Data - April 30

none of this will be market moving:

CANADA

February GDP came in as expected at -0.1% after January's drop of 0.7%

U.S.

personal income in March was down 0.3%

personal spending was down 0.2% MoM, but February was revised up to +0.4% from 0.2%

PCE Deflator was down to 0.6% YoY, but PCE Core stayed at 1.8% YoY, as expected

initial jobless claims fell to 631k from an upwardly-revised 645k

continuing claims rose more than expected to 6.27 million

INTERNATIONAL

Japanese industrial production was up 1.6% in March, but remains down 34% YoY; the Nomura/JMMA manufacturing PMI was up to 41 from 33.8 in April; construction orders down 38% YoY, vehicle production is down 50% YoY, housing starts down 21% YoY; the BoJ left rates unchanged at 0.10%

Germany's unemployment rate rose to 8.3% from 8.1%, while the Eurozone rate rose to 8.9% from an upwardly-revised 8.7%

Eurozone CPI was estimated at +0.6% YoY

U.K. consumer confidence survey rose a bit to -27 from -30, though house prices were down 0.4% during April and 15% YoY

French producer prices down 5.5% YoY

Data - April 29

U.S.

FOMC statement at 2:15

I agree with the guy from Across the Curve:

I think that the Committee will genuflect in the direction of the signs of stability which have crept into the economy. In that regard the statement should be more upbeat than the previous one. I think that the improvement in the economy and in the financial markets precludes any extension (increase) in QE). I see no reason for the group to fire new bullets when conditions (albeit slightly) are improving. I think that they will reiterate that the funds rate will remain low for an extended period and that the risks of weakness outweigh chances of growth. They will also note their collective concern about too low a rate of inflation.

that said, if the Fed doesn't upsize their Treasury-buying program, we could see 10s push quickly through that 3% level its been bumping off

but first we got the BEA's advance estimate of Q1 GDP; the survey hoped it would rebound to about -4.7% at an annualized rate, from -6.3% in Q4, on positive personal consumption growth; the latter was correct, as personal consumption was up a more-than-expected 2.2%, but, nonetheless, GDP contracted at a 6.1% annualized rate, and is now down 2.6% over the last year, which matches the 1982 low, but is otherwise the worst YoY rate since 1958; nominal GDP fell 3.5% annualized in Q1 and is down 0.5% YoY, the first time its been negative since 1958;

PCE was up 0.3% in the quarter (despite spending on energy falling nearly 16%), contributing +1.5% to total GDP; but private domestic investment was down 17% in Q1, so its contribution to the change in total GDP was -8.8%; residential investment, non-res investment and inventories were all drags; for residential investment, it was the 13th straight quarter as a drag on growth, and had been anticipated to be less so over time, but its 12.4% fall in Q1 contributed negative 1.4% to the total GDP figure, which is as bad as in any of the previous 12 quarters; inventory adjustments contributed -2.8% to the headline GDP figure, while non-residential investment dragged 4.7%; net exports added nearly 2% to growth, as exports were down 11%, but imports were down 17%; government spending detracted modestly from growth, both at the federal and state/local level

keep in mind that these are the "advance" estimates; the "preliminary" estimates, based on more comprehensive data, will be released May 29

INTERNATIONAL

Eurozone M3 money supply fell in March, is basically flat over the last five months, and is down to a YoY growth rate of 5.1%, down from as much as 12.5% in 2007, though not yet to past recession lows of under 4%

Eurozone consumer confidence improved a bit to -31 (from -34)

Worthwhile Reading - April 28

The Sweden example. James Surowiecki, The New Yorker.


Chinese demand v new Treasury supply. Brad Setser, Follow the Money.
There is a very widespread sense that the US “needs” China more now because it is issuing more Treasuries to finance its fiscal deficit. That isn’t quite true. As a result of the crisis, the US consumer has started to save and American businesses have reduced their investment, so the US “needs” to borrow a lot less from the rest of the world. The US needs to borrow from the world when private Americans do not want to save and the US running a large trade deficit, not when private Americans want to save and the trade deficit is down. The US government is borrowing more, from almost everyone. But other sectors of the economy are borrowing a lot less.

Data - April 28

CANADA

more Canadians are receiving unemployment benefits, up for the 6th straight month to 610k, up 7.8% MoM and 33% YoY; initial claims are up 62% YoY

BoC Governor Carney presents the MPR to the House Finance Committee

U.S.

S&P/Case-Shiller home price index for 20 major metropolitan markets declined 2.2% during February and is now down 18.6% YoY (vs -19% YoY through January), and is 30.7% lower than its 2006 peak

Consumer confidence recovered some ground to 39 in April, better than 5 of the previous 6 months --- but still lower than any other print in the history of the index since 1967

Richmond Fed Manufacturing index was also reported today, and, like everything else it seems, is less bad, at -9, up from -20 last month and as low as -55

INTERNATIONAL

French consumer confidence in April recovered a bit of ground to -41, but the business survey of overall demand fell to a new low, and French housing starts and building permits in March were off significantly (down 33.8% and 17.6%, respectively, in the last 3 months relative to the corresponding 3 months of the previous year)

German inflation continues to be modest, as CPI in April came in flat on the month and up just 0.7% YoY

Italian retail sales disappointed, down 3.1% YoY vs. expectations of -1.3%, but business confidence improved to 64.2 (relative to neutral level of 100)

Finnish unemployment jumped a half-percent more than expected, to 8.3% from 7.6%

Japanese retail trade fell a larger-than-expected 1.1% in March, though the YoY pace of decline was better than anticipated, moderating to -3.9%; small business confidence improved a tad to 30.8, off the January and February lows around 25 but still well below a neutral level of 50


Baltic Dry Index down again in the last couple of days (presumably on general risk aversion with the swine flu concerns) after 9 consecutive up days

LIBOR-OIS still gradually trending (very slowly) back towards normalcy, having drifted down over the last month from about 1% to 0.84%

Worthwhile Reading - April 27

Fed study puts ideal U.S. interest rate at -5%. FT.

Larry Summers' new model. Simon Johnson, Baseline Scenario.

Money for nothing. Paul Krugman, NYT.

Money doesn't grow on trees. John Hussman.

UPDATE:

Obama's secret plan. Charles Hugh Smith, Of Two Minds.
his thesis is that Obama is giving the investment banker aristocracy enough rope to hang itself, only after which time there'll be the possibility of real change; I don't buy it, but I'd like to; question is, can Obama scapegoat Geithner, Summers, Bernanke and the previous administration without blame for the failure of current policies also accruing to him? (so he and Volcker can provide the real fix!)

Data - April 27

CANADA

nothing until GDP on Thursday

U.S.

just Dallas Fed Manufacturing Activity

INTERNATIONAL

German import prices down 7.1% YoY

German consumer confidence in May unchanged from last month, but Italian consumer confidence was up

Hong Kong exports dwon 21% YoY through March, while imports down 22.7%

this evening, Japan retail trade data released

Bank of Israel will likely leave rates unchanged at 0.50%

Worthwhile Reading - April 26

The capital well is running dry and some economies will wither. Ambrose Evans-Pritchard, Telegraph.

The stress test cliff notes. Tyler Durden, Zero Hedge.

Back to the future recession. John Mauldin, Thoughts from the Frontline.

Quote of the Day

much ado about nothing; stress test white paper provides no new information; so says Josh Rosner, of Graham Fisher & Co."

"The most significant numbers provided by the Fed in the paper appear to be the page numbers.”

