The inflation hedge of choice

On Wednesday, the US Federal Reserve "shocked the world" by announcing plans to buy $300bn of government debt and double its purchases of Fannie and Freddie securities. According to the FT, once the Fed's plans are fully realized its balance sheet could swell to $4,ooobn, one third the size of the US economy. Hellicopter Ben, meet Bazooka Ben.

The Fed's actions are an attempt to literally shock life into the credit markets. It may also have the convenient effect of driving down the cost of government borrowing. However, the Fed runs the very real risk of stoking a very big inflationary problem down the road. Weimar Republic the US is not, but the money supply is growing at such a rapid rate that the Fed had better hope the US economy rebounds this year. Remember central bankers, there are unintended consequences to such dramatic monetary easing; like say, a housing bubble (Mr Greenspan, I'm looking in your direction).

What then are some of the likely consequences of the Fed's policy innovations? For one, the dollar was the big loser last week; in fact, it registered its worst week against the major currencies in 24 years. This fed into an accelerating rally in commodities, the moment's inflation hedge of choice. The benchmark S&P GSCI index was up 8% last week. Or take copper, up some 28% this year, a feat completely divorced from the underlying fundamentals. Though, the FT has an article this morning on the actions of a "secretive" Chinese state institution stockpiling copper supplies (which sounds like the perfect plot for Bond film). Oil is back over $50, supported by the OPEC cuts, but boosted in recent weeks by Fed policy. The speculative inflow into commodities, as an asset class, may be small compared to the bubble of recent years, but it is nonetheless paring the steep losses experienced in the second half of 2008.

The sustainability of this rally is highly suspect. With Chinese growth forecast at 6% for the year, and the G7 contracting by 3.2%, the global recession will depress demand for commodities well into the year (with the possible exception of food, but that's another discussion). However, loosey-goosey monetary policy (as A-Rod would call it) comes at a price, with inflation second only to a loss of confidence in US treasuries. Bernanke has demonstrated that he is willing to throw everything in the Fed's arsenal at the credit markets. Until he wins, expect commodities to outperform as an asset class.

(photo courtesy of Shiny Things' photostream)

Mo' Rubles Mo' Problems

Amidst the spring-time clouds and snow over the Moscow sky, there appears to be one bit of good news: the ruble, for now, seems to have stabilized, defying the critics of the Kremlin’s ruble stabilization program. When I was in Russia just two months ago, every stop at the ATM was like a special delivery from Ded Moroz, as the RUB/USD rate dropped from 29 to 32 in 8 short days. In the spirit of the season, I decided to do my part for the economy by “donating” my extra 10% of purchasing power to the fine brewhouses and eating establishments of St. Petersburg.

Yet, before we start celebrating, we should keep in mind that movements in the ruble have correlated almost entirely with movements in the price of oil, which is really the only marketable Russian export (in addition to vodka, defunct ideology, and depressing literature), and thus the indicator for the overall Russian economy. As crude has now stabilized above $40/bbl, so the ruble has stabilized below the euro-dollar basket of 41. This is a good thing, but it can also create an illusion of stability and economic upturn. Meanwhile, inflation continues to soar in Russia, outpacing other Eastern European countries. While inflation has picked up, salaries, both nominal and real, have been falling, and consumption has dropped sharply – it has even hit one of the most rock-solid sectors of retail! Sadly, many of my friends have recently had to choose between leaving their jobs or taking pay cuts of up to 50% - one friend tells me that her employer has not even paid her in the past 2 months, and she has taken out a line of credit to fund her basic living costs.

This last part is particularly worrying, especially since ruble stabilization has necessitated a significant rise in the already sky-high interest rates for personal and business loans at Russian banks. Faced with double-digit interest rates, Russians have done what many in the former Communist bloc have done over the past few years – take out loans in foreign currency, particularly in Euros, at much lower rates. This was great when emerging markets were booming, but now that currency devaluation has hit, consumers and businesses are struggling to make payments, with the latter raising prices on goods. Already in Russian cities, most real estate rental prices are set in Euros. As small businesses get hit with higher real costs for rent and loan payments, prices continue to rise. Moreover, as confidence in the ruble continues to wane, the desire for holdings (and lending) in foreign currencies grows still.

What is the Kremlin to do? Lowering interest rates on loans below the current 13% inflation rate would effectively mean government subsidization of lending, and would drive further devaluation of the ruble, and price inflation for imported goods. While this could cause a further flight of capital from Russia and could plant the seeds for ‘90s era economic chaos, it could also stimulate lending and growth, if coupled with prudent policy reforms, particularly toward small businesses which are drowning in bureaucracy and corruption. It might also cost the Kremlin less, and be more effective, than continuing to subsidize banks who then speculate against the ruble in the Forex markets. Keeping interest rates high, however, may create the illusion of stability, but will surely continue to stifle growth, and will hurt ordinary Russians most. In any case, winter in Russia may not end for some time to come.

