Mindboggling non-sense

At the end of its two-day policy meeting on January 25th, the Federal Reserve revealed its new communication strategy. It will now share with us all the forecasts made by all of the voting members of the Federal Open Market Committee (FOMC) and more on interest rates. It has a formal medium-term inflation target of 2% based on the price index for personal consumption expenditure (PCE). It does not have an employment target or unemployment rate. It has concluded, for better or worse, that it has more influence over inflation outcomes than over employment outcomes. It thinks that the natural rate of unemployment in the US is between 5.2% and 6.0%.

FOMC in December 2011

In addition to all of the above, what else did the FOMC decide on January 24-25? It decided that interest rates would stay low up to late 2014. The last time the FOMC met was on December 13th. The FOMC decided the following at that time:

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 per cent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

What was the economy doing then? This is what they said:

Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth.

Now, what did the FOMC decide on Jan. 25th?

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy.  In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 per cent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

That is a 15-18 month extension of the zero interest rate policy, pre-committed. What does the Federal Reserve need monetary policy autonomy and independence for, if they are going to chain themselves more and more? At least, is there any incremental logic in what they did between December 2011 and now? They repeated the same assessment of the economy:

Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth.

There was no incremental deterioration in their assessment. It was identical to the December statement, in fact.

In terms of actual economic data, the housing market index has improved beyond what they could have imagined. The unemployment rate has declined and so have did the initial jobless claims. Purchasing Managers’ indices in various Federal Reserve regions have shown first order or second order improvement. As usual, the US stock market is defying gravity.

Now, let us make one thing clear. We do not think these are lasting signs of economic recovery. We may even venture to add that some of the improvements do not pass the test of rigour. However, from a rational decision-making angle, what matters is the change; what happens at the margin. At the margin, things have certainly not deteriorated but got better.

Lastly, if we examined the forecasts developed by the Federal Reserve Board members and Federal Reserve Bank Presidents, it is hard to discern a case for extending the zero rate (or, low rate) pledge until late 2014. If anything, their unemployment rate projections are more optimistic now than the ones they made in November 2011!

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Medium-term inflation target – case for tightening

If the natural rate of unemployment is now estimated at between 5.2% and 6.0%, then it is logical that the output gap is not as negative as is deemed. When the excess capacity is not as large as thought of earlier, then it further weakens the case for extending the period of exceptional policy setting.

The Federal Reserve has now announced a medium-term inflation target of 2% measured by the annual change in the price index for PCE. The average annual inflation rate measured by the PCE Price Index is 3.2%. If we are somewhat more charitable to the Federal Reserve, omit the early years of the 1980s when the inflation rate was in double-digits and calculate the average inflation rate from the 1990s, the rate is 2.2% – still above the Federal Reserve target of 2.0%. The annual inflation rate in the last two quarters (June and September 2011) has been 2.5% and 2.9% respectively.

(Click on the image for a clearer view)

In other words, there is nothing in the data to warrant the Federal Reserve extending its zero interest rate policy by another 18 months.

Lastly, empirical evidence over the last three decades has shown that inflation targeting is useless in helping central banks avoid or contain systemic crises. If anything, inflation at or below target lulls central banks into policy complacency. Central banks need to look at a wide variety of indicators to identify and eliminate risks before they become too big to handle.  In a well-functioning market economy, prices of goods and services would automatically adjust as both demand and supply respond to price signals. There is really nothing for central banks to do except to oversee prudent money supply and credit growth.

Forsaking policy independence is irrational

What did the last episode of pre-commitment under Greenspan achieve? He kept the Federal Funds rate at 1.0% from 2003 until 2004 (he need not have brought it down to 1.0% in the first place) and then increased them gradually at a pre-announced pace of 25 basis points per meeting? Did it cause market participants to taper off their risk-exposure gradually? No. It made them take on more risk because he had removed monetary policy unpredictability and uncertainty, which are legitimate weapons in the policy arsenal.

So, what was the logic in extending the zero per cent interest rate commitment by another 15 to 18 months when mid-2013 is already some 18 months away? Is there something that they know that we do not know about the underlying economy? Are all the recent improvements in the data fabricated? If they do expect the economy to remain as sluggish as to warrant zero per cent interest rate for almost another three years, then why are they not simultaneously warning of irrational exuberance in the stock market?

With his excessively loose monetary policy in 2001-2004 and with his gradual tightening from 2004 to 2006, Greenspan played a major role in precipitating the global financial crisis of 2008. His successor has exceeded him in many ways. It should not surprise us if the consequences too are far worse.