Worthwhile Reading - April 25

*** The death of the Asian development model. Michael Pettis, China Financial Markets.


TALF disappointment and the Fed's balance sheet. Tim Duy, Fed Watch.

Markets cheer stress test double-speak. Yves Smith, naked capitalism.

Recession, far from over, already setting records. Floyd Norris, NYT. (worth checking out for the chart alone)

Worthwhile Reading - April 24 p.m.

Global bank writedowns: Canadian troublemakers. Paul Kedrosky.

Home sales: the distressing gap. Calculated Risk.

The Supervisory Capital Assessment Program: Design and Implementation. The Fed. [i.e. the stress test]

Fed's white paper: more should be released. Calculated Risk.

Above or below 3% tangible common equity? Jake, Econompic Data.

Trading volume separates bull markets from bear market rallies. William Hester, Hussman Funds.

China's syndrome: the "dollar trap" in historical perspective. Olivier Accominotti, voxeu.

Fannie Mae creates housing mirage with bum loans. David O'Reilly, Bloomberg.

a month late, but:

Welcome to America, the world's scariest emerging market. Desmond Lachman, Washington Post.

Quote of the Week

U.K. Chancellor Alistair Darling apparently conceded the current slump is comparable with the Great Depression but insisted it would be over by Christmas

Data - April 24

CANADA

no domestic data today

U.S.

durable goods orders, which were down 24% YoY through February, came in better than expected for March (down 0.8% MoM vs. -1.5% expected), largely because February's gain was revised down (to +2.1% from the original +3.4% reported); this was the 7th decrease in the last 8 months, so the YoY rate is now -25%; inventories continue to decrease, but not as fast as shipments, so the inventories-to-shipments ratio rose to 1.9; ex-transport orders, which were down 17% YoY through February, were -0.6% in March vs. -1.2% expected, after February was revised down from +3.9% to +2.0%; the YoY rate is now -20%; non-defense ex-aircraft capital goods orders were up 1.5%, after a 4.3% increase in February, but 12.3% decline in January and 5.9% decline in December, so the YoY rate is now -18.3%

new home sales were 356k in March, basically flat at February's upwardly-revised level of 358k (from 337k), (and up from January's revised low of 331k) down 31% in the last year and 74% from the 2005 peak

INTERNATIONAL

German IFO index, like ZEW previously, still contractionary, but not as badly, rising to 83.7 (business climate) from 82.1 (the current assessment and expectations components rose similarly)

U.K. GDP in Q1 was a little worse than expected, down 1.9% vs -1.5%, so the YoY rate is now -4.1%, despite retail sales having exceeded estimates (up in March, +1.5% YoY)

French consumer spending was up more than expected in March, so is back to positive territory on a YoY basis (+0.6%)

Spanish unemployment is now 17.4%

Worthwhile Reading - April 24

The global economy in the next year. Nouriel Roubini, Forbes.

A glimmer of hope? The Economist. (love the cover image, straight out of one of my favourite kids' movies)

Stress tests flash a lot more red. WSJ.

Fed reports over 30% loss on Bear Stearns mortgage loans Tyler Durden, Zero Hedge.

Is there a bubble forming in copper? Cornelius, Zero Hedge.

The collapse of the high-yield market, and why highly-leverage companies are in run-off mode. Tyler Durden.

88% of Canada's CEOs say pension funding crisis looms: poll. CBC.

Treasury department issues emergency recall of all U.S. dollars. The Onion.

Some thoughts on the MPR

The market reaction to the release of the MPR was all about the unconventional, but I'll start with the conventional.

The Bank reduced its forecasts for growth prospects, as expected, relative to the January MPR Update, to -3.0% expected this year, +2.5% next year, and +4.7% in 2011. It attributes the downgrades primarily to the significant unforeseen foreign weakness propagating through trade, financial and confidence channels (adverse feedback loop), and to delays in implementation of policies to stabilize the financial system (particularly in the U.S.).

But the Bank remains relatively more upbeat than some other forecasters (see previous post), and continues to project a more robust recovery in Canada than in other countries. So, though the recovery will be delayed and more gradual than previously anticipated due to the unanticipated intensification and synchronicity of the global recession (particularly acute in Europe and Japan, with knock-on effects on global trade), the Bank continues to expect above-potential growth in Canada in 2010 (albeit with a lower estimate of potential output growth).

The Bank has a long list of factors that it views as supportive of this prediction, including the scale of its own monetary policy response, the relatively well-functioning Canadian financial system, the past C$ depreciation, fiscal stimulus, a gradual rebound in external demand, the strength of balance sheets in Canada (household, business and bank), and the end of residential housing stock adjustments both in the U.S. and here. More generally, it believes that bold policy actions globally, an end this year to the U.S. housing drag, and a relatively robust China will all be positive factors for the global economy.

However, there are obviously numerous challenges also. Though Canadian households have entered this downturn with balance sheets that are not as stretched as elsewhere, they have reacted with a similar increase in their desired savings rates. And, though Canadian households have generally had lower rates passed on to them, businesses are facing difficult financing conditions. Further, U.S. weakness has mostly been in sectors that have a large impact on Canadian exports (housing and autos). Also, there has been significant unwanted inventory accumulation. And, due to the steep drop in the terms of trade, there has been a similar sharp drop in real gross domestic income (which is forecast to decline 6.4% this year). Investment in housing is expected to fall all this year and business fixed investment is expected to drop sharply. And the output gap, which is estimated to be about 3% currently, is expected to widen to 4.5%.

Perhaps the most notable change in the Bank's report is that it has dropped its estimate of the economy's potential output (i.e. the pace of output growth that would be non-inflationary). Previously, it had viewed potential as 2.4% (for this year, and 2.5% going forward). Because of the structural change going on in the economy (especially in autos and forest products), it now views potential output as just 1.2% for this year, 1.5% next year, and 1.9% in 2010. Clearly, lower potential output estimates, if accurate, will make it easier to close the output gap and thus start get inflation back towards the 2% target (not anticipated for 10 quarters, in Q3/'11).

The Bank notes that if the economy deteriorates any further than currently expected, because its overnight rate is currently at its effective lower bound for conventional monetary policy, it would need to react with unconventional policy. And, given the degree of uncertainty related to such new policies, it would therefore need to use prudence with these initiatives (i.e. it will be cautious about how much it uses these programs, if at all). Therefore, it says that implies that inflation risks remain tilted, though slightly, to the downside.

All this will likely be very sensitive to its assumptions on the stabilization of the global financial system, given that it continues to maintain that such stabilization is a precondition for recovery. And the Bank seems to be unimpressed so far with the pace of progress in this regard. The Bank did not really outline its expectations for further credit losses in the global financial system, nor for the pace of resolution of impaired legacy assets, so its hard to evaluate this element. Another risk is the ever-present one of the potential destabilizing resolution of global imbalances. (The Bank did not comment on the fact that it seems that most government stimulus that has been enacted so far seems to aggravate existing imbalances, i.e. that American stimulus is somewhat focused on reviving U.S. consumption, while Chinese stimulus is somewhat focused on the investment and export sectors.) The Bank's forecasts would also be sensitive to its assumptions on the currency (C$ = US$0.80), oil (from $50 now to $60 at year-end, to $70 in 2011, based on futures) and non-energy commodity prices (increasing progressively with global economy).


