Relevant and even prescient commentary on news, politics and the economy.

How the Fed Cornered the Long Bond

Fed Treasury Holdings 5-7-2014
The above link should take you to a PDF showing the Fed’s System Open Market Accounts holdings of Treasury Bonds and Notes which the second link will tell you comprise $2.224 trillion of the total $4.017 trillion of SOMA Holdings, with that total including $1.631 trillion of Fannie and Freddie Mac MBS’s. With the remainder in a variety of other Federal securities. In other words the ‘AFTER’ of three rounds of QE.

The PDF is extracted from a formatted Excel worksheet and shows all Fed SOMA holdings of Notes (1 to 10 years) and Bonds (20 & 30) by Maturity Date, Issue No, Coupon Rate, Par Value, and % (of Issue) Outstanding. As you scroll through the PDF a particular relationship jumps out at you: the higher the Coupon Rate the higer the % of Outstanding actually held by the Fed SOMA with a top limit apparently set at 70%. This isn’t entirely fixed, there is an additional layering of Long Term over Short Term with the Fed holding small percentages of all issues before jumping up to the 44.3% of the 9.25% Feb 15, 2016 and then taking progressively higher chunks of the Long Bonds maturing after that until holding peak as a percentage of issue with the 70% of the 8.13% 8/15/2019. Which percentage holds steady until the 8.00% 11/15/21 but then varies downward with holdings ranging mostly in the 55-70% range for issues between 2021 and 2042.

Feel free to prod at the numbers in this data table as you will. But the first order conclusion is that the higher the coupon rate in the out years of the Long Bond the larger the position of the Fed. With an apparent self-imposed limit of 70% of any given issue. I plan to comment on this at length in Comments but will allow readers the first crack. But would add one little fact nugget for your consideration: the Fed rebates all profits to Treasury. And to the extent that those profits are driven by those 8 and 9% interest payments on Bond issues where the Fed has holdings ranging up to 70% the end result is that a very large percentage of debt service on the Long Bond, a dollar amount that is recorded as an Outlay on the Federal Budget is effectively rebated back to Treasury.

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U.S. Federal Intergenerational Debt: Rendered and Layered

It is a common trope among Austerians that the U.S. is passing on unsustainable debt to our children and grandchildren. And certainly there are some scary numbers out there, for example “$17.4 trillion!!” A very real number. But maybe it would be useful to render that number down so as to calculate real incidence of that debt and debt service within and between generations. With some real numbers and associated tools. With commentary mostly defered until (duh) Comments.

Total U.S. Public Debt (to the Penny)
http://www.treasurydirect.gov/NP/debt/current
Public Debt: $17,472,131,682,925.49 in turn the sum of:
Intragovernmental Holdings: $4,992,508,245,067.06 and
Debt Held by the Public: $12,479,623,437,858.43

Now for reasons that can be explained in Comments there is no need to actually pay down Intragovernmental Holdings and instead reasons why the various accounts that comprise it should increase in nominal terms over time, so I am just going to ignore it for the purposes of this post.

Debt Held by the Public: $12,479,623,437,858.43
Almost all of this is held in a combination of Treasury Bonds, Notes, Bills and TIPS with the major balances being in the first two categories. The respective holdings can be seen in the following graphic with specific numbers available by hovering your cursor:
http://www.treasurydirect.gov/govt/charts/principal/principal_debt.htm
Treasury Bonds (20 and 30 year Securities): $1.463 trillion
Treasury Notes (1-10 year Securities): $8.034 trillion

So right away we can see that ‘Long Term Debt’ as a percentage of ‘Total Public Debt’ is $1.463 tn/$17.472 trillion or 8.4% of total Public Debt. But of course somewhere between a half and a third of current 20 and 30 year Bonds have maturities in the next 10 years meaning that the actual amount of Public Debt due in years 11+ is commensurately less than that number. (Precise number left to the commenters). Now of course this calculation ignores two factors: 1) rollover of shorter term debt and 2) debt service. So maybe we can address the second factor first:

Average Interest on Public Debt
http://www.treasurydirect.gov/govt/rates/pd/avg/2014/2014_04.htm
Total Marketable: 2.007%
Bonds (20 and 30 years): 5.011%
Notes (1-10 years): 1.808%

Okay those are the numbers. Implications, arguments and outright demagogery under the fold and in Comments.

