Fed´s exit strategy

RGE Monitor

The Fed's aggressive monetary easing has led to a sharp rise in money supply. This has sparked concerns of high inflation should the Fed fail to roll back easing once an economic recovery is underway. The Fed may be afraid to tighten monetary policy too early and kill the recovery. In the medium-term, deflationary pressures will most likely outweigh inflationary pressures. But in the longer-term, will the Fed be able to exit from balance sheet expansion in time to avoid breeding high inflation, particularly asset bubbles?

Exit strategies from the Fed's credit crisis intervention programs:
# 1) Wait for demand to wane: Many Fed lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly. In addition, since the lending rates in these programs are typically set above the rates that prevail in normal market conditions, borrower demand for these facilities should wane as conditions improve. (Bernanke)
# 2) Reverse repo or sale of securities: The Fed can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC. (Bernanke)
# 3) Supplemental financing from Treasury: Some reserves can be soaked up by the Treasury's Supplementary Financing Program. (Bernanke)
# 4) Raise interest rate on reserves: In October of last year, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold excess reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves. Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate. (Bernanke, Woodward/Hall)
# 5) Time commitment: The Fed needs to issue a pronouncement to assure the public that there is no need for concern about inflation after the recovery and to reaffirm its historical commitment to stable and low inflation (Woodward/Hall)
# 6) Raise reserve ratio: The Fed could increase liquidity requirements up to the point where excess reserves are fully sterilized. Once this is done, the money supply can be expanded as much as needed to reactivate the economy via open market purchases or by allowing financial institutions controlled access to the rediscount window (Cottani/Cavallo)
# 7) Issue debt: Fed could issue its own bills, as other central banks do. It could rely on a wider variety of investors, not just primary dealers, to manage its balance sheet. It would restrict the maturity of such bills to less than 30 days to avoid interfering with Treasury's longer-dated issuance. The hitch is that Congress has to authorize it (Economist)
# 8) Wait for asset markets to correct themselves: Risky assets - such as commodities, corporate bonds and equities - rallied this year on 'green shoots' but may correct their overshoots when it becomes clear that the economic rebounds around the world were inventory-driven and a recovery in global demand growth has not yet begun

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Commodities outlook

RGE Monitor

# Commodity prices have rallied since February on the belief that putative 'green shoots' around the world validated a V-shaped economic recovery in 2009. However, these 'green shoots' merely signal the stabilization of economic activity at low levels, rather than a return to trend growth. Even if GDP growth around the world has bottomed, growth will continue to be negative or sluggish until 2011. As such, commodity price gains are a false sign of economic recovery - like the recent spate of bear market rallies in stock markets. The strong uptrend in commodity prices has been propelled more by technicals (investment demand - arbitrage, opportunistic stockpiling at low prices) than fundamentals (real growth in physical demand and production). Commodity prices will likely snap back to reality before resuming a more moderate uptrend in line with a U-shaped global growth path2 factors to mitigate global slowdown impact on commodities: 1) Growth to continue to be strongest in EM economies whose consumption is most commodity-intensive and 2) Investment to raise production capacity takes time - investment cuts and delays due to lower prices may lead to supply crunch in the future
# Sectoral performance: Traditional sectors (metals, energy) remain fundamentally cyclical as they are more closely tied to industrial production than agriculturals. Agricultural commodities may outperform metals and energy due to less elastic demand and the increasing rarity of very good harvests

Review
# Mar 19 2009: Commodities surged the most this year, led by precious metals and energy, on speculation that the Fed's steps to revive the U.S. economy will spur demand for raw materials as a hedge against inflation. Silver jumped 13%, the most since 1979. Gold had the biggest increase since September, and crude oil topped $52 a barrel. Every commodity in the Reuters/Jefferies CRB Index of 19 prices climbed
# Worst annual performance: Reuters/Jefferies CRB Index of 19 raw materials fell 36% in 2008, the most since the gauge debuted in 1956, to 229.54. It rose to a record 473.97 on July 3, then dropped to the lowest since August 2002 on Dec 5
# Biggest 1-day drop since 1956: Sep 29, Reuters/Jefferies CRB Index fell 21.35 points or 5.8% to 343.2 after the House voted against US bailout plan
# Steepest monthly drop since 1980: In July, CRB Index fell 12%

