A week off

I’m taking a holiday so there won’t be any posts over the next week.

Hoenig calls for break up of Wall Street

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, said yesterday that regulators should be breaking up large financial institutions that pose a threat “to our capitalistic system.’’

Bank run in Korea

This is a bit left field. A bank run in Korea on Busan II Savings Bank. Worth keeping an eye on.

Gav on oil

Gavyn Davies in his FT blog has done some useful calculations on the impact of a rise in oil prices on the world economy. At the moment, the rise in oil prices seems to be a hurdle to growth rather than a brick wall. If oil prices went to $120 and stayed there for a year, then the barrier to growth might become more serious. Obviously, this depends on how the unrest in the Middle East pans out, which no-one can foretell. If it spills into Saudi Arabia, then the world will almost certainly face much higher oil prices and another global recession. I think he is underestimating the second order impact on fertilizer prices and how they will put further upward pressure on food prices. A sustained rise in oil prices would certainly lead to some doubts in the sustainability of growth in emerging markets and over their monetary policy.

More on the oil price

The press have cottoned on to the importance of the oil price and that a sustained spike might cause problems for growth. This article by Jeremy Warner is interesting. It points out how untransparent the pricing mechanism for oil is and how it is manipulated. I wonder whether the regulators will get a grip. Somehow, I doubt it. Further rises in the oil price and the uncertainty over energy pricing in general is emerging as a real threat this year. There’s probably enough momentum in global growth to carry the world forward this year, but next year is open to question.

Oil price warning

Unrest in the Middle East is cranking up with reports that Gaddafi is bombing his own people and is losing control of the military. Libya contributes 2.3% of world oil production. While this is significant, the wider concern is the speed with which these uprisings occur and the worry that they might spread to Saudi Arabia. You can follow events through Stratfor, as well as through the conventional media.

Who knows where this will lead, but it has increased the possibility of an economic slowdown or even a recession in the next 1-2 years. Below is a graph from the St. Louis Fed economic database showing the oil price and recessions (shaded areas).

What is immediately apparent is that recessions are associated with spikes in the oil price, either preceding or coincident. Clearly the oil price is not the only factor causing recessions and the world coped with rising oil prices in 2002 to 2006. However, unanticipated, exogenous shocks such as a spike in oil prices (and associated energy and commodity prices) can cause companies, governments and the personal sector to change economic behaviour. A rapid rise in prices acts as a tax shock, causing a rapid redistribution of spending. This can have a cascade effect through economies, producing a multiplier effect.

Although western economies are fragile, to an extent, they can probably ride the blow as they are more energy-efficient and less personal income is spent on energy. However, it could be a serious brake on emerging markets where energy counts for a higher percentage of personal expenditure. There are also knock-on effects of higher fertilizer prices, which may drive food prices even higher. Even the Chinese elite might be looking over their shoulders at how a seemingly stable regime suddenly imploded through a popular uprising. To be sure, China is a very different kettle of fish to the Middle East, but Chinese history is littered with long periods of peace punctuated by violent uprisings.

Projecting inflation

I think the Bank of England deserves credit for producing its Inflation Report and revealing its forecasts. It is commendable that they admit to uncertainty and confess their inaccuracies. The fan charts are always of interest. Below I reproduce the CPI inflation projection chart from the latest Inflation Report.

Source: BoE Inflation Report Feb 2011

As usual, this shows inflation returning to target over two years, using market forecasts of interest rates. The killer question that no-one asked in the press conference was:

“what would this chart look like if interest rates remained unchanged?“.

Repeatedly, Mervyn said that this chart did not forecast a rise in interest rates, but surely we can only take comfort from monetary policy if we have a  forecast of what might happen if policy is unchanged.

My guess is that a fan chart would show inflation being above target for the forecast period if interest rates are unchanged. If it doesn’t, why are we bothering with interest rates as a tool to control inflation. Will anyone pose these questions at the next Inflation Report press conference?

Clear as mud

I’ve just watched this morning’s BoE press conference on the Inflation Report. Clear as mud is a good description. Both journalists and Mervyn appeared exasperated. Amidst the jousting it became clear that the Bank has no hope of controlling inflation through interest rates when the causes are exogenous. Pretty simple really, but not very satisfactory for credibility. However, in my opinion, better to see living standards erode through higher inflation than by wage deflation. That is what is happening in Ireland and the Baltics and will need to happen in southern Europe.

