Dropping the Baton

The second law of thermodynamics states that entropy always increases. Put another way, "things change." How one reacts to changing environments can often make the difference between long-term success and failure.

Yesterday's Olympic relay action clearly demonstrated the dangers of taking a cavalier approach to changing circumstances. The abject failure of the US 4 x 100 relay teams (and indeed, the GB men's team) to manage the passing of the baton as leg-runners changed provides an object lesson in the importance of managing change well.

From Macro Man's perspective, the tone of the markets that he trades has changed markedly over the last couple of weeks. In contrast to the equity market crack addicts, he actually had a pretty reasonable run in July and the first week of August. Midway through his holidays, however, the tone of the market appeared to change, and he found it increasingly difficult to make money even where he was "right."

To Macro Man, this represented a change in market environment from one in which he was well rewarded for being right to one in which he was badly punished for being wrong. The way that he manages money is alter his style when the market tone changes; by dialing down the risk level and trading more tactically when things get difficult, he tries to avoid dropping the baton and giving P/L back too cheaply. And frankly, after a stressful holiday, dialing things down gives him a valuable mental respite.

Another set of people who need to focus on not dropping the baton are the world's central bankers. The Fed gathers for its annual brainstorming session at Jackson Hole today, and you'd have to think that they'll give quite a bit to thought on how to navigate between the central banking Scylla and Charybdis of higher energy prices and lower growth.

Not that the Fed is alone, of course; most other major central banks face a similar dilemma. Q2 growth in the UK, for example, was revised down to zero today, yet headline inflation is at fifteen year highs. Recent comments from the ECB suggest that they don't see much risk of a European recession, which leads Macro Man to wonder if they're bothering to look. Certainly the ECB officials from the PIGS can see the risk by simply looking out their front windows.

Yet the appropriate monetary action isn't clear. Bernanke has found to his chagrin that the Greenspan model of slashing rates willy-nilly carries substantial negative externalities. Yet it's not altogether clear that the European "financial Calvinist" approach is markedly superior. It wouldn't be a surprise to see Mervyn King start wearing a toga, as he resembles nothing so much as Nero fiddling while Rome burns.

The ECB, meanwhile, delivers a monthly lecture on the perils of second-round effects while appearing oblivious of the possible negative externalities from their own hawkish rhetoric. What's ironic is that despite the rise in European headline inflation, domestically-generated inflation pressures have been remarkably stable. The chart below shows the GDP deflator for a number of economies; observe how the European measure has flatlined for the better part of five years around the ECB inflation target of 2%.

Should the European economy continue to lose momentum, as seems likely, these domestically-generated inflation pressures should eventually recede, as they have in the United States. A monomaniacal focus on headline CPI from the ECB will, in the fullness of time, unnecessarily reduce the living standards of those 320 million Europeans whose interests M. Trichet claims to hold close to heart.

Whether the ECB can manage the transition from expansion to stagnation without dropping the baton will be a critical driver of financial market pricing over the next few quarters if not years.

If any HTML-savvy readers know how to get rid of the large left hand margin that's somehow appeared, please drop Macro Man a line or provide instructions in the comments section.
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vlade
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August 22, 2008 at 1:37 PM ×

At the moment, it's really pick-your-poison with CBs, and I wouldn't want to be in their shoes...
Japanese experience shows moreover that under some circumstances you might not be able to get out of a persistent deflation/slow growth even with ZIRP.
Maybe it's time to re-evaluate what we thought of economics and the constant drive for growth? (not to say there won't be any ever again, but that we grew very fast in the last 50/100/200 years, and we may re-enter the flat area for another decades/centuries or such a time as another technological quantum leap happens).

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August 22, 2008 at 1:46 PM ×

You have a lot of margin-left:15 's in your template, along with a generous padding:20px for content; try reducing these values.

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Macro Man
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August 22, 2008 at 2:28 PM ×

Autore, the problem is that there are so many margin-lefts and paddings, I don;t know which one to change....and if I change them all, it buggers the site and I have to re-install the template and widgets from scratch!

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August 22, 2008 at 2:31 PM ×

The standard procedure is to change them one by one until you get the desired result, or an approximation of it, and then repeat as necessary..

Anyway, if you download the template and send it to my email ill try to do it for you over the weekend - i'll send you a message so you have my address.

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Macro Man
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August 22, 2008 at 2:42 PM ×

I would really appreciate that. I am no HTML programmer, and with all the widgets et al that I have, it's a real pain in the ass to keep-re-installing the template, which I have to do whenever I change something badly and the whole things blows up, which has happened a few times this week!

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fajensen
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August 22, 2008 at 2:45 PM ×

"""
Should the European economy continue to lose momentum, as seems likely, these domestically-generated inflation pressures should eventually recede, as they have in the United States.
"""

The ECB + Policy Makers is IMO making a mistake in the interpretation of the inflation figures!

