Monday, November 30, 2009

The Message from Dubai

As the situation with Dubai and its investment arm, Dubai World, has nearly dominated the financial market headlines in the last several days, there are some important observation to be made:

1) Pockets of instability that can send ripples of anxiety across the global financial system still linger on, almost 15 months following the Lehman affair. Some of these pockets of potential trouble continue to fly under the markets' radar screen- as was the case with the Dubai episode- making them potentially more dangerous when they abruptly burst to the surface. In other words, we have now seen clearly that the global financial system remains prone to aftershocks.

2) The configuration of the various players affected by those aftershocks is not the same as in the previous major round of the crisis, or, at least, those players are not affected to the same degree. In the current Dubai affair, it appears that it is mostly the Britsh banks absorbing the brundt of the seemingly inevitable default by Dubai World, and particularly HSBC and the Royal Bank of Scotland. True, both of these institutions had been among those ravaged in the aftermath of Lehman's collapse, but one cannot but acknowledge that, this time, the major U.S. banks have stayed, mercifully, out of harm's way.

3) Despite its undeniable vulnerability, the global financial system is showing credible evidence of having healed considerably from its near-death experience late last year. Of course, credit-default swap prices on various countries' sovereign debt have risen since early last week and some stock markets around the world- particularly those with close geographical proximity to Dubai- have sold off. But, by and large, most major financial markets around the globe have continued to function properly, essentially casting a vote of confidence in their own ability to weather the storm. This takes particular significance today, after Dubai refused to come to the rescue of Dubai World's debt, essentially pushing the latter into restructuring.

The entire Dubai affair may help re-inject an element of caution toward some global spread products and sovereign debt of a number of other countries. It may even help complicate somewhat the economic recovery prospects in the U.K, the beleaguered banking system of which just took a fresh hit, and some banks on continental Europe may come under renewed pressure. Nobody argues that the world has become a perfectly safe place again, so soon after the harrowing experience of last year. But, financial markets and the global banking system, wounded as they may still be, are slowly regaining a sense of balance; and this is perhaps the key message from the Dubai story.

Anthony Karydakis

Monday, November 23, 2009

The Curious Case of Negative Yields

Certain Treasury bill rates briefly dipped into slightly negative territory in the last couple of days, which constitutes a pretty extraordinary phenomenon by any measure. This essentially means that investors are willing not only to forgo any interest on such holdings but are willing to pay in order to get their hands on Treasury bills that mature in January 2010.

Part of the reason for this highly unusual, and counter intuitive situation is of a somewhat technical nature and associated with an emotional reaction of the market to comments made by a Fed official late last week.

St. Louis Fed President James Bullard expressed the view that the Fed should keep its program of mortgage-backed securities purchases in effect beyond the currently planned time frame of March 2010 and also implied that, based on the pattern of how the Fed has reacted in past cycles, the central bank may refrain from tightening for as long as another two years. Although views expressed by individual Presidents of regional Federal Reserve Banks often do not reflect the FOMC's mainstream view, Bullard's comments triggered some excitement in the front end of the Treasury market, which, in turn, caused a scramble to close in a hurry any previously established short positions. The result was a wave of impulsive and technical buying that pushed yields briefly into below-zero territory.

However, there is something disconcerting about all of this insatiable demand for liquidity. At its core, lies the lingering fragility of the banking system and a strong need for institutions to fortify their balance sheet for year-end purposes with the safest-quality paper available. It is hard to forget that the only other such episode of negative Treasury bill yields in modern history occurred in December 2008 (and, in the case of the 1-month bill, in March of this year as well), right in the midst of the wave of anxiety and risk-aversion sweeping the financial system in the post-Lehman period. In this latest phase, bill rates had already been drifting lower in recent weeks, ultimately leading to the piercing of the zero percent level in the last couple of days.

The absence of any headline-making negative news about the financial system in the last few months is by no means tantamount to banking institutions' returning to an even passing semblance of soundness. Banks are still vulnerable, undermined by the vast majority of their toxic assets that they still carry on their balance sheet (despite a moderate rebound in some of the underlying markets), and the imperative for year-end, window-dressing operations remains as pressing as ever.