Stand by for pain

It looks increasingly likely that UK interest rates will rise this year and quite possibly soon. The Inflation Report today should be interesting reading along with the press conference. While the Bank of England’s credibility is under scrutiny, I’m not sure that raising interest rates will make much difference. The main drivers of inflation are external: rising world commodity and energy prices and the delayed impact of the fall in sterling. The rise in VAT has also been a factor in the headline rate.

Unless a rise in UK interest rates produces a significant rise in the exchange rate, raining interest rates isn’t going to have much impact. on inflation Indeed a rise in the exchange rate would impede the much-needed rebalancing of the UK economy. However, it will have a very negative effect on the housing market. According to the CML, 1 in 3 mortgages would become unaffordable if interest rates rose by 200bp, using the FSA guidelines. While that doesn’t mean that they will default, it will represent another big squeeze on consumer disposable income.

If the interest rate was passed through to savers, then the impact would be cushioned. However, any increase in interest income will be taxed and it is very likely that lenders will seek to rebuild deposit margins. I would expect to see bank net interest margins expand further, although some of this benefit will be offset by higher bad debts. Brace yourselves for a load more bad press on the money-grubbing banks.

I’m afraid economic policy in the UK looks a muddle at the moment. The Bank has been backed into a corner. The government’s” growth strategy” is a bad joke (nice one Vince). I’m afraid that the fiscal consolidation plans could also be blown off course. It’s going to take the constitution of the Iron Lady to keep this country on course. I reckon the coalition could blow apart within 18 months. The UK is not the place to be. Risk premiums are not high enough.

BoE forcasting record critisised

Now there’s a surprise. For the last three years I’ve been saying that the Bank of England’s forecasts have been consistently overoptimistic on inflation and that their record on forecasting growth is none too clever. Does that make them useless? By no means. I applaud the openness of the Bank in revealing its forecasts in reasonable detail, unlike many of its peers. Nils Bohr said “Prediction is very difficult, especially if it’s about the future”. If it’s difficult in physics, it’s nigh on impossible in economics.

We are currently in an especially uncertain decade for forecasting. The aftermath of the global financial crisis still has many years to run and there are many twists and turns to be revealed. It is emphatically not business as usual. Why is forecasting inflation so difficult in the UK?

Inflationary pressures in the UK can be divided into three categories:

1. Domestic pressures. These can mainly be tracked through wage settlements. They are subdued at the moment.
2. Exchange rate moves. As a very open economy, the UK is especially vulnerable to these moves. There is a limit to how much currency movement can be absorbed by corporate profit margins. This explains the lagged effect of moves as corporates may absorb an initial move, but when changes are perceived to be permanent, they attempt to adjust profit margins accordingly to recover profitability.
3. Global inflation. At the moment, developed economies have little internal inflationary pressures, but the developing world is hugely inflationary. As developing economies now have a higher weighting of global GDP, this is tilting the global environment towards inflation. This is most easily seen in energy and commodity prices, where the developing nations are the price setters.

Hence, the BoE economic model is easily knocked off course by volatility in exchange rates and global inflationary pressures. Their model will generally assume unchanged exchange rates, since they are no better than anyone else at exchange rate forecasting. As for global inflation, I suspect they have a mean-reverting model, which would have given poor predictions over the past few years.

An important question arises from this: can the Bank of England really control inflation through monetary tools, principally interest rates? My answer is sometimes. If pressures are mainly domestic, then interest rates will be an effective tool. If they are external, then interest rates can only have a limited effect. Hence, at the moment, the Bank of England seems powerless to control inflation and its credibility is being called into question.

It’s a shame that the talking heads and the quick quote brigade don’t think before they speak. They are doing serious damage to the Bank’s reputation with their carping. In an uncertain world, forecasts will often be wrong. I believe that the Bank is doing the best it can. We can all nuance interest rate policy, but the Bank is caught between a rock and a hard place. At the moment, its choice is about the least bad policy, rather than the optimum policy.

US consumer revival

I was interested to read that US credit card borrowing climbed $2.3bn in December, according to figures from the Federal Reserve, taking credit card debt to $800.5bn. It was the first increase since August 2008, the month before the collapse of the investment bank Lehman Brothers triggered a deepening of the financial crisis. This is impressive considering that US house prices are still weak. How can we explain this? It suggests that the employment figures may be understating the pick up in employment. They are notoriously unreliable. The ADP payroll numbers have been significantly better than the non-farm payroll numbers. The other explanation is that US consumers may be reducing their savings rate.

