Friday, May 30, 2008

I'll Be Back

I'm a cybernetic organism, living tissue, not really :-)
But even so, there's no need to worry, because I'll be back.

I've been extremely busy for the last few days with a number of things, most important and time consuming of which have been a paper about exchange rate movements with regard to the theories of uncovered interest parity in capital markets and purchasing power parity in goods markets. I've still got a lot left to do in the coming days, but I expect to be posting here again soon, probably -although that is not certain- as soon as tomorrow.

Tuesday, May 27, 2008

Trichet The Comedian

Bloomberg news has an article noting that the ECB has rather consistently overshot its inflation target, and that this leads some to argue that the target should be raised to 2.5% or that the ECB like the Fed should also consider employment as a target. As any regular reader knows, I think it is a bad idea to inflate as much as the ECB does and so it would be better if they restricted their money creation. However, if they are going to pursue their current more inflationary policies, they might as well be honest about it and formally raise the target to 2.5% or 3% or whatever.

ECB President Jean-Claude Trichet apparently opposes this however, as this would increase inflationary expectations. He further argues that

"investors have not lost faith in the ECB's ability to deliver price stability and that only temporary "shocks"' have caused its ceiling to be breached."

Temporary? If something goes on year after year it sure ain't temporary. And I'd like to see the investors who actually believe the ECB will deliver what they've almost never delivered so far during the latest 10 years. I don't know what these guys have been smoking, but it sure ain't tobacco, if you know what I mean.....

Still, his assertions of "temporary" factors that last a decade and investors who actually believe that did at least provide me with a good laugh.

Saturday, May 24, 2008

Austrian Business Cycle Theory Essay Now Available In English

Late March, I told you about how I had written an essay in Swedish in Swedish web magazine Captus arguing the case for the Austrian business cycle theory and why it is so important. However, while Sweden together with the United States is the biggest country of origin of readers of this blog, most readers are not Swedish. Even including the readers I have in Finland -where most people understand Swedish as it is a official language taught in school- and Swedes living in other countries and maybe even including my Danish and Norwegian readers (Danish and Norwegian are fairly similar to Swedish, so Scandinavians can generally understand most of what is written in the two other Scandinavian languages), that still meant that most of my readers were unable to read it.

Now I see Google Translation Service is finally available for Swedish, meaning that my non-Swedish readers can use the service to translate the text. Here is a direct link to a English version of the text. The service seems imperfect as some words aren't translated (for example räntepapper, which means interest bearing securities, vänsterdebattörer which means leftist pundits and aningslöst which means cluelessly) but hopefully it will be understandable anyway.

Weekend Humor-The Million Dollar Man

Last year, I told you about how I had started to look through my old VHS tapes and look through its contents. As I've been distracted by other things, this process have't progressed as fast as it should have been, and I'm still not done. However, recently, I found something really amusing: old "pro-wrestling" clips all the way back from 1990-91. American "pro-wrestling"
is a lot more show business than real athletic performance, but I actually like that. Real serious wrestling is quite boring and that is why it is a lot less popular.

In American "pro-wrestling", which at the time was mainly organized by the World Wrestling Federation (WWF)-now called WWE because the environmentalists in the World Wildlife Fund sued them-, wrestlers all adopt colorful characters, which are either "bad guys" or good guys". The matches almost always feature one "good guy" versus one "bad guy", although occassionally there can be duels between different "good guys" and different "bad guys". One such duel was the match between Hulk Hogan and Ultimate Warrior, which ended in Warrior winning the title from Hogan.

One of my favorite villains was the Million dollar man Ted Dibiase. These days, because of the inflation unleashed by Greenspan and Bernanke, the title million dollar man isn't worth as much as it used to be. But at any rate, it is a quite funny character. Here is his entry video

Friday, May 23, 2008

Monetary Policy, Money Supply And Price Inflation

My good friend Daniel Halvarsson has written yet another great post, this one about the link between money supply changes and price inflation. As he illustrates quite well in a graph in the post, there is little immediate correlation between money supply changes and price inflation. Although both money supply growth and price inflation have accelerated during the latest year, they have often diverged in the past. However, if you consider the fact that there is always a time lag between money supply changes and price inflation, you can see that money supply changes have tended to precede changes in price inflation by 1-2 years or so.

