what do you think of noland's comments tonight where he thinks the economy and mortgage bubble will be difficult to derail?
prudentbear.com
The Disparate Approaches of Messrs. Trichet and Greenspan:
Bloomberg’s John Berry noted that immediately after yesterday’s announcement from the Fed there was basically no movement in any instrument along the entire yield curve. “Call it, if you will, case of perfect transparency.” The market new exactly what to expect and it was fully discounted. Throughout the marketplace, the Fed’s policy of open transparency and “baby step” adjustments receives universal adoration. It shouldn’t.
Not only do I take exception that “perfect transparency” is a good idea to begin with – in a world of Global Wildcat Finance and endemic speculation - it also occurs to me that the Fed is really being less than forthright with its communications. We now appreciate that Federal Reserve meetings do include discussion of important issues such as asset prices and excessive risk taking, yet official meeting pronouncements offer little more than colorless boilerplate. And in public communications, as was demonstrated again today, our Fed Chairman retains distinction as The Master of Obfuscation.
I much prefer the ECB’s Straight Talk approach to disciplined central banking.
European Central Bank President Jean-Claude Trichet speaking yesterday at the regular ECB news conference: “Further insight into the outlook for price developments in the medium to long-term horizons is provided, as you know, by the monetary analysis. That latest monetary data confirm the strengthening of M3 growth observed since mid-2004. This increasingly reflects the stimulative effect of historically very low level of interest rates in the euro area. As a result of the persistently strong growth in M3 over the past few years, there remains substantially more liquidity in the euro area than is needed to finance non-inflationary economic growth. This could pose risks to price stability over the medium term and warrants vigilance. The very low level of interest rates is also fueling private sector demand for Credit. Growth in loans to non-financial corporations has picked up further in recent months. Moreover, demand for loans for house purchase has continued to be robust, contributing to strong house price dynamics in several euro area countries. The combination of ample liquidity and strong Credit growth could, in some part of the euro area, become a source of unsustainable price increases in property markets.”
That’s the way central bankers are supposed to talk! And from the question and answer session:
Mr. Trichet: “As for house prices…at the level of the full-body of the euro area, we are not alarmed. In some part of the euro area we see phenomenon that are not in our view sustainable and certainly are not necessarily welcome.”
Questioner: “You say you are not alarmed at the asset prices and housing prices”
Mr. Trichet: “At the level of the euro area as a whole!”
Questioner: “In your statement you said the combination of ample liquidity and strong Credit growth could become a source of unsustainable price increases in property markets. What is the function of forward-looking monetary policy? When you have to react – do you react before the Bubble is bursting or after the Bubble has burst?”
Mr. Trichet: “Before the Bubble burst…as you know full well. And it is the reason why I insist on vigilance, permanently. We also insist - even if it has not been noted in the question – on the fact that the monetary analysis calls for vigilance, as I said, because we see dynamism of M3 and dynamism by definition by the counterpart of M3, which means that we – from that standpoint, from that analysis – can see that we could have an overhang of liquidity and even in the short-run this does not necessarily materialize in inflation. In the long-run, we see in our own analysis that – and the reason that we have a monetary analysis – we see that it can materialize in inflation. So I would say we follow this evolution of the monetary aggregates with great care. We see phenomena that have to be monitored very, very clearly. We could see that the explanation we had on the portfolio shifts and then the unwinding of portfolio shifts – which was a convincing element to understand what was happening – doesn’t seem now, in our own analysis, to be convincing to explain the present dynamism of M3. So it is a real, real cause for being vigilant, that’s clear.”
Jean-Claude Trichet, speaking today before the Group of Seven meeting: “Clearly what we have ... is that there is a level of lack of savings which has to be corrected, certainly in the United States and we all agree on that… The industrialized world as a whole is in deficit, that is the current account deficit, and there is no offsetting of the US current account deficit by the other industrialized countries and that of course means that we are asking the rest of the world to finance us. It doesn’t seem to be that it’s acceptable as a sustainable, long-term feature of the present functioning of the global economy.”
Mr. Trichet speaks clearly and cautiously, befitting of the President of what has become the world’s preeminent central bank.
Chairman Greenspan, on the other hand, today gave another intriguing New Age Economics talk in London titled “Current Account.” He garrisons his Pollyannaish and New Paradigm view that “the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity.” I’ll provide a few excerpts, but I encourage readers to go to the Fed’s website and read it in its entirety.
“International trade has been expanding as a share of world gross domestic product since the end of World War II. Yet through 1995, the expansion was essentially a balanced grossing up of cross-border flows. Only in the past decade has expanding trade been associated with the emergence of ever-larger U.S. current account deficits…
A number of factors have recently converged to lessen restraints on cross-border financial flows as well as on trade in goods and services.
