 28-day cash loans to banks and big financial institutions. The Federal Reserve, in effect, is trying to ease an acute credit squeeze by agreeing to hold large volumes of mortgage-backed bonds that Wall Street firms are struggling to sell, and providing them with either cash or Treasury securities that they can immediately convert to cash.
If you want more the blogosphere has been fuming with comments and analysis on just exactly what it is the Fed is doing. Mark Thoma has basically been devoting his daily posting to the theme; especially these two are good. Also the WSJ's Real Time Economics adds some interesting comments to the roundtable as well as Steve Waldman from Interfluidity posts a much cited piece about the merits of the Fed's willingness to assume those dubious assets as collateral against lending out a large part of its treasuries. However, the much more pertinent question is the extent to which the Fed is still carrying credibility in the market place to do what it is actually doing which basically is the to strongly discount future and current inflation relative to fighting off an imminent and severe recession. One would think that this ultimately is a question of getting it right and given the fact that fundamentals always triumph I would still believe this to be the case. But, market discourses also matter and on this account the water is surely and steadily trickling in to the Fed's bastion. I could cite an endless amount of rants here but I tend to go for quality over quantity and in this respect I couldn't do much better than to point to Jim Hamilton's (from the excellent Econbrowser) recent piece. In his eloquent post Jim asks whether we are too demanding of monetary policy and thus implying that the Fed is perhaps over reacting to markets' cry for relief. Whether he is right or wrong is not really the question at this point but more so the question of the extent of a central bank's reach is the important puzzler to extract from this one.
Shifting gears and turning to the fast paced real world it also seems as if 'markets' in general are not quite sure that the Fed knows what it is doing. The USD is thundering down in turn stoking inflation even more and gold and oil prices have sky rocketed to a level and with a pace that can only indicate a massive surge of speculation that the Fed is out of control at this point (i.e. inflation hedging big time). I personally do not think this is the case but I do think that with this recent lending facility setting the cuts of nominal interest rates should be postponed or at least be taking down in pace. This is of course a normative opinion and not a forecast where the latter clearly points to further cuts in the nominal interest rate come next week.
In a more broad context the US slowdown is of course not only about the US economy but also crucially about the global economy and whether we are finally sowing the seeds for a process of re-balancing by which the US hands over the baton to another set of consumption nations to pull forward those economies of the world who are dependant on exports to grow. A lot of things are being said about this at the moment which is natural since the movements of markets seem, to some extent, to indicate that this is indeed what we are seeing. In terms of exchange rate adjustments the rally of the EUR/USD is perhaps the most telling sign here as is perhaps the USD/JPY although the latter case is quite special I feel. Yet, de-coupling and re-balancing were always about two separate issues which many commentators often fail to realize I feel (although I wouldn't count Brad Setser here even if our opinions differ)
1) Can the global economy grow even as the US slows and what would be the exact transmission mechanism here?
2) Will importers (external deficit nations) turn into exporters (external surplus nations) and vice versa?
These two questions are of course intimately interconnected but there are some important qualifiers to take aboard which I recently tried to formalize in two separate notes here at Alpha.Sources. Everybody with a basic understanding of economics can see that the USD has to fall or at least that it increasingly had to come under such pressure. The edifice known as BWII has of course prevented this and in many ways it still is since if we look at the currencies towards the USD which are now rallying the most we are eyeing the Euro and the Yen. This is not sustainable I think as a cure to the global imbalances since this is a proxy for the traditional de-coupling argument in which the Euro (and perhaps the Yen) rose to might and clawed the mantle of global reserve currency from the white pale exhausted debt laden hands of the US consumer as well as assuming the new main pole in a new variant of BWII. I thus think there are sound theoretical arguments as to why this is not likely to happen. Yet, all this does not mean that the USD cannot and should not fall. This is then the process I like to refer to as re-coupling in which new emerging economies such as China, India, Turkey and Brazil (etc) steadily but surely gains on the developed economies in terms of total clout in the global economy. China and for that matter the petro exporters who are still pegging to the USD are however rather important here since I still think it is unclear how these two can revert to consumption driven growth paths at the speed we are expecting at the present time. In this setup you also have an attempt to answer question 2 and thus why those structurally dependant on exports will remain in that role; their customers of course will just be different. In this respect Edward was very succinct recently in his description of the revised Japanese Q4 GDP release ...
This would seem to suggest, to say the very least, that Japanese growth is now significantly "decoupled" from the US - in the sense that exports to that market don't carry as much weight - but is most definitely NOT "decoupled" in the sense of being driven by autonomous domestic demand lead growth. Not only this, but Japanese exports are performing relatively well on the back of rising demand in the rapidly developing emerging economies. This phenomenon is being virtually replicated in Germany, that other ageing-society economy which is driven by export demand. So we need to follow carefully what happens next here, to see what can be learnt.
