The Fed, Chinese Tightening and Distribution

by Doug Noland

February 22, 2013


Federal Reserve Bank of St. Louis President James Bullard (February 21, 2013): “Let me just talk a minute about Jeremy Stein’s speechgovernor Stein is a Harvard finance professorsurely one of the leading finance people in the world. And we’re fortunate to have him on the [Federal Reserve] Board of Governors. He came out to a conference in St. Louis a couple of weeks ago and gave a speech in which he talked about potential imbalances in financial markets in the U.S. and a little bit around the world. The first point to make would be that – my main take away from the speech - he pushed back some against the ‘Bernanke doctrine.’ The Bernanke doctrine has been that we’re going to use monetary policy to deal with normal macro-economic concerns and then we’ll use regulatory policy to try to contain financial excess. And Jeremy Stein’s speech said, in effect, ‘I’m not sure that you’re always going to be able to take care of the financial excess with the regulatory policy.’ And in a key line, he said, ‘Raising interest rates is a way to get into all the corners of the financial markets that you might not be able to see or you might not be able to attack with the regulatory approach.’ I thought this was interesting and I would certainly listen to him. Everyone should take heed of this

This is an argument that maybe you should think about using interest rates to fight financial excess a little more than we have in the last few years where we’ve always said we’re going to use regulatory policies in that dimension. I thought it was a very interesting speech, but let me give a little broader context. The Fed has been talking about asset bubbles since the ‘irrational exuberance speech which was 1996. So it’s nothing new. We had a big bubble in the nineties. A big bubble in the two thousands. Those two bubbles ended very differently. The Fed’s been talking, talking, talking about this. So it’s certainly been a concern. It is a concern today. But it’s like nothing new. This has been going on for 20 years. Frankly, there aren’t good answers because we don’t have great models of financial instability.”

For the second straight month, the release of the most recent (January 29-30) Federal Open Market Committee (FOMC) meeting somewhat rattled the markets. From the New York Times (Binyamin Appelbaum): “There are widening divisions among Federal Reserve officials about the value of its efforts to reduce unemployment, but supporters of those efforts remain firmly in control… An increasingly vocal minority of Fed officials are concerned that buying about $85 billion of Treasury securities and mortgage-backed securities each month is doing more harm than good. They argue the purchases may need to end even before unemployment drops, because the Fed’s efforts are encouraging excessive risk-taking and may be difficult to reverse.”

There is dissention as well as confusion at our central bank. There are (“many”) members that believe open-ended QE was a mistake – and that this policy error should be corrected as soon as possible. Others believe aggressive QE could be continued indefinitely, or at least until unemployment has been reduced to a comfortable level. There is broad disagreement as to impacts, benefits and costs associated with the Fed’s long-term zero rate policy, quantitative easing, the mix of asset purchases, the ongoing balance sheet expansion (and, supposedly, eventualexit”), pre-committing on the future course of policy and communications more generally. While no one wants to admit as much, it’s all become one big and consequential mess

Those bullish on U.S. equities can easily ignore this increasingly contentious and complex debate. Understandably, they remain confident that Bernanke, Yellen, Dudley, Evans, Williams and Co. will continue to dictate ultra-easy policy for some years to come. What more do you need to know? And it is not outlandish to surmise that the more the doves’inflationiststrategy is called into question, the more insular and intransigent this group becomes.

There are those that believe that the Federal Reserve and global central bankers are on the right course. If QE/money printing is not getting the desired results, it’s because central banks aren’t using it with sufficient determination. And then there are those of us that see global monetary policy as an unmitigated disaster. Dr. Bullard is certainly accurate when he states “We had a big bubble in the nineties. A big bubble in the two thousands… This has been going on for 20 years.”