The advance of information and communication technology has effectively shrunk the time and distance that separate markets around the world. The vast improvements in these newer technologies have broadened investors’ vision to the point that foreign investment appears less exotic and risky…
Both deregulation and technological innovation have driven the globalization process… The effect of these developments has been to markedly increase the willingness and ability of financial market participants to reach beyond national borders to invest in foreign countries… Implicit in the movement of savings across national borders to fund investment has been the significant increase in the dispersion of national current account balances... The decline in home bias, as economists call the parochial tendency to invest domestic savings at home, has clearly enlarged the capacity of the United States to fund deficits.
Arguably, however, it has been economic characteristics special to the United States that have permitted our current account deficit to be driven ever higher, in an environment of greater international capital mobility. In particular, the dramatic increase in underlying growth of U.S. productivity over the past decade lifted real rates of return on dollar investments. These higher rates, in turn, appeared to be the principal cause of the notable rise in the exchange rate of the U.S. dollar in the late 1990s. As the dollar rose, gross operating profit margins of exporters to the United States increased even as trade and current account deficits in the United States widened markedly. But these deficits have continued to grow over the past three years despite a decline in the dollar, whose broadly weighted real index is now much of the way back to its previous low in 1995.
“To understand why the nominal trade deficit--the nominal dollar value of imports minus exports--has widened considerably since 2002, even as the dollar has declined, we must consider several additional factors. First, partly as a legacy of the dollar’s previous strength, the level of imports exceeds that of exports by about 50 percent. Thus exports must grow half again as quickly as imports just to keep the trade deficit from widening--a benchmark that has yet to be met. Second, as is well-documented, the responsiveness of U.S. imports to U.S. income exceeds the responsiveness of U.S. exports to foreign income; this difference leads to a tendency--even if the United States and foreign economies are growing at about the same rate--for the growth of U.S. imports to exceed that of our exports. Third, as of late, the growth of the U.S. economy has exceeded that of our trading partners, further reinforcing the factors leading imports to outstrip exports. Finally, our import bill has expanded significantly as oil prices have risen in recent years.”
“we may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins.”
Besides market pressures, which appear poised to stabilize and over the longer run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume… An increase in household saving should also act to diminish borrowing from abroad. The growth of home mortgage debt has been the major contributor…to the decline in the personal saving rate in the United States from almost 6 percent in 1993 to its current level of 1 percent. The fall in U.S. interest rates since the early 1980s has supported both home price increases and, in recent years, an unprecedented rate of existing home turnover.
All told, home mortgage debt, driven largely by equity extraction, has grown much more rapidly in the past five years than during the previous five years… Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit… over the past two decades, major innovations in the United States have improved the availability and lowered the costs of home mortgages. These developments likely spurred homeowners to tap increasing home equity to finance consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available among our trading partners as a vehicle to finance consumption expenditures.”
There is no mystery surrounding the correlation of home mortgage debt and the current account. By its very nature, home mortgage Credit excesses will tend to inflate home values, sales and construction - all the while stimulating consumption. After years of accommodation, such dynamics will ensure a powerful infrastructure dedicated to consumption and asset-based lending – along with the resulting deeply maladjusted economy. Mr. Greenspan is inferring that mortgage Credit can now be expected to slow meaningfully, thus stabilizing and improving the current account deficit. He is a brave man (as opposed to a cautious central banker!) for attempting to call the top of the Great Mortgage Finance Bubble.
And I take strong exception to much of Mr. Greenspan’s analysis. “Restraints on cross-border financial flows” have been “lessened” primarily because of the explosion in global speculative finance and the unparalleled expansion of central bank holdings. And let’s face a little reality here and recognize that these are not the most pristine of market dynamics. The U.S. government and financial sector have greatly inflated the quantity of dollar balances flowing to the rest of the world, and the global financial system has evolved to accommodate these flows. That tends to be the nature of Bubbles.
And I do believe that true economic returns have virtually noting to do with our massive current account deficits. The vast majority of inflows are merely the recycling of excess dollar balances back to U.S. securities markets. And, clearly, the onslaught of finance into the U.S. during the late-nineties was poorly rewarded. The technology Bubble burst, telecom debt collapsed and the boom in direct foreign investment came to a screeching halt. The King Dollar blow-off was then fueled by massive speculative flows (dollar “recycling”) into the U.S. bond market to profit from Greenspan’s widely-telegraphed post-tech Bubble interest rate collapse. Economic returns? No.
“It has been economic characteristics special to the United States that have permitted our current account deficit to be driven ever higher” qualifies as Mr. Greenspan’s most dangerous (“anti-cautious”) reasoning. My hunch is that the so-called “productivity revolution” is more related to the nature of inflating service-sector “output” and an undercounting of the hours actually worked. And if real returns of U.S. investment are so high, why has direct foreign investment remained so low? Why would most of the flows into the U.S. result in Treasuries, agencies, and ABS purchases? Why would foreign central banks be forced into the role of dollar buyers of last resort?