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Evidence of Hampered Monetary Policy Transmission Channel in the Euro Area

Evidence of Hampered Monetary Policy Transmission Channel in the Euro Area

by Rebecca Wilder

Mario Draghi cautioned on the ‘hampered’ transmission channel of monetary policy in his now famous London speech last week:

To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.

I referred to the clogging of rates policy back in April via evidence from mortgage lending rates.

I address Draghi’s point that the ECB 1% refi rate will support economic activity through the lens of the mortgage market. Specifically, I find that the interest rate channel is clogged in the economies that are in most desperate need of lower rates: Spain, Portugal, and Italy.

Here I show that on a relative basis, while the household lending rate is quietly trending down for key periphery markets, the real problem lies in the non-financial corporate rates transmission channel. Specifically, rates in Portugal, Italy, and Spain have seriously diverged from both the trend in the refi rate (ECB policy rate) and those of other countries in the Euro area.

The trend in key periphery household mortgage rates is consistent with the ECB rate cuts: down
Note: All ECB refi rate data is through June 2012, so the latest rate cut to 75 bps is not included in the charts.








The magnitude still favors the core – the drop in German mortgage rates is 91 basis points since the max mortgage rate of the Euro area as a whole in August 2011 – but the trend is down for all countries.




In stark contrast to the trend in household mortgages relative to the ECB refi rate, non-financial corporate lending rates in Portugal, Spain, and Italy diverged from the other country trends.


If the ECB means business on improving the monetary transmission channel, they’ll need to attack the price of corporate loans in the Periphery markets.

Rebecca Wilder


Data Note: All non-financial corporate AAR lending rates is the annualized agreed rate on new business loans with a maturity of greater than 5 years and amount between €0.25 bn and €1 bn. Irish data is not available in Ireland and the Greek data is too sporadic.

cross posted with The Wilder View…Economonitors

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Who Determines Short Term Interest Rates?

Do you think it’s the Fed?

It’s not.

The market determines short term interest rates.

Really.

The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates.  It does not lead the economy.  Here are some looks.  First the whole data set, going back to 1954, presented in Graph 1.

Federal Funds data from FRED.

T-Bill rates from a different Federal Reserve site

These are tabulated monthly values.  But the T-Bill rate is set in a weekly auction, and the Fed Funds rate is set by the Fed Open Market Committee, on an arbitrary schedule, at their discretion. 

Graph 1  Fed Funds and 3 Mo. T Bill Rates, 1954-2011

Not exactly lock step, but they are a couple of clinging vines.  At this scale, it’s pretty hard to tell who leads and who follows.  Let’s look closer at the last few decades.  First, the all-time highs of the early 80’s, in Graph 2.

Graph 2  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Here, the Fed Funds are in green and the T-Bill rate in orange, with the moves off of tops and bottoms highlighted in other colors.  Fed Funds tend to run a bit above T-Bills.  From this data, T-Bill rates generally change direction in the same month or the month prior to a Fed Funds change.

Graph 3  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Same story in Graph 3: either concurrent motion or T-Bills are slightly ahead.  For the two downward moves at the beginnings of 1990 and 1995, they are three to four months ahead.

The story is similar for the most recent decade, shown in Graph 4.

Graph 4  Fed Funds and 3 Mo. T Bill Rates, 2000-2008

Looks like the Fed is a close follower of T-Bill rates, usually within a month or so.  Coming off a diffuse top, the lag can be a little longer.

Graph 5 shows a close up of 2001-5, without the odd colors.  T-Bill leadership is easily seen.

