Economic releases roundup for w/e 29th April 2011

Mr Micawber central banks

The Bank of England and now the Federal Reserve are increasingly looking like Mr. Micawber. Both seem perplexed by disappointing growth and higher than expected inflation and are hoping that “something will turn up”. This week, the Fed lowered its growth forecast and raised its inflation expectation. However, the prevailing message is that core inflation is still low and that the surge in headline inflation from rising energy and commodity prices is “transitory”. The Bank of England, faced with even higher inflation, also continues to assert that the rise in inflation is temporary, but dissenting voices are getting louder. Time will tell whether these pressures really are temporary, but the risks of losing control over inflation and credibility being damaged are rising.

Weak growth in the UK and US

Both the UK and US released weak GDP growth figures. Growth in the UK in 1Q11 offset the contraction in 4Q10, meaning that over six months there was no overall growth in UK GDP. In the US, growth was 1.75%, below expectations of 2%. This was mainly due to a higher implicit price deflator and weak government activity. Recent regional manufacturing surveys have also been rather weaker than expected, confirming the softer trend in US growth. Ironically, this might be good for markets as it suggests that current easy monetary conditions are less likely to change in the near future, despite rising inflationary pressures.

Pricing pressures in Europe

While Europe has been quiet in terms of economic releases, the Producer Price Indices in Spain, France and Italy all confirmed strong upward pressure on input prices (+7.8%, +6.7%, +5.7% yoy, respectively). German employment trends continue to be buoyant, with the jobless number declining by 37,000. With the ECB highly sensitive to inflationary pressures (in contrast to the Fed and BoE), rhetoric from the ECB is likely to remain hawkish. Other interesting numbers were weak Spanish retail sales and weak French household consumption.

QE complications

Both the Federal Reserve and the Bank of England have pushed monetary policy to its extreme with their asset purchase programs. The unwinding of these purchases will take policy into uncharted territory. The chances of a policy misstep are high. It is worth reading this piece from John Hussman on what he thinks are some of the issues.

It’s an interesting perspective that raising interest rates without reducing the size of the Federal Reserve’s balance sheet might induce a surge in inflation. Not only that, but any reduction in its balance sheet must be front end loaded. In particular I draw your attention to this table, which shows the size of monetary base (roughly equivalent to the balance sheet of the Fed), consistent with price stability. In theory, the first 25bp rise in interest rates would require the complete reversal of the QE2 program.

Treasury bill yields and monetary base consistent with price stability

0.03%: $2.60 trillion
0.25%: $1.92 trillion
0.50%: $1.68 trillion
0.75%: $1.54 trillion
1.00%: $1.44 trillion
1.25%: $1.36 trillion
1.50%: $1.30 trillion
1.75%: $1.24 trillion
2.00%: $1.20 trillion
2.25%: $1.16 trillion
2.50%: $1.12 trillion

Source: Hussman

The other frightening point is how leveraged the Fed’s balance sheet has become. At 50 to 1 leverage, it would only take a 35bp rise in long-term yields to wipe out the Fed’s capital. Allowing for the income on its portfolio, gives it a little more room for manoeuvre, up to a further 50bp rise. So a greater than 85bp rise in yields bankrupts the Fed! The Bank of England may be in an even worse position as it owns a greater proportion of outstanding government debt with a longer duration profile. The ECB faces a different issue. It’s not duration it has to worry about, but sovereign default. Could we see the technical bankruptcy of our central banks in the next 2-3 years?

While the inflationary implications of Hussman’s analysis are pretty frightening, it is worth bearing in mind that the Fed can pay interest on bank reserves, so the imperative of banks to rid themselves of non-interest bearing reserves is not as acute as it was under the old system. Indeed, in New Zealand, which adopted the system of paying interest on bank reserves some time ago, the level of bank reserves in the system rose to a significantly higher level than prevailed before. This suggests that banks will not necessarily aggressively seek to multiply reserves into loans and that the velocity of money may not rise as dramatically as projected.

The other offset is that if inflation suddenly lurched upwards, central banks would have to raise interest rates, which would produce an interest payment shock to borrowers, producing a surge of bad debts, which would then induce banks to become more cautious. This is particularly pertinent in the UK where adjustable rate mortgages heighten the economy’s sensitivity to interest rates. The CML (Council of Mortgage Lenders) estimate that around a third of borrowers would fail FSA affordability guidelines if mortgage rates rose by 200bp. Anything other than a gentle rise in interest rates is likely to induce a sharp slowdown in economic growth.

Clearly, central banks are walking a tightrope in unwinding QE. Too slowly risks an inflationary pulse. Too quickly could bring about another recession and possibly deflation. What is fairly certain is that the next few years will see a heightened volatility in inflation, bond yields and wider asset markets as central banks struggle to normalise monetary policy.

On average

The average person in the eurozone is 49% male and 51% female. It follows that the average person has one breast. In the light of this, the European Commission has decided to regulate the design of underwear so that in future all bras will only have one cup. In order to maintain choice, they will be available in left or right.

This is no more absurd that the current interest rate policy for the Eurozone. The current level of interest rates is totally wrong for both Germany and the periphery. According to some commentators, the Taylor Rule is suggesting that interest rates should be +4.5% for Germany and -4.5% for the periphery. The current level of interest rates will produce a boom in Germany (buy German commercial real estate!) and depression in the periphery (short Greek and Portuguese banks).

Without fiscal transfers, the Eurozone just doesn’t stack up. Either there will be some transfer mechanism or the Eurozone will disintegrate under the inbuilt paradoxes of the system. The US is an interesting example where regional differences are compensated by federal transfers and movement of labour. It is also interesting to note that the US tends to suffer regional booms and busts in real estate, much in the way that we’ve seen occur in the Eurozone.

