Modeling in a complex world - watch your parameters

George Pelham-Box, one of the most influential statisticians of the 20th century, once remarked that "essentially all models are wrong, but some are useful".

Working with models provides enough support for his strong statement. Models can only capture the relationships that are actually included in the parameters. One-off events or events that are not included in the sample will not be able to be explained by the model. The new period of stagflation will be a strong test for any model developed in the last 25 years. Current models may not be able to track the actual behavior in the economy. Watching for a deterioration of current relationships may be the most important tasks for a systematic modeler.

Is this the right time to invest?

October [in this case June] . This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August, and February."
Mark Twain, Pudd'nhead Wilson, 1894

“The four most dangerous words in investing are ‘This time it’s different.’”-Sir John Templeton

While these are old phrases for the markets, it seems apt to read them as we come to the end of the quarter. June was not a good equity month. It was also a difficult period for fixed income as inflation is upon the global economy. The FX markets have been in turmoil as investors try and adjust to the new world of higher inflation and credit risk. The only area of positive returns was commodities but these returns are only had through taking high risk.

In a period of turmoil, let the second half of the year begin.

Changing expecations in an era of uncertainty

The market and dollar hit a low in mid-March at the fall of Bear Stearns. Since that time, there was a rally in the dollar and stocks as expectations moved from credit crisis to inflation fears. However, we have now moved back to credit fear expectations just when the Fed has declared it will focus on price stability. The stock market is at new lows for the year and the bank equity index is showing no support for financial institutions.

So what should be the focus of investors, inflation or credit crisis? It depends on the portfolio of assets, but the impact of credit risk surprises in much greater on a micro basis than any surprise in inflation. There is a limit on the size of the inflation surprise while there i a greater change for unbounded risk in credit.

There are some simple lessons on the behavior of the economy. First, most economic events take longer to work out than expected especially if loses have to be realized. Banks and other financial institutions regardless of shareholder anger will usually not take all of the pain at once. Second, illiquid assets will take longer to adjust and housing is an illiquid asset. The matching of buyer and seller takes time and there as to be agreement on price. Matching price expectations for unique assets is not easy. So even with write-downs, the credit process will take time.

The same applies to inflation. Shocks will take time to adjust as prices are changed with the changing cost structure. More importantly, inflation is affected in the long-run by expectations and these expectations are often adaptive. As inflation increases, expectations will start to slowly adjust. Once they reach a higher level it will take time for investors to turn them down to a lower level.

Some of the same strategies for allocating a portfolio apply in both an inflation and credit crisis environment. Cash exposure should go up. Fixed income exposure especially for non-Treasury securities should go down. Commodity exposure should increase in both cases. However, the impact on currencies is less clear.

A difference in portfolio structuring is with equities. Equities can do well in an inflationary environment. Equities will be more effected by the change in real rates. However, the impact of credit risk in unambiguously negative for equities especially for financial firms or those that are highly levered. Not a set of good choices for any investor.

Globalization and transportation costs – Killing the era of cheap trade

The cost of transporting people has gone through the roof with gasoline and airline prices well exceeding the inflation rate. Of course, we should only be worried about inflation ex food and energy.

An inflation issue that has strong ramifications for the global economy is the overall cost of transportation of goods and services. Supply shocks for a given commodity are usually not considered part of the core inflation rate because it is believed that these shocks will be temporary and adjust through changes in production or demand. A central bank does not want to monetize a shock if it is believed to be temporary. That is why monetary policy is driven by core inflation. But if a supply shock is big enough or lasts long enough to have an impact on the price of other inputs, then there will be a general rise in prices. The conventional wisdom is that the energy price shock will not lead to higher core inflation because the amount of oil used per dollar of GDP has fallen since the large oil shocks of the 1970’s; therefore, there should be less concern about the crude oil price increase. Of course, this argument is based on shocks that are less than 100% and for shocks that will last for relatively short time period like a year. We have now been with $100 oil for only four months but market analysts are not forecasting any steep decline. The story of peak oil seems to be resonating more with investors. Conventional wisdom has not accounted for global trade and the cost of transportation.

