Will Bernanke steal the punch bowl any time soon?

Remarks by US Federal Reserve Chairman Ben Bernanke regarding the return to more normal monetary policy are quoted widely today. Apparently, quite a number of pundits interpret his remarks as yet another indication that Federal Reserve will begin to tighten monetary policy "soon". Bernanke was thus taken as a character witness for the many strategists who believes that NOW is the time to sell stocks.

I profess to have great respect for seasoned "Fed Watchers", who have deep knowledge of monetary policy and of the political games around the Federal Reserve. Their insights are invaluable when it comes to understanding the current policy situation. Unfortunately, these market professionals had taken a day off yesterday and left the scene to rather more lightweight commentators.

In fact, Bernanke said the following: "My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road". This could have been taken right out of any of his speeches of the past two months or so. There is nothing new in his statement, and no reason to spill tons of ink because of it.

Bernanke marked right from his inauguration a change from his often Delphic predecessor Alan Greenspan. Whereas Greenspan according to his memoir took pride in making statements so convoluted that US lawmakers did not know what he really meant, Bernanke believes in straight talking. With the exception of the onset of the financial crisis where then-secretary of the treasury Hank Paulson did all the talking, Bernanke has indeed mostly been clear in his statements.

Even if Bernanke is a straight talker, he is, however, also a part of the political game. It makes it so much easier to interpret his statements. There is a simple rule that one can apply. It goes something like: If you take a given statement and wonder what it means, try and negate it. If what comes out is meaningless nonsense, then the original statement is simply idle talk. Let us try this on the quote above. The last phrase would then turn into

At some point, however, as economic recovery takes hold, we will NOT need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

Now that would be something. A central bank director stating that he will do nothing to fight inflation? He would be without a job faster than you can say "Federal Open Market Committee".

Try and use this simple principle in other situations. It is a very strong tool to identify idle talk, statements made simply because they have to be made, no matter how obvious they are. It will free up time and energy to focus on what is really important, namely to identify the many elements that together will mark the real turn of the monetary policy. Do not worry too much about Bernanke's various statements. When he wants to make himself heard because he has something to tell the markets, he will do so.

And by the way, no, the punch bowl will not be moved right now. US monetary policy will remain accommodating at least through this quarter and quite possibly through 2010Q1 as well.

The dollar’s days are numbered, or...

A couple of days ago, UK daily "The Independent" published an article according to which a group of countries, most notably China, Russia, Japan, France, Saudi Arabia and some other Arab states have secretly met and discussed to replace the USD as the main trading currency for oil. Instead they would be interested in using a basket of currencies and to phase it in over a period of nine years.

Predictably, this information created some buzz in the financial markets: are the dollar's days numbered? In response to such talk, the value of the USD fell immediately. It did not immediately recover, and now a couple of days after the event it all looks like an episode in the dollar's weakening trend which has been in place for some months. In this time perspective, the newspaper articles probably have little importance as they do not affect the actual business cycle trends. USA has repeatedly in the past months proven to be lagging the rest of the world in recovering after the downturn. Since many investors had managed to convince themselves that the US would lead the rest of the world back to economic growth, the current situation has created some turmoil. The reaction to the newspaper article was just another example of how the market selects news that fit in with the current thinking.

Yet, the reported meeting has quite an importance for the longer term prospective for the dollar, say, for the next 10 years or so. The reported story about the decline of the dollar is not new, however, except in the degree of details that have emerged, and that it in itself is worrying enough. Led by China, several large and influential countries are openly challenging one of the pillars of the dollar system put in place after WWII. By placing the dollar as the world's reserve currency, USA helped the world economy to pull out of devastations of the war – and granted herself enormous powers of leverage over the rest of the world.

In economic terms, this dominance has for more than 50 years given the USA more leeway to conduct irresponsible economic policies than would otherwise have been the case. The Reagan-Bush era was a first indication of what were to come. The Clinton years were characterised by relatively prudent economic policies that almost balanced the current account deficit, before the George W Bush administration let go completely.

