Fed as a dis-inflation fighter

Under normal circumstances I consider close reading of the Fed statements about as useful as Bible exegesis. Important for the believers, but an utter waste of time for everybody else. The early August statement was, however, right up my alley as Fed clearly gave the hyperinflationists a cold shower:  the ballooning of Fed’s balance sheet is not leading to any kind of inflationary pressures as long as the excess capacity in the US (you could substitute that by “OECD” if you like) is at the highest in decades.

This time, Fed is back at the same issue. But in a way that the FOMC is now risking to paint itself into a corner.

Firstly, Fed does not expect dis-inflation. Instead they expect inflation to hit a bottom at roughly zero: “The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term”. We are talking price stability, not falling prices.

But the inflation is clearly too low: “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability”.

And what will Fed do about it? Nothing, at least for now: “The Committee (...) is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”

Let us recapitulate. Inflation is falling towards zero because growth is below par. As the output gap is not closing at a fast clip, deflationary forces remain strong. Over time, this gap will close, so inflation will come back to desired levels. And in the meantime, we will be ready to add liquidity to the economy in order to stave off disinflation.

But honestly, since households are still restrained by “tight credit” and businesses are investing but at a slower pace than last year, what is it exactly that the “additional accommodation” that may materialise should actually do.

We are still in a classical “liquidity trap”, the QE has saved the banking sector but has not materially contributed to the economic growth. And now Fed has promised us more in case dis-inflation continues.

I am afraid it is not enough. Deflationary pressures remain strong, and monetary policy will not contribute to closing the output gap, as long as we are in a liquidity trap. More demand is needed. Which Fed of course cannot control.

This is good news for bond holders. Not so for equity investors, but they seem to be blissfully insouciant of the underlying situation.

Price trends appear never to be able to make it to the headlines. Until it is too late, that is.

There is one investment conclusion possible: go short inflation protection.

Don't ask, don't tell

During the Great Depression, the world had a fixed exchange rate system, tied to the gold standard.  But then a number of smaller countries began to devalue their currencies. The purpose was obviously to obtain export advantages, since domestic demand was flatlined.

Given that domestic demand is still disappointing in many countries, we see that quite a number of (smaller) countries have provoked a depreciation of their currencies by flooding their markets with liquidity. Obviously, without a global fixed exchange rate system there is no longer talk about a round of competitive devaluations. It would be more correct to talk about competitive depreciations.

But whatever the label, the end result is that there are some countries that end up being the big losers in this game, since obviously we cannot all obtain an increase in export competitiveness at the same time.

While some smaller countries – Sweden is a good example – have had an enormous success with letting their currencies weaken dramatically in late 2008, it becomes more complicated when talk is about the major currencies, dollar, euro, and yen.

These economies are closed enough that management of the exchange rate is not a primary concern. Federal Reserve has often stated that they have no exchange rate policy for the dollar. ECB just wants a “strong and stable” EUR. USA and Europe have maintained a studied silence, even if the ECB (and the rest of the EU policy-making elite) feels that the EUR is way too strong against the USD.

Predictably, there were no objections from the ECB when the financial markets decided to sell EUR as a result of Greek trouble. With no inflationary pressures in the Euro-zone, a weaker EUR would exactly give the European economy a shot in the arm. And indeed, the Eurozone exporters have done very well as a consequence.

The story is slightly different when it comes to Japan. The country has been mired in a recession/deflation situation for nearly 2 decades. A direct consequence of a rapidly aging population and a stunning inability to make the right policy choices. JPY nevertheless started to strengthen in 2007, and has continued as everybody else introduced quantitative easing in order to revive economic growth. Since late 2007, JPY has gained some 40 per cent against a trade-weighted average of other currencies. Read that again, 40%! Not exactly doctor’s orders for an export driven country in order to pull out of a recession.

Recently, the Japanese government has begun to make all the right noises, rumours of a substantial (quantitative) easing of the monetary policy have been floating around and last week the BoJ finally decided to step in and intervene directly in the forex market.

Absurdly enough, this decision drew ire from many market participants. The Chairman of the Eurozone council sharply berated Japan for the unilateral intervention. Politicians of all colours were suitably “appalled”. Most of the FX market was in shock that Japan would do it alone. Personally, I have a hard time understanding the hoopla. Intervention to stop a currency from strengthening further after it has already gained significantly somehow appears to make good sense. Except of course if your competitors had more or less secretly hoped to profit from the rise of your currency.

And China drew its own conclusions. A spokesperson stated that China would never commit the same mistake as Japan, to let herself be pressured into an appreciation of the currency.

What can we learn from all this? That manoeuvering your currency in order to gain an export advantage is still very bad style. Unless you do it discretely. The Japanese did not. 

Banks to become less profitable

So, there they are, the new Basel rules for solvency. Effectively, the required capital base to run a bank will have to double over the next 8 years. Despite what industry representatives will tell you, it is good news for the rest of us. Let me explain.