So, why is the Federal Reserve doing this?

There are many reasons.  First, they suffer from intellectual paralysis. All policymakers (and economists) work with dogmas and not with open minds. If they are lucky, the dogmas do not lead to disasters. Otherwise, it does. That is what happened in 2008. They do not learn from errors. They are human beings, after all.

Second, to be charitable to them, American policymakers see deflation and depression in every corner. Every other risk is worth taking to avoid that one risk. To be uncharitable and honest, their true goal is monetary debasement and inflation. That is how one takes care of the mountain of present, future and contingent debt. Savers, pensioners and creditors – domestic or foreign – be damned.

Third, given that they are worried about deflation, they could have considered another round of money printing as they did in 2009 and in 2010. Republican Presidential hopefuls have set their face against it. Hence, Bernanke has to resort to this subterfuge.

Fourth, the Federal Reserve was smug with confidence that they were the only one in the race to debase money. Now, they have a rival who has either already closed the gap or raced ahead of the Federal Reserve. The expansion of the European Central Bank (ECB) balance-sheet in recent months has been astounding. It does not even require high-school mathematics to estimate that the growth rate of the ECB balance-sheet has been just under 50% in the last seven months.

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Economists would argue that this would not cause inflation immediately because either (a) the money multiplier is weak or that (b) these are temporary expansions of the balance-sheet or (c) that the market believes them to be temporary and hence, they would not influence expectations. May be, all of it is true although we are sceptical of all the claims made above.

Even if they were true, the distortions it causes to human behaviour (encouraging speculation in contrast to investment), to asset prices (bubble-creation), to competitiveness of developing countries (their currencies appreciate too much too soon for them to adjust) and to social equality (asset price gains do not accrue to the majority of the population) are too serious to be intellectualised or dismissed with a wave of hand.

The actions of the Federal Reserve are irresponsible and hence, indefensible. Their putative gains, if any, outweigh both local and global costs.

Investors react like flies drawn to fire

In response to this decision, stock markets went up in the US and in Asia. May be, that pleases the FOMC. After all, they measure their success in terms of the reaction in stock markets. Previous episodes of excessive and prolonged loose monetary policy have shown that such gains are not sustainable. This one will be no different.

Commodity and carry-trade currencies have also surged ahead (Australian dollar, South African rand and Brazilian real, to name a few). Such gains are neither economically desirable for their countries nor are they sustainable.

Gains in precious metals and commodities are the only things that matter, as the race to make paper currencies worthless is now well under way. The number of participants is increasing by the day. We only have to wait for the Bank of Japan to join. They have resisted wisely so far. Will politicians and exporters let them stick to their sensible approach? When they too succumb, expect gold to soar.  Of course, gold does not need further impetus than what the Federal Reserve and the ECB have provided already.

RBI’s CRR cut

Bloomberg consensus expectations pointed to no change in monetary policy setting in India, ahead of the meeting of the Reserve Bank of India (RBI) held on January 24th. However, RBI left interest rates unchanged but reduced the cash reserve ratio (CRR) to 5.5% from 6.0% effective from January 28th. Many feel that the RBI had sent confusing signals again. Some of the analysis of the monetary policy action of the RBI also reflect that confusion.

RBI was expected to engage in Open Market Operations and tweak the Statutory Liquidity Ratio if it wanted to address liquidity. A cut in CRR is now interpreted to presage aggressive rate cuts. I wonder if it is the case. A 50-basis point cut in CRR could be a substitute for aggressive rate reductions.

Elsewhere, RBI lowered its growth estimate down to 7.0% from 7.6% for the current financial year ending March 2012. It expects growth in 2012-13 to be slightly better (we are not so sure). It left its forecast for the wholesale price index based inflation rate unchanged at 7% for 2011-12 and said that the forecast for inflation in 2012-13 is subject to considerable uncertainties. In other words, the central bank is not confident – and rightly so – that inflation would decline materially. Core inflation is not only higher now than when RBI began hiking rates but is showing no signs of topping out, yet.

Both in the press statement accompanying the policy decision and in its review of the macro-economic and monetary developments in the third quarter (Oct. – Dec. 2011), the central bank minced no words in holding profligate government spending responsible for higher inflation, for tight liquidity and for lower growth (crowding out effect on private sector capital formation). RBI expects the central government budget deficit for 2011-12 to be substantially higher than original estimates.

While State governments have made progress on consolidating their finances, their contingent liabilities arising from the guarantees they have extended on bank loans to electric power distribution companies are considerable and could nullify the progress on budget consolidation, if the guarantees are invoked.

