Author: Bonddad

For the week, the DIA’s (DOW) were up 1%, the SPY’s (S&P 500) were up 1.2% and the QQQQ’s (NASDAQ) was down 1%.  economic news whipsawed the market all week.  The market rallied on Bernanke’s nomination on Monday, sold-off on Tuesday’s consumer confidence number and Thursday’s durable goods report, and rallied on Friday’s GDP report.  The markets are still caught between strong economic crosscurrents.  The bears are looking at higher interest rates, rising energy costs and the Fed’s concern about inflation, while the bulls are looking at the economies overall resilience, especially in the wake of Katrina and Rita.  Neither side has been able to get the upper hand.  As a result, the markets are still mired see saw action that probably won’t break until events nullify one side’s perception.
Treasuries gained 17 basis points this week.  There were several reasons for the continued sell-off.  First, the nomination of Bernanke to head the Federal Reserve spooked traders.  They were concerned with a changing of the guard and a concern that Bernanke would accept higher inflation to promote growth in the economy.  The GDP report on Friday added fuel to the sell-off, as traders focused on the possibility of further interest rate hikes.  Finally, in addition to an information heavy week next week, the Fed meets.  The general consensus is they will again raise interest rates.  This simply adds to traders concern about the interest rate picture.  The Fed has continually raised rates all year, and traders see so reason for that to stop.  From a technical perspective, it appears Treasuries are looking for a new trading range above 4.50%, which has been the upper-level of their range for the last 2 years.

Oil was up 2% this week.  Although the market was relieved that Wilma spared the gulf oil production, traders focused their attention on a possible demand surge for winter heating products.  This concern was responsible for a large move on Tuesday.  The import figures helped to calm the markets on Wednesday.  The Department of energy reported a 1.5% increase in imports and a 2.2% drop in demand from 1 month ago.  Although higher prices are adding to the bear case, the gulf refinery situation provides a strong floor to prices.  As of Friday, 68% of gulf oil production and 55% of gulf gas production was still shut-in, meaning it is not working to refine crude oil products.  Considering the gulf is responsible for about 30% of US oil production, these numbers are very significant, and gain significance the longer they remain off-line.

The dollar was down 1% versus the euro and near unchanged versus the yen.  The currency markets were caught between strong counter-trends this week.  On the bulls side were US interest rates which are still higher than other countries and higher US growth.  On the bear’s side were technical trading considerations – the dollar is technically over-extended versus both currencies.  In addition, there was concern this week about the Bush administrations ability to implement policy considering the scandals currently plaguing the administration.  Finally, there is now talk of other Asian and European central banks raising their rates in the near future.  While their interest rates are still below US rates, an initial move to tighten their respective monetary policies is the first step to narrowing the US’ interest rate advantage.

Tuesday: Consumer Confidence

The Conference Board Consumer Confidence Index, which had plummeted in September, declined again in October. The Index now stands at 85.0 (1985=100), down from 87.5 in September. The Present Situation Index declined to 108.2 from 110.4. The Expectations Index decreased to 69.5 from 72.3 last month

“Much of the decline in confidence over the past two months can be attributed to the recent hurricanes, pump shock and a weakening labor market,” says Lynn Franco, Director of The Conference Board Consumer Research Center. “Consumers’ assessment of current conditions, however, remains above readings a year ago, but their short-term expectations are significantly below last October’s level. This degree of pessimism, in conjunction with the anticipation of much higher home heating bills this winter, may take some cheer out of the upcoming holiday season. In order to avoid a blue Christmas, retailers will need to lure shoppers with sales and discounts.

The hurricanes created a confusing situation for Americans.  Their overall effect is still negative, although not as large as after the disaster.  In addition, as high heating bills come in, this index is likely to drop further.  Various media reports place the possible hearing price spike in the range of 50-90%, which could be large enough to damper holiday shopping for low and middle-income consumers.

Tuesday: Existing Home Sales

The National Association of Realtors issues this report by projecting the total number of units sold on an annual basis.  This month’s projection increased .3% from last months, from 2,841,000 to 2,849,000.  The annual projection is still for 7.28 million units.  The inventory levels remained the same, with 4.7 months of inventory available for sale given current demand.  Although the inventory number did not increase, it steadily increased from March through August.  In addition, September’s inventory number was 19.6% higher than last years.  Finally, the South was the only region where sales meaningfully increased;  Sales in the south increased 3.7%.  The Northeast increased .8%, while the West dropped 4.1% and the Midwest dropped 3%.

Tuesday: Richmond Federal Reserve Manufacturing Survey.

In October, the seasonally adjusted manufacturing index, our broadest measure of manufacturing activity, increased to 12 from September’s reading of 8. Among the index’s components, shipments were little changed at 14, and new orders moved up seven points to 15. Turning to manufacturing job growth, the employment index strengthened, gaining five points to 5.

Most other indicators also strengthened. The orders backlogs indicator jumped twelve points to 2. Reflecting stronger demand, vendor lead-time added nine points to 19. In contrast, the capacity utilization index grew more slowly, inching down four points to 4 and indicators for both raw materials and finished goods inventories were lower. The finished goods inventories index fell eight points to 13, and the raw materials inventories moved down six points to 5.