Globalization and the world as a flat place is based on the idea that it cheap to move goods anywhere in the globe. It is also cheap to move people to do deals in this globalized world, but the reality is that the cost of moving goods for trades in on the way up and this will kill trade much faster than any political rhetoric. Trade gains have always been associated with changes in technology in three areas, the movement of capital, labor and goods. When shipping costs decreased in the 19^th century through steam power, trade boomed. When air freight became a reality, trade jumped. The cost of container shipping led to another cut in costs and more trade. The costs now of moving all goods have gone up in the last year and there is no technology to offset this price shock.

Capital costs have gone up with the uncertainty across countries about the credit crisis. There will be a greater home bias when there is more uncertainty. Market frictions have increased. More importantly, the cost of moving labor and goods have skyrocketed and this is drag on trade.

In a service economy, a cost of business is travel to see clients regardless of quality of the telecommunications. Trips are not going to happen as frequently as the price of fuel continues to advance. Local venders will have an advantage, so trade will become more biased to the home country.

In the goods economy, the just in time manufacturing processes will be push aside for holding larger bulk inventory. There is less reason to send partial loads of goods long distances if the cot per unit is increasing. Similarly, there will be a cost advantage for local vendors. In many businesses where the margins are especially low, an increase in the marginal cost of shipping will cut the profits significantly. Items which have more bulk or take up more space in right will be produced by more local manufacturers. This problem will be especially hard on places like China where components are brought to the factory assembled and then shipped to a final market. Prices for bulk shipments of inputs like ore and metals which have been imported to China will skyrocket. These trade issues will play out even in the EU where satellite countries on the periphery of core Europe will see a loss of their comparative advantage.

The cost issue is already showing up in import prices ex-petroleum increasing at a pace over 6% year-over-year. This is after spending 2007 in the 2-3% range. Imports numbers are also slowing. Just when US manufacturing should be able to capture new business given the fall in the dollar and good productivity, the cost of shipping will deter trade. This will be a major theme for the rest of the year.

Commodity pricing pressures in China

In the last two days we have seen significant price increases for two major Chinese production inputs that will have ramifications for the commodity markets and for the growth of China.

Gasoline prices were raised 17%, diesel by 18% and jet fuel 25%. Gasoline is subsidized in China, but the different between the global market price and the internal price was getting too large. This increase will not close the gap in price but starts to rationalize the market. This type of increase suggests that gasoline prices are going to stay at current high levels. Fuel lines have been formed around the country, but it is expected that this increase will have little impact on demand. Demand for gasoline is fairly inelastic. While we are seeing some cut in demand in the US, that has only occurred after 75% increase in some parts of the country.

China has negotiated for iron ore from Rio Tonto in Australia for a 96.5% price increase over last year. The increase in 2007 was only in the single digits. This will have an impact in all parts of the manufacturing and construction business in China. Additionally, it tells you how transportations costs are rising. The Chinese are willing to pay a premium for Australian ore over Brazilian ore which was negotiated for a 75% increase just a few months ago.

Bubbles and monetary policy

The key issue for the Fed is how to handle the housing bubbles and the fall-out from the credit crisis during a rising inflationary period. The choice was relatively easy when the US did not have growing inflation pressure. Bail-out housing in an effort to sustain growth. The inflationary pressures existed last year but the commodity shocks and the acceleration of inflation has made the trade-off a more pressing issue.

The current policy trade-off is further exacerbated by the context of any policy decision and the measurement framework for inflation. The Fed is a central bank with joint objectives. The Fed is responsible for both price stability and growth. If the sole objective was price stability, the issue of what to do or what would be allowed would be easier to address. Right now there is significant confusion on whether the Fed should focus on the real economy or on price stability. The market and the Fed itself seemingly vacillate between which of these objectives should have priority.

But even in the case of a single objective, the inflation problem is exacerbated because of how the US inflation indices are calculated and what the Fed means by inflation. Simply put, the composition of the price index matters. In the current situation, the issue is whether asset prices should be included in an inflation index. Because asset prices and the associated bubbles are outside the price system it is unclear what is the responsibility of the central bank. Whether the Fed should stop inflationary asset prices is not directly addressed in growth or inflation objectives. The aftermath of a bubble may cause the Fed to act but the run-up to the decline is not addressed. The policy of ignoring a bubble because they cannot be “identified” but acting to protect the economy from the fall-out is tantamount to creating a moral hazard problem. The Greenspan put is institutionalized.