By now, the “Greenspan doctrine” of unfettered market-based finance and asymmetrical policy responses should have been completely discredited. Ditto for the “Greenspan/Bernanke doctrine” of disregarding assets Bubbles while they’re inflating, focusing instead on reflationary monetary measures to “mop upafter they’ve burst. By accommodating even bigger – and more systemic - Bubbles, the Fed has perpetrated even bigger policy debacles. And we should today look at the “Bernanke doctrine” – “Use monetary policy to deal with normal macro-economic concerns and then we’ll use regulatory policy to try to contain financial excess” with heightened skepticism and outright alarm. 

Please explain howregulatory policy” is to address the unprecedented issuance of government debt coupled with unconventional experimental reflationary monetary policy – the heart of today’sglobal government finance Bubble”? It hasn’t – and it won’t. And, clearly, I’m not alone in recognizing the obvious: The Fed has become a rather conspicuous enabler of Washington fiscal dysfunction. The Fed has become an enabler of global speculation, along with ever-mounting financial and economic imbalances. The debate is not going away – and the timing of the wind down in the most recent batch of quantitative easing is not the real issue. 

Yet the sophisticated market operators’ immediate focus is to gauge when global risk onmight be imperiled by the Fed’s backtracking from its $85bn monthly money printing operation. Upon deeper inspection, however, one can see a central bank institution that’s flailing. They’ve opened the money printing Pandora’s Boxwithout a doctrine, a strategy or even a consensus view for how to approach its latest experiment with “open-endedquantitative easing. I believe the decision to proceed with aggressive liquidity creation was based more on global systemic issues than the U.S. jobless rate. But in reversing last year’s potentially destabilizing globalrisk off,” the Fed and global central bankers incited a historic period of “risk on excess and attendant fragilities. Now they’re stuck.

A lot is riding on the current risk on.” Six months ago, the consensus view was that monetary policy was largely out of ammunition. Today, irrational exuberance has central bankers enjoying unlimited firepower. Central banks will be there the moment markets require additional liquidity. And the more markets inflate, the more confident players are with notion that central bankers won’t dare rock the applecart. It’s increasingly clear that “risk oncomes with heightened excesses and imbalances. Let’s quickly go around the globe.

The Shanghai Composite sank 4.9% this week. Markets increasingly fear a government imposed tightening cycle in China. Recall that Chinese officials were in the process of attempting to cool an overheated economy and a national housing Bubble before the “Europeancrisis last year risked unwieldy downturns. Officials cautiously retreated from measuredtightening” and, as Bubbles tend to do in the face of timid policymaking, the Chinese economic, Credit and Housing market Bubbles sprung right back. Housing transactions have surged, price inflation has accelerated and Credit growth has gone from amazing to utterly astounding. Reports put total January system lending (“social financing”) at an incredible $400bn. There is the distinct possibility that the Chinese Credit boom has reached the point of being, literally, out of control. 

Importantly, global risk on” - with attendant liquidity and “hot money bonanzas - has worked to reenergize China’s historic Bubble. The bullish consensus view holds that Chinese leaders have their economy and Credit system well under control. Yet each passing year of Bubble excesscertainly exacerbated by global liquidity oversupply and timid domestic policyensures that myriad imbalances become more deeply embedded in financial and economic structures. 

There were indications this week that Chinese authorities are again moving to tighten housing finance (see *China Bubble Watch below). On the one hand, the consensus view holds that the Chinese will approach tightening gingerly. And, at this point, global markets seem rather numb to Chinese tightening risks. On the other hand, with Credit Bubble infrastructure and psychology now deeply embedded, authorities will need to inflict some real pain (break inflationary psychology) if they are indeed determined to see results. 

I would argue that a new Chinese tightening cycle would come with huge uncertainties and major unappreciated risks. Indeed, it could mark a significant inflection point for Chinese Credit, the imbalanced Chinese economy and global economies and markets more generally. It is worth noting that tin and nickel prices were down 7% this week, with silver, platinum and copper all down more than 5%. 