In October, District manufacturers reported that the prices they paid increased at an average annual rate of 3.87 percent compared to September’s reading of 2.11 percent–the biggest increase since March 1995. Respondents indicated that raw material prices were “skyrocketing”–especially prices for steel, oil, petroleum based products, gas, electrical power, and lumber. Finished goods prices rose at a 1.82 percent pace compared to a 0.74 percent rate reported last month. Looking towards the next six months, respondents expected input prices to increase at a 4.39 percent pace–the largest increase in the history of our survey–compared to September’s 3.87 percent reading. In addition, contacts looked for finished goods prices to advance at a 3.25 percent annual pace–also the largest increase since the beginning of the survey–compared to last month’s 1.71 percent rate.

While the strength in the manufacturing sector is good news, the prices paid component again showed an increase.  This is consistent with all other Fed surveys, which have unanimously reported sharp price increases.  In addition, the magnitude of this surveys increases – the largest in 10 years and the largest on record – may indicate the Fed’s course of rate hikes will continue beyond the first of the year.

Tuesday: Richmond Federal Reserve Services Survey

Revenue growth in the service sector quickened somewhat in October, while firms added workers at September’s pace. The overall revenues index rose to 25 compared to September’s 21. At 7, the index for employment slipped one point below its previous reading. However, the index for wage growth remained at 21 – equal to the September measure.

Survey respondents were generally optimistic regarding their outlook for the six months ahead. The index for expected demand in the broad service sector gained 3 points, to 38.

Overall service sector price growth moved higher again in October, at an annualized rate of 2.12 percent compared to 1.40 percent in September. Retail prices rose at a 2.64 percent pace in October, following last month’s 1.91 percent rate. At services firms, prices grew by 1.74 percent for the month, following a 1.21 percent rate in September.

Survey respondents anticipated increased price pressures in the next six months. They looked for overall sector prices to rise by 2.88 percent, versus last month’s expectation for 2.32 percent growth. Retailers expected prices to move up by 2.65 percent, compared to September’s outlook for a 2.40 percent rise. Service producers anticipated a 2.83 percent rate of price growth, compared to their expectation in September for 2.22 percent.

As with the Richmond manufacturing survey, the overall conditions of the retail sector are positive.  However, the price measures are cause for concern.  The chart available with the report indicates price spikes are moving to their highest level in over 2 years.  In addition, retailers are expecting higher prices over the next 6 months.  This indicates – again – that the Federal Reserve may continue its pace of rate increases beyond the first of the year.  

Thursday: Durable Goods

New orders for manufactured durable goods in September decreased $4.4 billion or 2.1 percent to $207.0 billion, the U.S. Census Bureau announced today. This followed a 3.8 percent August increase

Looking at the numbers, the primary declines came from the computer and technology sectors: new orders for computers dropped 6.8%, new orders for communication equipment fell 5.8%, and new orders for electrical equipment fell 3.5%.  The general interpretation of this report was business is taking a “wait and see” approach to orders.   Also important is last months durable goods orders were up.  It is possible business wants to put its latest orders to use before making further monetary commitments.  

Friday: GDP

Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 3.8 percent in the third quarter of 2005, according to advance estimates released by the Bureau of Economic Analysis.  In the second quarter, real GDP increased 3.3 percent.

The Bureau emphasized that the third-quarter “advance” estimates are based on source data that are incomplete or subject to further revision by the source agency (see the box on page 3).  The third-quarter “preliminary” estimates, based on more comprehensive data, will be released on November 30, 2005.

The major contributors to the increase in real GDP in the third quarter were personal consumption expenditures (PCE), equipment and software, federal government spending, and residential fixed investment. The contributions of these components were partly offset by a negative contribution from private inventory investment.

The acceleration in real GDP growth in the third quarter primarily reflected a smaller decrease in private inventory investment and accelerations in PCE and in federal government spending that were partly offset by decelerations in exports, in residential fixed investment, and in state and local government spending.

This was a solid report, and it lead to a strong rally on Friday.  These numbers include Katrina and Rita, adding more importance to the strength of the numbers.

There are a few interesting details in this report.  First, the motor vehicles and parts doubled from 11% of personal consumption expenditures to 22% of PCE.  The major auto companies have stopped their employee pricing promotion, indicating most consumers were taking advantage of the pricing while they could.  Household operations increased as well, although they comprise 2% of PCE.  It does appear that energy costs are starting to increase in importance and impact.  Inventories decreased as well, although the reason for this is most likely seasonal as retailers clear out summer stock and get ready for the holidays.  Federal spending increased as well and was responsible for 13% of this months increase.  This should not surprise anybody because of the government spending from the hurricanes.

The latest RWNM line is there is nothing in the indictment about the underlying crime — revealing a covert operatives name in violation of the statute.  What no one on the RWNM is mentioning is the Special Prosecutor has wide discretion to bring whatever charges he wants.  It is obvious Fitzgerald is going after a simpler case because it is far easier to win.
A case is essentially a story.  The simpler the narrative, the easier it is to get a conviction.

Let’s look at both cases.

