Tuesday, October 30, 2007

Bonds moved with Fed funds futures


Bonds price moved up with the changing expectations of the Fed funds futures. The chart shows the changing probability of the Fed funds futures over the month of October. The market has priced in the move to 4.5%, a 25 bps change. A close look at the bond futures chart would show that the bond market has rallied in tandem to the changes in these probabilities.

Currencies have followed a similar pattern. The dollar firmed earlier in the month until the probability of Fed moved significantly higher. The dollar decline matched the view for lower rates.

Are traders in Fed funds futures driving monetary policy?

The Fed funds futures had a significant change in October from not having a firm view concerning a cut in the Fed funds rates to an expectation that a 25 bps cut is almost a lock. Using the futures contract price, there is only a 6% chance of no change by the Fed. The continued credit crisis and tepid growth drove this change in expectations.

So what does the Fed do with this information? We know that the Fed watches closely the Fed funds futures, so if the market is expecting a 25 bps change the Fed may have to give it to them. It is the unanticipated portion of a change that causes a reaction in the market. The Fed’s desire for transparency and clarity means that it would not like market uncertainty about its actions.

The Fed does not work in a vacuum, so if it sees that the market is pricing in a change it has to consider the implications of not changing the rate. The reaction by the markets will be swift. There should be an immediate equity sell-off as well as rates rising along the yield curve. His type of reaction is not what the Fed wants during a fragile period. So if the market wants a cut the Fed may have to give them a cut regardless whether this is what they think it is what is needed in the long-run.

Monday, October 29, 2007

You have to have a view on housing -

You have to have a view on housing to make any macro decisions. In a word, the housing market is bad. But everyone already knows that information. Now the issue is the impact of a bad housing market on the US overall and world economy. When you start looking at residential housing as a portion of GDP and household wealth, the story gets more complex. A recent speech by Bill Poole, president of the St Louis Fed, provides good background information on this issue.

http://www.stlouisfed.org/news/speeches/2007/10_09_07.html

Some facts:

The value of residential real estate is just over $20 trillion and mortgage liabilities are worth about $9.8 trillion which means that the net value of residential real estate is close to $11 trillion dollars. The net value of the assets is positive. Now, there will be spillover effects from a decline in housing from defaults, foreclosures and forced liquidation, but the value of housing is a positive contributor to household wealth.

Yet, the value of residential real estate is only half the value of financial assets for each household. While for many a home is their leading financial assets, overall, household net worth is tied to cash, equity, and bonds through savings and retirement accounts. The non-housing portion of household wealth is double the net value of housing. There is a wealth effect from changes in the housing stock, but the impact may not be as immediate as many would expect given all of the subprime stories in the newspapers. Lower wealth will affect consumption but the link is not as direct as many may expect.

Residential construction represents about 30% of total private investments. Nonresidential construction is approximately 20%. There has been an increase in nonresidential construction since the peak in the housing market. The declines in residential investment have been offset by gains in the nonresidential area. While these offsets are not one for one, the investment sector has been cushioned by growth outside residential construction.

Construction represents about 7.7 workers but is still just over half of the number of workers in manufacturing. Health and education are also much larger sectors for employment. Construction is 5.5% of total non-farm payroll, so a loss of a significant portion of these jobs may not have a significant impact on overall employment if there are strong gains in other sectors.

Housing usually peaks before he beginning of a recession. On average it leads a recession by three quarters. Clearly, this time between the housing turndown and the decline in growth of the overall economy has been delayed. This delay is what is unusual for this business cycle. The size of this decline dwarfs many previous housing cycles but the run-up was also greater.

The impact -

These facts do not minimize the hazard faced from a housing credit problem, but some of the effect has been and will be muted by growth in other areas of the economy and by the mix of assets held by households or their net worth. Spillover effects across sectors are significant and the hardest to measure. For example, the hosing decline has had a high impact on equity values for retailers.

The impact on employment may be muted because of potential gains from manufacturing which is a larger sector than the construction area. A slow growth scenario in the US is most likely if the subprime problem can be muted.

Unfortunately, monetary policy cannot be focused on only the housing market. The continued lowering of interest rates to help the housing markets will also have spillover effects in other areas of the economy and on the international side through its impact on the dollar. These spillover effects may have a greater impact than contagion from housing.

These spillover issues will be driving Fed behavior at their meetings this week.

