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Quote of the day

on today’s seismic Treasury selloff:

“The point is that the world was long Treasury, and we can see how they’ve been suckered.”

In other news, more insanity from the federales, who think they can permanently reduce commodities prices by shoving out leveraged players.

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Huh?

Didn’t get this memo. No sir.

Fetch your tin helmets once again. The European Central Bank is opting for a monetary purge. So too is the US Federal Reserve, now ruled from Dallas.

Über-hawks and Cromwellians have gained the upper hand at the great fortress banks. Whether or not they admit it, both are embarked on policies that must lead to retrenchment across the Atlantic world.

The City mood turned wicked as the full import of this policy switch sank in last week. On Wall Street, the Dow’s 396-point dive on high volume late Friday had an ugly feel.

“There is now the distinct possibility of a simultaneous sell-off in global bonds, equities and commodities,” said Jonathan Wilmot from Credit Suisse.

I dunno. I saw Lehman almost die again, and we all knew that the Fed was ready to fire a paper fusillade in the hole.

Trichet’s hawkishness is not in doubt. Bernanke’s is. Spain and Ireland do not a dovish majority make.

Bernanke’s hawkishness is in doubt.

Thomas Palley, Open Society Institute pontificator emeritus cum DC-cocktail laude, mocks himself best when he’s most honest. As do most political people.

Defending the Bernanke Fed

Filed under: U.S. Policy, Uncategorized — Administrator @ 6:37 am

Federal Reserve Chairman Ben Bernanke has recently been on the receiving end of significant criticism for recent monetary policy. One critique can be labeled the American conservative critique, and is associated with the Wall Street Journal. The other can be termed the European critique, and is associated with prominent European Economist and Financial Times contributor, Willem Buiter.

Brought up on the intellectual ideas of Milton Friedman, American conservatives view inflation as the greatest economic threat and believe control of inflation should be the Fed’s primary job. In their eyes the Bernanke Fed has dangerously ignored emerging inflation dangers, and that policy failure risks a return to the disruptive stagflation of the 1970s.

Both argue the Fed has engaged in excessive monetary easing, cutting interest rates too much and ignoring the perils of inflation. Their criticisms raise core questions about the conduct of policy that warrant a response.

At least he didn’t call us “liquidationists.” Generous.

Rather than cutting interest rates as steeply as the Fed has, American conservatives maintain the proper way to address the financial crisis triggered by the deflating house price bubble is to re-capitalize the financial system.

Correct.

This explains the efforts of Treasury Secretary Paulson to reach out to foreign investors in places like Abu Dhabi. The logic is that foreign investors are sitting on mountains of liquidity, and they can therefore re-capitalize the system without recourse to lower interest rates that supposedly risk a return of ‘70’s style inflation.

“Supposedly.

The European critique of the Fed is slightly different, and is that the Fed has gone about responding to the financial crisis in the wrong way. The European view is that the crisis constitutes a massive liquidity crisis, and as such the Fed should have responded by making liquidity available without lowering rates. That is the course European Central Bank has taken, holding the line on its policy interest rate but making massive quantities of liquidity available to Euro zone banks.

In other words, the Buiter critique advocates one set of interest rates for banks, and a very different one for individuals, without regard to respective credit risk. Presumably, there would be no arbitrage between these two bifurcated markets. Presumably, liquidity provisions to other banks–“inflation by other means”–would both 1) save the banks, and 2) not institutionalize higher prices on the tabs of the people who didn’t take the stupid risks.

Never made much sense to me either. [I used to like Buiter because he was the only person who trashed Bernanke way back in the day. Unfortunately his “lender of last resort” bailout loophole was an unforgivable leap of illogic, and while formally very different from the Bank of Japan’s disastrous early-1990’s bailout, was functionally indistinguishable.]

According to the European critique the Fed should have done the same. Thus, the Fed’s new Term Securities Lending Facility that makes liquidity available to investment banks was the right move. However, there was no need for the accompanying sharp interest rate reductions given the inflation outlook. By lowering rates, the European view asserts the Fed has raised the risks of a return of significantly higher persistent inflation. Additionally, lowering rates in the current setting has damaged the Fed’s anti-inflation credibility and aggravated moral hazard in investing practices.

The problem with the American conservative critique is that inflation today is not what it used to be.

It’s different this time.

1970s inflation was rooted in a price – wage spiral in which price increases were matched by nominal wage increases. However, that spiral mechanism no longer exists because workers lack the power to protect themselves. The combination of globalization, the erosion of job security, and the evisceration of unions means that workers are unable to force matching wage increases.