India’s import of crude oil is rising and along with it, the subsidies extended by the government on fuel prices rise too. India’s energy policy encourages private means of transport as opposed to more efficient public transportation, environmental pollution and compounds its fiscal woes. RBI is correctly realistic about the outlook for the price of crude oil in the months ahead, in the light of aggressive monetary easing in the West and potential supply disruptions if the geopolitical environment worsens.

In sum, the picture one gets is that – going by the stated intent of the central bank – rate cuts would be slow and gradual. Rate cuts in the year 2012-13 might amount to 50-100 basis points but aggressive rate cuts are, by no means, assured. Much depends on the central government’s intent and delivery on budget consolidation. Both are suspect, to say the least.

It is hard to divine the intent and the ability of the central bank to deliver on its intent, based on its statements. That is no criticism. For the most part, RBI is making up policy on the fly, I guess.That perhaps is the only way to make policy under the circumstances – if it is buffeted by domestic growth and inflation challenges, global inflation pressures and political pressures from the government.

For what it is worth, I am not betting on aggressive rate cuts from RBI in 2012-13. May be, I am taking the Reserve Bank of India’s tough-talk on fiscal deficits and uncertain inflation outlook more seriously than it deserves to be.

Economist-21 Jan.2012

Caught up with the ‘Economist’ newspaper of the said date. Found several articles interesting:

(1) One is on the arrangement of mirrors that capture and help to convert sunlight into energy. Read the article. I doubt if ‘Economist’ understands the implications of its own sub-header but many ‘pagans’ would do.

(2) The article on Mangolia (‘Minegolia’) was well written too. The statement by the CEO of mining company is so quintessential. Reminds one of the glee that many robber-barons and the so-called voyagers like Columbus must have felt on discovering bounties to be expropriated or seized:

remarks made in the past by Robert Friedland, Ivanhoe’s boss, about “the cash machine we intend to build”, and how nice it was to have so few people around and “no NGOs”.

(3)  I do not think we should be surprised by how executives time their  share buybacks. Insider selling or buying is a poor signal?

(4) I wonder whether this article on corporate shareholder anonymity is an indirect response to the Indian Supreme Court’s verdict on the Vodafone tax demand by Indian Income-Tax authorities. Methinks they were on a stronger wicket vs. Vodafone.

(5) Did not know that there is a ‘Occupy London’ movement analogous to ‘Occupy Wall Street’. Ravin Thambapillai’s letter on ‘the City’ is a good one.

(6) Nearly 40% of America’s top 1% is made up by medical practitioners, lawyers and people from finance. That seems to be up from just over 30% in 1979. Difficult to reject the argument that they could be taxed more.

No matter how you slice it ,it is good

When one reviews the headlines on China’s fourth quarter 2011 GDP growth estimate (8.9% y/y) and the full-year 2011 estimate (9.2%), it is hard to know whether China’s economy has slowed or accelerated or if it is good news or bad news. In the end, it does not seem to matter since investors are in a mood to see, hear and speak no bad news. Either the economy did not slow, or if it slowed, it did not slow so much as the consensus expected or if it slowed, the government would ease monetary policy. So, the market was determined only to see good news in the report. It forces investors to take risks and construct arguments to justify those risks. China growth numbers were an excuse for commodity currencies to do well. South African rand reached a six-month high. That currency was a rank underperformer in 2011. On its part, the Australian dollar, after attempting to break down for a few days, soared high. AUDUSD is near 1.04 at the time of this note being written.

The European sovereign downgrades do not matter. The German GDP contraction does not matter but the German economists’ opinion that the economy is doing not so poorly as thought matters. The downgrade of the European Financial Stability Fund does not matter. That the financial sector is on life support system from the central banks does not matter. That the European Central Bank, under Mr. Draghi, is all set to match or beat America in money printing with dire consequences for global inflation and social stability does not matter. That Greece is virtually technically in default does not matter.

As my friend Jim Walker points out,

the numbers just totally defy logic, as do the expectations of the markets for what China will do next in policy terms. More. The numbers defy the ongoing collapse in transactions in the property sector. They defy the drop in fourth quarter PMI readings below the 50 boom-bust line. They defy the anecdotal evidence of severe SME pain that has been accumulating for months. They defy a slowdown in exports and a fall in the trade balance. They defy a deceleration in money supply and official credit growth. They defy the fact that local governments and the Railways Ministry have been forced to slow or abandon many projects. And most importantly they defy the downgrades and reports of slowing profitability in the corporate sector

No one wants to find out if the emperor has clothes or not. They are not interested. The emperor would, of course, never admit that he is naked, in any case. Yesterday’s numbers were proof of that.