Additionally, the concept of core versus headline inflation creates further noise in monetary policy. Specific shocks, that will have spillover effects for the general economy, will not be addressed until after they have been internalized in the general price level. Again there is uncertainty on how these shocks will be addressed. Finally, the adjustments which try and adjust for quality in the basket used for measuring inflation distorts what may be the actually income used to purchase a set of goods.

The lack of clear objectives and the uncertainty on what constitutes inflation means there is significant noise surrounding what the Fed will be or should be doing. No wonder there is so much focusing on the speech of the chairman and Fed presidents. The noise causes more volatility which further affects the financial system and causes a delay or reduction in the decisions by banks and other financial institutions.

As inflation rises and the level of inflation and policy noise increase, there will be further questions on the efficacy of the current targeting approach. One hopes that the Fed will provide clear signals for the market before too long.

Ireland rejects Lisbon Treaty ... no reaction after day one

Markets will often overreact in the short-term to elections and political events when in reality it is the economics that drive markets. That is not to say that politics do not matter, but there are few events that will change the direction of the underlying economics of a country. Change does not happen quickly regardless how much politicians want it.

The Irish rejected the Lisbon Treaty which would have pushed new regulation and governance in the EU. The treaty is a document of over 400 pages which having the populace vote on seems to be absurd. The treaty will clarify the EU presidency, provide for a strong foreign policy chief and a national defense pact. There are also a host of labor and economic issues which will further unify and standardize practices in the EU. Nevertheless, most countries seem to want to maintain their current level of independence even with relegating monetary policy to the ECB.

What is more important is the fact that interest rates will be expected to remain high in the EU and growth is still relatively strong. These issues override the treaty which has been in stalemate for more than 2 years.

The economic facts are poor

A good sentiment to have when listening to market analysts was expressed by the late Sen. Daniel Patrick Moynihan of New York, "Everyone is entitled to his own opinion, but not his own facts." Look at the facts and not the views.

The facts are not good for housing. Housing starts are below a below which is similar to what we have found in other deep recession during the post 1970 period. However, the starts were at a much higher level in 2005. Building permits are flat. Industrial production has gone negative an capacity utilization has fallen. PPI continued to stay in the 7% range, so slow growth with inflation seem to be the continued theme in the US, stagflation lite.

No G8 news is bad news

This weekend's meeting of G-8 finance ministers noted that " the world economy continues to face uncertainty and downside risk persist ... elevated commodity prices pose a serious challenge to stable growth."

Those expecting something more about the dollar were disappointed. These types of meeting are always hard to handicap and usually just add noise to the markets. The information impact is hard to measure so these communiques cannot usually be included in any systematic modeling approach. In fact, these types of meetings and announcements produce the worst type of financial journalism.

There is a mixing of causality. The dollar went down so the cause must have been the communiques. It could just as easily gone up and the the news reports would have been stating that the lack of any strong announcement was a sign that the world economy is starting to stabilize and should be good for the dollar.

The news could also be spun in different directions. For example, the G8 communique also stated the following: "We remain positive about the long-term resilience of our economies and emerging markets economies are still growing strongly.....Financial market conditions have improved somewhat in the past few months" Those comments could easily be interpreted that the dollar should be stronger, yet few market reporters or analysts would be willing to forecast what the impact of the G8 meeting.

Do not follow the words. Follow the numbers.

Starve-thy-neighbor policy and commodity prices

The commodity markets are in a global breakdown not from speculators but from government policies in the trade market. When countries follow policies of restricting the movement of grains in order to horde supply for their own people, there will be a supply disruptions. These disruptions will cause markets reactions which will increase the desire to horde and the lead to higher prices. Behavior which is intended to help the collective good of a country will create incentives for individuals to be driven by self-interest and for other countries to react in a similar fashion.