Perjury: essentially someone knowingly lied.  To prove this case, the prosecutor must get the statement into evidence which is pretty easy.  Then, he must prove he knew the statement was false.  The prosecutor can do this through circumstantial evidence.  However, he does not need to parade a large number of people in front of the jury.  In addition, lying is a very easy concept for the jury to grasp.

Revealing a Covert Agents Identity: This is far more complicated.  First, the prosecutor must prove the person was a covert agent.  This immediately runs into issues of national security.  Fitzgerald would have to get CIA documents into evidence.  Then he would have to prove no one knew Plame was undercover.  All Libby would have to produce is 1 credible person who claims they knew Plame was undercover and the case is gone.

In summation, Fitzgerald is using his discretion as a prosecutor to get the case e he knows he can win.  This is entirely within his discretion.  It also shows Fitzgerald is a bright guy.  Why make it more complicated than it has to be?

As Steven Roach notes, the financial markets have made a habit of testing new Fed chiefs:

Alan Greenspan faced a stock market crash two months after he took over in August 1987. Paul Volcker had to cope with a rout in the bond market three months after he became chairman in August 1979. G. William Miller was challenged immediately by a dollar crisis in the spring of 1978. For Arthur Burns, it was the inflation bogie in the early 1970s.

Should the Senate confirm Bernanke, there is no shortage of problems facing the new chairman.

Inflationary Pressures: For the last month, all of the Federal Reserve Presidents have unanimously stated in public appearances that the need to contain inflation was paramount to Fed policy.  There is a lot of information supporting their concern.  For the last few months, each Federal Reserve’s regional manufacturing report noted large increases in their respective prices paid components.  Winter fuel prices are projected to increase 50-90%.  The latest PPI number was 1.9% — one of the largest increases in recent years.  CPI showed a similarly large increase of 1.2% — another large jump.  Most economists place the blame on oil prices, which impact every aspect of the economy.  With gulf refineries still not operating at 100%, oil’s price pressures will remain for the foreseeable future.

Balance of Payments Deficit:  The US balance of payments deficit was 5.5% of US GDP last year – a level that has crashed other currencies.  This number is projected to set another record this year.  For the last year, the dollar has rallied versus other currencies, largely because of the higher growth and interest rates in the US.  Although still growing, the US trade deficit has taken a backseat in forex trader’s trading.  However, forex traders are unfamiliar with Bernanke.  There are conflicting views on his theories.  Markets don’t like uncertainty or untested leaders.  Bernanke’s new status as Fed Chief may be all the impetus forex traders need to aggressively sell the dollar, citing the trade deficit as the primary reason.

The Housing Bubble:  Earlier this year, the FDIC identified over 50 housing markets in a “bubble.”  However, there are many indicators this bubble is ending.  Inventories have been increasing for the last 6 months and have also increased from year ago levels.  Recently released numbers on new and existing home sales show all markets except the south slowing.  Interest rates – and mortgages — are creeping up.  Consumer confidence is way down – indicating consumers may delay buying a new home.  

Heavily Indebted Consumer:  Consumers have taken on an extraordinary amount of debt to keep the economy afloat.  The household debt service ratio stands at record levels.  Mortgages outstanding have nearly doubled in the last 4 years.  Wages after inflation are nearly stagnant for the last 5 years, indicating interest and principle payments are taking a larger portion of most people’s monthly budget.  To pay down debt, consumers will have to slow down their spending, which in turn will slowdown the economy.  

Greenspan has been a staple of the US economy for the last 18 years.  Regardless of your opinion of him or his policies, for almost two decades there has been consistency to US economic policy from the Federal Reserve.  That is about to change.  Take the record of early problems for new Federal Reserve chairman and combine it with the fundamental underlying problems of the US economy, and you get a high possibility of a problem bubbling to the surface to challenge the new Fed Chairman.

Other issues have fallen by the editorial wayside During the Fitzmas season.  This is understandable.  I am no fan of this administration in any policy area.  Domestically, they have done little to meaningfully grow the economy or unite the country.  Internationally they have alienated traditional allies and lowered US credibility in the court of world opinion.  

However, other issues continue to develop and deteriorate.  One of these is the horrendous US balance of payments deficit which is set to either break the old record (set last) or come very close to doing so.  Once again, the US will import far more than it exports.  This situation has only gotten worse for the last 4 years.  At some point, it will have to correct.  When it does, it could be extremely painful.

First, what exactly is the balance of payments?  There are two ways to measure international trade.  The first is the actual trade of goods.  Every month, the Bureau of Economic Analysis publishes the monthly trade report.  It compares the goods and services we import with those we export.  The second measure is the balance of payments.  This measures the actual flow of money into and out of a country.  If the number is positive, it means the country exports more than it imports.  If the number is negative, the country imports more than it exports.  

According to the Bureau of Economic Analysis, the total capital outflows from the US were $389,455 billion in 2001.  In 2004 this number was $668,007 billion – a 71% increase.  (Remember, these numbers include the money we import through trade.)  In 2001, the balance of payments deficit was 3.8% of GDP.  By 2004, that the balance of payments deficit was 5.5%.

