Friday 20 August 2010
American sucker
American Sucker tells the true story of David Denby, the New York film critic, who got a little too caught up in the late 1990s tech bubble. After splitting up with his wife in early 2000, Mr Denby liquidated most of his family’s assets and invested them in tech stocks. With prices rising rapidly, he became completely obsessed with the ‘new economy’ boom – religiously watching CNBC, attending conferences, and striking up personal acquaintances with Henry Blodget (the former Merrill Lynch tech analyst) and the biotech entrepreneur Sam Waksal (who was eventually jailed for corruption). Like the Titantic movie, the ending is entirely predictable – he loses a fortune – but the book still provides a valuable insight into asset bubble psychology.
As the market began to fall, Denby was convinced it would bounce back. Occasionally it did, but not for long. So he hung onto his tech stocks until the very end of the downturn, by which time many of them were worthless. Unfortunately, he couldn’t accept the market was largely a bubble because he could see evidence of the ‘new economy’ all around him – computers were everywhere and communications were changing rapidly. In some ways of course, he was right. The data show the US economy genuinely changed in the late 1990s – unemployment fell dramatically without triggering rampant wage inflation, productivity accelerated significantly and, once companies focused on exploiting all the efficiency gains (ironically, after the bubble had burst), profits eventually reached a record share of national income. But, as in many bubbles, the market took an idea with some fundamental basis and simply got carried away.
While such excesses are no longer obvious in equity markets, Macro Maestro thinks you can see signs of this bubble mentality in other markets – notably the bond market. Right now, it is certainly hard to get too worried about inflation. Most major economies are running large negative output gaps and Asian exporters, concerned about maintaining market share at a time of low growth and a weak dollar, are still cutting their prices in the West. But the absence of high inflation does not imply – as the bond market seems to be assuming – that deflation is inevitable. Yet, a US ten-year yield of 2.5% seems to be pricing exactly that. And more subtlety, the momentum (and commentary) in the market seems to suggest investors are buying bonds purely because they think yields will continue to fall. This is the same basic psychology behind all bubbles and it was certainly apparent in the late 1990s stock bubble. Bond investors should also remember, of course, the state of public finances in the US and UK. Surely these warrant some kind of risk premium on the paper they are buying?
Macro Maestro doesn’t expect global deflation, but he does see another 12-18 months of weak growth and low inflation. This alone will generate significant volatility in financial markets. Most investors currently seem to have a bimodal view of the world - they are asking only whether we face deflation or inflation. As always, somewhere in-between these two extremes lies the most likely outcome. So, as the news fluctuates and investors' expectations flicker between these two scenario, asset prices will be volatile and there will be plenty of opportunities for the savvy punter to make money. (As long as they don't get drawn into dangerous momentum trades.)
As the market began to fall, Denby was convinced it would bounce back. Occasionally it did, but not for long. So he hung onto his tech stocks until the very end of the downturn, by which time many of them were worthless. Unfortunately, he couldn’t accept the market was largely a bubble because he could see evidence of the ‘new economy’ all around him – computers were everywhere and communications were changing rapidly. In some ways of course, he was right. The data show the US economy genuinely changed in the late 1990s – unemployment fell dramatically without triggering rampant wage inflation, productivity accelerated significantly and, once companies focused on exploiting all the efficiency gains (ironically, after the bubble had burst), profits eventually reached a record share of national income. But, as in many bubbles, the market took an idea with some fundamental basis and simply got carried away.
While such excesses are no longer obvious in equity markets, Macro Maestro thinks you can see signs of this bubble mentality in other markets – notably the bond market. Right now, it is certainly hard to get too worried about inflation. Most major economies are running large negative output gaps and Asian exporters, concerned about maintaining market share at a time of low growth and a weak dollar, are still cutting their prices in the West. But the absence of high inflation does not imply – as the bond market seems to be assuming – that deflation is inevitable. Yet, a US ten-year yield of 2.5% seems to be pricing exactly that. And more subtlety, the momentum (and commentary) in the market seems to suggest investors are buying bonds purely because they think yields will continue to fall. This is the same basic psychology behind all bubbles and it was certainly apparent in the late 1990s stock bubble. Bond investors should also remember, of course, the state of public finances in the US and UK. Surely these warrant some kind of risk premium on the paper they are buying?