Graph 5  Fed Funds and 3 Mo. T Bill Rates, 2001-05

Two questions present themselves:

1) Does the Fed have any real power to influence interest rates?
2) What would happen if they attempted to move counter to the market?

In my mind, this casts serious doubt on the usefulness of interest rate manipulations as a monetary policy lever.   What do you think?
.

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The Non-Relationship Between Interest Rates and the Money Supply, Part 2

by Mike Kimel

The Non-Relationship Between Interest Rates and the Money Supply, Part 2
Cross-posted at the Presimetrics Blog.

This post is a bit less about Presidents than usual, but its a follow-up to last week’s post on the non-relationship between the money supply and interest rates. (That post appeared both at the Presimetrics and Angry Bear blogs. In that post, I noted that the Federal Reserve tends to move the money supply monthly and seasonally with no corresponding change in the fed funds rate. For example, the Fed will increase the money supply in December to make sure there’s adequate money in circulation for the Christmas shopping season, and yet interest rates don’t move at all.

This week, I want to expand on that, and point out that I wasn’t entirely accurate. There actually is a relationship between interest rates and the money supply, but its not the the one taught in textbooks. The textbook relationship, as I noted last week, can be described like this:

The Fed determines what the Federal Funds interest rate should be. If the Fed wants to reduce interest rates, it will create money out of thin air and use it to buy bonds. Because there is more money competing to buy bonds, the interest rate bonds have to pay falls. At the same time, the added money sloshing around becomes cheaper for anyone to borrow, whether they’re issuing bonds or not. On the flip side, if the Fed wants to raise interest rates, it sells bonds. That forces anyone else trying to sell bonds to raise interest rates to compete. Additionally, because the Fed retires the money it gets paid for the bonds it sells, that process reduces the amount of money available in the economy, making it harder to come by and hence more costly.

In other words, the money supply and interest rates are negatively correlated. An increase in money supply leads to a decrease in interest rates, and a decrease in the money supply leads to an increase in interest rates. There is an alternative story, but it only applies to high inflation environments. If you’re in Argentina in 1982, for example, the money supply is increasing so fast that any little bit of new money translates immediately into inflation and higher interest rates.

So there’s the theory, what everyone knows is true. But what really happens? For that, as always, we cut to the data. The Federal Reserve’s Economic Database (FRED) reports the federal funds rate going back to July of 1954. For the money supply, we used M1 from 1959 to the present, and the money stock for years before that.

The graph below shows the correlation between the 12 Month Percent Change in M1 and the Fed Funds rate in the same period, one month later, two months later, etc.:


Figure 1

The graph shows that the correlation between the percentage change in M1 over a year ending in a given month and the Fed Funds rate in the same month is about 14%. The correlation between the annual percent change in M1 and the Fed Funds rate in the next month rises to 16%, and so forth. The 1 year change in M1 has a higher correlation with the Fed Funds rate 36 months later than with any lag on the Fed Funds rate. In plain English, increases in M1 lead to increases in the Fed Funds rate, and decreases in M1 lead to decreases in the Fed Funds rate. That doesn’t sound at all the textbooks tell us we should expect in a world that isn’t suffering from hyperinflation.

Now, you may be thinking to yourself… maybe that relationship is a function of the fed trying to react to a slowing economy.

Strip out months in which the economy is in recession, plus the three months leading up to and the 3 months leading out of the recession, and the graph looks like this:


Figure 2.

Notice… the correlation drops a wee bit, but the shape of the curve is pretty much the same. Once again, it is fairly evident that this does not conform in any way to the classic textbook story.