There are several reasons why there is such a time lag, but the most important one is that most prices tend to be quite sticky and so will not respond immediately to changes in the money supply. A few prices, most notably fuel prices, are almost completely flexible and will for that reason respond almost immediately to money supply changes, but for most other prices, the response will be lagged. The reason is that first of all, because of inventories and forwards/futures contracts, it will take a while before most firms notice higher costs. And because they know many customers will be upset over price increases and that competitors might wait, they will often wait to pass on cost increases. As I've explained before, it is well-known that exporters usually in the short run adopt a pricing to market strategy, where they wait before they raise price and instead absorb cost increases through reduced margins. Eventually, however, when companies realize that exchange rate movements are permanent, they will adjust prices, causing a lagged effect on price inflation.

In this context I would also like to link to another graph, from Spencer at the Angry Bear blog, showing a very strong negative correlation between bond yields and money supply velocity. Money supply velocity is as you might know defined as money supply relative to GDP, or in this case personal income. As bond yields represent the opportunity cost of holding money, we would expect a negative correlation between interest rates and the demand for holding money. Higher demand for holding money is in turn associated with money supply velocity. If we see historically when money supply growth has been highest we can also see that it is during periods of aggressive interest rate cuts, such as in 1983, 2001 and now that money supply growth has been highest.

As there is a immediate link between monetary policy changes and money supply growth, and a lagged link between money supply growth and price inflation, it also follows that there is a lagged link between monetary policy changes and price inflation.

That in turn has two implications, one for current economic forecasting and one for economic policy. The economic forecasting effect, as Daniel pointed out, is that even if money supply growth slows, price inflation will remain high for a while. The economic policy effect is that price inflation targeting is very difficult to implement in practice. Policy makers only know about current inflation, but their influence on that is very small. They can however influence future price inflation, but as they don't know how high it would have been if they didn't make any policy moves, they could just as well end up pushing inflation further away from the target as closer to it (Although arguably, as this post demonstrates, if central banks starts paying attention to the lagged effect between money supply and price inflation, their forecasts would probably improve. But except for Austrians and the dwindling number of Monetarists, few pay attention to money supply today).

Tuesday, May 20, 2008

More On The Sucker Rally

Daniel Halvarsson has an interesting post where argues that the U.S. stock market is currently overbought from a technical point of view. There is certainly no doubt that the market is overvalued from a fundamental point of view. Stock prices are only slightly lower than year ago levels, even as earnings have plummeted some 26%.

Bulls of course usually respond to this by saying that if you exclude financial companies and consumer discretionals, then earnings are in fact up. But comparing earnings excluding financials and consumer discretionary companies with the market movements including these companies is a blatant case of comparing apples and pears. Since these stocks have fallen the most (Citigroup is for example down more than 50%) and the market too is up quite a bit excluding them and since stocks were very expensive to begin with, then the fact remains that stocks are very expensive.

Via Greg Mankiw I see this illustration of that point, with a chart comparing stock prices to a 10-year moving average of actual earnings. Although as you can see valuations are well below the peaks of the tech stock bubble and has recently slightly improved (unlike the p/e ratio for the most recent year's earning which has soared), valuation levels remain well above the levels seen before the tech stock bubble.

UPDATE: Daniel Halvarsson has noticed my post and posted an even better graph over how the use of 10-year moving averages in earnings indicate that U.S. stocks are generally overvalued.

Energy Prices Are Falling

Or so says the U.S. government. Meanwhile, Bloomberg news -and the other financial news sites- tells me that oil rose to its umpteenth record high this year, at over $129 per barrel. Who should I believe? Bloomberg news and the other financial news sites or the U.S. government? Hmmm, tough choice.......

Monday, May 19, 2008

Coincident Indicators Fall Again

Just as I predicted, the latest release on leading, coincident and lagging indicators included a downward revision of the March number for coincident indicators, as well as the February number. Instead of seeing a 0.2% decline in February and a 0.1%
rise in March, they fell 0.3% in February and was unchanged in March. Now they say the April number was unchanged. It seems clear however, especially with the sharp decline in industrial production that this number too will be revised down and so be negative.

Although usually ignored by the financial medua, the coincident indicators are important because they are used by NBER to determine if and when a recession has started.

I should however caution that the so-called tax rebates might give a temporary and artificial boost to one of the coincident indicators, real disposable income excluding transfer payments. To the extent the so-called rebate is treated as what it really is, a transfer payment, it won't affect these numbers. However, as some of it will be treated as a tax cut, and so boost real disposable income excluding transfer payments, this indicator will be boosted. This of course goes against the intent of this indicator, to measure market and employment based income, and so indirectly the value of production, but it will nevertheless probably be accounted for that way. This mean that this indicator, and by extension the coincident indicator index, will appear stronger than it really is. But those of you who read this blog will be able to see through it.

