Tim Duy's Fed Watch

ECB Still Not the White Knight

The Wall Street Journal has the story on today's speech by ECB President Mario Draghi:

The ECB's purchases of government bonds are "neither eternal, nor infinite," Mr. Draghi said in a speech in Berlin, stressing it would take "a lot" more than monetary-policy measures to restore market confidence in the euro zone.

Asked whether the ECB should copy the U.K. and U.S. in printing money to buy government bonds, a policy known as quantitative easing, Mr. Draghi said: "I don't see any evidence that quantitative easing leads to stellar economic performance" in those economies. EU treaties forbid monetary financing of government debt, he added.

This suggests Draghi believes quantitative easing should only be used if it delivers "stellar" economic performance.  This is depressing, not to mention severely misguided.  The appropriate metric should not be achieving a "stellar" economy, but what would have occurred in the absence of QE.  Hopefully, he will recognize this distinction should (when) the situation deteriorate further.

The combination of fiscal consolidation and ECB intransigence promises to keep the European crisis in the headlines for a long, long time.

Global Growth Struggles, Fed Stands Still

The news from Japan tonight:

Japanese business mood turned pessimistic in the three months to December, the central bank's tankan survey showed, a sign the stubbornly strong yen, Europe's debt crisis and slowing global growth were taking their toll on the export-reliant economy.

Earlier this week:

India's industrial production slid 5.1 percent in October, helping drive the rupee to a fresh record low against the dollar — more signs of the reversal of fortunes in Asia's third-largest economy.

The decline in output from a year earlier was driven by mining and manufacturing, as well as waning consumer demand and lackluster investment, according to government figures released Monday.

Another one, via Bloomberg:

Brazil’s real fell to a two-week low after data showed Latin America’s largest economy shrank for a third month in October...

..Brazil’s seasonally adjusted economic activity, a proxy for gross domestic product, fell 0.32 percent in October from the previous month, capping its longest contraction since the bankruptcy of Lehman Brothers Holdings Inc. in 2008, according to central bank data. The real fell along with other currencies of commodity-exporting countries such as the Australian dollar and South African rand after the Federal Reserve dashed some investors’ expectations yesterday for monetary easing.

And a depressing global outlook via the Financial Times:

Cargill has become the Dr Gloom of the commodities trading sector.

The Minnesota-based company was the first big trading house to warn about the economic slowdown; its latest quarterly results reflected a sharp drop year-on-year; and now it is firing 2,000 people due to the “continued weak global economy”.

This is no small matter: Cargill is at the centre of global trade, shipping commodities from wheat to beef, and the wide reach of its business network helps it anticipate changes in the economic cycle. Other top commodities trading houses – particularly Glencore and Noble Group – are, however, painting a much rosier outlook, offering a much more positive view both about the global economy and their businesses.

It is too early to say whether Cargill’s bearishness is justified. But it is worth noting that Cargill is a privately-owned company – still controlled by the MacMillan and Cargill families, descendants of the founders who set up the group in 1865 – so it does not feel obliged to put as brave a face on in a bad economic environment as its publicly-listed rivals...

..Back in September, Paul Conway, Cargill deputy chief executive, said that the company felt that global economic growth was “weak and weakening”. He said: “We are going through a long, slow, anaemic, tough recovery”. The statement over the weekend indicates that Cargill’s view has not changed at all, further pointing to a global economic slowdown. Mr Conway indicated back in September that the problem was that the economic slowdown was not only affecting the US and Europe, but was then already spreading to several Brics countries – Brazil, India and China.

In contrast to much of the globe, and despite Cargill's assertions, the United States is seen as weathering the storm, at least so far.  From the FOMC statement:

Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth.

The expectation is that the Fed's next move will be to alter its communication strategy at the January meeting.  Whether or not they gear up for another round of QE, this time via mortgage assets, remains dependent on the economy.  Since I tend to be cautious that the US can forever resist the global drag now firmly in place, I expect additional easing.  That said, I also believe the Fed will delay until the strains become more obvious, which may not be until deep into the first or second quarters of next year.  In other words, hopes that the Federal Reserve would jump in with QE3 to save financial markets from the European disastor were simply premature.  They should get ahead of this curve, in my opinion, but they won't.