Anthony Karydakis

Friday, November 20, 2009

Global Growth Looking Up

In the latest set of economic forecasts issued by the OECD earlier in the week, the picture of the global economic recovery seems a little more upbeat compared to the prevailing view as recently as a few months ago. Not only do the OECD projections for the major economies are more optimistic than those issued by the IMF at the beginning of October, but they suggest- despite the appropriate cautionary notes attached to them- that a global recovery is indeed taking hold and likely to consolidate further over the 2010-2011 period.,3343,en_2649_33733_20347538_1_1_1_1,00.html

The OECD forecasts GDP growth of 2.5% in the U.S. next year, versus 1.5% growth predicted by the IMF in its early October projections, which, in turn, represented an upgrade compared to its own previous forecast of only 0.8% issued last July. In regards to the euro area, the OECD now expects growth of 0.9% in 2010 versus 0.3% in the IMF numbers- which, again, represents a 0.6% upward revision from its own previous forecast in July. As for Japan, both the OECD and the IMF's latest report see growth in the 1.7%-1.8% range for 2010. Finally, the OECD projections, perhaps more importantly, show a further pick up in growth for the U.S. and euro zone in 2011 to 2.8% and 1.7% respectively, which would essentially represent a return to growth rates close to the long-term trend for both economies.

Granted- forecasts are just that, forecasts, and they are a famously unreliable exercise, as experience has shown numerous times over the years. In fact, the OECD itself is quick to acknowledge substantial both downside and upside risks to those projections, which it deems to be roughly balanced. It furthermore, warns that the global recovery will still be relatively timid and unlikely to prevent a further rise in the unemployment rate in the main member-countries in the first half of 2010, before the rate stabilizes.

Still, it is hard to ignore the reality that in the spate of the last several months, there is an unmistakable upgrade in the degree of confidence around the world that a sustainable economic recovery is taking hold. As a result, predictions of a double-dip recession that were much "in vogue" earlier in the summer (particularly in the context of the U.S.) are now melting away quickly.

The reasons for the newly-found sense of credibility in the unfolding global economic recovery are multi-faceted but, essentially, interconnected.

China's impressive turnaround (expected to return solidly to double-digit growth rates in 2010) is pulling the rest of Asia- including Japan- higher. The resulting vigorous comeback of the Pacific Rim region acts as a potent "locomotive" for the rest of the world economy and shows that the U.S. economy is no longer the only one that can play that role on the global stage.

Another major factor underlying the emergence of somewhat more upbeat expectations in the last few months has to do with the increasingly accepted premise that the banking systems in the U.S. and euro area have survived the financial crisis of the last two years; still deeply wounded- appreciably more so in the U.S. than in the euro zone- but, ultimately, survived. The diminution of fears of a downward spiral of the banking sector that would leave those economies seriously limping on a protracted basis are now diminishing.

This is not to say that the fragile shape their banking sector remains in will not represent a key headwind preventing a more robust economic recovery ahead, both here and in the euro area. But this is likely to find a partial offset in the anticipated quick turnaround in global trade already underway, set into motion by a number of other major economies elsewhere in the world that are coming back on line, as their banking systems escaped the financial crisis practically unscathed (China, Brazil, Japan, India come to mind).

Perhaps this serves as a stark reminder that the center of gravity of the world economy is slowly slipping away from the U.S.-Europe axis in the last decade or so and this can have significant implications for the way global business cycles play out in the future. Emerging markets are no longer the passive recipients of a "ripple effect" originating in the traditional major economic powers, but they are now becoming a major counter-balancing force and an engine of stability in the context of global business cycles.

Anthony Karydakis

Tuesday, November 17, 2009

The Euro: Jean-Claude Trichet's Little Problem

After a deeply skeptical reception by global financial markets in the early years following its introduction in 1999, the euro is now almost universally viewed as a great success story. In fact, so much so that recently concerns are being raised in the euro-area that the impressive strength of its currency may become an impediment to the emerging economic recovery in that part of the world.

It is against that backdrop that, in an interview published in today's Le Monde, the ECB President, Jean-Claude Trichet, makes another earnest attempt to downplay the seemingly irrepressible appeal of the euro, by presenting it essentially as simply the currency of the countries representing 330 million people in Europe, that was never intended to replace the dollar as an international reserve currency.

