Sunday, February 27, 2011
The New York Times produces a good graphic on the relative dynamics of oil and gas. They are both in the energy markets but they represent very different supply and demand dynamics. Oil is global market which has strengthened on the demand from developing countries while the natural gas market is more localized and will be effected by relative supply within a region.
Willem Buiter, chief economist of Citibank has constructed a "3G index" to measure economic progress; 3G stands for "Global Growth Generators" and is a weighted average of six growth drivers that the Citigroup economists consider important:
- A measure of domestic saving/ investment
- A measure of demographic prospects
- A measure of health
- A measure of education
- A measure of the quality of institutions and policies
- A measure of trade openness
Using that index the nations to watch over the coming years are Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, the Philippines, Sri Lanka and Vietnam.
It is interesting that there are no G10 countries in this list. Nothing from Eastern Europe. One oil country from Africa and no Latin American countries. The real issue is what policies are necessary to become a 3G country? Clearly all of the above countries are headed in the tight direction, but it is less clear how stable are those trajectories.
Friday, February 25, 2011
Former Vice Chairman Kohn at a UofC monetary policy conference:
A global increase in commodity prices is “an adverse thing for the economy,” Kohn said. “It makes the monetary policy process more difficult.”However, “if those inflation expectations can remain anchored, it doesn’t really require the kind of response that some people are calling for.”
The issue is the link between inflation expectations and commodity prices. The Fed views food and energy as exogenous shocks or relative value shocks. Hence, policy should not be swayed by increases in food prices. In reality, higher food prices may cause general price expectations to increase. Similarly, a price increase in energy may cause a drag on the economy which may force the Fed to monetize to spur growth. Again, inflationary expectations may increase.
If the market expects the Fed to stay more accomodative, then the result will be more accomodative. The unemployment rate would decline and core inflation would go up but this would all be good.
Wednesday, February 23, 2011
US core inflation rates are well below the 2% target even with recent increases. The PCE index of inflation, the Fed's choice, is below the 2% target. Headline inflation is also below the 2% target. Inflationary expectations are moving higher but still not in any danger zone. 10-year break even inflationary expectations are at 2.29 from a low of 1.5% at the end of August. Hence, the policy approach is going to be status quo.
The latest Fed comments are that core inflation expectations and reality will stay low. Do not worry, there will be no inflation. Yet, the result of the world is starting to think differently.
Tuesday, February 22, 2011
Baring Asset Management –
If, as central bankers say, it is the exogenous factors, such as commodities and food, that are driving inflation higher, the ones that they cannot control, then it makes sense to get exposure to them.”
This is an interesting argument for commodity exposure but makes sense. If the commodity prices will always be independent of central ban action, it would seem that this is the area of most potential risk. Obviously, if the central bank wants to generate inflation, then inflation linked bonds would be a better option. However, governments actually control the measurement of inflation.
The supply of inflation linked bonds have increases substantially over the last five years with the size doubling in France, UK and the US, but the size of deficits have increased even more so the relative importance of inflation linked bonds may have diminished in many countries.
Governments may not want to stop the issuance because that will send a clear signal to the market that inflation is going higher, but they really do not want to index all of their debt to inflation rates which are headed higher. Certainly inflation rates are near their lows in many G10 countries and have trended higher.
Inflation linked bonds have not been a great deal for investors because real rates have moved into negative territory. Paying the government to hold your money when they also may control inflation is not something that seems to be a good trade.Currently 5 year TIPS in the US are trading at -.28 yields The 10-year TIP is positive at 1.13 percent.
So how can investors escape the inflation cycle? An investment in commodities may serve as a useful addition to portfolios.There will be a price gain from the movement in commodities with a cash return based on the investment in futures.
Monday, February 21, 2011
Great graphic on inflation from the Wall Street Journal. This graphic provides information on the inflation each month for every economy and color codes the inflation by its intensity. Included is the url for using the interactive tool. It sends a clear message on which countries are facing higher inflation.
The global food and farming futures study came out last month and it is fairly pessimistic about the chance for cheap food around the world over the next few decades. It argues that an agricultural revolution is needed to feed the almost 9 billion people who will be on the planet in the next few years. There has to be "sustainable intensification" which will increase food production without hurting the environment.
There is no question that currently there is a major supply shock in many commodity markets but we have to realize that the real price of food has generally been declining for decades. Every time there is a sustained increase in prices does not mean that there will be a long-term shortfall in food.
These doomsday predictions are the traditional Malthusian approach to food analysis. We will run out of it if we are not too careful. Yet, it has not happened. Most of the famine in the world has been created by man-made events. The allocation process is the key to getting people feed not the long-term production. That being said, there has to be new innovation that will offset the fact that the cost of farming has increased and there is a shortage of land for farming. There will also be a shortfall in water. This means that food problems can only be solved if there is innovation to increase crop yields. Of course, innovation cannot be mandated through a simple policy.
