Inflation: The Latest US Import?

United States

April 20, 2007

By Richard Berner | New York

By any metric, US “core” inflation cooled significantly in March, renewing hopes for Fed ease and re-igniting risk appetite in global markets. Measured by the CPI, core inflation slowed to 2.5% in the year ended in March from 2.7% in February. Likewise, we estimate that measured by the core personal consumption price index (PCEPI) — the Fed’s preferred measure — core inflation slowed to just 2.1% in March. Both readings are fully 50 basis points (bp) below their peaks of last September, apparently putting inflation on track to come in at rates consistent with what the Fed deems to be price stability.

However, I think the March readings may represent a lull, and that some inflation risks are rising again. Like many other things these days, those risks are no longer entirely home grown; as in the 1970s, we may now be importing them from abroad. The upshot: Inflation has peaked, in my view, but there will continue to be flare-ups and the decline will still be gradual. Here’s why.

There’s no mistaking the decline in core inflation measured by the CPI over the past six months. While surging energy quotes drove up the headline rate to a 2.8% year/year gain in March — a seven-month high — the core rate decelerated to a ten-month low. Yet, three factors that depressed core prices in March were likely transitory, and all three may reverse in April. Seasonally adjusted hotel room rates plunged by 2.3%, as the actual increase failed by far to match the normal seasonal pre-vacation gains. Although such rates measured by the CPI rose just 1.3% from a year ago, hotel industry revenue per average room data suggest gains of 6-8%, so a rebound in the CPI version seems likely next month. Ditto for the 1% decline in apparel prices: This year they failed to match the normal increases accompanying the introduction of spring lines, and we suspect that a rebound is likely soon. Third, medical care goods quotes (mostly for prescription drugs) fell by 0.3% in March, marking the fourth decline in the last five months. With wholesale drug prices up by 3.5% in the last year, a rebound here also seems likely.

More important, several global factors seem likely to contribute to US inflation over the next few months. Among them: Strong global demand and limits on supply are boosting food and energy quotes. Energy quotes declined at an 11.5% annual rate in the three months ended in December, but jumped at a 22.9% annual clip in the three months ended in March. Food prices, meanwhile, have accelerated from a 2% annual rate in the September-December span to a 3.9% annual rate in the past three months. We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag, via transport fares, some rents, and other goods and services. Just as the energy price declines of late last year may thus have modestly cooled core inflation in the past few months, so will the recent acceleration likely, if temporarily, refuel the core composite in coming months.

Perhaps more lasting, US consumer import prices are accelerating and the dollar’s recent decline may magnify their faster rise. Over the year ended in March, import prices for consumer goods other than motor vehicles and parts accelerated to 1.8%, the fastest pace in more than eleven years. The acceleration was broadly based, including in prescription drugs (from -0.9% to +2.5%, a 340 bp acceleration); toiletries and cosmetics (to 2.1%, a 200 bp swing); household goods (1.6%, a 140 bp swing); toys and sporting goods (up 140 bp to 1.4%). The dollar’s decline probably influenced that acceleration; over the past year, the Fed‘s broad, nominal trade-weighted dollar index declined by 3.4%. Not all of the dollar’s recent decline has yet shown up in quotes for imported goods, however. If the dollar continues to slide, especially against the Asian currencies and to some extent Europe, as we suspect, import prices likely will accelerate further, and add a tenth of a percent or two to consumer inflation.

Importantly, the slipping dollar isn’t the whole story. The boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and ultimately consumer prices. Several Fed economists in a paper last year found that the decline is a global phenomenon. Across G7 currencies, their work suggests that exchange rate pass-though to import prices has declined to 40% over the past 15 years from 70% in the 1970s and 1980s, and in the US, it has declined to only 30% (see Jane Ihrig et al. “Exchange-Rate Pass-through in the G7 Countries,” International Finance Discussion Paper 851, January 2006). That is, a 10% sustained depreciation in the dollar might, other things equal, boost the import price level by 3% over a 2-3 year period.

The empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years, like the flattening in the Phillips curve, may reflect good monetary policies. As well, it probably results from the globalization of markets and production that has promoted “pricing to market.” That is, exporters not wanting to surrender market share have more closely matched domestic-origin prices in setting their export prices in foreign currency, and they tend to hedge their currency risk either ‘naturally’ by sourcing abroad or financially. That probably muted the pass-through and lengthened the lags from currency moves to changes in relative prices long before the dollar began its descent.

Notwithstanding disinflationary monetary policy, I also suspect that the pass-through link varies with the cyclical state of the global economy and inflation expectations. Considering those factors, the weaker dollar may explain half the recent increase in import prices. And the booming global economy may have accounted for the other half, by increasing the pricing power of exporters to the US. Looking ahead, the combined effect of the dollar’s decline and the global boom on US inflation now could be larger than it was over 2002-04 (for more discussion, see “The Dollar and Inflation,” Global Economic Forum, May 5, 2006). The cyclical state of the domestic economy also matters for assessing the impact of all these global factors on US consumer price inflation. Despite the sluggish pace of US economic activity over the past year, the level of resource utilization is still high, and sellers may thus succeed in passing such price hikes through to consumer inflation.

Global factors — higher energy and import quotes and a weaker currency — may also contribute to US inflation by reviving inflation expectations. So far, however, there’s little sign of that: Inflation compensation measured by 10-year TIPs spreads plunged by 10 bp on this week’s good inflation news, to 240 bp. To be sure, the reaction in distant-forward breakevens was more muted, amounting to 3-4 bp, hinting that these developments haven’t much altered market participants’ underlying inflation expectations. In mild contrast, survey-based inflation expectations, such as the measure of 5-10 year expectations compiled by the University of Michigan ticked up to 3% in March. But it’s early days for assessing the impact of these developments on expectations.

The most important factor affecting inflation expectations is back home: The Fed. Clear goals and objectives and a straightforward sense of how the Fed will get there are both critical to anchoring longer-term inflation expectations. And by an large, the Fed has been successful in doing exactly that over the past several years. Lately, however, when the Fed says inflation is too high, market participants aren’t sure how to calibrate such statements. That’s partly because there has been some ambiguity over the Fed’s implicit inflation objective.

Officials have described their preferences in terms of a 1% to 2% “comfort zone” for core PCE inflation, but for three years, core PCEPI has run above the upper end of that zone. Many market participants thus assume that officials’ de facto target is 2% and not the 1½% mid-point of the “comfort zone.” If the Fed were clearer about this critical issue — whether they pick one or the other — I think it would more firmly anchor inflation expectations. Personally, I prefer 2%, because it builds in a bigger cushion for measurement error and disinflationary shocks (see “More Clarity, Less Guidance From the Fed,” Weekly International Briefing, March 30, 2007). Either way, together with a set of global factors potentially pushing up inflation expectations, lingering questions about the Fed’s objectives may translate into market uncertainty, pushing up term premiums and steepening the yield curve.

That steepening seems to be irregularly underway, and is becoming a popular trade. Some investors are assuming that the Fed now has a green light to ease and thus look for a bullish re-steepening. Fixed-income markets now discount a better-than-even chance of a cut by September for the first time in about a month. Don’t count on it: “Base effects” may cap year-on-year inflation for now, since comparisons with last spring are tough. But one month’s good inflation data won’t likely be sufficient to convince the Fed that the risks are balanced, and officials also may worry that global fundamentals are no longer disinflationary. Instead, the curve may steepen bearishly as term premiums rise and inflation prints turn a bit less favorable. Investors in that context should also consider TIPs. They’re more attractive now with some inflation upside, and seasonal “carry” is now relatively favorable (because TIPS are priced off the headline CPI before seasonal adjustment, and the seasonal upswing in gasoline and energy quotes is still underway). According to Morgan Stanley Interest Rate Strategist George Goncalves, 10-year TIPS are priced for a widening of about 12 basis points from current levels. I’m willing to bet that inflation surprises could easily take spreads higher.

