Monday, February 28, 2011

Gold Fireworks are About to Begin

The gold bull is now on the verge of launching the most spectacular up leg of this 10 year bull market. This spring we should see the final parabolic rally of the massive C-wave advance that began in April `09 with a test of the 1980 high at $860.

First off let me explain gold's 4 wave pattern (and no it has nothing to do with Elliot wave). 

Gold moves in an ABCD wave pattern, driven not only by the fundamentals of the gold market (which I will get into in a minute) but also by the emotions of gold investors and the thin nature of the precious metals market.

The A-wave is an advancing wave that begins and is driven by the extremely oversold conditions created during a D-wave decline (more on that in a second). A-waves can often test the all time highs but rarely move above them. Usually they will retrace a good chunk of a D-wave decline.

The B-wave is a corrective wave spawned by the extreme overbought conditions reached at an A-wave top.

The C-wave is where the monster gains are made. They can last up to a year or more. The current C-wave is now almost two years old. They invariably end in a massive parabolic surge as investors and traders chase a huge momentum driven rally.

Of course as we all know parabolic rallies are not sustainable. So the final C-wave rally ends up toppling over into a severe D-wave correction as the parabola collapses. This is about the time we hear the conspiracy theorists start crying manipulation. In reality all that has happened is that smart money is taking profits into a move that they know can't be sustained. 

Then the entire process begins again.

Next, let me show you the fundamental driver of the secular gold bull. It's probably no surprise to most of you that the Fed's ongoing debasement of the dollar is one of the main drivers of this bull. But let me take this one step further and show you how the dollar's three year cycle drives these major C-wave advances and how the move down into the dollar's three year cycle low always drives a final parabolic C-wave rally.

Let's begin with a long term chart of the dollar. I've marked the last 7 three year cycle lows with blue arrows. The average duration from trough to trough is about 3 years and 3 months. As you can see the dollar is now moving into the timing band for that major spike down in the next 2 to 3 months. 

The extreme left translated nature (topped in less than 18 months) of the current cycle gives high odds that the final low when it arrives will move below the last three year cycle low. That means that sometime between now and the end of May we should see the dollar fall below the March `08 low of 70.70. 

That crash down into the final three year cycle low will drive the final parabolic move up in gold's ongoing C-wave advance. Every major leg down in the dollar has driven a major leg up in gold since the bull began. I really doubt this time will be any different.

I will be watching the dollar over the next couple of months for signs that the three year cycle low has been made. Because once the dollar bottoms and begins the explosive rally that always follows a major three year cycle low it will initiate the severe D-wave correction in the gold market. Gold investors will want to exit at the top of the C-wave if at all possible and avoid getting caught in the D-wave decline.

There is a developing pattern on the gold chart that once it reaches its target will be a strong warning for traders and investors to exit so they don't get caught in the D-wave profit taking event as the parabola collapses.

This T1 pattern is a four part pattern with the first and second legs up being almost equal in magnitude, separated by a midpoint consolidation that allows the 200 day moving average to "catch up". The current T1 has a target of roughly $1650ish once gold breaks out of the consolidation zone. 

The fourth part of the pattern is the D-wave correction which should retrace to test the consolidation zone between $1300 and $1425. At that point the next A-wave will begin and we'll repeat the whole process all over again.

Let me be clear though. I have no desire to buy gold. I doubt I will ever buy another ounce of gold again. The real money will be made in silver during this final C-wave advance and in the miners (I prefer silver miners).

During the last major moves higher in the gold market, miners, which are leveraged to the price of gold, stretched 35% to 45% above the 200 day moving average. At the latest peak the HUI was only 25% above the mean - a strong clue that this was not the final C-wave top.

I expect we will see the HUI stretch 40 to 60% above the 200 DMA at the final top later this spring. But like I said, I really have no desire to buy gold or the major gold miners. The real money is going to be made in silver and silver miners.

Silver has been exhibiting exceptional strength compared to gold for 7 months now. The consolidation on the silver chart is much larger than on the gold or gold miner charts. I expect that massive consolidation to drive silver up to test the old 1980 high of $50 by the time gold puts in its final C-wave top.

The time to get on board is before gold breaks out of the consolidation. Once it does the parabolic move should be underway and your chances of a significant pullback to enter the market will decrease significantly.

I've been helping investors time the gold and silver bull for several years now. If you are the kind of person that needs a coach to keep you focused on the big picture, someone to cut through the meaningless noise of all the myriad top callers and bubble proponents, someone to show you how these long and intermediate term cycles operate so you can actually make money from the gold bull, I have an invaluable offer for you.

For those of you that need a coach and want to learn how the gold bull works, I'm going to make available, this week, a special 15 month subscription. For the regular price of one year I will add three free months to your subscription which includes the daily and weekend reports. To take advantage of this offer, click here. 

Choose a username and password and enter goldscents15 in the promotional code box, then click continue. You will be taken to a page with the 15 month offer.

Now is the time to act before the bull comes roaring out of the gates and the golden fireworks begin.

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German Economic Growth Miracle is Not Miraculous Enough for an ECB Rate Hike

The case for an interest rate increase by the ECB is building. Inflation in the euro zone is creeping up, and tensions in the Middle East are adding fuel to the ‘inflation fire’ by sending oil prices higher. The biggest worry of the ECB is that, although the inflationary effects of higher oil prices are mostly temporary, it will lead to a positive wage-price spiral in Europe’s biggest economy: Germany.

Summer of 2008

The similarities with the summer of 2008 are striking. Oil and other commodity prices were rising rapidly, unemployment in most of Europe was low and the risk of a wage-price spiral was increasing. The ECB then raised interest rates, despite the fact that most economists acknowledged that the risk of a severe worldwide slowdown was growing bigger as a result of the US credit crisis. However, the ECB has one - and one only - policy goal of an inflation level close but below 2%. 

With the benefit of hindsight, this rate increase was badly timed and unnecessary. A few months later, the ECB had to rush to lower interest rates toward an all time low for the Eurozone of 1%. 

Today, speculation that the ECB is mulling another rate increase is increasing, pushing up EUR/USD as a consequence. We at ECR, attach a less than 50% probability that the ECB will increase the policy rate in the coming quarters. Moreover, we think its highly unlikely that, if the central bank raises the interest rate once, this is necessarily the start of a series of rate increases.

The ECB must deal with the difficult task of setting one policy rate for different economies. The fast growing economies in the stronger ‘core’ countries – e.g. Germany and France - require a tighter monetary policy, whereas the weaker countries like Greece, Spain and Portugal need a much looser monetary policy to offset the negative effects of fiscal tightening.

Monetary policy ‘for the average’ more difficult

Some analysts have compared this with someone sticking his head in the oven, but his feet in the freezer. His average temperature is about right, but his physical condition is deteriorating rapidly. The fact that the economic and financial situation in the weaker Eurozone countries is deteriorating is well documented, as are the causes of this, and the structural solutions needed to increase their competitiveness in order to generate export income to service their ballooning debt service costs. 

However, we believe the prospects for the stronger core countries are also deteriorating, slowly but steadily. Consensus thinks differently and expects the positive effects of brisk German export growth to spill over to domestic consumption, igniting a new German growth engine, which will pull other Eurozone countries out of the doldrums. 