Now, turning to the unconventional. The Bank views its commitment to keep its overnight rate at its current low level for over a year (and future conditional statements about the future path of policy rates) as its first main instrument of unconventional policy. It hopes that because long-term rates represent averages of current and expected future short-term rates (plus term premiums), that it can influence the government yield curve lower, and in turn support prices of other financial assets, and, in turn, aggregate demand.

That we already knew on Tuesday. And, unfortunately, there's really nothing in the MPR about quantitative easing (QE) (which would involve purchasing government or private assets, paid for by expanding the money supply), or credit easing (CE) (purchases of private sector assets, but sterilized, so the monetary base doesn't change) that's new or noteworthy either. The only new info is (1) that if it does purchase private assets, it will be restricted to those exhibiting a clear market failure, and (2) is the publication of the principles it will use to guide its actions. Newsflash #1, its focus is on its inflation target. 2) anything it does should be concentrated where it will have impact (perhaps purchasing 5yr GoCs would have more impact than buying 2s, particularly given that the impact the Bank is ultimately worried about is on private sector interest rates). Its principles of (3) neutrality (limit potential distortions) and of (4) prudence (don't unduly risk the Bank's balance sheet), seem to indicate a preference for QE over CE.

Other asset implications? Given how little detail is provided on this new monetary policy framework, its really hard to know. Probably there will be just as many guesses out there in the market today as to what they might do as there were yesterday (GoCs? provies? CMBs? corporate bonds? CP? ABCP? ABS?).

Ultimately, it appears that the Bank's outlook on the economy and inflation, and its conditional commitment to low rates, should be favourable for lower rates along the government curve. And, if anything, it appears that the Bank remains relatively optimistic that global financial instabilities will be resolved soon enough to foster the growth its looking for. Not that it can do anything about it, but that leaves the Bank relying on Timothy Geithner too much for my liking.

Really, what it comes down to is, will the Bank's forecasts be more accurate than those of the IMF and OECD, or not. If so, then no QE or CE. But, if not, it will take longer to get inflation back on target, with potentially a larger miss in the meantime, implying an announement in June (or more likely at another future fixed action date) about what particular QE or CE measure it decides it needs to employ.

But, in any case, it seems clear that the Bank feels there's a greater burden of proof that there's a need in order for it to go down that road. It too may be looking at 2nd derivatives and green shoots and hoping to not need to invoke too many extraordinary measures.

Global Economic Outlooks

The Bank of Canada released its MPR today, which, among other things (more later), lays out its projections for economic growth.

I thought it might be interesting to compare what the Bank is expecting relative to the recently released projections offered by the OECD and by the IMF.

Here are the BoC's forecasts for 2009 and 2010 real GDP growth:

Canada: -3.0; +2.5
U.S.: -2.4; +1.2
E.U.: -3.6; -0.2
World: -0.8; +2.2

Here are those from the OECD:

Canada: -3.0; +0.3
U.S.: -4.0; 0.0
E.U.: -4.1; -0.3
OECD: -4.3; -0.1
OECD+BRIC: -2.7; +1.2

And those from the IMF:

Canada: -2.5; +1.2
U.S.: -2.8; 0.0
E.U.: -4.2; -0.4
World: -1.3; +1.9

a few observations:

the OECD is the most pessimistic, both for 2009, but particularly regarding prospects for 2010 (basically bigger fall in '09 and then no bounceback in '10)

the BoC is more optimistic than either the OECD or IMF not just on how much the U.S. declines this year, but its prospects for next year; neither the OECD nor IMF have projected any 2010 growth for the U.S.

all three sets of forecasts are reasonably bearish on Europe (from -3.6 to -4.2 this year, and more slippage next year)

all three groups of forecasters predict Canada outperforms other advanced economies in 2010, presumably due to its linkages to developing economies

the BoC's forecasts aren't that far off from those of the IMF, but are definitely more optimistic (or, perhaps more accurately, less pessimistic), and the BoC, though it has pencilled in a more gradual recovery than it was previously forecasting, is definitely looking for more of a V-shape than either the OECD or IMF



UPDATE:
the OECD's more pessimistic outlook may be due to its assessment that it takes 4 to 6 quarters for changes in financial conditions to have their full impact on GDP, so the full effect of past tightening in conditions since Sept/08 has not yet been felt; also, it is expecting further large prospective declines in world trade, based on advance indicators; further, it notes that housing recessions are worsening almost everywhere other than the U.S.; it is also concerned that large cyclical increased in unemployment have a tendency to become structural in part, reducing productive potential

notably, the OECD's foresees:
- the U.S. output gap reaching 10% and therefore inflation, after going negative for much of 2009, only stabilizing near 0% at the end of 2010
- strong BRIC rebound in 2010 driving robust rebound in world trade
- the OECD's report noted that it is important to commit to low levels of monetary policy rates for a sufficient period of time, as studies have shown such a commitment to have an effect on lowering the yield curve

Worthwhile Reading - April 23

Outstanding CDS fall 29% globally. FT.

Credit bubble hangover. Jeff Harding, via Barry Ritholtz's The Big Picture.
a reality check on the green shoots

Data Watch - April 23

CANADA

retail sales, which were down 5.8% YoY through January, edged up 0.2% in February (vs. expectations of a 0.3% fall after a 1.8% rise in January, which followed terrible results in each month of Q4), so YoY is now -5.1%; ex-autos, they came in up 0.6%, vs. the survey's expectation of +0.2%; the February increases were price-driven, as total sales were down in volume terms (by 0.3% MoM and -3.2% YoY), so that will continue to drag on real GDP

but the real news of the day in Canada will come at 10:30 when the MPR gets released, and we'll get to see if there's any more in the works in terms of Q.E. or C.E. than what was already revealed on Tuesday (the increase in excess settlement balances to $3B and the extension of the terms of the PRAs to 6mth and 12mths)

U.S.

initial and continuing jobless claims climbed almost exactly as expected to to 640k and 6.137M, respectively

RPX house price index will be released at 9

existing home sales retreated more than expected in March to 4.57M (from 4.71 in February, but still up from the January low of 4.49); single-family homes were down 2.8%, while multi-family units were down 4.1%; the declines were broad-based regionally; sales are down 7.1% from a year ago and 37% from the peak level; the months' supply of unsold homes increased slightly to 9.8


INTERNATIONAL

April European PMIs still in contractionary territory, but improving; French Manufacturing up to 40 from 36.5, Services up to 46.2 from 43.6; Germany's showed same trends, but at lower levels of 35 (up from 32.4) and 43.5 (from 42.3), respectively; for total Eurozone, Manufacturing was up to 36.7 from 33.9, while Services was up to 43.1 from 40.9

European industrial new orders in February also did better than expected at a MoM level (down just 0.6%, with January's result revised to a better than previously estimated -2%), but the YoY rate deteriorated nonetheless, now down 34.5% vs. 34.3% last month

Worthwhile Reading - Earth Day (April 22)

The Financial Crisis: An inside view. Phillip Swagel, former Assistant Secretary for Economic Policy in the Treasury (until January 20, 2009).

Vast majorities. Paul Krugman.

Why the green shoots of recovery could yet wither. Martin Wolf, FT.

and for those who don't have time to read the full IMF GFSR (linked to yesterday), here's a few notes on it from two places:
Give the IMF credit (literally and figuratively). Brad Setser, Follow the Money.

We are not even half-way through the banking crisis, IMF. Edmund Conway, Telegraph.

World Economic Outlook: Crisis and Recovery. IMF. April 2009. (chapters 3 and 4 were made available earlier, but the full report was just released today.