There are risks in both directions, however. A rebound in inflation could quickly undermine today’s financial-market bullishness. The threat of protectionism could add another layer of risk to the inflation outlook, because it would block competition in US markets from cheaper overseas goods and services. Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline. Perhaps the biggest irony in this context is that while many believe that globalization will be eternally disinflationary, courtesy of ever more tightly-integrated global supply chains and other global spillovers, globalization in these circumstances may have — at least for now — turned into an inflation tailwind.

Richard Berner

A market correction is coming, this time for real

"A Market Correction is Coming....."

This comment, "A market correction is coming, this time for real," comes from William Rhodes, senior vice-chairman of Citigroup, and chairman, president and chief executive of Citibank. Consistent with the headline, Rhodes takes a bearish view (in fact, he says he has been concerned about leverage and indiscriminate pricing of risk for some time, and said he expected a market correction a year ago. Now not only does he say he expects a "market correction" in the next 12 months, but a "real correction," which presumably means a correction in the real economy (does that mean a recession, or merely a marked fall in growth?).

It's noteworthy that someone in a senior position in a major financial institution is forecasting a pessimistic (actually, quite pessimistic by the standards of this sort of thing) outlook for growth. And he was downbeat late last spring, and admits to having been premature. Now some financial services firms have bearish spokesmen they keep around (think Stephen Roach at Morgan Stanley, who is always worth listening too, even when he is wrong), so perhaps that is one of Rhodes' roles. But the pernabear function is generally occupied by an economist doing market or economic forecasts, not a member of management. So it's pretty certain Rhodes believes what he is saying (it's not a house view) and it's also pretty certain that it's at least in part based on information that is not widely reported (someone like Rhodes either talks directly to or is one step removed from top corporate executives, very wealthy individuals, central bankers, regulators, other senior bank executives, and major investors).

So while this is one man's view, he is likely to have better access to information than many of the pros....

The recent market turmoil should not have been un­expected. We are living in an increasingly interdependent world. Times have been good, even with the volatility of the past few weeks sparked by the Shanghai market and then fuelled by the subprime sector in the US. We have been living in extraordinary times in a global “Goldilocks” economy – not too hot, not too cold. The macro-economy still looks pretty good but the shaking of the trees over the past few weeks has, it is to be hoped, awakened investors and lenders to the risks in the marketplace.

High growth in emerging markets continues, as exemplified by the tremendous growth in China and India. Western and eastern Europe are growing. The Russian economy, driven by energy, has been strengthened well beyond what was expected a few years ago. The Middle Eastern oil-exporting countries are going through a boom fuelled by oil and gas: it is different from earlier periods of high oil prices because this time a substantial amount of the money is staying in the region, rather than being invested elsewhere as in the 1970s.

Africa is in many ways going through something of an economic renaissance. The Japanese economy also has improved and the US locomotive has continued, maintaining good growth of more than 3 per cent in 2006 notwithstanding the downward revision of fourth-quarter growth from 3.5 to 2.2 per cent.

However, much of the good news has come as a result of extraordinary levels of liquidity pouring into opportunities around the globe. To a large extent this is due to the Federal Reserve’s expansionary monetary policies early in the decade and the US administration’s fiscal stimulus. The yen carry trade has also facilitated the buoyant expansion of investments and leverage evident everywhere today. The low spreads, the tremendous build-up of liquidity, the reach for yield and the lack of differentiation among borrowers have stimulated both dynamic growth and some real concerns.

Pockets of excess are becoming harder to ignore. Problems in the housing and mortgage area such as the subprime sector in the US are one such example of excess that should come as no surprise. As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface. Too many countries and companies with vastly different risk profiles are still commanding similar pricing.

It has been my experience that periods of economic expansion tend to last between five and seven years. We are entering the sixth year of expansion in the US. Against that background, I believe that over the next 12 months a market correction will occur and this time it will be a real correction. I said as much last spring during the Inter-American Development Bank meetings in Belo Horizonte, Brazil. Soon afterwards, in May 2006, the markets did experience a correction but it was so mild and short-lived that it was in a way less effective than no correction at all. I say that because it left the inexperienced with the impression that it would be smooth sailing from there on.

