The Sky is Falling, USD Reserve Status Dieing!

As the Dollar reached 15-month low {and} Euro presses back above $1.50, there is bound to be renewed questions such as: Is the Dollar Fading as No. 1 Reserve Currency?

What Economists Predict.
While the future may be hard to predict we might get some educated guesses on the time frames for when structural changes may occur. Aside from a total and complete melt down of the present economic environment, Joseph Rosta {writer of last linked article} provides the views of 5 economists and what time frame they think it is possible {but unlikely} that the US fades as the number one reserve currency. Let me start with the section of the article on Wyss.

"A shift away from the dollar probably should happen, but it won't happen overnight," says Standard & Poor's chief economist David Wyss. He sees a 10-year process, with the dollar losing its dominant position to a basket of currencies. "You can't have a world currency before you have consistent global regulatory and fiscal policy," according to Wyss.

He does not explain as to why it "should happen" and it may not be good for the overall world economy even if it does happen. If in fact the world is moving toward a "basket of currencies" or a "world currency" then yes a global regulatory agency would be needed. Without a cataclysmic event like a world war then unlikely that would even be possible. It took the Euro nearly 50 years to get started and that was between a relatively small number of countries of approximately equal economic development. This basket of currencies would have to be "managed" in certain ways and the most obvious candidate for it is the IMF with "SDRs" that even has historical precedence for being suggested going back to WWII.

Steven Pearson, head of G10 currency strategy at Bank of America Merrill Lynch: Brazil, Russia, China and India are pressing for an expanded SDR, Pearson adds, but there are few stable currencies that are broadly enough traded to merit inclusion. Today SDRs are a mix of the dollar (44 percent), the euro (34 percent), the yen (11 percent) and the pound sterling (11 percent). Instead, the most likely near-term scenario will be a rebalancing of central bank currency holdings away from the dollar.

Correct, the near-term scenario is to rebalance holdings then the question is why has it not been done already and with as little fanfare as possible? One likely explanation is the idea of isolation paradox. Most of the NICs {Newly Industrialized Countries} have been export competing and with this maintaining a low valued currency with respect to the US dollar and as a result have been accumulating excess reserves. Now even the Chinese Dragon is afraid of being the leader and changing paths alone. More technically I am thinking of the Stackelberg leadership model but without the leader of the NICs willing to make the first move.

One dilemma with SDRs is that while trade patterns world wide would dictate a certain percentage breakdown of the currencies in the basket of a SDR that does not indicate that the levels of reserves of any particular country would coincide with those divisions. For example trade between Iran and the USA is nearly nothing so that the reserve percentages held by Iran should be very low in USD. And even putting aside the political aspects of the reserves, they may not wish to hold that much USD indirectly in dollar reserves. Secondly they may not just looking for holding reserves as individuals do with cash in respect to the "transaction demand for money". They may be holding it in reserves for speculation or hedging which would indicate holding not just the cash but in fact highly liquid financial instruments like T-bills. And as another economist states the following:

"SDRs are an old saw raised perennially, but without a government and central bank behind them they cannot become important," observes Paul Bennett, a fellow of Columbia University's program in law and economics.

He gives the remnimbi another 20 years before it challenges the dollar. And Bennett predicts a gradual increase in the use of euros as reserve holdings, "but nothing dramatic."

Without the discipline of a government that is held accountable then I too would agree that it is unlikely, and fear of world wide inflation could appear as the Americans objected strongly in the formation of the IMF and SDRs. There is already a growth of Euros as a reserve currency and it seems reasonable that it would continue especially based on trading patterns. But there are most definitely obstacles to the the remnimbi and to a lesser degree the euro. Back to Pearson's statement:

Others don't believe a brand new currency is likely, and doubt the remnimbi will be ready to take its place as a reserve currency anytime soon. "The remnimbi would have to be freely exchangeable and deliverable, and it's not," says Steven Pearson,...

Even if Roubini is cheering this on it does not change those facts of "exchangeable and deliverable". It also has to be robust enough to have "hot money flows" both in and out without disrupting trade flows. It must in fact be a world leader in openness to flows of goods and services and in fact have the most direct trade with all other nations. So far only the USA fits those shoes. While the Europeans may be relatively open, I am just not sure that they would be willing to face uncertainty as the world reserve currency when financial institutions like the eurodollar markets rose up because of restrictive banking practices in the USA.

Keith Leggett, senior economist at the American Bankers Association states it as the dollar will still be "a major component in these portfolios" which is supported by trade flows which are unlikely to change over the near future. And lastly, Scott Anderson, vice president and senior economist at Wells Fargo states any shift away from the dollar could take 10 years at least.