For those that believe the Fed has the tools to stop another crisis in its tracks, FT Alphaville has some sobering news.  Covering a report by Lewis Alexander, formerly of the US Treasury and Federal Reserve, currenty Nomura Chief US economist, they spot a particularly disconcerting element of Frank-Dodd:

DFA expressly prohibits the Federal Reserve from using 13(3) to support individual institutions. The legislative record on this provision indicates that Congress’ intent was to rule out the sorts of interventions that the Federal Reserve implemented to support the sale of Bear Stearns to JP Morgan and the backstop that was provided to AIG...

...In particular, the Federal Reserve could not have supported the Bear Stearns transaction, the backstop for AIG would not have been possible, the guarantees provided by the TLGP program would have required Congressional approval, and the ring fences provided for assets owned by Citi and the Bank of America would not have been possible.

It is not inconceivable that another US institution gets pulled in the European economic vortex. It would be unfortunate if, should that institution be in fact too big or connected to fail, the Fed could not be a backstop to hold the system together.  While I think many of us were initially shocked by some of the Fed's actions, particularly salvaging AIG, in retrospect we realize it would have been a bad time to start playing moral hazrd games.  Note also the process of winding down a too big to fail firm is untested.  I have to admit that an orderly wind down during a crisis is something of a contradiction.  Immovable object meet irresistable force.  

Read the whole piece, and part I as well.  They are worth the time, although they leave me feeling despite the lessons of the past few years, we are less prepare than we think we are.

Bottom Line:  The global economy is hitting turbulence, just as the US data turns more sanguine.  Can this decoupling be sustained as Europe sinks deeper into recession?  I would like to think so, but remain very cautious that the US can escape without some significant cuts and bruises.  So far, the Fed remains in a holding position.  I expect them to stay there until more significant signs of economic distress emerge.

Europe Still Heading For Collapse

The half-life of the effectiveness of European summits is growing increasingly shorter.  While I have been a long-term Europessimist, market participants are more willing to trade on whatever appears to be positive news, thus markets jump whenever it appears the Europeans are taking action.  But eventually the game will wear thin as market participants increasingly realize European "solutions" are never more than half-measures intended to kick the can down the road another few months.

And the last summit was no exception.  The reality is quickly sinking in that, relative to the dimensions of the challenge, very little was really accomplished two weeks ago.  And very little will be accomplished until European leaders come to the realization that they continue to treat the symptoms of the disease, not the cause of the disease.  They need to find a mechanism to address Europe's internal imbalances that does not rely exclusively on deflation as a cure.  Alan Blinder provided the background in the Wall Street Journal:

All financial eyes are fixed on the euro. Europe's common currency actually has two gigantic problems. The debt and banking crisis hogs all the attention because of its immediacy, plus the high drama of all those summit meetings. But the other, slower-acting problem—lopsided competitiveness within the euro zone—is far more intractable.

Blinder sees three paths out of the resultant mess:

There are three ways for the other countries to close the gap with Germany—and remember, the gap is large. First, Germany can volunteer for higher inflation than its euro partners by, for example, implementing a large fiscal stimulus or ending its wage restraint. How do you say "ain't gonna happen" in German?

Second, the other countries can engineer German-like productivity miracles through structural reforms while Germany, relatively speaking, stands still. Good luck with that. And even if it somehow happens, the timing is all wrong. Reforms take years to bear fruit while financial markets count time in seconds.

Third, the other countries can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—and generally happens only in protracted recessions. Sadly, this may be the most likely way out.

The reality of Blinder's view - that option two will not work and option three is excessively painful - is revealed by the most recent IMF update on Greece.  From the report:

Meanwhile, since the fourth review, the economic situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity.

Really, this is a surprise to IMF economists?  Yet apparently, the IMF still believes that structural change is an immediate cure:

We recognize the need to reach a critical mass of reforms and reform synergies to jump-start growth. 