DC establishment liberal: “Inflation is okay now, because workers have to eat all costs themselves.” As if workers will just sit back and take this? As if they can’t read these internet posts, which presume weakness, ignorance and stupidity on the part of American workers?

The problem with the European critique is it over-looks the scale of the demand shock the U.S. economy has received. Moreover, that demand shock is on-going. Falling house prices and the souring of hundreds of billions of dollars of mortgages has caused the financial crisis. However, in addition, falling house prices have wiped out hundreds of billions of household wealth. That in turn is weakening demand as consumer spending slows in response to lower household wealth.

Different. This. Time.

Countering this negative demand shock is the principal rationale for the Fed’s decision to lower interest rates. Whereas Europe has been impacted by the financial crisis, it has not experienced an equivalent demand shock. That explains the difference in policy responses between the Fed and the European Central Bank, and it explains why the European critique is off mark.

The bottom line is that current criticism of the Bernanke Fed is unjustified. Whereas the Fed was slow to respond to the crisis as it began unfolding in the summer of 2007, it has now caught up and the stance of policy seems right. Liquidity has been made available to the financial system. Low interest rates are countering the demand shock. And the Fed has signaled its awareness of inflationary dangers by speaking to the problem of exchange rates and indicating it may hold off from further rate cuts. The only failing is that is that the Fed has not been imaginative or daring enough in its engagement with financial regulatory reform.

Copyright Thomas I. Palley

The bottom line is, DC policy emerati are profoundly ignorant, sycophantic, and irresponsible people.

The Mofaz meme

There were about five pieces of news on Friday that delivered such a massive upside kick to oil.

1) Chinese oil consumption numbers came in much higher than expected.

Wall Street is still being blindsided by the impact of the Sichuan earthquake, and apparently most of it is ignorant that ~30 percent of Chinese oil/ natgas/ heating oil comes from Sichuan and Gansu (which was also thrown into chaos by the quake).

2) Shaul Mofaz rattled Kadima’s flimsy sabre at Iran, again. Anyone who took that seriously is ill-informed.

3) The dollar continued hemorrhaging. Brokers are cutting back trading with Lehman Brothers, and Bernanke will probably be called out on his fateful March 17 nationalization of banks’ default risk. He will have to throw hundreds of billions of dollars in Treasuries at Lehman’s crippled balance sheet, further debasing Treasuries specifically and US financial credibility generally.

4) Morgan Stanley said oil would go to $150.

5) The USD and EUR are both heavily overvalued. As long as China keeps its currency peg alive, the dollar and euro will both be overvalued. The only other large currency alternative is commodities, so that’s where money is going.

As I have said many times, government witch hunts against “speculators” never signal the top of a bull market.

Israel’s saber-rattling might have been good for 1 percent of oil’s gain. Obama’s triumph in the US presidential primaries multiplied that, for a total of maybe 3 percent.

In the meantime, Asia’s cracking currency regimes are effectively increasing their subsidies of fuel.

HONG KONG: Buckling under the weight of record oil prices, several Asian countries have cut or are thinking of cutting their fuel subsidies, which raises a pressing question for Beijing: Can China afford its own oil subsidies at a time when it is spending billions on post-earthquake reconstruction?

The short answer is yes, because China is blessed with both large trade account and fiscal surpluses. The reconstruction cost is projected to amount to about 1 percent of China’s gross domestic product, while the fuel subsidies account for another 1 percent, JPMorgan estimates.

Remember that China had a fiscal surplus of 0.7 percent of gross domestic product last year, or $174 billion. So even if spending on post-earthquake rebuilding and fuel subsidies were to cause a 1 percent fiscal deficit, that would still be very manageable.

But here is a more important question: Why should China keep domestic fuel prices at about half of the global average?

The usual answers are to keep inflation in check and stave off social instability that could result if prices were to rise too quickly.

But by distorting fuel prices, China is encouraging fuel consumption and discouraging the use of new energy. Since the Chinese still live in an $80-a-barrel oil environment, demand for anything from cars to chemical products will spiral higher and raise the risks of economic overheating.

Increasing subsidies on fuel will crowd out more investment in other areas, such as education or health care, to name two possibilities.

What’s more, a worsening fiscal situation might put downward pressure on the yuan. Fuel subsidies have exaggerated inflation in the developed world, while understating inflation in the developing world. China’s inflation could well hit 15 percent if Beijing were to free up caps on energy prices, Morgan Stanley estimates.

