interest rates

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The Dollar’s Decline

As if right on cue, given my comments yesterday about the US fiscal dilemma, the dollar has begun to take a beating in the currency markets. It is quite possible that this is the beginning of a long decline, lasting a few months, so it’s worth reflecting on the root causes of the decline. Two words: recovery and deficits.

One of the ironies of the past year or so is that the dollar has held its ground in value because the US economy, and hence its currency, was seen as a ‘safe haven’. The worse things looked in Europe and Asia, and especially the worse things became in the emerging economies, the better the US looked even though it was seemingly tottering on the brink of a new depression. This is even more ironic when we consider that the US was the cause of the worldwide melt down. Nonetheless inflows of cash flooded into the US as foreign investors sought to protect themselves against even worse conditions elsewhere.

This flood of money not only protected the dollar against decline, but actually boosted its value. It also helped the administration in its ongoing fight against the recession because it made it easier to issue bonds and other Treasury securities in order to fund the burgeoning deficit.

The only area where the dollar’s relative strength was a problem was in trade where it hindered efforts to boost exports, although it also made imports cheaper. Parenthetically: cheaper imports also lowered inflation and added to our original fear of deflation. But, given the collapse in world trade, the dollar became an issue to neither exports nor imports: there simply wasn’t anything to do about trade. Any dollar effect was swamped by the drop in worldwide demand.

Now though things are changing.

As fears of further decline in activity abate, and as confidence starts to re-appear, the ‘safe haven’ effect will wear off. Investors will start to look for returns based onfactorsother than just safety and so will start to pull their money out of the US and re-invest it elsewhere.

The consequences of this will be twofold: the dollar will decline so as to keep dollar denominated assets attractive relative to assets based in other currencies; and, possibly more importantly, US interest rates will start to creep up because investors will demand a higher return in order to retain all the US bonds they bought last year and earlier this year.

This latter issue is magnified by the sheer volume of bonds we have been pumping onto the market. It isn’t just that the US has been running an extraordinary budget deficit, but the Federal Reserve Board has been engaged in an equally unusual monetary policy called ‘quantitative easing’. Under this policy the Fed has been trying to pump money into the economy by buying up bonds – it pays in cash for the bonds and so adds to the money supply. This has to be a temporary procedure because it implies a potential upturn in inflation we want to avoid, so the markets are expecting the Fed to reverse course at some point in order to stave off this inflationary effect. The implication is that all those bonds will have to be sold back into private hands and this, obviously, adds to the supply of US government bonds in the market. Hence the need for higher interest rates to attract buyers for those bonds.

As you can see the administration will have to tread delicately in order to make sure it can extricate itself from the fiscal hole it now finds itself in without spooking the bond market. The best way to do this will most likely be to make a strong commitment to reducing the deficit quickly, say over the next four to five years.

In any case the dollar will fall. The surfeit of US debt on the market and the loss of the ‘safe haven’ status will combine to keep the downward pressure on for a while.

This is why I don’t think there’s much upside left to the dollar until the world economy is humming along again. And that seems to be quite a way off.

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The Outlook: Part 2

Following up on my short post yesterday about the Federal Reserve Board’s outlook for the economy, today I received the Congressional Budget Office [‘CBO’] forecast which takes the form of a briefing to Congress. The story is pretty much the same. But there are small differences we ought to be aware of.

The CBO takes a dimmer view of the outlook for unemployment. The Fed predicts the unemployment rate topping out at between 9.5% and 9.75%. The CBO expects it to go beyond 10.0%. The news this morning that jobless claims moderated very slightly seems to indicate that the job situation is settling down a little. The key statistic to watch is not the week to week data because that can easily be distorted by a single and unrepresentative event: last week’s figures was much higher because it included a rash of Chrysler lay-offs. Instead we should pay attention to a moving average stretching back a month or two. This allows us to remove distortions like the one caused by Chrysler and thus get a better reading on trends. When we do this the ‘bottoming out’ effect is more noticeable. It is clear that job losses are still very high, but that there is no discernible worsening. There’s a hint of stabilization. And I mean only a hint.

Nevertheless given the continued high level of job losses, and the very high degree of difficulty workers are encountering as they try to find new jobs – which is also embedded in this morning’s data release because continuing, as opposed to new, claims for unemployment benefits are still at record highs – I expect the CBO prediction to be more accurate. Plus I have a feeling the Fed deliberately erred on the optimistic side when talking about the job outlook because it wanted to use unemployment in its bank stress tests, and as you know, I think they wanted to soften those test for political reasons.

So unemployment will be a very significant drag on the economy right through the next year or two.