The personal savings rate peaked at a similar level to the 1991 recession and has now begun to decline. If I had a bullish hat on, I would say that there is a reasonable amount of scope for a further decline, particularly if unemployment declines. However, I think it unlikely that consumers will reduce their savings rate as aggressively as:

1. The decline in house prices has significantly dented consumer balance sheets and a period of rebuilding is likely.
2. Many people are becoming aware that their pension provision is woefully inadequate.
3. Cash-out mortgages are unlikely to be available in the near future (if ever).
4. Government disaving will have to be tackled. The personal sector has seen significant income transfers from the government sector. Budget consolidation will reverse this process.

Despite these caveats, the pick up in credit card debt suggests that a mini consumer revival might be on the cards. Of course the other thing that could spike a consumer boom is the trade deficit. Even here though, recent numbers have been rather better than expected suggesting that the decline in the dollar is having a positive impact on competitiveness. However, if an improvement in consumption is too aggressive, the trade account might deteriorate again, reviving concerns over a tariff war and a dollar crisis.

The honeymoon is over

There are increasing signs that the honeymoon period for the coalition government is over:

1. The need for a plan B for the economy has become increasingly mainstream. For example, recently the FT ran a Martin Wolf comment article and an OpEd piece.
2. The CBI and others have questioned whether the government really has a growth strategy. Pfizer’s closure of their research facility is a big blow to credibility.
3. Both Vince Cable and Chris Huhne look out of their depth. Cable’s credibility is near an all time low.
4. Rises in taxes, energy and food prices will bite viciously this year with the largest fall in living standards for a generation.
5. The key “Big Society” policy initiative is collapsing. Liverpool council has publicly withdrawn its support. Lord Wei (the BS czar) is cutting back his time spent on the project because he cannot afford it. Francis Maude (minister responsible for BS) couldn’t name any voluntary work that he was involved in when asked by the BBC. This has all the makings of a policy fiasco.
6. The normally supportive Daily Mail recently ran an article of some of the broken promises of the Conservative manifesto (law & order, immigration, EU, refuse collection etc.). The failure to deliver on election promises will undermine core support. Needless to say, the Liberals aren’t getting their manifesto commitments either.
7. Policies like the sale of publicly owned forests, which weren’t in the manifesto, are stirring up enormous opposition (nearly 500,000 signatures on a petition), uniting all sections of society. Unless the coalition back tracks, this could be a poll tax moment.

There are others, but you get the idea. Unless the coalition gets a grip, they run the risk of becoming a very unpopular government in double-quick time. In normal circumstances this might not matter, but with fragile finances and further unpopular belt-tightening to come, this could explode into a major problem. At the moment, international eyes are focussed elsewhere, but if the coalition ruptures because of its policy paradoxes, then the UK will suddenly look a lot more risky. There might be a sterling  crisis and the Bank of England might be forced to raise interest rates. Watch out for those opinion polls and for increasing dissention amongst the LibDems.

US interest rates, the first move

It’s still a bit early to be thinking about the Federal Reserve increasing interest rates but it is a good idea to be early in thinking about when this might happen. On the one hand, the Fed won’t want to repeat the policy error of the early 2000s and keep interest rates low for too long. On the other hand, they won’t want to abort any recovery, particularly in the run up to a presidential election year (2012).

The two guiding factors will be unemployment and bank lending behaviour. The table above shows the lag between the first interest rate move and the peak of unemployment and the change in loan officer behaviour from tightening to loosening.

US unemployment and first interest rate rise (vertical line)

The chart above shows this graphically. In the current cycle, unemployment peaked at the end of 2009, so we are already 13 months after the peak. However, the decline in unemployment has been sluggish. In an ideal world, the Fed will want unemployment below 8% before raising rates, but much will depend on inflationary pressures. I think the Fed could move when unemployment has fallen below 8.5%.

US senior loan officer survey (conditions to large and med. C&I firms) and first interest rate rise (vertical line)

The chart above shows the relationship between the first rise in interest rates and the senior loan officer survey. The Fed waits until lending conditions to C&I are loosening before moving. Conditions are already improving for C&I borrowers. The Fed will be keeping a close eye on whether banks start to run down bank reserves, thereby boosting the money multiplier. At the moment, this doesn’t seem to be happening, but the psychology of lending can change rapidly. The huge quantity of bank reserves is potentially inflationary, so the Fed would have to move quickly.

If the recovery really is gaining traction, and commodity and energy prices continue to rise, it is highly likely that the Fed will face pressures to raise interest rates by the end of this year. As markets start to anticipate this, we could see some further volatility in the summer and autumn. It will also begin the process of removing the liquidity support for the market.

