Monetary policy exit strategies pick-up momentum

We have the following on the monetary exit front:

Fed talking about exit strategy in WSJ. Officials saying they will have to be as aggressive in the exit as in the easing. The Fed is also closing some of their less active lending programs given there is not a strong market demand. Spreads have tighten so the credit easing programs are less necessary.

ECB cutting some of the longer-term lending programs as an precursor for exit. Although now we are hearing that ECB Trichet is worried about "sharp" currency moves.

BOJ is planning to end their emergency corporate debt-buying program. Corporate bonds have done especially well in Japan. This was a program started last December and extended in July. This action is expected even after the Tankan report which suggests that investment cuts will continue and the recovery in Japan will be slow. This is after an increase in confidence.

The exit plans will be slow but this will start to loosen the high correlation in interest rates within the G10.

The problems with QE and the Bank of England

You can buy bonds but you cannot make banks lend. That is the problem in the UK where the BOE has aggressively eased to solve the recession crisis only to see that the money supply is not growing as fast as expected.

The key issue is now understanding whether the credit crisis was a balance sheet problem or liquidity problem. We have seen spreads decrease in LIBOR and the corporate market as the perceived risk of corporate and financial institutions have declined, but there has been constraints on the amount of new lending. Bank balance sheets have yet to be cleaned up. Increasing the supply of money and cutting rates may not change the desire to lend money.

Watching the BOE is important because it is facing the same problems as the Fed. We are getting a preview of what is in store for the US.

Well-written peice by Kevin Warsh on the Fed

This WSJ editorial is a must read piece on the Fed, well written and thoughtful. The focus is on the exit strategy and that it will require "whatever it takes" focus.

Clear communication is required -

"Judgments made by policy makers in the current period are likely to be as consequential as any made in the depths of the panic. That means policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves."

Chance of policy error is high -

"It also means that policy makers should acknowledge the heightened costs of policy error. The stakes are high, in part, because the policy accommodation that requires timely removal as the economy rebounds is substantial."

In some cases, policy makers may have waited too long to remove easy-money policies. In other cases, policy makers may have acted too abruptly, normalizing policy before the economy was capable of self-sustaining growth. Errors of each sort are neither uncommon nor unexpected in the normal conduct of monetary policy. And the current period is anything but normal.

No ironclad rules but normalization may have to come sooner than expected -

"In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities."

"Whatever it Takes" required on the exit -

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers."


This piece does not tell us when policy will change but it is clear that the Fed is thinking about it and is contemplating strong action. Let the market be aware that they may do what is necessary to control money when they think the easing should be curtailed. Nevertheless, for the trader this can only make you nervous while you wait for the Fed to change directions.

Perfect debt conditions

I was at a recent Futures Industry Association Treasury Market Forum in New York and heard a fine presentation from Treasury on the success of their debt program. It was impressive. The Treasury has done a good job of engaging the street on determining what is the best way to minimize the impact of new debt on interest rates. The Treasury has been both lucky and good at their job. Unfortunately, it is the lucky part which should give pause for most investors.

What is scary is that the OMB is now projecting debt to GDP which will be higher than CBO. There is little wonder why the curve has remained steep and got steeper this year from the long-end going up especially outside the range where the Fed was active. (Of course, there was no room for the short-end to go down.)

The uncertainty about deficit is not a problem for today but in the future. The Treasury has hit a perfect spot of higher saving in the US, less corporate borrowing, less consumer borrowing, constraints on municipals, a better current account, strong official interest from central banks, and good interest from abroad. A great time to issue Treasury debt. But the fear is that the environment will change.

As risk aversion declines there will a greater demand for risky assets. This is already happening. The TIC data suggests that private flows are slowing into the US. The rates are low and the US is now thought of as a carry lender. Money will be moving into equities to capture the stock rally.

If the recovery takes hold, savings will decline and there will be more private borrowing. There will be competition for funds. Look for this to pick up in 2010.

Solving the global imbalance issue is not good for Treasuries. If consumer spending increases from foreign buyers, rates will have to rise.

Hard to be Treasury bull over longer term if you have any recovery story.

The story of global trade starts with a box

The Box: How the Shipping Container Made the world Smaller and the World Economy Bigger is a great history of the development of the shipping container. While written in 2006, Marc Levinson's work is a good explanation for why world trade has exploded over the last few decades. The cost of shipping has declined significantly and the time it takes to move any goods from one country to another has fallen like a stone. The coordination of shipping from truck, rail and ship has made manufacturing easier in any part of the world. The movement to just in time inventory management and the use of intermediary manufacturing has all been made possible by the use of container shipping. This is the story of true disruptive innovation which has changed the way trade is conducted.Shipping is a system not just a single mode of transport.