A lot has transpired in China over the past year. The Chinese people – and the world more generally - have become much more aware of China’s endemic corruption problem. Widespread toxic air (and water) pollution has also been recognized as a consequence of a runaway Chinese boom. Other more typical Credit inflation consequences notably asset Bubbles, widening wealth disparities and economic imbalances – have also become more pressing. Moreover, inflation continues to quietly impart pain upon the large population of impoverished Chinese. The new Chinese government faces daunting financial, economic, environmental and social challenges. The global love affair with money printing (QE) doesn’t today seem to work in their best interest.

When I ponder a future bursting of the Chinese Bubble, I fret China’s relationship with Japan. For now, however, we’ll focus on the yen and Japanese stocks and bonds. The hedge funds have placed big bearish bets on Japan’s currency, while yen weakness has fueled heightened speculation in Japanese equities and, likely, globalrisk on” “carry tradesmore generally. Markets this week seemed to indicate that a yen rally might endanger an increasingly vulnerable globalrisk onmarket backdrop. And if “risk on” is viewed as susceptible, yen weakness might not be such a sure one-way bet.

This week also provided added confirmation of European vulnerabilities. For starters, the euro dropped 1.4%. Euro weakness also seemed to pressure globalrisk on.” Euro-zone economic data was generally dismal. PMI manufacturing and services indices were indicative of economic contraction. “Corecountry France, in particular, was notable for signs of deepening recession. France’s compositePMI index of manufacturing and services index declined to 42.3 (from January’s 42.7), the low since 2009. And then on Friday, the European Commission again downgraded Europe’s growth prospects. Euro zone GDP is now expected to contract 0.3% in 2013, with unemployment climbing to 12.2%. 

A Reuters’ headline captured a growing market issue: “Core Problem for Europe as France and Germany Drift Apart.” Elsewhere, Spain’s 2012 deficit was reported at 10.2%. And Sunday commences the two-day Italian election, almost sure to raise concerns regarding Italy’s commitment to reform and the political stability to carry on with commitments. This week seemed to bring a spotlight on the huge chasm that has developed between “risk onmarket levels and the region’s troubling fundamental backdrop. 

I always find it fascinating how news and analyses follow the direction of the market. When the markets are strong, the media focuses on the positives and are content to disregard the negatives. As markets reversed this week, suddenly there’s awareness that the European economy remains a mess, the U.S. still has serious fiscal and monetary policy issues to address, and global growth dynamics remain challenged. News outlets also tend to find a simple explanation for market selloffs. This week, it was the Fed minutes – an issue conveniently dismissed by the reality that the Fed is under the tight control of the dovish contingent. 

When one takes an objective view of the world, I along with others see a deeply flawed monetary policy experiment run amuck. I see myriad historic Bubbles. I see, as well, a globalrisk onspeculative trading dynamic that will eventually impart pain upon the unsuspecting. The short-term is significantly less clear. Does the sophisticated leveraged speculating community continue to playrisk on” for all its worth? Or will a more susceptible global backdrop dictate a change in strategy? Will the speculating community now seek to begin selling their holdings to the less sophisticated rushing to participate in the “new bull market”? It’s traditionally calleddistribution.” In today’s highly distorted financial backdrop, it’s probably more aptly referred to as “wealth redistribution.”
One could add wealth redistribution to the list of “unintended consequences” from Federal Reserve reflationary policymaking. That is, except for the fact that the Bernanke Fed is rather open in its view that it prefers savers out of safety and into the risk markets (jungle).


*China Bubble Watch:

February 20 – Bloomberg: “Chinese Premier Wen Jiabao called for local authorities to ‘decisively’ curb real estate speculation and take steps to rein the property market after data showed prices surged the most in two years last month. Cities that have witnessed ‘excessively fast’ price gains should promptly impose home-purchase restrictions if they’ve not done so already, the central government said in a statement released after a meeting of the State Council headed by Wen. Provincial capitals and municipalities to report directly to the central government should also publish annual price control targets to keep new-home costs “basically stable,” according to the statement. Shares of Chinese developers listed in Shanghai fell the most in more than six months… Home prices rose 1% last month from December, the most since January 2011, according to… SouFun Holdings Ltd., the nation’s biggest property website.”