Seven broad lessons for the United States from Japan's lost decade. Adam Posen, Peterson Institute for International Economics.

The economic impact of increased U.S. savings. Charles Atkins and Susan Lund, McKinsey Global Institute.

Testimony before the Joint Economic Committee. Thomas Hoenig, President, Federal Reserve Bank of Kansas City.
Hoenig agrees with Stiglitz, Simon Johnson and others that too-big-to-fail firms are too big to exist; recommends process of triage, including negotiated conservatorship for nonviable firms, and constraining the political sway of financial oligarchs

Weak fundamentals suggest oil prices will remain low. Oxford Analytica, via Research Recap.

Warning: "What you don't report on your balance sheet can screw the average investor!" Reggie Middleton.

I didn't link to this on Monday b/c I figured I couldn't link to him EVERY week, but, once again, Hussman is well worth a read:
Wishful thinking. John Hussman.

The "great white-wash" of 1Q bank earnings. Meredith Whitney on Bloomberg, via YouTube.

one can only guess at how bad the stress is working at places like FNM or AIG; sadly:

Freddie Mac acting CFO David Kellermann found dead. Bloomberg.

Roubini Global Economics Forecast

from RGE:

Today we present some of the main conclusions of the recently released update to the RGE 2009 Global Economic Outlook.

The global economy is in the middle of a synchronized contraction that will push global growth into negative territory in 2009 for the first time in decades. . This will be the worst financial crisis since the Great Depression and the worst global economic downturn in decades. Global trade volumes face their sharpest contractions of the postwar era – trade is expected to contract 12% in 2009 due to the severe and prolonged global demand slump, excess capacity across supply chains and the continued crunch in trade finance.

Many analysts and commentators are pointing out that the second derivative of economic activity is turning positive (i.e. economies are still contracting but a slower rather than accelerated rate) and that green shoots of an economic recovery are blossoming. RGE Monitor’s analysis of the data suggests that the global economic contraction is still in full swing with a very severe, a deep and protracted U-shaped recession. Last year’s economic consensus forecast of a V-shaped short and shallow recession has vanished. While the rate of economic contraction is slowing compared to the free fall rates of Q4 of 2008 and Q1 of 2009, we are still a long way away from the economic bottom and from a sustained recovery of growth. In particular, in Europe and Japan there is little evidence of a positive second derivative of economic activity.

However by the end of Q1 2009, there were some signs that the pace of contraction had slowed in many economies especially in the U.S. and China, where policy responses have been more significant and leading indicators in the manufacturing sector may have bottomed before they did in Europe and Japan. However, major economies including all of the G7 will continue to contract throughout 2009, albeit at a slower pace than at the beginning of the year.

Moreover the global recovery might be sluggish at best in 2010 given the overhang of credit losses of financial institutions, lingering credit crunch, need for retrenchment by overstretched and over-indebted households in current account deficit countries and a slow resumption of demand prompted by extensive government stimulus.

Some key elements of RGE Monitor’s outlook include:

Global economic activity is expected to contract by 1.9% in 2009. Advanced economies are expected to contract 4% in 2009. Japan and the eurozone will suffer the sharpest downturns. U.S. GDP will continue to contract, albeit at a slower pace throughout 2009, with negative growth in every quarter.

Emerging markets will slow down sharply from the stellar growth rates of the past few years, with the BRIC economies growing at half their 2008 pace.

Deteriorated terms of trade, slower capital flows and tighter credit will push Latin America into recession from the 4.1% growth of 2008. Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela will all shift to negative territory on a year-over-year basis while smaller countries, like Peru, will experience a significant slowdown.

Countries in Eastern Europe and the CIS will experience some of the sharpest contractions given the withdrawal of foreign credit and the risk of a severe financial crisis. The reduction in oil revenues and financial stress will contribute to a 5% yoy contraction in Russia and some countries - especially in the Baltics – are at risk of double-digit contractions.

Export-dependent Asia's growth will slow significantly to less than 3% in 2009. China will have a hard landing with GDP growth falling to 5.5% while India will slow sharply to 4.3%. All four Asian Tigers (Singapore, Taiwan, South Korea and Hong Kong) as well as Malaysia and Thailand will experience recessions.

The Middle East and Africa will mark much slower growth, half of their 2008 pace, given the reduction in capital inflows, reduced demand from the U.S. and EU and decline in commodity prices and output. Israel and South Africa will suffer slight contractions.

The unprecedented fiscal and monetary stimulus may help alleviate the substantial contraction in private demand and reduce the risk of a global L-shaped near-depression. Debt financing may be a challenge for many countries though, especially emerging markets or the most vulnerable Western European economies.

Job losses during the current global recession might exceed those in recent recession, contributing to increases in defaults and posing additional risks to banks. The unemployment rate in developed countries will reach double-digits by 2010 (as early as mid-2009 in the U.S.) and push more people in developing countries into poverty. Moreover, despite new funding from multilateral institutions, severe contractions will raise the risk of social and political unrest.

Commodities as a class are likely to come under renewed pressure in 2009 despite some support from production cuts. RGE expects the WTI oil price to average about $40 a barrel in 2009 as demand destruction continues to outweigh crude supply destruction.

The entire RGE 2009 Global Economic Outlook is available to RGE subscribers.

Data Watch - Earth Day (April 22)

generally quiet data day

CANADA

leading indicators fell much more than the expected 0.8% in March, declining 1.3%; furthermore, February was downwardly revised to -1.3% from a 1.1% decline; money supply continued to be the lone positive contributor; however a number of components slowed their pace of negative contributions, but were overwhelmed by the new orders component which, thanks to autos, deteriorated markedly; the index is now down 5.2% YoY and 6.1% from its August peak

retail sales and MPR tomorrow

U.S.

claims and existing home sales tomorrow; not much today

INTERNATIONAL

Alistair Darling is predicting a contraction in U.K. GDP of 3.5% this year, and a resumption of growth in 2010, though of just 1.25%, followed by 3.5% growth in 2011

jobless claims in England nearly halved to 74k in March from 137k, though the ILO unemployment rate increased as expected to 6.7% from 6.5%

Japan merchandise trade exports were down 46% YoY through March, a bit better than the -49% through February, while trade imports were down 37% YoY in March vs. 43% the previous month

China wholesale prices are down 6.6% YoY

On Hold For a Year... We Promise (maybe?)

The Bank of Canada cut its rate in half today, to 0.25%, "which [it] judges to be the effective lower bound for that rate". Unlike the Fed, it did not set a range of 0-0.25; but it's not quite just a straight-up decrease of 0.25%, either. This is because the Bank did not reduce the deposit rate as it usually does when it drops its target overnight rate, so the former remains at 0.25% as well. So, as outlined in its new operating framework, the operating band has been reduced to 0.25% (i.e. from 0.25% to 0.50%) rather than 0.50% previously (yesterday it was 0.25% to 0.75%), with the target now set at the lower bound (0.25%) as opposed to the mid-point of the range (as had been the case). So, all in, this is supposed to be a rate cut of 25bps, but it might be something a bit less than 25 (given the constriction of the band and the unchanged lower bound).

What I find most interesting is not that they say it "commits to hold current policy rate until the end of the second quarter of 2010" (its making this guidance explicit "so as to influence rates at longer maturities"), but that it preceded that with "conditional on the inflation outlook". So, its a non-promise promise. In any case, the only reason they'd deviate from the promise is if inflation surprises to the upside from their current expectations.