Why is this so important?  Suppose you and your neighbor trade goods and services on a regular basis.  For a long continuous time, you buy more from him then you sell.  So, over this time, you give more money to your neighbor than you get from him in trade.  Where does this money you give to your neighbor as a result of trade come from?  (Remember, despite actively trading with your neighbor on a regular basis, your purchases exceed your sales.)  First you draw down your savings.  But eventually that runs out.  Now you have to increase your revenue from other sources to pay for this money going to your neighbor, or you can borrow the money.  Eventually, you can no longer afford to buy all of the goods and services you use to get from your neighbor because you have either over-extended your credit, or can no longer boost revenue from other sources to make-up for this capital outflow.

Let’s go back to the macro-level numbers.  In 2001, 3.8% of total US GDP went outside the US to pay for goods and services.  By 2004, that percentage increased to 5.5%.  Despite increasing total economic output, the US is still paying more of its total production to people outside the country.  Most economists consider 5% of GDP very bad.  5.5% is obviously beyond that judgment.  

The Republicans have spun this as a sign of economic strength.  The US is growing faster than other countries and therefore consumes more of the goods the rest of the world produces.  In addition, this administration has started to argue for other countries to more towards an economic model that consumers more goods, thereby creating a bigger market for US exports.

Notice something missing from these statements?  There is absolutely so discussion of the possibility of the US either lowering its consumption or being in any kind of economic trouble from being financially over-extended.  We don’t have to change – they do.  They need to become more like us.

By not dealing with the problem, this administration is inviting catastrophe.

Yesterday, I highlighted some of the more mainstream comments of Ben Bernanke.  In general, he comes across as a more or less right leaning economist.  This is the same school that taught Alan Greenspan.  Bernanke has made some other interesting policy observations and or arguments.  Several of these have raised concerns from some economi
sts.  

Here is the first comment:

But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Before you get really concerned about the above statement, it is very important to place it in context.  The statement comes from a 2002 speech titled Deflation: Making Sure “It” Doesn’t Happen Here.  He argued the Fed should use this policy only after it has lowered real interest rates to 0% and that policy has failed to reignite price appreciation.  Most people believe that after the Fed has lowered rates to 0%, it has no other policy options.  Bernanke is essentially arguing in times of crisis the fed has other policy options available when traditional options fail.  Should the US ever experience a deflationary spiral (which is an economic crisis), it is possible political leaders may call for this type of radical policy.  

There are some people who argue the above quote also demonstrate Bernanke will follow in Greenspan’s footsteps of allowing asset inflation based on cheap money.  This is essentially what is currently happening in the US economy with housing, and what happened during the 1980s and 1990s with the stock market.  This is an entirely valid argument and should be seriously considered.

Finally, Bernanke is the person who put forward the idea of a global savings glut to explain low US Treasury rates and the record US trade deficit.  He outlined his theory in a speech earlier this year.  I will summarize his basic points.  For more detail, please read his speech.  

First, an economy must have some amount of savings to expand.  Financial intermediaries – banks, investment firms, etc…. – pool these savings and lend them to business.  Business then invests the savings in productive capital to grow its respective business, which in turn grows the economy.

Bernanke argues there are countries with excess savings and countries with insufficient savings.  Most Asian countries are an example of the former and the US is representative of the latter.  He continues that for the last 10 or so years, countries with excess savings have been lending their excess savings to the US because the overall returns and risks are better in the US relative to other investment opportunities.  

This theories most interesting point is also its most dangerous.  Central to this argument is the idea forces outside the US are dictating the terms of the US trade imbalance.  As such, there is little the US can do to change the situation.  He makes the following comment at the beginning of his speech:

However, I believe–and I suspect that most economists would agree–that specific trade-related factors cannot explain either the magnitude of the U.S. current account imbalance or its recent sharp rise. Rather, the U.S. trade balance is the tail of the dog; for the most part, it has been passively determined by foreign and domestic incomes, asset prices, interest rates, and exchange rates, which are themselves in turn the products of more fundamental driving forces.

It is far too easy to use the above quote as justification for doing little if anything domestically and instead bullying other nations to change their internal policies.  As an example, for the last year, US officials have aggressively told Europe and China to change their domestic economies; to essentially develop more consumption oriented domestic policies.  The theory is this would create a larger market for US products, thusly enabling the US to export more goods to those countries and close the trade gap over time.  

At the same time, the US consumer’s debt level is at historical highs.  For the last 5 years, wages after inflation are near stagnant.  As a result, the 2/3 of the US economy represented by consumer spending has grown largely through debt financing.  There is no mention of this US economic development in any discussion of Treasury Secretary Snow or any other member of the Bush economic team.  

I don’t doubt Bernanke’s motives in putting forth this theory.  From what I have read, he appears to be a standard, right-leaning economist.  In addition, there may be some validity to his arguments about the international causes of the US trade imbalance.  

However, this theory can too easily instill a sense of passivity in US policymakers.  At a time when there should be a serious discussion about the lack of US savings, this theory leads far too easily to throwing up ones hands and saying “it’s all globalizations fault.  It will balance itself out in the end” and leaving it at that.  Enough editorializing.