I like this - the IMF does not believe in "confidence" fairies; they believe in "synergy" fairies.  I keep kicking myself for missing the "synergy" fairy lecture in graduate school.  Apparently all the IMF economists made it to that lecture.

Of course, it is not their fault.  The IMF attempts to shift some of the blame onto the Greeks:

Structural reforms have not yet delivered expected results, in part due to a disconnect between legislation and implementation. 

While likely true, this is something of a red herring.  The long-term nature of reforms was no match for the pace of financial market developments, while the willingness of the population to accept externally-driven reforms is understandably lacking given the desire of the external agents to support ongoing recession.  Without more direct transfers and debt relief, the IMF, ECB, and EU continue to use more stick than carrort.  

Arguably, European policymakers might see the fundamental problem, but also recognize a real solution in years away.  Via the Financial Times:

Member states of the eurozone have set themselves on an “irreversible course towards a fiscal union” to underpin their common currency, even if it may take years to reach that goal, Angela Merkel, the German chancellor, told her parliament on Wednesday. 

Europe doesn't have years.  The vice of austerity packages will eventually crush to hard, and the cost of staying within the Euro will exceed the costs of exit.

Meanwhile, the ECB is at best having mixed results.  On one hand, recent actions appear to have stabilized government debt markets in Spain, Belgium, and France.  On the other, Italian yields have retraced much of their collapse.  Probably more importantly, however, stabilization of the banking crisis remains elusive.  From the Financial Times:

But, despite the central bank facilities, the cost of obtaining dollar funding in the private market continues to soar, pointing to a dollar funding squeeze as Europe’s banks head into their all-important year-end reporting period.

The three-month euro-US dollar basis swap dropped to as low as -150 basis points on Wednesday, meaning banks would have to pay an extra 1.5 per cent premium to swap their euros into dollars for a three-month period. The premium has not been persistently below the -140bps region since late 2008, during the depths of the financial crisis.

Not good, not good at all.  Also, the hopes that the ECB will provide an unlimited backstop for soveriegn debt now look to be premature at best.  Via the Wall Street Journal:

With many in Europe still hoping against hope that the European Central Bank will step in more aggressively to buy bonds and bring down borrowing costs for struggling governments, Jens Weidmann, the president of Germany's Bundesbank and member of the ECB governing council, indicated his opposition to that hadn't softened.

The idea that the ECB should turn on the printing presses to help finance some debt-ridden euro-zone states should be put to rest for good, Mr. Weidmann said. Central bank "independence is lost when monetary policy is tied to the wagon of fiscal policy and then loses control over prices," he said.

Some argue the ECB is just jawboning to drive a hard bargain when it comes to fiscal and structural reforms.  I am not so sure - these guys sound pretty serious to me.

And perhaps you thought the Fed would ride to the rescue.  Think again.  From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke told Republican senators the Fed plans no additional aid to European banks amid the region’s sovereign debt crisis, according to two lawmakers who attended the meeting.

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. Lindsey Graham, a South Carolina Republican, said Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks. Both senators spoke to reporters after leaving the one-hour session at the Capitol in Washington.

Simply put, the Fed is politically limited in what it can do for Europe. I don't see the hopes that the Fed could step in for the ECB being realized.  Moreover, US lawmakers will resist efforts to contribute more to the IMF to help Europe, especially if this is the general attitude:

Senator Charles Grassley, speaking after leaving the meeting with Bernanke, said excessive U.S. financial support may enable Europe to avoid enacting necessary measures in fiscal austerity.

“If there’s too much of an effort on the part of the United States to help Europe, it’s going to impede their fiscal changes that must be made,” Grassley, a Republican from Iowa, said to reporters.

The belief in fiscal austerity runs deep.  We need to teach those Europeans a lesson even if it means shooting ourselves in the foot.  Now, in all honesty, you really can't expect US taxpayers to offer much support to Europe when German taxpayers themselves are resistant.  Because I think that fundamentally Blinder is right on the appropriate cure to save the Euro. Germany needs to issue a massive amount of debt to support demand in Europe, even at the cost of higher relative inflation.  And, better yet, to support debt writedowns in the periphery.  The response from Germany:  Nein.  