Thursday, October 25, 2007

What will cause home sales to go up?


Existing home sales saw a significant decline month over month and have fallen off a cliff from over 7 million units are year in the summer of 2005. We are at the worst levels since the index was available. Sales are running at about 5 million units annually. There is also a glut of homes on the market at 4.5 million units, so we have almost a year supply not including the new homes that are coming on the market. There are also 2.2 million vacant homes in the US. It is going to take some times to stabilize this market, more than a year if there is not an adjustment in prices to entice new buyers. We do not know how many homes have not even been put on the market because of diminished expectations.

The decline in sales suggests that there is a mismatch between price expectations of buyers and seller. If buyers perceive there will be further price declines they will delay any purchase. Sellers on the other hand do not want to realize a loss or a perceived decline from the high value for their homes.

Sellers are suffering from the full extent of behavioral biases which will cause them to hang onto their homes in the hope that their value anchors will be reached. Inventory and sales will not move until sellers realize that the value of their property has declined and buyers believe that there is no reason to delay their purchase.

The change in perceptions of sellers and buyers for long-term assets which have gone through a large and sustained increase will not happen overnight. Both parties will have to realize that the new equilibrium price level for homes is permanent and not transitory. This housing drag will exist through at least 2008.

Tuesday, October 23, 2007

Credit crisis was obvious to Greenspan -

Quotes of the day on the financial turmoil that erupted in August by Alan Greenspan:

'an accident waiting to happen,'

'Credit spreads across all global asset classes had become compressed to clearly unsustainable levels,'

'Something had to give. If the crisis had not been triggered by a mispricing of securitized US subprime mortgages, it would have eventually erupted in some other sector of our market,'

If it was that obvious, then why was not something done? In hindsight our vision is very good.

It is interesting to read the comments policy makers make, but that does not help with determining what will happen next. However, when policy-makers realize that their choices will have an impact on asset price inflation, we will be in a better position to move forward. A key issue over the last ten years for macro-trading is determining the relationship between monetary policy and asset inflation not goods inflation.

Waiting on the Fed –

Periods of market consolidation usually occur when investors are waiting for some information. It could be the employment number, corporate earnings, or in this case the Fed. Interest rates are the key driver of many global markets. (Of course, some will say when is it not?) A cut in the Fed funds rate will lower the interest differential between the dollar and other currencies. There is also the threat of higher expected inflation which will be negative for the dollar. Equity investors will look for more easing to help the stock market which has seen a spike in volatility in response to the unsettling news on the credit front. Commodity markets will also react to an easing under the premise that extra liquidity will drive up real asset markets.


The market has changed perceptions radically in the last week even with only mixed macroeconomic news. That is if you discount the housing market debacle. The Fed funds futures provide a mechanism for determining the implied probability of a Fed funds cut. The calculations are straightforward. While last week the probability was that the Fed would be on hold as measured by the futures and options markets, the current data shows that the Fed has a greater than 50% chance of seeing a decline of 25 bps. The change in expectations has pushed the dollar lower, commodities higher, and interest rates lower. Now the market will sit and wait for its expectations to be realized.

Monday, October 22, 2007

What is going on in the economy?


An often overlooked index which can be a useful is the CFNAI or Chicago Fed National Activity Index.

According to the Chicago Fed:

The CFNAI is a weighted average of 85 existing monthly indicators of national economic activity. It is constructed to have an average value of zero and a standard deviation of one. Since economic activity tends toward trend growth rate over time, a positive index reading corresponds to growth above trend and a negative index reading corresponds to growth below trend.

The 85 economic indicators that are included in the CFNAI are drawn from four broad categories of data: production and income; employment, unemployment, and hours; personal consumption and housing; and sales, orders, and inventories. Each of these data series measures some aspect of overall macroeconomic activity. The derived index provides a single, summary measure of a factor common to these national economic data.

The CFNAI corresponds to the index of economic activity developed by James Stock of Harvard University and Mark Watson of Princeton University in an article, "Forecasting Inflation," published in the Journal of Monetary Economics in 1999. The idea behind their approach is that there is some factor common to all of the various inflation indicators, and it is this common factor, or index, that is useful for predicting inflation. Research has found that the CFNAI provides a useful gauge on current and future economic activity and inflation in the United States.