This situation has worried quite a number of observers. The U.S. government's budget deficit together with the current account gap represent "unsound underpinnings" in an otherwise "good" economic landscape, Already in 2006, Robert Rubin, chairman of Citigroup Inc.'s executive committee and former Treasury Secretary in President Bill Clinton's administration, said the following in an interview:

"At some point, these kinds of deficits are not viable," Rubin said. "The probabilities are extremely high that if we don't address these imbalances, then at some point, and it could be years down the road, we'll pay a very big price."

That price is obvious now. After years of living above its means, the US is now losing economic influence, and it is symbolised by the moves by the countries mentioned above to reduce the role of the dollar in trading oil. It is more than a symbolical move. The US has used the fact that oil is traded in dollar as a means to exert influence over the oil producing countries and no single move could do more to undermine the dollar's position as a reserve currency. In other words, the threat to the US economic world dominance is utterly real. Apart from being the result of failed economic policies, it is also a move that will happen as the fast growth of the Asian economies will reduce significantly the relative weight of the USA in the world economy.

The problem is what US policy makers can do. The answer is: very little. Gone are the days where US military power could be used to impose certain policies on reticent states. Posturing angrily would only have negative effects. So apart from some shrill comments from commentators from the more silly part of the right-wing establishment, US officials have wisely kept shtumm. Expect to see a wave of comments trying to persuade us that the US administration is really happy at the current levels of the USD. Such comments will change nothing on neither short nor long term.

Australia hikes interest rates

Overnight, the Royal Bank of Australia hiked its money market rate from 3% to 3.25%. This action is being hailed worldwide as a first sign we are moving out of the deep global recession. Some economists even profess to be surprised that the move came now and not in 4 weeks. Apart from the fact that Israel hiked rates already on 24 August, the question is whether RBA's move signals the turning point for anything at all.

We all know that interest rates eventually will go back up. Central banks do not continue rescue missions forever, particularly not as it becomes increasingly clear that the patient, i.e. the global economy, did in fact survive. Recently, there has been a lot of writing about the coming wave of monetary policy tightening and many pundits have concluded that given the interest rates will increase, the stock markets are overvalued, and the only reasonable thing to do is to SELL.

Well, maybe not quite. Yet, at least. It is true that the past weeks have seen some volatility in the stock markets that might give a first indication that the uptrend that began in March is running its course. But in all probability it is too early to panic.

There is no shortage of analyses pointing out that the economic recovery may well be a rather anaemic one, as several of the large economies are saddled with consumer debt that will block the way for a strong recovery. Instead we appear to be headed for a longer period of sub-par growth, as consumers are working to rebuild their balance sheets. This outlook appears to be close to a consensus by now.

Then there is what happened in the stock market. Far from being subject to a U-shaped or L-shaped recovery, the markets have seen a profit recovery that by some measure has been surprising. Obviously, there has been no help from the demand, so virtually all of the good news for the stock markets have come from the massive cost reductions that have taken place – and which were at the heart of the very steep fall in economic activity in Q4 of last year and Q1 of 2009.

As if on cue, companies worldwide cut orders, stocks and production capacity. And thereby they made the first moves to rebuild profitability and profitability did indeed come back almost with a vengeance. Stock markets reacted correctly and we have seen a 50%+ recovery.

And then to the 64 bn question: why would it continue? A 50% recovery after a 50% loss sums up to a 25% loss. Aren't the markets priced fairly for the slower economic growth ahead? Should we prepare for a setback? Probably not. Or maybe just not yet. There are two reasons for that.

One is that the Australian interest rate hike is obviously a signal, but it is no signal that the interest rates worldwide will now be pushed up in and the brakes put on. All indications from G20 and down are that central banks are in absolutely no hurry. And a finer point: the arsenal of weapons put in place by the central banks is so much wider than just interest rates. The term "Quantitative Easing" that was so in fashion long time ago – like last Monday – covers a number of initiatives to create liquidity and to bolster bank's balances. The QE will be phased out slowly before short term interest rates are hiked. It will be a relatively slow process and most market participants will not really notice until the monetary tightening is a reality. And only then the interest rates will begin to hike.