Trade cost reduction has changed the world, but the savings have now plateaued. The next wave of increased trade will have to come from governments that want trade to occur. That is why the Doha trade talks are so important and need to be jump-started.

The Age of Unthinkable - Complexity is upon us

The Age of the Unthinkable: Why the New World Disorder Constantly Surprises Us and What We can Do About It by Joshua Ramo is the Black Swan tome for politics. The Black Swan events is that we will constantly be surprised by the totally unexpected. These changes could have radical impact on markets. In this book, Ramo argues that complexity is upon us and that we will be surprised by the what has not be imagined or anticipated.

The book suffers from the problem of other risk books that talk about Black Swans. We will be surprised and change will come from unexpected places. We should be prepared for change and the world is a complex place, but there is no real road map on how to best be prepared for change and surprise. Look for the unexpected, but by definition we will have a hard time finding it. The approaches of the past will not work and simple truisms are not often useful, but we have known this for centuries. Few expected WWI. No one expected the fall of the USSR or the British Empire. It is true that the idea of nation-states as the foundation for change is outmoded, but our ability to explain the behavior of nation-states was always very poor.

Complexity surrounds us. The unthinkable is possible, but our ability to deal with this change is still in a state of flux.

The myth of rational markets and the march of science

Anyone who has read the work of Thomas Kuhn knows that the advancement of science does not occur in a straight line. There will be the development of a new thesis that replaces old science when the old theory does not fit the facts. However, this process can be very messy.

There is empirical testing of a theory or view which will initially provide support for the theory. Unfortunately, the theory cannot explain all of the events and empirical irregularities start to exist. The original theory has to be twisted and changed to explain these events until one day there is a new theory or alternative hypothesis to replace the old. While this process is going on, careers are made and broken. Personalities will often drive the direction of the new science. Feelings will be hurt, intellectual battles will be fought and defenses of life's work will be made. The Myth of Rational Markets by Justin Fox is the story of how the theory of efficient markets has developed and been changed over the last few decades.It is a history of financial theory. It is very good at describing the personalities associated with this story. It is not about myths but how science is created.

Having lived through a good portion of this period and worked on efficient market studies, I was not surprised by this rough science and debate. Was the theory of efficient markets full of delusions? No. It was a very good starting assumption. Markets will be competitive and include all available information. It was like any theory that is put through rigorous testing. Unfortunately, the advancement in finance on efficient markets will often escape the students who have been indoctrinated by faculty in their introductory investment classes.

Efficient markets never was supposed to rule all of the decisions of investment professionals. It has served as a useful foundation, but this foundation needs new support. Markets are rational until there is a new level of uncertainty. However, we may say that it was perfectly rational for bigger mortgage bets when rates are low and there have not been previous loses in housing. Our ability to see irrationality is usually only in hindsight. Fox does a great job of telling the story of efficient markets but there is expose here. It is just the history of science.

The Geopolitics of Emotion - interesting perspective on country personalities

The Geopolitics of Emotion; How Cultures of Fear, Humiliation, and Hope are Reshaping the World by Dominique Moisi provides an interesting perspective on the how we should look at the personalities of countries. The premise that the cultural personality will affect how a country will react to a given situation. Understanding their emotions is a useful perspective in today's geopolitical environment. The reaction of countries to news or policy shifts of their neighbors is not just about real rational responses to self interest but could be driven by fears. A trade tariff may be based on the fear of losing strength and not just the fact that a country is undercutting prices.

Moisi has a more nuanced view than those who describe the differences in countries as a clashes of culture. He would argue that a country or culture has a emotional component that may cloud its view of other countries. Its perception of itself will effect how it interprets the actions of other countries.

The developed countries like Europe and the US may have the emotion of fear. The fear of losing its identity and the fear of "others" who are culturally different. The Arab and Muslin world could be driven by the emotion of humiliation from exploitation in the past and a belief that they have been excluded from the global boon of economic progress. Asia is driven by the emotion of hope as it seizes the opportunities from strong growth. Finally, there are some countries that have a combination of these emotions which make then extremely sensitive and difficult to understand.

This work does not lend itself to quantification and it is simplistic in trying to fit countries into a limited set of emotions, but Moisi provides a different viewpoint that can help understand the actions of other countries.

More dollar negative talk

World Bank president Zoellick states that the special status of the dollar should be not be taken as a given.

"The United States would be mistaken to take for granted the dollar's place as the world's predominant reserve currency," he said. "Looking forward, there will increasingly be other options."

“Peer review of a new Framework for Strong, Sustainable and Balanced Growth agreed at last week’s G-20 Summit is a good start, but it will require a new level of international cooperation and coordination, including a new willingness to take the findings of global monitoring seriously. Peer review will need to be peer pressure.”