The CFNAI index will provide a good general overview of what economic activity is like in the United States. The most recent rating released today shows that activity moved up slightly from -.68 to -.45. While all of the categories showed negative performance, there was a pick-up in activity. Growth is below trend which should be expected given the decline in housing but does not seem to be in bad shape. The index also does not indicate that there is a potential inflation problem. It is off of the highs seen in 2006. Looking at this index suggest that rates should be more range-bound except for reaction to news on the credit crunch issue.

Finance ministers meet – much ado about nothing

G7 finance ministers met over the week-end to discuss global economic issues. What were they able to conclude? Not much. While there is more agreement that the Chinese Yuan should have an "accelerated appreciation", there were no specific comments on the dollar. The Chinese appreciation story is one of general agreement now that Europeans are seeing the impact of a cheap Yuan. Their trade with China has seen increased imports because of the close tie between the dollar and Yuan. When the dollar declines, Chinese goods get cheaper in terms of euro. This was an American problem before, but it is now a G7 issue.


Let’s look at some of the highlights from the meetings. One of the stronger statements from the meeting was, "We expect market participants to address many of the shortcomings that were exposed by recent events." Or, how about this pronouncement from Treasury secretary Paulson, "I believe a strong dollar is in our nation's interest." We have heard this since the Clinton White House and now the dollar is at all time lows.


Different from those strong comments was the statement from developing countries which are no flexing their current economic growth muscles and fiscal soundness. Said one emerging market finance minister, “Developing countries are a new driving force as well as a stabilizing factor in the world economy." The most important current theme is the power of emerging market countries that have strong balance of payment surpluses and money to invest around the world. These are the countries that now control the fate of the dollar based on their investment practices. If they decide to change their reserve allocations away from the dollar, there will be a sustained dollar decline. Portfolio balances will be the driving theme over the next few months.

Thursday, October 18, 2007

If the Fed cannot find the inflation – Look at the housing problem


CPI numbers were reported yesterday but they were right in line with expectations. CPI ex food and energy was 2.1% which was back down to numbers that are similar to 2005. The CI overall was at 2.8 percent which is higher than the Fed target but still below levels that were seen in 2006. The real rate of interest is positive which suggests that monetary policy s not too loose and the implied inflation in TIPS is similar to current CPI levels . If there are no inflation fears, then we have a green light for the Fed to lower interest rates to meet policy objectives on the real economy. This is one of the main causes for a gain in eurodollar futures after a sell-off.

Here again the main issue is housing. The numbers are bad and we are starting to see earnings of banks decline. Housing starts and building permits are both down relative to expectations. These are the expectations that have already been beat-up. The decline in housing starts has been swift and deep. This decline has a trajectory much worse than the 1980's housing decline. Note that home sales do not add to GDP, but housing starts does affect growth rates.

The expectations should be that the Fed will have to add more liquidity and the impact on the real economy has yet to be seen.

Wednesday, October 17, 2007

Limited reaction to TIC data

The Treasury TIC data on the international capital account was released yesterday, but there was limited reaction in the currency markets http://www.treas.gov/press/releases/hp611.htm.

Maybe the market already anticipated this net outflow, but the numbers were very sobering. Net purchase of long-term securities by foreigners was just under negative $70 billion. There was a strong exit from equities by private investors but official government accounts showed a strong decline in bonds. The total of both long and short-term asset flowing out of the US was over -$150 billion.

As long as the US is running a current account deficit, there has to be capital entering the country to maintain equilibrium. The financing has to occur or there will have to be a change in the price of the dollar. If there are countries that have fixed their currencies to the dollar, the adjustment will have to come from those which are floating, namely, the euro. The stampede out of dollar assets seems to be the main cause for the gains in the euro in September.

This report is just old news of what has been going on at any FX trading desk, but a decline in the capital account trend will place more downward pressure on the dollar.

Tuesday, October 16, 2007

Housing only getting worse



How bad is the housing crisis? There is no positive news from home builders. The NAHB index reports this month the lowest survey values since the index was introduced in 1985. The NAHB/Wells Fargo index is made up of three survey components, current conditions, expected conditions over the next six months, and traffic conditions. All have hit the lows since the inception of the survey. The index is set between 1 and 100 so there is a lower bound in how low it can go. A number above 50 means that there is the belief that conditions are good.