As of January's MPR Update, the Bank of Canada expected Canadian growth to be -1.2% this year and +3.8% in 2010. They've admitted (informally) before now that the recession will be deeper than anticipated; they've now put numbers to that. Their new forecast is for -3.0% this year and +2.5% next year (i.e. a smaller rebound off an even lower base), with the start of the recovery delayed until the fourth quarter. The Bank believes we'll have to wait until the third quarter of 2011 to get back to productive capacity, even though they've revised down their estimate of potential growth.

The inflation outlook hasn't changed much, presumably due to the fact that not only has forecast growth been ratcheted down, but so has potential growth. Core inflation is still expected (as in January) to diminish all this year and return to the 2% target in Q3/2011 (instead of the more nebulous "mid-2011"). Headline is expected to trough at -0.8 in this year's third quarter (they said -1.0 in January), before also returning to target at the same time as core. Its hard to know how much these return-to-target assumptions are predicated on their 4.7% GDP growth forecast for 2011. The Bank admits that the risks to inflation remain tilted to the downside (albeit slightly).

The Bank insists that it retains "considerable flexibility in the conduct of monetary policy" despite the low level of interest rates. But we'll have to wait for Thursday's MPR to get a full outline of what that flexibility entails, in terms of quantitative and/or credit easing.

Worthwhile Reading - April 21

*** Quarterly Review and Outlook -- First Quarter 2009: Inflation/Deflation. Van Hoisington and Dr. Lacy Hunt, Hoisington Investment Management Co.

Global Financial Stability Report: Responding to the Financial Crisis and Measuring Systemic Risks. IMF.
IMF boosts global loss estimate to $4.1T ($2.7T in U.S., $1.2T in Europe, $150B in Japan) by the end of 2010

The prophets of doom. Andrew Leonard, Salon. I read 8 of these 14 "prophets" regularly --- none of those 8 are picking on the Obama administration; they (a) have simply been the realists who have seen the problems coming down the pipe, (b) had hoped the new administration would do things better then the old, and (c) have been disappointed that there hasn't been a fundamental enough shift from the old to the new administration's approach at fixing the economy, such that (d) the policies are not sufficient to deal with the problems. In any case, their Cassandra-like prophesying did not begin Jan. 20, but much longer than that. (p.s.
I find it odd that neither Joe Stiglitz nor Ken Rogoff are on the list, particularly the former).

Update: From Barry Ritholtz, one of the 14 on the list above:
"My big criticism of Obama is not his policies, but his appointments of Larry Summers and Tim Geithner. These two may end up being the Dick Cheney and Donald Rumsfeld of the Obama administration."

I think I get what Ritholtz is saying, but if Summers and Geithner are problems, its because of the policies they've been given the scope to run with, and, by giving them that authority, they've become Obama's policies too.

Data Watch - April 21

CANADA

Bank of Canada at 9 a.m.

in the Bank's FAQ page on its website, it distinguishes between quantitative easing and credit easing as follows:

What is quantitative easing?
Quantitative easing is the purchase by a central bank of financial assets through creation of central bank reserves. As a result, the price of the purchased assets (which can include government securities or private assets) rises and the yield on the assets falls. The expansion of reserves available to commercial banks also encourages them to increase the supply of credit to households and businesses. In economic terminology, quantitative easing uses 'unsterilized' funding; in other words, the reserves of the central bank are increased to finance asset purchases.

What is credit easing?
Credit easing is the targeted purchase by a central bank of private sector assets in certain credit markets which are important to the functioning of the financial system. The goal of credit easing is to reduce risk premiums and improve liquidity and trading activity in specific markets so that credit will flow and demand in the economy will expand. Credit easing can be done on a 'sterilized' basis; in other words, there is no need to increase central bank reserves in order to undertake credit easing. If undertaken on an unsterilized basis, this amounts to combining credit easing with quantitative easing.

so, clearly I was likely wrong about my guess that the Bank would be sticking to buying government bonds; it seems credit easing is in the cards


February wholesales sales fell 0.6% MoM (despite an increase in the month in auto sales), versus expectations of a 1% rise; that's the 6th decline in 7 months, though January's -4.2% was revised upwards to -3.9%; the YoY rate is now -4.4%, vs. -5.2% in January; the inventory-to-sales ratio, which was at 1.22 in July, has climbed abruptly to 1.44, highest since 1995, due to both the drop in sales and an increase in inventories

U.S.

just earnings reports (plus Geithner testifying in front of Congressional Oversight Panel)

INTERNATIONAL

German producer prices fell a worse-than-expected 0.7% in March, dragging the YoY rate into negative territory (-0.5%); energy prices dominated, although there were price declines in other areas as well

German ZEW survey, which measures institutional investors' expectations of German economic growth in the next 6 months, was upbeat, rising out of negative territory for the first time since July 2007 to 13

English March CPI came in as expected, at 0.2% MoM and 2.9% YoY, though the core surprised to the upside (1.7% YoY vs 1.5% expected); this despite the fact that the retail price index fell into negative ground for the YoY (by the by, public sector pay in the U.K. is tied to the RPI, not CPI; RPI includes housing while CPI does not)

Swedish Riksbank cut its benchmark rate, as expected, to 0.5% from 1.0%

India dropped its benchmark interest rate, the repo rate, by a quarter to 4.75% and is predicting growth of just 6% this year

Baltic Dry Index has been heading upwards again, up for 6 straight days

Where is the tipping point for the U.S.?

In Erin go broke, Paul Krugman discusses in his NYT Opinion piece Ireland's difficulties.

The recent IMF report detailed how in a recession paired with a financial crisis, monetary policy was much less potent than in normal recessions, so fiscal policy had to do the heavy lifting. But fiscal policy was only effective if the sustainability of public finances doesn't become a concern; i.e. the degree of public indebtedness reduces the effectiveness of fiscal policy (crowding out of private spending, plus higher interest rates). Due to the size of the financial sector problems in Ireland relative to GDP, that is exactly the situation the Irish face.

But, is Krugman right that the U.S. needs to be aware of this possible predicament but is not yet close to being in it? The IMF's report suggested that once debt levels exceed 60% of GDP (albeit with high uncertainty around this point estimate of the threshold), increased debt actually has a negative impact on the economy.

Let's assume that because of the special status of the U.S. as the world's reserve currency and deepest / most liquid market, it can sustain a higher debt-to-GDP level than other countries would. So 60% is probably not a relevant point estimate for the U.S. (particularly for the point when a foreign funding crisis begins, resulting in higher interest rates; however, I can't think of a reason why crowding out of private spending wouldn't happen in the U.S. at a similar level to as in other countries, and, in fact, given the impetus for private sector savings and deleveraging, I could easily believe that fiscal spending would lead to crowding out already)

U.S. public debt outstandinding is about $11T, while GDP is a little over $14T. So, on that basis, the debt-to-GDP ratio is already over 70%. However, federal debt held by the public is just $6.4T, so the ratio on that basis would be about 46%. But the market also knows the U.S. debt-to-GDP is calculated only on a cash basis, not an accrual basis, and it ignores all the unfunded liabilities that are a huge problem, particularly given the aging of the Baby Boomers. It also does not include all the promises the Feds have made to guarantee its banking system.

So, where is the threshold for the U.S. Who knows? (But the IMF's study suggests a debt-to-GDP ratio of 130% would be pretty unambiguosly negative (at a 90% confidence interval).