As I have argued before in this space, Trichet is a brilliant and highly sophisticated central banker, whose modesty in regards to the role of the euro displayed in this interview can only be viewed as a desperate act of a desperate man. Unable to embark on a campaign of massive foreign exchange market intervention to bring the currency down, and confronted with the side-effects of its impressive rise, he is limited to making frequent public statements extorting the virtuous of a strong dollar (see: a lower euro) in recent months.

The trouble for Mr. Trichet is that he has done a phenomenally good job at steering the euro-zone's monetary policy in the last several years, which has helped cement the ECB's crdibility, by presenting to the world impeccable credentials of steadfastness, flexibility, and unwavering commitment to its infamous "single mandate" of price stability. As the ECB's credibility has reached the sphere of irreproachability in the eyes of global financial markets, the euro's appeal has been rising accordingly.

One has to wonder whether it had ever occurred to Mr. Trichet that the success in the ECB's 10-year-old struggle to establish both its own and the euro's credibility would ultimately result in the latter being viewed as a serious alternative to the dollar- and, therefore, considered as an appealing reserve currency. His pretention now that the ECB had not envisioned the euro as becoming an alternate vehicle for central banks' foreign reserves around the world sounds rather unconvincing. Still, his predicament is understandable, as, given the levels the euro is at currently, any sustained trend toward reallocation of foreign central banks' reserves in favor of the euro in the coming years could undermine the growth prospects in the euro-zone over the medium-term.

Still, there are reasons for Mr. Trichet to be encouraged that the latest rise of the euro will ultimately be contained, as the current levels are far from unprecedented. Foreign exchange markets, like any market, have cycles and currencies go up and down over time; for example, the euro hit a record 1.60 against the dollar in April 2008, only to retreat to 1.25 six months later and resumed its rise since February of this year. So, there is certainly reasonable hope that another cycle of retreat for the euro will ultimately kick in, as a result of the markets' natural dynamics. Although this would still not be addressing the issue of the longer-term trend for the currency, it would alleviate at least some of the immediate anxiety over its behavior.

Of course, Mr. Trichet always holds the ultimate weapon to address his concern over the strong euro; he can always mess up the ECB's monetary policy...and, badly so.

Anthony Karydakis

Sunday, November 15, 2009

The U.S. Trade Deficit: No Lasting Improvement

The size of the U.S. trade deficit since the beginning of the decade has been a source of concern and often identified by many as one of the most persistent and unsettling imbalances facing the U.S. economy. Throughout that period, the worst-kept secret among people in the broader field of macroeconomics has been that, pragmatically speaking, there is only one way we could reasonably expect to see a significant reduction in the trade deficit: a deep and prolonged recession.

The effectiveness of that "prescription" has now been tested and fully validated; in fact, at first glance, it has passed with flying colors. After totaling approximately $700 billion in both 2007 and 2008, the international trade balance of goods and services is now on track to be a little over half that amount in the current year. Differently put, average monthly deficit numbers close to $60 billion in 2007 and most of 2008 have been running at an average of $30 billion a month since the beginning of the year. While both exports and imports have suffered in the midst of the global economic downturn, imports have declined by 80% in the first nine months of 2009 versus a 62% drop in exports during that period- resulting in the dramatic improvement in the overall deficit.

While this certainly seems to be good news, there is not much encouragement one can derive regarding the prospects for the deficit over the medium-term. As the U.S. economy slowly exits its recession, and most other countries are recovering to various degrees, the U.S. trade deficit is bound to slowly deteriorate again over the next 12 to 24 months. In fact, to a considerable extent, that was the key message from last week's report on the September deficit, which widened sharply to $36.5 billion from $30.8 billion in August. As consumer spending picked up dramatically in the third quarter, so did imports. While a good part of the 5.8% surge in overall imports was due to a higher petroleum import bill and automotive imports related to the cash-for-clunkers program, the reality is that the spectacular improvement that the deficit showed in the first half of the year- averaging $27.7 billion a month between February and June, at the depth of the recession- is already behind us and a partial reversal of that process is already underway as the U.S. economy recovers.