The survey has fallen off of cliff, but has been declining for some time. The peak survey results was in June 2005 at just over 72 and is now just over 18. What is most damning about the current survey is the increase in poor prospects for the future. The current conditions have been bad, but even at the beginning of the year home builders were mixed about the future. The latest survey shows that they have thrown in the towel.

What fire sale? The credit crisis and asset pricing


The reason given for the new super bank fund to solve the credit crisis in SIV’s is that if this is not done securities will have to be sold at fire sale prices. The CP market has not responded well to the crisis and it is argued that CDO prices do not reflect the reality of their value. There is no question that prices have taken a significant discount but it is hard to define what is meant by fire sale prices. If these securities are so cheap why don’t more investors buy them? What are they waiting for?

Perhaps the prices actually do reflect reality at this time!

Why is the reprising of these assets so slow? Clearly, there is no capital to take the other side of the trade. With the cut in the Fed funds rate liquidity is present in the market, so there must be other reasons for the lack of capital to buy these securities.


1. These securities are riskier than before

a. The subprime mortgages serving as collateral for many CDO are experiencing higher default rates and delinquencies. The levels have not only risen but have become more volatile which makes for riskier securities. This will not change in the near-term and may actually continue. This increase in riskiness has actually been occurring for some time. The August crisis is just a point in time where the level of risk has started to move above a critical threshold.

b. Price adjustments of the collateral will have to be reflected in the price of securities. If collateral declines by x% there will have to be a similar decline in the value of securities. It may not be spread across all securities equally but there will have to be a decline. This is the principal of conservation of risk. Risk cannot be destroyed. It can only be transferred among parties.

2. Uncertainty is greater than before

a. The rating agencies have changed the standard for the game through rerating many deals. This was an uncertain event which is ongoing. If the ratings for deals change or are uncertain, the price has to go down. The process of what and how the ratings will change is unprecedented and is hard to price.

b. The subprime problem is unique. We have not had this type of problem in the housing markets before because lending was not conducted with the wide range of products and will such a wide range of borrowers.

3. The underlying economics have changed

a. The housing market has gone through a bubble and there has been a slowing of the economy. There are few investors who believe that growth in the US will swing up and allow for new buyers in the housing market to materialize in the near-term.

b. The housing cycle takes time. Housing as an asset market takes longer to clear than would be the case of other asset markets; consequently, we cannot impose a time frame on CDO’s that is not similar to what may be happening to the collateral.

4. Size of the problem

a. The size of the subprime market problem is very large so there has to be more time to raise the appropriate capital to add liquidity in the market.

b. Expertise has to increase. Associated with the size of the problem is the need for expertise in evaluating these securities. There will have to be a discount for those whose are less educated in pricing these securities to have them compensated for buying these securities.


So is this a fire sale or the normal behavior of markets? There have to be a discount for risk and uncertainty. There have to be discounts for the underlying collateral which has not reached its maximum decline, and there has to be compensation for the size of the problem. Any structure to solve the problem will have to still address these issues.


What is the size of the discount is hard to say but we may not be in a fire sale. Just because you do not like the price you get does not mean that it is the wrong price.

Monday, October 15, 2007

Manufacturing shows strength –



The dollar decline is starting to have a positive impact on manufacturing. The Empire State Manufacturing Survey showed a strong surge today reached levels we have not seen since 2004. See http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html.

This was a good news surprise for the economy. While the survey does not go into enough detail to determine whether this is coming from international trade, trade changes will have a strong effect on manufacturing. This survey data matches what has been seen in the real export side of the economy. Exports have been surging while imports have been languishing. Exports are posting strong growth relative to their moving averages while imports have been almost flat. Part of the decline in imports is due to the slower growth in the US.

This economic story is consistent with the weak dollar and strong economic growth outside the US. The exports numbers are still relatively small versus all of the value-added from residential housing over the last few years, but this shift in economic growth is real and starting to support the overall economy.

Credit bail-out in the works to stop fire sale


The stock market is up. The Fed has lowered interest rates. Credit spreads have compressed and LIBOR rates have fallen, but there is a still a rotten credit problem with CDO and other conduit programs. The crux of the matter is the pricing of these securities which is an alternative way of saying that there is no liquidity in these markets.

An important story in the Sunday NYT suggests that leading money center banks are in discussion with the US Treasury to structure an $80+ billion buy-out fund to support the SIV’s which are having trouble financing their portfolios and may be forced to sell at what would be considered fire-sale prices. The fund is named the Single-Master Liquidity Enhancement Conduit (SMLEC). So much for letting markets work.