Innovation is still one of the major mysteries of economics. R&D money will help and when prices increase the need and response of innovation will also increase, but it is not clear that ingenuity will arise spontaneously. Governments can help with research by allowing for the sharing of information on plant genetics. This is one area which cannot be lock-up through patent restrictions.
Looking at planting intentions and the clear backwardation of many commodity prices, there will be a increase in supply as a resposne to recent price gains. This will be a good first start to help in the short-run. In the long-run, governments can push policies that do not overuse commodities or restrict farm output.
While there has been talk about the emerging market inflation, all of the countries cannot be placed in the same bucket. The inflation rates across countries can be divided or conditioned on the output gap within the country. Those countries which have high output gaps generally do not have inflation worries while most countries which are facing high or increasing inflation rates do have strong output gaps. Countries which have some output gap and inflation worries are usually those with a commodity focus. Consistent with economic theory, those countries which have economic slack will have less price pressure.
The places to worry about inflation include the following:
Overheating economies - inflation and negative output gap -Argentina, China, South Korea, and Singapore
Inflation and no output gap - Brazil, India and Poland
Citigroup has develop a index of vulnerability to rising food prices which looks at the weight of food in the CPI index, a measure industrial capacity utilization and monetary looseness to measure the impact of food inflation on an economy. A high food component will mean that food will always be important to inflation. High capacity utilization means there is no output gap which means that higher food inflation can be translated into higher overall prices. Loose monetary policy always help to allow prices to move higher as buying increases from excess money.
China happens to top the list and provides ample reason for monetary tightening. Places like Russia and South Africa do not seem to have the same problems with food price increases.
The Economist had an interesting article concerning a new index from a UBS economist to check the inflation rates in the street versus official inflation numbers. Called the McFlation index, it looks at the price change of Big Macs around the world and compares against official inflation rates.
Now comparing one item against a basket is never a good way to check inflation statistics, but it does provide a nice universal measure of a good with multiple inputs. The data suggest that Argentina and Brazil inflation is much higher than measured by official numbers while Russia and Indonesia may have over-reported the inflation rate over the last ten years.
This is not a good measure to make any inflation bets, but it does focus on a simple good traded all around the world. Food costs have gone up in all countries so a general increase in meat would not bias the numbers. It is something to watch in the coming year to see if the Big Mac inflation index tells us more about relative inflation against official announcements.
Watch-out, the G20 has noticed there is a food problem with higher prices so that means that they want to do something. With commodity prices reaching near highs of 2008, there is a growing concern that governments should act to allay the increase in prices. There has been a rise in hunger and political instability in many developing countries so the governments should do something instead of just letting market forces work.
French president Sarkozy is placing food security at the top of the G20 agenda; however, some of the blame of any food crisis should be associated with the current agricultural policies of the G20. In 2009 at the L’Aquila summit, the G20 promised $22 billion in financial support to third world countries including a special fund called Global Agriculture and Food Security Program. Only $350 mm has been received for this program. Just stop with the money promises that cannot be kept.
If you want to solve a shortfall in corn, stop subsidies for ethanol. Stop subsidies to inefficient production in the EU. Stop policies that stilt production in third world countries through developed market import restrictions. Allow for more genetic crop production, or at least let the science try and improve crop yields.
Regulation of agricultural markets cannot be a substitute for production. Allow markets to allocate funds through reduced interference in agricultural markets. It is not what policy-makers want to hear, but it is worth a try.
Emerging market stock indices have been on a decline since November. For some these markets have lost their luster, yet growth in the emerging markets should well top the growth in the developed markets. Does this make sense?
This is where the inflation story in emerging markets is useful. Many emerging market central banks have started to raise rates in an effort to stop inflation. For example, the India central bank has increased rates seven times since March in order to cool the economy. The impact on stock prices is being felt. Until it is viewed that central banks have some control over emerging market inflation, we will see weak equity markets. The weak inflation in G1o countries with continued easing monetary policy seems to be more attractive to global equity investors.
The Economist Buttonwood column has a nice story on savings and equity markets from research done by Barclays Capital. We know that savings will have a key impact on equity markets. You need more savings to provide flows to invest in order to get equity markets to go higher. What Barclays found and what is consistent with research on equity risk premia is that relative savings may be the key ingredient for driving equity markets.
In particular, the ratio of young and old investors relative to middle age will determine long cycles in equities. When there is a skew to younger or retiree age groups as a percent of the population there will be less savings. This would be the 25-34 age group and those over 65. As the population of the 34-54 age group increases, there will be an increase in savings and more money invested in the stock market.