In America close to the tipping point, Benign Brodwicz concludes a little too definitively that if the IMF is right, the U.S. will tip into a debt-deflationary spiral. I still think that's the likely outcome (but not because U.S. public debt exceeds the IMF's point estimate). In any case, Brodwicz makes the very relevant conclusion that:

"The Democrats may have good intentions, but they’re listening to the wrong economists, Keynesians who have been out of power for too long and who now are listening to a scribbler of 70 years ago (that they read in their halcyon graduate school days), a Keynes, most of them seem not to realize, who was preaching to an America that was the largest creditor nation in the world, not the greatest debtor."


UPDATE: Andy Harless, in Ireland?, believes these fears are unfounded; one big reason why is that Ireland is in the Euro, whereas the U.S. has its own currency, so rather than spiking interest rates on government debt, the U.S. dollar would instead decline, which would help stimulate the economy (and which wouldn't be particularly inflationary in a deflationary environment).

Worthwhile Reading - April 20

Feldstein: inflation is looming. Mark Thoma, Economist's View with Feldstein's FT piece, plus his own comments.

Erin go broke. Paul Krugman, NYT.

America close to the tipping point. Benign Brodwicz, The Animal Spirits Page.

Richard Bernstein: 10 guidelines learned in 20 years. via Prieur du Plessis, Investment Postcards from Cape Town.

What's the real P/E ratio? Charlie Minter and Marty Weiner, Comstock Partners, in Barron's.

Mortgage industry changes throw new hurdles in borrowers' way. LA Times.

Will demographic trends impede recovery? Yves Smith, naked capitalism.

The Fed's cash machine. The Atlantic. includes cool interactive graphic breaking down Obama stimulus and various Fed programs.

The threat of GECC's disappearing tangible common equity value. Tyler Durden, Zero Hedge.

This is getting tiresome, so please let's declare the crisis over. Michael Pettis, China Financial Markets.
a summary of his sentiment:

it is hard to take forecasts seriously when they seem to fluctuate so directly with the most current numbers, but given the history of previous long crises – everyone of which had more than one temporary rebound, sometimes very sharp, on the way down – I would be reluctant to declare my optimism without a lot more data and a real sense that the underlying imbalances had truly been resolved. I am pretty sure this hasn’t happened yet. On the contrary, I would argue that the temporary “rebound” (which seems more to be a slowdown in the rate of contraction than a real rebound) has probably been caused by little more than policies aimed at temporarily exacerbating the imbalances.... [so] more worrying, if you believe, as I do, that the fiscal response to the crisis may temporarily slow down the pace of contraction while making the ultimate cost deeper... The paths as I see it lead either to a very deep, short-term contraction followed by a healthy and balanced recovery, or to a slow contraction that may take many years and may result in much slower productivity growth over the next decade or so – perhaps we could call it a US-style crisis versus a Japanese-style crisis. “When you come to a fork in the road, take it,” advised Yogi Berra.

Data Watch - April 20

CANADA

just international securities transactions data today

tomorrow is of course the big day, but not because wholesale sales for February will be released at 8:30 (expected to be up 1% after January's 4.2% fall)

this will be the first BoC Tuesday in a while where there was much doubt about what the Bank might do; will it cut rates from 0.50 or not? (I guess that it will set a range, like the Fed did, but at a higher level, leaving the ceiling at 0.50, and establishing a floor of something greater than 0 but no more than 0.25); what will its QE plan look like? will it buy GoCs? CMBs? CP? ABS? corporate bonds? (I guess that it will buy just GoCs and let the federal government agencies like BDB, EDC and the Finance Ministry target certain areas of the market to alleviate lending conditions); and, will it announce just what it COULD do, or will it also say that it WILL do it, or even announce that it is starting it? we should find out some, if not all, of this at 9 a.m. Tuesday; anything we don't find out then will have to wait for the MPR on Thursday at 10:30; February's retail sales will also be announced that day (expected to be down 0.3% MoM on headline but up 0.2% ex-autos after larger gains in January off of a very weak 4th quarter).

US

UPDATE:
March leading indicators, which have been on a downward trend since July 2007, were released at 10a.m.; the Conference Board LEI declined 0.3% in March, more than the forecasted decline of 0.2%, though February's result was revised to be less bad; real money supply and the slope of the yield curve contributed positively again in March, but were overwhelmed by building permits, stock prices and supplier deliveries; the coincident index declined 0.4%, led down by employment and industrial production, and the lagging index also fell 0.4%, leaving the coincident-to-lagging ratio unchanged

the Chicago Fed National Activity Index declined in March to -2.96, though the 3-mth moving average increased to -3.27 from -3.57, as December's -3.84 dropped out of the M.A., and will likely improve again next month when January's -4.03 drops out; employment made the largest negative contribution to the index yet again, though production and income also made a large negative contribution; about the same number of indicators improved from February to March as worsened; just 13 of the 85 indicators provided positive contributions, while 72 made negative

its mostly a back-end loaded week; jobless claims, as usual, on Thursday; existing home sales that day as well, with durable goods orders and new home sales to be released on Friday

INTERNATIONAL

the Japanese leading index for February was finalized at 75.0, a tick lower than expected, and the lowest its been since 1983; the coincident index is at 86, not yet as low as it was in '93 (80), '98 (84) or '01 (also 84)

not much else to report out there (unless anyone cares that Pakistan surprisingly dropped its benchmark interest rate from 15% to 14%)

Worthwhile Reading - April 19

The eternal optimism of opening day. Barry Ritholtz, The Big Picture.

The trend may not be your friend. John Mauldin, Thoughts from the Frontline.

Fitch says corporate debt market will not recover until 2011. Research Recap.

Emerging markets could trigger global currency devaluations. Oxford Analytica, via Research Recap.

The Japanese economic lesson: demographics matter, a lot. Mark Sunshine, First Capital.

Generation debt is in for a rough ride. Leah McLaren, Globe and Mail.

Mugabe abandons worthless currency. Canberra Times.
damn, I think I.M. overpaid for the Christmas gifts he got us!

not allowed to talk, but at least I can blog:
Dilbert. Scott Adams.

Worthwhile Reading - April 18

Citi: net credit losses rising rapidly. Calculated Risk.

Citigroup posts Potemkin profits. Yves Smith, naked capitalism.

a month old, but worthwhile:

Absolute confidence? Andy Harless, Employment, Interest and Money.

Are credit markets reopening? Floyd Norris, NYT, via Barry Ritholtz, The Big Picture.

Fed shrouding $2 trillion in bank loans in secrecy, suit says. Bloomberg.




Understatement of the day. Dani Rodrik's website.