Saturday, May 17, 2008

Norway's Gladstone Gander Economy

Today is May 17th, Norway's national day, so perhaps a review of the Norwegian economy is warranted. I actually did review it 2 years ago on the Der Invest Informant web site. In these two years, not much have changed so what I wrote there still holds so I won't repeat it here and instead recommends you to follow the link and read it the article. The only difference is that the oil price is even higher now than then, and that the Norwegian krona has strengthened even more (at that time a US$ stood at 6 NOK, now it costs only 5 NOK), so the Norwegian budget- and current account surplus is even higher now, particularly in dollar terms. And because of this, the relative wealth of the Norwegians are even greater now than then. Indeed, at current exchange rates, Norway's GDP per capita will likely surpass $100,000-more than twice as high as in the United States and most Western European countries. While this advantage is much lower if you consider the very high cost of living in Norway, it is certainly the case that Norway is richer than any other country in the world except for Luxembourg and maybe also some Arab Gulf state.

Not that Norwegians can actually enjoy it as the government forcibly saves all of the oil revenues in a special oil fund that invests in foreign securities. This policy, as I wrote in the article is basically supported by all parties except the in theory libertarian but in practical politics right-wing populist Progress Party (Fremskrittspartiet (FRP) in Norwegian), who wants to if not halt, then at least reduce this forced savings and use it for dramatic tax cuts combined with increased spending in some areas. A somewhat humorous note was in the latest Progress Party congress, when the party's taxation spokesman Gjermund Hagesæter attacked socialist finance minister Kristin Halvorsen and said she was like Onkel Skrue, the Norwegian name for Uncle Scrooge or Scrooge McDuck, and had brought a figure of that Ddisney character to illustrate this.

After having pointed out that despite the record oil wealth, Norwegans were forced to pay more taxes than ever, he asked the gathering what the similarities between Halvorssen and Scrogge McDuck was and answered this himself by saying

"Ja, for uten at de begge er store i nebbet da. De sitter begge på store pengesekker og de er like gjerrige. Kristin Halvorsen er Norges svar på Onkel Skrue!"

Which in English means: "Well, I mean aside from both having a big beak. They are both sitting on hugh amounts of money and they are both equally greedy. Kristin Halvorsen is Norway's version of Uncle Scrooge!"

Still, while Kristin Halvorsen may be a statist version of Scrooge McDuck, the Disney character that best describes the Norwegian economy is arguably Gladstone Gander.

Gladstone Gander is the cousin to Donald Duck that is a rival for Daisy Duck, but in sharp contrast to Donald has really unbelievable luck. Gladstone Gander never works or save any money, but because of his unbelievable luck he still always have enough money to live comfortably, because whenever he runs out of cash he simply walks out on the street where he finds a lottery ticket which gives him a winning of $100,000 or some other large sum that enables him to live comfortably without working.

Of course, most Norwegians do work and so it is certainly not the case that all of their wealth can be attributed to luck, in the way that all of Gladstone Gander's money is acquired through sheer luck. So Norway is not purely a Gladstone Gander economy, and certain Arab Gulf states have arguably an even stronger Gladstone Gander character. But it is clearly the case that reason why Norway is so much richer than the rest of Western Europe is because they had the luck of having all that oil, which is becoming more and more advantageous for them as oil prices just keeps rising.

Friday, May 16, 2008

Chinese Earthquake Raise Oil Price

The price of oil rose to a new all time high of more than $127 per barrel per day. The reason was apparently the Chinese earthquake. Many people would perhaps have expected the earthquake to, if anything, lower the oil price as it will temporarily lower Chinese economic growth and so cut demad for oil there. But as much of the negative supply shock will occur through problems in coal distribution, which in turn means that the need rises for a substitute in the form of oil.

U.S. Industrial Production Collapse

When I wrote last month about Don Luskin's pathetic recession denial, I mentioned his argument that because industrial production at the time had been reported to rise 0.3% in March, there were no recession, an argument which was really misleading for reasons I mentioned then.