This scenario has not been lost on the bond markets, where the yield curves have steepened in anticipation of the policy changes.

The second reason is that as long as the liquidity boost is intact, investors will remain willing to take on more risk. In the time-honoured way of the financial markets, this implies that arguments will be sought and found that the markets can go higher. It is not that difficult: while cost reductions can restore profitability at a given activity level, they cannot provide for profit growth. Profit growth will in the medium term have to come from top-line growth. There is a possibility that the improved profitability from the cost reductions can carry the better results all the way until demand begins to show some life, probably sometime next year.

So yes, at some point in time this strong rally in the stock markets will end and for all the right reasons. The profit recovery will peter out, monetary policy will tighten, and the risk appetite will drop. It is probably just not now and the Australian rate hike has preciously little to do with it.

Ready to adjust your portfolio

Are you ready for the next piece of chocking news? The financial crisis is over. Well, maybe not quite, but I am pretty confident that the financial markets will beat this drum roll over the next weeks. The result is likely to be that the stock markets will run up further and that there will be significant moves in selected commodities. Oil has started and it will likely continue. Government bonds should technically suffer significantly, but probably will not, as they are subject to central bank manipulation at a historical scale.

All of this sums up to a change in the market sentiment. Governments and financial institutions across the world will latch on to it for reasons easy to understand. But the underlying situation has in fact not changed a lot since, say, the beginning of March.

True, over the past weeks we have seen the first signs of a slowing of the downwards momentum in the US economy. The rest of the world still has not yet seen such signs, but some good news could be in the offing in the coming weeks. Look out for the New Orders component in the ISM statistics and for rebounds in the property market as early indicators.

True, the US has more or less put a banking rescue plan in place. It is a terrible, expensive muddle, but it will eventually work. Yesterday's partial suspension of the Mark-to-Market rule by the FASB is another element in propping up the banks' balance sheets. It has now been replaced by a Mark-to-Whatever-You-Like rule for toxic assets which greatly helps the banks annointed as winners. European governments and banking regulators have also put in place a series of packages that will secure the survival of the banks. None of the plans have attacked the issue of expelling the boards and the CEO's responsible for the mess, so the same people will maintain their influence, once the party gets going again.

Quite significant stimulus packages have been introduced, USA, Germany and China are leading the pack, and some more may come from Europe. Over the past weeks, virtually all economic institutions with OECD in the lead have been revising downward their growth estimates for 2009 but expressed more optimism for 2010.

Last but not least, the stock market rally that began on March 9 has pushed past some important levels. At the beginning of March, the market rallied on a significant short squeeze, and optimism that the US plan to rescue banks would actually work. Since then the rally has been fed by investors who wanted to bring up their equity holdings, and now we are on the cusp of breaking out of the downtrend that has set the tone for the past many months. On top of that, remember the magical 9 months. That is the time the market is supposed to lead the real economy. It just forgot that in early 2007, but it surely has learnt from its own mistakes.

Of course we will now be persuaded to cheer up, things are not that bad. Most people still have their jobs, most houses will not be repossessed: Above all your country wants you! It wants you to start spending so demand for goods and services can grow. Your pension plan will recover.

I believe this rally still has some legs. Unfortunately there is no doubt that the foundation for the rally is not that strong – to say the least. Consumers still need to reduce their debts across the world. The CDS bubble is still out there. So are resets on the US mortgage loans. France, Italy, Spain have not done a lot for their national economies. Eastern Europe is still a mess. Long term interest rates will have to go up worldwide and the Euro-zone will have to come to grips with the fact that the Euro has been the victim of "competitive depreciations" and will eventually have to weaken. Government deficits will have to be curtailed. Banks are still not lending.

In other words, not a lot has changed, except for the subjective perception of risk. But for now, that is not really important. It will be important later.

A true capitalist solution to the banking crisis

In an interview in the London Financial Times, former Federal Reserve Chairman Alan Greenspan has made a stunning turnaround: he now believes that a temporary nationalisation of significant portions of the US banking sector is required.