The restrictions on exports from grain producing countries may make sense from self-interest of one country but this will have am impact on the prices for grains globally. The flow of commodities form those who have to to those who need it is disrupted. The trade concept is simple goods should flow between supplier and demander at a price which is acceptable for both parties.

Should grain producing countries horde? The concept of holding back grain is a form of commodity mercantilism though some have called these policies starve-thy-neighbor trade behavior. The hording is not the form of restricting all exports to feed the starving mass in producing countries but export tariff. For example, Argentina has added a new export tariff of 44% on every tonne while Russia has added new tariffs on all wheat exports for 2007. http://www.ft.com/indepth/commoditiesboom

These export restrictions have been coupled with price controls internally to reduce the price inflation internally. Prices are not able to adjust to the global shortage. Local prices are kept artificially low while countries that are grain importers are left with higher prices from shortages.

No wonder the futures markets have seen increases in volatility and have hit new highs this year. The US is a major suppliers who have not added any restrictions. Hence exports have increased and supplies have become tighter in a market that is facing massive flooding in the Midwest.

So where are the international organizations now to help this process?

Commodity markets are too important to be left to hedger

Senator Joe Lieberman said that he will propose a ban on speculation that would prohibit institutional investors from participating in commodity markets.

If we leave the futures markets to the hedger, then who will take the other side of the trades? The market needs a mix of buyers and sellers to function properly. Of course, only simplistic views support the idea that hedgers are always short and speculators are only long. The question is whether there is an appropriate mix of buyers and sellers when there are large number of speculative long positions associated with indexing. These long traders are like any index traders, informationless. Their actions are not based on the value of the commodity or on recent news. The action is somewhat mechanism to ensure exposure to the commodity markets as an diversifying asset. An increase in speculative long open interest may actually cause more hedger participation in the market. More farmers may hedge if they know that there is strong liquidity in the futures markets.

Rational analysis of the buyers and sellers of futures markets is necessary. Oversight to ensure that there is no market manipulation and the market is believed to be fair is essential, but legislation that will will reduce some market participation will only hurt the functioning of the markets at this time.

Comment on inflation and toothpaste

Karl Otto Pohl, former president of the German Bundesbank, said "it's [inflation] like toothpaste. Once it gets out of the tube, it's very hard to put back". Inflation expectations are the key issue right now. The question is whether the price shocks that we have seen in the commodity markets will be converted into beliefs that inflation will rise around the world.

More talk about evil speculators from Congress

Congress has been haranguing the CFTC and their oversight of speculators in the futures markets. Congress "knows" that speculators must be responsible for the high commodity prices. It is not high demand for oil from emerging markets. It is not the high demand for ethanol and the bad weather or droughts around the world. It has to be speculators.

There is no doubt that index players have increased their presence in the markets and that commodity fund trading has increased significantly. However, beyond the fact that there is more trading volume and larger open interest there is not a lot of work concerning the impact of indexers and speculation on the futures market. Here are some ideas on how to look at this issue:

• Analyze the basis - If there is excessive speculation in the futures markets then there will be unusual behavior in the basis between cash and futures markets. Futures should be moving higher without the same impact on the cash price.
• Analyze the backwardation - Speculative long positions will drive up prices relative to the cash price which will change the market from backwardation to contango. Note that if the market goes into contango, the long speculators will have losing positions regardless of the cash price moving. This will force some of the indexers out of the market.
  
• Testing the roll periods - The commodity indexes have specific rules on the roll of futures from one contract period to another. The size of indexers will cause price pressure on the roll period that would not exist for contracts that are not included in the index. Periods outside the roll rules will see less price pressure. This is easy to determine and would show if indexers are not being matched by other market participants.

It is a good time for testing of market behavior without value-laden demagoguery.

Corn and weather

Just when you thought that the corn and other grain markets could not go any higher there is a weather shock. Corn is above $7 a bushel on too much rain. Soybeans which are grown in the same region are advancing to the highs.