They believe that they have successfully managed the economy to create inflation-less growth but what really has been happening has been the depression of wages and product prices by outsourcing to countries with low wages and no environment taxes.

Now the gears are going into reverse: The Chinese and Asian workers also want wages and goods for themselves now (especially since earning USD is becoming less and less rewarding).

This shift away from USD and from being the worlds sweatshop will mean that the West have to compete directly with Asia for raw materials, energy and manufactured goods and that the prices for the aforementioned items will eventually rise in proportion with the growth in Asia - currently ~8% p/a!!!

I.O.W: The EU has seen absolutely nothing yet; In this environment it is easily possible to have *both* 6-10% inflation rates and *negative* growth!!

The only way out for the ECB will be to raise rates so high that the EUR rises faster than the Asian growth rates; i.e. above 10% p/a.

It will be fun to watch the wailing and screaming!

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normal being
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August 22, 2008 at 3:56 PM ×

@fajensen

You're refering to purely quantitative growth. That never happens.

Although qualitative growth (technological progress and efficiency)is way more stochastic, thereby complicating the picture a lot.
What we're seeing resembles a "Kondratieff winter", only there is no such thing as an underlying cycle. The development of key bottleneck technologies is not fully predictable, but it will happen and pain speeds up the process.

In India energy-efficiency is growing a lot and in China they're trying everything to capital-starve certain low-tech industries.

Therefore growth in Asia is not equal demand pressure. Demand pressure is a lot lower than 8%.

Still, CBs will have a hard time in the West until the "next technological quantum leap" comes along. It's been seen on the horizon. I have no idea, if it will be here 5 years from now or not. I certainly hope so.

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David Pearson
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August 22, 2008 at 4:59 PM ×

MAcroman,

You argue that European inflation will subside along with growth. That has not been the case in the U.S., which has seen sub-trend growth for three quarters without reducing inflation.

One place to gauge future inflation is in "pipeline" inflaiton -- core intermediate ppi. Pull up a chart of it (year over year) along with real interest rates. You will see that 1) its only been at this level (10%) in the 70's; 2) it has never come off of this level without a determined rate hike campaign.

In fact, 8% seems to be the magic number that the Fed has used to determine whether it should aggressively attack inflation. Not this time. And yet, the consensus around inflation coming down without Fed action seems as strong as I have ever seen it.

To paraphrase Nixon, "we're all deflationists now."

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Macro Man
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August 22, 2008 at 5:17 PM ×

David, I am not arguing that European inflation will come lower. I am arguing that endogenously-generated European inflation, which is what the ECB claims to be worried about, will come lower. This is actually what has indeed ocurred in the US- while broad measures of inflation such as CPI and PPI have risen, the vast bulk of that has been imported inflation via commodity prices. These are NOT domestically generated inflation pressures, as the GDP chart illustrates. Now, over long periods of time high imported inflation will eventually feed thru into domestic inflation, but that will only happen once demand returns and incomes rise. The low GDP deflator in the Q2 nipa data was not a rogue print; it reflected stagnant wages and no upward pressure on prices from demand. The same fate awaits the calvinist ECB and BOE.

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David Pearson
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August 22, 2008 at 5:27 PM ×

Macroman,

Perhaps the entire spike in pipeline PPI is imported, but I am not so sure.

For one thing, putting my "Microman" hat on, I have not heard many U.S. companies warn of lower margins ahead. If anything, they are talking about raising prices, which reflects a surprising amount of pricing power, not only at this point in the cycle, but also in light of the decade-long secular trend of pricing discipline. IMO, this is perhaps the best measure of whether declining growth is impacting domestic inflation expectations. The answer appears to be, "not yet".

Of course, "Microman" observations are anecdotal and sloppy. If anyone had a different impression from 2q conference calls, I'd like hear about it.

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"Cassandra"
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August 22, 2008 at 6:18 PM ×

MM - I will respectfully suggest to you again that with 3 to 3.5% rates of interest (particularly with long rates where they are) talk of ECB monetary policy impoverishing hundreds of millions is sheer hyperbole.

Any "future impoverishment" is the result of decade-long housing booms in GB, Spain, Ireland, France, the winner's curse that resulted from (relatively) more prudent monetary and fiscal policies and higher energy taxes, and a tanking in primary export-led markets for which the europeans have been relatively more dependent. Moreover, with Europeans (ex-GB, irish and spaniards) being reasonably large net savers, surely lower rates will merely impoverish the hundreds of millions of savers throughout the EU. Surely it is not that continentals are too tight as much as the a reasonable amount of the rest of the world is too loose. 3% rates is plenty sufficient to drive all manner of stupid marginal investment without lowering them further. And following the anglo-saxons down Perdition St. of competitive devaluations by racing to see who can achieve the most negative real rates cannot be tenable objective of any sound policy-maker.