I cannot see that Germany (and others) will accept significant transfers to the periphery. Equally, I cannot see that the populations in the periphery will accept grinding depressions year after year to keep the Eurozone banking system afloat. When will the denouement occur? My guess it will be when the next recession hits or when there is unbearable popular political pressure. Perhaps not a very helpful answer.

Economic releases roundup for w/e 15th April 2011

Here’s a quick summary of some of the important news and data from this week:

Inflation pressures

This week saw a slew of CPI releases which confirm that inflationary pressures are continuing to build. In the Eurozone, German inflation rose to 2.3% YoY, while in Spain prices rose by 3.6%. It is concerning that despite the deflationary squeeze in Spain, prices are still rising faster than core Europe, suggesting that Spanish consumers are seeing an acute drop in living standards. Overall Eurozone inflation rose from 2.4% to 2.7%, putting more pressure on monetary policymakers. Elsewhere, Chinese GDP figure showed inflation above estimates at 5.4%, precipitating further administrative measures to control prices. In their latest World Economic Outlook, the IMF cautioned that tolerance of higher inflation could lead to a rise in embedded inflation expectations, which could require a strong policy response by 2013.

Clouds on the US horizon

Generally economic releases have been quite positive for the US recently. Indeed the Beige Book released this week was broadly positive across most regions and industries. However, the National Federation of Independent Businesses (the US small business industry association) showed a sharp deterioration in confidence in the economic expansion. This may be an aberration relating to the budget impasse or the Japanese Tsunami. One month’s reading doesn’t make a trend, but the SME sector is an important driver of the US economy, so next month’s survey will be closely watched. The US trade figures also suggest some slowdown with weakness in both import and export numbers. Finally, jobless claims ticked up unexpectedly. All of these releases may just be blips. Equally, they may be harbingers of some weakness.

More nervousness over banks

Unhelpful comments from Wolfgang Schäuble led to a rise in yields on periphery sovereign bond yields. Further nervousness has been compounded by the latest IMF Global Financial Stability Report, which suggested that European banks still need raise more capital. Additionally, banks around the world need to refinance $3.6trn of maturing debt in the next two years. The report suggested that the rollover requirements were most acute for Ireland and Germany.

Two red flags

It is a mistake to project a trend from a single month’s data point. However, it can signal a change in trend and makes the following month’s reading far more important. Yesterday we had two data points in the US which may be signalling a slowing in activity, in contrast to recent data points, which have all suggested robustness in the recovery. Both the trade data and the National Federation of Independent Business Survey point to a weakening in activity, which makes them interesting. Month to month volatility makes it impossible to say whether these are aberrations or not.

Taking the trade figures first, both imports and exports fell. Exports fell 1.4% to $165.1 billion, and imports fell 1.7% to $210.9 billion. The real trade deficit narrowed 1.6% to $49.5 billion as real gross exports fell 3.7% to $97.2 billion, and real gross imports fell 3% to $146.6 billion. Some caution has to be exercised as these figures are somewhat distorted by the Chinese New Year and the deficit with China narrowed by $18bn. The next set of figures will be distorted by the Japanese Tsunami, so we may not get a clear picture for at least two months. Nonetheless, the fact that both imports and exports fell suggest some weakness in economic activity.

The second data point worth looking at is the NFIB survey, which polls small businesses in the US for confidence and other indicators. The headline confidence index fell unexpectedly to below the level last seen in November. In the past the NFIB survey has been volatile month to month, but if this is confirmed next month, then this could be a worry for the sustainability of the US recovery, especially as QE2 is ending. The main driver of the index is that small business owners have suddenly become more pessimistic about the prospects for the economy. The other components are little changed. It might be a reaction to the Japanese Tsunami or to the budget wrangling. Next month’s figure will be keenly watched.

Source: Dismal.com

Neither of these in themselves mean that the US is about to relapse, but they are warning signs that activity may be softening. A couple of Wall Street’s finest have reduced their estimates for 1Q GDP growth. . Morgan Stanley’s 1st quarter GDP estimate is 1.5% down from 1.9%. Barclays also lowered GDP estimates by a half-point to a range of 1.5% to 2%.

Barking up the wrong tree

Flawed analysis is at the heart of catastrophic policy mistakes. The central tenet of the austerity policies of the eurozone bailout packages are that the fundamental problem of the periphery countries is a loss of competitiveness and that a meaningful reduction in labour costs will rectify the problem.

Well, maybe not. I was doing a bit of catch up reading after my yomp across Dartmoor when I came across this fascinating article on Vox. Two economists from the Asian Development Bank are suggesting that a reduction in unit labour costs in Greece, Ireland, Portugal, Italy and Spain are largely meaningless as they don’t compete with Germany in most product categories. Their main competitors are Asian. Look at table 3 in the article.

The policy they need to pursue is one of moving higher up the complexity and value added chain. This is difficult to achieve quickly and may actually be hindered by the austerity measures as investment, which aids this process, is depressed. It could also be argued that education is also hindered.

Current policies are almost bound to fail because the analysis of the problem is flawed and the prescribed cure will not only fail, but it is likely to make matters worse. By pursuing harshly deflationary policies, debt servicing ability is severely impaired and a crushing burden is being imposed on the populations of these countries.

Not only that, but their political freedom is being taken away. To me, this is a highly dangerous and volatile cocktail. High unemployment and a massive squeeze on living standards are likely to engender a massive political backlash.

Perhaps I should have entitled this post: “driving over the cliff”.

No posts next week

I’m away for a bit of R&R, walking across Dartmoor, so there will be no posts next week.