Bottom Line:  I still don't see where this ends well.  Play the news cycle if you are so inclined, but keep one eye on the key issue.  Is Europe working to resolve their fundamental internal imbalances with anything other than deflation?  As long as the answer continues to be "no," be afraid.  Be very afraid.

A Mixed Bag From Europe

I find it somewhat hard to judge the merits of this week's developments in Europe.  Some positives, some negatives.  On net, though, I remain a Europessimist.  In my opinion, the issues of internal rebalancing remain completely ignored, and this will eventually doom the Euro if not addressed.

The European Central Bank moved forward with additional easing specifically intended to alleviate pressures in the banking system.  The breakdown in the interbank lending market threatened to create a Lehman-type event sooner than later, and that threat was receded with the ECB's extension of liquidity facilities and cutting in half reserve requirements for commercial banks.  The ECB also cut interest rates to 1%, with more cuts expected.

That said, the European financial system remains under pressure with continuing deleveraging and eventually more bank recapitalizations efforts needed.  The result will be a worsening of the European recession, an event that is only in its infancy.  And, as has been widely reported, ECB President Mario Draghi did not offer unlimited support for Eurozone sovereign debt, which was greeted with disappointment yesterday.  I think it is premature to expect such a commitment; they will only play that card as a very last measure.  

Overall, somewhat more aggressive than than I expected, and a clear indication that the ECB now realizes the depth of the Eurozone's financial problems.  So far, so good.  Yes, I would be happier with a clear statement that the ECB is the lender of last resort for European sovereign debt, but I just don't expect to hear this yet anyway.

In contrast, the Eurozone summit predictably failed to meet expectations.  The UK bowed out of the agreement, guaranteeing a lack of EU wide commitment.  At best you get the 17 Eurozone nations plus a few others to sign up.  This opens up the possibility of more EU ruptures  in the future.  The seal has been broken.  Second, as Felix Salmon points out, we have an agreement in principle, but ratification battles lie ahead:

 It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.

Many opportunities for national politics to blow this agreement apart in the weeks ahead.

As far as Eurozone crisis-management tools are concerned, we are simply still where we have always been - the wealthier nations of the Eurozone - largely Germany - continue to resist putting in the necessary capital to create effective crisis funds.  Moreover, the ECB appears to remain unwilling to lend the necessary money to rescue funds.  In the absence of internal support, Europe continues to look toward international support.  I still think this is ludicrous.  How much help should Europe really expect knowing that Germany is not willing to go all-in financially to save the Euro, and now that we know the UK is making a calculated bet that the Euro is already a doomed experiment?

Let's put aside the above concerns for a minute.  When all is said and done, I am still amazed that the outcome of this summit is being described as a move toward fiscal union.  It is not that - it is commitment to unified fiscal austerity, nothing more.  Consider just a strict enforcement of the 3% deficit ceiling in light of actual deficits in the EU.  Via NPR:

Just on the surface, it is tough to see any commitment to fiscal austerity as credible.  Germany itself exceeded the targets in 7 out of the past 11 years.  Talk about the pot calling the kettle black.  France missed 6 in the past 11 years.  And Italy 8 times.  Thus, in addition to the periphery nations, the biggest economies in the Eurozone will all need to increase government saving to meet these targets.

Such saving will be attempted in the context of a recession in which the private sector also will be increasing savings as well.  In other words, the public sector will be engaging in massive pro-cyclical fiscal policy as the recession intensifies.  You have to imagine the end result is a substantial deflationary environment.

In short, I think Europe is rushing full speed to a Japanese outcome, with slow growth coupled with an appreciating currency.  And it is that promise of slow growth and a strong currency will be what eventually tears the Eurozone apart.  And this is truly sad given that deficits are not really the problem to begin with.