In conclusion, Bernanke appears to be more or less a standard right-leaning economist right out of the Greenspan mold.  He believes in inflation targeting and the idea the Fed should be a neutral player in the political arena.  He has advanced some theories that have caused a heated debate (especially the global savings glut theory) in economic circles.  However, none of these ideas are so completely radical to make him a member of the extreme wing of conservatism.  I believe Bernanke will in general continue more or less in Greenspan’s economic shoes for the foreseeable future.  

[From the diaries by susanhu.]

President Bush has nominated Ben Bernanke to replace Alan Greenspan as head of the Federal Reserve.  Bernanke has a “name” resume – a resume with a lot of well-respected names on it: Harvard, MIT and Princeton.  I have started to comb through the information available online about him and will present it over the next few days or weeks so people can become better acquainted with him.  Below are excerpts from an interview in 2004.

Rolnick: For several years now, you’ve argued that inflation targeting will improve monetary policymaking by anchoring the public’s inflation expectations and by improving Fed accountability. Some of us would argue that we’re already practicing something like that de facto, with our public commitment to price stability. In what sense is your proposal a substantive change in policy? If we did move to an explicit target, what would be the benefits?

Bernanke: It’s true that the Federal Reserve is already practicing something close to de facto inflation targeting, and I think we’ve seen many benefits from that. My main suggestion is to take the natural next step and to give an explicit objective, that is, to provide the public with a working definition of price stability in the form of a number or a numerical range for inflation. I believe that that step, though incremental, would have significant marginal benefits relative to current practice.

First and very importantly, such a step would increase the coherence of policy. Currently, the FOMC [Federal Open Market Committee] makes its decisions without an agreed-upon definition of price stability or of the inflation objective, and one wonders how oarsmen pulling in different directions can get the boat to go in a straight line. I think the FOMC’s decision-making process would be improved if members shared a collective view of where we want the inflation rate to be once the economy is on a steady expansion path.

Second, there’s a great deal of evidence now that tightly anchored public expectations of inflation are very beneficial, not only for stabilizing inflation but also in reducing the volatility of output and giving the Federal Reserve more ability in the short run to respond flexibly to shocks that may hit the economy.

Inflation expectations in the United States are better anchored than they used to be but are still too volatile for optimum performance of the economy. Announcing an actual number or range would serve to anchor public expectations of inflation more firmly and avoid the risk of “inflation scares” that might unnecessarily raise nominal bond yields.

Third, from a communications viewpoint, financial markets would be well served by knowing the medium- to long-term inflation objective of the Fed. An explicit inflation objective would help market participants accurately price long-term assets, both by anchoring long-term inflation expectations and by giving the market better information about the likely path of short-term policy as the Fed moves toward its long-term target. And fourth and finally, I think an inflation target does introduce an additional measure of accountability for the Federal Reserve, although I would put that as least important of the things I’ve mentioned.

Greenspan took great pains to make the Fed more transparent, allowing the markets to see inside the inner-workings of the Fed to get a better idea of the overall interest rate direction.  This is beneficial because it allows the markets to plan more effectively.  If you own a business, and you have a really good idea interest rates are increasing, your ability to plan for debt-financed future expenditures is better.

Personally, I think targeting an inflation window as opposed to an actual number is a good idea.  From a macro-level policy perspective, targeting a single number is much harder than a window.

Rolnick: The federal deficit has once again become a major economic concern. By some estimates, the present value of future debt is over $40 trillion. Can you envision constraints on fiscal policy that are similar to the kind of constraints you’re advocating with inflation targeting? And what is the public role of the central bank on this issue? As a central bank, how should we respond to this kind of scenario?

Bernanke: Well, the central bank has the responsibility to be a nonpartisan adviser on general matters of macroeconomic and financial stability. So to the extent that deficits and debt are threatening macroeconomic and financial stability, the central bank is one actor that can provide advice and counsel to the fiscal policymakers.

Ultimately, though, the determination of the fiscal debt and deficits is the responsibility of the president and the Congress. To the extent that rules or caps can be useful in forcing Congress to look at the whole budget, as opposed to each individual component and then adding them all up, I think that’s certainly worth looking at. But again, that’s a decision for the president and Congress to make.

One of the major allegations levels against Greenspan is he was too political.  According to this quote, Bernanke would be less political in his role as Fed Chairman.  However, this is one where we will have to wait and see.

According to this quote, it also appears that Bernanke sees the Fed as more independent, reacting to Congressional and Presidential policy decisions rather than trying to implement policy.  Again, we’ll have to wait and see on this one.  

Rolnick: Some claim they can identify a speculative bubble in a variety of markets. The dot-com sector was viewed as an asset bubble, and then some said we have had a speculative bubble in housing. How confident can we be in identifying such bubbles, and if we can be confident, what’s the role of the central bank in dealing with these events?

Bernanke: I think it’s extraordinarily difficult for the central bank to know in advance or even after the fact whether or not there’s been a bubble in an asset price. The mere fact that an asset price has gone up and come back down again doesn’t mean that there was a bubble in the technical sense that the price movement was completely divorced from fundamentals. Moreover, if a bubble does exist, there is no guarantee that an attempt to “pop” it won’t lead to violent and undesired adjustments in both markets and the economy. The central bank should focus the use of its single macroeconomic instrument, the short-term interest rate, on price and output stability. It is rarely, if ever, advisable for the central bank to use its interest rate instrument to try to target or control asset price movements, thereby implicitly imposing its view of the proper level of asset prices on financial markets. History has shown us clearly that that type of policy has more often than not led not only to a large decline in asset prices but also to a large decline in the general economy.