Source: Bloomberg, Haver Analytics

The moderate overall decline of the dollar on a trade-weighted basis since February has often been mentioned as a key factor for this year's improvement in the trade deficit so far. However, this is unlikely to have been a crucial factor. There are significant lags between the time a sustained decline in the value of a currency takes place and its impact on the trade balance of that country; these two forces are not contemporaneous, as pre-existing pricing contracts in international trade remain in effect for a while- irrespective of changes in the exchange rates involved in the interim- until the time comes for such contracts to be renegotiated. Given that the dramatic improvement in the trade numbers occurred in the period between November 2008 (prior to the start of the dollar's slide) and June 2009, it is unlikely that the weaker dollar has been an appreciable factor so far.

The lower dollar will be somewhat helpful in containing the amount of deterioration that the U.S trade deficit is likely to suffer over the next twelve months. Once again, though, that factor should not be overestimated as the dollar may recoup some of its lost ground in 2010, when the Fed starts being viewed as approaching the time when they will be doing away with the zero short-term rate policy.

This leaves the pace of the U.S. economic recovery, particularly compared to the rest of the world, as the key determinant of the direction of the trade deficit from here. While the U.S. recovery may be somewhat choppy and of the historically moderate kind, the same is likely to be the case for at least two of our key trading partners: Euro zone and Japan; so, not much relief on that front.

Given a) the heavy pent-up demand that has been created in the last 18 months or so in the U.S. in the midst of a particularly scary economic and financial market environment, b) the fact that a stabilization of labor markets (with encouraging signs of further improvement in the "pipeline") is already underway, paving the way for a pick-up in consumer spending, and c) that personal consumption represents a whopping 70% of the U.S. economy, the most likely outcome of all of this is that a sustained increase in the demand for imports will cause the trade deficit to deteriorate moderately again in 2010. The stronger the economic recovery turns out to be, the wider the deficit should get. It would not return quickly to pre-recession levels, but it will probably move closer to the $450 billion plus range next year, compared to $375 billion or so this year.

So, the recession will turn out to have been not a real "cure" for the trade deficit but rather a short-acting medicine of sorts. The true cure would be a fundamental reorientation of the U.S. economy away from spending and toward more saving- a prospect that does not look very promising at all.

Anthony Karydakis

Thursday, November 12, 2009

For Job Growth to Return, More Hiring Not Necessary

Initial unemployment claims continue to drift lower, declining by 12,000 in the latest week to 502,000- their lowest level since January. Although weekly claims are a notoriously noisy indicator, the "smoother" 4-week average version of the series leaves no doubt about a solid downtrend being underway, which helps cast the underlying dynamic of labor market conditions under a more positive light than the recent headlines that focused on the cycle-high unemployment rate of 10.2%.

The steady downtrend in the claims data since a peak of about 670,000 in the first quarter to around 500,000 currently simply reflects a very significant cooling in layoffs. While the ongoing declines in the monthly nonfarm payroll data are somewhat disappointing, there is a key element that is often not properly recognized in the interpretation of the various labor market indicators as offered in the press.

Source: Bloomberg, Haver Analytics

The emphasis seems to remain recently on the reported reluctance of employers to step up their hiring plans in the near future. As a result, the superficial conclusion that is drawn is that, as long as that pattern persists, we are unlikely to see actual job growth in the monthly payroll figures, This represents a misconception of what the payroll numbers are about, which is essentially the net of the total number of people hired in the course of the month minus the total number of people laid off. Even if, for the argument's sake, the total number of people hired does not increase for a while, if the number of people laid off continues to decline (which is what the initial unemployment claims data are reflecting), then the payroll numbers can still become positive- showing, on the face of it, job growth again. In other words, all we need is for layoffs not to exceed hiring.

With the downtrend in claims seemingly intact, and the monthly payroll declines recently averaging only about 25% of the magnitude of those declines in the first quarter, then we are steadily approaching the point where actual jobs growth will manifest itself in the monthly data- without the need for employers to actually increase their hiring.

