25th August 2011 by Shaun Richards
Tomorrow comes an event which has been awaited ever since the American economy showed yet more signs of a slowdown. This is the speech that is going to be given by the Chairman of the Federal Reserve Ben Bernanke at Jackson Hole. Expectations are high for what he might say and markets have suddenly become very volatile again. For example we have had a day this week where the US Dow Jones Industrial Average has risen 322 points and yesterday we saw the gold price fall by US $105 after reaching a new high on Monday of US $1917 in terms of front month futures. And yesterday we saw US ten year bond prices fall and yields back up to 2.27% only a week after they have fallen below 2%!
So in a week where because of us being in the holiday season there is less news flow than might be normal we can look to expectations for tomorrow’s speech as a cause of much of the wild swings. Some market participants are clearly hoping that Ben Bernanke can pull the equivalent of a conjurer’s trick and pull a rabbit out of a hat and that furthermore the rabbit will metamorphose into the Easter Bunny. He made substantial announcements at the same speech last year which the Federal Reserve then backed up with more further action in November. So I guess many are hoping for a type of deja vu.
However rather than discuss what he might do I wish to take a leaf out of David Byrne’s songsheet and ask.
How did I get here?
If we go back in time I made a prediction for 2011 in the title of my post on the 22nd of December 2010.
Inflation and deflation are likely to be the joint themes for 2011
I realise that much of the media are imprecise in their definitions so let me point out that deflation strictly means a fall in aggregate demand in an economy and more loosely can be used to describe a sustained decline. So let us take a look at what has happened.
We saw in the early part of 2011 a surge in commodity prices as well as in the price of oil. This has been a contributor to the rise in consumer price inflation that has been seen in so many parts of the world. If we look at official inflation indices we see that the United States has hit 3.6%, the Euro zone is at 2.5%,the UK at 4.4% , China at 6.5% and India is at 9.22%. So we can see that the inflation upsurge is widespread and has led to inflation being over target in wide sections of the world.
The upsurge in food prices also had the effect of making it unaffordable for some of the poorest and to my mind was a contributor to the Arab Spring and other unrest around the world. For those who have follow my updates the foodstuffs component has drifted back from the highs of earlier this year but at 501 is still substantially up on where 2011 started.
One influence here has been as I expected
Plainly the peripheral nations in the Euro zone are an example of a deflationary influence with Greece and Ireland clear example of this and Portugal is in a situation where she too is in an unsustainable position. (This was several months before Portugal asked for help.)
To this I added the prospect of “Contagion for Spain and Italy.” These matters have come to pass and if we view the recent economic growth figures we can see that it is not only the periphery of the Euro zone that is slowing down as for example in the second quarter of 2011 France had no growth at all. If we stick with France and look forwards it was only yesterday that she reduced her official growth forecast for 2012 to 1.75%. As official forecasts these days are usually somewhat rose tinted I think the reduction is of more significance than the new forecast.
If we step back in time to December 2010 many economists at places such as Goldman Sachs were telling us that the fiscal stimulus just incepted combined with the monetary stimulus of QE2 would lead to economic growth of over 3% and the more excitable predicted 4%. In reality we got an annualised rate of 0.4% in the first quarter and an advance estimate of an annualised rate of 1.3% for the second (which may well get revised down tomorrow). Accordingly the US has fitted a general deflationary story too.
My own country the UK has rumbled on in a stagflationary pattern where growth after the shock fall in the last quarter of 2010 has been rather insipid. I obviously did not know that Japan would be hit by a tsunami but in the event it has now been in recession for three quarters of a year.
Other parts of the world have recorded much better figures but there have plainly been deflationary influences as indicated above.
As you can see from the detail above the question, how did I get here? poses real problems for Ben Bernanke and for those who feel he has the ability to improve the world economy. He must review the results of his actions with dismay. If we were able to borrow Doctor Who’s Tardis and go back to 2003 when he wrote his economic paper on what central banks could do in the situation he now finds himself in he was full of optimism and bombast whereas reality has proved much more inconvenient.
Our results provide some grounds for optimism about the likely efficacy of nonstandard policies
So tomorrow he must feel under pressure as he knows if he is honest with himself that events have not turned out as he hoped. This is before we get to the opinion of those such as me who have argued it was always likely to fail as presumably Ben did actually believe in it. Thus we are in a dangerous position as he is under pressure to “do something” when his ammunition locker is looking pretty empty.
This is why those who examine events are coming up with some recommedations out of left field such as Bruce Krasting’s suggestion that central bank swap lines could be opened on a substantial scale. As this is an area not well covered in the media I have written an explanation guide for this subject in the Explainer section of this site. However if Ben remains true to the paper I have quoted above there is some room here.
changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate
If you read of Operation Twist in the media then it comes under that category. However let me give you a word of warning as many seem to treat talk of Operation Twist 2 or Let’s Twist Again (sorry!) as a type of Holy Grail. This rather ignores the fact that the original Operation Twist failed…
Yet more problems in the Euro zone
I have written twio updates on this general subject already this week discussing problems for Greece and the European Central Bank. Yesterday we heard this from the German President.
I regard the massive acquisition of the bonds of individual states via the European Central Bank as legally questionable
As you can imagine such a statement poses a lot of questions particularly as it comes hot on the heels of criticism of such purchases from the German Bundesbank. Next month will see such matters be debated in the German Constitutional Court and those who have taken their case to it will feel emboldened by the President’s comment.
The ability of the Euro zone to score own goals seems almost never ending. This latest problem comes hot on the heels of the debate about collateral on loans to Greece which I discussed on here only on Monday. The joint effect can be seen on the Greek government bond market where prices have fallen and yields risen. The two-year maturity now yields over 44% and the five year over 22%. Remember it was only just over a month ago that she had a new bail out package.
If you look at the two year bond you would receive more in interest than par value of the bond (100) if you reinvested the interest. The “rub” as Shakespeare put it is that it actually has to be paid and the price is plainly putting a lot of doubt on that.
Another way of looking at the calamity of the situation is simply to look at the price of the Greek ten-year bond. It has fallen below 50 again which means that in spite of the backing of the EU,ECB,IMF and the Greek government and their new plans we are back to real fears of default again.
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