Why will the Eurozone fail?  Because we still see nothing that addresses the internal imbalances between the core (largely Germany), and the periphery.  That is the result of failing to commit to a real fiscal union.  Such a union would include automatic internal fiscal transfers that are essential to maintaining regional economic stability.  For example, economic distress in a US state results in an automatic relative transfer of resources via decreased tax revenue from and increased transfer payments to that state.  Lacking such a mechanism, a slow growth, hard money regime will increasingly ratchet up the levels of economic distress in the periphery.  And eventually the costs of staying in the Euro will exceed the costs of exit.

If Europe was serious about saving the Euro, they would commit to issuing more safe assets (more sovereign debt), using the ECB backstop to create such assets, and engage in direct fiscal transfers to reduce economic pain in the periphery while encouraging continuing structural and budget reforms in recipient economies.  I don't think we are anywhere near such a plan - and are arguably moving in the opposite direction.

Bottom Line:  I remain a Europessimist.  The ECB is moving aggressively to preventing an imminent financial collapse.  That should be seen as good news.  But there remain unresolved deeper issues.   At the core of those issues is the inability to see Europe as one large, fiscal unified economy rather than a combination of separate, fiscally austere economies.  And in that remains the long-term vulnerability of the Euro experiment.

Demographic Shift?

Bloomberg appears to attribute the drop in the labor force participation rate to retiring baby-boomers:

The drop in U.S. unemployment so far this year may be an early glimpse of what’s to come as the workforce ages...

...At play is a decline in the share of the working-age population, known as the participation rate, meaning that the economy needs to create fewer jobs to bring down unemployment. While some of the decrease has been caused by discouraged workers dropping out of the labor force, another driver is that the baby-boom generation is starting to move into retirement, according to economist Dean Maki.

“Demographic forces are the single biggest factor pushing the participation rate down,” said Maki, chief U.S. economist at Barclays Capital Inc. in New York and a former economist at the Federal Reserve. “This is a bit of a slow-moving drama but it’s likely to become more important in coming years.”

I think it is important to focus on the "slow-moving drama" part, otherwise the problem with this story is the facts.  Labor force participation rates of the 65 and older group:

Note that labor force participation rates begin to rise at the end of the last decade, after the collapse of the internet bubble.  It seems that this event, not to mention the subsequent rise and fall of housing markets, played havoc with retirement plans.  Many who thought they could retiree suddenly realized they couldn't afford retirement, and were stuck working longer than anticipated. 

A little more support for Maki's case can be found in near-retirees:

I looks like labor force participation rates in this group might be topping out, but not enough to be the "single biggest factor" pushing rate down.  To get to that story, you need to go lower on the demographic ladder:

That looks like a pretty dramatic shift to me - 23 percentage points or so.  Too be sure, the intermediate group has also declined:

Given the wide range of ages in this group, it is difficult to apply all of the deterioration to the baby-boomers.  Looking across the data, we very much see young people fleeing the labor market.  To where?  Given the weak labor market this decade, the opportunity cost of education is low, and thus many are continuing their education.  Interestingly, Karl Smith looks at the data and concludes:

The United States is becoming more educated faster than the economy would absorb educated workers.

Presumably, this is good in the lon-run, as eventually those more educated workers will be absorbed by the labor market.  Here I would caution, however, that defining educated or high-skilled workers as those with college degrees may be too-broad a classification.  I sense the college-educated population is much more heterogeneous than commonly believed, and in reality contains a mix of high- and low-skilled workers.  In other words, just because we are pushing people through the hoops that lead to a college education does not guarantee that those students have gathered skills marketable in the real world.  Which means that we don't really know if we are creating "educated" workers faster than the economy can absorb.  We could simply be overestimating the number of "educated" workers.

I think the article would have felt better if it began not with the impression that baby boomers are the driving force behind recent declines in the participation rate, but could be more of an influence in over time.  This, I sense, is what Maki really wants to say:

The effect of the baby-boomer exit from the labor force will become more evident in the coming decade, Maki said. The policy implications may be more pressing, as Fed officials keep interest rates near record low levels for longer than may be required given the likely drop in the jobless rate. That may fuel price pressures in the economy, he said.