Now that argument appears more pathetic than ever. Not only has that increase been revised down to 0.2%, but industrial production for April was reported to fall by a full 0.7%. As industrial production fell with 0.7% in February too, this means that April industrial production is 1.2% lower than January industrial production, a decline of nearly 5% at an annual rate. The decline is even bigger if you look at manufacturing alone.

I wonder if Luskin will mention industrial production figures in his next column. Somehow I doubt it....

Thursday, May 15, 2008

Euro Area Economy Show Resilience

In sharp contrast to Estonia, the euro area economy showed great resilience during the first quarter, with growth accelerating to 0.7%, from 0.4% in the first quarter. Growth was primarily driven by Germany which saw a full 1.5% growth rate. Growth was also fairly strong in Greece and Austria. France saw growth of 0.6%, which if not strong in a absolute sense, is strong by French standards. By contrast, growth weakened considerably in the Iberian peninsula, with perennial laggard Portugal seeing negative growth, and Spain seeing growth slowing to 0.3%, the lowest in a very long time. Holland also saw growth slowing significantly. Of the countries not yet reporting, Finland and Slovenia probably saw high growth, while Ireland and Italy probably saw very little or negative growth.

Note that these growth numbers are expressed in the European way, that is simple quarterly change. Expressed in the American way, quarterly change at an annual rate, these numbers would be 4 (or slightly more than 4 due to the compound growth effect) times higher.

Growth in Germany appears to have been boosted to some extent by one-off factors, such as a mild winter that boosted construction activity, and so we should certainly not expect any more quarters with the same growth rate as this one. Still, there is considerable underlying strength in the German economy as free market reforms have boosted the structural growth rate and as German households and companies have high savings and low debt. The same is essentially true for Finland, Austria and Holland (whose growth rate was probably suppressed temporary factors). Slovenia is at the same time experiencing something of an inflationary boom. On the other hand, countries like France, Italy and Portugal have deep structural weaknesses. And Spain and Ireland are being dragged down by housing busts.

The net result of the relatively strong north Eastern bloc and the structural or cyclical weakness in the rest will probably be weak, but still positive growth.

Estonian Recession Confirmed

Yesterday's GDP number for Estonia confirms the assessment I made a few days ago that the country is in a recession. GDP fell a full 1.9% compared to the previous quarter, or almost 7.5% at an annual rate, something which lowered year over year growth to just 0.4%.

Wednesday, May 14, 2008

Seasonal Adjustment Time Bomb

In the 3 most recent months, the cumulative seasonally adjusted increase in the U.S. CPI has been just 0.5%. Yet the actual CPI increase, which is to say the non-seasonally adjusted increase, has been a full 1.8%.The Bureau of Labor Statistics has in other words assumed a full 1.3% seasonal increase in prices for the last 3 months. This assumed seasonal increase is 0.3%:points higher than it was last year during February to April.

One can argue whether this seasonal adjustment is right or not. I personally suspect it is too high, meaning that the seasonally adjusted increase for the last few months has been underestimated. However, it should be remembered that seasonal adjustments are a zero sum game on a yearly basis. This means that during the coming 9 months, the reported seasonally adjusted increase should be 1.3% higher than the actual increase. Looking at the data for seasonally adjusted and non-seasonally adjusted increase, you can see that this month (May), the actual and the seasonally adjusted increase will be equal. After that, the seasonally adjusted increase will mostly be either equal or higher than the actual increase, with the biggest difference in favor of the seasonally adjusted measure (When in other words the biggest seasonal price cuts are assumed) being in July and December.

The point here is that while the official inflation numbers have probably been understated by a too great seasonal adjustment, this will not be repeated in the coming months. And as actual inflation remains high that in turn means that there will almost certainly be a lot higher headline inflation numbers in coming months than in the previous months.

Tuesday, May 13, 2008

Stagflation In U.K., U.S.

During the lastest month, consumer price inflation and producer price inflation both rose significantly in the U.K. During previous months, the U.K. actually had surprisingly low inflation compared to the rest of Europe. Until March, the U.K. at 2.5% actually had the lowest inflation rate of all EU countries except Holland(1.9%). But now the effects of the weaker pound are starting to get felt. And as the effects of currency depreciation generally lag quite significantly, it will likely cause inflation to rise even further from the April number of 3.0%, which is going to force Bank of England chief Mervyn King to write a letter to the Chancellor of the Exchequer Alistair Darling to explain the failure to meet the goal and specify what will be done to push it back below 3%. Most likely that letter will likely be a bunch of nonsense ignoring how it is Bank of England policy that is responsible for it, while predicting that inflation will soon fall again without any real basis for that assertion.