Given the recent broader trends in both claims and payrolls, we are probably on track to start seeing positive numbers for the latter series in the first quarter of 2010.

Anthony Karydakis

Tuesday, November 10, 2009

The Challenge With the Fed's Balance Sheet

The bloated size of the Fed's balance sheet in the post-Lehman period has become the subject of concerns of varying intensity, as it represents a potential inflation flashpoint when the economic recovery starts gaining traction. The dramatic increase in the Fed's balance sheet is, of course, the direct result of the unprecedented amount of liquidity that needed to be injected into the banking system in order to prevent a complete meltdown of the financial structure since September 2008.

The injection of that liquidity has been delivered via a combination of a number of special lending facilities and outright purchases of different kinds of securities. While in the early phase of such liquidity injections, the vehicle of choice was mostly the array of special lending facilities established by the Fed late last year and early 2009, in the last seven months or so, the mix has shifted heavily away from such programs and in favor of outright purchases of securities. As of November 4, 2009, approximately 75% of the Fed's total balance sheet consisted of securities held outright (vs. about 1/3 in March), while the remaining 25% consisted of the various special liquidity facilities.

The downtrend in the size of the Fed's special liquidity facilities reflects the easing of the most acute phase of the seizing up of credit market conditions late last year, and, therefore, the quiet winding down of programs like the TAF (Term Auction Facility), the Primary Dealer Credit Facility, the Commercial Paper Funding Facility, etc. However, this trend has been fully offset by the Fed;s stepping up of two key programs of purchasing securities outright: $300 billion of Treasuries (the program was just completed at the end of October), and the still ongoing massive program to purchase a total of $1.25 trillion of agency mortgage-backed securities and $175 billion of agency debt (both of which are expected to be completed by the end of the first quarter of 2010). The net result of that shift among the Fed's various programs has had no discernible effect on the total size of the central bank's balance sheet, which actually remains in the vicinity of $2.2 trillion- essentially close to its peak reached since the fourth quarter of 2008.

The gradual winding down of the special liquidity facilities can, on the face of it, be viewed as a positive development, reflecting the relative restoration of normalcy in credit market conditions. However, this is the easier part of the Fed's challenge ahead to ultimately withdraw the massive amount of liquidity injected into the financial system during the peak of the crisis. The tougher part of the Fed's job is still ahead, which remains the eventual unwinding of a portfolio of holdings consisting, to a very considerable degree, of mortgage-backed and other non-Treasury securities.

With the mortgage-backed securities market still scarred by its near-apocalyptic experience of the last two years, the Fed's hands are tied in terms of its ability to resell those securities back into the market any time soon. So, the stage is set for the Fed to remain the proud owner of well over a trillion of low-quality securities over an extended period, mostly counting on the slow runoff of these holdings over a multi-year horizon.

As a result, when the time comes for the Fed to move decisively to start draining the excess liquidity, actively dumping its bloated portfolio of outright holding is unlikely to be a viable component of its exit strategy. Instead, in implementing the latter, the emphasis will need to be more on both conventional (reverse Repurchase Agreements) and more recently introduced tools (interest paid on bank reserves).

Anthony Karydakis

Sunday, November 8, 2009

And Now, the Dollar Carry Trade

The popularity of the yen carry trade since the mid-90s has waxed and waned and has defied several times premature proclamations of its demise. It has been linked to the development of market bubbles around the world, including the Asian financial crisis in 1997 and the global stock market rally in the late 90s.

For a good part of the last 15 years, the trade has been the darling of the hedge fund community, allowing investors and speculators to borrow in yen at the practically zero Japanese short-terms rates and then convert such borrowing into investments in other countries that were offering an appreciably higher rate of return. By doing so, they were, naturally, exposed to the risk associated with the country they were invested in as well as to the risk that the yen would appreciate sharply by the time they had to repay back the original loan. Still, the yen carry trade was offering lucrative rewards that were vastly overshadowing its implied risks, and this helps explain its remarkable longevity as the financing tool of choice for both speculation and more legitimate investment around the globe.

