Micro versus Macro

Friday, December 14, 2007

Go figure. Just two days after the Fed was lambasted for not cutting the discount rate by 0.50%, a set of data are released that suggest that Bernanke and co. should be hiking, rather than cutting, interest rates. OK, that's a bit of a simplification.

Macro Man, for one, has tried to separate macroeconomic policy drivers from microeconomic drivers. The microeconomic case for policy relief is fairly strong, as a market fairly central to the entire financial system (and by extension the economy) has more or less ceased to operate. Providing term liquidity is not about bailing out rich bankers or hedge fund managers; rather, it's about helping to ensure that Main Street banks are not so risk averse that they refuse to lend to high quality household and business borrowers. That's why he thought that doing 0.25% on the discount rate was an own goal.

And what of the macroeconomic case for policy easing? As far as Macro Man can make out, the entire case can be summarized in the chart below.
Housing has taken a dent out of growth mechanistically via reduced housing investment from homebuilders. And yes, as the chart above indicates, there has been a hit to household wealth, and thus to consumption. But housing equity doesn't tell the whole story, of course. Aggregate household wealth is still comfortably positive on a y/y basis.

Now it's true that housing wealth is spread more democratically than aggregate household wealth. But the studies that Macro Man has seen can divine no real difference in the macroeconomic consumption function from housing as opposed to equity wealth. At the end of the day, aggregate wealth is what matters....insofar as wealth matters at all. Income remains the primary driver of spending, and despite recent revisions US income growth remains supportive.
And so we're left with the chart below, which isn't the sort of thing that you'd expect to see accompnaying a 100 bps easing cycle, with plenty more baked into the cake as well!
Nor is the chart below. Yesterday's PPI data notched a couple of milestones: the highest monthly rise in finished goods prices since 1973, and the highest y/y rise in 25 years. Today sees the release of CPI which, if it prints 4% or above on headline, will win Macro Man a crisp £20 note from a colleague.
Given the relatively complacent Fed inflation forecast for 2008 and beyond, it's really worth considering how much more inflation the Fed will be prepared to tolerate, particularly in the absence of contagion. Now that the world's central banks have at least started to get their finger out in developing microeconomic solutions to the money market problem, perhaps it is time to start contemplating what the macroeconomic consequences might be.
For a start, one would have to think that an easing in January is less than a 100% chance, which is what's currently priced into markets. Of course, the environment could deteriorate on the data front, but Macro Man is mindful that last January saw the release of a skein of stronger-than-expected US data.
By the same token, further reductions in Fed funds with the Main Street economy doing OK will simply stoke further inflation pressures and probably generate a rise in the US import bill. Neither would be particularly supportive for the dollar.
For the time being, of course, anything remains possible due to the uncertainty surrounding the money market. No one ever said that the Fed and other central banks have an easy job....but then again, neither do those of us charged with making profitable trades on the back of what those guys decide to do. As long as market confidence remains this fragile, smaller-than-usual positions make sense. In many ways, Macro Man was relieved to see a signal to take off his FX carry basket this morning; FX carry is no place to be when liquidity is lousy, interest rates are rising, and there's a potentially high CPI print in the pipeline.

Posted by Macro Man at 8:17 AM  

15 comments:

I'd say your £20 is as safe as whatever the new safe thing is now that houses aren't safe any more. 4.3 isn't out of the question.

jdc said...
9:33 AM  

Yeah, I made the bet a few months ago that CPI would print 4% by year end. He's more or less conceded defeat already.....

Macro Man said...
9:41 AM  

Questioning one's premises is one of the most difficult things to do. After all, if you hold a premise, that is one of the things at the base of your knowledge. It's easy to question one's higher level assumptions. For example, if growth speeds up in the US, should the USD go up or down? It's easy to question your assumptions about that because you can point to weaker growth in the US helping the USD through a slowdown in imports that help to reduce the US trade deficit. Or you could say that slower growth in the US would undermine rates of return on capital, which would hurt the USD.

However, it is more difficult to question one's assumption that Fed rate cuts would boost the rate of inflation. This is a closely held premise of Macro Man and probably others who read this blog. I say, question your premise. No, I am not going to give you the alternative answer. That's for you to figure out. I merely point out that you can go very badly wrong in your trading conclusions based on a faulty premise.

Anonymous said...
9:47 AM  

Anonymous, the primary driver of inflation in this economic cycle has been the inability of commodity supply to keep up with increased commodity demand. This is "real" inflation rather than a monetary phenomenon.

However, commodity prices have also been impacted by an invoice currency issue; a falling dollar has generated a rise in the dollar-denominated price of many commodities. There have been a few recent econometric studies demonstrating a degree of causality between recent dollar weakness in exchange markets and higher dollar-denominated commodity prices. This causality is not always present, but it has been recently.