1st and 2nd derivatives

This is a work in progress. I need to flesh this out some more, particularly with harder data on some of these points, and by adding more Canadian and international data as opposed to primarily U.S., and also need to juggle some points around (maybe new categories, like Terrible, but not worsening). But as a start at trying to identify which "green shoots" are really green and which are just not dying as fast:

Declining / Deteriorating
Industrial production --- down 13.3% since Dec. 2007
Capacity utilization --- under 70% (growing slack à no reason for capex)
Headline CPI --- down 0.4% YoY
Retail sales --- down 10.7% YoY, 11.6% real
Construction spending --- residential down 59% from peak; non-res down 9%
International trade
Foreclosures
Mortgage delinquencies --- OCC: under 90% of mortgages performing
House prices --- C-S down 30% from peak
Vacancies – personal --- houses; apartments 7.2%
Vacancies – commercial --- offices 15.2% (from 12.5%); malls 9.5% (from 7.7%)
Rents --- office rents in SF -24% YoY, Manhattan -6%
Initial Jobless Claims --- 4wk-M.A. 650+k
Continuing Jobless Claims --- 6+ mil
Payrolls --- -3.7% YoY; 5mil jobs lost (SA), 7mil (NSA) since peak
Unemployment --- U-3 8.5%; U-6 15.6% (both SA; 9.0% and 16.2% NSA)
Hours worked --- avg. wkly hrs 33.2; aggregate hrs worked index down 7% YoY
Credit card charge-offs
Bankruptcies
Mortgage Equity W/Ds
Federal tax receipts --- down 28% YoY (individuals down 27%, corporate -90%)

State and local tax receipts
Hotel occupancy rates --- 56% occupancy, down 10% from year ago
Vehicle miles driven --- down 3.6% YoY (biggest drop ever)
Leading economic indicators
NFIB small business optimism index

Commercial real estate
Credit writedowns / loan losses --- IMF forecasts up to $4T; Mayo, Whitney, Roubini

Declining / Deteriorating, but not as fast
Core CPI --- up 1.8% YoY
Home builders index --- still very low, but not at record low
Housing starts and building permits

ISM

Regional manufacturing surveys

L.A. port traffic
Baltic Dry index
VIX
Auto sales
New home sales
Existing home sales
Credit availability
Architecture billings index --- still very low, but not at record low
Restaurant performance index --- still very low, but not at record low

Not Declining / Deteriorating
Inflation expectations
TED spread
Corporate credit spreads
Pending home sales
Consumer confidence
Housing inventories

Improving Significantly
China lending and money supply
China auto sales
Mortgage rates

Stumbling blocks for central banks

A post at Worthwhile Canadian Initiative, Say's Law, Walras' Law and monetary policy, by Nick Rowe got me thinking more about reasons, other than just the liquidity trap, that central banks are (potentially) being stymied. Rowe's post is rather long, but the beginning and the end are worth a read --- and, unfortunately, the middle might be necessary to get the gist of his conclusion.

But, in any case, I'll try to summarize my takeaways from his thought experiments.


Basically, there are four sectors in the economy: the financial sector (banks), the corporate sector (businesses), the individual sector (households) and the government sector (which we'll ignore for now, although we know how it is behaving in order to try to fill in some of the gap from declining activity in the other sectors, though it seems unlikely that the marginal increase in government activity (so far) is sufficient to offset the marginal decrease in private sector activity).

The banks are principally in the business of (selling) offering loans to two of the other sectors: businesses and households (they really intermediate between the various parties in those sectors, receiving funds in from them, typically of shorter duration (deposits), and then lending it back out, typically of longer duration; of course, there's some leverage involved due to the fractional reserve system). The main point is banks have already offered too many loans, in the sense that many of those are at risk of not being paid back as expected, and, as such, the banking sector is not, for rational profit-seeking reasons, inclined to offer nearly as many new loans as had been the norm.

Non-financial corporations, meanwhile, in the business of selling goods, have an excess supply of those goods (both in terms of excessive inventories and excess capacity). Because the goods they sell are sold not in barter but for cash, an excess supply of goods implies an excess demand for cash.

Similarly, households have an excess supply of labour; they have more labour that they'd like to sell/offer to the business sector than the business sector is demanding or has need for. As such, individuals' excess supply of labour also implies an excess demand for money.

The central banks have recognized these issues. First, they pursued their conventional policy measure of dropping interest rates. This is normally done to spur increased lending (and to motivate private players to reduce their demand for cash, given that they can now receive less of a return on that cash) and thus spur economic activity. However, the central banks' goal of spurring lending has faced the constraint posed by what the banks are doing (or not doing). (They've also faced the constraint that households are starting to save to pay down debt; in this case, for households, lower rates have offsetting effects, as the lower rates hurt savers who earn less interest income, but helps debtors by lowering their interest burdens; nonetheless, lower rates don't satisfy the central banks' goal).

So the central banks recognize an excess demand for money in the private sector, and they endeavour to increase the supply of money. Except there's a problem with the mechanism which the central banks use to get more money into the system. They do that by buying bills and bonds from the public sector in exchange for the central banks' (electronic) cash (i.e. Q.E. or printing money).

Two problems: First, if, due to low rates, there's a liquidity trap, cash and bills are effectively inter-changeable; so printing money by taking bills out of the private sector's hands accomplishes nothing (exchanging an apple for an apple is no exchange at all). Second, even though bonds are not interchangeable with cash (there is a meaningful difference on the rates of return earned by each) (apple for canteloupe?), the bonds are being taken out of the wrong part of the private sector, i.e. the cash is being infused into the wrong part of the private sector. As Rowe says:
Just because one market is satiated with money does not mean that the economy as a whole is satiated with money. In a monetary exchange economy, there are as many different excess demands for money as there are goods (excluding money). If central banks "run out of ammunition" in one market, they can just switch to one of the other N-1 markets. And the market for very short term and very safe and very liquid bonds is a very peculiar market for central banks to be operating in anyway, just because they are so close to money.

Its the financial system that is the beneficiary of this money creation. But so long as the banking system continues to face the same constraints first mentioned (they have too many loans already on their books, and some portion of them are going bad; also, due to declining asset values and net worth and increasing unemployment, there's a decreasing number of creditworthy customers, particularly those who are in the market to increase their debt), there is no profit motive for them to do what the central bank hopes they'll do; sitting on idle cash is better than putting more loans (there are always new loans, but we're referring to net new loans) at risk of negative returns.

So the printing of money, like dropping interest rates, has no impact on either the corporate sector nor on the household sector, at least not until the problems in the financial sector are dealt with. And clearly that requires not just stop-gap measures such as we've seen to date (which do nothing more than stringing this crisis along and kicking the can down the road in the naive hopes that things start to get better soon and take care of themselves) but real measures to clean up the banks' balance sheets so that they are demonstrably and confidently solvent so that they are not just willing but eager to pursue their main line of business, offering loans (and not sitting idly on cash). This is where fiscal policy, as implemented in particular by Geithner and Paulson, has so far failed (and in Europe too and perhaps elsewhere, though Canada does not seem to face this issue).

Even that, however, while necessary, is not sufficient. Even healthy banks won't be willing to lend to an unhealthy private sector. So, given the limitations to monetary policy, both of the conventional and unconventional sort, fiscal policy must take precedence not just in restoring financial system stability (not the current ineffective Japanese way, but something more akin to the Swedish way), but of fully filling the private sector output gap (to stop the deterioration of the labour markets and give businesses a market for their excess goods).

[The preceding applies less to Canada, I think, than it does to many other economies, principally the U.S., but even for Canada it is at least relevant at the margin. Besides which, as exposed as Canada is as a small open economy that is reliant on exports, the normal business cycle dynamics, as opposed to financial crisis problems, are more than sufficient from global economic deterioration to overwhelm any internal positives Canada retains.]

Not worried about inflation

Despite money-printing, there are reasons not to be worried about inflation, and not just due to the growing size of the output gap. Andy Harless, an economist from Harvard now at an asset manager, says that there will be no inflationary episode... unfortunately; and I believe him.

Rapid money creation usually results in rapid inflation. That point is hardly disputable. It is indisputable that the Fed has been creating money rapidly over the past six months, and there is every indication that it intends to continue doing so in the immediate future. Will this rapid money creation result in rapid inflation?

In the immediate time frame – say over the next 12 months – the answer is clearly “no,” for two reasons. First, the Fed’s money creation is designed in part to offset money (and credit) destruction by the banking system. Second, the demand for money is unusually high, and the increase in the demand for money offsets the increase in supply, leaving the value of money approximately constant.