Note that this increase in inflation ocurred even as the U.K. economic growth is rapidly deteriorating, indicating that the U.K. economy is increasingly characterized by stagflation.

Another economy charactericed by stagflation is clearly the U.S., something which was confirmed by today's reports. The import price index rose another 1.8%, and is up by a full 15.4% the latest year. Even the index for non-fuel imports rose 1.0% compared to the previous month and with 5.8% compared to 12 months earlier. Tomorrow's CPI report should show a lot slower increases as the BLS assume large seasonal increases this time of the year. Still, the increase should be comfortably above zero.

Meanwhile even nominal retail sales fell last month and rose just 2.0% compared to 12 months earlier. This implies that real retail sales are falling significantly.

The Not So Brilliant Chinese Leaders

When I last analyzed the Chinese economy, I noted that during the first quarter China was hit by a negative supply shock in the form of severe winter weather. But as the winter weather was highly unlikely to continue during the second quarter, I reckoned China's growth would pick up again during the second quarter. Now China has been hit by another negative supply shock. Not cold and snow, but an earthquake. The main effect of this earth quake is of course mass deaths and suffering, but it will likely also have an effect on the Chinese economy similar to the severe winter weather in the form of lower growth and higher inflation.

At the same time, growth in domestic demand seems to be picking up as retail sales grew at a record 22% rate in nominal terms. The combined effect of the negative supply shock and rising growth in domestic demand is that price inflation will likely stay high. To combat this, Chinese leaders are mainly relying on raising bank reserve requirements.

At the same time, Chinese leaders are noting the conflict between on the one hand reducing demand to reduce inflation and on the other hand boosting consumer demand to reduce dependence on exports. To quote People's Bank of China leader Zhou Xiaochuan:

"On the one hand, we need to boost consumption to adjust the economic growth structure, but on the other hand we also need to prevent excessive demand from fueling inflation."

It seems that Zhou must have failed his international economics class. There is in fact one way of solving this apparent conflict, one way to increase consumer demand without increasing overall demand. Namely, to let your currency rise in value. That will boost consumer purchasing power and so help rebalance the Chinese economy, while not increasing overall demand as it reduces net exports. But after accelerating the rate of appreciation earlier in the year, the yuan appreciation has stalled in recent weeks. Chinese leaders should again accelerate the rate of appreciation (or better yet make a really big one off revaluation, or even better, allow the yuan to float) if they want to decrease the dependence on exports while containing price inflation.

Monday, May 12, 2008

Baltics Head Into Stagflation

The Baltic states for long enjoyed the highest growth rate in the EU and was therefore held up by many free market advocates, including me, as a good example of the positive effects of low tax and low spending policies. However, unlike most others, I also warned already back in 2005 that the Baltic boom had an unsound element in the form of excessive monetary expansion. After I wrote that, these excesses became worse and worse, so my general assessment of the Baltic economies and particularly Latvia became more and more bearish.

In recent month, the state of the Baltic economies has deteriorated quite significantly. First of all, consumer price inflation have gotten worse and worse, with Estonia seeing an inflation rate of 11.4%, Lithuania an inflation rate of 11.7% and Latvia an inflation rate of 17.5%.

And while Claus Vistesen is not yet willing to call the Baltic downturn a recession, I am (at least with regard to Estonia and Latvia). While there are no official confirmation of that yet in the form of quarterly changes in GDP (or for that matter, NBER-style coincident indicator index), there are yearly changes available. And we saw in Latvia
how year over year growth nose dived, from 8.0% to just 3.6%.
A decline in 4.4%: points between two quarters almost certainly imply negative quarterly growth. In Lithuania on the other hand, quarterly growth could be on the plus side, if only slightly, as the decline in year over year growth was just from 8.0% to 6.4%. For Estonia, no preliminary GDP figures are available, but sharp declines in retail sales and industrial production on even year over year terms clearly indicate that Estonia is in a recession.

Given the fixed exchange rate policy, this economic downturn will likely result in a significant downturn in inflation. And given the strong microeconomic fundamentals, the Baltic economies should eventually recover and again see rapid economic growth. But hadn't they copied the ECB's inflationary policies this boom-bust cycle wouldn't have happened and would have passed faster than it now will.

UPDATE:As Claus Vistesen points out and as I also see in the latest Eurostat release on EU GDP, Lithuania did in fact see a falling quarterly GDP in Q1 2008.