“Bretton Woods is being overhauled before our eyes. This time, it will take longer than three weeks in New Hampshire. It will have more participants. But it is just as necessary. The next upheaval, whatever it may be, is taking form now. Shape it or be shaped by it.”

If the dollar enters this period of changing global financial structure with a weak currency, it is assured to have a weaker place at policy table.

Strong dollar policy affirmed - more of the same

"A strong dollar is very important to the United States," Geithner said at a news conference on Thursday at the opening of the two-day summit in Pittsburgh, where leaders of the largest rich and emerging economies are discussing the global economic crisis.

If we poked a Treasury secretary in his sleep, would he say that the US has a strong dollar policy? How would we tell the difference between a strong a weak dollar? If we had a strong dollar policy does that mean that the dollar would be overvalued versus other countries? There is a need to articulate what a strong dollar means for the world.

It is the macro policy that drive behavior.

"We are not going to walk away from the greatest economic crisis since the Great Depression and leave unchanged, and leave in place, the tragic vulnerabilities that caused this crisis," he said.

So what does that mean for monetary policy which pushed interest rates to lows in the early 2000's only to set off a commodity boom and a speculative bubble? What does that mean for fiscal policy and our ability to balance budgets in the future?

G20 meetings - where is the macro talk?

The G20 meeting was upstaged by the new knowledge on the nuclear ambitions of Iran, but there was not much meat coming from this meeting. Yes, there was talk about new guidelines for restricting pay of bankers, a timetable for regulatory reform, and a framework for balanced growth, but no progress was made on trade or climate change. Why regulate banker's pay? This institutions are weaker than countries and easier to solve. You lend them money and you get to control the rules. The G20 can control the bonus culture, but it still has not focused clearly on the root cause of the problems. The G20 allowed the flood of capital into deficit countries. The savings imbalance and loose monetary policies of the last ten years problem are the root causes which were barely touched.

Gordon Brown suggested that the G20 should be the world's main economic governing council. So much for the great talk about multilateralism at the UN. The G20 is now more equal than the rest of the world (i.e. the UN) for making policy. There is nothing wrong with that given it represents so much of the global economy. So much for the G8. This is fine given it was a EU dominated construct. The G20 is taking over from the developed world as expected given the shift if economic power. The issue is that this "organization" was not set-up to provide for global policy coordination. It is good for joint discussions but not for setting and directing policy. So what has happened to the IMF which has the cash for lending. What is its role within the G20 construct? The G20 agreed that emerging countries should be given more say within the IMF. They will get a 5% tranfer in quotes at the IMF and 3% at the World Bank. They are on track to make a final decision by January 2011. This is moving fast.

We will have a more uncertain and confused international financial environment if we move forward with this type of talk from the G20 without clarity of their overall role.

The G20 declared that they will develop goals to counter destabilizing economic imbalances, the Framework for Strong Sustainable and Balanced Growth. The countries will have shared policy objectives. What does that mean?

One of the destabilizing imbalances was the loose monetary policy of the US which has been repeated again. Once the Fed lowers rates, there is an effect on other country's monetary policy. They will usually have to lower rates or there is a feedback effect to the rest of the world. The 800 lb gorilla gets to sit where it wants and everyone else has to adjust. The other issue with the global imbalances has been the continued use of monetary policy to promote exchange rate policies that foster exports. There is no change suggested at this G20 meeting.

The inverted square root recession - one more shape theme for growth

We have heard the market talk about V, U and W-shaped recessions, but now we have discussion on the inverted square root sign recession from George Soros, and Alphaville. This shape suggests a recovery followed by another decline and then flat or low growth. Are we trying to over-think all of these scenarios?

Right now the focus should be on the near-term and that means two things. One, will the current upswing have legs after accounting for fiscal stimulus and two, will the current business cycles continue to be synchronized.

The latest numbers suggest that confidence is improving but there is not a strong consumer lead recovery. Manufacturing is increasing to offset some of the inventory decline. Auto sales had a gain and housing has generally come off the bottom, but most of this effect is based on active government programs. The growth has been pushed forward through incentives. This is an issue with all of the global stimulus.

The synchronous business cycle issue will effect the relative changes in interest rates and equities. Right now we are seeing a growth pick-up in many countries, but there has not been any change in monetary policies. Short rates are all low and there is little expectation of an increase between now and the end of the year. The break-out or break-down of growth will be the major theme to look between now and the end of the year. This change will be the driver for asset price opportunities.

