Blogs

Last month in our EcoTrends® Executive Summary we discussed the likelihood of our current deficit spending leading to inflation and how, in concert with the demographic trends of the US, this would lead to a particularly difficult decade sometime around 2030 – 2040. 

We have been asked what could be (or should be) done to avoid this future.  One of several potential alternatives to dealing with the trends now taking shape is to restore some responsibility and accountability to the federal budget process.  We look to history as a guide and note that

A subscriber wrote in today asking about the impact of the recent Chilean earthquake on copper prices.

There has been a spike in copper prices today, but this is likely to be short lived.  Power has already been restored to some of the mines affected by outages, roads serving mining operations are reported to be in good condition, and there isn’t any major damage reported to the mines themselves.  

This chart comparing the monthly copper futures price following major earthquakes in Chile over the past few years shows that they don’t appear to have a decisive impact on the pricing trend.   The longer term trends usually swamp any short term blips due to random events such as earthquakes.  We do expect higher prices in 2010, but this is more due to general economic trends.

You may have heard that the latest report on New Home Sales in the US shows that a record low amount of new homes were sold in January.  Our own databases at ITR confirm this fact and we have data on new home sales stretching back 47 years. 

For sure, a record low number of new homes sold in the US is not a good thing for the economy.  However, I am not too worried about this record low for a few reasons. One principle reason is that January is traditionally a slow month for home sales, so the relative decline compared to previous months is nothing new.

Another reason is the homebuyer’s tax credit.  We saw the first time homebuyers tax credit increase sales in November and October when buyers where expecting the tax credits to expire.  Once Congress extended the tax credits, sales in December dropped.  January’s decline in New Home Sales is just an extension of the distortion that a large subsidy plays on a market.  I bet the closer we get to April, the higher home sales will go again as buyers rush to get the credit that is due to expire.  

A subscriber recently wrote in to ask why the current interest rate spread between Treasury Inflation Protected Securities (TIPS) and standard Treasuries seems to imply a much lower rate of expected inflation over the next few years (around 2%) than we have been forecasting (up to 7%).  The common assumption is that this interest rate spread corresponds to market inflation expectations, but we do not hold to this view.  

The TIPS – Treasury spread is not a very reliable indicator of inflation expectations for a few reasons.  For one thing, in order for the spread to really be reliable the two securities would have to be identical in every regard other than the inflation indexing offered on TIPS.  This isn’t really the case because the market for TIPS is so much smaller than for standard Treasuries, about 1/5 to ¼ the size, so there’s a substantial liquidity premium on TIPS yields.  This narrows the spread, which means that it understates inflation expectations.  

The Kansas City Fed put out a good research article on this and other factors, and finds that the TIPS spread understates expected inflation relative to both historical inflation rates and estimates based on surveys of economists’ forecasts.  This is especially the case during periods of financial stress and crisis.  So the popular assumption that this spread provides a good indicator of inflation expectations is not valid.

The Consumer Price Index (CPI) rose to a 15-month high in January.  The cause for alarm may not seem so pertinent when you take out food and energy costs.  Core CPI barely rose at all.  However, food and energy are important factors when considering long-term inflation and with oil prices trending upward, the problems of controlling inflation become very real. 

Energy prices spiked 2.8% in the month of January and gasoline rose 4.4%.  These numbers will fluctuate from month to month, but there is no denying the overall rising trend in CPI recently.  The CPI has risen in 11 of the past 13 months. We at ITR will be watching this trend carefully for future signs of inflation as the economy recovers in 2010.

Immediately after the stock market closed Thursday, the Fed announced a ¼ percent hike in its emergency discount rate for troubled banks.  It’s a pretty tentative move, but markets are reacting strongly; the dollar is up sharply, stock futures, US Treasuries, and commodity prices are down.  

The reaction is remarkable considering that the Fed has been signaling this move for some time.  Bernanke said in his recent testimony to Congress that raising the discount rate would be an early component of the Fed’s exit strategy.  Just in the past week, at least three Fed regional governors have publicly argued that the looming inflationary effects of monetary and fiscal stimulus need to be addressed soon. 

There’s not all that much discount lending activity going on now that they’ve unwound most of the special facilities, so the reaction must be driven by expectation that this signals continued tightening rather than any immediate curtailment of discount lending. This is despite explicit statements in the Fed announcement that this rate hike is not a tightening on monetary policy, which indicates a decline in the Fed’s credibility among market participants.   

The Fed has dipped its toe in to test the water, and the markets have gotten cold feet.

