Asian inflation poses a problem
Thursday, 15 November 2007
Tim Bond
IF history is any guide, despite the economic strength visible in the second and third quarter, the current tightening of credit conditions pose a risk to US growth in 2008.
The Federal Reserve's Senior Loan Officer Survey, conducted in October, reported very tight conditions in real estate credit, together with a more moderate tightening for business credit. The historical relationship between this survey and subsequent gross domestic product (GDP) growth informs us that the forecasting consensus is correct to anticipate a slowing to 1.5 per cent in the current quarter from 3.9 per cent, with a clear risk that this weakness will extend further into 2008.
In recent weeks there have been further large price declines for the most highly rated subprime mortgage securities and collateralised debt obligations, which account for the bulk of the losses sustained by Wall Street banks. With off-balance-sheet vehicles becoming strained and losses mounting, the credit squeeze looks set to intensify. The result is pressure on the Fed to ease policy and prevent a recession.
However, the Fed's freedom of manoeuvre is constrained. Just as growth seems likely to slow to a crawl, inflation is poised to move near to 4.0 per cent, as the rise in crude oil and agricultural prices feeds through to consumer prices. Although the combination of above-trend inflation and below-trend growth is often seen at the end of business expansions, the current juncture is unusual. US monetary easing is provoking an almost immediate acceleration in inflation.
To understand why this is the case, we need to consider how US rate cuts interact with Asian monetary policy. US rate cuts are prompting dollar weakness. Dollar weakness encourages Asian policymakers to keep interest rates much lower than is appropriate for their booming economies to fend off local currency appreciation. With interest rates far below nominal GDP growth rates, Asian monetary conditions are becoming much more stimulative. Chinese and Indian inflation rates have risen, while local equity markets are displaying classic signs of a bubble.
Official foreign exchange reserves are also rising quickly as a result of currency interventions. When an Asian central bank buys dollars in exchange for local currency, the net result is an addition to the domestic money supply. Ordinarily, these monetary injections are mopped up with sales of government bonds and bills. However, it appears that such sterilisations are at best incomplete and that Asian money supply is consequently growing unusually fast. These monetary injections are contributing to inflationary pressures.
Rates of Asian consumer and asset price inflation, together with global commodity price trends, have begun to display strong correlations with foreign exchange reserve growth. The origin of the impending rise in US inflation can therefore be traced back to US monetary easing, via a chain of transmission that runs from a weak dollar through Asian policy settings and unsterilised foreign exchange reserve growth to global resource prices.
This presents the Fed with an acute dilemma. The past few years have shown that inflation expectations are influenced by actual inflation rates. Although the Federal Open Market Committee does not generally respond to what may be transitory increases in headline inflation, they do respond to changes in inflation expectations, econometric modelling suggesting a one-for-one change of rates in response to a move in inflation expectations.
So, although the tightening in credit conditions argues for further Fed rate cuts, the imminent rise in inflation and inflation expectations points in the opposite direction. This no doubt played a key role in the latest FOMC statement, which highlighted the upward risks to inflation and downward risks to growth. For equity markets, the constraint on the Fed's freedom of manoeuvre is a problem. On the one hand, there may be concerns that the risks to growth will discourage the Fed from containing inflation. On the other, there will be worries that the inflation threat will inhibit the Fed from supporting growth.
The only way out of this dilemma is to change the interaction between Asian and US monetary policy. International agreement is required, whereby Asian policymakers allow currency appreciation against the dollar and, in so doing, adopt less stimulative domestic monetary stances, helping to cool the inflation in world resource prices. Since such an agreement seems unlikely, the outlook for US financial asset markets is poor.
(The writer is head of asset allocation strategy at Barclays Capital.)
...........................................
— FT Syndication Service
IF history is any guide, despite the economic strength visible in the second and third quarter, the current tightening of credit conditions pose a risk to US growth in 2008.
The Federal Reserve's Senior Loan Officer Survey, conducted in October, reported very tight conditions in real estate credit, together with a more moderate tightening for business credit. The historical relationship between this survey and subsequent gross domestic product (GDP) growth informs us that the forecasting consensus is correct to anticipate a slowing to 1.5 per cent in the current quarter from 3.9 per cent, with a clear risk that this weakness will extend further into 2008.
In recent weeks there have been further large price declines for the most highly rated subprime mortgage securities and collateralised debt obligations, which account for the bulk of the losses sustained by Wall Street banks. With off-balance-sheet vehicles becoming strained and losses mounting, the credit squeeze looks set to intensify. The result is pressure on the Fed to ease policy and prevent a recession.
However, the Fed's freedom of manoeuvre is constrained. Just as growth seems likely to slow to a crawl, inflation is poised to move near to 4.0 per cent, as the rise in crude oil and agricultural prices feeds through to consumer prices. Although the combination of above-trend inflation and below-trend growth is often seen at the end of business expansions, the current juncture is unusual. US monetary easing is provoking an almost immediate acceleration in inflation.
To understand why this is the case, we need to consider how US rate cuts interact with Asian monetary policy. US rate cuts are prompting dollar weakness. Dollar weakness encourages Asian policymakers to keep interest rates much lower than is appropriate for their booming economies to fend off local currency appreciation. With interest rates far below nominal GDP growth rates, Asian monetary conditions are becoming much more stimulative. Chinese and Indian inflation rates have risen, while local equity markets are displaying classic signs of a bubble.
Official foreign exchange reserves are also rising quickly as a result of currency interventions. When an Asian central bank buys dollars in exchange for local currency, the net result is an addition to the domestic money supply. Ordinarily, these monetary injections are mopped up with sales of government bonds and bills. However, it appears that such sterilisations are at best incomplete and that Asian money supply is consequently growing unusually fast. These monetary injections are contributing to inflationary pressures.
Rates of Asian consumer and asset price inflation, together with global commodity price trends, have begun to display strong correlations with foreign exchange reserve growth. The origin of the impending rise in US inflation can therefore be traced back to US monetary easing, via a chain of transmission that runs from a weak dollar through Asian policy settings and unsterilised foreign exchange reserve growth to global resource prices.
This presents the Fed with an acute dilemma. The past few years have shown that inflation expectations are influenced by actual inflation rates. Although the Federal Open Market Committee does not generally respond to what may be transitory increases in headline inflation, they do respond to changes in inflation expectations, econometric modelling suggesting a one-for-one change of rates in response to a move in inflation expectations.
So, although the tightening in credit conditions argues for further Fed rate cuts, the imminent rise in inflation and inflation expectations points in the opposite direction. This no doubt played a key role in the latest FOMC statement, which highlighted the upward risks to inflation and downward risks to growth. For equity markets, the constraint on the Fed's freedom of manoeuvre is a problem. On the one hand, there may be concerns that the risks to growth will discourage the Fed from containing inflation. On the other, there will be worries that the inflation threat will inhibit the Fed from supporting growth.
The only way out of this dilemma is to change the interaction between Asian and US monetary policy. International agreement is required, whereby Asian policymakers allow currency appreciation against the dollar and, in so doing, adopt less stimulative domestic monetary stances, helping to cool the inflation in world resource prices. Since such an agreement seems unlikely, the outlook for US financial asset markets is poor.
(The writer is head of asset allocation strategy at Barclays Capital.)
...........................................
— FT Syndication Service