Darn "permanent income" and "life-cycle" theories actually work

There has been significant work on the consumption patterns in macroeconomics. The key consumption theories have been the permanent-income and life-cycle hypotheses. Both theories tell us the same thing. In the permanent-income theory, a temporary change in income will not lead to a large change in consumption because consumers base consumption on what they view is a permanent change in their income. In the life cycle theory, consumption is smoothed over consumer's entire life so a small one-time change will not lead to n increase in consumption.

The impact of these theories is discussed clearly in the WSJ editorial, "The Stimulus Didn't Work" by some well-regarded economists. The tax rebates went out but there was no increase in consumption. Why spend the money if you are worried over the longer-run? why spend the money if you believe taxes may go up? The government spending may not have had a strong impact on savings either. The jump in GDP my have to do with private investment not consumption.

Economic theory works even if you don't want to believe it is true.

A Japanese finance minister not linked to exporters?

Likely Japanese finance minister Fujii commented that "it is not right" to weaken yen to benefit exporters and that the government must refrain "in principle" from intervention.

"If some countries devalue their currencies again and again, others will follow suit to protect their competitiveness. So there are rules regarding foreign exchange, and we must abide by them," Mr. Fujii said. "From that perspective, I think it's a wrong policy for a nation to just weaken its currency to boost its exports."

He added, "There could be cases where some steps would be taken when there are abnormal, speculative money flows. But in principle, we must not take such action."

- From WSJ Sept 16.

These comments took some pressure off yen from rising. The last time Japan intervened in the currency markets was in 2003 through March 2004 when approximately 35 trillion yen was used to hold the yen decline. The line was held at 120 for most of 2003 and then ended at lows of 105 in Spring 2004. We are currently off the mid80's lows and hovering round 91. This is a lot lower and been rough on exporters during this global decline. Surprisingly, the Nikkei is up 17.88% while the Topix is up only 9.34% this year. Large exporters have done better.

You still have to be nervous when the yen gets down to these levels that we will be seeing a rebound as money moves out of the country and growth picks up. large manufacturing is positive and industrial production is starting to inch higher, up 2.1 MOM but still down 22.7 YOY.

More good news in the US, but what about the dollar

The inflation picture has stabilized which may lessen fears of deflation. Capacity utilization moved up closer to 70% which means some of the idle factories are starting to be turned on. The auto industry got a boost from the clunkers program, but we will have to see if this production move has legs. The Empire State index also improved so the US is starting to look better, but this also means that there is more risk taking around the world and the opportunities may not be in Treasuries.

The dollar continues to slide and we saw a fall in net long-term flows. We expect to see flows decrease in months not associated with quarter-end, but the the net was worse than expected. The net flows in Treasuries were weak. Agencies and corporates were also weak. Equities were slightly stronger. While looking at flows only helps to explain the past picture, it does provide good insight in the mindset of investors. If risk taking increases, there will be a a movement out of safe assets. This shifting of assets is occurring.

Swiss looking strong with ZEW survey

The ZEW survey expectations comes in with a very strong 58 versus 18.6 last month. You have to go back to 2006 when the survey was introduced to see these numbers. The strength of the economy is showing up in the currency with strong appreciation this month. While it looked liked the central bank tried to hold the line at 106 against the dollar, we are now back at the pre-Lehman levels. (Everyone uses the Lehman crash as the demarcation of the crisis.) The Swiss stock market is inching up to October levels as the banks have improved strongly. However, there is a good Swiss story across the board.

"Go home there is nothing to see here", the recession is over.

"The recession is very likely over at this point," Bernanke said in responding to questions at the Brookings Institution.

So we are in a new regime. The economic world is now going to be different. We have been seeing a change in the dollar behavior with the long-term downtrend back in play, but it does not feel like the recession is over. But let's be precise. A recession could be over, but that does not mean expansion. We are now in the recovery phase which is the period from the low in economic activity to the point when we are at the previous high in economic activity.

Advanced retail sales was at 2.7% after a revised negative -.2% last month. The value was good, the best since 2006, but the 12 month trend is still negative and the value was inflated from government programs.

So let's not confuse recovery with expansion and there is still a chance for a W-shaped recovery.

Lehman failure one year later

Someone asked me about the Obama Speech yesterday on the anniversary of the Lehman failure. Good talk. Some strong points but unclear how we will deal with the key issues. The recurring theme is uncertainty about policy. This is the old dynamic inconsistency issue of monetary policy but applied to fiscal and regulatory behavior. How do we know what the government will do and when. If we do not know or cannot measure their possible action then, we are left in a state of uncertainty.

For example, what is the solution or what are we going to do about systemic risk and the "too big to fail" problem? It is not clear who will be receive a bail-out. Who is too big to fail? If this issue is more fluid, then there is more uncertainty. We actually merge banks that are going to fail to make bigger institutions which will be all the harder to let fail in the future.