With a lack of liquidity, there is no reason anyone wants to provide financing in the public commercial paper. This means that banks will have to provide credit facilities for the SIV commercial paper issuers. The size of the SIV market is over #00 billion so having to support the SIV would be a costly proposition Nevertheless, there is still the problem of pricing and liquidity. At what price should the banks mark this paper if it comes onto their balance sheets?

This dynamics of pricing is the reason for the Treasury to help negotiate some form of joint facility of what some have started to call a super-SIV. With the help p the government and agreement among all of the banks, there could be a way for the bad loans to be bundled in some form at prices which will not fully represent the fact that there is no liquidity.

This type of structure is full of difficulties. What are the values for these CDO? Who should get to participate in this deal? What is the impact on shareholders of the participating banks? What about firms that are holding CDO paper that is not participating in this deal. What should be the role of the US government? Most importantly, why is this needed in the first place, shouldn’t the market sort out the problem first. I thought the Treasury secretary stated that there was no liquidity problem?

There are many micro financial issues which are going to have to be discussed, but our focus is on the macro side and the picture does not look good. The effort to contain the problem just highlights the fact there is a problem which should spill over to US growth. At the very least, there will be a continuing story of global growth coming from outside of the US. This has been a change from what we have really seen from the last decade. The growth differential story will play out in all for the major asset classes. Growth differentials not favorable to the US will put more pressure on the dollar. The slow growth in the US will also mean that rates in the front-end of the curve will come down relative to the rest of the world. The global equity markets will also continue to outperform the US.


This credit bail-out will be important to watch and no a story that will disappear.

Wednesday, October 10, 2007

Trade will be a big issue

Hillary Clinton, frontrunner for the Democratic party’s presidential nomination Monday said that all US trade agreements should be evaluated every five years and, if necessary, amended. – FT story


The trade issue is always complex when you get into the weeds of specifics but the world and the US has benefited greatly from international trade. Exports as well as imports have increased substantially during the last decade and millions have been taken out of poverty through trade. Trade is becoming especially important to the US because it is the very area which we expect to grow to offset the free-fall in housing. The dollar is at a low, so US good are cheaper. This may not be the time for renegotiation of our agreements.

Another important reason for trying to enhance trade is the potential for a calmer world. Isolation is bad for the world and for the United States. Anything that helps America be more aware of the world aand interact with others is good.

As quoted by Michael Shermer in “What is Your Dangerous Idea?” –


“Where goods cross frontiers, armies won’t"

Thursday, October 4, 2007

BIS Triennial Bank survey – the effect of more globalization

The Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007 was released, http://www.bis.org/publ/rpfx07.pdf. Done every three years, this is the most comprehensive survey of foreign exchange trading turnover. This is a pretty dry report but it provides some interesting insight in the foreign exchange market. I came away with three major observations.


First, the growth of trading in these markets has not abated. Since the last survey, there has been continued double digit growth in overall trading. In many ways, this should not be surprising given the continued increase in global trade and economic growth. From the capital account side, the continued globalization of capital markets surely has been a driver for the increases in foreign exchange trading. The move to international diversification which has continued over the last three years provides the background for hedging and speculative trading. However, this growth is still surprising given the relatively low volatility environment for currencies. This trading growth is structural and not a function of the market environment.


Second, trading has become more disperse across currencies. The dollar is still dominant with the euro and yen following behind, but emerging market currencies are growing in importance. Again, the increase in globalization has lead to further dispersion in trading across currencies. The percentage of transaction between USD and currencies other than G10 has moved from 16 to 19%. That being said, many currencies represent a small fraction of trading. There has been a sizable increase in OTC interest rate derivatives in yen and sterling. Japan is seeing growing cross border business base don carry and the movement of domestic money offshore.


Third, there continues to be a change in the distribution of trading across players and maturities. London is still the largest center for FX trading at 34% followed by the US at 16%. The percentage of total OTC derivative transaction volume for London is even higher at 42%. Again, the US is second. However, the amount of trading with dealers continues to decline. The market has moved away for a dealer structure to one that involves trading outside the normal reporting bank-dealer network. The market microstructure continues to evolve with electronic trading growing in importance.