But both these factors are at least partly temporary. Eventually, the condition of the banking system will improve, and it will start creating more money and credit, multiplying the money already created by the Fed. And eventually, households and institutions will get more comfortable and stop wanting to hold so much of their assets in the form of money, thus reducing money demand and causing the value of money to go down (i.e., inflation). At least that’s the way the story is typically told. And the usual version of the story suggests that, in order to prevent this inflation, the Fed will have to scamper very quickly to destroy much of the money it has recently created. It is often argued that losses on assets, or market inefficiency, or political pressure, will prevent the Fed from doing so, thus making an inflationary episode likely.

I’m extremely skeptical of that argument. In particular, I’m skeptical of the premise that the Fed will ever have to scamper quickly to prevent an inflationary episode. To see why I’m so skeptical, consider what “inflation” means: inflation is an ongoing pattern of rising prices. For the moment, let’s leave aside the “ongoing pattern” issue and just say that inflation means rising prices. In a modern economy, what is the immediate cause of rising prices?

In a commodity market, of course, the immediate cause of rising prices would simply be an excess of buyers over sellers at the current price. But most goods and (especially) services (which are more important than goods today) in a modern economy do not trade in commodity markets. Rather, their prices are set by sellers. The only immediate cause of rising prices is that sellers decide to raise them.

So why would sellers decide to raise prices? It boils down to two possibilities: an increase in actual or anticipated demand, so that they can (or think they can) get away with raising prices without losing customers, or an increase in actual or anticipated costs, so that they are forced to raise prices to keep their profit margins positive. The impact of money creation on prices must operate through one of these two channels.

We saw this process operating during the 1960’s and 1970’s. Over the course of the 1960’s, the Fed began to create money more rapidly than it had in the past. Gradually, over several years during the late 1960’s, the increase in actual demand induced sellers to start raising prices more quickly than in the past. Then gradually, over the course of the 1970’s, sellers began to anticipate higher and higher levels of (nominal) demand and higher and higher levels of (nominal) costs, so they started raising prices even before the demand materialized. Under the circumstances, the only way to keep the economy growing was to create enough money to realize the anticipated level of demand, so the inflation rate remained high until Paul Volcker’s Fed finally decided to stop the economy from growing for a while.

But that whole process took a long time. The inflation rate rose from 1% (in 1964) to 10% (in 1980), but it took 16 years to do so. And it took a series of policy errors, not just a one-time failure. William Martin’s Fed (along with the Johnson administration) made errors in the late 1960’s; Arthur Burns’ Fed (along with the Nixon administration) made errors in the early 1970’s; William Miller’s Fed (along with Carter administration) made errors in the late 1970’s; and OPEC took several unprecedented moves to restrict oil production over the course of the 1970’s. And the whole process began with a huge economic boom. The unemployment rate fell from 5.7% in 1963 to 3.5% in 1969. The inflationary pressure didn’t happen overnight: boom conditions, with the unemployment rate below 4%, lasted for about four years, from 1966 through 1969.

For whatever reason – misguided economic theories, pressure from the Johnson administration, inexperience with policymaking during boom conditions, timorousness about restricting credit too much, political bias, concern about the war effort in Vietnam, or come up with your own reason – the Fed repeatedly chose to allow the boom to continue, until sellers learned to anticipate rapid growth of nominal demand. And once the Fed finally did put its foot on the brake, President Nixon took the first opportunity to replace the Fed chairman with one who promptly put his foot back on the accelerator.

The unemployment rate remained at or below 4% from December 1965 through January 1970. Most economists expect the unemployment rate to be above 9% in 2010 and to fall only slowly thereafter. We will not get a late-1960’s-style boom any time soon, certainly not in 2010, 2011, or 2012. Over the next few years, the pressure will be on workers to accept flat wages at best. If actual demand, or actual domestic costs, are going to induce rapid price increases, it is going to happen in the distant future, and one will hardly be able to blame today’s rapid money creation.

There are two ways in which high inflation could conceivably happen in the not-too-distant future, but both seem highly unlikely to me. The first is that costs of foreign products and inputs could rise so quickly that they have a large effect on the overall price level and anticipated future costs. That’s the typical “emerging market” scenario that some fear for the US.

But the US is not at all like a typical emerging market country. The US is a large country, and though it may seem otherwise at times, statistics show that the vast bulk of the value consumed in the US is produced in the US. The ratio of imports to GDP is only about 16%. If the foreign exchange value of the dollar were to fall by half, theoretically doubling the prices of foreign products (under the unrealistically pessimistic assumptions that foreign sellers fully pass on the increased cost and that Americans continue to buy the same foreign products), the resulting increase in the domestic price level would only be about 16%, and that would likely be spread over several years. That’s inflation (by some definitions) but hardly the runaway inflation that some are worried about.

In any case the foreign exchange value of the dollar is not going to fall by anywhere near half, because the consequences would be disastrous for the rest of the world’s economies. China won’t let that happen; Japan won’t let that happen; Europe won’t let that happen. Until today’s weak conditions are completely reversed and turn into a major boom, every other country or currency area will find it in their national interest to buy huge quantities of dollars, if necessary, to prevent a dollar crash. In all likelihood, the dollar will fall slowly over the next decade, imparting only a tiny amount of inflation, certainly not making the difference between a high-inflation economy and a low-inflation economy.

The other theoretical inflationary possibility is that, even if actual domestic demand rises only slowly, anticipated nominal demand will rise quickly due to the observation that the money supply has risen quickly. If so, theoretically, inflation could become a self-fulfilling prophecy.

But there’s a problem with that scenario. If sellers raise prices in the face of high anticipated demand, actual demand will come in far below their expectations, forcing them to cut prices again. In the slow recovery that is likely over the next several years, no matter what the Fed does, sellers will not be able to make large price increases stick. Eventually, presumably, the recovery will run its course and we’ll arrive at the point where demand expectations could be validated by a sufficiently loose monetary policy. But by the time we get to that point, sellers will have been kicked in the face repeatedly and are unlikely to have the courage to implement large price increases.

The Fed will have years to unwind the positions wherewith it has created money so quickly in recent months. Egged on by economists of all stripes, the Fed has stated in no uncertain terms its intention to do so. I have every confidence that it will.

But “confidence” may not be quite the right word. It’s kind of like being confident that someone’s blackjack hand is not going to go bust. You can be confident that a particular bad outcome is not going to happen, but that doesn’t mean being confident that the actual outcome will be a good one. Unless it’s feeling particularly daring, the Fed is going to stand on 12, and history shows that to be a losing strategy.

It’s what the US did in 1937, when 3% inflation was too much. It’s what Japan did in 2006, when 1% inflation was too much. The US subsequently went into the second dip of the Great Depression. Japan became part of the international downturn that we’re all experiencing today.

The next chapter of Japan’s story has yet to be written. The story of the US in the 1930’s eventually has a happy ending (at least for those who survived World War II without crippling injuries), but it’s an ending that involves a lot of inflation. With the excuse of the war, the Fed let the inflation rate rise to an average of about 6% during the early years of the war, before inflation was tamed by price controls. After wartime price controls were lifted, the inflation rate rose to around 10% for a couple of years, making the average inflation rate between 1933 and 1948 a little higher than 4%. Ultimately, the US had chosen to err on the side of too much, rather than too little, inflation – and it was that error that conclusively ended the Great Depression.