What about coordination of regulatory issues across countries. This is not not a US issue but a global issue and there is significant uncertainty on what this will mean for many institutions that see most of their business within the US.

Another example of the uncertainty issue is the current article in the WSJ by Prof Cochrane and Zingales of the University of Chicago, "Lehman and the Financial Crisis; The lesson is that institutions that take trading risks must be allowed to fail". The article discusses the point that Lehman should have been allowed to fail, but the real focus was on the fact that the financial markets started to have real problems when Treasury asked for the $700 billion TARP money. The uncertainty of what was needed and why created a the market scare. Again, the uncertainty of what the government will do created a flight to quality.

I could go on with other issues but the point is straightforward. The idea that there are simple "common sense" solutions is flawed. The law of unintended consequences is present. There will not be easy banking solutions.

New trade war over tires?

The Obama administration announced that it will place a duty o 35% on Chinese tires. This is is on top of the existing 4% tariff. This is an issue that has been brewing since the Spring when the US International Trade Commission ruled that a tariff was necessary. The Chines have 16.7 market share in tires up from 4.7 in 2004.

China has now accused the US of "rampant protectionism" for imposing heavy duties on the tires and has threatened action against imports of US poultry parts and auto parts. China estimates that the impact will be a loss of 100,000 jobs and $1 billion. The Chinese note that tire export growth to the US was up 2.2 in 2008 and down 16% in 2009.

This will give the leaders of the G20 something to talk about in Pittsburgh on Sept 24-25. This is after the G20 agreed that every effort should be made to ensure that protectionism does not take hold around the world.

I am surprised that there has not been more reaction to this information. Perhaps it is because it occurred on Friday afternoon but this could be the spark to a protectionist fire. Watch this closely.

The dollar as a carry trade?

Every rate in the G10 is now higher than the US 3-month rate. What usually happens when we have low rates in global market with capital mobility? Carry. Fund in the cheap currency and buy the higher yielding alternative. The FX market has been feeding on this for years. If you believe that the dollar rally last year was from deleveraging and a shortage of dollars, then we should expect a releveraging now that rates have turned against the US.

But wait, the dollar decline form the USD borrowing before crisis was at higher rates, so what should happen now? The world borrowed dollars because of the funding availability in the banking system. Now we have availability and low rates. This is not dollar positive.

I thought that capital was flowing into the US because we were a liquid safe haven? Yes, that was happening at the official level, but there are many sources or dollar funding. Now we will have to look at the flow data to find the answer. All of these stories cannot be right.

Trade balance sends signal

The US economy is doing better. We are buying more goods from the rest of the world. While the trade balance will be affected to a degree by changes in the exchange, the key driver is still the level of income growth. The dollar has fallen, but we saw imports spike this last month. The trade signal also tell us that closing the trade gap will be more than just a price problem. You have to look beyond the Marshall-Lerner conditions which is the old school approach to solving trade balance problems.

"A tale of two depressions" is getting old

"A Tale of Two Depressions" is getting old. The "tale" report is one of the most interesting pieces of research in 2009. The two economist who have studied the current crisis and Great Depression take the performance of the global economy back in the 1930's and overwrite the current data to see how close the two match. The pictures were stark. The current recession was following the same global path as the depression. We were heading in the same direction and with the same intensity.

Now we are starting to following a different path. Global growth is turning. This may just be noise but it looks like we are veering off path. There is still a concern about trade but the numbers are starting to change. What is working is the stimulus shock. This is a lot different than the 1930's. The big question will be whether private growth can take over from the government shock.

UNCTAD calls for movement away from dollar

RTT news The role of the U.S. dollar as the main reserve currency should be given to a new global currency, overseen by a new global bank, the Geneva-based UN Conference on Trade and Development said on Monday.

According to the UN body, the dollar has significantly lost its value and a country like the United States that has current account deficit is under no obligation to adjust to growing unbalance in the current account.

“The current international monetary system, with flexible exchange rates between the major currencies, the dollar as the main international reserve currency, and free international capital flows, has failed to achieve the smooth adjustment of payments imbalances,” the UNCTAD said in its Trade and Development Report 2009.

"A viable solution to the exchange-rate problem would be a system of managed flexible exchange rates targeting a rate that is consistent with a sustainable current-account position, which is preferable to any 'corner solution.' But since the exchange rate is a variable that involves more than one currency, there is a much better chance of achieving a stable pattern of exchange rates in a multilaterally agreed framework for exchange-rate management,"

"An economy whose currency is used as a reserve currency is not under the same obligation as others to make the necessary macroeconomic or exchange-rate adjustments for avoiding continuing current account deficits. Thus, the dominance of the dollar as the main means of international payments also played an important role in the build-up of the global imbalances in the run-up to the financial crisis."