Well, one could be sarcastic about those words coming from a man whose near-religious beliefs in the self-regulating forces of capitalism led him to introduce still more lax standards of regulation and work for the same to happen across the world. But strangely enough, aged 83, he appears to be faster on the button than many of his younger students.

Of course what leads Greenspan to this 180 degree turn is that despite mind-numbing amounts having already been thrown at banks have not had the desired effect. Bank lending remains seriously constrained, the banks are notoriously unwilling to come out and be honest about the correct amount of losses, and, most provoking of all, bankers appear to believe they still deserve bonuses. Even if the funds come from the tax payers.

Banks have no incentive to be honest
The key here is that the banks are still not honest about the real amount of losses. There are probably two reasons for that. One is that they do not know, since now where the economic downturn is hitting the loan books, it is a difficult call to guess delinquency rates in the near future. Except of course that credit losses will begin to mount in the coming months. The other is that there is a stand-off between the banking sector and the US lawmakers. By proxy, the outcome of this standoff will probably set the standard for what will happen elsewhere.

Banks of course hope to receive a maximum amount of cash while to the fullest extent trying to avoid limitations to their activities. Lawmakers have been struggling to find various models to avoid that banks receiving cash injections spend the received money in unwanted ways. Hence the suggestions that in order to receive more money, the banks should comply with certain rules.

This situation is not to be understood in the terms of bankers being immoral (which may indeed be the case), but in terms of banks being competitive entities trying to maximise their long term survival and profits. Their strategies are obviously determined by the existing playing field. In this case the playing field is determined by the models for rescue being discussed.

Getting out of the pinch
Being a bit crude, there are three ways out of the current stalemate. Two are being mulled over again and again in these weeks all over the world. One is to create a government-sponsored bad bank which will buy the bad assets off the banks, who after this cleaning will have much healthier balance sheets and hence can go back to their intended activity, namely taking deposits and giving credits. Another is to recapitalise the banks and issue a guarantee for their bad assets.

In both cases the banks will have an interest in receiving a maximum amount of money for their bad assets, as this will position them favourably for the titanic struggle for dominance which will break out once the downturn ends. So either the government will overpay for bad assets or issue too large guarantees while being in a situation that they will have to continue pouring money into the banks as credit losses mount. We have already seen the effects of lining up the choices this way. In the US banks have received some €350bn in help and it is fair to say that this amount has not helped at all. The banks are not saying it openly, but a lot more money is needed if the banks are to be rescued. In the UK, where we are bit further down the road than in the US, nationalisation is creeping in as losses mount.

For buffs, it is a simple game theoretic situation where the banks hope to maximise their pay-off (at the expense of tax payers) by not supplying the correct information to the public. A sort of "Liar's Poker" if you want....

Given this situation, it is surprising that politicians are not discussing the third option right away: a temporary nationalisation. Sweden set a precedent for that in the early '90s, where the banks had got themselves in a pinch by excessive lending to the property sector. Banks were simply taken over, management and boards were kicked out, bad assets lifted off the balance sheets and sold off in the market a few years in a bundle. After some years, the banks were again sold in the market, and actually, Swedish tax payers appear to have made a small profit on the whole transaction. In the meantime, it did not really matter at what price the bad assets were evaluated or indeed how the balance sheet of the banks looked, since it all was part of the government balances.

A capitalist model
But this sounds as pure socialism, so for sure it should not be used as a model?? Think again. The Swedish model is in fact more conforming to the market than any of the models currently being discussed in the US or elsewhere.

If you own a substantial part of a business, but do not put in place a board who controls the management properly and act in your interests, you may lose the business and with it of course the money invested initially. If you do it right, you win. If you screw up, you lose. Nothing could be more capitalist. But strangely enough, this principle is apparently not popular when it comes to the banks across the world right now.

Instead the owners (i.e. the shareholders), who have not put in efficient oversight, and who have permitted the management to run the banks into the ground, now argue that taxpayers should compensate them for lack of business success? This is more socialist than to let the banks fall and let shareholders, board and management pay for their follies.