I do think there are several useful things that central banks can do about potential mispricing in asset markets. First, I think that many distortions in asset prices have arisen historically because of various kinds of structural regulatory problems in the underlying markets. For example, research on historical episodes suggests that large asset price increases are sometimes preceded by credit booms. In many cases, this pattern results from the fact that the country in question deregulated its banking system, giving banks extra powers, but did not enhance the supervisory structure adequately at the same time. The result is that institutions have an incentive to make economically bad investments, to take advantage of the “put” provided by the government safety net.

In the wonkish world of Central Bankers, a debate currently rages about a central banks role in asset markets.  There are strong arguments on both sides.  On the pro-intervention side is the argument the central bank has the opportunity to provide more economic stability by loosely targeting asset prices by cutting off credit when prices seem to lack a fundamental basis.  The central question on the con side is: “How can a central bank decide what an appropriate price level is?”  Bernanke clearly comes down on the non-intervention side.  However, his statement also implies he may be more aware and/or sensitive to the idea of a credit bubble existing, which is clearly within a central banks powers to impact.  Although his statements imply he would not directly react to the current housing bubble, he may react to the current over-extension of the US consumer.

The trade deficit has lost power to grab headlines.  Every month, the BEA announces the figure, the markets react to the number for a few days, then everybody goes back to their regularly scheduled program until next month.  In addition, the primary mechanism that brings the trade deficit into the public spotlight – a deterioration of the dollar’s value – hasn’t happened since the first of the year.  Starting in January, dollar has rallied versus other currencies because US interest rates are high relative to other countries.
 

So, everything must be OK, right?  Wrong.  The trade deficit will probably set another record this year with little sign of correction in the near future.  It still endangers the US economy in a fundamental way, threatening our economic security.  

Last week, NY Fed President Timothy F. Geithner  spoke to the Asia Society’s CEO forum.  He used the speech to discuss the trade deficit and why it is so important to deal with it now before it deals with us later.  His comments outline the problem’s causes and implications for US policy.

What caused the problem?

In the United States, public savings and household savings fell, while investment spending stayed reasonably strong and housing investment very strong, even during the latest recession.

The second feature of this dynamic has been an increase in the willingness of the rest of the world to invest its savings in the United States.

An economy must have a savings base to expand.  Savers place their excess funds into various financial intermediaries – banks, the stock market etc….  These financial intermediaries then lend the money to business who in turn use the money to invest in new productive capital to expand their respective businesses.

The problem is the US savings rate has declined for the last 20+ years, and now stands at 0.  Yes, you read that correctly.  We have a 0 savings rate.  This doesn’t mean what you probably think it means.  For economists, “savings” is what is left over after monthly consumption expenditures.  So, for the last 20 years, Americans have slowly decreased the amount of money they set aside after they are paid wages, pay taxes and purchase items.  At the macro level, Americans now set aside nothing.  They immediately spend everything they make.  

So, domestic funds for the national financial intermediaries has been decreasing.  But, the US economy is still expanding.  Where does the money come from?  

Overseas.  Foreign investors take their excess money and invest it in the US because they perceive the US as the best and safest place to invest.  The Republicans have now framed this issue as a sign of American strength – we’re so great, people want to invest their excess cash in the US!!!!  The US is strong!!!  No need to worry about the trade deficit!!!!

Well, we need to worry about the deficit.  Why?  Well, according to the same speech, here are some of the reasons:

It matters because of the size of the U.S. imbalance. Our current account deficit is now running at a rate of above 6 percent of GDP, a level without precedent for a major economy.

Just to give you an idea, 5% is considered really bad by most economists.  6% is, well, really, really bad.  Usually this would spell disaster for a currency.  In fact, it did for the dollar last year when the dollar was ready to fall through important levels.  However, the US also has the highest interest rates in the first world, which is currently bolstering the dollar in the forex markets.  In fact, it’s pretty much the only thing holding the dollar up right now.

It matters because of the trajectory of the U.S. imbalance. On reasonable assumptions about its likely near term path, this deficit will produce a very large net deterioration in our net external liabilities relative to national income, with progressively larger net transfers of income to the rest of the world

Simply put, if the trade deficit continues on its current course, the US will have to pay more and more money to overseas investors.  This money going overseas will continue to increase relative to US national income, meaning more and more of our GDP will go overseas instead of into domestic business.

It should concern us because of how the imbalance has been financed.  A substantial portion of the capital inflows that finance our current account deficit has come from foreign central banks–which have been accumulating dollar reserves to preserve exchange rate arrangements that are unlikely to be sustainable and are already in the process of change. The impact of a reduction in the scale of official accumulation of dollar assets could be fully offset by increases in purchases by private investors. But even in the context of a continued high degree of confidence in the relative return on claims on the United States, it is hard to know with confidence how the preferences of private savers might respond to the process of gradual evolution in their nation’s exchange rate regimes now underway.