Predictably enough, there was a massive unwinding of such yen carry trades in response to the financial crisis set off by the Lehman affair last year, as emerging market economies were viewed as particularly vulnerable to the unusual intensity of the turmoil sweeping global finance. In recent months though, as emerging markets have largely defied those dire expectations and are increasingly coming out of the crisis, if anything, in better shape than most industrialized economies, the lessening of the earlier anxiety over their resilience has led to an impressive revival of the carry trade. The only difference is that the yen has now been joined by a very powerful partner that threatens to take the lead in that game: the U.S. dollar.

The dollar's joining of the global carry trade is the direct, and natural, result of the near-zero short-term rates in the U.S. since December 2008; in a way, it was almost an inevitable outcome. After some initial hesitation to assess the likely duration of the Fed's zero interest rate policy, global financial market participants have, in recent months, felt increasingly confident that the record low short-term rates in the U.S. are not likely to be reversed any time soon- an expectation that the Fed continues to nurture in its public pronouncements.

Having the currencies of the two major economies in the world (a somewhat qualified statement, as Japan is likely to be surpassed by China as the #2 economy by early 2010) becoming the vehicles for a global carry trade has some very potent implications. A record amount of foreign capital has been coming into emerging market economies in the last couple of quarters, fueling not only major stock market and commodity rallies but also classic speculative bubbles in real estate markets and other assets. (

In a somewhat ironic twist of events, it is precisely the very fact that the financial system in the major industrial countries suffered major damage in the midst of the crisis in the last eighteen months, that set the stage (via the zero short-term rates that it created in the U.S.) for the latest round of speculative bubbles already springing up around the world now. This dynamic, if it gathers more steam in the coming months (and, given that it involves a number of the Pacific Rim countries), may soon resemble the period leading up to the Asian financial crisis in 1997, which ended famously not so well.

Few emerging market countries have the luxury of taking measures to actually restrict such massive capital inflows, as they rely heavily on such flows to resume the faster growth rates they desperately need to continue lifting the living standards of large parts of their population. That is why it is an impressive testament to Brazil's solid position as an increasingly emerging economic global powerhouse that, last month, it imposed a 2% tax on capital inflows. This was a first, measured, act to stem the unfettered streaming of "hot-money" in to the country, that could plant the seeds of destabilization of one of the most successful economies in the world today.

The emergence of the dollar carry trade, which has clearly played its role in the weakening of the dollar since the first quarter of the year, and its already observable implications in a number of countries, creates another source from which the next pop in global financial markets may come. The risk for the latter will become more palpable when the time comes for the Fed to start reversing its near zero short-term rate policy.

Anthony Karydakis

Friday, November 6, 2009

October Employment Data: Disappointing But Not Uniformly Bad

Although the spike in the unemployment rate to 10.2% is attracting most of the attention because of its presumed psychological implication, the rest of the employment data for October paints a somewhat more complex picture of the labor market.

As we have emphasized repeatedly in this space, despite its high visibility as a barometer of labor market conditions, the unemployment rate is a lagging indicator and typically tends to drift higher in the early stage of an economic recovery (and, as such, it is not a useful gauge for detecting relatively changes in labor market conditions around turning points in the cycle). The reason for that seeming paradox is that the rate tends to move higher due to an expansion of the civilian labor force as a result of previously discouraged workers that return to it when the economic environment starts improving. Still, in October, the spike in the unemployment rate was not caused by an increase in the size of the labor force but by a huge decline (-589,000) in household employment. (This is a survey completely separate from the establishment survey that produces the nonfarm payroll data).

What is becoming an increasingly curious pattern here is that there is a very big gap that has opened up between the household employment data and the payroll data, as the former have declined by a total of 1.77 million in the last three months alone versus a total decline of "only" 563,000 in payroll employment during the same period. Such gaps between the two surveys are not totally unheard of over a number of a few months but, ultimately, that gap will need to narrow moving forward. Given that the improving trend in payrolls has been well established by now and is unlikely to be reversed suddenly (despite the fact that they are still turning out monthly declines), the most likely outcome is that the gap will diminish with household employment improving somewhat and the unemployment rate dipping in the next couple of months.