Macro Maestro doesn’t expect global deflation, but he does see another 12-18 months of weak growth and low inflation. This alone will generate significant volatility in financial markets. Most investors currently seem to have a bimodal view of the world - they are asking only whether we face deflation or inflation. As always, somewhere in-between these two extremes lies the most likely outcome. So, as the news fluctuates and investors' expectations flicker between these two scenario, asset prices will be volatile and there will be plenty of opportunities for the savvy punter to make money. (As long as they don't get drawn into dangerous momentum trades.)
Wednesday 18 August 2010
Ménage à trois
Comments from Fed member James Bullard suggest the Fed, like the BoE, could soon have a three-way split. (Assuming Hoenig continues to vote for rate rises). This is becoming like the old economist joke about hiring two economists and getting three different points of view. So why have such extreme differences in opinion on these committees emerged? Macro Maestro suggests its a case of:
1. Huge uncertainty about the outlook. Though growth has slowed in line with what most commentators were expecting earlier in the year, it's incredibly hard to work out whether this is just a 'soft spot' or something more sinister. (Macro Maestro suspects the latter.) The economic models used by policymakers failed to predict the recession, so they are understandably reluctant to use them to try to forecast recovery. As these models have broken down, any existing consensus has fragmented.
2. Quantitative Easing has made it difficult to judge how loose current monetary policy is and what effect it is having on the wider economy. Some policymaker believe monetary conditions are so expansionary they are risking asset-price bubbles and further financial instability (eg the Fed's Hoenig and the BoE's Sentance), while others argue policy isn't yet doing enough. In the past, it was sufficient just to draw a Taylor rule to figure out the stance of monetary policy, but now with rates at zero, such analysis has become largely redundant. Most Taylor rules would now point to negative nominal interest rates. While QE might be equivalent to negative nominal rates, there is no way to judge how far negative.
This all points to a further period of inactivity from the Fed and the BoE. Unless of course, these economies slip back into recession. Then these differences in opinion would evaporate and central bankers will once again be united in doing everything they can to get their economies moving again.. And this time they might need to try something extreme. (See my next post.)
1. Huge uncertainty about the outlook. Though growth has slowed in line with what most commentators were expecting earlier in the year, it's incredibly hard to work out whether this is just a 'soft spot' or something more sinister. (Macro Maestro suspects the latter.) The economic models used by policymakers failed to predict the recession, so they are understandably reluctant to use them to try to forecast recovery. As these models have broken down, any existing consensus has fragmented.
2. Quantitative Easing has made it difficult to judge how loose current monetary policy is and what effect it is having on the wider economy. Some policymaker believe monetary conditions are so expansionary they are risking asset-price bubbles and further financial instability (eg the Fed's Hoenig and the BoE's Sentance), while others argue policy isn't yet doing enough. In the past, it was sufficient just to draw a Taylor rule to figure out the stance of monetary policy, but now with rates at zero, such analysis has become largely redundant. Most Taylor rules would now point to negative nominal interest rates. While QE might be equivalent to negative nominal rates, there is no way to judge how far negative.
This all points to a further period of inactivity from the Fed and the BoE. Unless of course, these economies slip back into recession. Then these differences in opinion would evaporate and central bankers will once again be united in doing everything they can to get their economies moving again.. And this time they might need to try something extreme. (See my next post.)
Convergence criteria
Macro Maestro was struck by the way some parts of the media interpreted last week's Euro area GDP data. Several influential commentators argued the large differences in GDP growth, say between Spain (+0.2% QoQ) and Germany (+2.2% QoQ), showed the euro area was 'continuing to diverge'. On the contrary, these data suggest the euro area is finally converging. While we should welcome this from a longer-term persective, unfortunately it's going to involve some pain for a while longer.