Outlook

# UniCredit: Despite current correction, the secular trend remains upward due to tight supply/demand fundamentals. In the medium term though, focus will be on global slowdown, easing inflationary pressures, dollar recovery, and credit tightening - all bearish for commodities
# Danske: There is a risk that some commodity markets have decoupled from fundamentals. The fundamental outlook represented by e.g. stocks for aluminium, nickel and lead has not changed significantly in the last month. Demand for oil in the US is also still pretty weak. It seems that the commodity market has run a bit ahead of the fundamental picture. Both base metals and oil are quite vulnerable if we get a set-back in risk sentiment.
# UBS: Supply has been a big support for industrial metals. Demand destruction has led to a correction in energy prices. Agricultural prices have corrected significantly based on improved crop conditions and concerns regarding increased regulation of commodities markets in the US. Prospects for higher inflation has been muted by the correction in energy and has depressed the gold price
# Citi: There is only so much demand to accommodate price increases amid tightening in credit markets, falling asset prices and slowing nominal incomes. Maintaining the bull run in commodities in the face of sharply slowing US demand will require that decoupling theories hold

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Brand equity

FT.com / Companies / Personal Goods - Brands left to ponder price of loyalty

Brands left to ponder price of loyalty

By Andrew Edgecliffe-Johnson in New York

Big brands’ best customers have been defecting in droves since the beginning of the US recession, according to a study. By this year, more than half of a typical US brand’s most loyal shoppers in 2007 had switched to rival products.

Brand loyaltyA two-year analysis of 685 grocery and pharmacy-stocked brands, using data from 32m consumers’ supermarket loyalty cards, found that in 2008 the average brand lost a third of its formerly highly loyal customers.

The study will alarm packaged goods groups, as the most loyal customers – those choosing one brand for more than 70 per cent of their purchases in a category – should also be their most lucrative.

“Defection is top of mind for brand managers now because they’re the most profitable customers,” said Eric Anderson, associate professor of marketing at Kellogg School of Management, Northwestern University.

“Price and promotion have become so salient at retail, that what we thought was the loyal customer can be moved with discounts,” he added.

Past recessions have seen similar defections from top-tier national brands to stores’ private-label goods, Mr Anderson said. Academic research showed that customers could be quickly persuaded to switch by a cheaper price but took far longer to switch back.

The study was conducted by the CMO Council, which represents chief marketing officers, and Catalina Marketing’s Pointer Media Network, which has equipment in 25,000 stores analysing buying behaviour. Catalina can provide a two-year anonymous purchasing history on individual customers. Brand managers and retailers who had seen the data had been startled by it, said Todd Morris, senior vice-president at Catalina.

“They’ve always known there was churn but could never put their finger on how big the issue is.”

The study comes as marketers are leaning more heavily on research and on targeted advertising, as they seek to improve on the “spray and pray” approach of mass media marketing formats, such as 30-second television advertisements.

Copyright The Financial Times Limited 2009

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"Buy China" risks

China risks trade suicide - Telegraph

China risks trade suicide
Beijing is playing with fire by issuing a `Buy China' edict for its stimulus package.


By Ambrose Evans-Pritchard
Published: 6:08PM BST 17 Jun 2009

As the world’s top exporter with a $400bn current account suplus and an economy that lives off the America and European market, it will pay the highest price if it triggers a global retreat into protectionist blocs.

The Chinese elite no doubt feel provoked by what they call the “poison” of the US `Buy American’ clause, but the Obama White House managed to tone down the worst excesses of Capitol Hill and in any case the Chinese version is more restrictive.

It bans the purchase of foreign equipment for investment projects unless a special exemption is obtained. The measures apply to European goods, even though EU states have not imposed any such “Buy Europe” clause of their own. EU producers of wind turbines have already been excluded from a $5bn wind project, whether or not they have factories in China.

Beijing risks making the same catastrophic error as the US Congress when it passed the US Smoot-Hawley Tariff Act in 1930. America was then the rising surplus power, like China today. It was the chief beneficiary of an open global system.

By imposing tariffs, Washington triggered massive retaliation. While nobody escaped the Great Depression that ensued, the effects were unequal. The US suffered a far steeper decline in output than the rest of the world. Britain muddled through relatively well in a trade bloc behind Imperial Preference.

China’s action is extremely disturbing. It confirms what we have long feared, that the Chinese government is sufficiently worried about rising unemployment to adopt suicidal measures. Nor does this episode instill confidence in the `China recovery story’.

