Ben Benanke makes some encouraging noises whilst the Bank of Japan eases policy unwisely

Friday was a day which gave us not only some solid economic news but also gave us the thoughts of Federal Reserve Chairman Ben Bernanke. This was followed over the weekend at the Jackson Hole symposium by a speech from the Bank Of England’s Charles Bean and to continue the central banking theme by some new action from the Bank of Japan which I shall discuss in a moment as to whether it was “appropriate”. Returning to Friday the combination of Ben Bernanke’s speech and the better than expected US Gross Domestic Product figures led to a strong rally in the US equity market as the Dow Jones Industrial Average rose by some 164 points to 10,150 erasing some of the recent losses for it. European equity markets rallied too and overnight have been joined by Far eAstern equity markets with the Japanese Nikkei 225 rising some 158 points to 9149.However the strongest response to Ben Bernanke’s speech came from the US government bond market where what is called the long bond fell by more than 3 points or approximately 3% in a strong reversal of recent bond market trends although to reverse the gains of recent weeks fully it would still have to do much more.

The Commodity Research Bureau spot index was virtually unchanged as a rally in metals prices was offset by other components whereas oil prices rose to nearly US $77 per barrel of Brent Crude Oil.

US economic growth revision for the second quarter of 2010.

The US figures were revised down as expected but not by quite so much. The original flash estimate had been for 2.4% growth on an annualised basis and this was reduced to 1.6% 0r as the rest of the world might put it from 0.6% to 0.4%. Many were expecting annualised growth to be reduced to 1% and the consensus was for 1.4%. According to the Bureau for Economic Analysis the reasons for the downgrade were as follows.

The deceleration in real GDP in the second quarter primarily reflected a sharp acceleration in imports and a sharp deceleration in private inventory investment that were partly offset by an upturn in residential fixed investment, an acceleration in non-residential fixed investment, an upturn in state and local government spending, and an acceleration in federal government spending.

Whilst equity markets took the figures well I expect over time concerns to be raised about the trend which has gone 5%,3.7% and now 1.6%. If one uses the figures calculated by the independent Congressional Budget Office for the effect of stimulus policies in the US for the second quarter which ranged between 1.7 and 4.5% then you get slightly negative growth at best and possibly quite negative growth ex-stimulus. Sooner or later this will trouble markets when their minds switch to considering the implications these facts have for the second half of 2010.

The UK’s figures showed an uptick in inflation

The UK ‘s revision was much happier as I reported on Friday but as it has had so little publicity elsewhere I thought that I would repeat the section on the UK implied GDP deflator. According to the ONS.

The GDP implied deflator rose by 4.1 per cent compared with the second quarter of 2009, up from 2.9 per cent in the previous quarter.

Ben Bernanke’s speech at Jackson Hole

I think that Mr. Bernanke probably had three main thoughts in his mind on Friday. The first was to avoid phrases like “unusual uncertainty” which so upset markets when he used it, the second was to be somewhat guarded as the Fed. itself is split (one member Mr. Hoenig voted against the last move) and three to express confidence in the ability of the Federal Reserve. The third may well have been the most important as the economic growth figures just out has tended to suggest the complete opposite. If growth is stalling in the US then the enormous stimulus programme has had less impact than expected. To my mind this sends a clear signal as to how effective any future stimulus plans are likely to be.

If we look at the speech itself we get some implied humility.

the task of economic recovery and repair remains far from complete……monetary policy continues to play a prominent role in promoting the economic recovery……..the pace of that growth recently appears somewhat less vigorous than we expected.

Accompanied then by his view of how the US economy can recover.

For a sustained expansion to take hold, growth in private final demand–notably, consumer spending and business fixed investment–must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.

So,in a way we do get some humility as he is admitting that the Fed. cannot do the job alone and relies on the private-sector. Of course this is the current economic hot topic where official action is struggling to get a reaction leading to questions about transmission mechanisms and how well they are working or not as the case seems more to be. We also then get the fallback of central bankers if something is inconvenient label it as temporary.

Like others, we were surprised by the sharp deterioration in the U.S. trade balance in the second quarter. However, that deterioration seems to have reflected a number of temporary and special factors.

The US trade deficit temporary? Affected by special factors? Many might consider it to be a return to its trend as the world economy recovers. Anyway we also got a suggestion of the alternatives available open to the Federal Reserve should conditions deteriorate and he gave us four of them.

1) conducting additional purchases of longer-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists–namely, that the FOMC increase its inflation goals

They are meant to sound impressive but in fact if you analyse them they are much weaker than they appear.If we consider option one then one would be applying it because the first effort at it had failed with the Fed. having spent some US $1.3 trillion on it first time around. The second option suggests that if the Fed. communicates it intentions better by presumably announcing it will keep rates lower for longer then good things will come from this. As everybody expects low rates for quite some time and are probably extending the time horizon of this then this policy is very weak. For number 3 there is the problem of the fact that the interest rate on excess reserves is already very low at 0.25% so there is little scope here unless of course he is considering taking them negative. As to number 4 I fail to see what good it would do as if an economy is slowing down raising the inflation target achieves nothing until the Fed. actually makes a move to raise inflation which would presumably be option one.

So here we have the crux of the problem. Of the options the only one with any power is option one and this has already been tried on a large-scale. So going for QE has this fundamental problem, if it is being tried it means QE 1 has failed so why can one reasonably expect QE 2 to work? To that we do not get an answer. As to what Ben will do if the US economy does continue to struggle I think we did get an answer.

the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation

and in a move which concerned the bond markets and got the long bond to drop three points we got

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do.