Developments in unit labour costs drove the underlying divergences within the euro area over the past decade. With the ECB setting policy rates for the whole region, real interest rates were simply too low for the likes of Spain, Portugal, Greece and Ireland (because of their higher inflation rates). This triggered rapid growth in house prices and huge, ultimately unsustainable construction booms. Employment in those sectors surged, their labour markets tightened and real wages grew out of control.
Higher labour costs made these economies increasingly uncompetitive - their real exchange rates appreciated, notably against Germany. (German companies were still trying to restore their competitiveness following reunification in the early 1990s - an event that, because of the way it was managed, turned a healthy current account surplus into a huge deficit.)
In the past, euro area countries would have addressed their competitiveness problems by devaluing their currencies. But being part of EMU, this is no longer an option. Instead, these economies are going to have to restore competitiveness the hard way.
The latest data suggest this convergence process is now underway. The financial crisis popped the housing bubbles in these smaller euro-area countries, unemployment jumped higher and wage pressures are finally starting to ease. So far, it seems Ireland has made more progress than Spain - largely because the Irish labour market is more flexible.
The bad news, unfortunately, is that this process has a lot further to run. Though construction employment (as a share of the total) has now returned to pre-boom levels, real exchange rates still seem too high for many of the smaller euro-area economies. Until they are lowered, unemployment in these countries seems certain to remain high (and perhaps rise further). In turn, falling real wages should continue to depress consumer demand and aggregate GDP. So GDP data will diverge, as the press point out, but the underlying health of the euro area (and the ECB' ability to manage it) is arguably improving..
Developments in unit labour costs drove the underlying divergences within the euro area over the past decade. With the ECB setting policy rates for the whole region, real interest rates were simply too low for the likes of Spain, Portugal, Greece and Ireland (because of their higher inflation rates). This triggered rapid growth in house prices and huge, ultimately unsustainable construction booms. Employment in those sectors surged, their labour markets tightened and real wages grew out of control.
In the past, euro area countries would have addressed their competitiveness problems by devaluing their currencies. But being part of EMU, this is no longer an option. Instead, these economies are going to have to restore competitiveness the hard way.
The latest data suggest this convergence process is now underway. The financial crisis popped the housing bubbles in these smaller euro-area countries, unemployment jumped higher and wage pressures are finally starting to ease. So far, it seems Ireland has made more progress than Spain - largely because the Irish labour market is more flexible.
The bad news, unfortunately, is that this process has a lot further to run. Though construction employment (as a share of the total) has now returned to pre-boom levels, real exchange rates still seem too high for many of the smaller euro-area economies. Until they are lowered, unemployment in these countries seems certain to remain high (and perhaps rise further). In turn, falling real wages should continue to depress consumer demand and aggregate GDP. So GDP data will diverge, as the press point out, but the underlying health of the euro area (and the ECB' ability to manage it) is arguably improving..
Monday 16 August 2010
2003 rate oddity
Kansas City Fed President Thomas Hoenig argues the FOMC is making a mistake by not raising interests rates. He worries the Fed is making the same error it made in 2003, keeping interest rates too low for too long and encouraging asset price bubbles. Andrew Sentance has made similar claims in the UK.
Macro Maestro doesn't find this argument too compelling, for several reasons. First, temporary factors - particularly falling import prices- temporarily depressed inflation in 2003. Investors and policymakers misunderstood these trends and assumed they would continue, triggering a deflation hoax. Even if inflation was about to turn negative, it would have been a relatively benign type of deflation. The situation now is more disturbing - huge negative output gaps in the West are forcing inflation lower and this trend seems likely to continue. Moreover, the private sector is still deleveraging, trying to rebuild its balance sheets and pay back debt. Falling consumer prices, which would raise the real value of existing debts, would be far from benign.
