ECB taking a hard line

ECB has sent a clear signal to the market that it is more worried about inflation than growth. This has always been the mandate of the ECB but the comments by ban president Trichet make it very clear, or as clear as central bankers are on these issues. He stated that a rate increase is "not excluded" and that it is monitoring prices with "heightened alertness".

The impact on the markets have also been clear. Regardless of whether the Fed is on hold, the comments form the ECB means that the spread in short-rates will be more favorable to Europe. With the Fed still fighting the credit crisis and with being surrounded by recession fears, it is hard pressed to believe there will be the same desire to raise rates. The dollar rally was to some degree associated with the belief that the Fed was on hold, but this is all relative to what is going on in other countries.

Like investors there can be a change in central bank sentiment and in this case it is decidedly moving toward controlling inflation.

Commodity price shocks causing adjustment

Airlines -

UAL grounding fleet to save costs and increase loads. Continental announced that it will cut flights which reduces capacity.

Notice that this is not a change in the price for seats but a reduction in capacity or the service provided by the airline. You cannot fly when you want. The fixed cost of running flights that are not full is too high relative to what would be the impact of raising ticket prices in response to the change in the marginal cost of fuel. The airline industry has aways been marginally profitable but the latest change is another attempt to rationalize the industry. Will it work? The only thing we can say is that the airlines must believe that oil price increases will last for a long-term otherwise firms would not cut their capacity.

Food -
Pepsi announced that it will cut the contents of its snack packages while raising prices. Pay more for less. Smithfield is reducing its hog breeding herd. Its stock plunged after it reported lower earnings.

The costs of price shocks are real and the longer the shock goes on the more firms will adjust. The real problem for inflation is whether we will see a wage price spiral. This is 1970's lingo, but it was the link between price shocks and wages which caused the main increase in inflation. Currently, the world is in a different place but what we are seeing is some wage adjustments and shortages in places outside the US, like China.

CFTC and market disclosure

One of the key roles of government with respect to the economy is in gathering and monitoring information that normally would not be acquired by markets. This information may not be gathered because competitors may see little value in providing sensitive information like positions in the market even though there is value in knowing in aggregate what the market is doing for oversight. here is also a free rider problem. Industry data may be useful but no single user may want to go to the expense of gathering it.

The gathering of information on exchange trading may be useful for the overall market through oversight by the government. There are externalities associated with trading and position taking that may negatively affect the markets. Large positioning may lead to market squeezes or manipulation which will destroy the viability of the marketplace, yet there are cost with information gathering. There is the direct costs of processing the information but there is also the market cost of providing information of positions especially if it focused on a well-defined group.

To eliminate the potential for market manipulation, there have been cap set on the size of speculative positions. To enforce this rule, market position information has to be collected. This aggregation may be best done by the government across all exchanges.

The commitment of traders report from the CFTC provides information on market futures positions by large traders. It has been broken into two major categories, commercial users which would be hedgers and non-commercial users who would be speculators. This is not the case for commercial users who are able to get exemptions based on their business needs. Unfortunately, the breakdown of the market into these two simple categories are not enough to provide useful information for the market as whole as well as regulators who have to watch for speculative excess or market manipulation.

Index funds who buy commodity futures as an investment fall into the grey area of being neither commercial users in the processing or growing of some commodity or represent true speculators who try and profit from the rising and falling of prices in markets. The index trader is a hedger only to the extent that the investment that he makes in commodities is uncorrelated with the equity exposure that may represent the bulk of their risk exposure, Clearly, the index investors would not be a hedger in any sense of the word if there long commodity exposure was highly correlated with the other assets in their portfolio. Indexers are hedgers only because of the statistical artifact that the correlation is low. The idea of viewing these markets participants as commercial users stretches the intent of the rules. Broker dealers who offer commodity products to pension funds may be considered hedgers because they serve as intermediaries, but there is still the issue of there overall trading in this area. However, the market and regulators have been unwilling to make this argument to date because the added participation to the markets was viewed as a positive.

The proposals of adding a separate category for indexers makes sense. This traders are supposed to be information-less much like an index traders. The idea of being more stringent on hedge exemptions also makes sense, but it there may be the fallout that more traders will be done off-exchange which would not be beneficial.

There is still the issue of whether index traders have driven prices higher but I will leave that to another posting.

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.