So what is going on? My guess is that in the U.S., for the period for which we have data, in general:

1. changing the money supply has had no direct relationship on the Fed Funds rate
2. changing the money supply has had a direct effect on the economy; increasing M1 (actually, real M1 per capita) causes the economy to grow more rapidly, and decreasing the real money supply causes the economy to grow more slowly or contract
3. because increases in the (real) money supply cause the economy to grow more rapidly, eventually an increase in the money supply will lead the Fed to raise interest rates in an attempt to slow the economy (to avoid inflation). On the other hand, because reductions in the (real) money supply lead to slower economic growth or economic contraction, these reductions will eventually lead the Fed to lower interest rates to try to get the economy to grow more quickly.

Step 2 is something we cover in the book, but I hope to write another post showing that soon.

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The Non-Relationship Between Interest Rates and the Money Supply

by Mike Kimel

This piece has been cross-posted at The Presimetrics Blog.

The Non-Relationship Between Interest Rates and the Money Supply


Figure 1

The graph shows that all but one recession since 1948 was preceded by a big drop in the real money supply per person over the length of a year. The exception – July of 1953 – wasn’t much of an exception; the 12 month change in the real money stock per capita went negative in August of 1953 and remained negative throughout the length of that recession.

Now, I use real M1 per capita a lot in my posts; I think it’s a largely unused but very good (in part because it is largely unused) measure of monetary policy, and its one Michael Kanell and I use in Presimetrics. For instance, we discuss how it affects economic growth, and we look at how much real M1 per capita increased over the length of each administration. (Note – the change in real M1 per capita, like other measures of monetary policy, is under the control of the Federal Reserve, not the executive branch.)

But because it isn’t used much, every time I do use it, I find there is a bit of confusion. And because it is so useful, I think it is worth spending a bit of time covering it.

I’d like to start with a question I get asked a lot, which will be the topic of this post: what sense does it make to use real M1 per capita (or any other measure of the money supply) as a way to monitor the Fed’s monetary policy? After all, what the Fed does is set interest rates, or rather, one interest rate in particular: the Federal Funds rate. And when it does that, the money supply gets set by default. A fair number of college seniors majoring in econ, when pressed, could probably tell you a story like this:

The Fed determines what the Federal Funds interest rate should be. If the Fed wants to reduce interest rates, it will create money out of thin air and use it to buy bonds. Because there is more money competing to buy bonds, the interest rate bonds have to pay falls. At the same time, the added money sloshing around becomes cheaper for anyone to borrow, whether they’re issuing bonds or not. On the flip side, if the Fed wants to raise interest rates, it sells bonds. That forces anyone else trying to sell bonds to raise interest rates to compete. Additionally, because the Fed retires the money it gets paid for the bonds it sells, that process reduces the amount of money available in the economy, making it harder to come by and hence more costly.

It’s a nice story, and like many others that is taught in economics classes across the country, it works fine in theory. It may even apply in a lot of real world situations. As I will show below, however, it doesn’t have much if anything to do with the way the U.S. economy operates.

Now, I’ve got a lot of ground to cover today, and being charge of watching the newborn while the wife is out and about, I don’t have a whole heck of a lot of time, so whereas I’d normally be throwing up a lot of graphs to show what I mean, instead I’m going to tell a little story and then show you that the folks responsible for setting the money supply agree with the story.

Here’s the story: Americans like to shop, and they seem to really like to shop in December. (Apologies for the lack of a graph, but you can find one example of the data here.) Shopping is easier when there’s more liquidity in the system – that is to say, when money is looser and easier to come by – so the Fed should be expected to loosen the real money supply somewhat to accommodate the end –of-year shopping season. On the other hand, as anyone who watches the news can tell you, the Fed doesn’t exactly move interest rates around in a way that would suggest any loosening around December each year with a subsequent tightening up early in the next year. Which means either: a) the Fed does nothing to accommodate the end –of-year shopping season or b) the money supply and the interest rates, at least within some not-so-narrow range, have very little to do with each other.

Now, if the Fed is trying to loosen the money spigot to help the shopping season along every year, it isn’t doing it with interest rates. Interest rates don’t seem to display much of a pattern when it comes to the calendar. You don’t hear anyone say, “I’m waiting until to December to refinance the house since rates are always lower then.”