Such is the power of liquidity and zero interest rates to fool most of the people most of the time. This can only end in one way – in tears.

Uneasy Davies

Before I delve into the blog posts of Gavyn Davies, I shall give him his due first. He is uneasy and uncomfortable with the unprecedented central bank support to the financial systems on either side of the Atlantic. That is a plus. Not too many are uncomfortable. That is unfortunate.

However, he is not bold enough to go beyond that. In fact, he falls back on the side of the ‘system’. There is too much at stake for many to come out and state that the system is broke and that trying to keep it going is like trying to pump the heart of a dead body.

I refer to his blog posts of Jan. 8th and Dec. 11th. In the post of Jan. 8th, he takes up from where he left off on December 11th. His conclusion on Dec. 11th sounded good and set a good platform to launch into a further critique of these central bank actions. But, on January 8th, he held his fire.

First, his conclusion on Dec. 11th:

Because this behaviour is so unprecedented, it is hard to predict the medium term consequences of such a massive dose of QE. Many economists argue that, in the absence of any rise in inflation expectations, central bank balance sheets are in effect infinitely large, and can be used as needed to combat the crisis.

Given the outsize scale of what the central banks are now doing, this argument needs increasingly careful examination in future blogs. But one conclusion already seems clear. If this strategy does not work, there will be little else left in the locker of the emergency services.

It is the careful examination that he promises in his concluding remarks that eluded him on Jan. 8th. Here is what he states on the inflation risk of central bank action:

I do not share the alarmist view that an explosion in central bank liabilities must inevitably lead to higher inflation. That basic monetarist link has already been shown to be invalid, at least over short periods, and at least when a liquidity trap is in operation.

This is unfortunate. This is what many people said about the unprecedented central bank rate cuts and ultra-loose monetary policy of 2001-2004. The results were there for all to see in 2007-08. Inflation eventually arrived. In the meantime, it made many indebted and insolvent and many a saver went unrewarded. That is being repeated now on a more massive scale. How can it now have consequences?

The distortionary effects of zero interest rates and loose money are too well known not to be probed rigorously by analysts. Casual dismissal of their effects by simply looking at current inflation rates won’t do because such a behaviour boomeranged on us.

In any case, inflation is not exactly low either in Europe or in the US, notwithstanding the known tendency of official inflation indices to understate true inflation due to their assumption of substitution effects and hedonic adjustments.

The second aspect that he does not treat at length – he might yet do so in future posts – is this:

In the absence of these injections, private banks would have been forced to delever their balance sheets in order to remain liquid. In all probability, some would have gone bankrupt, causing contagion throughout the financial sector and the economy at large. While no-one doubts that these central bank actions have been necessary, they have lasted much longer than ever before.

It is not much of an exaggeration to say that large parts of the financial sector have been quasi-nationalised. As liquidity injections have become semi-permanent, the private banking sector has existed only at the mercy of the central banks, and the distinction between solvency issues  and liquidity issues in the private sector has been increasingly blurred. The rise in the central bank balance sheet has prevented the need for further, and more overt, injections of capital into private banks by governments, and therefore by taxpayers. Whether this alternative would have been politically feasible is a moot point.

In other words, he admits that central banks have kept alive zombie banks. Those who are solid, trustworthy and credible would have been able to raise capital even if at higher costs. That would have had a salutary effect on their risk-taking. Central banks have basically allowed the financial system on both sides of the Atlantic to evade the discipline of market capitalism. So much for free-market capitalism!

Next, he comments on the helping hand that central banks have extended sovereign governments:

In the absence of these injections, private banks would have been forced to delever their balance sheets in order to remain liquid. In all probability, some would have gone bankrupt, causing contagion throughout the financial sector and the economy at large. While no-one doubts that these central bank actions have been necessary, they have lasted much longer than ever before.

It is not much of an exaggeration to say that large parts of the financial sector have been quasi-nationalised. As liquidity injections have become semi-permanent, the private banking sector has existed only at the mercy of the central banks, and the distinction between solvency issues  and liquidity issues in the private sector has been increasingly blurred. The rise in the central bank balance sheet has prevented the need for further, and more overt, injections of capital into private banks by governments, and therefore by taxpayers. Whether this alternative would have been politically feasible is a moot point.

It is clear that, here too, central banks have muted the information content of bond market yields with their aggressive purchases. That they are not directly monetising government debt is an eye-wash and downright hypocrisy. In fact, much worse, some Keynesians have the audacity to suggest that since the bond market has not revolted at the fiscal spending of governments, there is room for the governments to borrow more! It will be hard to beat this for chutzpah.

