naked capitalism

The Financial Times’ John Authers, who called a market turn in bonds in early June of last year, sees another major shift in sentiment on the outlook for inflation and the dollar:

For months, through all the volatility of the credit crisis, one bet has been enough to make profits. It is very simple: bet on the dollar to fall and oil to rise.

Logically, there must come a “tipping point” when this trade no longer works.

Defining that point has provoked intense debate. But the best definition for that point, to use Supreme Court justice Potter Stewart’s definition of hard-core pornography, is simple: “I know it when I see it.”

This week, the market seems to have acted on that dictum. With aggressive words in support of the dollar coming from a procession of the most senior economic policymakers in the US, fixed-income markets capitulated. Futures markets now price as a certainty a rise to 2.5 per cent in the fed funds rate (from 2 per cent) by autumn. Days ago a rise to 2.25 per cent was seen as a less than evens chance.

Bond yields shot up as a result, greatly strengthening the dollar and undoing all the damage done last week by the poor US employment data and by the signal from the European Central Bank that it, too, would be raising rates.

Gold, usually a hedge for uncertainty, seems to be taking its cue from the currency market, falling sharply as the dollar strengthened.

Emerging markets fell badly. They had benefited from dollar weakness and strong commodities. But the tight relationship between oil and the dollar went into reverse. Rises in oil lately have correlated with doses of dollar weakness. But oil initially rose on Tuesday as the dollar strengthened.

Some effects so far look perverse. Bank stocks should be harmed by rising rates. And yet they gained in early trading.

All perhaps are symptoms of a situation in which traders have seen a turning point. They do not yet understand the consequences, but they know one when they see one.

Nouriel Roubini, in a lengthy discussion, “Global Stagflation Ahead? The Interplay of Aggregate Demand and Aggregate Supply Shocks,” doesn’t buy that things have changed all that much. He believes that inflationary pressures will be reduced by economic weakness and currency realignment

We’re in Roubini’s camp for much simpler reasons. The banking sector is much weaker than is widely acknowledged. Regional and local banks are only beginning to experience the stresses that hit their larger brethren. In addition, while financial institutions have marked down their subprime portfolios considerably, they do not appear to have made anywhere near the requisite cuts on their just-about-as-bad Alt As and Option ARM exposures and their even-worse HELOCs (update: some indirect confirmation comes via this Housing Wire post, “Fitch: Problems in Housing Greater than Originally Estimated“.) As we have said repeatedly, the credit default swaps market is a disaster waiting to happen. Not only will it be tested and likely to be found wanting as corporate defaults rise to levels not seen since the market has been operating on a large scale, but litigation to avoid payout can create unexpected side effects.

While the ECB may raise rates (the Europeans have a much greater fear of inflation than we do and are willing to inflict pain to avoid it), the Fed has repeatedly taken the “break glass in case of emergency” approach at any sign of distress in the financial markets. Dean Baker regularly criticizes the New York Times and other media outlets for continuing to solicit opinions on the housing market from economists who completely missed the brewing real estate crisis. Similarly, the markets are putting undue faith in the forecasting ability of a Fed chief that thought the subprime problem would be contained.

Thus, while the Fed may have some intermediate success in jawboning higher interest rates and a stronger dollar, we still believe their desire to raise rates will be dashed by continued wobbliness in the financial sector (mind you, unlike Roubini, we think the Fed is unduly protective of its charges, so we are describing expected outcomes, rather than voting for them). And once traders see that, we’ll see a reversion of the dollar and interest rates, albeit from a higher level. While the Fed may not see enough bad news in the data to hold them back from a 25 basis point rise in August, our guesstimate is that this “eye of the storm” phase won’t last beyond the third quarter.

Note that Roubini continues to mention the idea of an Israeli attack against Iranian nuclear facilities. Although that idea should be relegated to Dr. Strangelove (see the comments in this post for details), since a strike on a operating nuclear reactor would make Chernobyl look tame, it would produce massive dislocations. From RGE Monitor.

A true stagflationary shock requires a negative supply-side shock that increases prices/inflation while reducing output/growth. Instead, positive aggregate demand shocks – like an overheating in emerging markets following a growth in aggregate spending – would be associated with rising inflation and rising growth…..

In the 2004-2006 period global growth was robust while inflation was low. This ideal situation can be interpreted as the outcome a positive global supply shock – the increase in productivity and productive capacity of China, India and emerging markets – that allowed global growth to increase while prices of goods and services remained low or falling….This positive supply side shock was followed – starting in 2006 but more strongly in 2007 – by a positive global demand shock: the fast growth of demand in Chindia and other emerging market economies started to put pressure on the demand and prices of a variety of commodities and lead to a rise in inflationary pressures. Thus, strong global growth in 2007 was associated with the beginning of a rise in global inflation, a phenomenon that with some caveats – the sharp slowdown in growth in the US and some advanced economies – continued in 2008.