The reasons why we differ from consensus are as follows:
  1. The high German growth rate over 2010 must be seen in perspective. In 2009, Germany was one of the countries most affected by the credit crisis and consequently plunged 4.7%. A growth rate of 3.6% in 2010 is a significant improvement indeed, but the economy still ‘needs’ a 1.29% growth this year to fully recover all output lost during the credit crisis.
  2. The major part of German growth is still based on export growth. However, important export markets in Europe and China are all expected to slow down as a result of fiscal and monetary tightening respectively. It must be seen if German consumers are willing to pick up the baton by spending enough to compensate for slower growth in exports. Rising energy prices are not helpful in this regard, as they destroy consumer purchasing power and thus redirect spending towards energy.
  3. Although the German growth rate will be reasonably high over the coming quarters, it will probably not be enough to pull the weaker euro zone countries along. Weak countries like Greece are facing an increasing difficult situation of negative growth, high interest rates and a pressing need to restructure government finances and gain competitiveness. All of these bring economic pain in the short term, lowering growth and tax revenues, increasing government deficits and frustrating efforts to bring down interest rates. These countries need substantial fiscal transfers from the stronger countries to sufficiently improve their solvency. Current programs as the EFSF are mainly designed to solve liquidity problems. However, the stronger countries are fiercely opposed to give ‘unlimited and unconditional’ financial assistance and are only willing to give liquidity assistance against interest rates, which are too high compared to their potential growth rates for the coming years. Ultimately, no one gains from this policy. Weaker countries will become weaker, limiting their ability to repay their loans in full to the stronger countries.  
Policy rate increase will aggravate Eurozone problems

To raise interest rates against this background appears suicidal for the Eurozone. First, already problematic debt service costs in the weaker countries will increase further. Furthermore, a tighter ECB policy reduces the supply of money. When money becomes relatively scarcer, the price of money – e.g. interest rates – are pushed upwards. As a result, banks - especially those in the weaker countries - will find it increasingly difficult (if not impossible) to attract sufficient liquidity against affordable rates.  

Second, a rate increase will not directly negate the inflationary force. The Fed’s monetary policy and growth in China are as important, if not more important, for commodity prices, as is the ECB’s monetary policy.
Third, there is no evidence yet that probably the ECB’s biggest concern and the most important reason to consider a rate increase are materializing, namely: that higher commodity prices are feeding into higher wages in Germany. On the other hand, deflationary forces are building in the weaker economies. Current inflation rates in these countries are surprisingly high, but that is mostly the result of higher VAT and commodity prices. However, these are initial effects; the secondary effects are deflationary, as higher VAT and commodity prices extract purchasing power of consumers, leaving them with less income to spend on other goods. 

As a consequence, it is doubtful whether the ECB will increase its policy rate in the near future. If the ECB indeed will not change its policy rate, the upward pressure on EUR/USD will likely be reversed. There are of course other factors at play, which could contribute to more downside pressure on EUR/USD. For example, speculation on a less loose monetary policy by the Fed (i.e. no QE III) and declining differentials between US en Eurozone interest rates. 

In case the ECB decides to raise the interest rate, in order to limit the risk of a positive wage-price spiral, then its very unlikely that it would be the start of a series of rate hikes. It will merely result in lower growth expectations once the rate hike impacts the weak countries. Then it is very likely that the summer of 2008 will be repeated, when the rate hike of the ECB just preceded a fall in economic activity.

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European Sovereign Debt Crisis Wake Up Call for US?

The American fiscal condition faces a perfect storm. The outlook for the medium term has deteriorated markedly. Some important causes are the Big Recession and the extension of the Bush tax cuts. Nor are the projections cheerful in the long term. In the coming period these issues will come to a head. 

Two essential dates on the US political-financial agenda are approaching fast. On March 4, the spending authority that has kept the US going in the past budgetary period is set to expire. Last year, Congress did not pass a budget, and a special measure was put in place to legally underpin public spending in the absence of an official budget. This “stop-gap” bill needs to be replaced. Otherwise federal government cannot continue to spend during the remaining seven months of the fiscal year 2011.

The other looming deadline is the day the US hits its debt ceiling. By law, the US budget deficit should not exceed $14.3 trillion. It will likely reach this maximum at the end of May. To raise the ceiling would require Act of Congress.

Democrats and Republicans have climbed the barricades in preparation for the fight about these financial hot potatoes. Actually, the term “barricades” may well be misplaced. More likely, both Democrats and Republicans will dig themselves deeper into the trenches and only raise their heads above the parapet if the other party makes a significant move. Obama’s 2012 budget proposal is no more than a long wish list that offers few real solutions to the US debt problem. Its main aim seems to be to draw out the Republicans. The Democrats may be trying to divide the Republican Party (GOP) by playing off the right wing (which includes the Tea Party politicians) against the moderate conservatives in hopes of forcing the GOP to come up with iron-fisted measures that would allow the Democrats to paint the Republicans as cold-blooded and cruel. 

A likely scenario is that far-reaching reforms will be deferred until after the presidential elections in November 2012. The political climate in Washington has become so poisonous and partisan that both parties fear a catastrophic outcome of the presidential election if they fall foul of the electorate. Recent opinion polls are partly responsible for this angst. A large majority of respondents expressed the wish that deficits should be curtailed whilst simultaneously rejecting cuts in specific programs. 

However, the parties cannot continue to stick their heads in the sand from now up to November 2012. If the federal government is to function during the rest of the fiscal year Congress needs to pass a budget resolution and raise the debt ceiling. That government will temporary grind to a halt is not unheard of – it happened twice in the mid-1990s. Yet it would be a mistake to assume that the Republicans won’t think twice about switching off the lights in the government buildings in the belief that the people will automatically blame the party occupying the White House. In 1995, the Democrats were also in power yet voters largely held the Republicans responsible for the government shutdown. 

The parties may remove the obstacles that could stop the federal government from operating in the short term. However, we doubt if they will tackle the essential issues. Lawmakers are shouting at the top of their voices that the US should pursue a sustainable fiscal policy but there are five extremely costly achievements of the (welfare) state that no politician would dare touch. We’re talking about the military, Medicare, Medicaid, rebates and other tax breaks plus, albeit to a lesser degree, Social Security.  

Perhaps the two parties will finally muster the courage to reform those spending areas and safeguard the sustainability of the US welfare state after the presidential elections. Yet if the Democrats and Republicans fail to strike a Grand Bargain the markets will be merciless. The US will end up in a vicious circle of mounting indebtedness, soaring interest rates, increasing interest payments, even more debt, and so on. Until the start of 2013 the markets may still show patience towards the US but once it turns out that no major progress is made after the 2012 elections, they will rise up in arms.

In the end, both politicians and the general public will need to recognize that the welfare state is not sustainable in its present form. Not least because the population is aging, while untenable promises have been made and money has been squandered in the past. 