Having said that the CBO still predicts that the recession will end later this year and that we will see very slow growth during the third and fourth quarters of 2009 followed by a slightly better outlook in 2010. Currently the CBO is predicting GDP to grow by about 2.9%, adjusted for inflation, next year. There are two ways of looking at that. One is that it is quite low given that ‘normal’ recoveries usually get off to a flying start and then settle down later. The second is that it is quite good given the huge hole we are climbing out of and the ongoing risks we still have to overcome. I am in the second school.

There are huge imbalances still to be reduced. Consumer debt reduction will cramp consumption and business investment still looks very weak. And exports simply will not be a factor. The collapse in world trade has hammered economies that rely on exports: Japan’s economy dropped like a stone in the first quarter this year – it fell at an annualized rate of 15.2% from January through March which is astonishing by any standard – so it is extraordinarily unlikely that the US economy will be lifted by trade. That leaves government spending as the lynchpin of growth for a while to come. The Federal Deficit is the essential fuel we need until consumption adjusts to the new less indebted world of the future.

The problem with that is the glut of US government bonds that are now out on the world markets. There are signs that our ability to fund the debt will run into difficulty if the rate of deficit spending is not curtailed soon. Already recent bond auctions – the Treasury sells its debt through an auction process – have been less than enthusiastically received and there are even rumblings that the US may lose its AAA bond rating later this year. For those who doubt this I point to the UK as exhibit ‘A’: their bond rating was lowered by Standard and Poor’s just today. Rumors of a US downgrade are picking up steam. While not a catastrophe a downgrade would signify a historic moment for the US economy and would not just raise the interest rates the government has to pay, but, because so much domestic US debt is priced at spreads from Treasuries, it would cause the entire nation’s interest rate structure to shift upwards also. Plus, historians may well look back on such a downgrade as the defining moment in America’s transition from world economic dominance to mere parity with China or the European Union.

Who would benefit from higher rates?

The banks.

The CBO report documents that the credit markets have climbed back from the edge of doom: the apocalyptic spreads we saw in the immediate aftermath of the Lehmann debacle have fallen away to being merely high. Confidence is evidently flowing back into the world’s financial system -as it should given all the taxpayer money that we have thrown at it. Nonetheless as banks start to look forwards at earnings trends over the next few years their ability to grow profits will depend heavily on the nature of the yield curve – the difference between short and long term rates. Without a resurgence of inflation I expect the Fed to keep short term rates quite low for years ahead in order to help growth. The potential of higher US bond rates will tend to drive longer term rates upward and thus widen the yield curve. Why will this help banks? Because the essence of banking is to borrow short and lend long: their cost of funds lies at the lower end of the curve and the prices they charge on loans lies at the higher end. So the steeper the yield curve, the more profitable banking becomes.

This will make Tim Geithner smile since he is relying on the banks to ‘earn they way’ back out of their capital malaise. But it will tend to press down on borrowers, both consumers and businesses, and will thus slow the recovery.

Finally the CBO highlights an essential conundrum we should all be aware of: there is a massive conflict between the near term requirements of fiscal policy and the longer term requirements.

Near term we need to run huge deficits. That is the only way we know to stop the economy falling into a depression. It is testimony to the efforts that have been necessary so far to avoid total collapse that the US budget outlook over the near term is, frankly, terrible. The Federal Deficit has shot up as a result of things like TARP and the stimulus package. This is as it should be and follows the prescription of Keynesian economics perfectly. But: fiscal policy cannot remain that loose. At some point we will have to start work on reducing all this debt we are now issuing.

I have said before that our task has been made much worse by the Reagan/Bush legacy. We ran horribly lax fiscal policies through both the 1980’s and the 2000’s. The result is the world is awash with our bonds just as we need to flood the market even more. Hence the glut I mentioned above. Instead of running fiscally conservative policies both Reagan and Bush ran incredibly irresponsible ones. It was Cheney who famously said that ‘deficits don’t matter’. Well they always did. And they matter very much right now.

There is no doubt that fiscal policy will have to revert to very tight standards in a couple of years. That implies both higher taxes and less spending.

Once again this will put a lid on consumption.

So for all these reasons: debt reduction, the collapse of trade; higher cost of debt; and the need for higher taxes, I just cannot see a return to strong GDP growth for a while.

In fact that 2.9% GDP forecast by the CBO looks ambitious to me.

Let’s hope they’re right.

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Fed Funds Rate: Minus 5%?

Buried in this weekend’s news was a report on the internal analysis being undertaken by the Federal Reserve Board with respect to its ongoing efforts to stimulate the economy. One of the more interesting nuggets is the calculation that, given the state of the economy right now, especially the balance between inflation and unemployment, the Fed should be setting its benchmark overnight interest rate, the Fed Funds rate, at -5%. Yes that’s minus 5%.

