The Weekly Report
Welcome to a Weekly Report special, incorporating further discussion of last weeks Occasional Letter.
This week we look at an example of Eggertsson Theory in practise, what really worries the Fed and what is their favourite import, how expectations can be managed, why General Electric are going to struggle and I announce something a little different. A lot to cover and I am pressed for time so let's get on with it.
The Bank of England Applies Eggertsson Theory - An Example
For background please read this article The Future Actions of The Federal Reserve And US Govt Are Known in which I assert that the Federal Reserve is applying a monetarist/Friedman solution, formalized in a theory put forward by G B Eggertsson in The Deflation Bias and Committing to Being Irresponsible.
I have been watching for signs that other Central Banks may also be applying similar methods in an attempt to offset deflationary tendencies and the Bank of England (BofE) duly obliged:
- 11:00 am 8th APRIL LONG-TERM REPO OMO
In its scheduled long-term repo OMO on 15 April, the Bank will offer Stg 15bn at the 3-month maturity. In this operation, there will be a minimum bid rate at the 3-month maturity. This will be determined by the Bank based on the 3-month overnight index swap (OIS) rate, and will be announced shortly before the operation. The maximum total size of a counterparty's bids, across all maturities offered in the long-term repo OMO, may not be greater than 20% of the total size, across all maturities, of the long-term repo OMO. The wider range of high quality collateral will be the same as that accepted in the December, January and March operations.
Reserves will also be offered as usual at the 6, 9 and 12 month maturities, in the standard size and against the Bank's standard published list of eligible collateral. The total size of the April operation will therefore be Stg 16.35 billion.
The Bank is committed to providing the liquidity assistance that the system as a whole needs to function normally.
It's the type of action undertaken by the Federal Reserve on a now routine basis and since September '07 has become a rolling monthly programme for the BofE. As we can see from the figures above the lending requirement is heavily concentrated in the 3 month maturity window, helping to alleviate strains in longer maturity money markets.
So we see stage one of an Eggertsson Theory based currency infusion into the Banking system. However as Eggertsson pointed out we need to see an increase in Government debt to raise expectations that a credible attempt is being made to inflate.
This is from the aptly named United Kingdom Debt Management Office:
- CREATION OF COLLATERAL FOR CASH MANAGEMENT OPERATIONS: APRIL 2008
On Wednesday 16 April 2008, in accordance with paragraph 6.10 of the 2008-09 DMO Exchequer cash management remit, an additional £15,000 million (cash) of collateral will be created and issued to the DMO for use in the DMO's Exchequer cash management operations. The collateral to be created will comprise £11,650 million (nominal) of gilts (excluding gilts maturing within one year, double-dated, undated and rump gilts) plus £483 million (nominal) of the Treasury bill maturing on 7 July 2008.
The additional collateral will be held on the Debt Management Account by the DMO and will not be available for outright sale. Specific gilts will not be available to the repo market for a period of three months, during which time these new issues will only be used in Delivery-by-Value (DBV) transactions. The additional Treasury bills being created will also only be used in DBV transactions.
So, here is the second stage, the creation of Govt debt to facilitate the use of the BofE largesse. Here is the definition of delivery-by-value:
- "DBV: Delivery by Value
Mechanism whereby a CREST member who has borrowed money against overnight gilt collateral may have gilts on its account to the required value delivered automatically by the system to the CREST account of the money lender."
You can, as a Crest member, swap the 3 month maturity BofE cash for Treasuries that will be available for.....3 months. The cash issued has been collateralised against newly created Govt debt.
Now to ensure this is seen as an inflationary move, we need rhetoric from the BofE who are in charge of the attempts to meet the 2% inflation target rule.
As if by magic the BofE excels itself (I will underline the inflationary bias):
- The Bank of England's Monetary Policy Committee today voted to reduce
the official Bank Rate paid on commercial bank reserves by 0.25 percentage
points to 5.0%. CPI inflation rose to 2.5% in February. The Committee
expects inflation to rise further this year, reflecting the continuing
impact of higher energy and food prices, as well as the recent depreciation
of sterling on import costs. Such pressures are already evident in producer
input costs and pricing intentions.
Even if commodity prices remain at their current high levels, inflation should fall back. But to ensure that inflation meets the 2% target in the medium term, the Committee needs to balance two risks. On the upside, above-target inflation this year could raise inflation expectations so that, in the absence of some margin of spare capacity, inflation would remain above the target. On the downside, the disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target.
In the Committee's judgement, the balance of these risks to the inflation outlook in the medium term justifies a cut in Bank Rate this month. Credit conditions have tightened and the availability of credit appears to be worsening. While the recent depreciation in sterling will support net exports, the prospects for output growth abroad have deteriorated. In the United Kingdom, business surveys suggest that growth has begun to moderate and that a margin of spare capacity will emerge during this year. This should help to keep domestic inflationary pressures in check in the medium term.
