Finance ministers and policy games

Let me start the week with a new blog. So much has been going on recently (central bank policy, financial market turbulance - or a lack of it, indicating complacency -, international policy coordination - or a lack of it, especially when looking underneath the surface -, etc.) , that it becomes increasingly difficult to choose just one topic and elaborate upon it. Especially if, like me, you just want to read and know everything. Little time left then to reflect and write down your thoughts. However, that is what I will try to do. This time it's about international policy coordination, trade, competitive currency devaluations covered up as monetary easing, and the promises made during the G20 meeting last weekend.

Some good news after the G20 meeting of central bankers and finance ministers: the IMF's legitimacy was said to be enhanced by a shift of votes and quotas from the 6% most overrepresented to the 6% most underrepresented members. Great, of course, as it is a big surprise that the members agreed, but will this really change the way China approaches its diplomatic relations? Moreover, the problem of the illegitimacy of the IMF was just a top of the iceberg of problems that the political world-stage is dealing with today.

Just underneath the surface are currency issues. Although the Brazilian finance minister even mentioned a "currency war", it has not come this far (yet). For now, countries seem willing to cooperate. The G20 communiqué mentioned that: "we [read: the G20] will, continue to resist all forms of protectionist measures and seek to make significant progress to further reduce barriers to trade.", and "... continue with monetary policy which is appropriate to achieve price stability". Okay, this sounds good. Or, does it really? Monetary policy to achieve price stability? That is what the Fed is trying to achieve. However, it requires QE2 according to the Fed, and that is exactly what more the communiqué is saying countries should NOT do: "we will [...] refrain from competitive devaluations of currencies".

Unfortunately, the G20 lacks supranational power and the apparent willingness to cooperate might go no further than the communiqué. None of these agreements are binding. Moverover, since the dispute is mainly between China and the U.S., there is no member strong enough to exert the political pressure that would force them to come to a solution.

So China and the U.S. would have to come to a solution over the currency dispute on their own. And will this dispute get settled? Not if the U.S. keeps desiring fast Yuan appreciation in order to make Chinese imports less attractive and their exports to China more attractive, and if China maintains committed to very slow appreciation of the Yuan in order not to hurt the export sector's very thin profit margins and provoke social unrest. Overall, it is very unlikely that the dispute gets settled on its own, given that neither of the two is willing to give in.

And then there is the deeper lying issue of trade imbalances. The G20 communiqué shortly addressed this, by stating that the G20 will "strengthen multilateral cooperation to promote ... reducing excessive imbalances and maintain current account imbalances at sustainable levels". But since when are imbalances not excessive, and since when can imbalances be at sustainable levels? Apparently, leaders at the G20 could not agree on when, how, and why to address these imbalances that are one of the main causes of the crisis.

The bottom line is that the deeper lying issues will not get resolved. The path of the least resistance is that countries (the U.S. first, and other countries could follow) resort to some kind of protectionism. Either in the form of trade measures or in the form of quantitative easing. The first is less likely to occur, as the biggest and most efficient U.S. companies are the ones that engage in exporting and importing, and precisely these profit-generating firms stand to loose from this. Given their large profit-making potential, it would be a very silly move. Nevertheless, it would not be the first time that politicians made silly moves (silly being a heavy understatement) .The second option, quantitative easing, is more likely, even though the G20 communiqué explicitly tells countries to refrain from competitive devaluations of currencies. The Fed, for example, can resort to its dual mandate to explain the need for further monetary easing and claim that devaluation of the U.S. dollar is just a side effect. Nobody in the real world, obviously, believes this, but it is just part of the political game.

FAQs part II

In my last blog I posed some questions for which we still don’t have a (more) definitive answer, except perhaps for the first question. With the Fed taking steps to quantitative easing 2.0 (albeit baby steps, since for now it has announced only to maintain the size of its balance sheet, and not let is shrink – indicated by the FOMC’s public statement last Tuesday), the markets are certainly not responding enthusiastic. More accurately: the past week has been a very hectic week for the financial markets. Worries about the recovery in the U.S. spread to more concerns about mainly the periphery of Europe. German export-led growth for now pulls the Eurozone ahead, but how long will that last? Quarterly growth was well above expected, but if countries importing German goods see their economies weaken, German growth will be unable to sustain itself. The ECB has indicated it will slowly move to exit strategies. Although problems in the periphery are still very concerning and dependence of banks in Portugal, Spain and Greece on ECB financing is increasing steadily.

The Fed, on the other hand, is much more willing to support the economy with an even looser monetary policy. Analysts and commentators alike are very pessimistic about the effectiveness of further quantitative easing. If it has not worked in the past, why would it work next time? Is there so much more the Fed can do? Well, actually, yes. But that is just in theory. Central banks worldwide are constrained by the whims of the market. Should a sudden worry for hyperinflation pop up, better beware! If central bankers do not respond quickly taking the money out of the system within a week or so, double-digit inflation may be the result.

But for now, the Fed is walking a very thin line between high inflation and deflation. Core inflation in the U.S. (excluding food and energy prices) is already in negative territory and should economic activity not pick up, negative annual core inflation is not unlikely. Of course, for a large part this is driven by the still declining housing prices. Nevertheless, deflation is a dangerous phenomenon and Ben Bernanke will do everything in its power to prevent it, but he has not indicated directly what he will do should the economy get even worse. If such measures are taken (the measures the Fed could possibly take are in an earlier blog of mine), however, the market will interpret this as a sign that the economy is doing really, really, really, really terrible. No need to explain here what that means. But on the other hand, when signs of the economy weaken, and the Fed does not respond, the markets will also react negatively.

