Volume 60 | Number 7
The big Jackson Holemonetary policy confab was held this week and nothing happened. Federal Reserve Chairman Ben Bernanke said little about monetary policy except that the Fed stood ready to act – and would have a special two day meeting in September (to try and find a consensus after three dissents at the last meeting.) He also criticized the fiscal authorities for a failure to act – a call to step up. The following day, European Central Bank President Claude Trichet also said little about monetary policy and spent his speech comparing regional disparities within Europe with those in theUS. The not so subtle message was back off, the Euro zone will survive just like theUS. The lack of groundbreaking news is in stark juxtaposition with the announcement of QE2 last year. Does that mean the economy is in less dire straits or that the monetary authorities are out of bullets. We lean toward the economy is better off than last year (not hard to do) though stuck in a muddle through – but that the Fed has little left in its quiver other than perhaps Operation Twist, which would substitute long term securities for short term without changing the size of the balance sheet. That final arrow would be of very limited benefit – especially given exceptionally low short term rates do not yet seem to be stimulating a refinancing boom. Bottom line, if the Congress and Administration remain stalemated (as seems likely in this political season) and the Fed is out of ammo, then we are subject to the invisible hand, which will straighten out the imbalances – but like theMississippiwhen it reaches flood stage, its path is often uncontrollable and destructive. Be careful what you wish for…
Ben Bernanke Has a Problem
Chairman Bernanke in his analysis of the economy reiterated the position that the recent surge in inflation was transitory – would that that were true. Unfortunately, the detailed data on the GDP deflator – the broadest measure of inflation in theUSeconomy – suggest a more intractable problem. The GDP deflator rose at a 2.4% annual rate in the second quarter, after a 2.5% growth rate in the first quarter. This is a considerable acceleration from the 1.6% inflation in 2010. Nor can it be blamed directly on energy asUSenergy costs have actually been declining for the past six months! The price of natural gas and West Texas Intermediate crude have moved in the opposite direction of Brent crude (the marker for imported oil) and domestic energy is much less oil intensive than imports. Rather, it has been food prices driving the commodities side inflation over the past six months as soaring corn and meat prices lifted food inflation over 5.7% in the first half of the year. Yet, GDP inflation ex-food and energy remains a problem, rising at a 2.6% annual rate in the second quarter after a 2.5% growth rate in the first quarter. This is almost double the 1.3% averaged in the four quarters of 2010. Import energy inflation is being passed along by corporateAmerica– with no corresponding rise in wages to soften the blow. As a result, more and more of slowing US nominal growth has been eaten up by inflation resulting in the miserably slow real growth in the first half of the year.
To boost nominal growth, one looks for more aggressive lending by the banking sector – but it is the banks that have been hardest hit by the recent economic slowdown. Financial sector domestic profits fell $93 billion in the first half of 2011. All of this wealth has been transferred to the non-financial sector via lower interest rates – where profits rose by $104 billion. Still, growth in aggregate domestic profits has been a tepid 1.5% annual rate in the first half of the year – as the only way for one sector to gain is to steal strength from another given the slow growth in the pie.
And therein lies the rub for Bernanke and the rest ofWashington. It is unlikely thatUSenergy inflation will remain negative in coming quarters. It does not look to us like there will be much improvement in food inflation. Imported energy costs were still uncomfortably high in recent weeks despite weak economic performance and success inLibya, with Brent crude back over $110 a barrel. Businesses facing limited competition due to the lack of new entrants are free to push prices higher – passing along the higher inflation in all kinds of GDP goods and services — while still holding the line on hiring. Volume growth is weak, but bottom line growth remains solid – and cost control keeps profits at near record highs as a share of GDP. An end to falling interest rates may shift profits back to the financial sector – at the expense of non-financial profits – but firms may try and pass along that cost as well. The Fed ignored GDP inflation north of 3% starting in 2004 because the economy did not yet appear strong enough – and was very late to the party reining in a new bubble. Tighter policy seems very unlikely right now given Bernanke’s bias – but it is not hard to see why three voting Fed Presidents dissented and several other non-voting Presidents suggested they would have as well. Should be an exciting two day meeting in September – but don’t look for any new help from the Fed.
Bits and Pieces
Though firms remain reticent to invest in new plant and equipment, the strongest hands are snapping up financial deals. Mr. Buffet’s latest $5 billion venture comes at a far lower return than his bailout of Goldman, reflecting the lower bar for financial success. Meanwhile, JPMorgan and Wells Fargo were gobbling up nearly $10 billion in detritus from Anglo Irish. The tech firms have also been n a buying binge with Microsoft swallowing Skype for $8.5 billion, Google got Motorola Mobility for $12.5 billion, and HP took Autonomy for $10.2 billion. Cash is king. This may be good for the players involved, but we expect few jobs as a result of these moves – and without investment in real capital goods, the stagnation in the economy will continue.
Finally, it appears that the Chinese may be making one last drastic move to halt inflation before it can tarnish the final year of the Hu and Wen leadership. A widening of reserve requirements to include customer’s margin deposits may drain $140 billion from liquidity over the next six months. Various estimates suggest this is equivalent to roughly another 125 basis point hike in the reserve requirement – already at 21.5% for large banks. Clearly, the central authorities have not been happy with the continuing strength in off balance sheet lending vehicles and are cracking down. They are obviously less afraid of what a credit crunch will do to GDP growth than they are of continuing inflation. Bottom line,Chinaknows how to get out of a recession – just pump huge amounts of debt into the system. Now, they are working on reining in inflation by closing loopholes in their notoriously porous financial system. The Chinese are traditionally incrementalists and a move this substantial only comes with strong commitment from the central leadership. In our view, Chinese monetary and fiscal policies have far more to do with swings in commodity prices than anything in the developed world. They appear to be embarking on their own operation twist, with easier fiscal policy – as seen in recent tax cuts for low income households – but tighter monetary policy to limit inflation and the credit based asset inflation for the wealthy. Another nation, another experiment in economic policy mix – but this one bears the closest watching of all.