In fact, the payroll trend continues to improve, as the 190,000 decline in October was accompanied by a 91,000 net upward revision to the previous two months. This brings the average decline in payrolls in the most recent 3-month period to 188,000 versus 357,000 in the prior three months and 690,000 in the first quarter of the year. In other words, things are getting steadily, and appreciably, better on the labor market front, but not fast enough to project a confident turnaround of the employment picture.

One element that was relatively disappointing in today's data was that the average workweek remained at its cycle-low of 33.0 hours. Normally, an upward drift in the workweek (despite its heavily choppy pattern on a month-to-month basis) is supposed to precede a pick up in hiring patterns, as companies tend to utilize their existing labor force more intensely first (when the economic environment starts improving) before they hire more workers.

All in all, despite the eye-catching pop in the unemployment rate, the employment report did little to challenge the premise that an economic recovery is slowly getting underway but it did reinforce the view that this recovery will be of the moderate variety for some time.

Anthony Karydakis

Tuesday, November 3, 2009

Three Fed Officials to Watch

As the economic recovery slowly starts gaining some credibility, the financial markets' favorite guessing game is poised to become the timing of when the Fed will start tightening policy. Although some dialing down of a number of the emergency liquidity programs has already been occurring quietly in the last few months, the prospect of a rate hike and aggressive draining of reserves from the banking system would understandably represent a more decisive stage of the tightening process, and, as such, raise a higher level of anxiety among market participants. It was in that context that the New York Fed felt compelled to issue an unusual clarification last month to the effect that although they are already examining closely the mechanics of how the draining of liquidity will be achieved when the time comes, this should not be interpreted as suggesting that any decision has been made as to when this might happen.

Against that backdrop, statements made by various Fed officials in the next couple of months will be scrutinized closely for any hints of an upcoming change in monetary policy. Given the financial markets' notorious propensity for overreaction to just about anything, it is quite possible that some of these statements, while expressing, in many cases, simply the personal views of the FOMC member, will be misconstrued as a hidden message to the markets and can cause an undeserving degree of noise.

It is fair to argue though that, inasmuch as all voting FOMC members are technically equal, some members are more equal than others and their views carry a significant amount of weight in terms of providing hints about the likely inflection point in interest rate policy. Other members' views are immensely less important in that regard, as they often express personal biases that may not be shared by the majority within the Committee.

At the top of the list of Fed officials whose views really matter is obviously Ben Bernanke himself. His comments, as always, deserve a close degree of scrutiny in the period ahead, as he is certainly in a position to steer a number of other FOMC members that may have less strong conviction on the issue to his camp of thinking. He also has more high profile opportunities than any other Fed official to express any subtle changes in his thinking regarding the assessment of the economic recovery and the need (or, lack of thereof) to maintain the near-zero interest rate policy of the last 11 months.

The other two Fed officials that should be presumed as expressing the mainstream Fed view on policy are Vice Chairman Don Kohn and New York Fed President Bill Dudley. Don Kohn is an old hand at the Fed, a true product of the system and his views tend to adhere very closely to the "official" view at the institution (which should be taken as including Ben Bernanke's as well). Given his role as a semi-official statesman within the Federal Reserve System, he often feels subconsciously restrained to avoid veering far from the Chairman's official thinking. Although, prior to his appointment as Vice Chairman at the Fed, he had expressed views strongly skeptical of the concept of inflation targeting (which Bernanke was openly advocating), there have been no instances in the last three years or so where he has deviated from the Fed "party line".

Given the special role that the New York Fed occupies within the Federal Reserve System, its President has historically been viewed as always closely aligned with the Chairman of the Fed and Bill Dudley is no exception. He has loyally preserved that tradition since his appointment in that position in January of this year and in his public speeches, he always offers an eloquent and unapologetic defense of official Fed policy, using arguments that are often identical to those that Bernanke is making in his own appearances.

In the search for early hints that things in the Fed's thinking are starting to change, markets would be well served if they focused more on comments made by those three key Fed officials only and view the true significance of any comments made by other regional Fed Reserve Bank Presidents with extreme caution. In recent years, the latter have caused, all too often, a lot of commotion for their purported significance regarding Fed policy, while in the end they have turned out to mean not much at all. Regional Fed Presidents are independent thinkers and are obviously entitled to expressing their own views in their public appearances. But when the time for a vote at an FOMC meeting comes, there is usually only token dissent (1 or 2 votes), as they tend to fall in line with the majority represented by the Chairman, and always, the President of the New York Fed.