While exports fell 26pc in April, imports were down by almost as much. There is no real rebalancing under way from external to internal demand. China is still running a massive surplus. It is flooding the world with excess goods, and exporting deflation. This is untenable. At some point, the West will react.

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Land shortage?

Gulf Times – Qatar’s top-selling English daily newspaper - Opinion

Unlearned lessons from the housing bubble
Every major country of the world has abundant land in the form of farms and forests, much of which can be converted someday into urban land

By Robert J Shiller/New Haven, US

There is a lot of misunderstanding about home prices. Many people all over the world seem to have thought that since we are running out of land in a rapidly growing world economy, the prices of houses and apartments should increase at huge rates.

That misunderstanding encouraged people to buy homes for their investment value – and thus was a major cause of the real estate bubbles around the world whose collapse fuelled the current economic crisis. This misunderstanding may also contribute to an increase in home prices again, after the crisis ends. Indeed, some people are already starting to salivate at the speculative possibilities of buying homes in currently depressed markets.

But we do not really have a land shortage. Every major country of the world has abundant land in the form of farms and forests, much of which can be converted someday into urban land. Less than 1% of the earth’s land area is densely urbanised, and even in the most populated major countries, the share is less than 10%.

There are often regulatory barriers to converting farmland into urban land, but these barriers tend to be thwarted in the long run if economic incentives to work around them become sufficiently powerful. It becomes increasingly difficult for governments to keep telling their citizens that they can’t have an affordable home because of land restrictions.

The price of farmland hasn’t grown so fast as to make investors rich. In the United States, the price of agricultural land grew only 0.9% a year in real (inflation-adjusted) terms over the entire twentieth century. Most of the benefit from land for investors has to be from the profit that agribusiness can make from their operations, not just from the appreciation of the price of land.

Despite a huge 21st century boom in cropland prices in the US that parallels the housing boom of the 2000’s, the average price of a hectare of cropland was still only $6,800 in 2008, according to the US Department of Agriculture, and one could build 10-20 single-family houses surrounded by comfortable-sized lots on this land, or one could build an apartment building housing 300 people.

Land costs could easily be as low as $20 per person, or less than $0.50 per year over a lifetime. Of course, such land may not be in desirable locations today, but desirable locations can be created by urban planning.

Many people seem to think that the US experience is not generalisable, because the US has so much land relative to its population. Population per square kilometre in 2005 was 31 in the US, compared with 53 in Mexico, 138 in China, 246 in the United Kingdom, 337 in Japan, and 344 in India.

But, to the extent that the products of land (food, timber, ethanol) are traded on world markets, the price of any particular kind of land should be roughly the same everywhere. Farmers will not be able to make a profit operating in some country where land is very expensive, and farmers would give up in those countries unless the price of land fell roughly to world levels, though corrections would have to be made for differing labor costs and other factors.

Shortages of construction materials do not seem to be a reason to expect high home prices, either. For example, in the US, the Engineering News Record Building Cost Index (which is based on prices of labour, concrete, steel, and lumber) has actually fallen relative to consumer prices over the past 30 years. To the extent that there is a world market for these factors of production, the situation should not be entirely different in other countries.

An even more troublesome fallacy is that people tend to confuse price levels with rates of price change. They think that arguments implying that home prices are higher in one country than another are also arguments that the rate of increase in those prices should be higher there.

But, the truth may be just the opposite. Higher home prices in a given country may tend to create conditions for falling home prices there in the future.

The kinds of expectations for real estate prices that have informed public thinking during the recent bubbles were often totally unrealistic. A few years ago Karl Case and I asked random home buyers in US cities undergoing bubbles how much they think the price of their home will rise each year on average over the next ten years. The median answer was sometimes 10% a year.

If one compounds that rate over 10 years, they were expecting an increase of a factor of 2.5, and, if one extrapolates, a 2000-fold increase over the course of a lifetime. Home prices cannot have shown such increases over long time periods, for then no one could afford a home.

The sobering truth is that the current world economic crisis was substantially caused by the collapse of speculative bubbles in real estate (and stock) markets – bubbles that were made possible by widespread misunderstandings of the factors influencing prices.