Don’t worry about the dollar - the Fed isn't

I have always argued very strongly that it is not a good idea to focus on asset prices like the exchange rate over and above the effect it has in terms of things we should care about as central banks," Frederic Mishkin, in response to a question at an economics event in Frankfurt.


Mishkin’s view is consistent with our earlier comments that the Fed is willing to forsake the dollar in order to focus on saving the domestic housing market. The dollar will have to be sacrificed if the Fed believes that a preemptive lowering of rates is the solution to the housing debacle.


However, this does not mean and that the dollar will see a huge plunge in the near-term. Rate cuts are already included in expectations. If the US economy stabilizes, there will be less reason to cut rates. (The fed funds futures will lower their probability of a rate decline.) There will also be less likelihood of a decline in stocks; at least based on time line earnings. (Nevertheless, much of the recent stock gain has been driven by the discount factor.) Financial flows may not be one directional out of the dollar if growth and rates become range-bound. Also, as mentioned before, a slowdown in Europe or the appearance of inflation will make the Euro less attractive.


There will need to be a catalyst for further dollar declines. The catalyst which is most likely is a carryover from the housing market to the rest of the economy. To date, the economic numbers have not shown this carryover even though the conditions are ripe for a further slowdown. If this catalyst appears, the Fed will lower rates which will have the impact of making dollar assets less attractive based on interest differentials.

Tuesday, October 2, 2007

Thinking Like a Central Banker -if only it ccould be that easy

William Poole, the President, Federal Reserve Bank of St. Louis gave a speech in New York last week which was very insightful for those who want to take a long view of monetary policy. It is available on the St Louis Fed website, http://stlouisfed.org/news/speeches/2007/09_28_07.html.

This speech is a good review of how central bankers think. It does not provide a telling of the inner workings of the Fed but tries to provide an overview on what is the thought process for the central bank and contrast their work with those of private firms. While investors are trying to figure out what will be the nuances in policy from the next FOMC meeting, Poole wants everyone to step back and consider that the Fed is trying to send clear messages and does not want to confuse the markets. There should be no surprises. If there are surprises, then the Fed has not done its job of sending a clear message. I have taken excerpts from the speech because his message is critically for understanding how the Fed thinks on a macro level.


1. Central bankers do not sweat the daily data. While there is significant data analysis done at the Fed to prepare for FOMC committee meetings, most FOMC members do not track the daily or hourly movements in the same way as investors.


Traders and portfolio managers base their trades on the current flow of information, which needs to be updated throughout the trading day. Fed policymakers, on the other hand, do not continuously adjust the stance of policy in the same way managers adjust portfolio holdings.


2. The choices of the central banker are limited, so major changes or adjustment in policy are unlikely to happen.


One important difference between a financial firm and the central bank is that a firm has a much wider array of strategies available to mitigate risk than does a central bank… A central bank pretty much has to accept policy risks to the economy arising from the economy’s institutional structure and market environment.


3. Reputational risk is paramount. The Fed always has to worry about perception and trust. Hence, there is a natural level of conservatism in the actions they take.


A risk that is often incompletely understood by those outside management is reputational risk. The issue is much more than simple embarrassment. Trust is an essential capital asset for a financial firm and for a central bank.


4. Central bank focus on interpreting what are market expectations. They are constantly trying to understand how the market will react to a policy message. They do not want market surprises.


There is an important policy purpose for the Fed to study these market expectations. Understanding how the flow of new information affects market expectations can be useful to policymakers.


5. The objective function of central bankers is focused on minimizing losses. There is no profit maximizing behavior. Central bankers focus on differences or loss from inflation and from growth.


Policymakers think in terms of a loss function that depends on departures of outcomes from desired outcomes.


6. The central bank is a price maker, or would like to have this power. They will try and move markets and expectations to meet policy objectives.


What is a critically important difference between a central bank and a private financial firm is that the central bank, in the short run anyway, sets a policy interest rate and, importantly, influences longer-term interest rates though effects on market expectations. The central bank is a price maker in the interbank funds market. Private financial firms are essentially price takers in that market and in the government securities market.


7. Central bank looks for consistency. There is no secret agenda or effort to surprise the market.


What is important is not the policy action at the next FOMC meeting, which is typically what people want to know, but the policy regularity that will extend across many FOMC meetings, which is what people should want to know.


An important corollary to the task of defining a policy rule is that the central bank ought not to be a source of random disturbances.