Weather shocks and the relationship with price is what makes any discussion about a commodity bubble irrelevant. At this point, it is unclear what will be the size of the corn crop so the question of whether prices are too high cannot be answered. The hallmark of the grain markets is that every few year there is a weather spike and a corresponding spike in prices. Unfortunately, a simple review of the long-term price patterns shows that the spike have become more frequent and combine with a structural uptrend in prices. There usually is a season spike in prices which is related to planting and pollination uncertainty, but we are focusing on moves that are more than 20%. The weather spike could come in a number of forms, wet and cold weather in Spring which delays planting; heat during pollination period; heat in later season which stunts growth. The uncertainty comes because the size of the crop cannot be determined with precision like the output from a factory.

Looking at the corn market from 1980 to the present, we can see these "weather" price spikes in the following years:
1983 - major uptrend from Fall 1982
1988 - large summer spike
1990 - one season spike maxing during June
1993 - harvest shortfall decline in 1994; maxing in December
1994 - spike until Spring 1996; This was the previous largest move since 1980.
2000 - one season spike; max in May
2002 - one season spike; max in September
2004 - one season spike; max in May
2005 - one season spike; max in July
2006 - spike with structural uptrend from ethanol; move at end of season
2007 - spike and with continued structural trend
2008 - current spike

The prices will decline as the supply imbalance is eliminated. The data also show that for most of the 1990's the corn market was relatively calm except for the 1996 weather shock. We have been lucky with the weather.

Bernanke speaks ... The New Maestro

The dollar rose to the highest levels in three months based on comments from Fed Chairman Bernanke about how the Fed will "strongly resist an erosion of longer-term inflation expectations" . Translation, the Fed will fight inflation. Bernanke talks and markets move. It seems like we are back in a Greenspan era of markets getting jittery and reacting to every pronouncement.

Bernanke was actually giving a speech at the Fed of Boston's 52nd annual economic conference. For the text of the speech, see, "Outstanding Issues in the Analysis of Inflation". http://www.federalreserve.gov/newsevents/speech/bernanke20080609a.htm

The speech was very insightful on a number of fronts and not really associated with the comments that were reported in the newspaper. Bernanke first discusses commodity prices and inflation and notes that the forecast of prices through futures markets have not been very good and that the link between commodity prices and inflation is not usually strong. The issue of what futures are telling us about inflation is unclear. The latest poor predictions concerning the run-up in prices has exacerbated the problem. Unanticipated price changes will have real effects.
The speech also discusses the issue of labor costs in the inflation process. Wages are where we have not seen a significant increase in the US. Some emerging markets are seeing a wage price spiral, but to date the labor pipeline costs have not exacerbated with the commodity price increases. Th link between prices, labor costs and product mark-ups is no clear and this is the area where inflation will have the biggest potential effect.

Even if we can find the links in the economy, there is the additional problem of measurement in real time of inflation. If we can not measure inflation in real time there is limited policy responses that can be implemented in the short-run. We do not want to end up with the 1970's problem of driving in the rear view mirror of what happened in the past. when the world is changing quickly.

Of course, perhaps the most important issue is the formation of inflationary expectations. The process of learning, internalizing and acting on inflation is still unclear. Bernanke notes that recent survey research suggests that there is little clarity on how inflationary expectations are actually converted to price increases.

While we have learned a lot since the 1970's on the inflationary process, the problem is that we still have uncertainty on what is the process of how price shocks move to inflation and what can be done about it. This is a sobering testimony of what we do not know and what we have to learn to makes good investments decisions during a period of rising prices.

Credit swap clearinghouse needed now

Banks have agreed to form a system to serve as a clearinghouse for credit-default swaps, or more precisely, 17 banks and the Fed have agreed to build a clearing house system. This is one of the great vulnerabilities in the financial system and need to be plugged now. This is where a futures exchange-type clearinghouse could be helpful with standardized margin structure. This area is also where the government needs to exert its regulatory power to push the market in this direction.

While banks are less likely to hand over this lucrative business to the Chicago Mercantile Exchange, there is an alternative, the Clearing Corp which used to clear trades for the CBOT and is owned by a set of banks. Rules could be standardized and all trades cold be matched with the clearinghouse. There will be a increase in back office efficiency and an increase in liquidity from the standardization but most important the likelihood of fails will decrease. Outstanding contracts that match could be terminated no different than futures offsets so that the logjam of paper would be reduced.

This is a good idea not only for securing the existing contracts and the viability of the market but also as an effort to better the future financial system.