Most right-minded persons must agree that the western model of the democratic-capitalist welfare state is coming apart at the seams. However, it seems that nobody is prepared to make great sacrifices to imbue a slenderized version of the welfare state with new life and ensure that the perspectives of the younger generations are not all gloom and doom. If the markets spring to action, they will demand hard choices. By then it will no longer be possible to implement gradual reform that is spread evenly among people over a lengthy period of time. Discontent and uncertainty will prevail while populism could become even more entrenched. This will make it harder to effect the necessary changes.

This negative scenario is not a given. Americans could acknowledge that the course the US has set for itself will irrevocably lead to the abyss and beyond. Ironically, Europe could help the Americans become aware of this. Especially if other weak euro countries are forced to go cap in hand to the stronger EMU states. The eurozone is shaking to its foundations, Europe’s population will age sooner, and its national debts are a heavy burden. Some countries are already weighed down with almost unbearably high interest charges. Yes, one could learn a lot from the bad example that Europe is setting. If the Americans take heed, there may still be time to avert disaster.

Timing the China Property Crash

Inquiring minds are investigating Analysis of the Chinese Property Bubble by Huw McKay, Senior International Economist, for Westpac Bank. 

The strength in China’s January trade data was absolutely remarkable. Going back to 2000, the level of unadjusted exports or imports in a January month has never exceeded the level in the immediately prior December: until now. There are deep-seated seasonal reasons why this just shouldn’t happen - and history had never offered an exception to the rule. So, clearly, seasonally adjusted month-on-month growth was huge - around 12% for exports and 16% for imports. Iron ore import volumes were a monthly record by almost 7%. 
Sure, global manufacturing had a strong end to the year and business surveys had a respectable January, but this sort of implied demand is bordering on ridiculous. While three consecutive months of triple digit growth in imports to the special economic zones through Q4 argue the export numbers should not be a total surprise (at least on the supply side, never mind who the customers are), we remain astonished by the import surge.

Yes, commodity prices rose and some public and private discretionary inventory building ahead of the lunar new year was likely underway, but neither factor goes all that far in explaining the level of apparent demand. Getting away from levels and getting back to growth, at 51%yr imports are as strong as they were in the first half of 2004, when the authorities saw fit to clamp down on out of control heavy industrial investment, overall fixed investment began the year up 53% and 24 of 31 provinces experienced power shortages as an overloaded grid strained under the pressure. Is that a good description of the current climate? No, not really, but to say that the economy has good momentum opening the year would be an egregious understatement.

So, the Chinese economy is expanding at a rapid pace – for now. However, the imbalances that have emerged in the policy induced recovery phase have not disappeared. In fact, they have been inflamed. When real estate policy began to be tightened in the first half of 2010, the volume of sales moved broadly sideways (with regional variation), but the volume of new starts continued to rise .

The implications of this are many. One, bringing these projects to completion will generate very significant demand for raw and intermediate materials. This should keep commodity markets well supported in coming months - even if a pull-back from extraordinary January import levels must be assumed, and the fact that base metals prices are extremely elevated already. But the stronger implication is that once these starts do reach completion it seems extremely unlikely that the level of sales will be high enough to comfortably absorb the new supply. That implies that the developer industry will run into some trouble later this year and into early 2012 – and that will impact on activity levels in the construction sector, with predictable flow-on effects for upstream industries inside China and out.

Estimating a precise lead time between starts and completions is not easy. The private construction cycle is young enough that it has yet to establish firm “rules of thumb” for forecasters to adopt. Chinese housing ownership reforms date back to just 1998 and the explosion in private sector housing activity dates to only 2003. We have a single national downturn to ponder (late 2008) in addition to the Shanghai experiment of 2004/05. While the cycle does appear to be settling into more of an established groove, we are not at a point where we can be confident about the leads and lags. Our best efforts suggest that a lead period of between 1½ and 2 years is a reasonable if imprecise guide. As the surge in starts dates back to the middle of 2009, the first “cluster” of completions should be hitting the market in physical form later this year, and in “off-theplan” form somewhat earlier. But the post-April rise in starts is a story for early-mid 2012. Where will sales demand be at this time against a backdrop of monetary tightening? Not high enough.

It should be emphasized that we are talking about new supply coming to market. Secondary stock is to be added to the amount of housing available for sale. When the volume of sales fell below completions in late 2008 (Chart 2) developers were forced to discount aggressively to offload their properties. In the absence of a supportive policy shift as part of the second stimulus package, realised prices could have fallen by 20-30%, essentially consuming the entire margin rumoured to be enjoyed by the luxury development sector. The policy response should events play out as expected is a vitally important question. On the one hand, history argues that the “Wen put” (an analogue of the legendary “Greenspan put”) will again be exercised, thereby sparking another wave of subsidised housing speculation and downstream demand for the heavy industrial sector. On the other, the administration’s oft-stated and pragmatic desire to tackle housing affordability concerns, and their desire to ignite the latent consumption impulse, might argue for a very public sacrifice of the developers. Taken together with the current focus on inflationary risks – both immediate and medium term – and a disinflationary trend emanating from residential real estate doesn’t appear to be wildly inconsistent with the broader aims of policy. Whatever balance the policymakers strike, the implications will resonate far afield.
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ISO cuts sugar hopes - but cautions on prices


The International Sugar Organization cut to less than 200,000 tonnes its forecast for the world sugar surplus in 2010-11 – but cautioned against this supporting expectations of a further leg up in prices.
The intergovernmental group said that world sugar output would, at 167.8m tonnes, set a record during the season by a lower margin than had been thought, after "cold weather and heavy sleet" last month reduced China's output potential, while last summer's drought had hurt Ukraine's beet crop more than had been expected.
The ISO downgraded its estimate for output in Australia, the third largest exporter, by 700,000 tonnes, citing rainy weather which left significant quantities of cane uncut even before the arrival of Cyclone Yasi, which destroyed an estimated 25% of the north Queensland crop.
However, consumption was proving marginally more buoyant than had been expected, supported largely by growth in India's use which, at 31.4m tonnes, would account for just under 20% of world demand.
Although the world was on course for its first sugar production surplus in three seasons, the excess would, at 196,000 tonnes, come in way below the 1.29m tonnes forecast in November.
"No rebuilding of stocks is foreseen for the current season," the ISO said.
Trade dynamics 
The small size of the surplus had increased the potential for low stocks to influence prices, which earlier this month hit their highest for 30 years.
Indeed, the ISO, which had already estimated sugar's stocks-to-use ratio falling to a 20-year low, trimmed its estimate further, to 35.0%. The stocks-to-use ratio is a key measure of the availability of a crop's supply, and therefore of its pricing potential.
However, examination of trade flows raised doubts over whether this extra squeeze in sugar output would instil a further rally in prices, with export availability still expected to exceed import demand, if by less than 190,000 tonnes..
"It has to be stressed that, despite the downward revision introduced for world production, export availability still covers projected import demand," the ISO said.
"The absence of a physical trade deficit may act to cap prices for the rest of 2010-11 season."
Brazil question 
Prices may, nonetheless, prove volatile for now, until around June, when more is known about Brazil's 2011-12 crop.
Currently, Brazil's sugar output, which is expected to have grown by 15.4% in the year to the end of April, is expected to show a "further increase" in 2011-12.
Furthermore, speculators' interest in sugar futures "is expected to continue providing support for world prices", the ISO said, adding that the "growing strength of commodity prices in general" represented a further prop.
Managed funds added nearly 3,200 lots to their net long position in sugar in the week to last Tuesday, taking it to a historically high level of 125,000 tonnes, weekly regulatory data on Friday showed.
New York raw sugar for March stood 3.5% higher at 32.62 cents a pound on Monday, with London white sugar for May up 2.0% at $74.00 a tonne.