Against that background, the Committee judged that a reduction in Bank Rate of 0.25 percentage points to 5.0% was necessary to meet the 2% target for CPI inflation in the medium term.
It is a stunning piece of work and effective on so many levels as the stage three requirement in Eggertsson's Theory. It would take a huge "volte face" by a non-Austrian based economist to find fault with the reasoning. Yet it is deeply self-contradictory.
"CPI inflation rose to 2.5% in February."
"The Committee expects inflation to rise further this year, reflecting the continuing impact of higher energy and food prices,"
"depreciation of sterling"
"pressures are already evident in producer input costs and pricing intentions"
"to ensure that inflation meets the 2% target"
"above-target inflation this year could raise inflation expectations"
"inflation would remain above the target."
Seeing statements like those above, you could have been forgiven for thinking rates should stay at 5.25% or maybe go higher. The expectation is for higher inflation linked (by the BofE) to rising prices and depreciation in sterling.
The reasoning for the rate cut is beautiful:
- "On the downside, the disruption in financial markets could lead to
a slowdown in the economy that was sufficiently sharp to pull inflation
below the target.
In the Committee's judgement, the balance of these risks to the inflation outlook in the medium term justifies a cut in Bank Rate this month. Credit conditions have tightened and the availability of credit appears to be worsening. While the recent depreciation in sterling will support net exports, the prospects for output growth abroad have deteriorated. In the United Kingdom, business surveys suggest that growth has begun to moderate and that a margin of spare capacity will emerge during this year. This should help to keep domestic inflationary pressures in check in the medium term."
After all the emphasis on the inflation target and the possibility of overshooting, here we get the opposite. Now it is clear that a target of 2% is desirable, indeed it is essential. Any threat that allows the possibility of inflation being below 2% must be combated.
Notice the committee expect inflation to rise further this year, yet their actions are dictated by the possible slowdown of the economy and a specific mention about the lack of available credit (which is the same as "disruption in the financial markets"). It is the expected slowdown in growth and an increase in spare capacity (unemployment up, capacity utilization down) that will keep inflationary pressures in check.
I'll put it this way. If you feel you need to cut rates, engendering an inflationary expectation and are then relying on a recession or slowdown to keep inflation in check at a lower level, you are not really expecting inflationary forces in the medium term.
- "Committee judged that a reduction in Bank Rate of 0.25 percentage points to 5.0% was necessary to meet the 2% target for CPI inflation in the medium term."
The BofE is encouraging higher inflation (by cutting rates and raising rhetoric) to offset deflationary symptoms that they do not wish to acknowledge in the statement or wish to have discussed openly.
This is an attempt to front run deflation. The giveaway is this snippet:
- "Even if commodity prices remain at their current high levels, inflation should fall back."
It is extremely unusual for the BofE to clarify the difference between high prices and inflation. It is probably the closest they will come to acknowledging the deflationary forces unleashed by the collapse of credit markets.
Is this policy succeeding, do we have evidence that inflation expectations are being driven higher by "credible actions"?
Quite possibly we do and current actions by the BofE can only reinforce such expectations. The following is from Finfacts, reported on 13th March:
- "A survey by the Bank(of England) showed Britons' expectations of future inflation rose to a record 3.3% in February, more than a percentage point above the actual rate of inflation.....At 3.3%, inflation expectations are at their highest since the Bank began its survey in November 1999. Britons' expectations of future inflation have risen steadily higher over the past year as food prices, energy bills and petrol costs have all rocketed. In November, the median was 3%. A year ago it was 2.7%."
If you want to see how much media interest there is, type "UK inflation expectations" into google. Then compare it to typing in "UK deflation expectations".
Is the Federal Reserve achieving the same result as it talks up inflation and appears to be credibly inflating along with the US Govt? Here is the latest University of Michigan Sentiment Index readings:
- Sentiment Index 63.2 mid-April vs 69.5 in March Current conditions 78.4 vs 84.2 Future expectations 53.4 vs 60.1 One-year inflation expectations 4.8%, 5-year 3.1% Economic outlook 78.4 vs 84.2
These are some of the worst readings since 1982. But notice, amongst all the gloom, the huge move higher in inflation expectations. The Fed and US Govt actions are being seen as credible. Yet, what of consumer spending? Is the Fed engendering a "spend now because it will be more expensive tomorrow" attitude?
- RBC Consumer Attitude and Spending by Household index for April showing the overall index hit a new record low of 29.5
Are the consumers in the RBC index feeling confident about purchases?
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