Credit crisis iceberg - risk below the surface

It seems like the credit crisis has fallen off the radar screen from the attention of many analysts but it more like a iceberg where a lot is going on below the surface.

• Lehman Brothers is having a capital call for $5 billion to shore up its capital structure. This is not Bear Stearns brokerage, firms are still facing some difficult times for the same reasons that were driving the crisis at the beginning of the year.
• Auction-rate market has been destroyed and some investors will not get their money back. This is a $330 billion market that is in financial gridlock and uncertainty.
• Ambac and MBIA downgraded to AA with negative credit watch from S&P.
• Fed still using auction process to buy Non-Treasury collateral.
• Sub-prime losses $8 billion for Japanese banks.

The credit crisis is still alive regardless of what the market is seeing above the surface.

Bond insurance debacle

MBIA and Ambac lost their triple-A rating which brings the credit crisis back into the picture after the Bear Stearns blow-up. We have found it interesting that a dollar floor was formed with the Fed intervention and it seems like there was a turn in the market perception of the credit crisis. Now those issues are going to come back into the forefront.

What are the values for all of the securities that had insurance from MBIA and Ambac. We know that they were less before, but it is possible that many of the securities were marked at book value given the rating. Now we know that they are not worth the same as other triple-A rated securities.

You cannot hide from these problems.

1970's and oil price shocks

Everyone wants to go back to the 1970's to compare the current commodity oil price shock. The decade of the 1970's were a period of significant commodity shocks. Oil prices had twin price shocks in the 1970's. Grains had a shock with the poor harvest in Russia and rest of the world. The inflation rate had a significant shock and the US as well as many of the countries of the world went into a recession. On the surface it seems to be the same issue 35 years later. Yet, making those types of analogies is dangerous. Perhaps the only thing that we can say will be true is Stein's Law that “If something cannot go on forever, it will stop”.

The price gains in commodities will stop because the economy will adjust to the increase; however, the real issue for the 1970's inflation analogy is whether the price shocks in commodities will be monetized and will there be a wage (cost) price spiral that will fuel inflation. It is the link between the shock and the economy that will determine whether this will be a story with a different ending. The key issues are threefold:

1. The behavior of the monetary authorities. We have moved from trying to worry about multiple goals of inflation fighting and high growth to a critical focus on inflation targeting. Central banks are less worried about setting interest rates but trying to hit a target for the increase in prices. This is a vast improvement over the behavior of the 1970's when there was still a focus on Keynesian control If central banks follow their goal of inflation targeting there will less likelihood that this will be like the 1970's with entral banks first trying to help the real economy and then playing catch up with controlling interest rates. Unfortunately, we do not know what will be the creditability of these central banks during a prolong inflation. The bankers have not been tested during this scenario.
2. The sensitivity of the economy to the price shocks. The economy is less sensitive to the change in oil prices. It takes about 50% less oil for a dollar worth of GDP. There is less reliance on hevay industry than in the 1970's for the US; nevertheless, the key issue is the emerging market economic engine which is more driven by energy costs. Given a looser link between energy and the economy, the size for the price increase will have less of an impact. No doubt the increase has been significant and it will have a appreciable drag on economic performance, but for the same increase price gain the economy may be more resilient than would be the case during the 1970's.
   
3. The link between these price increases and inflation. The wage price link has fallen from what was th case during the 1970's. The more diverse economy means that wage-earners have less control over their earnings adjustment to inflation. The impact of globalization is that the the slack in the economy for wages is on an international level not just a country level. While wages are increasing in emerging markets, there is still slack in the economy that will cap the size of increases in all prices around the work. The issue will be what are the inflationary expectations embedded in the economy later this year. However, on a percentage increase, the rise in inflation is real. We have stated at a lower price level but so the absolute level of inflation may not match the increases in the 1970's.

The analogy with the 1970's may be a little too easy. yes, there are similarities but a close look at the stories between then and now show only a weak connection. We may face higher inflation but it will be a new story for a new century.