February Sees Gold up 6% and Silver up 19% on Inflation and Escalating Geopolitical Risk

The paper-driven sell off in the gold market seen in January has been trumped by continuing robust physical demand in January and February. This has resulted in gold rising nearly 6% in February and silver’s strong industrial and investment demand leading to a 19% rise to new nominal 30-year highs.
Gold in USD – 6-Month (Daily) and 150-Day Moving Average GoldCore
Gold in USD – 6-Month (Daily) and 150-Day Moving Average
Political, and more importantly socioeconomic, revolutions in the Middle East and North Africa are leading to a degree of geopolitical instability and risk not seen in many years. This is leading to concerns about oil supplies from the region and hence the 14% jump in US crude oil just last week and deepening inflation concerns.

Hopes that the feudal Saudi regime will contain the situation by increasing production and exporting more oil are misplaced as the Saudis are already producing oil at maximum capacity and indeed are likely to have been overstating their oil reserves for some years, possibly considerably.
Ireland Government Bonds 10-Year – 1 Year (Daily) GoldCore
Ireland Government Bonds 10-Year – 1 Year (Daily)
With all eyes on the Middle East and North Africa, there has been less focus on the continuing European sovereign debt crisis. However, the crisis continues and recent days and weeks have seen government bonds in Greece and Ireland again come under pressure.

The yield on Greek bonds (10-year) have risen to over 11.6% in recent days and the yield on Ireland’s 10-year reached a new record high of 9.40% this morning after the Irish electorate “liquidated” the Fianna Fail/Green government over the weekend. While the new government is likely to be a centrist Fine Gael and Labour one, there has been a swing to the left with Sinn Fein, the Workers Party and many left leaning independents elected.

The majority of Irish people are seeking that the massive debts of the Irish and European banking systems, incurred against them, be restructured or defaulted. Therefore, the new government will be under pressure to negotiate a fairer, more equitable settlement with the European Commission and the ECB with possible ramifications for the many European banks who lent irresponsibly to Irish banks.
US Dollar Index – 10-Year (Weekly) GoldCore
US Dollar Index – 10-Year (Weekly)
Political and economic instability in Europe is set to continue and while the Irish used the ballot box, citizens in some EU countries may not be as peaceful or passive. While the euro has bounced against the beleaguered US dollar recently (the dollar looks very vulnerable to breaking down technically (see chart above), gold above EUR 1,000/oz (€1,020/oz this morning) is a sign that the euro’s troubles are far from over and further euro weakness in the coming months will see gold rise above the EUR 1,072/oz high seen at the end of 2010 (December 28th).

The move by the popular Egyptian Front for Reclaiming the People’s Wealth to ban the export of gold in order to preserve the wealth of the impoverished Egyptian people is a prudent one. The move may be emulated in other countries in the coming months leading to a further decline in scrap supply from emerging markets.

Conversely, mooted proposals by the Vietnamese Central Bank to ban “gold bullion trading” (see news below) are somewhat bizarre. If true this would be a very important development as the Vietnamese are some of the largest buyers of gold bullion in the world. It is unclear whether the proposed ban is simply to prevent “trading” or speculative short term buying and selling, or actually a move to ban the buying of gold bullion ingots and jewellery by Vietnamese households. If it is the latter, it will be unworkable as buying will simply move to the black market or Vietnamese will buy from overseas from bullion dealers.

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Trade Solutions That Won’t Work

Americans in recent decades have not, of course, been entirely unaware that America has a trade problem. This has drawn into public debate a long list of proposed solutions. Unfortunately, many will not work, some are based on analytical confusions, and a few are outright nonsense. If we are to understand the true scope of our problem and frame solutions that will work, these false hopes must be debunked forthwith.

For example, since the early 1990s it has been repeatedly suggested that the U.S. is on the verge of an export boom that will erase our trade deficit and produce a surge of high-paying jobs. Bill Clinton was fond of this idea, and Barack Obama proposed in 2010 that America double its exports in five years.

The possibility looks tantalizing when we observe that America’s exports have indeed been growing rapidly—just not as rapidly as our imports. (Between 1992 and 2008, our exports more than doubled, from $806 billion to $1,827 billion.) This seems to imply that we are not uncompetitive in world markets after all, and that if only our export growth would climb just a few points higher, the whole problem would go away.

Unfortunately, our deficit is now so large that our exports would have to outgrow our imports by two percent a year for over a decade just to eliminate the deficit—let alone run the surplus we need to start digging ourselves out from under our now-massive foreign debt. This doesn’t sound like much, but it is, in fact, a very strong export performance for a developed country, and unlikely in the present international economic environment, where every other nation is also trying to expand its exports.

Much of our recent export growth has been hollow anyway, consisting largely in raw materials and intermediate goods destined to be manufactured into articles imported back into the U.S. For example, our gross (i.e., not net of imports) exports to Mexico have been booming, to feed the maquiladora plants of American companies along the border. But this is obviously a losing race, as the value of a product’s inputs can never exceed the value of a finished product sold at a profit.

Not only is America’s trade deficit the world’s largest, but our ratio between imports and exports (1.28 to 1 in 2010) is one of the world’s most unbalanced. Given that our imports are now 17 percent of GDP and our entire manufacturing sector only 11.5 percent, we could quite literally export our entire manufacturing output and still not balance our trade. Import-driven deindustrialization has so badly warped the structure of our economy that we no longer have the productive capacity to balance our trade by exporting more goods, even if foreign nations wanted and allowed this (which they don’t, anyway). Therefore, the solution will have to come from import contraction one way or another.

Exporting services won’t balance our trade either, as our surplus in services isn’t remotely big enough, compared to our deficit in goods (in 2010, $148 billion vs. $652 billion).

Neither will agricultural exports balance our trade (a prima facie bizarre idea for a developed nation). Our 2010 surplus in agriculture was only $28 billion—about one eighteenth the size of our overall deficit. 2010 was also an exceptionally good year for agricultural exports; our average annual agricultural surplus from 2000 to 2010 was a mere $15 billion.

It is sometimes suggested that to solve our trade mess, America merely needs to regain export competitiveness through productivity growth. Comforting statistics, showing our productivity still comfortably above the nations we compete with, are often paraded in support of this idea. Unfortunately, those figures on the productivity of Chinese, Mexican, and Indian workers concern average productivity in these nations. They do not concern productivity in their export industries, the only industries which compete with our own. These nations are held to low overall productivity by the fact that hundreds of millions of their workers are still peasant farmers. But American electronics workers compete with Chinese electronics workers, not Chinese peasants.