Since interest rates cannot go below zero that presents quite a difficulty!

But, ever the innovative crowd, the Fed has come up with all sorts of tricks to provide monetary stimulus even though its primary weaponry has been rendered useless.

They have undertaken a slew of actions, such as buying Treasury bonds and holding them in a portfolio, that are collectively called ‘quantitative easing’ or unconventional monetary policy.

The net objective of lowering interest rates is, of course, to stimulate the economy by making borrowing more attractive and simultaneously easing the cost of debt burdens. An increase in lending that results from lower interest rates causes a flood of money, i.e. the lent cash, to enter the economy. This additional money then greases the economic wheels, and activity rises. or so the notion goes.

When interest rates are so low that they cannot be lowered to generate this stimulus effect the Fed has to resort to its irregular bag of tricks. Its acquisition of Treasury bonds also is a way of pushing money into the economy since the cash its uses to buy the bonds is now in the hands of the former bondholders who can now use it for something else.

So we should all applaud the Fed for being willing to undertake all these unusual actions: its aggression is helping offset the timidity of the politicians who passed a relatively small fiscal stimulus. Small that is relative to the size of the problem.

So overall I give the Fed a high grade for its efforts.

But that -5% should grab our attention. If that is the ideal interest rate for the moment we can immediately sense the depth of our continuing crisis. Given that a target Fed funds rate in ‘normal times’ might be 3% to 4%, the Fed would have to raise rates by 8% to 9% to get back to ‘normal’. Such a run up in rates would be unbelievably restrictive: it would kill any chance of recovery and then some. So we can infer from the -5% that interest rates are going to be low, maybe even zero, for quite some time. I would guess that, barring some dramatic event, we will not see Fed funds much above zero for the next two years at least.

Naturally there are huge risks associated with all this unconventional policy and the extent of the monetary stimulus. In particular we have to be careful not to prime a surge in inflation. I don’t see this as a problem right now since the economy is operating so far from capacity: all that cash will be put too use closing the gap between where we are now and our capacity limitations.

One last thing: since no one really knows just when this monetary easing will show up as inflation, it is good to see the Fed is already planning its ‘exit strategy’.

Still: minus 5%. That seems a little ridiculous doesn’t it?

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Europe, Deflation Fears, and Us

This morning’s New York Times carries a very disturbing report on the Spanish economy. In particular it highlights what appears to be the onset of a bout of deflation. Apparently retailers throughout the country are now having to cut prices in order to encourage any kind of spending, and the rate in the reduction in price levels is now reaching an alarming pace. The most disturbing aspect of the Spanish situation is that their unemployment rate is now up at 15.5% and is heading higher: it might easily reach 20%. The combination of unemployment at those levels and falling prices is exactly the combustible mix that characterized the Great Depression so events in Spain bear considerable attention.

And Spain is not alone: other European countries are facing disastrous economic declines as well, not least Ireland which is arguably worse off than even Spain.

So the obvious question becomes: could we also fall into this deflationary and high unemployment trap?

A quick answer would be no.

The reason is that the US has taken some extraordinary measures that the Europeans have not. For instance, the Federal Reserve Board has pursued a very aggressive monetary policy from the beginning of the crisis. It started by reducing interest rates quickly and when that failed to produce the normal or expected response it adopted a series of highly unusual, some might say unorthodox, policy steps such as beefing up its own balance sheet by buying securities from private investors. Such purchases have the effect of putting more cash into private hands and therefore increasing the nation’s money supply,i.e. the total amount of cash and cash equivalent money in circulation. In theory this should boost economic activity, or more likely prevent further contraction.

In conjunction with the Fed’s creative activities, the US has also gone on a binge of deficit spending, which is the classic ‘Keynesian’ response to a fall in demand in the private sector – recall that ‘recession’ is simply a term used to describe an economy that is shrinking, and that the shrinkage is, in turn, usually caused by a drop in demand for goods or services by private consumers.

Traditional economic theory teaches that the Fed’s ‘normal’ monetary policy, cutting interest rates, should be sufficient to return a shrinking economy to growth. This is because lower interest rates encourage a new bout of borrowing, which means that cash is freshly available for boosting spending.

A moment’s thought of that traditional policy will immediately lead you to see the reason the current crisis is so difficult to deal with.

It relies on lending.

Without healthy banks the drop in interest rates will have little effect due to the fact that there are no banks prepared to lend. So the recovery effort stalls at the first hurdle.

Plus, this time consumers are so snake bitten by declining home values and collapsing stock prices, both of which are wiping our household savings, that the amount of effort needed to get people out borrowing and spending again is beyond the reach of normal policy.