ECB taking a hard line

ECB has sent a clear signal to the market that it is more worried about inflation than growth. This has always been the mandate of the ECB but the comments by ban president Trichet make it very clear, or as clear as central bankers are on these issues. He stated that a rate increase is "not excluded" and that it is monitoring prices with "heightened alertness".

The impact on the markets have also been clear. Regardless of whether the Fed is on hold, the comments form the ECB means that the spread in short-rates will be more favorable to Europe. With the Fed still fighting the credit crisis and with being surrounded by recession fears, it is hard pressed to believe there will be the same desire to raise rates. The dollar rally was to some degree associated with the belief that the Fed was on hold, but this is all relative to what is going on in other countries.

Like investors there can be a change in central bank sentiment and in this case it is decidedly moving toward controlling inflation.

Commodity price shocks causing adjustment

Airlines -

UAL grounding fleet to save costs and increase loads. Continental announced that it will cut flights which reduces capacity.

Notice that this is not a change in the price for seats but a reduction in capacity or the service provided by the airline. You cannot fly when you want. The fixed cost of running flights that are not full is too high relative to what would be the impact of raising ticket prices in response to the change in the marginal cost of fuel. The airline industry has aways been marginally profitable but the latest change is another attempt to rationalize the industry. Will it work? The only thing we can say is that the airlines must believe that oil price increases will last for a long-term otherwise firms would not cut their capacity.

Food -
Pepsi announced that it will cut the contents of its snack packages while raising prices. Pay more for less. Smithfield is reducing its hog breeding herd. Its stock plunged after it reported lower earnings.

The costs of price shocks are real and the longer the shock goes on the more firms will adjust. The real problem for inflation is whether we will see a wage price spiral. This is 1970's lingo, but it was the link between price shocks and wages which caused the main increase in inflation. Currently, the world is in a different place but what we are seeing is some wage adjustments and shortages in places outside the US, like China.

CFTC and market disclosure

One of the key roles of government with respect to the economy is in gathering and monitoring information that normally would not be acquired by markets. This information may not be gathered because competitors may see little value in providing sensitive information like positions in the market even though there is value in knowing in aggregate what the market is doing for oversight. here is also a free rider problem. Industry data may be useful but no single user may want to go to the expense of gathering it.

The gathering of information on exchange trading may be useful for the overall market through oversight by the government. There are externalities associated with trading and position taking that may negatively affect the markets. Large positioning may lead to market squeezes or manipulation which will destroy the viability of the marketplace, yet there are cost with information gathering. There is the direct costs of processing the information but there is also the market cost of providing information of positions especially if it focused on a well-defined group.

To eliminate the potential for market manipulation, there have been cap set on the size of speculative positions. To enforce this rule, market position information has to be collected. This aggregation may be best done by the government across all exchanges.

The commitment of traders report from the CFTC provides information on market futures positions by large traders. It has been broken into two major categories, commercial users which would be hedgers and non-commercial users who would be speculators. This is not the case for commercial users who are able to get exemptions based on their business needs. Unfortunately, the breakdown of the market into these two simple categories are not enough to provide useful information for the market as whole as well as regulators who have to watch for speculative excess or market manipulation.

Index funds who buy commodity futures as an investment fall into the grey area of being neither commercial users in the processing or growing of some commodity or represent true speculators who try and profit from the rising and falling of prices in markets. The index trader is a hedger only to the extent that the investment that he makes in commodities is uncorrelated with the equity exposure that may represent the bulk of their risk exposure, Clearly, the index investors would not be a hedger in any sense of the word if there long commodity exposure was highly correlated with the other assets in their portfolio. Indexers are hedgers only because of the statistical artifact that the correlation is low. The idea of viewing these markets participants as commercial users stretches the intent of the rules. Broker dealers who offer commodity products to pension funds may be considered hedgers because they serve as intermediaries, but there is still the issue of there overall trading in this area. However, the market and regulators have been unwilling to make this argument to date because the added participation to the markets was viewed as a positive.

The proposals of adding a separate category for indexers makes sense. This traders are supposed to be information-less much like an index traders. The idea of being more stringent on hedge exemptions also makes sense, but it there may be the fallout that more traders will be done off-exchange which would not be beneficial.

There is still the issue of whether index traders have driven prices higher but I will leave that to another posting.