It is narrowly true that if foreign productivity is as low as foreign wages—an easy claim to make with aggressively free-market theory and cherry-picked statistics—then low foreign wages won’t threaten American workers. But a problem emerges when low foreign wages are not balanced by low productivity. It is the combination of Third World wages with First World productivity, thanks largely to the ability of multinational corporations to spread their technology around, that has considerably weakened the traditional correlation of low wages with low productivity. For ex-ample, it takes an average of 3.3 man-hours to produce a ton of steel in the U.S. and 11.8 man-hours in China—a ratio of nearly four to one. But the wage gap between the U.S. and China is considerably more than that.

In any case, productivity is not in itself a guarantee of high wages. U.S. manufacturing productivity actually doubled in the two decades from 1987 to 2008, but inflation-adjusted manufacturing wages rose only 11 percent. From roughly 1947 to 1973, productivity and wage growth were fairly closely coupled in the U.S., but since then, American workers have been running ever faster simply to stay in place. Wage-productivity decoupling has been even starker in some foreign countries: in Mexico, for example, productivity rose 40 percent from 1980 to 1994, but following the peso devaluation of 1994, real wages were down 40 percent.

As I've been saying for a while now, a tariff is the real solution.

Gold Dome Break Out Held at Resistance, Stocks Bearish Pattern

Gold broke out above its Dome boundary last week, which was not what we were expecting. Fundamentally this action was due to fears relating to the worsening situation in Libya, and while this breakout is a bullish development, it has not as yet led to a breakout to new highs, and the bearish overall behaviour of PM stocks last week means that it could have been a fakeout.

On the 8-month chart for gold we can see the breakout, which, while not exactly breathtakingly robust, has improved the technical picture, especially as it has resulted in the 50-day moving average starting to turn up. On this chart it is clear that upon breaking out gold was immediately held in check by the strong resistance approaching the highs, which until now at least, has prevented further progress. This resistance level is of major importance and we can therefore presume that a breakout above it will lead to a strong advance. One scenario here that would be likely to precede a breakout to new highs is a reaction back to test what is now support at the upper Dome boundary currently at about $1380.

The 2-year chart for gold continues to look positive, but because of the growing importance of the strong resistance approaching the highs, those looking to go long or add to positions should wait for a clear breakout above $1430 before doing so, or otherwise wait for a favorable setup following a reaction. On the downside this chart makes clear the importance of the support at and above $1300 - for if this level should fail it would mean that gold would have to break below its supporting long-term trendline, the support level at the January low and the 200-day moving average. For these reasons a closing break below $1300 would be regarded as a negative development.

A worrying background influence for gold and silver bulls is the continuing marked weakness in the PM stock index charts. They barely made any progress at all last week on gold's breakout and silver's continued rally, and bearish price/volume action continued. On the 8-month chart for the Market Vectors Gold Miners Index we can see that the bearish "shooting star" candlestick that we observed in the last update has been followed by a pair of "bearish engulfing patterns" both of which were characterized by higher volume on the down days, and the continuing abysmally weak volume pattern has resulted in a sick looking On-balance Volume line - it would thus appear that astute traders have been dumping onto this rally. As pointed out before there is thus the danger that the latest rally in the PM stock indices constitutes the Right Shoulder of a Head-and-Shoulders top. This is definitely not what the doctor ordered and the contradiction between the seemingly bullish gold chart and the frail looking PM stock index charts is stark and something we would be unwise to ignore. The large stock XAU index looks horribly weak and like it is now completing a bearmarket rally, also the potential Right Shoulder of a Head-and-Shoulders top. This is the reason that we dumped some of our PM stocks for a good profit over the past week or two as they rose to hit resistance. 

Fundamentally of course much depends on whether the "Mexican Wave" of revolutions in the arab world continues and engulfs big important countries like Saudi Arabia and Iran. Oil prices spiked last week on fears of a worst case scenario, but the fact that the Rydex Funds, who perform very well as a contrary indicator, have ramped up their holdings in the energy sector close to the levels they were at just before the 2008 crash, and that Large Spec long positions in oil as revealed by the latest COT charts have risen to what is believed to be record levels, suggests that if the "revolutions crisis" in the arab world starts to ease, the oil sector could go down like the Hindenburg. In this situation gold and silver could also suffer from an easing of the fear factor which is largely what generated last week's gains. 

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Prospects for the Economy and Monetary Policy

By Guest Author

William C. Dudley, President and Chief Executive Officer
Remarks at New York University’s Stern School of Business, New York City

It is a pleasure to have the opportunity to speak here today. My remarks will focus primarily on two areas. First, what is the outlook for economic activity, employment and inflation? In particular, what are the areas of vulnerability that we should be most concerned about? Second, what does the outlook imply for monetary policy? As always, what I will say reflects my own views and opinions, not necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve System.

In my talk, I’ll argue that the economic outlook has improved considerably. Despite this, we are still very far away from achieving our dual mandate of maximum sustainable employment and price stability. Faster progress toward these objectives would be very welcome and need not require an early change in the stance of monetary policy.

However, I’ll also focus on some issues with respect to inflation that will merit careful monitoring. In particular, we need to keep a close watch on how households and businesses respond to commodity price pressures. The key issue here is whether the rise in commodity prices will unduly push up inflation expectations.

Inflation expectations are well-anchored today and we intend to keep it that way. A sustained rise in medium-term inflation expectations would represent a threat to our price stability mandate and would not be tolerated.

Turning first to the economic outlook, the situation looks considerably brighter than six months ago. On the activity side, a wide range of indicators show a broadening and strengthening of demand and production. For example, on the demand side, real personal consumption expenditures rose at a 4.1 percent annual rate during the fourth quarter. This compares with only a 2.2 percent annual rate during the first three quarters of 2010
(Chart 1). Orders and production are following suit. For example, the Institute of Supply Management index of new orders for manufacturers climbed to 67.8 in January, the highest level since January of 2004 (Chart 2).

The revival in activity, in turn, has been accompanied by improving consumer and business confidence. For example, the University of Michigan consumer sentiment index rose to 77.5 in February, up from 68.9 six months earlier (Chart 3).

Indeed, the 2.8 percent annualized growth rate of real gross domestic product (GDP) in the fourth quarter may understate the economy’s forward momentum. That is because real GDP growth in the quarter was held back by a sharp slowing in the pace of inventory accumulation. The revival in demand, production and confidence strongly suggests that we may be much closer to establishing a virtuous circle in which rising demand generates more rapid income and employment growth, which in turn bolsters confidence and leads to further increases in spending. The only major missing piece of the puzzle is the absence of strong payroll employment growth. We will need to see sustained strong employment growth in order to be certain that this virtuous circle has become firmly established.

With respect to the labor market, there are conflicting signals. On one hand, the unemployment rate has fallen sharply over the past two months, dropping to 9.0 percent from 9.8 percent two months earlier (Chart 4). This is the biggest two-month drop in the unemployment rate since November of 1958. On the other hand, payroll employment gains have remained very modest—rising by only 83,000 per month over the last three months (Chart 5). Such modest payroll growth is not consistent with a sustained drop in the unemployment rate.
The true story doubtless lies somewhere in between—but probably more on the side of the household survey that tracks unemployment. That is because measured payroll employment growth in January was probably temporarily depressed by unusually bad winter weather. Although some of the recent decline in unemployment is due to a drop in the number of people actively seeking work, the household survey does show a pick-up in hiring. Other labor market indicators, such as initial claims and the employment components of the ISM surveys for manufacturing and nonmanufacturing, have also shown improvement recently
(Chart 6 and Chart 7), which suggests that the weakness in payroll growth is the outlier.