What about real M1 per capita? Well, there we see a pattern. Using data from January of 1948 to December of 2008, we can construct 721 blocks made up of 12 consecutive months. The first of these blocks runs from January of 1948 to December of 1948, the second from February of 1948 to January of 1948, and so forth, until January of 2008 through December of 2008.

The graph below shows the percentage of these blocks in which each month had the highest real M1 per capita. For example, the percent of blocks for which the peak real M1 per capita for the block occurred in January is shown in the first bar, the percent of blocks for which the peak real M1 per capita for the block occurred in February is shown in the second bar, etc. So look what happens:


Figure 2.

Clearly, by far, the real money supply per capita is looser in December than any other month, and by a degree well outside the range that anything resembling chance would support. The fact that January comes in second is probably a function of spillover from December – the Fed doesn’t always drain out the money supply as quickly as it might otherwise like.

So… to sum up what we have… the Fed has a reason to loosen the money supply in December. Interest rates don’t show any pattern that works with the Fed’s goals, but real M1 per capita does. This indicates that unless there’s some really big coincidence going on, interest rates and real M1 per capita do not move together and the Fed is/seems to be using real M1 per capita (or something very similar) to accomplish many of its liquidity goals.

While I tend to let data speak for itself, I’d like share a couple of quotes. Here’s the first

Because of these difficulties in achieving a subtle response of the Federal funds rate to changes in the amount of borrowing, achieving the degree of reserve pressures specified in the directive has been interpreted since the late 1980s to mean creating conditions consistent with the FOMC’s desired Federal funds rate. That rate has generally been apparent to the banks; since 1994 it has been announced formally and in prior years it was clearly indicated through an open market operation. The rate has tended to move to the new, preferred level as soon as the banks knew the intended rate, with little or no change in the amount of borrowing allowed for when constructing the path for nonborrowed reserves (described below).

I bolded a key sentence in the above paragraph; it indicates that the Federal funds rate is set not by the buying and selling of bonds, as textbooks will tell us, but rather by the Fed’s wish. Since 1994, the Fed has announced its target rate, and the rate starts moving in that direction immediately upon the announcement, not waiting for open market operations. Prior to 1994, the target rate wasn’t announced, but banks tried to get figure out that target through statements made by Fed officials and head to that rate anyhow.

A second quote from the same source:

A prominent seasonal factor affecting deposits is the buildup in balances to accommodate the extra transactions during the holiday period, stretching from late November to early January (and the sharp reversal during January). A shorter term seasonal pattern arises from the payment of social security benefits on the third of each month; most recipients allow their cash balances to rise initially, then gradually work down the deposits as they pay their bills. (The Treasury’s total cash position might show offsetting movements, but most Treasury cash is not subject to reserve requirements.3)

This quote indicates that the Fed does, indeed, try to accommodate additional seasonal liquidity (including those in December I noted in Figure 2).

So, these quotes match the data I described and support my conclusion. Which is to say, I’ve found another heathen who refuses to accept the standard textbook monetary policy story about how the money supply and interest rates behave. So where do these quotes come from, you ask?

You’ll find the quotes I cited on pp. 141 – 142 and p. 142, respectively, of the chapter on Open Market Operations in a textbook on monetary policy produced by the New York Fed. That is to say – the people directly responsible for the buying and selling of bonds on behalf of the Federal Reserve aren’t don’t seem to feel that their activities have anything to do with the setting of interest rates. But what does it say about the economics profession that the rest of us are under the misimpression that it does?

I’ll have at least one more post soon on real M1 per capita and its effect on the economy.


Data Sources

FRED, the Federal Reserve Database, was the source for most of the data used to compute real M1 per capita: population from 1952 to the present , M1 from 1958 on and M1 from 1958 on.

Quarterly data on real GDP per capita and population. Note – the quarterly population figures were used to extrapolate monthly population for 1947 to 1952.