This is particularly true because we went into the crisis with interest rates already fairly low: so there was not much leeway for aggressive interest rate cuts before we reached zero. And interest rates cannot go below zero.

All this is familiar on both sides of the Atlantic.

What is different in Europe is their resistance to running a Keynesian style fiscal policy, i.e. going into deficit spending to stimulate demand; and this is coupled with a level of denial, until quite recently, about the true situation in the larger European countries like France and Germany. Since the European Union acts as a single entity for monetary policy purposes, through the European Central Bank, countries like Spain are left to fend for themselves. They have to comply with the central monetary policy and so have to rely heavily on fiscal policy at their local levels.

It is easy to get a little haughty at this point and criticize the centralization that seems to have caught Spain in a terrible vice. But we should all recall that the US also has huge regional differences in its economic performance: just look at the damage being wrought in Michigan by the auto industry collapse; or in Nevada, California and Florida by the real estate collapse and our air of superiority should evaporate quickly.

In fact much of the beneficial effect of the Federal stimulus package is being entirely offset by highly restrictive policies being enacted at the state level. Just as cash is pumped into the economy by the Feds local jurisdictions are cutting back on spending and therefore negating the Fed stimulus.

In this regard, the only reason that California is not being touted as an economic disaster of Spanish proportions is that no one sees it as an independent country! Its budgetary crisis, which is of epic proportions, gets treated as a local disturbance rather than a national implosion.

With home and stock prices still falling [or at least remaining weak]; with lower demand reducing commodity prices – things like oil are costing less because consumption has fallen faster than output; and with unemployment likely to rise well into next year the scene is set for deflation here too.

And that fear has been sufficient for some, myself included, to urge the Fed to induce a bout of inflation. Some of you may have noticed that Ben Bernanke actually went on record as saying the Fed was targeting a 2% inflation rate over the medium term. This was his way of letting the credit markets know that he was prepared to stoke inflation rather than allow deflation set in.

How would he do that?

By pumping tons of cash into the economy. If the money supply grows faster than the potential growth rate of the economy we normally get inflation. As of now the economy is running well below its potential, so all the cash being injected will simply lift activity towards that potential rather than result in inflation. The tough part comes when the economy starts growing again and the money supply remains higher than needed – as it would given all the Fed’s extraordinary efforts of late. The ‘neat trick’ the Fed is trying to pull off is to signal its intention to produce modest inflation, and hence calm deflationary fears, while at the same time attempt to judge the right moment to rein in money supply to prevent inflation exploding.

Rather them than me.

Unfortunately for Spain they are tethered to the less expansionary policies of the European Central Bank and the highly conservative fiscal policies of its largest trading partners. It is in awful trap. And deflation is an almost inevitable result of it having to contract its economy severely to achieve a rebalancing rather employing the kinds of tools we have here.

So, coming back to the question of whether we can expect a Spanish style crisis here, the long answer is also no.

But there is no room for complacency: our political willpower to pursue the necessary bailouts and stimulus has been wafer thin at times. Raging on about the future costs of ballooning Federal deficits, or about the cost of saving the banks, and debating the efficacy of government spending at times like these are corrosive to that willpower.

In other words, we could easily become like Spain.

We dodged the big one because we did the ‘right thing’. Let’s hope we have the sense to keep on doing it.

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Interest Rates Are Rising

This may be the beginning of a steady slowdown in the economy: long term US government bond rates are rising with the ten year bond now topping 5.0%. The New York Times reports here: Cheap Money Fades as 10-Year Note Tops 5%

This may seem like a low interest rate, but the economy for the whole of the last decade has been built around low interest rates: we haven’t seen the ten year bond over 5.0% for a few years. One result of low rates was the real estate bubble that is now beginning to deflate. Rising rates will put more pressure on housing and could push what is now a stable price environment into a full scale retreat. That would cause all sorts of disruption across the economy, and is coming at a time when inflation seems to be picking up. This latter phenomenon would add fuel to the fire if the Federal Reserve Board has to push short term rates up to damp inflation.

I am not arguing that it’s time to panic, but the negative signs are accumulating: rising interest rates, declining property values, inflation increasing, stagnant wages and flattening profits. All in all a bad deal.

And because we have huge deficits already the administration has no room to use fiscal stimulus to offset the coming slowdown. Typically the Fed would cut rates and the government cut taxes to stimulate the economy and avoid a recession. With inflation rising the Fed can’t help us, and with deficits already out of control the government can’t either.

Plus we have a reckless foreign policy that adds uncertainty which will push interest rates up further.

The last few years have exposed us to the potential of a major recession. Bush’s policies have made the problem worse.

Maybe we’ll struggle through, but it won’t be because of anything Washington is doing.

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