Then again, maybe not:

“It means there is less slack in the economy than is commonly perceived, and the slack will diminish more quickly than people think,” Maki said. As a result, “there are more inflationary risks with the very accommodative monetary policy we have now than one might believe.”

I think the near-term reality is a little less dire.  And the article eventually gets there:

To be sure, the outlook for jobs may brighten as the economic expansion develops, drawing more people back into the workforce and limiting declines in unemployment. In addition, some economists argue that retiring baby boomers may not be the best explanation for the decrease already in train in the participation rate.

“Demographic trends are pushing down, over time, the normal labor force participation rate,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. Nonetheless, he said, “the speed of the decline seen this year is in excess of what one would expect just given the demographic trend.”

A much more measured analysis, one I think consistent with the data. Too bad it wasn't the central point of the story.  Yes, demographic shifts are likely to put downward pressure on labor force participation rates.  But the tendency for those 65 and older to work longer than expected pushes in the other direction.  Moreover, an improving economy would also increase labor force participation, especially among younger workers. Simply put, the aging of the baby boomers is just one of many factors currently influencing labor force participation rates and, by extension, the amount of slack in the labor markets.  

Possible Fed Communication Strategy

As is widely known, the Federal Reserve is working on improving its communication strategy to provide better guidance about monetary policy and thus hopefully induce better outcomes.  From today's Wall Street Journal:

The Fed has taken ad hoc steps in this direction. During the financial crisis, it said rates would stay low for an "extended period." In August, it said they would stay low "at least through mid-2013." Quarterly projections would formalize this guidance and make it more specific. If the Fed signals that rates will stay lower even longer than investors expect, it could push long-term interest rates down now, spurring investment, spending and growth.

"The scope remains to provide additional accommodation through enhanced guidance on the path of the federal funds rate," Fed vice chairwoman Janet Yellen said in a speech last week. She is chairing the Fed subcommittee designing the communications overhaul.

The "mid-2013" formulation is especially problematic. At some point it will need to be updated. With unemployment high and not falling quickly, it is possible the Fed won't raise interest rates until much later. Of course, if inflation surprisingly picks up, it might need to move rates up sooner.

What form might "enhanced" guidance take?  It seems unlikely that the Fed would limit itself to point estimates on the future course of interest rates.  Reality is much more probabilistic, and I would expect additional Fed guidance to reflect forecast uncertainty via confidence intervals.  One such example would be the Monetary Report of the Swedens' central bank.  Forecasts for inflation:

yield interest rate guidance:

Essentially, this formalizes what we already expect - if inflation exceeds forecasts, then it is likely interest rates will rise at a greater rate than currently expected. It also provides information on the magnitude of any deviation from the interest rate forecast given differing inflation forecasts.  Of course, we would expect the Fed to include a similar forecast for unemployment.  And, given the current range of policy tools, it would be nice to have guidance on the balance sheet as well, although I sense it to be unlikely.

Expect some push back from some Federal Reserve policymakers:

Some Fed officials still aren't convinced this is the right approach. Giving interest rate guidance "might be an interesting exercise," Richard Fisher, president of the Dallas Fed, said in an interview last week. "Its utility I wonder about."

Some officials, like Mr. Fisher, doubt it will accomplish much. One risk is the Fed's signals about the expected path of rates might even confuse the public, rather than clarify the central bank's intentions.

I tend to think this is misguided - that a probabilistic assessment of the Feds' forecast will make it easier to interpret the implications of incoming data for the evolution of Fed policy, thus making the public less reliant on the often discordant views of Fed officials.  Importantly, in the current environment I think additional guidance would make clear that the more hawkish policymakers are outliers, thus minimizing the likelihood of raising premature expectations of policy tightening as we experienced earlier this year.  Which would explain Fisher's resistance to chance - he would prefer not to be further marginalized in the policymaking process.

Note:  Sorry to be short on posts recently.  I have been running around the last few days trying to tie up loose ends at the end of the term.