Monday, December 27, 2010

Is raising inflation expectations a good idea, and will it work?

There have been several discussions about the viability of monetary policy right now, just when the economic authorities need to create demand while at the same time rates are at the zero bound*

Focusing on interest rates had always been what monetary authorities focused on. And for a long time, it seemed the effective and fiscally prudent policy choice. For as long as tweaking rates could increase or decrease economic activity, there was no sense in putting focus on extensive fiscal action. Fiscal policy determination is a politically-charged process, and very often ends up being directed at wasteful projects, and cutting the most fruitful activities in the worst possible way.

But for as long as the challenge is to simply reduce demand, increasing rates will do. If the challenge were to increase demand, as it is in the US right now, you also have to address several factors. I could list a few things other than rate/price that could influence, or put a limit on demand at the individual level.

Level of current income, level of current expenses, current level of indebtedness, capacity to service existing debt, capacity to borrow more-to financing more spending, confidence in stability of future income, expectations about future increases in fixed expenses, confidence in future value of purchasing power of current savings (if you have any), non-existence of any lender calling on their debt, confidence in future positive value of existing savings/investments/net worth, ease of liquidating current savings –to finance current spending, tax implications of using current income/net worth to spend now vs. later, confidence about over-all economy, and how it is being run… the list goes on further.

These can be addressed either directly, via fiscal policy action, or indirectly, via monetary policy action. When you are at the zero rate bound, the monetary policy tools to use (QE, etc) have the objective of increasing inflation expectations. If people expect heightened inflation, monetary authorities intend them to do several rational acts: buy stuff now that they would have postponed ‘til the future, and make investments in businesses, stocks, and others that rise in tandem with inflation.

Examples were made of buying a canoe now, buying a farm, buying oil and gas shares, as well as buying a restaurant meal now. The point was also made that rising inflation will spur people to borrow money, since the rising inflation will increase the value of physical assets, while inflating away the real cost of borrowing.

But rising inflation expectations cuts both ways. If a lender is going to lend to a borrower to buy his canoes now, it's now going to lend him at the rate that incorporates the higher inflation expectations for next year. So the higher borrowing rate effectively offsets the value of buying canoes now rather than buying it at a higher price next year and just borrowing less (or not at all). There's no way to get ahead if the other side also knows what one side knows.

And if Farm sellers and oil and gas shares owners know that inflation will be higher next year, they won't sell their farm now. Or they will sell their shares at a price that reflects the higher inflation. Intentional buyers may end up not wanting to buy anymore.

Having the restaurant meal now will likely be the best bet to get ahead, since the restaurant will likely still be selling at the price level that he already bought his cost inputs. But then, if one is worried about looming inflation, he may be less likely to eat out, too. For if people can be influenced that inflation can and will be increased by monetary authorities, they can also, and might be, influenced that inflation will get out of control (maybe because the currency is depreciating and higher imported input costs are wreaking havoc on the economy). In this sense, increasing inflation expectations may backfire, and cause demand destruction, the opposite of the intended effect. He may now be thinking that he needs to preserve his soon to be diminished purchasing power for basic necessities. He will trade down to less costly substitutes. He will ration his supplies. He will repair stuff rather than buy new ones. These are rational actions to make during runaway inflation.

It would be better yet, if the challenge were to increase demand, to just directly address the following: level of current income, level of current expenses, current level of indebtedness, capacity to service existing debt, capacity to borrow more-to financing more spending, confidence in stability of future income, expectations about future increases in fixed expenses, confidence in future value of purchasing power of current savings (if have any), non-existence of any lender calling on their debt, confidence in future positive value of existing savings/investments/net worth, ease of liquidating current savings –to finance current spending, tax implications of using current income/net worth to spend now vs. later, confidence about over-all economy, and how it is being run…..via fiscal policy action instead.

*This post flows from two unrelated comments I made in discussions elsewhere. It doesn't particularly react to the original post where those discussions arose.

Tuesday, December 14, 2010

Flaws in the belief in effectiveness of Fed monetary easing

QE2 is hailed by some economists as the tool needed to jumpstart the laggard US economy. The mechanism here is - The build-up of the monetary base eventually leads to rising inflation expectations. This is supposed to then encourage people to start buying things now, in anticipation of rising future prices, which then leads to a positive multiplier effect for the economy. There are several flaws in this belief. Here are reasons that I could think off the top of my head:

Debt among economic agents is ignored/inflation expectations is over-estimated. Debt does make a difference. Inflationary measures can be hindered in a recession economy with a lot of debt, because the indebted that are undergoing deflation, i.e. balance sheet recession, will not be induced to make more purchases if paying off the debt is already eating up much of their income. They will hope that the non-indebted ones will come to the rescue, and be induced to consume more via increased inflation expectations. But then, the non-indebted have to be convinced that the ongoing balance sheet recession among the indebted will not counteract any of the inflationary measures.

This was effective on the way up to becoming a debt society. Now no longer.

Transmission to the larger economy will be via even more debt. QE2 puts more reserves on the banks, but no money goes directly to people who will spend it on consumption. For this to get to the end-consumers, those remaining non-indebted will have to take one for the team, get into debt, and spend it in the local economy.

On the way towards becoming a debt-centered society, people managed to continue their consumption activities by getting into more debt. They were able to secure debt because they were able to borrow against the increasing values of homes and investments. This increasing value was only possible for as long as more people were chasing into appreciating assets, but had to stop when many people can no longer realistically afford the increasing prices. The debt deleveraging that follows results in depreciating assets, and which leads to more insolvencies, leading to even more deleveraging.