The idea of a value-added tax is gaining traction among some economists and policy makers, as a possible tool to reduce the projected chronic federal budget deficits and avert fiscal crisis.  A VAT is similar to a retail sales tax except that the tax is levied and passed on as part of the4 mark up at each step in the supply chain.  The tax is ultimately still passed on to the consumer.  VATs are common in most of the developed world outside the US.

Two points on a VAT:

1) A major argument used in favor of a VAT is that it discourages economic growth less than the current system of income taxation because it is a tax on consumer behavior rather than productive activity that generates income, so instead of discouraging saving and investment it discourages over consumption.  This argument falls flat however, because the fact that value-added by the consumer inevitably avoids the tax, which leads to one of the most well know unintended consequences of a VAT: vertical integration at the consumer level. 

Consumers can significantly reduce their VAT burden by buying unfinished or wholesale goods and doing final assembly, maintenance, and services for themselves rather than hiring or purchasing from someone who specializes.  This reduces the productivity of the overall economy by eroding the division of labor; the average Joe consumer is simply not going to do as good a job assembling a car stereo or plumbing a house as a trained professional would.  There’s no reason to believe that the improved incentives that result from a move away from income taxation would necessarily out weigh this effect. 

 2) The idea that significantly raising taxes to boost federal revenue by either introducing a VAT or just raising current taxes will be an especially effective means of reducing budget deficits and the federal debt flies in the face of historical precedent.  

Federal debt reduction is always associated with military demobilization following the end of a major war, not with an increase in federal revenue.  If anything, the chart demonstrates that episodes of significant increase in federal revenue are associated with a steeply growing debt.  While sustained higher revenues do appear to lead some debt reduction over a few decades, like an ideal gas spending then expands to fill the available volume of revenue.  The cycle repeats and with each stage revenue, spending, and the total debt all grow.

Former Federal Reserve chairman Paul Volcker recently proclaimed that big financial institutions that are in trouble need to be properly liquidated and not saved.  We at the Institute could not agree more! The perverse economic incentives that come with bailouts only encourage more risky behavior in the future.  There is a role for the government and the court system to intervene when an integrally important institution is approaching insolvency, but their task needs to be guiding that institution to non-market-crashing liquidation and not a ‘bailout’. 

Volcker has some heavy criticism for the current Federal Reserve board, saying, “I don’t think there’s any question the Federal Reserve and other regulators were not on top of the housing picture”.  The words may seem like common sense to some, but it is encouraging to see an Obama administration advisor speak clear economic sense in the face of the often economically uninformed decisions being made in Congress and at the Fed.

It is important to be well aware of the sticky situation the Federal Reserve has gotten in concerning the risk of future inflation.  Normally in a period of expanding economic activity the Fed reigns in the money supply by selling Treasuries on the open market and waiting for the short term market to respond with interest rate rise.  This strategy works well when the initial money placed in the economy is through the Fed buying US Treasuries from banks.  The Federal Reserve has built a reputation by accurate targeting of the overnight (Fed Funds Rate) money market using this method. 

However, in 2010, more than half of Federal Reserves balances are comprised of non-treasury securities.  These cannot be easily sold back on the open market to reign in inflation.  The open market for Mortgage Backed Securities (MBS) is only beginning to return and the Fed selling their share of MBS in large quantities would likely cause mortgage rates to soar and another housing crisis.  In essence, the Fed has one hand tied behind its back when dealing with inflation because they can only soak up a portion of the money they placed in to the economy in the past few years. 

And Ben Bernanke is well aware of this situation.  This is why he has proposed three different methods of draining excess money from the economy besides the usual means of selling treasuries.  One method would be to raise the interest rate paid on excess reserves held by banks at the Federal Reserve.  The other two methods are offering reverse repurchase agreements and term deposits to banks, which would essentially incentivize banks from lending for periods of time controlled by the Fed. 

These alternative approaches should all have a similar end effect as the Fed selling treasuries but have not been tested on a large scale as a way of moving short term money markets in the U.S.  This leaves some reasonable grounds for concern about the Federal Reserve’s future ability to tame inflation in the next five years.  With unprecedented monetary injection, the stakes are high.  We will have to stay tuned to see if these new methods will work as intended.

Chinese banking authorities announced another hike in bank reserve requirements Friday in an effort to slow what they believe to be an over heated economy.  They also indicated willingness to raise interest rates to further rein in bank lending. 

The attempt to dampen the economy is driven by rising price inflation and a perceptible real estate bubble.  We’ve previously discussed what appears to be apparently massive malinvestment that has been accumulating during China’s boom.  In order to rein in the bubble the Chinese may finally be moving toward letting their currency appreciate against the dollar.