February 21 – Bloomberg: “China told local authorities to ‘decisively’ curb real estate speculation and take steps to rein in the property market after prices rose the most in two years last month. Shares of developers declined. Cities that have had ‘excessively fast’ price gains should ‘promptly’ impose home-purchase restrictions if they’ve not done so already, according to a statement yesterday after a State Council meeting headed by Premier Wen Jiabao. Provincial capitals and municipalities reporting directly to the central government should publish annual price control targets to keep new-home costs ‘basically stable,’ according to the statement.”

February 21 – Bloomberg: “The People’s Bank of China’s first draining of cash since June, seeking to damp a property-market revival, is prompting Citigroup Inc. to predict one-year yields will rise faster than longer-term rates. The central bank sold repurchase agreements for the first time in eight months on Feb. 19, withdrawing capital from banks after they lent the most money in two years in January… ‘The PBOC regards the current liquidity conditions as overly loose,’ said Weisheng He, a strategist in Shanghai at Citigroup.”

February 19 – MarketNews International: “China's central bank is expected to book a record total forex purchase position of CNY660 billion in January, and there are conflicting views of how that number, seen as a gauge of capital inflows, should be accurately interpreted. The most obvious impact and apparently the most widely accepted view is that expectations of monetary tightening by the central bank has started to build despite no official confirmation of that number.”

February 22 – Bloomberg (Weiyi Lim): “China’s stocks fell, dragging the benchmark index to its steepest weekly loss in 20 months, as higher home prices boosted concern the government will adopt tighter policies to prevent asset bubbles… China Construction Bank Corp., the largest mortgage lender, led declines for financial companies this week. A gauge of Shanghai property developers posted its worst weekly loss since July… The Shanghai Composite Index slid 0.5%..., adding to a 4.9% slump this week…”

February 22 – Bloomberg: “China’s new home prices rose in most cities the government tracks for a third month, adding pressure on leaders to intensify policy-tightening efforts to prevent asset bubbles and inflation as the economy rebounds. Prices climbed in January from December in 53 of the 70 cities… Shenzhen, which borders Hong Kong, led the gains with a 2.2% jump from December, while Beijing and Shanghai also rose, as prices accelerated in the nation’s most expensive markets.”
February 19 – Bloomberg: “China’s army may be behind a hacking group that has attacked at least 141 companies worldwide since 2006, according to a report by a U.S. security firm. The attacks, mainly directed at U.S. companies, were carried out by a group that is ‘likely government sponsored’ and is similar ‘in its mission, capabilities, and resources’ to a unit of the People’s Liberation Army, Mandiant Corp. said… Mandiant said it traced the group, labeled Advanced Persistent Threat 1, to four large computer networks in Shanghai. Two of the networks serve the Pudong New Area district, where a secret army unit called 61398 is based, the report said. ‘It is time to acknowledge the threat is originating in China,’ …Mandiant said. ‘Our research and observations indicate that the Communist Party of China is tasking the Chinese People’s Liberation Army to commit systematic cyber espionage and data theft against organizations around the world.’”

February 22 – Bloomberg (Kelvin Wong and Stephanie Tong): “Hong Kong doubled the sales tax on property costing more than HK$2 million ($258,000) and targeted commercial real estate for the first time as bubble risks spread from apartments to parking spaces, shops and hotels. The stamp duty will increase to 8.5% of the purchase price for all properties… The Hong Kong Monetary Authority also tightened mortgage terms for commercial properties and parking spaces.”

