Wednesday, September 19, 2007

The Dollar, The Fed, PBoC and BOJ

The Fed cut a larger than expected 50 bp, almost entirely to delay or forestall the most serious effects of the asset/credit crunch. In plain language, lines of bank customers outside British banks waiting to withdraw their money must have scared the dickens out of Mr. Bernanke, who has made a whole career out of constantly repeating Milton Friedman's "the Fed should have cut more in 1929".

The immediate positive effect on the economy (the real one, not Wall Street) will come through the reduction in existing ARM payments, easing the pressure on household debt service and hopefully slowing the wave of foreclosures now upon us. (Yesterday RealtyTrac announced that monthly foreclosures in August jumped an astonishing 115% from last year. ) So the Fed giveth some debt relief with one hand - but what has it taketh away with the other? The value of the dollar is dropping, causing new highs in the prices of just about every significant commodity, oil in particular. Isn't a jump in inflation closely behind?

There is a seemingly logical counter argument: the two most significant foreign currencies for the US economy are the Chinese yuan (cheap imports) and the Japanese yen (cheap loans). The yuan is essentially pegged to the dollar, so Chinese imports are not going to get more expensive. The yen is perennially weak and its interest rates are not very likely to rise much. In other words, where it matters the dollar is stable and does not create imported inflation.

This, however, is a static and simplistic approach. China is already experiencing high domestic CPI inflation (6.5% in August, the highest in 11 years) and the PBoC has had to raise official rates and reserve requirements repeatedly, to little avail so far. One of the next measures may involve an upward revaluation of the yuan to cool the economy somewhat and prevent higher wage demands and to guard against imported inflation. This will immediately result in higher import prices in the US, i.e. inflation.

Japan is also at risk of experiencing cost-push inflation: it is completely dependent on oil and other commodity imports and cannot forever pay for them with a weak yen. At some point, the positive effects of the weak yen on exports are going to be out-weighted by expensive imports and that's when we may see the yen move higher, too.

The US cannot ignore the inflationary effects of a cheaper dollar just because its two most important counterparties are currently "pegging" their currencies at advantageous rates. They are doing so because it is (or was) in their own best interests and not out of consideration for the US. Once their domestic interests change those "pegs" are going to go away.

In the case of China the need to revalue is pressing and the PBoC is setting the stage by rapidly narrowing the gap between US and Chinese interest rates. After yesterday's Fed cut and last Saturday's PBoC rate hike the spread between Fed Funds (4.75%) and the PBoC benchmark 12 month depo (3.87%) has narrowed to 88 bp, down from 300 bp a year ago. But despite hiking seven times since last year, real interest rates in China are still very negative at -263 bp (The Economist chart below is 6 months old, but serves for perspective.) This means that China needs to urgently loosen its foreign exchange-rate regime so that it can fight inflation more efficiently.

Chart from The Economist

The conclusion is that the Fed did what it had to do to avoid the phantasm of Depression from haunting Mr. Bernanke. Fine - now it must pay attention to the value of the dollar because it cannot long depend on the good graces of the PBoC and BOJ. They have other fish to fry.


P.S. Fact vs. Virtual Reality

The following news item is presented in the interest of separating virtual reality (created chiefly at the intersection of Wall & Broad) from hard fact.

British Airways is suspending its London to Detroit flights. Demand is lacking due to auto slump.

This little snippet has a reality quotient 10x bigger than any FOMC meeting note.


  1. Well, you've addressed the issue of import inflation with respect to China and Japan's relationship to the U.S. economy, but what about the issue of higher long term interest rates that are all but a certainty once capital flight ensues.

    This will have a fantastically deflationary impact. So, the fools and their ARMs may get some relief, but who will want to buy a home when fixed rate mortgages ascend towards the sky? And how will governments and corporations do business when they can't get financing except at loan shark rates?
    Care to guess how long it will be before the shares market figures out that the cure IS the disease?

    Riddle me these

  2. The Washington/Wall consensus is that the capital that matters is dollar neutral because it comes precisely from those same Japan (#1 Treasury holder) and China (#1 dollar holder) plus the the Oil Sheikdoms who also peg to the USD (I believe #3 Treasury holders).

    Therefore, that capital will not fly away. This is what is called global financial "balance", US style.


  3. From now on, the importance of every new piece of US economic data has been magnified immensely.

    Each new sign of economic weakness will be automatically equated with further rate cuts, which will cause more foreign capital to flee from the US. The prospect of any more rate cuts could instigate a massive run on the US dollar.

    Beyond that, among our domestic investors it won't be long before they realize the rate cuts aren't helping the economic situation, at which point they will panic and run for the exits.


  4. Hellasious,

    Isn't it true that a large portion of total U.S. ARMs is LIBOR (plus) not Fed Funds so, to extent that interbank rate fails to follow the Fed line, we may not see quite as much bailing out of homedebtors as imagined?

  5. Re: LIBOR

    Yes, most ARMs do not use Fed Funds as a benchmark. LIBOR is the real cost of interbank money, at least for those banks that can get their name done, i.e. accepted as creditworthy counterparties by other banks. Many small banks pay over LIBOR on a regular basis.

    Fed Funds is essentially an artificial rate, a guidance as to where the Fed wishes rates to be. As you said, they don't always follow the guidance exactly.

    In times of tight money conditions - as right now - the difference between o/n LIBOR and FF can be very substantial.

    Another issue is the tenor: LIBOR has a yield curve from O/N out to 12m. With the troubles in the MBS/ABCP market there is lack of 3m money, which is reflected in 3m rates. Even those that are willing to buy ABCP are doing so strictly on an O/N basis.


  6. to rescue those foolish home buyer, now everyone has to deal with inflation.


    As resources diminish yet none will curtail their use,
    It´s each man for himself as frantic grows the restless crowd,
    As restlessness competitive leads men into abuse,
    Nor in the situation any crudeness disallowed.

    If bonds of mutual respect and common understanding
    Got set in place before the crisis struck and overwhelmed
    There were some recourse, diligence and honesty commanding,
    Yet each man by himself can hardly be by prospects calmed.

    Upon the left, upon the right sits evidence aplenty
    That none will help each occupied with his unique distress,
    As good Samaritans account for less than one in twenty,
    And by some calculations drastically extremely less.

    Those as accustomed to "cash flow" when all the flowing stops
    May know it´s economics though they blame themselves at first,
    And soon it´s caging contraband and fleeing from the cops,
    While murder as a method grows increasingly dispersed.

    When one was schooled in virtue no they didn´t teach one that
    All´s well for common courtesy but when push turns to shove
    One´s lean starvation notes another´s little bit of fat,
    At which time one is justified to doubt fraternal love.

    Curtailment of excesses comes externally applied,
    While consequences turn the neighborhood into a zone
    As fraught with violation, not so many shows of pride,
    Nor what one has he wants his competition to have known.

    Alas for human virtue! If one only understood
    That by no other means is formed the common human bond,
    Which when it disappears transforms the tenor of the ´hood,
    Though it be Lower East Side or eternity beyond.