The sweet spot and its destruction

A book that deserves to be more widely read is “The liquidity theory of asset prices” by Gordon Pepper. It explains elegantly in 150 pages why liquidity conditions are the most potent driver of markets. Forget, economics and politics, liquidity overwhelms them both.

The last two years have been a potent demonstration of this simple theory. More recently, the Fed’s announcement of QE2 led to the strong rally in the equity market since late summer last year.

Investors should not only take liquidity into account but also the various manufacturing surveys. The ISM Manufacturing Survey is the most important, but the Chinese and European surveys are also influential. Yesterday’s data confirmed that manufacturing is enjoying a decent recovery. As I pointed out a few month’s ago, the regional Fed surveys had been improving since late autumn, suggesting a reacceleration of the manufacturing recovery.

For equity markets, the combination of loose monetary conditions and strong industrial data is a heady mix. It has enabled equity markets to sail through the travails of the Eurozone periphery debt crisis and the political disturbances in the Middle East.

In the early stages of any economic recovery, liquidity that has been created by central banks naturally flows into asset markets. The real economy has little need for financing as the corporate sector hoards cash and the personal sector re-trenches its financial position by de-gearing.

A transition into a maturing recovery, however, spells a more difficult environment for asset markets. The real economy gains confidence and begins to require financing from the financial sector, causing liquidity to become less abundant. Even if central banks do nothing with monetary policy, interest rates are pushed up. This is exactly what we are seeing in fixed interest markets at the moment.

This liquidity squeeze is at a very early stage and is unlikely to inhibit markets too much in the short-term. Indeed, it may boost equity markets further as asset allocators switch from fixed interest into equities and a stronger growth backdrop underpins equity earnings.

Eventually, though, central banks will have to tighten liquidity conditions. The latest manufacturing surveys suggest that early stage pricing pressures have intensified. Emerging markets are showing signs of acute inflationary pressures.

Central banks in emerging markets are caught in a dilemma as tightening causes currency appreciation and loss of competitiveness. The reluctance to bite the bullet will come back to haunt them as higher inflation will cause a loss of competitiveness anyway, so it’s better to move early and suffer some currency appreciation to head off inflationary pressures.

I’ve always been a bit suspicious of the output gap theory of inflation. Just because an economy has a large output gap, doesn’t mean that inflation cannot arise. The UK is a classic example of this. An open economy like the UK will always be more prone to imported inflationary pressures. Early stage inflation is now evident in the German PPI numbers as well.

Competition is as much about perception as it is about the hard facts of overcapacity. If companies perceive that we are in a more inflation prone environment, then they will test pricing. Raw material and input costs are rising, so manufacturers are bound to test pricing. Mindsets appear to be changing.

This is going to be a significant challenge for central banks in developed countries. At the moment it is being suggested by the Fed that the US is under threat from deflation. That deflation is largely coming from a further move down in the housing market. Any stabilisation and inflationary pressures from food, energy and imported goods might become threatening.

Focussing just on core inflation was a major policy mistake by the Fed in the late 1960s and early 1970s. Are we seeing the same mistake being repeated?

It seems plausible that central banks will be relatively cautious, especially the Fed and the BoE in raising rates. I think the catalyst for rate rises will be a pick up in bank lending, so keep a close eye on the credit aggregates.

My research suggests that the Fed has waited for bank loan growth to go positive by around 5% Yoy before tightening monetary policy. The chart below shows that US commercial banking total loans grew by 1% in 3Q10. It seems plausible to suggest that by the end of this year, loan growth might be above 5% and the Fed will get an itchy trigger finger.

US commercial banking total loans (% YoY growth)

Source: Freelunch.com

So my best guess is that the sweet spot of abundant liquidity will start to disappear later this year. Corporate earnings growth should be reasonable this year, but corporate profit margins have recovered dramatically and are not far off cyclical highs. Therefore, 2012 could see much slower corporate earnings growth and tightening liquidity conditions.

2013 will be an interesting year. It will either be a mid-cycle slowdown or another recession. I think a recession is more likely as China will have to tackle its asset bubble and the US will have to tackle its budget excesses. It will also be the first year of the new sovereign debt arrangements for the Eurozone. The joker in the pack could be a commodity bust. It’s worth reading the Oliver Wyman piece on the next financial crisis.

 

Slough of despond

The UK seems to be stuck in a slough of despond. However, I agree with Jeremy Warner. I think there are some grounds for optimism, even though I think in the longer term US fiscal profligacy will lead to problems, China will face a brutal adjustment when its property bubble bursts and the eurozone has long-term structural problems. Enjoy it while it lasts. 2013 could be the year of reckoning.