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Thursday, November 20, 2008

As The Federal Reserve Readies-Up Quantitative Easing, The Bank of Spain Sees Little Prospect Of Deflation

by Edward Hugh: Barcelona

While we are likely to see a "substantial'' drop in euro-region inflation, Bank of Spain forecasts for the 15-nation euro area do not show price drops. That is they "show an enormous moderation in price gains, but they do show price gains,'' according to the latest statements by Miquel Angel Fernandez Ordoñez, ECB Council member and Governor of the Bank of Spain. Bank of Spain eurozone forecasts "don't show deflation" he told reporters in Madrid yesterday (Wednesday).

The reason for this swift and adroit response to the question of the day in Spain was that EU Economy and Finance Commissioner Joaquin Almunia (not exactly your garden-variety world authority on macroeconomic topics) had earier said that the Europe's economies were "facing the prospect of deflation" amidst the worst financial crisis since the 1930s. In fact Fernandez Ordoñez is right, as is his want - right on a technicality. The Eurozone as a whole is almost certainly not heading straight into deflation (yet), but this begs the question which he could have been answering: what about poor little Spain?

As I reported last week, Spain's consumer price index has now been dropping since June (see chart below), and it is very possible (I would say probable) that the index will move in negative territory throughout 2009 (and possibly by between 1 and 3 percent). True a significant part of the drop at this point is due to the drop in energy costs, but even the core-core index (excluding energy and fresh vegetables) was only up around 0.4% in October (HICP) over June, or an annual 1.2% rate, and it is my very very strong opinion that we will start to see "downwards pass through" as the recession deepens, profits melt (rather than just being squeezed) and everyone struggles hard to try and find a bottom.

According to data from the National Statistics Institute earlier this week, Spanish household spending contracted 1 percent in the third quarter of 2008 over the previous quarter, while investment contracted by 1.9%. We can only realistically expect this process to continue during 2009 and unemployment to continue to rise, creating a considerable capacity overhang which will exert a downward pressure on wages and prices (remember around one third of new employment contracts in Spain are temporary, making salary reductions comparatively straightforward, at least for one part of the labour force).

The Federal Reserve - On The Other Hand - Readies Its Plans

Meantime in the United States the Federal Reserve has been busy stressing that it will do whatever it has to do to ensure the US does not fall into a deflation trap. This view was reinforced by statements from vice-chairman Dohn Kohn yesterday (Wednesday), as US stocks fell below 8,000 on the Dow Jones Index (their lowest level so far in this financial crisis) and consumer prices fell 1% in October when compared with November. That was the largest monthly drop in at least 61 years (since the current index only goes back to 1947). Even core consumer prices, which exclude food and energy, fell by 0.1 percent month on month, and this was the first monthly drop in core prices in more than a quarter of a century.

Don Kohn stressed he did not believe deflation was the most likely outcome for the US economy, but he did say he thought it was a “less remote” possibility than he previously thought.

“Some people have argued that we should save our ammunition, that interest rate cuts aren’t effective,’’ Mr Kohn said. “I think that were we to see this possibility, that we should be very aggressive with our monetary policy, as aggressive as we can be.”

The lions share of the fall in headline inflation, of course, came from energy prices dropping 8.6 per cent. Yesterday crude oil fell to a $53.30 a barrel, its lowest since January 2007.

Treasury inflation-protected securities now indicate that investors anticpate deflation in the US, though Fed officials stressed in interpreting the data that prices were being distorted by a lack of liquidity. The five-year break-even rate, which provides an expectation of future inflation, currently suggests that investors expect annualised inflation at a minus 0.70% rate over the next five years.

It is also worth noting that it is getting much more difficult to read Fed policy intentions, at least as far as movements in the key policy rate go. Massive injections of liquidity have now driven the interbank overnight lending rate to less than half the current 1% Fed FOMC rate. The presence of this gap seems to be now shifting investors' focus toward the amount of money in the banking system as a better gauge of Fed intentions than possible movements in the policy rate. Kohn in fact stressed that the US central bank is simultaneously reducing interest rates and expanding its balance sheet (in a process known as quantitative easing) and explicitly avoiding reliance on one strategy "in favor of another".

Analysts point to the surplus cash that banks keep on deposit at the Fed as an important gauge of the Fed's true monetary-policy stance. These so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed has added one measure to another in its emergency lending program package. Excess reserves are now bigger than the overnight lending market between banks (aka the federal funds market), but it is in this market thatthe Fed sets its key rate target. As a result of the large volume of excess liquidity it is becoming more and more difficult for Bernanke to control the federal funds rate (he recently described it to the House Financial Services Committee. as an issue he was "working on") - and the effective federal funds rate was 0.38 percent Novber 18, and has averaged 0.29 percent since the Federal Open Market Committee cut the rate to 1 percent on October 29.