My overall conclusion therefore is: whatever monetary policy does, it will not improve the matter much (the matter being the U.S. economy), and it is fiscal policy that should get things going again. But please not in the way fiscal policy has been used in previous U.S. fiscal stimulus packages. Let’s look at China; they really set a good example.

More on that later.

The Federal Reserve and blood pressure

Yesterday I wrote on the U.S. economy and the Fed that will have to act someway or the other to at least try to avoid Japanese deflation scenarios. So as I promised, today you could have read the options available to the Fed. Not in my blog, but on the front page of the Wall Street Journal. Surprise!

First of all a word on my new colleagues: they are really great (they must be reading this sooner or later, so if I wanted to say something bad about them, I couldn’t anyway, for my own sake). The first day of my internship at iCC has past and I have to say that I look forward working there and doing the research for my master thesis (and for iCC, as the report is also in their interest), but more on this some other time.

Anyway, I don’t want to disappoint you already after my third blog (this will scare away the few loyal followers) so I will write here what I promised to write; let me quickly summarise what the article said (and which is, of course, exactly what I was going to write J).

So hang on: here is what the Fed could (COULD, not should) do:

1. Ideally, the Fed would strengthen its promise of keeping the fed funds rate low for an extended period of time, in order to encourage investors to borrow and take risks. Forecasts already expect the rate to stay close to zero well into 2011, so if this is not encouraging enough, what is? An yes, there is the problem of credibility. Because once investors borrowed, why not increase the rate?

2. A road the Fed could take is to push short-term rates to zero, but they are very reluctant to do so as it would disrupt the money market.

3. An attractive thing to do would be to use cash received from mortgage-backed securities or underlying loans that are paid off to invest in new mortgage-backed securities. At least, it seems to be an attractive option as it signals the Fed’s attempt to stimulate growth and so avoid deflation. A likely course of action, but the estimated impact is small, as mortgage rates are already very low so further stimulation is unnecessary.

4. Lastly, a very aggressive option would be to repurchase U.S. government bonds or mortgage-backed securities, to push down the long-term interest rate. The only problem here is that also this effect is likely to be small; the Fed would then have an even smaller portfolio to pour money from into the economy. The damage would be huge if the plan would backfire and inflation expectations rise.

So this was the theoretical part. Basically, the hands of the Fed are tightened and there are drawbacks to every option it has. Pumping money into the economy to get people to spend can stimulate growth, but whatever the Fed does, it comes at the cost of further increasing budget deficit and so it further constrains fiscal policy. What is really needed are tools to get employment up, fight falling wages and prices, but this is not the job of the Fed.

Currently the Fed is debating internally about what to do, and I think that is the best they can do; let them sit there and debate, because loosening monetary policy even more will do more harm than good. Let the U.S. government solve out how to fight unemployment and get spending and investment up.

To close with, I want to warn you. Research performed at the University of Chicago shows that loneliness can raise blood pressure. Such a relief: this holds only for those aged above 50. Don’t think: ‘time to start making friends before I’m that old’! First of all: 50 is not that old, I plan on becoming 110. Second, it’s not the amount of friends you have that determine how lonely you feel, but rather how long you can wait before someone write/calls you and how long you can stand to be alone (i.e. feelings of loneliness). Obviously perhaps, but nice that this gets confirmed by research.

The U.S. economy and the Fed

As a skip tonight’s news broadcast (just came back from a board meeting) and still have some time before I hit the bed but it’s too late to engage in some physical activity like my favourite dance game with the Wii, let me share with you my view on the U.S. economy. (That’s having your priorities straight.)

My curiosity on this topic was triggered by Paul Krugman’s blog on the Feckless Fed (btw. feckless means something like not fit to assume responsibility or being generally incompetent – nice word huh?). Paul Krugman is obviously pessimistic on the U.S. economy (rightly so), but moreover he is sceptical on how the U.S. Federal Reserve responds to the situation in the U.S., e.g. high unemployment rates, a huge government debt, too costly reform of the health system and already slow growth.

The first question that came to my mind was how it can be that the IMF in the world economic outlook predicts a growth rate for the U.S. of 3.3% in 2010 and 2.9% in 2011, while the prospects look so bleak. Of course, the states are recovering from the nadir and restoring from such a low does not require much. On the other hand, the fundamentals are really flawed and not much have been done to restore the financial system. The only good news in the last few weeks came from rallying stock indices and releases of macro-economic figures that were not too bad. However, these good figures and the following rallies again stem from increasing imbalances; too high borrowing from emerging economies and future generations. All in all, can we really believe these positive growth projections? I think we should be much more careful than taking these figures at face value.

The second question that came to my mind was when the Fed will make its move to avoid Japanese-style deflation and what move this will be. Paul Krugman’s worries about deflation are not completely ungrounded (and if they were, I wouldn’t dare to say so) and the Fed too has to confess that deflation in the near future is not completely unlikely to occur. So far, they have not taken any concrete action to do so. Even worse, the last statement of the Federal Open Market Committee suggests that economic prospects and the labour market start to improve gradually, but where does this recovery come from? There is only modest income growth and the housing market is still locked due to high unemployment. Okay, business spending is increasing, but confidence is decreasing, and many banks have not yet recognised their losses on commercial mortgage backed securities. The Eurozone economy does also not contribute positively to U.S. growth. These are the reasons for deflation not being completely unlikely.

If the Fed does not recognise this, surely they will not do anything to avoid deflation. If they would recognise it, what can they do? I range the options from hardly credible to somewhat more credible:

1. 1. ...

2. 2. ...

But this you can read tomorrow! J Sleep tight.