For me it wasn’t a great change as should be US economy continue to slow I expected the Fed. to act again anyway. After responding to market pressure with QE lite at the last meeting any further slowing in US economic data will mean that the next meeting will take place in a fevered atmosphere. This will be applied to a body which has made what I consider to be panic moves. As to the bond market whilst they welcome purchases of securities by the Fed I think the speech reminded them of the size of purchases which may be required and the implications thereof.

The Bank of Japan Acts unwisely

After many rumours over the past week or so  the Bank of Japan finally held an emergency meeting and decided to take some action. It decided to expand the size of a bank loan programme it has been running and also the maturity of the instruments. So we have a programme of 30 trillion Yen rather than 20 trillion and 6 month maturities as well as the previous 3 months. In effect the Bank of Japan is offering Japan’s banks some 10 billion Yen in 6 monthly loans which translates to 116 billion US dollars at current exchange rates. Unfortunately this is an expansion of a scheme which is failing to have much impact. It was introduced last year and was previously expanded in March but I am not sure if anybody really believes it has done much good.

Actually as this move follows political pressure I suspect the Bank of Japan thinks this too, as in it felt forced to do something so did as little as possible. If we widen the debate and ask what could the Bank of Japan do to improve things then I think that one sees the depth of Japan’s problems. Short-term interest rates are already at 0.1%, QE has been tried and failed, and foreign currency intervention has been tried and mostly failed. It is currently the hardest job in the world of central banking. With longer-term rates as illustrated by Japanese Government Bonds yielding around 1%  at the ten-year maturity there is little scope here either.

Impact of the Move

If there was any hope for an improvement from this then the initial response will have disappointed. The Yen strengthened against the US dollar to 84.85 and against the Euro to 107.93. Even the rally in the Nikkei dipped when the announcement was released. So in the short-term the move contributed to the strength of the Yen which is exactly the reverse of what is required to do any good. Moving forwards I do not think anyone really believes this move will help Japan’s economy much if at all. At least they didn’t try foreign exchange intervention, although times are grim when you are relieved that a central bank hasn’t actively made things worse!

Comment and Trends

With the split vote at the Bank of Japan we now have a dissension with official policy at the worlds main central banks. Mr Hoenig voted no at the Fed, Mr.Sentance voted for a rise in the UK,Axel Weber voted no to the Securities Markets Programme at the ECB and now we get a no vote at the BoJ. Perhaps this symbolises our times and the difficulties we face.

There is enormous pressure on central banks at this time to “do something”,sometimes this pressure even comes without a suggestion as to what this should be. In my view they should resist it and stay calm. On this basis Mr.Bernanke and the Fed worry me the most as some of their rate moves and with the recent QE lite they succumbed to this pressure which leads me to the conclusion that they are likely to do so again.



6 thoughts on “Ben Benanke makes some encouraging noises whilst the Bank of Japan eases policy unwisely

  1. Hi Shaun: do you think that the Triffin Dilemma will play any part in the global economic situation in the near future, or is this akin to Astrology again?

    • Hi Drf
      It’s an excellent question. For those unaware of what is being asked essentially the issue or dilemma is of a currency being a national currency whilst also being seen as or actually being the worlds reserve currency. This is a role the US dollar pretty much fulfils or rather roles. The dilemma really arrives when the country makes moves to suit itself which do not fit with its world role.Thus we may have to few or too many US dollars.

      Bring this into the modern day one could argue that the first type or effort at Quantitative Easing by the US Federal Reserve could have lead to this dilemma being activated as its main objective was to increase the US money supply which may not have suited its role as a reserve currency. One possible transmission mechanism would have been for this to have led to a fall in the US dollar exchange rate such that its role as a reserve currency was questioned. In the event the failure of QE to influence the wider measures of the US money supply meant that there is no great danger for now.

      However it is possible that it will come to play. I believe that if the US economy continues to slow the Fed will come under a lot of pressure to institute a new wave of Quantitative Easing. Adding this QE2 to its predecessor does have the danger that so much money will be poured into the system it could affect the exchange rate adversely. This is all conjecture because the effects of a programme which has not happened yet are obviously undefined. However the chances are increasing by the day,in my view and this week we will get a lot more data on this subject.

      There are two ironies I think in Mr.Triffins work. The first is that he was concerned about an end to US trade deficits, oops,although to be fair he was thinking this some 50 years ago.The second is that his work led to the construction of Special Drawing Rights at the IMF, it is not clear to me that they have turned out to be an improvement as they are in effect a creation of fiat money but by who? Put this another way do we have the right number of SDRs?

      In a sense there is another question at the heart of Mr.triffin’s work. Is there a correct number for equlibrium or was it always unstable? Then there is the measurement problem if there is a right number we may not know what it is and in fact probably never have known.

      So a dilemma which poses question after question and I am sure as time goes by I will think of some more.

  2. Central Banks have cut rates to near zero and,in some cases, tried printing money.Essentially they have done what they can to stimulate and it either hasn’t worked or delayed the reckoning.

    Of course they know real growth in mature post industrial economies needs painful structural reform that will take decades.Do they have the nerve to say that they are not all powerful and the next steps are in the hands of the politicians to impose unpopular changes?

  3. Exactly, andy of yarm. Politicians (in democracies) need a lot of courage to risk their comfortable positions by telling their electorates the truth rather than perpetuating dissimulation. There is also the risk of ‘talking down’, a risk that I would be prepared to run in exchange for a reputation for calling a spade a spade. If permanent spinning is needed to placate the markets and electorate, something fundamental is wrong. It’s obvious that the BoE is floundering for want of a way to perpetuate support for the economy without causing significant and immediate economic damage. Rather high inflation is one obvious outcome of this situation. They will have to do something soon, but unfortunately it may be more QE rather than a much needed rise in the base rate.

    • I think we have ingrained spin inflation.

      Unless a politician talks up the economy in the most hyperbolic fashion, the press and public read disaster between the lines.

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