Right now, foreign central banks are the big purchasers of US debt.  If that starts to drop off, foreign private investors could pick-up the slack.  However, if foreign central banks are no longer investing in the US, why should their citizens?  Wouldn’t a drop-off by foreign central banks mean the US was no longer a great place to invest?  If their governments won’t invest, why should their citizens?

This pattern should concern us because it is not simply the result of the savings and investment decisions of the private sector. The fact that we are using a substantial part of the savings we are borrowing from the rest of the world to finance an unsustainable level of public borrowing leaves us more vulnerable than if those savings were being used for productive private investment. Large structural fiscal deficits limit the size of the sustainable external imbalance for any country, even the United States, and they necessarily increase concern about the terms on which we are likely to finance the present imbalance.

The federal deficit – (again) created by those fiscally responsible Republicans — is soaking up foreign central banks investments in the US instead of going to US industry (like out deteriorating manufacturing and information technology sector).  As a result, the US isn’t investing in productive assets that could help grow the US out of the trade imbalance.  Looking at the trade figures, imports are still growing at a faster rate than exports.

And most importantly, perhaps, these imbalances matter because at some point they will have to reverse. Market forces will at some point induce an adjustment. And that inevitable process of adjustment will bring with it the risk of large movements in relative prices, greater volatility in asset prices and slower growth in the United States and in the rest of the world.

The magnitude of this risk is difficult to measure with any confidence. Past episodes of external adjustment offer some reassurance, but the present circumstances seem sufficiently different from historical precedent that history may not be a particularly useful guide.

This situation can’t last forever.  And as market forces take over and start to correct the situation, the US could experience some serious pain:

The risks associated with this adjustment process may be magnified by changes in the household balance sheet in the United States. The average household in the United States today has a higher level of debt to income and is somewhat more exposed to interest rate risk than in the past. The sustained rise in housing prices and the scale of borrowing against housing assets raises the possibility that a rise in risk premia could have a greater impact on household spending that would have been true in the past

Paul Volcker puts it far more succinctly:

I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.

Health care – or the remarkable lack of it available to the US population – is one of my pet issues.  Regrettably, it has flown under the radar for a long time.  This is too bad, because no other issues has such a profound effect on the well being of the middle class.  If people don’t have the opportunity to take care of their basic health, their entire standard of living comes into jeopardy.  
The current US system is a joke.  There are over 44 million people uninsured.  If they get sick, they’re essentially SOL.  Even if you have insurance, the health insurance company will do everything they can to tell you they don’t cover that particular problem.  And now, higher co-payments and deductibles are increasing in popularity, leaving more and more insured with higher and higher bills.

Now, without further adieu, the American Health Care Crisis in all it’s <s>glory</s&gt gory.  

Premiums and Deductibles

From 2001-2005, health insurance premiums increased 10.9%, 12.9%, 13.9%, 11.2 and 9.2%, respectively.  Over the same time, the use of high co deductibles has come into vogue.  For conventional health plans, the average national deductible has increased 141% from 1999 ($249) to 2005 ($602).

Let’s think about that for a minute.  The average person is not only paying higher premiums, he is also footing a larger percentage of the bill in the form a high deductibles.  In other words, there is a clear trend to shift the actual burden of the cost from the insurance company to the insured, making health insurance nothing more that a payment with no benefit.

Paying For Services

The Kaiser Foundation and USA Today worked together on a series of health care articles.  

Sixty-two percent of those struggling to pay medical bills have health insurance, underscoring how increasing premiums, deductibles and gaps in coverage are affecting families.

The survey, a wide-ranging look at the impact of medical costs on the nation’s families, found that 28% of adults were unable to pay for some form of medical care in the past year. That’s nearly double the 15% who reported such a problem in 1976.

Medical costs are a growing burden for middle-income families with children, as well as for the working class, people with chronic illnesses, the disabled and the uninsured. Many who cannot pay skimp on health care, go without prescription drugs or simply ignore their bills, the survey showed

Medical Insurance is looking more and more like a mafia protection racket.  You pay money for a service you never use.

A message to Republicans (the party in power): There are plenty of people out there acting responsibly who are getting screwed.  Why don’t you care about them?

Getting Insurance

Most Americans get their health insurance through their employers.  The problem here is fewer firms are offering health insurance.  The overall percentage of firms offering health insurance has dropped from 68% in 2001 to 60% in 2005.  And the smaller the company, the less chance they will offer insurance.  Only 47% of companies that had 3-9 workers offered health insurance.  74% of firms with 10-24 employees offered health insurance, and 87% of firms with 24-49 workers had insurance.  So, the entrepreneur – the people Bush is supposed to love – are having a hard time getting health insurance to get and keep good employees.

The main reason for the lack of insurance?  COST.  73% of those surveyed responded cost was a very important reason for their not having coverage.

So, let’s review.  It’s harder to get insurance that is increasingly covering less.  Even if you have insurance, you have a 1 in 4 chance of struggling to pay for medical bills.  

Wow – this is one of the most successful plans I have ever seen.  