Getting into new debt will be the last thing on the minds of those currently deleveraging.

It floods the banking system with trillions in reserves but zero new capital. Banks do not need reserves to do their lending activities. If a bank is to grant more loans, it needs adequate capital, in order to buy risk-weight assets, and needs to have credit-worthy borrowers. If it has both of these, it can always raise any deficiency in its reserves, i.e. deposit base, by borrowing in the interbank market, or from the Fed’s discount window. If it doesn’t have adequate capital, or a compelling borrower, no loans will be extended.

The continuing deleveraging doesn’t help in building up bank equity, or confidence to lend.

It assumes that in deciding to borrow, companies care more about cost of funds than improving sales and profit. QE2 is supposed to decrease long-term interest rates. That’s meant to elicit more company borrowing for long-term capex. But without improvement in aggregate demand, sales prospects and profits do not improve. Also, to the extent that QE2 results in more funds being diverted towards asset bubbles, it’s going to make cost of funds more expensive.

These arguments doesn’t necessarily mean that I believe monetary policy/quantitative easing will have no effect on sentiment whatsoever. I think the effect will not be evident while having a long build-up. In the end, there will be a big snap. This comes when people lose confidence in the debased currency (which is toxic when not matched by a growing economy), and people begin to trash it.

Wednesday, December 8, 2010

Computing for the Bail-Staff jobs save factor

My last post expressed surprise that McD’s was involved in the massive Fed emergency program. But then, I got to thinking, if one of the purposes of the bailout had been to save jobs, then McD’s should be right up there with the rest of them, right? After all, McD’s employs lots of entry level staff positions, contributing significantly to aggregate demand. So I wondered further, why don’t we try to evaluate the effectiveness of the Fed bailouts in terms of saving jobs? What if we were to use a new metric, something like the Bailout dollar amount to number of staff jobs saved, or more simply, a Bailout to Staff multiple. To be short, let’s simply call it the “BS factor”. Here then is a table, evaluating the Fed emergency loans in terms of its BS factor among a sampling of recipients (click for full view):
From the list, it is evident that McD’s actually registers the lowest multiple on our newly-minted “BS factor” scale. The highest BS factor belongs, far and away, to Bear, followed distantly by a close tie between Merrill and Morgan.

Citi and BofA register much lower BS factors because of their higher staffing numbers (Taking into consideration, of course, that much of this staffing number is actually outside the U.S. putting them outside the Fed’s purview. But then, every nation that hosts a Citi or a BofA branch likely has sizeable dollar holdings. While the dollar is the US currency, if the Fed debases, it is everybody else’s problem).

Now I don’t know if looking at emergency loans provides a comprehensive picture of the overall assistance back in ’08. After all, the Fed also took on derivative positions and bought toxic assets, so this table may actually be discounting a large multiple of BS factor .

Also, looking at the “beneficial” effects of the bailout simply on the number of staff positions saved is an incomplete analysis. After all, many of the bailoutees were highly interconnected entities whose failure may have caused even more staff positions lost in the economy, whether directly employed by the bailoutees, or not. (A failure by one of these guys has a negative effect on the viability of companies like McD’s, whose business operations are facilitated by the financial system). So the table may also be overestimating “BS factor”.

If there's anything to learn in this exercise, it’s nigh impossible to calculate the effectiveness multiple when we are talking about bailouts – you get lost in all the layers of BS.

Wednesday, December 1, 2010

The Fed's beneficiaries list


We ’ ve been getting big interesting news today. The Fed finally made public its list of the biggest beneficiaries of its emergency program during the 2008 financial crisis. In case you didn’t know, this is the long-held secret list that Ben Bernanke and the rest of the Fed had wanted to take with them to their grave. But due to some astute legal maneouvers by media, this is now seeing the light of day.

And according to the list, among the biggest beneficiaries were, no surprise here, European banks. But surprise, surprise, we also see that non-bank non-financial firms Mcdonald’s and Harley Davidson are on the list. So it seems Mcdonald’s has found a rich new revenue source - satisfying the Fed’s Super-sized hunger for toxic assets. From Huffington Post. HT: CW

The data revealed that the Fed's aid was scattered much more widely than previously understood. Two European megabanks -- Deutsche Bank and Credit Suisse -- were the largest beneficiaries of the Fed's purchase of mortgage-backed securities. The Fed's dollars also flowed to major American companies that are not financial players, including McDonald's and Harley-Davidson, through unsecured short-term loans.

Wow. That’s $billions$ worth of two all-beef patties, subprime sauce, lettuce, cheese, pickles, onions on a CDO bun. I guess I now have to ask the question that’s probably on a lot of people’s minds right now… did that amount come with a large side of fries and coke?

UPDATE: McD's issues a correction statement: The Fed determined that McDonald’s, while not listed as a borrower under the CPFF, benefited from the program as a “parent/sponsor” of Golden Funding Corp., which sold a total of $203.5 million in commercial paper.

The designation is incorrect, McDonald’s spokeswoman Heidi Barker Sa Shekhem said in a statement. “McDonald’s Corp. was erroneously listed by the Federal Reserve Bank as a recipient of federal funds during the financial crisis of 2008,” she said. So it's not McD's, it's a subsidiary (you see a difference?), and I should clarify that the Fed assistance is in buying their paper, not mortgage bonds that they own.