Second, even if central banks are currently inflating asset prices, this is not being matched by rising indebtedness. Bursting asset-price bubbles usually only have important real economy consequences if they encourage debt growth. (When prices subsequently decline they make these debts unsustainable - this is why house-price bubbles are usually more devastating than stock-market bubbles.)
So, Macro Maestro believes central banks are right to hold off policy tightening for now. At least until the main downside risks have gone. Sure, growth has only slowed in line with many economists' forecasts earlier in the year but we should wait till we can be sure there is nothing sinister behind this slowdown..
Macro Maestro doesn't find this argument too compelling, for several reasons. First, temporary factors - particularly falling import prices- temporarily depressed inflation in 2003. Investors and policymakers misunderstood these trends and assumed they would continue, triggering a deflation hoax. Even if inflation was about to turn negative, it would have been a relatively benign type of deflation. The situation now is more disturbing - huge negative output gaps in the West are forcing inflation lower and this trend seems likely to continue. Moreover, the private sector is still deleveraging, trying to rebuild its balance sheets and pay back debt. Falling consumer prices, which would raise the real value of existing debts, would be far from benign.
Second, even if central banks are currently inflating asset prices, this is not being matched by rising indebtedness. Bursting asset-price bubbles usually only have important real economy consequences if they encourage debt growth. (When prices subsequently decline they make these debts unsustainable - this is why house-price bubbles are usually more devastating than stock-market bubbles.)
So, Macro Maestro believes central banks are right to hold off policy tightening for now. At least until the main downside risks have gone. Sure, growth has only slowed in line with many economists' forecasts earlier in the year but we should wait till we can be sure there is nothing sinister behind this slowdown..
Friday 13 August 2010
German deficiency
Macro maestro is finding it hard to get excited about today's German GDP release. Sure, 2.2% growth on the quarter is impressive but once again it is likely global demand is driving this rather than anything domestically generated. While we don't have any details on the composition of German GDP, we can get a rough idea by looking at other data from Europe's largest economy.
In particular, while manufacturing orders have surged, strong demand for exports and domestic 'intermediate' goods largely explain this improvement (see chart). These intermediate goods are presumably being used to produce more exports. Crucially, consumer orders remain depressed and have barely recovered from their recession lows.
In particular, while manufacturing orders have surged, strong demand for exports and domestic 'intermediate' goods largely explain this improvement (see chart). These intermediate goods are presumably being used to produce more exports. Crucially, consumer orders remain depressed and have barely recovered from their recession lows.
Repeating the pattern of the last decade, this weakness in German consumption shouldn't be suprising. As in 2005-2008, German consumers are feeling more optimistic (consumer confidence has jumped higher) but are reluctant/unable to spend. A quick glance at wages explains why - after a modest recovery in 2007 as the labour market tightened and German unions became more militant - pay growth promptly returned to its usual depressed levels.
So where does this leave us? Again the situation in Germany is dependent on developments elsewhere - the economy remains geared to the global growth cycle. If global demand contines to grow, German activity might eventually become more balanced. The labour market should continue to impove, so wage growth might rise and the German consumers will probably start to spend. There is also pent up demand for investment. But if the global economy starts to low - and recent indicators in the US and China suggest this has already started - Germany will surely follow.
Those hoping Germany can help sustain global demand look sadly deluded. (Macro Maestro was once one of them but generally tries to learn from his mistakes..)
Wednesday 11 August 2010
Japanned
In early 2008, as global stock markets hit their lows and many of the world's banks seemed on the brink of outright collapse, Macro maestro was reading a lot of comparisons between the US/UK economies and Japan. He was told the Anglo-Saxon economies now faced a similar 'lost decade' of growth. At the time, this analysis didn't seem right. Sure there were similarities - huge private-sector debts, rapidly falling asset prices, zombie banks - but there were also important differences.