Although there is uncertainty over the timing and speed of the labor market recovery, I do expect that payroll employment growth will increase considerably more rapidly in the coming months. We should welcome this. A substantial pickup is needed. Even if we were to generate growth of 300,000 jobs per month, we would still likely have considerable slack in the labor market at the end of 2012.

In monitoring employment trends, we also need to recognize that the data are likely to be quite noisy on a month-to-month basis. This is particularly the case during the winter months, when weather can play an important role. Recall, for example, the aftermath of the blizzard of 1996 in the Northeast when the February payroll employment count was originally reported as rising by 705,000 workers. It will be important not to overreact to monthly data but to focus on the underlying trend.

So why is the economy finally showing more signs of life? In my view, the improvement reflects three developments. First, household and financial institution balance sheets continue to improve. On the household side, the saving rate, which moved up sharply in 2008 and 2009, appears to have stabilized in the 5 percent to 6 percent range. Meanwhile, debt service burdens have fallen sharply to levels that prevailed during the mid-1990s. Debt service has been pushed lower by a combination of debt repayment, refinancing at lower interest rates and debt write-offs (Chart 8). Financial institutions have strengthened their balance sheets by retaining earnings and by issuing equity. For many larger institutions, a release of loan loss reserves has been important in supporting earnings. Credit availability has improved somewhat as very tight standards start to loosen (Chart 9). As a result, some measures of bank credit are beginning to expand again
(Chart 10).

Second, monetary policy and fiscal policy have provided support to the recovery. On the monetary policy side, the unusually low level of short-term interest rates and the Federal Reserve’s large-scale asset purchase programs (LSAPs) have fostered a sharp improvement in financial market conditions. Since August 2010, for example, when market participants began to anticipate that the Federal Reserve would initiate another LSAP, U.S. equity prices have risen sharply and credit spreads have narrowed (Chart 11 and Chart 12). Long-term interest rates have moved higher after initially declining, but this does not appear troublesome as it primarily reflects the brightening economic outlook.

On the fiscal side, the economy has been supported by the shift in policy toward near-term accommodation. In particular, the temporary reduction in payroll taxes is providing substantial support to real disposable income and consumption. This could have a particularly strong impact on growth during the first part of the year.

Third, growth abroad—especially among emerging market economies—has been strong and this has led to an increase in the demand for U.S.-made goods and services. Over the four quarters of 2010 real exports rose 9.2 percent (Chart 13). After a disappointing performance earlier in the year, U.S. net exports surged in the fourth quarter (Chart 14).

The firming in economic activity, in short, is due both to natural healing and past and present policy support.
In this regard, it important to emphasize that we did expect growth to strengthen. We provided additional monetary policy stimulus via the asset purchase program in order to help ensure the recovery did regain momentum. A stronger recovery with more rapid progress toward our dual mandate objectives is what we have been seeking. This is welcome and not a reason to reverse course.

We also have to be careful not to be overly optimistic about the growth outlook. The coast is not completely clear—the healing process in the aftermath of the crisis takes time and there are still several areas of vulnerability and weakness. In particular, housing activity remains unusually weak and home prices have begun to soften again in many parts of the country (Chart 15 and Chart 16). State and local government finances remain under stress, and this is likely to lead to further fiscal consolidation and job losses in this sector that will offset at least a part of the federal fiscal stimulus (Chart 17). And we cannot rule out the possibility of further shocks from abroad, whether in the form of stress in sovereign debt markets or geopolitical events. Higher oil prices act as a tax on disposable income, and the situation in the Middle East remains uncertain and dynamic. Also, we cannot ignore the risks stemming from the longer-term fiscal challenges that we face in the United States.

But in the near-term, the most immediate domestic problems may recede rather than become more prevalent. On the housing side, stronger employment growth should lead to increased household formation, which should provide more support to housing demand. And anxieties about the large overhang of unsold homes represented by the foreclosure pipeline may overstate the magnitude of the excess supply of housing. Families that have lost their homes through foreclosures are likely to seek new homes as their income permits, even though many may re-enter the housing market as renters rather than buyers. On the state and local side, a rising economy should boost sales and income tax revenue and help narrow near-term fiscal shortfalls.1

Moreover, although we do need to remain ever-watchful for signs that low interest rates could foster a buildup of financial excesses or bubbles that might pose a medium-term risk to both full employment and price stability, risk premia on U.S. financial assets do not appear unduly compressed at this juncture.

On the inflation side of the ledger, there are some signs that core inflation is now stabilizing. However, both headline and core inflation remain below levels consistent with our dual mandate objectives—which most members of the FOMC consider to be 2 percent or a bit less on the personal consumption expenditures (PCE) measure.

Recent evidence shows that the large amount of slack in the economy has contributed to disinflation over the past couple of years. This can be seen in the steady decline in core inflation between mid-2008 and the end of 2010. As shown in Chart 18, core PCE inflation in December had risen at just 0.7 percent on a year-over-year basis, down from 2.5 percent in mid-2008. Slack in our economy is still very large, and this will continue to be a factor that acts to dampen price pressures.

Nevertheless, there are several reasons why we need to be careful about inflation even in an environment of ample spare capacity. First, commodity prices have been rising rapidly (Chart 19). This has already increased headline inflation relative to core inflation, and the commodity price changes that have already taken place will almost certainly continue to push the headline rate on year-over-year basis higher over the next few months. 

Second, some of this pressure could feed into core inflation. Third, medium-term inflation expectations have recently risen back to levels consistent with our dual mandate objectives (Chart 20). If medium-term inflation expectations were to move significantly higher from here on a sustained basis, that would pose a risk to inflation and, thus, would have important implications for monetary policy.

With respect to the inflation outlook, I think there are four important questions that deserve attention.
  1. How much slack is there in the economy? In other words, how fast can the economy grow for how long until the economy is close to full employment?
  2. Are there speed-limit effects on inflation? In other words, could inflation rise because the rate of economic growth was unusually high, even though plenty of slack remained in the economy?
  3. Given the emergence of such economies as China and India, can commodity price pressures be safely ignored as temporary “noise” in terms of the long-term inflation outlook or are these pressures likely to prove persistent? If commodity price pressures persisted, this could undercut one rationale for focusing on core measures of inflation—the argument that core measures are better predictors of future headline inflation than today’s headline rate.
  4. What can the Federal Reserve do to ensure that inflation expectations stay well-anchored?
With respect to the first question, the economy retains a very large amount of slack by virtually all measures. For example, last month the industrial capacity utilization rate was 76.1 percent. This compares with a long-term average of 80.9 percent (Chart 21). Similarly, the current unemployment rate of 9 percent is well above most estimates of the non-accelerating inflation rate of unemployment (NAIRU)—the lowest rate of unemployment consistent with sustained price stability.