Just when you think there will be some rally in the dollar. You get the anti-dollar reserve forces stepping up and announcing the dollar reserve system is dead and should be replaced. The reaction was swift. There is truth in many of the comments in the UNCTAD report, but there is not a viable solution or alternative at this point to the dollar system. The recommendation is diversity of reserves. This is going on right now. The market gets spooked and we have to deal with the fall-out.

Price level versus inflation targeting - the new monetary policy

The orthodoxy of monetary policy has been inflation targeting for almost two decades. Central banks are still trying to fit this orthodoxy into the current crisis, yet there is a growing belief that there may be a need for a new view, price level targeting. In this monetary regime, the central bank will try to control the level of prices and not inflation. So if there was a deflation of one percent there will have to be a corresponding increase in future inflation of three percent if the long-term target of the price level is expected to increase by 2 percent per year.

Deflation has to be offset with higher inflation in the future to re-inflate or adjust nominal prices. This will keep real prices flat, so rel price adjustments would not be able to clear the markets. An interesting theory, but how will it be implemented and what will be the effect on markets. It is hard to say but we think that this policy story is worthy of significant review and will be a focus of our research.

When will US rates increase? More on the the Taylor rue

Fed officials have never raised the funds rate following a recession before the unemployment rate had peaked.

An interesting piece of research from the people at Goldman Sachs. Are we seeing unemployment starting to cap? No. So here is little reason to expect that the Fed will exit from the easing game.

The policy of the Fed is closely tied to the Taylor Rule. This is what makes the rule so effective and this is why we should still listen to what it has to say about the actions of the Fed and other central banks. The Taylor rue or formula states that the target interest rate of the central bank should be related to the the inflation rate, the real rate of interest, the output gap, and the difference between the inflation rate and its central bank target. The idea includes the goals of the Fed through some reaction function.

There is a neutral real rate of interest which is associated with the long-run growth rate of the economy. There is the current inflation rate which is associated with, in the case of the Fed, the core PCE. The reaction function will be associated with the difference between the inflation rate and the target set by the Fed. A higher coefficient associated with the inflation gap will mean there is more sensitivity to the gap between the inflation rate and the target set. The final factor will be the factor associated with the output or Okun gap named after the 1960's macroeconomist who studied the difference between actual and long-term GDP growth.

One of the flaws with using the Taylor rule for forecasting is determining what are the reaction speeds of adjustment actually used by the central bank. We can estimate the reaction variables back in time but it is less clear how much wait the current Fed places on inflation versus output gap.

Regardless of these problems, the Taylor rule has been used to assess current monetary policy. The current zero rate policy can be compared with the rate that the Taylor Rule would give based on the past behavior of the Fed during recession. What this analysis finds is that the nominal Fed funds rate should be negative. There is a gap between the current policy and what the rule would tell which some have called the monetary policy funds rate shortfall. These policy rates cannot be obtained but the exercise tells us that there will be a shortfall of growth or a sustained output gap which will be closed through continued easy monetary policy.

Do not expect the Fed to raise rates anytime soon.

The time value of money problem for consumers and government

We have become Blimpie from the Popeye cartoons: "I will gladly repay you Tuesday for a hamburger today."

The problem with the credit crisis has been the desire of many to consume today and pay tomorrow. The banks feed on this desire by consumers. The government fostered this desire by saying that everyone should have a home. For derivatives you can have the current income today for risks that you may have to pay for tomorrow. For the government you can stimulate today for debt that will have to be paid tomorrow. The time value of money problem cannot be ignored.

How does all of this get paid for? The answer is what has not been discussed with government policy, growth, innovation, and increases in productivity. If you want to pay for health care, we will have to grow the economy. You want to pay-off the stimulus of the economy, we will have to grow the economy. If you want housing to stabilize and wealth to return, we have to grow the economy. So what are the current policies which promote growth? Not the works projects but innovation and ideas for productivity enhancement. Any dollar of government spending is not the same.

To grow you may have to forgo consumption today to prepare for tomorrow. The time value of money problem.

What will be the new policy mistakes

"Why repeat previous mistakes when there are so many new mistakes to make." Bertrand Russel

What will be the new policy mistakes between now and the end of the year? It seems like the most likely will be to believe that the recovery will be strong so we can reverse some of the monetary and fiscal stimulus. G20 countries want to discuss the reversal of the monetary easing in September so this will be top of any discussion. Second, will be policies to offset the current fiscal stimulus. This change may not be a outright reversal of stimulus policies, but a change in tax policies based on "prudent" debt management. The talk of raising taxes to pay for the current debt is increasing but is certainly premature. The other fiscal mistake is the belief that rules are costless and that now is the time to change the regulatory environment. The added uncertainty with some new regulations may retard growth. Let's learn first and change the rules second.