LINK (PDF)

I know – there is no housing bubble; it’s all a liberal fantasy to scare people.  At least, this is what people on the political right say.  According to one pundit on Fox news, there are a few markets that are slightly overpriced but nothing to worry about.   (The FDIC has contradicted this assessment.)  Well, the reality is there is a housing bubble and it is very dangerous for many reasons.  
Consumers – whose wages have been near stagnant after inflation for the last 5 years – have financed their spending with home equity loans.  

Instead of playing the stock market, people are now entering the world of flipping real estate – buying and selling property quickly hoping to make a profit.  This is great if it works.  However, it is conceivable a buyer could be stuck with a home that he can’t afford long-term.  

Almost 40% of the paltry few jobs created in this expansion are tied to housing, meaning a slowdown in the market could significantly lower job growth.  

In short, the housing market is the engine of this expansion.  

Now there are increased signs of it’s slowing.

In Orange County, sellers are lowering prices and inventory is increasing

The frustration experienced by sellers like Hong reflects a cooling in the market for higher-priced homes in Los Angeles and Orange counties, according to recent price and sales data. Faced with reduced buyer demand and rising inventories of unsold properties, many sellers of homes worth more than $750,000 are dropping asking prices.

Many also are taking weeks before landing buyers.

The slowdown in pricier homes is typical of the latter stages of a housing boom, analysts say, as expensive properties were the first to rise sharply at the beginning of the current cycle.

In some of the ritziest areas, such as the 90210 ZIP Code of Beverly Hills where the average home price is $3 million, sellers have cut asking prices by an average of at least 10%.

In the first half of 2004, by contrast, sellers of pricier homes typically got 5% to 10% above their asking prices.

Sales are slowing in New York:

Until recently, apartments in prime locations sold fast. Often bidding wars broke out, and the most aggressive buyer won by paying more than the asking price.

But now flats sit for an average of four-and-a-half months before a sale contract is signed. While that’s well within the normal range for a healthy, balanced market – one in which supply and demand are in sync – that’s a month longer than the process took last spring.

Mortgage rates are rising

Rates on 30-year mortgages rose this week to the highest level in 15 months while one-year adjustable rate mortgages climbed to the highest level in 4 1/2 years. Analysts expect rising mortgage rates to cool the booming housing market in coming months.

The mortgage company Freddie Mac reported Thursday that the nationwide average for 30-year, fixed-rate mortgages rose this week to 6.10 percent, the highest level since 30-year mortgages were at 6.21 percent in late July 2004.

Last week the 30-year mortgage had risen to 6.03 percent, marking the first time it had been above 6 percent since the last two weeks in March.

There is other fragmentary evidence:

The Federal Reserve’s latest beige book contained 10 references to cooling markets, up from three in the prior beige book and zero before that.

The unsold inventory of existing homes rose to 4.7 months’ supply in August, the highest since November 2003 and a marked gain from January’s 3.8 months.

Condo inventories are climbing to even higher highs – to a 5 months’ supply from a low of 3.1 months in July 2004.

The unsold inventory of new homes, after 2-plus million in housing starts for five months running, has jumped to a five-year high of 4.7 months’ supply from 4.1 months in July.

New-home price appreciation has slowed to a 1 percent annualized rate from the peak of 18 percent in October 2004.

The National Association of Home Builders index fell for a third straight month in September to the lowest level since July 2003.

Homebuyer traffic is at its lowest level since February 2004
and has been flat to down for three months in a row.

This winter could be the rally killer.  As energy prices escalate a projected 50-90%, consumers will find their thin budgets stretched further.  The Federal Reserve has spoken with a unified voice regarding inflation, implying interest rate hikes will continue through 2005 and possibly into 2006.  Consumer sentiment is low, implying fewer people will take the plunge into home ownership.  In short, there are a lot of factors indicating the slowdown will continue.

Will housing pop or simply slow?  I don’t know.  The reality is it doesn’t really matter.  While a slowdown would be preferable, it will still have strong negative ramifications for the economy.  

Workers, however, will receive an average base salary increase of just 3.6 percent next year, according to Hewitt Associates’ 29th annual survey of more than 1,000 organizations. That’s the same that workers received nationwide this year.

Employees are expected to spend an average of $3,136 next year in premiums, deductibles and co-pays, a 12 percent increase from this year, according to Hewitt.

“So that means our entire raise — plus a little extra — is going to pay for those higher health care costs,” said Ken Abosch, business leader in the talent consulting group for the Lincolnshire, Ill.-based firm. “Plus, we’re paying more for energy.”

Let’s review the above numbers.  Employers are planning a national average wage increase of 3.6%.  But, employees premiums, deductibles, and co-pays increased 12% — or 3 times their pay increase.  Thanks, boss.

But, it gets better.  Let’s look at this year.  According to the Bureau of Labor Statistics, the average hourly wage of non-supervisory workers rose from $15.90 to $16.18 this year, and increase of 1.76%.  At the same time, the inflation index increased from 190.7 to 198.8%, an a 4.24% increase – almost 2.5 times the increase in base salary.

So, the average wage increase is going to necessities like health insurance and oil increases, leaving the average person little room for personal expenditures.

The plight of the middle class continues.

Link