Talk is cheap. Hence, central bank chiefs are delivering lectures on fiscal prudence and price stability. But, in action, they are distorting markets, price signals and creating inflation and bubble-bust risks throughout the world with consequences for social stability.

After all, only the well-heeled and endowed can post margins to be able to borrow at record low interest rates. For others, asset prices are too high to be affordable, even if borrowing rates are low. So, these zero interest rate policies encourage wealthy borrowers, punish savers and hence do their bit to widen inequality.

This is serious crime.

Conflation and clarity

Just caught up with this piece by Anil Padmanabhan of MINT written on Dec. 25th. He conflates big time.

The problem is not that rural consumption has risen. But, that it has risen for the wrong reasons and without commensurate increase in productivity or by creating productive assets. That is the flaw in the design of NREGA. It is a rural entitlement programme and not a rural opportunity programme.

Yes, that does not mean that the State should go soft on KingFisher. Why are both mutually exclusive? In fact, both problems have a common source: a paternalistic and feudal state with no accountability, in collusion with vested interests (poverty and business) as opposed to lifting the poor out of poverty and helping markets.

T. N. Ninan has made up more than required ground for some of his recent wishy-washy weekend ruminations with this brilliant piece on how the Congress has brought back all the ills that we thought or hoped that the reforms of the 1990s would slowly begin to eradicate. My only quibble, if at all, is that he has addressed it to Anna Hazare & Co. Not that it is wrong. But, it is the people who support Anna Hazare and yet file for BPL status that need to be addressed.

I have based my Tuesday column in MINT on this piece, to a large extent.

A very stark warning by Pratap Bhanu Mehta here in this Q&A with Business Standard:

You are back to the seventies. State discretion has grown. State interference in regulators has grown. That basic structure that we wanted in 1991, a rule-bound system, friendly to business, a new social contract that says the job of business is to generate wealth and the government will tax that wealth to help those who cannot participate in this economy. All elements of that social contract have broken down. That doesn’t mean that India will come to a grinding halt. There are some underlying drivers. If the savings rate can remain in the 30 per cent range, you have at least some investment going. But nobody in the political system realises that the historical window of opportunity for putting in lasting changes is very small. In our case, it is 10 to 15 years given our demography.

If we don’t lay the foundation for wealth and prosperity in the next 15 years, then the India story is gone forever. You will then grow old, before you grow rich. Our confusions are very much at the structural level.

The third kind of lie

I was just marvelling at the US and European Statistics:

(1)    German retail sales (what is the quality of this data? – I do not know) declined 0.9% (m/m) in November. Expectation was for +0.2%.  Previous month was revised from +0.7% to -0.2%. The annual change in retail sales shows +0.8% against consensus of +0.7% for the month of November! October data, as one would expect, revised down to -0.6% from -0.4%. How does November retail sales annual growth come in at +0.8%?

Is there any link to German employment numbers and retail sales? The former looks too good. This latter piece of data now has notched up two back-to-back negative months.

(2)    French consumer spending records -0.1% in November. October revised to +0.1% from 0.0%. The annual change in November is reasonably consistent with the m/m number: -2.1% vs. -1.8% (exp.). October revised to -1.0% from -0.9%.

Surprising, in this case, is the consumer confidence indicator remaining unchanged at 80 in December from 80 in November!

(3)    In the case of the UK, Lloyds Business  Barometer indicator weakens to -23 from -20 in December. If you see the chart in Bloomberg, you will notice the dramatic collapse. M4 growth has collapsed. It is now contracting at 2.6% (y/y). Yet, PMI manufacturing ‘improves’ (second derivative). PMI Construction expands at an accelerating rate. PMI Services expands and accelerates too!

(4)    In the US, real disposable personal income (and this includes government transfers) is now contracting at 0.1%. Consumer credit is growing. Savings rate is  stuck below 4.0%. Personal Income transfers from government has stagnated, absent fresh fiscal stimuluses. No surprise that real disposable personal income has  stagnated. Real personal spending too is declining, although still positive. Yet, the US retail sales numbers look healthy! How?

(5)    The ECRI Weekly Growth Index is stuck at below -7 (it is -7.6) unlike in 2010 when it improved from the low summer readings.

What on earth is US S&P 500 doing near 1300?!

I think there is a lot of manipulation going on with the connivance of Treasury and Central  Bank officials in the US and in Europe, in propping up markets/asset prices.