Frederic Mishkin leaves Fed

Governor Mishkin has been a strong central bank official at the Fed who was willing do the heavy research work necessary to make thoughtful responses to monetary problems. He has been at the forefront of monetary policy research for the last 25 years. He is one of the few Fed officials who is at perfect ease moving between academic research and policy issues. He has been a strong empiricist who also was an advocate for central bank transparency.

More recently, he has been one of the leaders in the movement to inflation targeting. Inflation targeting is now the mechanism used by most central banks around the world. In fact, the central bank who does not use inflation targeting I the exception. One of his most recent speeches has been on inflation ranges for central bank targeting called “Comfort Zones, Shmumfort Zones”. This is a clear presentation on the differences between point targets and inflation zones for monetary policy.

http://www.federalreserve.gov/newsevents/speech/mishkin20080327a.htm

The loss of MIshkin may be significant. He has been one of the advocates for following the loose monetary policy to help the housing crisis, so there may be a willingness to take positions which are more conservative and focused on inflation.

Inflation trouble watch --

There is a growing focus on inflation around the world and it is interesting to keep tabs on the what is happening on the micro level not just with the reported inflation numbers. The effect of inflation is real. Recent stories this week:

• Diesel fuel - rising costs is causing shippers to sell rigs and export them. Small firms cannot make money if they do not run full loads.
• Cattle - Prices for meat is going up because feed and shipping costs have increased. Corn is up over $3 a bushel in the last year.
• Airfreight - The cost of fuel has caused airfreight to increase so much that less planes are running from the Far East.
• Dow Chemical - Announced across the board increases in products by up to 20%. The petrochemical and plastics prices are on the rise with oil prices over $125 a barrel.
• Russia will not invest internally in infra-structure because of high inflation, 7.5%.
  
• Large financing of public debt in Italy this year through inflation linked bonds, 18 bil euros.
  
• Hungary central banks sees risk to inflation target.
  
• Mexican restaurants increase prices 20%.
  
• Polish inflation above 3.5% target.
  
• Norway inflation above 2.5% target.
• Taiwan cuts producer tax to ease inflation. Chip maker suggests price rise
• South Africa core inflation at 10.2%
  

Is there a bubble in commodities?

There has been a significant amount of talk about bubbles in the commodity market. Most of this commentary is unclear and poorly thought through. There is no clear definition of what many of these people define as a bubble. Just because prices increase quickly does not mean that there is a bubble. Just because prices fall after a prolonged rise does not mean that a bubble has burst.

Lets' just take a simple case of how markets operate. I like to use Stein's Law, "If something cannot go on forever, it will stop." Commdity prices cannot go up forever. We know because we have see these spikes before. They are often associated with fundamentals. Any prolonged increase in price will cause a response in supply and demand. The speed and type of response doe not create a bubble. In the case of commodities, there are a number of forces at work.

First, there is the increase in demand which has been a direct result of rising incomes in many merging markets. There is also demand that is inelastic to price. The demand for gasoline is inelastic to price. Only with a significant increase from say $2 to $4 a gallon has there begun a change in demand. Even now the process is slow because to change consumption often requires a capital investment, a new car with higher gas mileage. In the case of food such as meat, the demand is a function of income levels. With the rise in emerging market incomes, there has been a corresponding increase in protein demand. This will only abate if real income falls.

Second, commodity supply is inelastic. So the world wants more oil, let's just drill another well and suck it into a pipeline. Unfortunately, that is not the way supply increases. The Saudis may not be able to increase production regardless of how much they are asked by Western heads of state. They may not have the capacity and increasing the pull from the fields may actually do more harm in the long-run. For the case of grains, planting only occurs once year for many crops so there is limited amount of time to make a change in supply. You cannot add a third shift for production. Also the cost of inputs in the production process have increased with the both the price of energy and fertilizer increasing by healthy amounts.

A good op-ed article called "The Rich Get Hungrier" in the New York Times by Noble prize winner Amartya Sen a leading development economist provides another perspective on the commodity issue.
http://www.nytimes.com/2008/05/28/opinion/28sen.html?ex=1369627200&en=73a97d22b4ea2c62&ei=5124&partner=permalink&exprod=permalink

Is some of the increase in price due to momentum players who have got on the commodity bandwagon? Of course. This is often the nature of commodity markets which have a high percentage of technical traders. But that is that the same as saying that there is a wild bubble. We will see prices move lower. The volatility suggests that the range of potential prices is wide. Prices will also adjust with demand and supply but that is not the result of bubbles popping.

New home sales increase

It is hard to say an increase in new home sales is a good sign since prices are still declining. Think of any retailer who is marking down merchandise in order for it to move off the shelves. Counting the turnover is not a measure health. The only positive would be that inventories are dropping, so that the supply of homes has declined slightly.

The Case-Shiller home price index is down 14.1% yoy which is the worst decline on record. Foreclosures are increasing and prices are being marked down as banks want this collateral out of their portfolio.

Affordability is increasing but consumption is really driven by wealth and as prices go down, wealth is continued to be destroyed. The crisis portion of this credit cycle may be dissipating but that is not the same as suggesting a turn around. What it does mean is that inflation will become the most important issue for the economy.

End of the "nice" period

The Governor of the Bank of England, Mervyn King, has declared the “nice decade” to be over. In Mervyn King’s own words: ‘For the time being, at least, the ‘nice’ decade is behind us. The credit cycle has turned. Commodity prices are rising. We are travelling along a bumpy road as the economy rebalances. Monetary policy ‘cannot, and should not try to, prevent that adjustment.'

If the nice period is over, what do we call the current period, "naughty" or "nasty"? Many economists have written about the great calm over the post 1990 period. When analyzed closely, the answer for this period of calm was good monetary policy but that only represented 50% of the explanation. The other key reason was just good luck. There were few major supply or demand shocks like we are currently seeing.

The current economic environment is looking more like the 1970's. We have commodity shocks though this time it is coming more from the demand side as emerging markets growth continues. We are also seeing accommodating monetary policy in response to the shock which is also similar to the 1970's. Growth is also slowing in the US.

While some may argue that the story is different, inflation can only be slowed if there is a change in inflation expectations which translates into higher interest rates and slower growth. While we have moved beyond the classic Keynesian story, a 1970's environment will only be checked with a slowing of credit and a rising of rates.

Temporary Hiatus ...

Lakewood is taking a break while we prepare for our next venture. We should be back on a regular basis in a few weeks. We are still following the markets closely and have been surprised by investor optimism.

"Facts do not cease to exist because they are ignored."

Aldous Huxley