The Fed is not completely knowable but they do want to be as transparent as possible. Policy should not be a surprise. There should not be a mystery and if the market is confused, the Fed should clarify their intentions.


Investors should stay calm before Fed meetings. This is not supposed to give anyone heartburn.

The bet is on manufacturing trade to offset the housing market decline

The lowering of interest rates in the United Sates has been devastating on the dollar. The dollar has declined 6 points or over 3.5% against the euro in the month of September. What happened to the “strong” dollar policy that has been often espoused by US government officials?

Clearly, the benefit of strong dollar has been discarded. The implicit bet by the Fed is that lowering interest rates to save the housing market is worth the potential decline in the dollar. More wealth is tied up in the housing market than in offshore investments by most middle class investors. Wall Street may be better able to hedge currency risk than credit or economic risk.

Foreign investors do not vote, and the dollar decline may help the export business in the US. If workers can move from the construction site to the manufacturing site, the economy may not be plunged into a recession. While there is a delayed reaction in trade numbers from a decline in the currency, the trade balance is starting to see some improvement.

The real problem is whether the government will allow markets to work and grow exports without “a little help”. There has been a growing drumbeat in Congress to help the manufacturing sector through protectionist trade-related bills. The argument is that the manufacturing sector has been hurt by unfair trade practices, manipulated currencies, and trade barriers. Unfortunately, these types of bills usually lead to retaliation on the part of trading partners. The net results will often been less trade which may not be what we want for our labor markets.

A more careful look at the manufacturing sector in the US may actually suggest that the US manufacturing sector has not been in as bad of shape as stated by politicians. There have been large reductions in the labor force associated with export manufacturing but the size of exports and export growth has been strong. Much of the labor decline has come because of competitive pressures which have increased productivity.

The value-added in manufacturing is at all-time highs. The level of output, revenues, operating profits, return on equity, and the value of exports are all at all-time highs in the manufacturing sector. The US still accounts for over one-fifth of world manufacturing added. In fact, Daniel Ikenson in, "Thriving in a Global Economy: The truth about US manufacturing and trade", a paper from the Center for Trade Policy Studies at the Cato Institute would argue that US manufacturing is very healthy. Perhaps the best policy right now would be to let manufacturing grow with the lower dollar instead of trying to save this sector with new trade laws.

Monday, October 1, 2007

Is helicopter money falling from the sky?


A quick call from Nelson Lam of The Lam Group asking about the concept of “helicopter money” got me thinking about monetary policy and why the stock market is exploding. Market pundits are now calling Chairman Bernanke “Helicopter Ben” based on his latest cut of 50 bps. Gregg Mankiw as well as James Hamilton also wrote about the topic last week.


The concept of helicopter money has been around for decades and has been associated with Milton Friedman as well as Keynes in another form. The idea is to run a thought experiment of increasing the money supply through the analogy of money dropping from a helicopter. If there was a one-time increase in money, the thought experiment reviews the impact on inflation and aggregate demand. In a rational expectations world, there may not be an impact on aggregate demand as prices will increase with the increase in money. Under different expectations, there may be a short-run impact on aggregate demand.


The last time the “helicopter” analogy was discussed seriously in policy circles was during the zero interest rate period in Japan. It was believed that monetary policy should have pushed money into the economy to ignite inflation and end the problem of deflation. The issue of how to deal with a liquidity trap in Japan was real. This issue needed careful analysis beyond the normal policy alternatives and helicopter analogy was good starting point for discussion. The US is not Japan. We are not in a liquidity trap.


So does Chairman Bernanke fit the name “Helicopter Ben”? There is no doubt perception is that the monetary flood gates have opened and it is raining dollar from the Fed. The Fed has moved away from looking at inflation fears and is now firmly interested in stimulating growth. Of course, the Fed has mandate to look at more than price stability. The equity markets believe that the growth goal will be achieved even if it means further lowering of rates. Both the gold and dollar market thinks the floodgates are open. Commodity prices are rising albeit mostly due to supply shocks.


The Fed has lowered the rate but it may be early to assume it is raining money. The real rate of interest is actually positive which is not suggestive of an overly loose Fed policy. Inflation fears are up but the bond market seems to be looking in more detail at the impact of the rate cut. If anything, the decline in housing is having a greater effect on bonds. TIPS prices have not exploded higher and are at levels we saw before the rate decline. Ben may be a “chopper pilot” but it may be early to say he has taken to the air.