G20 - the talk of exit strategies very uncertain

One of the topics for the G20 meeting agenda will be monetary policy exit strategies. There has been unprecedented stimulus across most central banks. The market is flooded with liquidity through lowering rates and quantitative easing. Not all of this is being used by banks. as measured by the excess reserves in the many countries. If the recovery continues, central banks will have to deal with how to reverse this stimulus. The method will effect inflationary expectations and the whether global growth will continue. Stimulate too long and there will be the potential for inflation. Cut the stimulus too quickly and there will be a reversal of the growth.

The importance of the exit is demonstrated by looking at how the Fed tried to get out of the Great Depression. If the Depression was caused or accentuated by poor monetary policy, it was made even worse because of the exit strategy of 1936. The Fed raised reserve requirements under the mistaken belief that the crisis was over. The result was the recession of 1937. 1937 also was when there was a reversal of fiscal policy but there is little doubt that monetary policy tightening contributed to the decline in 1937.

To say the G20 is interested in an exit strategy is the equivalent of asking what will the Fed do and when will they do it. Governments want answers, but there is little clarity of what will happen and at what time.

Japanese election and more uncertainty

Throw the bums out! That is what the Japanese said with their recent election. The DPJ trounced the LDP with the DPJ holding 308 seats in the 480 seat lower house of the Diet. This is not normal Japanese behavior but then these are not normal times. What became a bad recession from a real estate bubble turned into the lost decade, but now we are closing in on a second decade of no growth. Japan will lose their position as the number two economy to China and there is no end in sight. Nominal GDP is at about the same level seen in the early 1990's. Child poverty is higher than the OECD average.

Monetary policy with zero interest rates have been tried. Fiscal stimulus has been tried and then some with debt to GDP enough to make any country shutter. So it is time to try something totally different like end the one party rule for the last 50 years. Unfortunately, it is not clear that the new party has some magic formula for solving the economic woes of Japan. The slogans suggest that there will be more consumer focus and less same old policies to support large businesses, but it is unclear how this will be implemented.

So what does this mean for investors? A lot more uncertainty which is not good. More of the same will not change the economic dynamics but there are limited choices of what to do as an alternative.

"How did economist get it so wrong?" - a piece worth reading

Paul Krugman has a well-written piece on the current state of macroeconomics, "How did Economics Get it so Wrong?" in the NY Times Magazine. It does a good job of presenting the current state of macroeconomics. There has been a failure in macroeconomics. It was not able to correctly forecast the current downturn. Of course, macroeconomics has never been good at forecasting any downturn but that may be another issue. There also has been a failure in the policies that can be used to solve the problem. Macroeconomics does not seem to have easy solutions for current crisis, but then we have not seem many crises like this one.

Nevertheless, the current state of economics may not be as bad as Krugman suggests. We have been aware of the problems with macroeconomics and there has been significant work in trying to solve the limitations within the field. The problems are fundamental to all of economics. The study of market behavior is a social science that is affected by the actions of market participants. The aggregation of behavior is not well understood in any field especially when faced with high uncertainty. We like to believe that everyone is rational but that may not be the case. Market may be rational in the long-run and on average but not at all times. What it means to be rational also differs across individuals. If by rational we mean that behavior is consistent, then we may see that behavior with most investors. If by rational you mean that investors are able to effectively use all information to properly assess the value of all assets, then there may be problems.

There is no ready solution. Krugman dos not have the answers even though he may be able to present a spirited critique of the current state of the field. If we do not understand macro behavior, why would we think that a Keynesian approach is the solution. Keynesian economics is not going to solve the basic problems of determining investor and consumer behavior. This is one of the reasons why Keynes discusses "animal spirits" to describe the behavior of market participants who make investment decisions. The animal spirits represents an unknown that has to be jump-started by fiscal policy. It is difficult to determine what drives investments decisions is more important that then often quoted view of the stock market as a beauty pageant.

We do not have a grip on why investors make investments and take risks that are hard to handicap. We also do not understand how consumers will react to uncertainty and to changes in policies like tax changes. Changes in taxes cause changes in behavior. The markets are rational about the impact of taxes and that they will have to be paid in the future. If we cut taxes, will this money be spent? What will it take to get people to change their savings behavior? We already know that there are behavior biases and this effects investment decisions. We just do not know the extent of behavior biases across the entire economy.