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Macro Man
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August 22, 2008 at 6:33 PM ×

Cassie, not to nitpick, but policy rates are 4.25% and cash rates are 5%, and if one believes Herren Liebscher und Wellink, neither one is coming down any time soon.

Moreover, there is a pretty big difference between " reducing living standards" and "impoverishing hundreds of millions", so I'd humbly submit to you that the hyperbole is on your end.

The point I am trying to make is that the ECB were justified in ignoring the teeth-gnashing from the financial industry earlier in the year (indeed, I wrote to that effect a few months ago), but that the facts have changed. The economy has very perceptibly and noticably slowed, and global trade volume growth is declining. The facts have changed, and the risk of second round effects (which have, after all, shown little signs of materialzing; ask a German about the boom of the last few years and he's apt to ask you what the hell you are on about, given that his real wage growth has been negative and the price of his house hasn't budged)has fallen dramatically.

A rational policy-maker changes his mind when the facts change; M. Trichet, on the other hand, seem more keen on simpering in front of a camera.

Ben Bernanke has a lot of faults as a policymaker, but one thing that he does have over Trichet is that he doesn't make you want to give him a slap whenever he opens his mouth.

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August 22, 2008 at 7:50 PM ×

The only thing preventing Spaniards from being big savers is that this would interfere to an unacceptable degree with their ability to hoard - the national pastime. Until Spain seriously goes to work clogging up the various legal and administrative leaks through which hoarded money finds its way to the surface, untouched by taxes and unsullied by ever having earned a day's interest, savings rate stats will be meaningless (except as they might affect the solvency of banks, say). But isn't that another good reason to indulge?

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normal being
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August 22, 2008 at 9:52 PM ×

macro...
I'm a firm believer, that (tiny) recessions are necessary.
Essentially they're a stress test for investment, flushing out malinvestment, which of course frees up production factors and more importantly stabilizes the system as a whole. In the long run this is benevolent, even if it might seem unwise in the short run.

It is also good for bank balance sheets in the long run, because malinvestment doesn't get accumulated to the impressive towering leverage we have witnessed in Anglo economies.

So we're talking about the regular little recession in Europe, actually a sign, that banks here are healthy enough for that sort of braking manoeuvre. Rates will come down soon enough, but not quite tomorrow.
While you may joke about that kind of "Calvinism", that's exactly what makes the EUR an attractive reserve currency in the long run, definitely a strategic goal for the ECB.
And maybe just ignore Trichet and listen doubly intensively to A.Weber instead.

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Anonymous
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August 23, 2008 at 5:52 AM ×

"Ben Bernanke has a lot of faults as a policymaker, but one thing that he does have over Trichet is that he doesn't make you want to give him a slap whenever he opens his mouth."

I'd like to slap the crap out of him whether his mouth was open or shut given the chance but maybe that's just me.

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Anonymous
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August 23, 2008 at 8:40 AM ×

Anon@5:52,

I'll hold your coat...or maybe we could take turns?

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"Cassandra"
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August 23, 2008 at 12:28 PM ×

I take many of your points in your well-reasoned reply. I'll put my cards on the table. The ECB is operating in a tough neighborhood. Joke CBs are everywhere, taking the mickey for mercantile reasons(BOJ PBOC) , or financial advanatge (SNB), having no scruples at all (all GCCs) or merely suffering from bi-polar schizophrenia (US Fed). The ECB has resembled more of an actual central bank because they've retained their dignity, telling policymakers to FU and holding fast against Cramer-like rants of action (in both directions) by people talking their books (and I don;t mean you here). Thy've used stealth action, jawboning, and while not perfect, are a head above peers (if peers can be called peers in CB land).

It's obvious they''ll cut (on their schedule) as things deteriorate. Though they wlll not be jerked or bullied into it which is key to the maintenance of dignity which translates into market power, something Bernanke lost when Kerviel's pecadillo bullied them into massive cuts. But really, MM, your derision is mis-directed for BoE is far guiltier having kept rates higher for longer and still having them relatively high, given the horror that awaits and is unfolding in the UK. For with the speed of the unraveling, and the jobs massacre well-nigh in the City, surely with the same expectations you have for the ECB, BoE rates should be under US rates, and sterling south of 1.50 ?!?!

-C-

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Macro Man
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August 23, 2008 at 12:38 PM ×

In fairness, C, I did single out Mervyn in the Toga comment. And per the GDP deflator chart, domestically-generated inflation pressures have been relatively high, but now seem likely to decline more. While Merv has done his share of bum-clenching moralizing (in the days before NRK hit the tape), at least he hasn't descended into the Trichetesque farce of using code words and monthly references to "320 million Europeans."