Saturday, May 10, 2008

Does The Dollar/Oil Link Still Hold?

In the most recent year, there has been a very strong correlation between the movement of the dollar against other currencies, particularly the euro, and the dollar price of oil. That link is of course not coincidental. If the dollar falls against the euro, then given a certain dollar price of oil, the euro price of oil will fall. This in turn means that for the global average price to remain unchanged, the dollar price of oil must rise, although not by as much as the dollar decline against the euro.

Yet during the last few weeks, the euro has fallen from its all time high of $1.60/€ to $1.548/€, a decline of more than 3%. Meanwhile, the dollar price of oil is up nearly 6%, from $119 per barrel to $126 per barrel. That means a quite dramatic rise in the euro price of oil, up from €74.5 per barrel of oil to more than €81 per barrel of oil, representing a 9% increase.

The fact that the price of the euro and oil have moved in opposite directions during the last few weeks would perhaps by some be taken as a falsification of the link between these two factors. But that would be mistaken. The link between the two is always a ceteris paribus link, i.e. the link is that all other things being equal a higher euro will also raise the dollar price of oil. But in the real world, all other things aren't equal. There have been two other things pushing up oil, two things which have overwhelmed the price lowering effect of the weaker euro.

First of all, monetary expansion will push up oil prices even without exchange rate effects. Because the price of oil is fully flexible, it will move up immediately in response to monetary expansion, and it will do so even if the exchange rate of the domestic currency does not fall against other paper currencies. Or to put it another way, assume that we had only one central bank and one currency in the entire world, a Global Monetary Union. Even though at that point there wouldn't be any exchange rate movements, any inflating by the Global Central Bank would push up oil prices disproportionately in the beginning as, again, oil prices are fully flexible in contrast to the much more sticky prices of the things we see in the supermarkets. And returning to the analysis of the current oil price, as we see not only the Fed, but the ECB and most other central banks inflating this is pushing up oil prices.

Moreover, some non-monetary factors have also been at work here, including almost constant reports of supply disruptions of oil from Nigeria.

In the medium-term, the tight supply conditions and inflationary conditions around the world should cause oil prices to continue to rise to new all-time highs( $150 or more is certainly not out of the question). However, there is a high probability of some form of short term correction considering how fast oil has risen in the last few weeks and months.

Friday, May 09, 2008

U.S. Trade Deficit At 5-Year Low?

The U.S. trade deficit for March was somewhat lower than expected as exports dropped but imports dropped even more. All other things being equal this will raise GDP, but it is not certain that GDP really will be upwardly revised as for example inventories unexpectedly fell. These two numbers are probably connected in the sense that less was imported and put into inventories.

Illustrating the point I made in my LRC article, the trade deficit fell to what was said to be a 5-year low of $47.5 billion adjusted for the import- and export price indexes. Yet back in 2003, the monthly trade deficit was running at $40 billion per month, compared to $58.2 billion now. Considering that the gross domestic purchases index has risen just about 15% since then, that seems unreasonable. What is at work here is instead a significant deterioration in terms of trade. While the export price index has risen about 20% since then, the import price index is up 30%, thereby significantly reducing the price adjusted real imports significantly, even though the cost for Americans is significantly up. Americans are paying much more relative to their income, but they're not getting more.

For April, the deficit seems likely to rise again significantly, mainly due to oil. While the volume of oil imports fell in March, they rose again in April according to the EIA. And the price will certainly continue to rise. The average price paid in March was just $89 per barrel, compared to the current level of $125. The combination of higher volumes and higher prices will of course cause the cost to soar, something which will likely boost the overall trade deficit.

Thursday, May 08, 2008

Inflation Targeting During Negative Supply Shocks

Inflation targeting has in recent decades been adopted by more and more central banks and has until recently been considered a success. Yet that was never true. Instead, what seemingly was a success for central bank policy in the form of high growth and low inflation was instead a result of various positive supply shocks, most related to globalization and the entry of China, India and other emerging economies into the world economy. Because these factors often pushed inflation below the inflation target, central banks responded by inflating more in order to push up inflation to the target. But because central bank policy in the short term has much stronger effect on asset prices than consumer prices, the main result of this was to create asset price bubbles.

Now, for a number of reasons, including the lagged effect on consumer prices from previous monetary inflation, we are seeing what could be described as negative supply shocks, which have resulted in the combination of weaker growth and higher consumer price inflation in America, Europe, Japan and many other parts of the world.