Japan Watch:

February 22 – Bloomberg (Isabel Reynolds): “Japanese Prime Minister Shinzo Abe is vowing that Japan won’t tolerate any challenges to the country’s control of islands at the center of a territorial dispute with China. In a speech he’s delivering today after meeting with U.S. President Barack Obama, Abe also will underscore Japan’s plans to beef up its military and to form closer ties with other democracies in the region. ‘We simply cannot tolerate any challenge,’ Abe will say, according to the text of an address he’ll deliver to the Center for Strategic and International Studies in Washington. ‘No nation should underestimate the firmness of our resolve. No one should ever doubt the robustness of the Japan-U.S. alliance.’”

February 22 – Financial Times (Ben McLannahan): “Investors’ excitement over ‘Abenomics’ is showing signs of flagging, almost 100 days on from the market turnround triggered by hopes of aggressive monetary and fiscal stimulus under a new Japanese prime minister. This week, stock trading volumes on the Tokyo Stock Exchange’s first section have dipped about a quarter from the average so far this year, while volumes of Nikkei 225 futures contracts have dropped below 100,000 a day for the first time since December. Over the past two weeks, the index itself has fallen as often as it has risen, bringing an end to the longest streak of gains in more than 50 years.”

February 20 – Bloomberg (James Mayger and Andy Sharp): “Japan’s trade deficit swelled to a record 1.63 trillion yen ($17.4bn) on energy imports and a weaker yen, highlighting one cost of Prime Minister Shinzo Abe’s policies that are driving down the currency. Exports climbed 6.4% in January from a year earlier, the first rise in eight months… Imports increased 7.3%... Weakness in the yen that aids exporters such as Sharp Corp. and Sony Corp. also means the country pays more to import fossil fuels needed as nuclear reactors stand idle after the Fukushima crisis in 2011. That burden may encourage the government to limit the currency’s slide, with Deputy Economy Minister Yasutoshi Nishimura signaling in a Jan. 24 interview that the government may prefer a yen stronger than 110 per dollar.”

February 24, 2013 3:08 pm
Austerity obstructs real economic reform

In Europe, the wordreform” is as misleading as it is ubiquitous. You heard it during the Italian election campaign, when politicians – such as Mario Monti, the country’s outgoing prime minister – were classified as pro-reform. Others, the rest of Italy’s political class, have been deemed anti-reform. It is as though reform has become an issue of religious dogma. You are either in or you are out.

In or out of exactly what, one may ask? What, exactly, is reform? Growing up in Germany in the 1960s and 1970s, I recall Willy Brandt, West Germany’s chancellor during some of those years, talking endlessly about reforms. For him, the word meant more workers’ rights and an increase in welfare payments. This has always been the meaning I first think of when I hear it.

A decade later, in the UK under Margaret (now Baroness) Thatcher, reform became synonymous with privatisation and deregulation, and a reduction in the rights of trade unions. This is closer to the meaning that it holds for most people today.

There is certainly a clear, positive – though often overstated case for structural changes such as the liberalisation of services, changes to labour markets to help younger workers and pension reforms to ensure long-term fiscal solvency. These reforms would probably increase the gross domestic product of several countries by a non-trivial but unknown amount.

A former editor of The Economist used to advise young reporters to “simplify, then exaggerate”. This is exactly what happened to the debate on reform in Europe. You might want to adddistort” as a third element. The simplification consisted of the notion that there is a link between some vague idea of reform and economic success, as measured in GDP per capita. No such link exists.

The richest countries in the world include those with both liberal and regulated labour markets. Per capita GDP in the highly regulated French economy has been higher than in the deregulated UK. The relatively solid performance of a largely unreformed France does not obviate the need for reforms. But it shows that the relationship is much more subtle than the dogmatists acknowledge.

The exaggeration consists of overstating the actual impact of reforms when they take place. Has financial liberalisation really increased long-run economic growth, or may it merely have given us a housing bubble? Has German labour market reform really increased long-term productivity or were other factors at work?

This distortion has become even worse recently, as reform has been conflated with austerity. Whenever you hear a European official applauding Mr Monti’sreforms”, what they are really praising is his fiscal consolidation. In other words, they applaud the many of his policies that reduced economic growth, and not the few that might have a chance to increase it one day.