And why use the language “the responsiveness of U.S. imports to U.S. income exceeds the responsiveness of U.S. exports to foreign income.” Of course we consume more of our income than anyone else, and the structure of our economy dictates that a large portion of any additional consumption must come from imports. That’s precisely why we have enormous Current Account Deficits: We consume too much and invest too little in productive capacity. And I do not believe that it is accurate to today claim that our economy is growing more rapidly than our trade partners – this is certainly not the case with Asia or, increasingly, the emerging markets. And, yes, part of the ballooning trade deficit is related to higher fuel prices. And these prices are rising specifically because of unrelenting Credit inflation, U.S. trade deficits, and the weak dollar. There is no way to grow our way out of this dilemma, nor is possible to rectify imbalances through currency devaluation.
The only way to return to some semblance of a balanced current account would be to sharply reduce mortgage debt growth. Mr. Greenspan, presumably, believes that higher interest rates will soon induce this process. Indeed, at 2.5%, we have already reached a level that many not all too long ago forecasted would mark the end of Fed “tightenings.” The Fed may have raised the cost of overnight borrowings 150 basis points, but 10-year Treasury yields are actually a few basis point lower today than they were a year ago. And mortgage rates remain at historically low levels and, not surprisingly, real estate lending remains robust. General Credit availability and marketplace liquidity are as easy as ever. The backdrop is not conducive to restraint, and the Fed has a lot of work to do.
But this is the very nature of Bubbles: they so refuse to succumb easily or quietly. And the bigger they are the more challenging it is to get them to fall – that is without causing one heck of a ruckus. This is why Mr. Trichet is committed to caution and vigilance – why there is a focus on the short, medium and long-term prospects for price stability. As consummate central bankers, Mr. Trichet and the ECB are resolute in their pursuit of comprehensive monetary analysis and forward-looking monetary policy. They don’t have to partake in creative analysis or sophisticated obfuscation. And, importantly, they appreciate the necessity for reacting to Bubble “dynamism” as it develops and not waiting for Bubbles to burst.
Mr. Trichet repeatedly refers to “price stability.” Contemporary finance and economics dictate that this term must be used broadly. One important consequence of globalization is that a price index for a basket of goods (largely produced in Asia) is no longer a good indicator of domestic monetary conditions. Securities markets and asset prices must now be the focus. U.S. Credit inflation clearly manifests foremost into asset inflation and Trade Deficits. And, especially over the past two years, massive Current Account deficits manifest into unprecedented official flows into U.S. Treasuries and agency markets. The securities markets are at the threshold of contemporary Monetary Disorder.
Today was as good a day as any to witness Monetary Disorder and Price Instability at work in the U.S. bond market (ok, equities also). A somewhat weaker-than-expected report on non-farm payrolls incited a huge short-squeeze and derivatives unwind that saw yields lurch lower. The consensus view may be that a slowing economy explains the bond rally, but I remain quite skeptical. It would appear to me that this is one more example of any ebb in the typical ebb and flow of economic activity fostering an exaggerated response from the bond market. There’s too much liquidity at home and abroad.
Ten-year yields are now more than 30 basis points below where they spiked in early December, while mortgage rates are at the lowest level since late last March. There remains a strong inflationary bias in the nation’s housing markets, and I believe there is an unappreciated expansionary bias throughout much of the economy. I cannot at this time buy into the “deflation” story, but instead continue to believe the surprise going forward will be the resiliency of the Mortgage Finance Bubble and the U.S. and global economy overall.
Perhaps I will be proved dead wrong. The U.S. Bubble economy could be weaker than I perceive and the global economy not as sensitive to the extraordinary liquidity backdrop. And, perhaps, the Wild Mortgage Finance Bubble is poised to quietly succumb. But there is just nothing in my analytical war chest that points toward a warm and happy ending to this story. Mortgage rates need to be moving higher, but the distorted marketplace and the global liquidity Bubble are thus far incapable of orchestrating an orderly adjustment. And these artificially low rates will stimulate continued robust demand for mortgage and other borrowings.
Imbalances – most important being the Current Account – will not conform to Mr. Greenspan’s expectations. And a ballooning Current Account equates to further inflationary distortions, including the inflating pool of destabilizing global speculative finance. And, I will suggest, a surge in economic activity would these days catch the bond market especially unprepared. Bubble dynamics have forced the marketplace into a destabilizing squeeze and derivatives unwind that creates only greater vulnerability for a reversal and problematic spike later on. My fear of a 2005 dislocation in the interest-rate markets is being anything but allayed.
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