These misunderstandings have not been corrected, which means that the same kinds of speculative dislocations could recur. - Project Syndicate

lRobert Shiller, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

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Roubini on deflation vs inflation

RGE Monitor

Overview:German Chancellor Merkel on June 3: “We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years’ time.” So far, government policies are replacing shrinking private demand in order to stave off a deflationary spiral. Crowding out occurs in a situation of full employment as opposed to the current situation of low capacity utilization (Krugman). However, sustained QE and loose fiscal policy need credible government backup (Buiter). Ultimately, deleveraging requires the writing down of debt as reflationary policies are not a free lunch and won't solve the debt overhang problem (Roubini). Important case study: Japan back into deflationary territory despite huge public debt and QE (Chinn). Rather than a sign of inflation, higher long-term yields may be pointing to higher real interest rates which are compatible with a deflationary environment (BofA).
# Ben Bernanke: “I respectfully disagree with her views”-->Exit Strategies from Monetary Easing: Will the Fed Avoid High Inflation?
# Jean-Claude Trichet: "I told her that we were very strongly determined to both, taking the appropriate decision in the current exceptional circumstances and being absolutely crystal clear on the exit strategy."--> ECB Unconventional Monetary Policy: QE to Begin July 2009
# Bank of America via ATX Markets, June 8: Between the inflation vs. deflation debate stands another possibility: rising interest rates. They reflect an increase in borrowing costs. A rise in real interest rates would be consistent with both rising nominal yields and a continued disinflationary environment accompanying a prolonged economic recovery.
# Spiegel Online: Unlike 1929, debts are being fought with debts, meaning that not only banks but entire countries could end up bankrupt. Perhaps the efforts to combat the current crisis are merely laying the foundations for the next crisis, which will be bigger still.--> 1929 vs. 2009: Parallels And Differences To The Great Depression
# Willem Buiter: 1) The nominal zero-bound need not restrict monetary policy in practice as central banks engage in quantitative easing (QE). However: 2) Central banks engaged in QE need a long‐term credible fiscal partner; 3) Central banks engaged in CE need a full fiscal indemnity for capital losses due to private sector asset purchases or secured lending
# Buiter: Problem in Europe: The ECB has no fiscal back-up. There is no guarantee, insurance or indemnity for any private credit risk it assumes. This huge error and omission in the design of the ECB. See Who Is The ECB's Recapitalizer Of Last Resort?
# June 1, Menzie Chinn (Econbrowser); Japan was facing rapidly rising net debt-to-GDP ratios (rising from 60.4 ppts of GDP to 84.6 ppts from 2000 to 2005), and was embarking upon a policy of quantitative easing in an attempt to stave off a deep recession. And yet opponents of quantitative easing worried about hyper-inflation, even as y/y inflation at the time remained mired in the negative range. I didn't understand the fears at the time; and I still don't. --> Japan: Worries Over Huge Public Debt, Is It Sustainable?; and Japan Is Facing Deflation Yet Again
# Chinn: Main difference to Japan: America is a big net debtor to the rest of the world, with extremely large holdings of US Treasurys by foreign private and state actors. This is why high real interest rates are more detrimental for the U.S. than higher inflation. Still, real yields according to TIPS seem fairly low in historical perspective.
# Niall Ferguson: The running of massive fiscal deficits in excess of 12 per cent of gross domestic product in 2009, and the issuance therefore of vast quantities of freshly-minted bonds is likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. This may lead to a “painful tug-of-war between our monetary policy and our fiscal policy."
# Paul Krugman: "What I hear again and again is either the assertion that all this borrowing must drive up interest rates, or worries that the Chinese won’t be willing to lend us the money. We know as a matter of principle that these concerns are misplaced: if there were a shortage of savings, the economy wouldn’t be depressed. Indeed, one way to think about our current problem is that the world as a whole wants to save more than it’s willing to invest." --> Back to Global Reserves Accumulation?
# Axel Weber: Call for a more symmetric monetary policy across asset price cycles. To be more specific, a more symmetric policy would also realize implicit risks in times when money and credit growth is dynamic, asset prices go up and risk perceptions decline, possibly creating a need to act despite current inflation rates being sufficiently low.--> Should Central Banks Fight Asset Bubbles?
# Mohamed El-Erian (PIMCO), June: Relative to where it is coming from, the financial system will be de-levered, de-globalized, and re-regulated. Global growth will be lower and unemployment higher, notwithstanding the continued rotation of dynamism away from industrial countries and toward emerging economies.

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