Austerity and reform are the opposite of each other. If you are serious about structural reform, it will cost you upfront money. If you want to open your labour market to a hire-and-fire rule, you will need policies to deal with those who are laid off. These costs may outweigh the financial benefits of reforms in the short term but the reforms may still pay off in the long run. Structural reforms, properly done, are not suited to the task of delivering austerity.

By contrast, austerity higher taxes and cuts in public sector investmentsweaken the economy’s capacity in the short run, and possibly also in the long run. If you have youth unemployment of more than 50 per cent for a sustained period, as is now the case in Greece, Italy and Spain, many of those people will never find good jobs in their lives.

Economists speak of a so-calledhysteresis effectpermanent economic damage that will not be repaired even if there is a full recovery. Austerity could well leave an economic and social scar across the eurozone.

Italy and Spain would have been a lot better off to come up with a list of front-loaded targeted structural reforms and backloaded fiscal consolidation. When you do it the other way round, cutting investment and raising taxes in a recession, you never get out of the hole, and you waste your political capital on austerity, leaving none for reforms.

By putting fiscal consolidation first, the political establishment also took a big gamble against what we know from history. A senior Italian official told me a while back that they had the situation under control. There would be a slight bump but the economy would take off afterwards.

He was wrong. As last week’s European Commission forecasts confirm, the southern European economies are behaving as was predicted by those who thought austerity would sap growth and using monetary policy to offset it would be ineffective.

I am not surprised that European electorates are rejecting these policies, and the politicians who delivered them. Tonight we will know how Italy has voted. My hunch is that it is not going to be a good evening for the “Austerians”.

Copyright The Financial Times Limited 2013.


Updated February 24, 2013, 2:37 p.m. ET

Hidden Risks of a Hard Landing in China


The rebound in China's economy has helped underpin a rally in global markets. The truth, though, may be less rosy than official data suggest.

Government figures indicate a moderate economic slowdown over the past two years. Gross domestic product grew 7.8% in 2012, down from 10.4% in 2010, and above the official target of 7.5% for the year.

But those numbers may underestimate inflation, resulting in an overestimate of real growth, says Stephen Green, China economist at Standard Chartered. Using an alternative measure of inflation that better reflects rising rents and prices for services like health care and education, Mr. Green calculates GDP growth at just 5.5% in 2012.

There is more to be concerned about. On trade, official data show a strong rebound coming into 2013, with exports in December up 14% year on year. But comparing China's export numbers to import data from Hong Kong—the first destination for many of China's goods—suggests that is too high. Louis Kuijs, China economist at RBS, calculates the real export growth rate could be four percentage points lower.

On consumption, the official retail-sales index in December is up 15.2% year on year. Other data paint a different picture. ielsen's index of sales of fast-moving consumer goods, which should include fewer of the government purchases that distort the official data, was up just 9% in December, for instance.

Dismal recent results for some major retailers also suggest all is not well at the cash register. The latest results from sports retailer Nike, fast-food peddler Yum Brands and home-electronics giant Gome are all weak.

On investment, the government figures show fixed asset investment increased 21% year on year in the year to December. But that looks odd against a 14% year-on-year fall in sales of excavators in December and a 19% drop in steel pricesmeasures that should track investment growth.

Second-guessing China's growth rate is fraught with difficulties. The quality of the official data is sharply improved from even a few years ago, and alternative measures are often unrepresentative.

It is important, too, that labor markets appear tight and employers say staffing costs are rising. Yum Brands reported 10% year-on-year wage inflation in the fourth quarter, for example. That suggests China can live with slower economic growth without suffering crippling unemployment and social instability.

In the rest of the world, though,slower growth in China would be tough to swallow. The global marketrally is about growing confidence in the U.S. and hopes that the worst for Europe is over, as well as China's recovery.
But a 5.5% growth rate would put the world's second-largest economy in hard-landing territory—and that should be enough to shake anyone's confidence.