Market developments in the past few weeks should be seen as a warning. What has been evident for a number of months is that, in the US, we are seeing lagging inflation and slower growth. Whether this means that we are going to have to fend off recessionary tendencies is not yet clear. However, what is clear to me is that in the next year a material correction in the markets will occur.

During the last big adjustment that started in July 1997 in Thailand and spread to a number of Asian economies including South Korea, followed by Russia in 1998 – and led ultimately to the bail-out of Long Term Capital Management, the US hedge fund – a number of today’s large market operat­ors were not yet in the mix.

Today, hedge funds, private equity and those involved in credit derivatives play important, and as yet largely untested, roles. The primary worry of many who make or regulate the market is not inflation or growth or interest rates, but instead the coming adjustment and the possible destabilising effect these new players could have on the functioning of international markets as liquidity recedes. It is also possible that they could provide relief for markets that face shortages of liquidity.

Either way, this clearly is the time to exercise greater prudence in lending and in investing and to resist any temptation to relax standards.

Fed Accused of Encouraging Subprime Loans: 'Perfect Storm’

Fed accused of subprime ‘perfect storm’

By Eoin Callan, Edward Luce and Krishna Guha in Washington

Published: March 22 2007 18:50 | Last updated: March 23 2007 00:33

The Federal Reserve helped create a “perfect storm” in the US subprime mortgage market that could expose up to 2.2m more Americans to the threat of home foreclosure, Chris Dodd, chairman of the Senate Banking committee, said on Thursday.

Mr Dodd, who is also a Democratic Party candidate for the 2008 presidential nomination, alleged the Fed had failed in its oversight role when the growth in high-risk “adjustable rate mortgages (ARM)” to risky borrowers was exploding.

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While questioning leading mortgage lenders and federal banking regulators, Mr Dodd also promised legislation to crack down on predatory lending in the US mortgage market, where a rising level of repayment delinquency has caused global market jitters during the past month.

Mr Dodd said that US regulators had relaxed guidelines on mortgage lending at precisely the point in 2004 and 2005 when the riskiest ARM loans – which impose initially light monthly payments that escalate quickly at a later date – were increasing most rapidly. That also coincided with the start of the Fed’s consecutive 17-stage rise in rates.

“Despite those warning signals the leadership of the Federal Reserve seemed to encourage the development and use of ARMs that, today, are defaulting and going into foreclosure at record rates,” he said.

Mr Dodd, who was supported by Richard Shelby, the senior Republican on the committee, also expressed frustration at the fact the Fed had so far failed to issue promised guidance to tighten controls on the $1,200bn subprime mortgage market.

An estimated 1m subprime borrowers will have their rates adjusted sharply upwards this year and another 800,000 next. Roger Cole, a senior Fed official, said the guidance would come out by May at the earliest. But he conceded that the Fed could have done more.

Thursday’s hearing could mark the start of a backlash against leading subprime mortgage lenders. Senior executives from four of the leading lenders – HSBC, Countrywide, WMC Mortgage, First Franklin – testified. Of those invited, only New Century, the largest subprime lender, declined to send a witness.

Mr Dodd said the lenders had engaged in “unconscionable and deceptive” practices. But he also admitted that it would be hard to pass a stricter law.

The Center for Responsive Politics, a watchdog, said New Century more than doubled its Washington lobbying efforts between 2004 and 2005 and contributed $342,000 in campaign funds to candidates in last year’s mid-term congressional elections.

Mr Dodd said lenders had engaged in “unconscionable and deceptive” practices.

Copyright The Financial Times Limited 2007

Reasons Why the U.S. Economy is Much More Vulnerable Than it Was in 2001

Mar 21st, 2007

A study recently published by the Bank for International Settlements (Monetary and Prudential Policies at a Crossroad?) says:

“Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth. The serious costs of financial repression around the world have been well documented. But financial liberalization has also greatly facilitated the access to credit… more than just metaphorically. We have shifted from a cash flow-constrained to an asset-backed economy.”