Former St. Louis Fed President William Poole has described this as a move to quantitative easing, a process which forces a large volume of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset. Such quantitative easing in fact formed the backbone of the Bank of Japan anti-deflation stance between 2001 and 2006 (as in the case of the Fed, it was this easing rather than the more headline catching ZIRP - zero interest rate policy - which was doing the bulk of the donkey-work), but it is worth noting that while this policy stabilised Japan's situation temporarily, the Japanese economy never actually came out of deflation (at least as far as the core core index goes) and now once more under the grip of recession it seems almost certain to fall back even further into negative price territory. The basic problem is that the banks themselves may well fail to freely lend the excess reserves to businesses and consumers, in the process prolonging the credit freeze. That is basically the underlying story of what actually happened in Japan.

Normally, when central banks launch explicit quantitative easing strategies they abandon the interest-rate target and start purchasing assets in order to boost the money supply. This is what Bernanke calls "expanding the Fed's balance sheet". Typically, such activities can have two effects on an economy.

In the first place banks can decide to earn more than the nominal rate they earn at the central bank and start to lend aggressively. We have seen no signs of this happening as of yet, and measures of bank reserves are growing faster than most money supply measures. Secondly, the central bank can target some assets that are thought to have a broad impact on the economy, such as Treasuries or mortgage-backed bonds. The US Federal Reserve has already taken a half-step in that direction by purchasing the commercial paper of U.S. corporations at predefined rates. The central bank's Commercial Paper Funding Facility held $256.1 billion as of November 12.

Basically returning to the issue at the start of this post concerning Miquel Angel Fernandez Ordoñez's statement on deflation, we should not take everything here at face value. Communicational techniques are different between one side of the Atlantic and the other, and we might note that even Don Kohn says that he doesn't consider deflation a "likely" outcome (he couldn't very well say so, could he, as saying it was likely would be like saying in advance that it wasn't very probable the Fed's preferred policy option would work, and this he isn't going to say, even if he has serious concerns about effectiveness).

By the same token all Fernandez Ordoñez has really told us is that the Bank of Spain forceast isn't currently showing price falls in 2009 (and I am sure it isn't) but only a pack of fools would draw the conclusion from that that they should have no "plan B" for deflation just in case, and while I may think many things about the current Governing Council at the ECB, a pack of fools I do not think they are. It is also worth remembering that with the present occupant of the Bank of Spain governorship it is very important that you read the fine print in what he says, since while he definitely tells the truth, and nothing but the truth, he doesn't always tell "the whole" truth, as when he said that Spanish banks had no exposure to off-balance-sheet SIV-type securitisation (which it didn't), which is not the same thing as saying Spanish banks have no exposure to potentially toxic instruments, since as we are now seeing they do, and I'm sure he was aware of that at the time. Prudently, he was simply keeping his fingers crossed, and saying what he had to say.

Like Chalk and Cheese, Definitely Not Two Of A Kind

So we should be aware that Señor Ordoñez is a very astute customer, which Joaquin Almunia evidently isn't, and the difference between the two is apparent in the way the former has to rapidly jump up out of his foxhole in an attempt to undo the damage potentially done by the latter's rather eyebrow raising "faux-pas".

And just to ram the matter home, I will leave you with an earlier effort on the part of our much beloved Economy and Finance Commissioner to win for himself the acollade of economic illiterate of the year.

The European Union's Economic and Monetary Affairs Commissioner Joaquin Almunia said on Monday (27 October) that while lower financing costs were needed interest rates should not fall to negative levels in real terms.

"At this moment, it would be good for the cost of financing to go down," Almunia told a live Internet chat with readers of Spanish newspaper El Pais (www.elpais.com), adding: "We shouldn't go back to a situation in which real interest rates are negative, as we know from experience that this leads to excess indebtedness, low perception of risk and new bubbles which always end by blowing up in our faces." Almunia said it was hard to say how long the present bout of financial turbulence would last but he thought the uncertainty plaguing markets should have cleared with a year.

Essentially two things are being confused here. Negative interest rates (such as those Spain had between 2002 and 2006, you know, the ones that lead to the current crisis) are highly undesireable during the upswing in a business cycle, since you are simply giving more stimulus to economies which are already stretched to capacity - and negative rates may thus produce "bubbles", as they obviously did in both Ireland and Spain - but they are of course highly desireable during a downturn, and especially during recessions, since they can stimulate slumping economies. And of course, we are all currently heading into one of the most important recessions since WWII, or hadn't our "machine-reader" commissioner noticed?

I mean, as I say, basically the man is a total economic illiterate, and indeed his policy pronouncements more often than not lead me to feel what the Spanish would call "verguenza ajena" for any club of economists who would entertain him as a member, or indeed group of Commissioners who get stuck with him fielding the economics portfolio. And what better proof of all of this could there be? Well, take a sneak peak at the above chart, and you will see that Spain once more had negative interest rates after the end of 2007 - ie at just the time when Almunia was speaking - as, of course, the textbook recommends it should. As I said, a complete pack of fools is something the ECB Governing Council aren't. But, and here we come full circle, as inflation is falling interest rates get near to turning positive again (once more giving Spain a dose of "restrictive" monetary policy) and the problem is going to be how we maintain negative rates as Spain enters deflation. We had all better join Fernandez Ordoñez in keeping our fingers crossed and hope that our ECB Council Members prove to be just as inventive as Messrs Benanke and Kohn at the Federal Reserve, and equally astute as those Honourable Gentlemen over at the Bank of Japan.