In the pre-crisis period, the NAIRU was likely in the region of 4.5 percent to 5 percent. There are several reasons why the NAIRU may now be higher. First, extended unemployment compensation benefits create incentives for prospective workers to keep looking for better jobs rather than accept less attractive positions. Empirical work on this subject suggests that the NAIRU might currently be roughly 1 percentage point higher because of this factor. However, this effect will only persist for as long as the extended benefits are in place.

Second, the rise in unemployment has been associated with an increase in the degree of mismatch between unemployed workers’ job skills and available job vacancies. Some cite the upward shift in the Beveridge curve, which illustrates the relationship between unemployment and job vacancies (Chart 22), as evidence of this effect.

Third, the longer that people are unemployed, the more their skills tend to atrophy, which makes it harder for them to become employed in the future. For unemployed workers, the median duration of unemployment has climbed and a growing proportion of the unemployed has been jobless for long periods (Chart 23).

In my view, these last two factors have probably pushed up the NAIRU by 0.5 to 1 percentage point on top of the about 1 percentage point effect of extended unemployment benefits, which is likely to be a temporary effect. Taken together, this suggests that the current NAIRU might be between 6 percent and 7 percent.

Although undesirable, this rise should not create concern about the medium-term inflation outlook. First, even the higher estimate of NAIRU is still far below the current unemployment rate of 9 percent. Second, as discussed above, much of this rise is likely to be temporary rather than permanent. As the labor market improves, the extension of unemployment claims benefits will almost certainly be allowed to lapse. When this occurs, the NAIRU is likely to drop back to somewhere in the region of 5 percent to 6 percent.

Third, some of the evidence that the NAIRU has increased is not particularly compelling. For example, the loop in the Beveridge curve that is evident now has been seen in past business cycles—cycles in which there was no persistent rise in the NAIRU. This strongly suggests that the rise in job mismatch has a cyclical component. Fourth, the 9 percent unemployment rate may understate the amount of labor market slack. That is because the labor participation rate has fallen sharply.

In my view, the large gap between the current unemployment rate and the long-run NAIRU suggests there is little payoff from investing much energy to more precisely estimate the NAIRU. As the economy expands and the unemployment rate falls, we will have plenty of time to be able to refine our estimates of NAIRU in light of what happens to labor cost trends such as the employment cost index, and to unit labor costs. Currently, all these measures are quiescent and consistent with a large amount of labor market slack (Chart 24).

The second question is whether the economy could grow so fast that inflation pressures could rise even with an unemployment rate still well above the NAIRU. The notion is that at very fast growth rates wages and prices might have to rise in order to funnel labor and capital to those areas where demand and output were rising particularly rapidly.

Although this possibility shouldn’t be ruled out, we should not be too worried about this, particularly if growth is broadly based. In particular, the economy is not growing quickly right now relative to past recoveries. For example, in the rebound from the comparably deep early 1980s recession, the annualized growth rate exceeded 7 percent for five consecutive quarters. Moreover, empirically there is little historical evidence that discontinuous “speed limit” effects play a significant role in influencing inflation in the United States.

The third issue is whether the rise in commodity prices will turn out to be persistent and, if so, how this might impact the inflation outlook. Recently, commodity prices have risen sharply. For example, the spot GSCI—a broad measure of commodity prices—has risen more than 35 percent over the past year. This was in train before the upheavals in the Middle East raised market concerns about potential disruption to oil supplies, pushing energy prices—though not other commodity prices—still higher. Commodity price pressures are pushing measures of headline inflation above measures of core inflation, which exclude food and energy prices. How worried should policymakers be about this development?

Although there have been commodity price cycles in the past, commodity prices have not consistently increased relative to other prices, and indeed have declined in relative terms over the very long term. Historically, if commodity prices rose sharply in a given year, it has been reasonable to expect that these prices would stabilize or fall within a year or two. This property has been important because it has meant that measures of current “core” inflation, rather than current headline inflation, have been more reliable in predicting future headline inflation rates.

In contrast, over the past decade, commodity prices generally have been on an upward trend. For example, as shown in Chart 25, fuel prices have generally been in a rising trend since 1999 and non-fuel prices since 2001—both trends interrupted temporarily by the financial crisis.

Setting to one side the near-term effects of geopolitical developments, the rapid urbanization and industrialization of nations such as China and India could be generating an ongoing secular rise in commodity prices that might not be fully captured in today’s spot and futures market prices. If so, this would undercut the role of core inflation as a good predictor of future headline inflation.

Nevertheless, there are important mitigating factors that suggest that it would be unwise for the Federal Reserve to over-react to recent commodity price pressures. First, despite the general uptrend, some of the recent commodity price pressures are likely to be temporary. In particular, much of the most recent rise in food prices is due to a sharp drop in production caused by poor weather rather than a surge in consumption (Chart 26). More typical weather and higher prices should generate a rise in production that should push prices somewhat lower. This is certainly what is anticipated by market participants, as shown in Chart 27.

Second, even if commodity price pressures were to prove persistent, the U.S. situation differs markedly from that of many other countries. Relative to most other major economies, the U.S. inflation rate is lower and the amount of slack much greater.

Moreover, for the United States, commodities represent a relatively small share of the consumption basket (Chart 28). This small share helps to explain why the pass-through of commodity prices into core measures of inflation has been very low in the United States for several decades.

Third, the Federal Reserve’s success in anchoring inflation expectations has also been important in limiting pass-through. Since 1984, for example, when the Federal Reserve began to achieve success in driving down and then subsequently anchoring long-term inflation expectations, there has been very little evidence of commodity price pass-through into core inflation. In contrast, prior to 1984, when inflation expectations were much less well-anchored, pass-through did occur and, at times, played an important role in pushing underlying inflation higher.

This leads to our final issue—the importance of inflation expectations in shaping the inflation outlook.

Rising inflation expectations tends to push up inflation in a number of ways—by reducing the expected cost of borrowing at a given level of interest rates, by pulling forward buying decisions to beat future expected price increases, and by encouraging more aggressive price and wage setting behavior. In a world of unanchored inflation expectations, commodity price pressures would more easily be passed through into core inflation.

Fortunately, inflation expectations remain well-anchored. This can be seen in all three major measures of inflation expectations. First, market-based measures of inflation expectations are generally well-behaved. For example, the five-year forward measure of breakeven inflation generated from differences in the nominal Treasury yield curve and the TIPS yield curve has shown a modest rise since mid-2010 back into the range that has generally been in place for the past decade (Chart 29). Second, the long-term inflation expectations of professional forecasters have been very stable. As shown in Chart 30, the median long-term inflation forecast in the Professional Forecasters’ survey remains around 2.1 percent for the PCE deflator. In terms of household expectations, there has been an increase in short-term expectations. This typically occurs when commodities such as gasoline go up sharply in price. However, even here longer-term expectations remain well-anchored. As shown in Chart 31, the University of Michigan median five-year inflation expectations measure remains around 2.9 percent—comfortably within its normal range and historically consistent with slightly lower realized inflation.

To summarize the main points, we have a considerable amount of slack, little evidence of discontinuous speed limit effects, and little inflation pass-through from commodities into core inflation when inflation expectations are well-anchored, which is currently the case. This suggests that the biggest risk in terms of higher underlying inflation over the next year or two is that inflation expectations could become unanchored. This might occur, for example, if there were a loss of confidence in the ability and/or willingness of the Federal Reserve to tighten monetary policy in a timely way in order to keep inflation in check.