This have led a number of observers, including the IMF and Joseph Stiglitz, to call for suspension of the inflation target during the current era of rising inflation. They point out that particularly in third world countries, where food constitutes a much higher proportion of the consumer price index, pushing down inflation to the target would require a tightening of monetary policy that is so dramatic that it would cause a severe economic downturn.

However, not pushing down inflation now in the same way as inflation was pushed up in the past would make inflation targeting asymmetric and would cause inflation and inflationary expectations to rise permanently. Something which would cause permanent damage to the economy. So, the correct conclusion is not that we should have asymmetric inflation targeting rather than symmetric, the conclusion is that inflation targeting is in itself damaging, whether applied in an asymmetric or symmetric way.

Tuesday, May 06, 2008

Why The Stock Market Sucker Rally Will End

Bloomberg News has an unusually bearish article about the U.S. stock market where it is pointed out that the recent rally is most likely a sucker rally. The article points out that based on trailing earnings, which is to say actual earnings, stocks are historically very expensive. Current prices seem to be based on completely unrealistic expectations about future earnings growth. For example, profits in the fourth quarter of this year are expected to rise 51.1 %(!). While analysts have historically tended to be systematically over-optimistic and while this estimate largely reflects the depressed level of profits in Q4 2007, this forecast is simply absurd.

The current rally is thus based on wishful thinking and will soon end, just like previous sucker rallies since the bear market began in October last year. That also means that assets negatively correlated with stocks, such as gold, bonds, the Swiss franc and the yen will rise.

Gas Taxes, Politicians & Economists

Robert Reich claims to be appalled that Hillary Clinton has said that she won't listen to economists on the issue of her proposed gas tax holiday, and calls it "politics as usual".

But if Reich hadn't been an Obama supporter, he would have recognized her comment as being anything but "politics as usual", as it is instead a case of unusual honesty. Politicians generally ignore the advice of economists when they consider it politically beneficial. That certainly includes Obama and during his time as Labor secretary, Reich himself. So, the only difference between Hillary Clinton on the one hand and Obama and Reich on the other hand is that at least Hillary is honest about ignoring economics.

Reich's reasoning on the issue of gas taxes certainly doesn't qualify him as an economist one should listen to. For example, he argues that it would increase demand for gas and cause prices to rise". But why would demand increase if prices rise? A necessary condition in order for the gas tax cut to cause an increase in demand is that it will first lower the price. Now someone might object that perhaps Reich is referring to the price excluding taxes. In that case his economic reasoning is correct but his presentation dishonest as the focus of the debate is prices including taxes. Reich's post is thus ironically itself a case of "politics as usual", as he is either economically ignorant or dishonest.

Regarding the issue, the temporary gas tax cut that Hillary and McCain proposes is certainly not the best solution to reduce gas prices in either the short term or long term. The best short term solutions would be to reduce or at least stop increasing the Strategic Petroleum Reserve and to stop the Fed's inflationary policies. In the long term, permanently abolishing the tax and even more importantly, stopping the environmentalist obstacles to extracting more oil are the best solutions.

Still, as Bryan Caplan points out, given the current political situation the gas tax holiday might be if not a good thing, then at least the lesser evil of the politically realistic alternatives.

Monday, May 05, 2008

Europe Too Discover The Disadvantage Of Inflation

I recently reported how many Japanese are after seeing the end of price deflation realizes that paying more for the things you buy isn't as beneficial as non-Austrian economists have claimed. Now Bloomberg News similarly reports how some of the criticism against the ECB for allegedly being too focused on fighting inflation have silenced, as the surge in energy and food prices have reduced the purchasing power of European consumers. Keynesians have long dismissed concerns about the long-term effects of inflating the money supply and focused only on the short term effects of increasing the money supply. But now we are living in that long run and the long-term purchasing power reducing effect of previous money supply increases is what is now being felt.

The Reality Of The U.S. Recession

Today on LRC I explain why America really is in a recession and has been so since at least November last year despite the seemingly positive growth (Which as I explain really isn't positive). So if you haven't already read it, do it now.

Sunday, May 04, 2008

Brilliant Thinking

The Russian government is worried over the decline in oil production. So what does it do to reverse this trend? Well, they raise the tax on oil exports. That's brilliant! What better way of encouraging production than to tax it more?

Having these kinds of master minds running oil producing countries is definitely bullish for oil.