The above analysis thus suggest that – barring a true supply side stagflationary shock such as a war with Iran – a true stagflationary outcome (rising inflation and recession) is unlikely in the global economy. The recent rise in oil, energy and other commodity prices is – in spite of the deepening US recession – the result of a variety of factors, rather than a mere negative supply side shock. First, high growth in demand for oil and other commodities among fast growing and urbanizing emerging market economies at the time when the supply of new oil is constrained the political instability – and ensuing lack of enough investment in new oil exploration – of a number of unstable petro-states (Nigeria, Venezuela, Iran, Iraq and, possibly, Russia) while the supply of other commodities is constrained in the short run by productive capacity and need for longer term investments. Second, the weakening US dollar that pushes higher the dollar price of oil as the purchasing power of oil exporter over non-dollar regions is reduced. Third, the discovery of commodities as a new asset class by many investors (hedge funds, pension funds, sovereign wealth funds) leading to both short run speculative and long run investment demand for commodities. Fourth, the diversion of land towards bio-fuels production; this is a phenomenon that has reduced the land available to produce agricultural commodities. Fifth, very easy monetary policy by the US forcing easy monetary policy in countries that formally peg to the US dollar (as in the Gulf) or that heavily manage their exchange rates to maintain undervalued currencies and achieve export led growth (China and other informal members of what is referred to as the Bretton Woods 2 “dollar zone”) leading to a new asset bubble in commodities and overheating of their economies. Most of these factors are akin to global aggregate demand shocks – rather than supply shocks – that should lead to growth overheating and a rise in global inflation.

The last factor – the exchange rate policies of many emerging market economies – is particularly important….Indeed, policies of forex intervention that tried to prevent the nominal appreciation have led to a massive increase in foreign exchange reserves whose effect on base money has been only partially sterilized; thus the ensuing low policy rates and increases in monetary base growth and of credit growth have eventually led to both asset inflation (real estate bubbles and equity bubbles) and, more recently, to goods inflation as the recent rise in inflation in most emerging market economies shows. Thus, the most important way to control inflation – while regaining monetary and credit policy autonomy that requires higher policy rates to control inflation – is to allow currencies in these economies to appreciate significantly rather that prevent such appreciation….

Unfortunately this need for currency appreciation and monetary tightening in overheated emerging market economies is occurring at a time when the effects of the housing bust, the credit crunch and high oil prices in a number of advanced economies (US, parts of Europe and in Japan that depends heavily on US growth) is leading to a sharp economic slowdown in these advanced economies – and outright recession in some of them – that, in due time, will slow down growth in emerging market economies as economic recoupling will emerge. Thus, rising inflation and slowing growth in many advanced and emerging economies is becoming a nightmare for their central banks that should be tightening monetary policy to fight inflation and ease monetary policy to reduce the downside risks to growth.

If the nature of the shock hitting the advanced economies is now a negative aggregate demand shock – a fall in demand driven by the bust of housing and the ensuing credit crunch – inflationary forces should – over time – diminish as there will be, especially in economies entering a recession, three forces that will tend to reduce inflation: a slack of aggregate demand relative to aggregate supply reducing the pricing power of firms (and indeed we are already seeing deflation in the US in home prices, auto prices and consumer durables); a slack in labor markets where a rising unemployment rate will lead to a reduction in wage pressures and labor costs; and eventually a fall in commodity prices from their recent peaks if a severe US contraction leads to a global economic slowdown and lower demand for commodities; indeed a fall in global commodities demand – given short run inelastic supply of commodities –would lead to a relatively sharp – about 20% plus – fall in commodity prices…..

Thus, deflationary pressure in some economies that are contracting could occur in parallel to inflationary pressures in economies that – so far – are still growing fast. Certainly the year ahead will be a much more difficult one for the global economy and central bankers as a combination of rising inflationary risks and downside risks to growth is emerging in complex and different ways for different economies.

The Fed is now signaling its concerns about rising inflation and inflation expectations – especially with a weakening US dollar – but it is still recognizing that there are significant downside risks to growth. Thus, in spite of the new hawkish rhetoric the Fed will stay on hold – and may even ease further – if the US turns out to be severe and prolonged rather than short and shallow. The ECB is even more hawkish given its mandate giving priority to price stability; but its aim to tighten monetary policy to stem inflationary pressures will be challenged by the rapid growth slowdown of Europe where high oil prices, a credit and liquidity crunch, a strong euro, anemic real wage growth, a weakening of the U.S. and the lack of policy rate easing are taking a toll on growth even in Germany while a number of other European and Eurozone economies are headed towards a hard landing (Spain, Ireland, Italy, Portugal and the UK).

For U.S., Europe and Japan a rise in oil and commodity prices is “stagflationary” even if it is driven in part by strong demand in emerging market economies. So while rising inflation caused by the commodity shock may require tighter monetary policy the weakening in demand caused by a different combination of housing busts, credit crunch and other factors weakening growth (such as strong currencies in Europe and Japan) is leading to a rapid slowdown and outright contraction in some economies. Whether monetary policies will be tightened or kept on hold will depend on how much the downside risk to growth become larger than upside risks to inflation.