Ultimately, I'd agree that the ECB has been among the best of the CBs (excepting perhaps the RBA)....now that the facts have changed, however, the ECB's convoluted decision-making structure may well be exposed for the weakness that it is...with the concomitant follow-through of policy error.

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"Cassandra"
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August 23, 2008 at 3:33 PM ×

Yes I grant you Mervyn hasn't got a pass, but I feel the strength of the cast of your evil eye is inverted and all things considered should more directed at BoE or SNb than ECB (at least in this hemishere . The baton allusion is apt in any event, and as always, you;re a pleasure to disagree with...

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Anonymous
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August 25, 2008 at 2:58 AM ×

Notice Axel Weber's comment at Jackson Hole included;

``You shouldn't be getting too hung up about the volatility
in quarter-to-quarter GDP readings,'' said Weber. Still, the
third quarter may show ``some weakness'' and the economy will
expand below its potential rate of 2 percent ``into next year,''
he said.
``The medium-term perspective for the European economy in
my view is still in tact,'' he said. European banks ``don't
really see a credit crunch,'' though ``there will be weaker
credit growth, Weber said.


Note he said, "in my view" ...this is a different from the strident uberhawkish tone over recent months...perhaps an indication that he's losing some power on the council (rightfully so).

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calvino
admin
August 25, 2008 at 3:26 AM ×

Funny.. in the USA, all we want is for the beard to acknowledge the cpi.. you want the ecb to forget it. Speak for yourself Macro.. and I guess you do, however when I heard that three quarter point emergency cut on the morn of Jan 19, to save the BNP bad trades, I have wanted nothing more than slap that bald fool upside his head. I would suggest to Misseur Trichet that he buy and monetize all the bad Spanish mortgage debt, a la beard style.. and use the proceeds to madly buy the yen. Just buy, drill, buy until it's around 1.36 .. then will see how the BOJ will guard against incipient inflation risks. Finally, what do you mean by 'financial Calvinism.' We are predestined to print?

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Mario
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August 25, 2008 at 2:09 PM ×

1) Such things as exogenous/endogenous inflations, don't exist. Inflation in a fractional reserve banking system is a purely monetary phenomenon.
2) ECB's monetary policy is now expansionary, M3 is growing fast, real rates are negative.
3) I'm a "PIGS", I work in Italy, I'm watching out of my window and my company's window and I don't see a recession.
4) It's not nice being called "PIGS"

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Macro Man
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August 25, 2008 at 2:18 PM ×

1) You really don't think there's a difference between headline inflation caused via imported tradeable goods (whose price is NOT set by marginal European demand) and inflation in non-tradeables + wages?

2) M3 growth has been above the ECB's target for...well, forever. Private sector credit growth is slowing, and in any event broad money indicators during periods of financial distress can be significantly distorted as assets are converted into cash/quasi-cash, and thus magically appear in the monetary aggregates. UK M4 growth of 40% plus y/y isn't exactly a healthy sign.

3)Italian GDP shark 0.3% in Q2; it could well shrink again this quarter. Perhaps you should raise the blinds.

4) I've been called worse!

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Mario
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August 25, 2008 at 3:03 PM ×

1-2) Of course price is set by demand. In fact now I can afford paying my gas 1,5€/L, so I buy it. Sadly my buying power comes for the most part not from growth but from the inflation, alias the new money, created every day by the banking system.
I rememeber that the greater is the existing amount of any commodity, the less it's worth. And paper money is a commodity like any other.
So, given the huge amount of money around, created by FED&ECB since 2003 during the real estate bubble, the level of $100+ for oil is appropriate.

3) My blinds are fully raised in these times, more then ever. I have in my mind what a recession is, the one in 1993. THAT was a recession. Now we are at full employment, everyone can find a job, people keep spending, only a little less then before; but they complain, much more then before, like drug addicts without the dope of easy money. I call this is only a slowing down, nothing comparable to 1993/1994.

4) Well... actually me too :D

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normal being
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August 25, 2008 at 5:01 PM ×

@Mario

I don't want to sound unfriendly, but Inflation is not a monetary phenomenon. That's just parroting Friedman and has no basis in reality.

It's a) a credit phenomenon, credit can be influenced by CBs sometimes, sometimes not.
Credit enables companies to start businesses and pay the required at-the-margin-competitive salaries that determine your spending power.
So the actual underlying commodity would be called credit and if you find a way to accurately measure that one, I promise to worship you.

And b) it's a function of goods available. Old Friedman assumed that to be more or less static, it isn't. The money in my pocket right now has a different value, if we assume a crude production of 120 Mill. barrel in 2015 or just 75 Mill.

Please simply forget Friedman. Stiglitz is helpful though (A new paradigm for monetary economics).

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