Though we basically agree with the analysis and the conclusions of the study, we radically disagree with the one sentence that “Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth.” The indispensable first condition for proper resource allocation at a national as well as global scale is avoidance of excessive money and credit creation. In many countries, and in particular in the United States, they are excessive as never before.

If Mr. Bernanke complains about irregularities of M2, this is nothing in comparison with the fact that credit and debt growth in the United States has exploded for more than two decades. When Mr. Greenspan took over at the helm of the Fed in 1987, outstanding debt in the United States totaled $10.5 billion. In less than 20 years, this sum has quadrupled to $41.9 billion. In reality, this significantly understates the rise in debts because, for example, highly leveraged hedge funds with trillions of outstanding debts are not captured. In 1987, indebtedness was equivalent to 223% of GDP, which was already pretty high. Lately, it is up to 317% of GDP.

In actual fact, there used to be a very stable relationship between money or credit growth and GDP or income growth until the early 1980s. Growth of aggregate outstanding indebtedness of all nonfinancial borrowers - private households, businesses and government - had narrowly hovered around $1.40 for each $1 of the economy’s gross national product. Debt growth of the financial sector was minimal.

The breakdown of this relationship started in the early 1980s. Financial liberalization and innovation certainly played a role. But the most important change definitely occurred in the link between money and credit growth to asset markets. Money and credit began to pour into asset markets, boosting their prices, while the traditional inflation rates of goods and services declined. The worst case of this kind at the time was, of course, Japan.

Do not be fooled by the sharp decline in consumer borrowing into the belief that money and credit has been tightened in the United States. Instead, borrowing for leveraged securities purchases (in particular, carry trade and merger and acquisition financings) has been outright rocketing, with security brokers and dealers playing a key role. Over the three quarters of 2006, their net acquisitions of financial assets have been running at an annual rate of more than $600 billion, more than double their expansion in the past.

Federal funds and repurchase agreements expanded in the third quarter at an annual rate of $606.3 billion, or an annual 26%. The main borrowers were brokers and dealers. During the first three quarters of the year, their assets increased $427 billion, or 27% annualized, to $2.57 billion. A large part of the money came from the highly liquid corporations. There is no reason to wonder about low and falling long-term interest rates.

All this confirms that financial conditions remain extraordinarily loose. Even that is a gross understatement. Credit for financial speculation is available at liberty. Expectations for weaker economic activity only foster greater financial sector leverage. Why such unusually aggressive speculative expansion in the face of a slowing economy?

The apparent explanation is that the financial sector intends to make the greatest possible profit from the coming decline of interest rates, promising further rises in asset prices against falling interest rates. While the real economy slows, the leveraged speculation by the financial fraternity goes into overdrive. Principally, there is nothing new about such speculation. New, however, is its exorbitant scale.

Before leading his jumbo-sized delegation to Beijing, Henry Paulson, U.S. Treasury secretary, cautioned against expecting any big breakthroughs from the visit. And so it has turned out. The meeting produced plenty of statements about the desirability of improving relations, but nothing concrete to do so.

Of course, the Chinese are in a very strong position with the central bank holding more than $1 trillion of bonds in its portfolio, mostly denominated in dollars. According to reports, the American visit was initiated by Mr. Paulson in an effort to contain rising Sinophobia in the U.S. Congress, which increasingly blames China for America’s economic problems, from its huge current account deficit to stagnating real incomes. In other words, those troublemakers, not the trade deficit, are the problem.

One cannot say that U.S. policymakers and economists have been preoccupied with worries about possible harmful effects of the exploding trade deficit. They appear obsessed with the conventional wisdom that free trade is good and must always be good under any and all circumstances, as postulated in the early 19th century by David Ricardo.

Ricardo exemplified this by comparing trade in wine and cloth between Portugal and England. Portugal was cheaper in both products, but its comparative advantage was greater in wine. As a result, according to Ricardo, Portugal boosted its production and exports of wine. In contrast, England gave up its wine production and could produce more sophisticated goods. In both countries, living standards rose.