Finally, money stock figures were substituted in for M1 from 1947 to 1957. Those were copied by hand from this document at the

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Economists = Idiots? Part 1829

It was their idea, so it’s no surprise they like paying interest on reserves, even excess reserves:

For quite a while, the Fed was quite happy to have that money on its books. Indeed, the power to pay interest on reserves was considered a key tool to keep control over all the liquidity the Fed pumped into the system during the financial crisis. The Fed wanted to see bank lending increase, but in a controlled fashion, so as not to fan the flames of an inflation surge.

But as worries about the outlook have risen, the game has changed. Some see a move to drive all those reserves into the economy as a key way to produce better economic growth. Markets got to thinking Fed Chairman Ben Bernanke would indicate this as a possible path when he testifies before the Senate Wednesday and the House of Representatives Thursday on the economic and monetary policy outlook.

Economists, however, think ending the interest on reserves policy would be a bad idea.

Right, because the $2,534,722.22 a year paid in interest on $1 Billion in excess reserves is a drop in the bucket for the U.S. Federal deficit.

And because the risk-free rate of return that features in so many economic models should be different for intermediaries (financial institutions) than wealth-creators (businesses).

And because “excess reserves” are money issued by the government which is inflationary because of the multiplier effect of money—which, of course, assumes the money is being invested. (As this money is, in taxing our tax dollars and giving them to Vikram Pandit, Ken Lewis, Lloyd Blankfein, and Jamie Dimon [in descending order of theft; YMMV].)

And, of course, because that $1 Billion that is not being used in the economy would only produce about $5-8 Billion in GDP, which is roughly, what, 50,000 to 80,000 new jobs?

But, of course, banks have better use for the money than potential workers.

[Barclays Capital’s Joseph Abate] noted much of the money that constitutes this giant pile of reserves is “precautionary liquidity.” If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum. [emphasis mine]

Oh, well, since they’re not going to lend the money anyway, we should have no trouble paying them interest on it. What is The Fed other than a mattress stuffed by tax dollars?

The key phrase is “precautionary liquidity.” If you assume that the recovery started in June or July of last year,* then you would expect “excess reserves” held for “precautionary liquidity” to have declined over time, as the need for “precautions” is reduced as the economy becomes safer. But that hasn’t been the case.

Choose one (or both) from: (1) the banks don’t believe the economy is recovering or (2) the banks are holding assets on their books at higher levels than they know they are worth, and are therefore using “excess reserves” to cover real losses until they can’t any more.

It is unclear whether Abate sees the banks’s unwillingness to be intermediaries as a feature. But at least he knows not everyone is doing it.

Abate buttressed his argument that banks really just want to stay liquid by noting who is holding reserves at the Fed. He said the 25 largest U.S. banks account for just over half of aggregate reserve levels, with three by themselves making up 21% of the reserves.

So the biggest of the Too Big to Fail banks have decided not to act as financial intermediaries, preferring instead to continue feeding from the taxpayer trough (where the $25MM in interest really is a drop in the bucket) and/or pretend that they are more solvent than they really are.

And, according to the Wall Street Journal, economists believe we should continue to pay those banks for misvaluing their assets and refusing to perform their economic function.

The economic theory I learned is that capital is paid its marginal product. The marginal product of those excess reserves is zero, while the required reserves are intended to explicitly provide “precautionary liquidity.”

Unless the TBTF banks are arguing that the Fed’s current Reserve Requirements are too low—a possibility, perhaps, though the FT cites evidence contrariwise—the basis of all economic and financial theory indicates that they should receive no interest on those reserves.

An “economist” who says otherwise is either lying or selling something.

*I would argue—see yesterday’s post—that June 2009 is rather eliminated by the non-recovery of more than half the states’s job markets a full year later.

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Get ready for a little EM inflation

Today I was thinking about tightening cycles in emerging markets; and more specifically, about that in China. Because let’s face it, China matters. China matters to the rest of Asia via competition for export income. China matters to Europe via competition for jobs. China matters to Brazil via domestic production via imports. China matters.