“If China is not able to take away the subsidy and cut down its demand, it will have huge implications for the world,” said Shikha Jha, a senior economist at Asian Development Bank.

Countries like China and India, along with Gulf nations whose retail oil prices are kept below global prices, contributed 61 percent of the increase in global consumption of crude oil from 2000 to 2006, according to JPMorgan.

Other than Japan, Hong Kong, Singapore and South Korea, most Asian nations subsidize domestic fuel prices. The more countries subsidize them, the less likely high oil prices will have any affect in reducing overall demand, forcing governments in weaker financial situations to surrender first and stop their subsidies.

That is what happened over the past two weeks. Indonesia, Taiwan, Sri Lanka, Bangladesh, India and Malaysia have either raised regulated fuel prices or pledged that they will.

Actions taken by those countries will not be able to tame a rally in prices though unless China, the second-largest oil user in the world, changes its policy. While the West is critical of China’s energy policy, there is little outcry for change within the country, except for complaints from two loss-making refineries.

By contrast, Indonesia has convinced its people that fuel subsidies benefit the rich more than the poor, because rich people drive more and consume more electricity. Jakarta rolled out a $1.5 billion cash subsidy program to help low-income Indonesians cope with higher prices. Although no country wants to build a system on subsidies, the cash subsidy at least makes fuel subsidy cuts politically feasible.

“The people need to wonder, who pays for the subsidies?” said Louis Vincent Gave, chief executive of GaveKal, a research and asset management company. “Most Asian countries are printing money to pay for them.”

Fuel subsidies compromise countries’ ability to control their own budget spending. If China and India can cut their subsidies, they would be able to spend more on infrastructure and education.

While Asian governments dole out cheap food and cheap energy, Asian currencies settle the bill. Morgan Stanley expects some emerging market currencies to face downward pressure, probably for the first time in a decade, as those countries unwind their fuel subsidies and domestic inflation shoots up.

China’s domestic fuel prices are among the lowest in the world, equal to about 61 percent of prices in the United States, 41 percent of Japan and 28 percent of England. The longer it waits, the more painful it will be when it tries to remove the subsidy.

China actually doesn’t have much freedom to splash dollars for fuel. Its entire macroeconomic policy can be summarized as “long USD, short RMB.” Not a good trade.

Apologies

for the lack of posting recently.

I have been extremely busy, but things should lighten up by Saturday or Sunday.

via

May 30 (Bloomberg) — Iceland’s lawmakers passed a bill allowing the central bank to sell as much as 500 billion kronur ($6.76 billion) of foreign-currency bonds, equivalent to more than a third of the country’s gross domestic product.

The bill was passed late yesterday, Thorsteinn Thorgeirsson, chief economist at the Finance Ministry in Reykjavik, said in a telephone interview. The move would allow the central bank to more than triple foreign reserves.

The bank needs to restore confidence in an economy whose currency slumped 20 percent against the euro this year on concern commercial banks may have expanded abroad too fast. The assets of Iceland’s three biggest banks were nine times the size of the economy last year. Kaupthing Bank hf, the biggest of the three, had 87 percent of its assets denominated in foreign currencies.

“This definitely helps to boost confidence in the economy,” said Bjarke Roed-Frederiksen, an economist at Nordea Bank AB in Copenhagen, the biggest Nordic lender. “But it’ll be an expensive loan, if they decide to act on it.”

The krona gained for the first day in four, rising 0.3 percent to trade at 115.4969 against the euro as of 12:16 p.m. in Reykjavik.

“The central bank will probably take advantage of the bill,” said Ingolfur Bender, head of economic research at Glitnir Bank hf in Reykjavik. “That’s what the government wants them to do and that’s what they will do.”

An official at the central bank, or Sedlabanki, declined to comment.

Currency Slump

The krona has tumbled this year on concern the global credit crunch may force some of the island’s banks, who rely on money- market funding to run their operations, to turn to the central bank for aid. Interest rates at a record high have failed to reverse the slump in the currency, which pushed the inflation rate to an 18-year high of 12.3 percent this month.

The central bank on May 22 kept the benchmark rate unchanged at a record 15.5 percent, indicating policy makers may prefer to boost foreign reserves to support the currency rather than raise rates further.

“I know the central bank is working quite hard on it right now; they’re on a roadshow talking to possible investors in London today and yesterday,” Bender said. “I definitely expect them to announce something within the next couple of weeks.”