In the past 20 years or so, the banks' importance in the economy has grown disproportionately, and the weight of the bank's stock in the stock market indices has followed.

Most of the explanation is that banks essentially have been very imaginative in influencing what could be counted as "capital base". As a result, the bank sector has been able to inflate their balances, and thereby increasing the return on the equity. As a consequence, banks have been highly profitable in the past.

The way banks operate has also had a tendency to allow them to increase loans when the economy was doing well. Conversely, they were quick to cut back lending activities once the economy was doing badly. By having this "procyclical" element, the banks have played a role in augmenting the volatility of the economy as a whole.

The crisis that began in the banking sector was to a large extent caused by the banks effectively increasing their leverage in the pursuit of a higher profitability. They did so by pushing the possibility of using their own investment products (mortgage loans, CDO) as part of their capital reserves. When that is a possibility, of course the banks could leverage their real capital harder and earn more money.

Obviously, when the sub-prime crisis started, many banks saw that a part of their reserves simply evaporatedand the banks became insolvent overnight. Since they did not have detailed knowledge of how bad the situation was at the neighbour's, they stopped lending to each other. The rest is history.

I wrote more than a year ago that one element in the Big Cleanout would be stricter capital rules. That is exactly what we are getting now. Unless the banking industry manages to lobby significant changes to be introduced between now and 2018 when the rules are fully implemented, it will mean that the profitability of the banking sector will trend downwards over the coming years. Probably it will also mean that the finance sector will end up weighing less in the stock market indices.

In my book, it is all good news. Of course we all need an effective solid banking sector. Increasing the capital reserve will only contribute to that. Tightening the rules for what can be counted as capital will also be positive. Reducing the banks' possibilities of using the capital reserves to play the financial markets will not be a negative influence on their lending activities.

Banking industry representatives have already been out there telling that the new rules will "delay the recovery". Excuse me! For new rules that are implemented in 2018?? In the past year, at a time of record profits and government guarantees, the banks have not resumed lending but have preferred to place their liquidity reserves with the central banks and play the bond market yield curve as best they could.

The risk willingness of the sector has shrunk dramatically in the recent past, and leads to yet another bout of behaviour that holds the rest of the economy hostage. This time it delays the recovery.

The banking sector as a whole had demonstrated its greed-driven incompetence beyond any reasonable doubt in the past two years. So when regulators now tighten up the rules, it is in order to protect the rest of us from a yet another repeat performance. That implies reducing that bank balances and increasing the capital reserve requirements. Time for the banking sector to go back to work.

Judging deflation risk

Are you afraid of deflation? Probably not, and for two reasons. One is that we have not had any experience with deflation for more than 70 years. The other is that because of this time distance, we have no real experience in estimating the conditions under which deflation will prevail.

For many years, the dominant way of thinking was that inflation is purely a monetary phenomenon. If the central bank for some reason "prints too many bank notes", we will end up with "too much money chasing too little goods" and that will force up prices.

However, this simplistic theory ignores another fact, that when increased demand can be met quickly by increasing output, no inflationary pressures will emerge. Only when production cannot keep up with demand, the foundation for inflation is laid. Several institutions, eg. OECD, regularly publish an estimation for how much extra capacity the economy has available. It is commonly referred to as the "Output Gap". For many years, this gap has comfortably been around 2 percent.

In 2008, the Western world saw the fastest contraction of output ever seen. My perception is that Cisco-style production and inventory management combined with a carpet bombing of media coverage of the bank crisis created an extraordinary fear in business managers. As a result, orders were cancelled, inventories were slashed, investment plans were binned, all at a pace never seen before. It is probably fair to assume that managers still have a tendency to act quickly in case of bad news.

As a result, the Western world today has the largest output gap on record. Probably, the economies could increase output by 5-7% before reaching capacity. Add that despite the downturn, the technological progress continues, adding quite a bit every year through new technologies and work routines.

And here we come to the real problem. Despite the economic recovery seen over the past 12 months, the growth speed has not been enough to significant reduce the output gap. It means that despite economic growth, the deflationary pressures remain. On top of that, the intense price competition from Asia continues as strong as ever.

Add now that economic growth is slowing. In the US and the UK, it is a structural phenomenon, as households continue to repair and reduce their balance sheets, killing the much-hoped-for recovery in private sector demand and will continue to do so for the next 4-5 years. Elsewhere, the slowdown appears to be a combination of premature austerity programs and a regular "mid-cycle" slowing of growth.

I do not (yet) subscribe to the double dip view. But the fact that the economic growth is anaemic is enough for the Output Gap to remain wide open. In other words, there is nothing out there that can counter the deflationary forces of having a huge output gap for an extensive period of time. If it continues we will enter a period of negative inflation sometime in 2011

Oddly enough, only the bond markets have reacted rationally to the situation. And they have only reacted to the ever-falling inflation, not to the expectation of a lower future inflation. The stock market has not yet eyed the risk. Caveat emptor.