The inflation pressures are building in key emerging economies, especially in the BIICs (Brazil, India, Indonesia, and China) – see this previous post regarding my new acronym, and this article at the Curious Capitalist (curiously posted just shortly after my post), which leaves my omitted “R” but relays the intuition behind the second “I”.

Although the inflation is not prevalent in any BIIC except India, really, I wanted to comment about why it will build…quickly.

First round, the construction of consumer prices is heavily weighted toward food and energy costs across the BIICs. Indonesia, India, and China are highly susceptible to food price shocks (either driven by shortages or demand growth). Expect this as a first-round driver of inflation as the global economy recovers further. It’s already happening.

Second round, the BIICs are growing quickly and nearing, or are already at, potential. Annual industrial production growth has recovered or surpassed its pre-crisis rate in China, Brazil, and India, 19%, 16%, and 17%, respectively. This is expected, given the drop-off in world trade (an illustration can be found from this May 2009 pos), but unsustainable as the output gap closes.

Third round, interest rate differentials. This year, the BIICs’ central banks are expected to raise policy rates. In fact, Brazil, China, and India have already boosted reserve requirements. But with US rates expected to stay low for an “extended period”, international interest rate differentials will change and monetary flows will shift. Capital inflows can lead to inflation if not properly sterilized.

To date, inflows are not properly sterilized, as evidenced by the ongoing accumulation of reserves and rising money supply growth (again, I refer you to my previous post on M1 growth rates.

The chart above illustrates the one-year-ahead nominal interest-rate differential between the 2yr forward government rate for each respective BIIC country versus the 2 yr forward US Treasury rate. The forward differentials for China and India are on a steady upward trajectory, while those for Brazil and Indonesia are simply steady. I believe that this appropriately represents the sterilization efforts and monetary policy management on the part of the BIICs’ central banks: more managed in Brazil and Indonesia, not as much in China and India.

So where does this analysis leave us? With a very interesting policy mix in the emerging market space. In fact, in my view this is the riskiest part of the emerging market cycle: the recovery. If policymakers get this wrong, we could see a lot of price action, final goods and assets alike, on the horizon.

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Fed Policy

Discussion point: Is it time for the Fed to start contracting its’ balance sheet and otherwise withdrawing the special financing it provided while it was faced with the zero interest rate bound
and preparing to soon raise fed funds.

My fed policy index says the zero bound should no longer apply and that it is time for the fed to start preparing to soon raise fed funds.

This is my version of the Taylor Rule. The biggest difference is that my index gives inflation and unemployment equal weight while the standard Taylor Rule gives inflation double the weight of the various measures of excess capacity.

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Today in "Economists Are NOT Totally Clueless" (Interlude; Part 2 of 3 or 4)

Tyler Cowen can count:

In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread. Maybe we need that zero nominal short rate or at least the Fed thinks we do….

I also regard this as a somewhat gruesome hypothesis. It means that “Main Street” is paying for “Wall Street” (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one’s savings….

The term structure also implies that the market is expecting rising short rates, so if the bank mess isn’t cleaned up soon, heaven forbid. The spread, as a means of restoring bank profitability, won’t last forever.

And Ryan Avent (via Brad DeLong) points out the next piece of that puzzle:

[T]he Fed’s commitment to undo its interventions is already having an effect. In expectation of more of these moves to come (as well as, perhaps, increases in interest rates) markets have been bidding up the dollar, which has busily appreciated during the month of December. That, in turn, will deprive the American economy of a potential source of demand—growth in consumption of American exports thanks to the effect of a weak dollar.

More bluntly, we’re seeing a move toward contractionary monetary policy at a time when unemployment is at 10%. Funny that.

I can’t think of a scarier way to end the year. Sorry about that. Best wishes for 2010—we’re all going to need them.

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