As you can see Edward even managed to slip in a comment on Germany here and if we accept the general theory (which is of course testable as we move along) what the global economy need at present, and more so in the long run, is a slew of economies who are able to provide the capacity for all that liquidity in the form of FX reserves and savings so desperately in search for yield. This is perhaps the most striking feature of global capital markets at the moment in the sense that what we have is a disconnect in liquidity conditions. Ultimately, this is also why I am leaning a bit to the skeptical side after all when it comes to the ability of the global economy to de-couple from the current economic malaise in the US. Quite simply, I don't see how many of the surplus nations and most notably, in the present case, China and the petro exporters can recycle all that liquidity into their own economies not to speak of shipping it off to Italy, Portugal or Greece etc. Clearly, the term structure and accumulation of US treasuries are telling us this much in the sense that yields are not what drives the purchasing at this point in time but rather the preference of having a place that can actually absorb the proceeds. We need to understand in this respect I think that from the point of view of a 'nation' a surplus cannot be spent (dissaved) but rather it must be invested. Consumers can dissave but nations cannot since this erodes long term growth rates and then of course we get into the whole demography matters predicament since as the global economies age their consumers will most likely dissave but more importantly their inter temporal demand for consumption over saving will tend to crowd in the same end of the spectrum in the sense that they all want to ship off their capital abroad and live off of the income. Ok, I am moving far astray at this point which was not really the main idea. In general, I have some unfinished business to attend to and in this respect some comments on the recent ECB meeting and general Euro area/Eastern Europe outlook are at the forefront. I also want to come in soon on the debacle which is evolving in Japan as the opposition expectedly decided to shun the main party's proposition for Muto as the new governor of the BOJ. Finally, I recently received a slew of academic papers in my inbox so expect some reviews too.
Meanwhile; stay on top, don't rant, and most importantly be careful out there in the real world.
The tide is moving fast at the moment, very fast. On FX markets the EUR/USD rose to close to 1.56 which is an eyeboggling level but as I noted in a comment over at Macro Man recently it is not that surprising after Trichet made his choice to go for inflation at the last ECB meeting. For all it is worth it could go to 1.60+ with the pace we are seeing. The problem however is that those currencies taking the heat (i.e. the Euro and the Yen) are not up for it in the long run and this means that we are likely to see a lot of volatility going forward. And now that we are talking about the Yen we are moving ever closer to the 100 mark. As I am typing these words we are looking at 100.90. All these movements seem to be spawned at least in part by the fact that a Carlyle Group hedge fund has been unable to repackage its debt and now needs to default on a respectable amount. This also begs the question of whether we will see intervention from Japan. I am not so certain as I was before I have to say but truth be told nobody really knows. I would advice traders who are shorting the Yen to keep a weary eye on their screens and to implement a stop/limit order to get out if it suddenly reverses. The fiscal miniser Ota is certainly blowing life into the rumours with his latest comments ...
A rising yen and record energy prices are starting to weigh on corporate earnings, Economic and Fiscal Policy Minister Hiroko Ota said after Japan's currency rose to a 12-year high and crude oil exceeded $110 a barrel.
``The dollar's weakness, the yen's strength and rising crude oil prices are beginning to have an impact on corporate earnings,'' Ota said in parliament in Tokyo today. Japan's export-driven economy is coming under pressure from two fronts. A rising yen hurts the earnings of Toyota Motor Corp. and Sony Corp., while Nippon Steel Corp. last week blamed higher raw-material costs as a reason for forecasting its first full- year profit drop in five years.
Meanwhile, equities are pairing yesterday's gains it seems and oil and gold seems set as ever to fly for the heavens.
Mark Thoma is so kind as to include this post in his semi-daily 'links' postings and in the comment sections a commenter makes the following interesting point.
Looking at Claus' very interesting article, one comment struck me:
Quite simply, I don't see how many of the surplus nations and most notably, in the present case, China and the petro exporters can recycle all that liquidity into their own economies not to speak of shipping it off to Italy, Portugal or Greece etc.
Let's assume that this is true, and there is no way to get decent returns on petrodollars. Then, if you're an oil state, doesn't it make sense to only pump enough oil for your own domestic consumption needs? It seems that the oil in the ground would likely be a better investment than anything in which you could invest the proceeds.
To which I reply ...
Thanks for the comment. I do think that what you point to is at the heart of the current global system. What we need to think about is simply the level of the reserves in China and the Middle East relative to their capacity to make the capital work. Obviously there is a limit as to how much those illusive 'cranes of Dubai' can be put to use as well as the call for China to shift towards a consumption driven growth path is also somewhat out of sync with realities I think. (Even though of course we are seeing impressive numbers for retail sales and income growth but also inflation it seems).
In terms of your concrete question I think that may very well be the case. However, the relationship is also somewhat symbiotic since I think that many of those Petro dollar owners kind of like the idea of holding the US in a tight leash with respect to financing the US' excess demand . I mean, if the petro exporters don't pump oil what do they have then?
Ultimately, the big story of the global economy at this point in time and in the future is going to be asset management and how returns can be earned on all that liquidity. Two major driving forces can de identified ... FX reserves and demographics where I am particularly focusing on the latter in my research. As such, I don't buy the whole dissaving argument since countries/investors will try long and hard to earn a return on those savings in stead of dissaving since dissaving on an aggregate macroeconomic scale implies that a country has an end point and it doesn't or I don't think we should want it to that is.