Above all, the Federal Reserve and Bank of England seemed to have learned the lessons of the Japanese experience. Rather than wait for their economies to enter recession, they cut interest rates rapidly in anticipation of that weakness. Then, when there was no more space to cut interest rates, they moved to quantitative easing (QE) - adding further monetary stimulus by effectively printing money. It took the Bank of Japan almost a decade to try quantitative easing, the Bank of England tried it within 18 months of the crisis hitting their economy.
By the end of 2009, it seemed QE was having the desired effects. While the money supply and bank lending remained weak, asset prices were growing strongly. Stock markets had surged, credit conditions had improved and in the UK, even house prices had confounded expectations and started to rise again. The world's central banks seemed to have convinced markets that 1) they would do whatever it took to restore growth and 2) there were new monetary policy options available even at the zero bound (zero nominal interest rates).
But once again things are starting to look decidedly shaky. Growth has returned, but it is uneven and fragile. Bank lending and money supply remains weak. The US housing market is yet to see any genuine improvement and the UK market seems to be turning down. To some extent, this loss of momentum was inevitable. The effects of past monetary stimulus must eventually start to fade. For example, cutting interest rates boosts disposable income growth for a while but then as rates stabilize the effects on additional growth diminishes. Still, the problems seems to go deeper than that.
In response, the Fed and the BoE seem to be hinting at another round of QE. But will this be effective? The main benefit of QE last time was that is stabilized desperate private-sector sentiment and reassured financial markets. But if the first wave of QE failed to encourage a genuine self-sustaining economic recovery, it seems likely the private sector will be more skeptical this time. Indeed, additional QE might actually undermine confidence rather than restore it. ("Are policymakers really that desperate? Damn, things must be worse than I thought!") And that, of course, leaves us in a genuine nasty position. Bond markets seem to have imposed a limit on fiscal consolidation, at least in Europe. While monetary policy seems to have run out of effective options. Suddenly, those comparisons with Japan don't seem so misguided...
Above all, the Federal Reserve and Bank of England seemed to have learned the lessons of the Japanese experience. Rather than wait for their economies to enter recession, they cut interest rates rapidly in anticipation of that weakness. Then, when there was no more space to cut interest rates, they moved to quantitative easing (QE) - adding further monetary stimulus by effectively printing money. It took the Bank of Japan almost a decade to try quantitative easing, the Bank of England tried it within 18 months of the crisis hitting their economy.
By the end of 2009, it seemed QE was having the desired effects. While the money supply and bank lending remained weak, asset prices were growing strongly. Stock markets had surged, credit conditions had improved and in the UK, even house prices had confounded expectations and started to rise again. The world's central banks seemed to have convinced markets that 1) they would do whatever it took to restore growth and 2) there were new monetary policy options available even at the zero bound (zero nominal interest rates).
But once again things are starting to look decidedly shaky. Growth has returned, but it is uneven and fragile. Bank lending and money supply remains weak. The US housing market is yet to see any genuine improvement and the UK market seems to be turning down. To some extent, this loss of momentum was inevitable. The effects of past monetary stimulus must eventually start to fade. For example, cutting interest rates boosts disposable income growth for a while but then as rates stabilize the effects on additional growth diminishes. Still, the problems seems to go deeper than that.
In response, the Fed and the BoE seem to be hinting at another round of QE. But will this be effective? The main benefit of QE last time was that is stabilized desperate private-sector sentiment and reassured financial markets. But if the first wave of QE failed to encourage a genuine self-sustaining economic recovery, it seems likely the private sector will be more skeptical this time. Indeed, additional QE might actually undermine confidence rather than restore it. ("Are policymakers really that desperate? Damn, things must be worse than I thought!") And that, of course, leaves us in a genuine nasty position. Bond markets seem to have imposed a limit on fiscal consolidation, at least in Europe. While monetary policy seems to have run out of effective options. Suddenly, those comparisons with Japan don't seem so misguided...
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