I feel quite comfortable in concluding that further monetary easing in the face of decent US growth will lead to a weaker dollar...and thus boost comoodity prices via the invoice currency effect.

If I am wrong, my P/L will show it. But if I am right, my P/L will also show it. Let's just say that at this juncture, I am comfortable with my assumptions.

Macro Man said...
9:58 AM  

"4.3 isn't out of the question"

Do I get £20?

jdc said...
1:34 PM  

The Fed usually starts to ease before the recession starts. But monetary policy takes time to work its way through the economy, so it usually is not sufficient, and the recession happens anyway. In the current circumstances, it looks like it will take longer than usual, so the probability of a recession is probably higher.

I do not understand how household net worth would be a good indicator for a trader. Surely this is a coincident indicator at best? If you wait until household net worth is already declining, then you probably missed the equity market decline (or worse, were on the wrong side of the trade). The news is currently mixed, yes, but the news is always mixed at turning points. Several forward looking indicators are not very pretty right now e.g. consumer confidence (particularly future expectations) and the 4 week average of initial jobless claims.
You are correct, however, that inflation is a structural problem, and future fed easing is not going to help the situation, and will probably make it worse. The fed knows this too, otherwise they would be doing 50 bps at a time instead of only 25. This recession will probably not be good for either bonds or equities, though the bond market may take some more time before it figures that out.

CDN Trader said...
6:11 PM  

"Anonymous, the primary driver of inflation in this economic cycle has been the inability of commodity supply to keep up with increased commodity demand. This is "real" inflation rather than a monetary phenomenon."

I would argue that the supply of dollars funding this accumulation of commodities comes right back to the US current account and thus is a monetary phenomenon at it's source. This will continue as long as the commodity buyers are content to accumulate dollar balances and as long as the flow of dollars continues....

Of course as the US economy weakens, the flow of dollars will slow... which of course leads to the same conclusion you draw in that continued economic strength in the US will lead to a weak dollar, but I view the entire situation as a monetary issue.

Throw said...
6:34 PM  

MM, what was your source for the first chart? From the Q3 Flow of Funds report, household percent equity has been declining fairly steadily, and is currently at an all time low.

Thanks,

ajh said...
6:46 PM  

On best advice, or on best guess, do you think current moves will unfreeze illiquid commercial paper markets? Any signs?

The credit cycle seems to be driving the real economy, not the other way around.

Anonymous said...
8:12 PM  
This comment has been removed by the author.
Jin said...
8:44 PM  

Whoops, ignore my last comment; should've looked at the equation more closely.

The first figure misses the steady decline in equity as a percent of house value, which is now at historic lows. This seems critical, especially when it comes alongside an exceptional rise in prices, which is likely to be followed by an exceptional decline.

ajh said...
4:20 AM  

Providing term liquidity is not about bailing out rich bankers or hedge fund managers; rather, it's about helping to ensure that Main Street banks are not so risk averse that they refuse to lend to high quality household and business borrowers.

Oh rilly?

And it's just a coincidence that the road to less-risk aversion happens to be paved with december bonii and 2 and 20?

Why perchance can't non-financial institutions, who make real things with real humans on real payrolls, whose commercial papers have ignited, and are generally blameless, win some of Ben's Bernanke's Money at the discount window?

Bueller? Bueller? anyone?

serindippity said...
7:29 AM  

Why perchance can't non-financial institutions, who make real things with real humans on real payrolls, whose commercial papers have ignited, and are generally blameless, win some of Ben's Bernanke's Money at the discount window?

Err...because the discount window was created as a mechanism for managing reserve balances in the baking system, and is thus directed towards depository insitutions that maintain reserve balances? You may as well ask why fish aren't allowed to be Formula 1 drivers.

Macro Man said...
10:50 AM  

The "baking system", very good. We're all cooked.myittx

Anonymous said...
6:04 PM  

Providing term liquidity is not about bailing out rich bankers or hedge fund managers; rather, it's about helping to ensure that Main Street banks are not so risk averse that they refuse to lend to high quality household and business borrowers.


As someone on Main Street Macro Man I happen to disagree on that one but then again I'm just one of the fish. Main Street is just cannon fodder for what happens on Wall Street and just like in war there a civilian casualties and in this case Main Street is no different. Sitting on Main Street and experiencing inflation skyrocketing, the currency fall like a rock, real wages stagnating along with increasing job losses (stagflation) while watching the FED flip-flopping around it is hard not to view this as bailing out the same ones that caused the mess in the first place. The top 20% are suffering very few effects from all of this but the bottom 80%are being shredded. Perhaps one day the bottom 80% will rise up and chop the hands off of the money changers.

Anonymous said...
6:38 PM  

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