Apart from being yet another sign of the monumental greed and talent for self preservation rampant among bank managements, arguing that the taxpayers should bail out the banks is based on a serious misunderstanding of what needs to be saved and what is not really necessary.

The Swedish politicians were very clear that what needed to be saved were not the individual banks, but a banking system that would be able to act as the all-important intermediary between savers and borrowers. And that will not work without confidence and a high degree of transparency. They created that by acting swiftly and radically.

A lot of banking activities are nice to have, but definitely not "need to have". Securitisation of dud mortgage loans is an example of something we could do without. Or totally unregulated credit default swaps, to name another.

In the current situation, every bank across the world knows that the next competitor is economical with the truth. So the entire banking system, despite astronomical amounts already spent, is still not in a situation to resume normal lending activities.

Meanwhile the world economy is contracting at a disturbing phase. Every major financial institution has postponed the end of the downturn to 2010. Banks will begin to see serious losses on normal commercial loans in a few months.

The quicker we progress towards the true capitalist solution, and nationalise the banks, the better.

It is still downhill from here

IMF's most recent revision of the global growth estimate came as a surprise to many. However, it was largely in line with our position in December – namely that the market consensus regarding economic growth in 2009 was way too optimistic. IMF has now confirmed this view with a strong downwards revision of the global growth from the previously expected 2.2% to 0.5%. We believe that this view will have to be revised downwards once again.

There were, however, several interesting points. One is that the UK economy is now considered basketcase #1 in the industrialised world. Household debts to mortgage institutions (-banks) and credit card companies are worse than is the case in the US. The housing market is probably even more inflated than elsewhere, and adding insult to injury, both current account and public sector were heavily in deficit as the crisis struck. Forecasting a contraction of 2.8% in 2009 still appears a bit on the positive side, but rightfully places UK among the hardest hit economies.

The forecast for USA of a modest 1.6% negative growth in 2009 followed by positive growth of the same magnitude in 2010, however, indicates some kind of heavy meddling from political circles. A number of respected US economists have estimated that the accumulated contraction in output would end up anywhere between 5 and 10% over a three year period. We know that 3^rd quarter 2008 was bad for the US economy and that 4^th quarter was even worse. But probably they did not add up to anything that would bring the combined fall in output anywhere near 5% in 2008 and 2009. US consumers have already redressed their savings rate considerably, as fears for the future have driven many away from spending on holidays, new cars and so on. But it is not enough to save the economy from a severe downturn. The overhang of bad debt is worse than in the UK, so even a hike in households' savings rates, a period of sub-par growth is highly likely.

Germany also finds a place among the laggards, with an expected contraction in output of no less than 2.5% per cent in 2009 and almost zero in 2010. Main driver for this collapse is of course the exports, which are being hit hard by the rapidly shrinking international trade flows.

China and other east Asian nations have been held out by many as the best hope for a growth pole, able to pull the global economy. This idea is also being reviewed now, and the result is not nice. China and India will both see significant slowing in 2009. Even if the growth numbers for these countries are dodgy, the hope that the domestic demand in those two countries would "replace" falling consumption in the developed economies is now off the table.

While all of this is interesting, there are a couple of things that deserve mention. The noble art of making growth forecasts always implies making a number of heroic assumptions regarding the behaviour of governments and other background variables. In this case, these variables deserve some extra assumptions. IMF is in commendably clear about some background variables. It assumes that political efforts to solve the banking crisis will eventually bear fruit. And that the various stimulus packages in fact arrive on time and have the desired effects on domestic demand.

It is probably exactly on this point where the IMF report has its weakest point. For political reasons, IMF cannot at this point in time begin to publicly vent doubts that the various programmes or policy packages will not work. With the most recent near-panic in the UK banking sector and the slow deterioration of credits worldwide, it appears we are entering a phase where it will be clear that the good money so far thrown after the bad money will not have the desired effect. The stimulus packages so far are far from being enough to lift the economies out of the slump, but IMF cannot make a blanket criticism of the programs.

