Jim Chappelow's blog

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.

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.

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.

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.

To grasp the general similarities in the pattern of business cycles is a critical part of economic understanding and foresight, but it is also important to look at the particular historical circumstances and trends that make each business cycle unique.  An example from the recent recession is the way housing and labor markets are interacting to exacerbate long-term unemployment. 

Flexible labor markets are one of the most critical factors in speeding economic recovery.  As the structure of production adjusts to new economic conditions, labor needs to be free to flow

Concerns over top appointments of big players in economic policy have been a contributing factor in this week’s market downturn.  Opposition to Bernanke’s reappointment as Chairman of the Federal Reserve is growing and spreading across party lines in the Senate.  His term expires in a week and criticism of his role in the housing boom and the financial bailouts are clouding his prospects for reappointment. 

Treasury Secretary Tim Geithner is also taking heat from Congress and is scheduled to appear at a House hearing next on improprieties related to the AIG bailout.&

Yale economist Robert Shiller recently opined in the New York Times that while most corporations are financed through both debt and equity, the US Treasury relies solely on debt issuance, to its detriment, and should begin issuing equity claims as well.  The foundation of this peculiar idea is a false analogy that Shiller draws between corporate equity and his proposed

On the topic of my previous post, a client asks:

"I understand that the Treasury sold $1.2 trillion of debt in 2009 and that the Fed bought 80% of it. This is magic. I didn't check my Ecotrend[s] but was told that the ten year Treasury bond interest went from near 1% a year ago to 2.3% a month or so ago, and is now approaching 4%. Is this new risk premium?

Can you put what is going on in layman's terms, and suggest what the future fallout may be?"

The really short answer is that the increase reflects the premium for inflation risk.

In the news this week, the IRS announced plans to regulate tax preparers, restricting anyone not registered and credentialed by the IRS or a state licensing body from providing tax preparation services.  They cite the usual justification, “consumer protection”, for imposing the new controls, even though IRS Commissione