Saturday, May 03, 2008

More Republicans Than Ron Paul Getting It?

The Wall Street Journal reports that Republican Congressional leaders wants to hold hearings on the role of the Fed in driving up the price of energy and food. Of course, one Republican by the name of Ron Paul has long emphasized this, but this has until now been largely ignored by other Republicans. Perhaps Paul's educational campaign has actually affected Republican congressional leaders. At any rate, it is good if there is increased awareness of the consequences of Fed policy.

Friday, May 02, 2008

U.S. Employment Report Weaker Than It Seems

Stocks and the dollar rallied, while bonds sold off, after the slightly stronger than expected U.S. employment numbers. Still, while the numbers were more bullish than I had expected in some aspects, the details do not look as relatively benign as the headline.

The headline talks of a decline of 20,000 payroll jobs, less than most analysts including me had expected. And unlike in previous months, government employment boosted the number only slightly, by 9,000 to be more precise. Meaning that private sector employment fell by only 29,000, much lower than in previous months. However, as in previous months many of those jobs were imputed jobs by the flawed so-called "birth/death" model. Indeed, they again raised the number of assumed jobs to 66,000 per month, up from 64,000 in March and 53,000 in February. Thus, even as reported employment continues to decline, the government implausibly assumes that new business start-ups are accelerating.

During the latest 12 months, private sector employment according to the government is up by 238,000. However that includes the 787,000 "birth/death" model-jobs, so actually reported private sector employment is in fact down by 549,000. That decline is of course something which occurred entirely during the latest 6 months, when total private sector employment is down 282,000 to which one can add the 394,000 imputed jobs, meaning that actually reported private sector employment is down 676,000, or on average 113,000 per month.

This was probably what was at work in the sectors that supposedly created so many jobs, and so supposedly to a large extent compensated for continued massive job losses in manufacturing and construction. Supposedly, professional services -meaning more specifically accountants, computer programmers and administrative services- and health care saw massive employment gains of a magnitude that looks suspicious. They did in fact also have massive number of jobs imputed by the "birth-death" model, although it is unclear to what extent that reflects seasonal factors and to what extent it reflects seasonally adjusted numbers, as the Bureau of Labor Statistics strangely only report non-seasonally adjusted numbers for jobs imputed by the "birth-death" model.

The one bullish indicator in the report was the decline in the unemployment rate and the rise in employment in the household survey. However, the household survey number tends to be extremely erratic and volatile on a month to month basis so that number can be ignored unless it is repeated during the coming months, which is highly unlikely. Meanwhile, the decline in hour's worked and hourly earnings in particularly manufacturing implies a decline in industrial production and real income excluding the temporary so-called tax rebates.

Thursday, May 01, 2008

About U.K. House Prices

My friend Daniel Halvarsson has a great post about U.K. housing prices with a graph over historic U.K. house prices which is very telling. The post should be of particular readers for those of my readers that have recently been buying in the U.K. housing market (I'm not suggesting that was a bad decision as there might be good personal reasons for doing so. But from an investment point of view, the timing was bad).

Sexy Currency Depreciation

Wille Faler has tipped me of this article by Roger Bootle, managing director of Capital Economics, which argues that the key for saving Britain from its current problems are a weaker pound, something which of course have already happened. While he cautions that a weaker pound may not improve British people's sex life, he seems so generally enthusiastic about it that one might be forgiven for getting the impression that it turns him on.

But setting aside the issue of Bootle's possible weird sexual leanings, is it true that a weak currency is the key to economic success. In short, no. A weak currency will no doubt boost net exports, but it will also depress domestic demand by reducing domestic purchasing power. So, ultimately all it will do is shift economic activity from domestic to foreign demand.

Because it enables looser monetary policy (indeed, in the case of freely floating currencies it is in most cases caused by that in the first place). It is no coincidence that the pound, along with the U.S. and Canadian dollars, has been the weakest currencies in recent months-, and because import prices are somewhat sticky in the short-term, a weaker currency might create a short-term upswing. But in the long-term, the reduction in domestic purchasing power will cancel out the higher net exports.

What about Bootle's empirical claim that currency devaluation was what enabled Britain to recover after 1992? That hardly proves anything, as there were other factors, most notably the upswing for London's financial sector which enabled it to boom in the 1990s. There are several examples of countries with weak currencies that did not experience any sustainable upswing, for example Italy that devalued at the same time. Other examples include Mexico and Japan in recent years.