In this regard, the proof of the pudding will be in our actions—talk is cheap. What is key—that the appropriate policy steps are taken in a timely manner.

However, let me make two points. First, I am very confident that the enlarged Federal Reserve balance sheet will not compromise our ability to tighten monetary policy when needed consistent with our dual mandate goals. Second, I am equally confident that no one on the FOMC is willing to countenance a sustained rise in either inflation expectations or inflation.

Let me explain why our enlarged balance sheet does not compromise our ability to tighten monetary policy. Although our enlarged balance sheet has led to a sharp rise in excess reserves in the banking system, this has the potential to spur inflation only if banks lend out these reserves in a manner that generates a rapid expansion of credit and an associated sharp rise in economic activity. The ability of the Federal Reserve to pay interest on excess reserves (IOER) provides a means to prevent such excessive credit growth.

Because the Federal Reserve is the safest of counterparties, the IOER rate is effectively the risk-free rate. By raising that rate, the Federal Reserve can raise the cost of credit more generally. That is because banks will not lend at rates below the IOER rate when they can instead hold their excess reserves on deposit with the Fed and earn that risk-free rate. In this way, the Federal Reserve can drive up the rate at which banks are willing to lend to more risky borrowers, restraining the demand for credit and preventing credit from growing sufficiently rapidly to fuel an inflationary spiral.

For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding needed to achieve its dual mandate of full employment and price stability. If the demand for credit were to exceed what was appropriate, the Federal Reserve would raise the IOER rate—pushing up the federal funds rate and other short term rates—to tighten broader financial conditions and reduce demand.2 If the demand for credit were insufficient to push the economy to full employment, then the Federal Reserve would reduce the IOER rate—pushing down the fed funds rate and other short term rates—to ease financial conditions and support demand, recognizing that the IOER rate cannot fall below zero. While the mechanism is different, the basic approach is very similar to the way the Federal Reserve has behaved historically.

Although our ability to pay interest on excess reserves is sufficient to retain control of monetary policy, it is not bad policy to have both a “belt and suspenders” in place. As a result, we have developed means of draining reserves to provide reassurance that we will not—under any circumstance—lose control of monetary policy. These include reverse repo transactions with dealers and other counterparties, auctions of term deposits for banks, or securities sales from the Fed’s portfolio.

A related concern is whether the Federal Reserve will be able to act sufficiently fast once it determines that it is time to raise the IOER. This concern reflects the view that the excess reserves sitting on banks’ balance sheets are essentially “dry tinder” that could quickly fuel excessive credit creation and put the Fed behind the curve in tightening monetary policy.

In terms of imagery, this concern seems compelling—the banks sitting on piles of money that could be used to extend credit on a moment’s notice. However, this reasoning ignores a very important point. Banks have always had the ability to expand credit whenever they like. They didn’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve’s standard operating procedure for several decades has been a commitment to supply sufficient reserves to keep the fed funds rate at its target. If banks wanted to expand credit that would drive up the demand for reserves, the Fed would automatically meet that demand by supplying additional reserves as needed to maintain the fed funds rate at its target rate. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves on their own balance sheets or can source whatever reserves they need from the fed funds market at the fed funds rate.3

So we have the means to tighten monetary policy when the time comes, but do we have the will? I think there should be no doubt about this. It is well understood among all the members of the FOMC that allowing inflation to gain a foothold is a losing game with large costs and few, if any, benefits.

In this regard, some have argued that Fed officials might be reluctant to raise short-term rates because such increases would squeeze the net interest margin on the Fed’s System Open Market Account (SOMA) portfolio. Although it is true that a rise in short-term interest rates would reduce the Fed’s net income from the extraordinary high levels seen in 2009 and 2010,4 this will not play a significant role in the Fed’s monetary policy deliberations.

Fed policy is driven by the objectives set out in the dual mandate, and the net income earned by the Fed is the consequence of the policy choices that advance those objectives. The Federal Reserve’s net income statement does not drive or constrain our policy actions. In short, we act as a central bank, not an investment manager.

It is also worth pointing out in passing that a failure to raise short-term interest rates at the appropriate moment based on our dual mandate objectives would also be a losing strategy with respect to net income. Inflation would climb, bond yields would rise and the Fed would ultimately be forced to raise short-term rates more aggressively, or to sell more assets at lower prices to regain control of inflation. This would almost certainly result in larger reductions in net income than a timelier exit from the current stance of monetary policy. So what does this all imply for monetary policy? First, barring a sustained period of economic growth so strong that the economy’s substantial excess slack is quickly exhausted or a noteworthy rise in inflation expectations, the outlook implies that short-term interest rates are likely to remain unusually low for “an extended period.” The economy can be allowed to grow rapidly for quite some time before there is a real risk that shrinking slack will result in a rise in underlying inflation. We will learn more as we go, and, as always, should be prepared to adjust course in a timely manner if incoming information suggests a different strategy would better promote our objectives.

Second, the Federal Reserve needs to continue to communicate effectively about its objectives, the efficacy of the tools it has at its disposal to achieve those objectives, and the willingness to use these tools as necessary. This is important in order to keep inflation expectations well-anchored. If inflation expectations were to become unanchored because Federal Reserve policymakers failed to communicate clearly, this would be a self-inflicted wound that would make our pursuit of the dual mandate of full employment and price stability more difficult. If we consistently and effectively communicate our objectives and our strategies, we can avoid this outcome.

Thank you for your kind attention. I would be happy to take a few questions.
1 However, growth alone will not resolve the longer-term problem of the disparity between promises made to state and local workers in terms of their public employee pension and health benefits and the resources set aside to pay for those benefits.
2 The IOER rate and the federal funds rate are likely to track each other closely in most circumstances. Banks do not have any incentive to lend reserves in the fed funds market at rates below the IOER rate, and can arbitrage away any significant price gap that emerges from the activity of non-depository institutions that can buy and sell federal funds, but cannot hold reserves at the Fed. Thus, through the IOER rate, the Federal Reserve can effectively control the fed funds rate.
3 Indeed, even the opportunity cost of making the loan is similar in both instances. A bank that has excess reserves and decides to extend credit forgoes the chance to earn the IOER on the money lent out. A bank that borrows reserves in the fed funds market in order to extend credit pays the fed funds rate in order to do so. The IOER and fed funds rate are likely to be similar.
4 As a byproduct of actions taken to combat the crisis, the Fed generated record net income in 2009 and 2010, and remitted $125 billion to Treasury. In the early phase a significant part of this income came from liquidity programs. More recently, the main contributor has been net interest on the expanded SOMA portfolio. At this juncture, SOMA continues to generate abnormally high net income. As policy eventually normalizes and the cost of financing assets via interest on excess reserves goes up, the net interest margin on the SOMA assets will return to more normal levels. However, the net interest margin is unlikely to turn negative because roughly $950 billion of assets are—and have been for many years—funded by notes and coins in circulation, on which the Fed does not pay interest.

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