Some of the failures of the distinctions across macroeconomics are not for real. There is little disagreement that regulation is needed in any economy. The issue is what is the level that is necessary to get the job done. Will regulation increase the proper functioning of markets. We do not know. Regulation has a cost and a benefit.

There is little disagreement that taxes have to fund the government, but what is the level that is appropriate. Is a 50% marginal tax rate too high or too low? Will taxing small business to fund government programs create more long-term jobs? Do deficits matter? These are all questions for which we do not have the answers. This is not a failure concerning the crisis but a failure for economists to understand their field.

We already know that there will be bubbles in markets both on the upside and the downside. When did the tech boom become a bubble? When did housing become a bubble? The issue whether we can identify these events before they burst and do something about them. After the fact, it is easy to see we should not have gone down this path. There will always be someone who warned us about these dangers. Does that mean there was a collective failure?

Krugman is correct in noting that macroeconomics stagnated between 1985 and 2007 because we were in the period of great moderation. Since there were limited shocks to the global economy there was little interest in answering and developing the vexing questions of macroeconomics. Why work on issues which may be of limited value given they have a low probability of occurring?

The unsatisfying theories of unemployment have been issues for macroeconomist for decades. Krugman notes the problem with current theory, but they are well known by most economists. These are the same issues that I was exposed to as a grad student in the early 1980's. This was one of the reasons for the ongoing pursuit of micro foundations for macroeconomics.

The problem of efficient markets have been well-know and the idea that behavior financial is useful is not surprising. So where is the failure? Yes, a neat answer has not been found to explain macroeconomics but that is not failure but the pursuit of science.

What is so surprising about this current crisis? It is a banking crisis and they are hard to manage from just adding liquidity. Banking crises take longer than normal recessions. The fact that financial firm balance sheets are in disarray means that normal monetary policy of just lowering rates will not work is not surprising. The fact that financial firms are not lending when there balance sheet are in disarray is not surprising. The fact that financial firms and consumer believed there was a Greenspan put and acted rationally is not surprising. The excessive speculative behavior is a reaction to low interest rates and excessive liquidity from the early 2000 Greenspan era. The failure of certain financial institutions which have lead the investors into a environment that is truly uncertainty has caused a flight top quality. This is not surprising. The fact that savings was too low during the great moderation and now consumers are saving more and not spending tax cuts is not surprising. So where is the failure? Why would we expect that excessive behavior for the last few years will now be reversed in a matter of months?

The failure of current macroeconomics is with patience. After setting behavior for a period of years, it will take some time for investor and consumer behavior to change once again. The failure of policy markets is that they want the same level of immediacy that consumers wanted from their earlier spending binge. It cannot happen and we already know that.

Money market funds still relatively stable

Looking at money market fund flows will tell us something about what consumers and business are doing with their cash. The answer seem to be - not much. The money short-term funds is stil higher than last Fall. We peaked at the end of the year. There has been some decline bu tthere is not a lot of risk taking as evidenced by these numbers. This means there is a lot of cash to push stocks higher if investors have a change in risk taking..

Dollars in money market funds have declined by over $300 billion with most of that coming from government funds. The non-government funds have stayed stable. This would make sense that risk taking would first occur with funds from the least risky assets which have the lowest yield. However this is a just a transfer inot other short-term assets. A real rally would see money moving into longer term assets and out of cash.

There was good news beyond the employment numbers

Yes the unemployment number is at 9.7% and we still lost 200,000 jobs this month but there was some good news. The average hourly earnings was up.3 and up 2.6% YOY. If earnings are up, there is the potential for future spending and improvement of consumer balance sheets. This is no consolation for the unemployed but it is a brightening spot. The earnings decline is still in place, we were at 3.9 YOY at the end of the year but the monthly numbers are looking better. These numbers are consistent with the good productivity numbers. Firms are cutting back workers but having them earn more and work harder.

A recovery is taking hold. What type is less clear. Firms have been slashing inventories and workers to get lean. It would seem that they believe a "new normal" theory and want to cut costs as fast as possible. No we wait for the demand.

What happens when the music stops in China

Bank of China Ltd., the nation’s third-largest by assets, plans to slow credit growth in the second half of the year and improve loan quality after posting an unexpected profit gain in the second quarter.

…Lending in the second half will be “much smaller,” with new credit in July and August dropping from the monthly averages of the first half, President Li Lihui told reporters yesterday.

Monday saw a large decline in the China equities market which capped the monthly decline to seven percent. The reason was straightforward given the report on Bloomberg last Friday. Credit will slow in the second half of the year, so the equity bubble started to pop. What will happen to the rest of the world if central banks do not supply the credit? We need to know whether the current economic upswing is a function of credit expansion or end demand. Right now consumer behavior is still the key to future market advances.