(photo from Alcoyotl's photostream)

Quantitative easing explained

The FT has a great new interactive feature explaining the central bank policy of quantitative easing. The British narrator sounds reassuringly competent.

China: cooperation or competition?

It seems clear that combating a global recession will require a good deal of international cooperation. There are a number of policy arenas where coordinated government action makes sense, such as monetary, fiscal and trade policy. So far, world leaders have said the right things in regards to working together, and they’ve explicitly acknowledged the dangers of protectionism. So what do you do when a rising economic power decides that it will do whatever it takes to avoid recession, even if it means harming other economies?

From the Asia Times:

As for the beggar thy neighbor, it has become clear over the past week that
Chinese government officials intend to export their way out of the global
economic crisis. This is all too readily apparent in the recent downward
movements of the Chinese yuan relative to the dollar. Stripped of any rhetoric,
this movement represents a "competitive devaluation" designed to boost Chinese
exports to the US at the expense of both domestic US manufacturers and competing
countries such as South Korea and Japan.

Such a move, if deliberate and sustained, is potentially disturbing for three reasons. One, as Martin Wolf has argued, in order for the root causes of this recession to be addressed, the world’s massive surplus countries (ahem… China) must expand domestic demand to mitigate imbalances. China is neglecting its systemic responsibilities to satisfy domestic concerns, which brings me to my second point. I tend to think that when a government’s legitimacy and mandate to rule are predicated on delivering sustained rapid economic growth, such a government will be more tempted by “beggar-thy-neighbor” strategies.

Finally, in this particular economic climate, we really do need to be wary of the ghosts of Smoot-Hawley. I’m not fear-mongering, nor am I suggesting that we’re entering a new period of trade-destroying protectionism; in fact, I’ve argued the opposite. But there is a lot of damage to trade that could be done legally, without violating existing WTO commitments, mainly due to the gap between applied and bound tariff rates. This sort of posturing by China merely provides fodder for the Lou Dobbs crowd and makes international cooperation all the more difficult to sustain politically.

Monetary policy: Between a rock and a hard place

Blog note: sorry for being off the radar for a few days - the next few weeks are crunch time for my Master's dissertation. Fortunately, I see my illustrious coauthor has kept you entertained with stories about kites, voicemail, and Schlitz. I'll do my absolute best to keep posting at least once a day.

Anyways, right now is a good time to thank your lucky stars that your name isn't Ben Bernanke and that your business cards don't read "Chairman of the Federal Reserve." Mr. Bernanke is facing a daunting combination of high inflation (year-to-year inflation in June was 4.1%, the largest annual increase since May 1991), anemic growth (1.9% in the 2Q, largely on the back of fiscal stimulus checks), and stubbornly high food and energy prices.

Going into the Fed's August meeting on Tuesday, it's an impossible position to be in. Raise interest rates and you risk aggravating a delicate situation where credit remains tight, energy prices remain volatile, and the housing market may not have quite bottomed out yet. Lower interest rates and you risk stoking the fires of inflation.

What to do? Realistically, probably nothing. In June, the last time the Fed met, they left interest rates unchanged at 2%. Wall Street is betting that they'll do the same thing this time, and I think they've got it right. When interest rates are this low, realistically it's hard to lower them much further, and Mr. Bernanke is still more concerned about pumping liquidity into the system than inflation. The real question becomes: how much inflation is Mr. Bernanke willing to tolerate? If he wants to keep rates this low, it will have to be a lot.

Steady as she goes

The FED opted yesterday to keep interest rates at 2%, indicating that while inflation is a growing concern, it is still secondary to stimulating growth. Meanwhile, the ECB is getting even more hawkish on the issue, with Trichet signaling that they will likely raise rates by 0.25 points to 4.25%.

Essentially, the US and the EU are taking opposite bets on what's a bigger economic threat: recession or inflation. In a way this is par for the course: as an institution modeled on the Bundesbank, the ECB is much more inflation-adverse by design. But you can't help wonder if somebody's making a mistake.

That the dollar is still the world's primary reserve currency only complicates things. Countries pegged to the dollar cede their monetary autonomy to the FED and have to follow its decisions or get knocked off their peg. In China, where inflation is closer to 8%, low interest rates are probably not what you want.

Add to this the fact that lower interest rates are more likely to cause further dollar depreciation, and you've got some real problems. Especially when you need to import things like oil (black gold, Texas tea), where contracts are denominated in dollars. If dollars are worth less, it will drive up the price. 

Spooky, scary, indeed.