For sure, it appears highly plausible that American policymakers feel they are following Ricardo’s logic. Only they are disregarding some caveats of Ricardo’s. For equal benefit, first of all, balanced foreign trade is required. “Exports pay for imports” was a dogma of classical economic theory. Ricardo, furthermore, disapproved of foreign investment, with the argument that it slows down the home economy.

With an annual current account deficit of more than $800 billion, the U.S. economy is definitely a big loser in foreign trade. To offset this loss of domestic spending and income, alternative additional demand creation is needed. Essentially, all job losses are in high-wage manufacturing, and most gains are in low-wage services. In essence, the U.S. economy is restructuring downward, while the Chinese economy is restructuring upward.

Considering that Chinese wages are just a fraction of U.S. or European wages, it appears absurd that the Chinese authorities deem it necessary to additionally subsidize their booming exports by a grossly undervalued currency, held down by pegging the yuan to the dollar.

In the U.S. financial sphere, the year 2006 has set new records everywhere: records in stock prices, records in mergers and acquisitions, records in private equity deals, record-low spreads, record-low volatility. Manifestly, there is not the slightest check on borrowing for financial speculation. There is epic inflation in Wall Street profits.

One wonders what can stop this unprecedented speculative binge. Pondering this question, we note in the first place that the gains in asset prices - look at equities, commodities and bonds - have been rather moderate. To make super-sized profits, immense leverage is needed. We think the speculation is unmatched for its scope, intensity and peril. Plainly, it assumes absence of any serious risk in the financial system and the economy. The surest thing to predict is that the next interest move by the Fed will be downward.

In our view, the obvious major risk for speculation is in the economy - that is, in the impending bust of the gigantic housing bubble. Homeownership is broadly spread among the population, in contrast to owning stocks. So the breaking of the housing bubble will hurt the American people far more than did the collapse in stock prices in 2000-02. For sure, the U.S. economy is incomparably more vulnerable than in 2001. Another big risk is in the dollar.

Regards,

Dr. Kurt Richebacher
for The Daily Reckoning Australia

Crash and Bernanke

Financial Times

Published: 20/3/2007 | Last Updated: 20/3/2007 20:45 London Time

"Alan, you're it. Goddammit, it's up to you." On Black Monday 1987, the president of the New York Federal Reserve joined the ranks of those relying on Alan Greenspan during a meltdown. He was not the last. By the time the Fed chairman retired, many believed in the so-called "Greenspan put" – that if markets got really bad the Fed would cut rates and bail investors out.

Today, with nervy markets, is there a Bernanke put? Central banks react to shocks in the real world: the co-ordinated global cut after September 11 is one example. But moral hazard makes underwriting markets a dubious activity. Even so, monetary officials know that unduly tight policy after crashes in the US in the 1930s and Japan in the 1990s may have contributed to economic slumps.

Investors should not be complacent, as the precedents are mixed. The Fed eased after the 7 per cent fall in the stock market on October 13 1989 and cut in 1998 after Russia's default and the Long-Term Capital Management crisis caused bond market jitters. But the liquidity boost in 1987 was aimed at forestalling a payments crisis on Wall Street rather than influencing asset prices. And in 2000, the Fed watched Nasdaq fall by 45 per cent, only signalling an easing in December, when it was more clear that the real economy had slowed.

Now the Fed does not have that much "ammunition". At 2.8 per cent, real rates, defined as the target rate less inflation, are about 50-150 basis points more lax than before the 1989, 1998 and 2000 responses. Whether the Fed now has the inclination to bail out markets is even more debatable. Like Mr Greenspan, Ben Bernanke thinks central banks should not try to burst asset bubbles. Unlike Mr Greenspan, Mr Bernanke also rejected a shoot-from-the-hip approach to market slumps during his academic career. His preferred philosophy of inflation-targeting, with a focus on the degree of spare capacity in the economy, suggests taking action only if market moves clearly signal or threaten a deterioration of the real economy. If the emergency phone from New York rings, Ben may be a little less sympathetic.

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