The bank on May 16 entered an agreement with its Norwegian, Swedish and Danish counterparts to swap kronur for as much as 1.5 billion euros, allowing it to almost double its foreign reserves.

Reserves

“It’s clear that this move, and the swap agreement, are more significant at the moment than changes in the interest rate in supporting the krona,” Roed-Frederiksen said.

Currency reserves stood at 206.8 billion kronur at the end of April, the bank said on May 8. That compares with combined assets of 11.4 trillion kronur at Kaupthing, Landsbanki Islands hf and Glitnir Bank hf at the end of last year. Including the value of the swap agreement entered earlier this month and the debt sale approved today, reserves could rise as high as 880 billion kronur at today’s exchange rates.

Moody’s Investors Service cut Iceland’s credit rating on May 20 to Aa1 from Aaa citing concern that the government may have to cover liabilities at the nation’s banks.

As noted here time and again, Iran has nothing to lose by waiting out the end of George Bush’s term.

Iranian Foreign Minister Manouchehr Mottaki said May 29 that Iran thinks U.S. voters want to change the foreign policies of President George W. Bush, and he said that the present U.S. presidential campaigns make that clear, The Associated Press reported. Mottaki, who would not endorse a candidate, said that foreign policy would play an important part in the election of the next U.S. president.

Iran could not have had a better March-May. A rumored Israeli Gaza offensive, against Iran’s proxy Hamas, failed to materialize. Hezbollah, staked by Iran, was forced to go all-in in Lebanon, won, and has returned to a defensive crouch.

Mottaki’s announcement is a signal to Ahmadinejad’s domestic foes that Iraq is worth waiting for for a little while longer. He happens to be right.

US econo-political analysis is divided into two camps. The “mainstream” camp sees US growth figures as credible, and takes at face value the idea that the US, by sheer economic vitality, has avoided a recession. This school views US inflation as temporary. It views 10/90 “right track/wrong track” numbers as merely a dubious poll, a product of stampeding pessimism, spawned by the media’s sensationalizing of US malaise. This group has faith in government and banking institutions, and little faith in consumers’ ability to assess or predict their own behavior. Curiously, this group is also disproportionately Republican and “free-market.” It does not see much potential for an economic- or inflation-driven political upheaval in November 2008.

The “cynics,” e.g., Bill Gross, Mish Shedlock, and John Williams, trust consumers’ perceptions over the government’s. Cynics argue that consumers are telling the truth when they say how pessimistic they are, and trace the dissonance between official and consumer perceptions to vagaries of BLS unemployment and inflation accounting–a story flogged to death here, and much more persuasively on other sites.

The cynics see much higher potential for political upheaval in November 2008.

Apparently, so does Iran.

Bush Administration policy vis-a-vis Iran/Iraq usually means dialing up tensions over Iranian nukes and weapons supplies into Iraq, bringing up aircraft carriers, launching large operations against Iran’s Mehdi Army Iraqi proxy, slapping sanctions on Iranian banks, using its own militias to incinerate strategic people inside Iran, etc.

After Hezbollah routed the US alliance in Lebanon (followed by an abrupt end to the US/Iraqi crackdown on Sadr in Baghdad) one would assume that the Bush Administration policy of “we’d like to talk, but we’re happy to pull the trigger too” attitude has lost credibility. Iran is quietly leveraging its gains by edging the US out of Iraq:

May 29, 2008 1419 GMT
Senior Iraqi official Sa’ad Javad Qandil told Alalam television May 29 that a draft of an agreement to extend U.S. troops in Iraq beyond 2008 was problematic, especially any condition that would allow the U.S. to establish a military base there.

Predictably, Qandil is a member of the Islamic Supreme Council of Iraq, Teheran’s “mainstream” Iraq proxy (the Mehdi Army is, most of the time, its militant proxy). Hezbollah’s unanswered victory in Lebanon has ramifications across the entire region, not so much in the eyes of Americans as in the eyes of Arabs who were reminded, once again, that the personal bonds between Ahmadinejad and militia leaders can result in very quick and decisive action when Teheran’s interest are threatened.

Anyway, Iran hasn’t been deterred by US tough talk in the past, and there’s less reason than ever to think that louder tough talk will change Iran’s behavior at all. Lebanon has changed the game.

I would repeat my “sh*t or get off the pot” mantra about the US and Iran, but the US has backed down one too many times. I’m beginning to believe we should throw the Saudis the keys as soon as possible, to hedge against a probably adverse US election outcome while it’s still possible.