In this way, the IMF forecast is an important statement to politicians that things are continuing to go downhill, but as regards the actual forecasts it is very likely to be more politically correct than anything else.

Barack Obama – a one-term president?

About this time of the year 8 years ago I prophesised that George W Bush would live to regret having been elected president because of the impending downturn arriving hot on the heels of the Dot-com bubble. Of course it went differently, with W setting out for higher goals and leaving the economy to a Treasury Secretaries almost anonymous enough that they are already forgotten (O'Neill and Snow, just in case). In the Federal Reserve they were matched by a self-declared ideological crusader, who saw it as one of his life's missions to keep state intervention in the economy to a minimum in the belief that human greed would engender the necessary caution and stability in the markets.

In the aftermath of the Dot-Com bubble, Greenspan did what he had done in earlier cases of economic turmoil: he lowered the interest rates. However, in 2001 profound liberalisations had been introduced by the Clinton administration. And everybody went on a lending or borrowing spree. In the US, the accumulation of debt relative to GDP rose to an all time high. And then last summer, this bubble also burst. George W had in the meantime replaced John Snow in the Treasury by Henry (Hank) Paulson. A former star athlete, White House insider, and Government Sachs CEO, Paulson demonstrated great energy in his attempts to avert the crisis.

As Barack Obama was sworn in as the 44^th President of the United States, the economic crisis was as deep as ever, and worsening. Judged by early data, the US economy could have shrunk by as much as 5 per cent annualised in the last quarter of 2008. Lay-offs continue faster than any time since World War II. World trade is nosediving, hitting a nascent American export boom. The economy needs between $850bn and $1000bn as a stimulus package, and counting for every day. Paulson's ill-formulated TARP programme to salvage the US banking system is gradually proving as ineffectual as critics believed it would be, while largely leaving untouched the very individuals who were responsible for reckless lending and underwriting activities. Abroad – in the export markets - things have not been much better with demand falling off a cliff.

Obviously, the markets are looking to Obama and his team to take decisive action. I am just afraid that they may be too optimistic. Obama and his team are probably fully aware that they need to take painful action now in order for it to be forgotten when re-election is up in 2012. There is just a snag here. This crisis is no normal bump-in-the-well-paved road economic crisis. The root lies with what one could call the American Way of Lending. And it will take a while to fix.

Let me be precise about the use of words here. By American Way of Lending I refer to a culture of easy credit, lax regulatory standards, banks underwriting securities instead of lending, generous rules for personal bankruptcies, and so on. Roughly since the Reagan era, the US economy has been gradually liberalised. There is no doubt that the positive side of this that the US economy has been as vibrant and innovating as it is the case. But the negative side has been a household sector which has gradually – and over the time span of a whole generation – learnt the consume first and pay later. This culture, paired with a low-interest rate policy and financial innovation has created not only the biggest housing bubble in history. It has also created the biggest current account deficit in history.

I have on earlier occasions written that it takes time to get out of a situation like this. First, the households have to increase their savings rate. To pay off debts. Given that a lot of private debt is mortgage debt, and given that the employment situation will not improve until maybe sometime in 2010, many consumers will experience negative equity and perceive of their economic situation to be more insecure than just 6 months ago. This leads to an even sharper economic downturn. It is therefore unlikely that the US consumer will begin to consume at a rapid clip again until debts have been worked off and the negative equity have been removed. Other countries have made experiments with the same combination, and invariably it has taken a period of 4-5 years until the decks have been cleared. Typically, the economy shrinks sharply in the beginning of the period as the savings rate is pushed up, and the economy grows slower than potential for a while, because of a slow growth in private consumption.

Barack Obama was elected on a promise of change. Probably it was not supposed to be a change for the worse, economically speaking, and for a longer period of subpar economic growth. Bill Clinton famously beat George HW Bush on a simplistic "It's the economy, Stupid" message. For all his compelling rhetoric, I am afraid that Barack Obama in 2011 may find himself open to exactly the same criticism, as the economy may still be subdued. Even if he and his economics team arrive at just the right actions. Life is tough, but unfair...