Anthony Karydakis

Sunday, November 1, 2009

The Trouble With Complaining About the Budget Deficit

Let's start with an indisputable fact. The U.S. budget deficit recently reached near-stratospheric levels, representing (at $1.42 trillion in fiscal year 2009), approximately 10% of GDP. This is about 3 times higher the rate that is generally considered as acceptable, or manageable, among the industrialized economies. The natural implication of that is that there needs to be an extremely high degree of awareness about the need for the deficit to come down in the next few years. No sane person would object to any of that so far.

But, judging by opinion polls in the last few months- meant to evaluate the degree of approval that President Obama enjoys with the American public- it appears that one of the main consistent criticisms leveled at his job performance so far is that he is doing a poor job at handling the fiscal situation. That is where things seem to get dangerously off the path of both reality and rationality- no doubt due to a poor understanding by the broader public of the factors that shape the fiscal picture of the country.

To begin with, the new Administration cannot be held responsible for the fiscal 2009 deficit, as this was based on a budget that had already been set by the Bush Administration and the fiscal year was already one third underway when Obama took office in late January.

The reason for the explosion of the budget deficit in the last fiscal year was the combined result of two factors that had nothing to do with the new President: the meltdown of the financial system with its associated bank bailouts and an unusually deep and prolonged recession. The first of the two represents very simply the cost of cleaning up after the banking crisis (which had was already underway some five months before Obama even took office), while the second reflects the massive loss of tax revenue and increase in certain types of government spending that are always associated with an economic downturn and higher unemployment.

So, now we have established -and there is probably very little quarrel with that outside the Fox News Channel's "commentators"- that the Obama Administration did not at least cause the skyrocketing deficit. Let's take a closer look at the repeatedly expressed "concerns" of the American public that the Administration is not doing enough to control the deficits.

There are two types of action that the Administration can take to actively seek the reduction of the deficit: cut spending or increase taxes. Increasing taxes in the midst of a severe recession is simply a catastrophic action, as it would have weakened much further an already plunging pace of consumer spending, therefore throwing the economy into an even more pronounced downward spiral. Cutting spending on programs, like the federally-funded, multiple extensions of unemployment benefits, would not only increase immensely the economic hardship of millions of Americans but would have also, from the strictly macroeconomic standpoint, allowed income growth to suffer more severe damage (which would have contributed to a further deepening of the recession).

One finds it almost irresistible to ask those who state that one of their main concerns about the direction of the country is the administration's poor handling of the fiscal deficit, whether they would have preferred a sharp increase in their taxes and shorter unemployment benefits when they lose their job, so that the new President shows a tougher stance on tackling the deficit. Or, whether, they would have preferred less spending on the various government assistance programs designed to prop up the economy in their own state, like construction projects and the like. When confronted with these options for dealing with the deficit problem more aggressively, perhaps they might (but, then again...they might not) recognize how ill-informed and misguided their criticism of the fiscal situation and those they consider responsible for it is.

The deficit is bound to come down appreciably in the current fiscal year- perhaps close to $1 trillion- as a direct result of the improvement in economic activity and the ensuing pick up in tax revenues. Left to its own devices, it should continue to move lower in fiscal year 2011, as the economic recovery gathers momentum. This is the way things always work with regard to the part of the budget deficit that has been affected by the down phase of the business cycle ("cyclical deficit").

In fiscal 2010, in particular, there is still a moderate headwind toward any further shrinking of the deficit coming from the remainder of the fiscal stimulus package coming on line, but ultimately, the deficit will be trending lower in the next few years. Whether such a downtrend will come soon enough on its own to return it to the 3.0% range by 2013, as Obama has promised, or whether more "pro-active" steps will be needed, that remains to be seen. For the time being, though, as Tim Geithner sensibly put it in an interview today (link below)

the deficit can wait, as the undiluted emphasis should remain on securing that the emerging economic recovery will acquire a self-sustaining dynamic soon.

Anthony Karydakis