The demographics run against the US stock market because the number of retires will be increasing. The young will also be increasing. Hence there will be demographic headwinds against the stock market. Note that this same demographic headwind will have an impact on the global savings glut. Many of the emerging markets have young populations which will be spending money and not savings.
Ben Bernanke's November speech led to a second round of equity gains. The first round came with announcement of QE2 in August. This equity rally will continue until there is a new vision on monetary policy.
“…Higher stock prices will boost consumer wealth and help increase confidence, which will also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion…”
Bernanke is following a Greenspan playbook of using financial markets to gain a wealth effect. The wealth effect has not been viewed as very strong but it seems to be one of the key tenants of current monetary policy.
The stocks markets should make most investors nervous. In spite of nice gains since August, investors should be unsettled by the increases in equity prices. First, valuations look like they are high as measured by the Robert Shiller cyclically-adjusted P/E ratios. Second, there is a disconnect between central bank behavior and the robust gains in equities. Low interest rates are necessary to help fragile economies, yet if economies are fragile we should not need low rates. Low rates which help equities may not be a positive sign for long-term gains; nevertheless, as long as the Fed signals that it wants to get financial asset prices higher you have to be part of the wave.
Understanding the difference in real versus nominal exchange rate changes is a key concept in currency economics. It should be the case that real exchange rate appreciation will change the competitiveness of goods and will affect the balance of payments. An increase in the real rate should lead to a decline in the trade surplus. Nevertheless, empirical research by Chinn and Wei has found that there is little link between flexible exchange rates and changes in the current account.
For all of the talk about fixed or controlled rates in China, there has been a clear appreciation in real terms. The Economist provides a nice graphic which shows that on a real basis, the Yuan has seen significant gains. The problem is that has not resulted in declines in the current account.
In real terms, the US and rest of the world may actually like for China to have higher inflation. If higher inflation leads to higher nominal wages, some of the costs will be past in export prices. This will make Chinese goods more expensive which will change the terms of trade. The effect will be the same as an increase in the exchange rate. Notably this effect will also export inflation to the rest of the world.
There are no easy answers with the China imbalance but we are heading in the right direction.
The G20 meeting provided some guidelines for tracking global imbalances but there was little coordination to solve the problem. See the complete text. The following provides the broad guidelines that were discussed. It includes everything possible for discussion on international finance.
While not targets, these indicative guidelines will be used to assess the following indicators: (i) public debt and fiscal deficits; and private savings rate and private debt (ii) and the external imbalance composed of the trade balance and net investment income flows and transfers, taking due consideration of exchange rate, fiscal, monetary and other policies.
As highlighted by a Goldman Sachs economist, “The number of potential indicators and measures references in these sentences reads like a concentrated summary of a textbook on international economics.”
Sunday, February 20, 2011
Friday, February 18, 2011
- 2007 – For the year, the gold-silver ratio averaged 51.
- 1991 – When silver hit its lows, the ratio peaked at 100.
- 1980 – At the time of the last great surge in gold and silver, the ratio stood at 17.
- End of 19th Century – The nearly universal, fixed ratio of 15 came to a close with the end of the bi-metallism era.
- Roman Empire – The ratio was set at 12.
- 323 B.C. – The ratio stood at 12.5 upon the death of Alexander the Great.
This also means that the link between commodity prices and inflation will be stronger with emerging markets. Commodities will play a more important role as an inflation hedge in these countries.
Of course, the PBOC has stated that any changes are not the result of external pressure for appreciation.
PBOC governor Zhou Xiaochuan reiterated that Beijing would decide the pace of yuan appreciation on its own and would not take into account pressure from other countries. "External pressure has never been an important factor of consideration and we have never paid special attention to it," Zhou said in Paris at a G20 gathering of monetary policy heads.
Some have noted that yuan appreciation usually occurs around political events like the G20 meetings, major elections or summits.
Interestingly, some of the countries with the slowest growth in the EU have the highest inflation rates. The World Bank is now saying that rising food prices has pushed 44 million into extreme poverty.
All of this pressure may force more central banks to raise rates. We are seeing this occur in emerging markets, but the true global monetary tightening will begin when the G3 start to raise rates.
Wednesday, February 2, 2011
"Faced with the choice between changing one's mind and proving there is no need to do so, almost everyone gets busy on the proof." ~ John Kenneth Galbraith'I have done that', says my memory. 'I cannot have done that', says my pride, and remains inexorable. Eventually--memory yields. ~ Friedrich Nietzsche"Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes." ~ Jesse Livermore"Not choice, but habit rules the unreflecting herd." ~ William Wordsworth