Barry Eichengreen ,professor of economics and political science at the UC Berkeley, states his forecasts for the dollar {at Reports of the dollar's death are exaggerated}:

Beyond this, the dollar isn't going anywhere. It is not about to be replaced by the euro or the yen, given that both Europe and Japan have serious economic problems of their own. The renminbi is coming, but not before 2020, by which time Shanghai will have become a first-class international financial center. And, even then, the renminbi will presumably share the international stage with the dollar, not replace it.

The rest of the article is worth reading and spells out much of the points made at The Sabrient Blog » Macro View of the Markets.

A Counter Voice and a Short Term Prediction.
But there are still some that predict the collapse of the dollar much sooner as Daisuke Uno, Sumitomo Mitsui Banking Corp.’s chief strategist, states at Dollar to Hit 50 Yen, Cease as Reserve, Sumitomo Says:

“The U.S. economy will deteriorate into 2011 as the effects of excess consumption and the financial bubble linger,” said Daisuke Uno at Sumitomo Mitsui, a unit of Japan’s third- biggest bank. “The dollar’s fall won’t stop until there’s a change to the global currency system.”
...
“We can no longer stop the big wave of dollar weakness,” said Uno, who correctly predicted the dollar would fall under 100 yen and the Dow Jones Industrial Average would sink below 7,000 after the bankruptcy of Lehman Brothers Holdings Inc. last year. If the U.S. currency breaks through record levels, “there will be no downside limit, and even coordinated intervention won’t work,” he said.

There is no denying the effects of the most recent financial crisis, but it takes more than just momentum analysis to predict a crash. If we look at other events similarly then we can note that even given Japan's financial collapse and subsequent lost decades, the yen is still used as a reserve currency. The USD also experienced huge changes in value during the mid 1980s and still maintained it reserve currency status and much of that was done with policy coordination. Unlike the experiences in Japan, there is likely to be much more policy coordination for the USD as no one wants to lose the "borrower of last resort". Lastly, the US has been a much more flexible economy and more than likely will adapt more quickly to the changing world economy. For a fairly long article about some of these last points: Last Man Standing by Tyler Cowen.

Menzie Chinn at Econbrowser has some analysis of short term prospects of the USD at The Dollar.

Both series are plotted in logs, and exchange rates defined such that up implies a stronger dollar. In both cases the 95 percent interval is shown. What is clear is the (geometric) mean forecast for the dollar implies relative stability. It's true that the lower bound implies some depreciation over the next year -- but no more than 5.6 percent decline (in log terms). That's hardly calamitous. But it would be helpful in terms of facilitating rebalancing (as I pointed out a few weeks ago [6] [7], dollar decline makes a lot of sense, perhaps even more than the 5.6 percent implied by the lower bound).

If one is more concerned about the dollar's value against major currencies (perhaps because of an interest in cross-border valuation effects on financial assets), one would want to see how the dollar evolves against the euro. Here, it appears the mean forecst implies strength over the medium term. Even the scenario for the weakest dollar implies no more than a 7.5 percent decline, at the 3 month horizon.

Nothing to Fear Except Fear Itself?
There is a lot of logical reasons to conclude that the USD will maintain its status with some weakening in reserve holdings of the USD but that should be overall a good thing to unwind the global imbalances. I find nothing that can credibly replace the dollar for the foreseeable future.



Tons of links:
South-South Trade Tensions

Here's your recovery

Dollar Demise and Double Dip: Latest Forecasts

Guest Contribution: East Asian Production Networks, Global Imbalances, and Exchange Rate Coordination

Dollar to Hit 50 Yen, Cease as Reserve, Sumitomo Says

Two Views: Blame It on Beijing Redux, or Joint Determination

Reports of the dollar's death are exaggerated

Reports of the dollar's death are exaggerated

Süddeutsche Zeitung, Germany On Government Life Support

It's Italy for America and Japan for Europe

Soros: China will emerge as winner from current economic turmoil

Last Man Standing

The return of capital controls February 18, 2009

What RMB appreciation?

EU Girds for China Fight Over RMB

The Future of the US Dollar

Global Imbalances...Part Two|Krugman no Longer on Dweeb Status

In the first post of The Sabrient Blog » Macro View of the Markets I concluded with the line: But in the meantime, do not expect the global imbalances to be corrected. This time I continue on with some of that same spirit by bringing up an article by Paul Krugman entitled: The Chinese Disconnect. Although it is widely common knowledge now about global imbalances, Krugman still has a platform to address these pedestrian issues which draws considerable attention.

Senior monetary officials usually talk in code. So when Ben Bernanke, the Federal Reserve chairman, spoke recently about Asia, international imbalances and the financial crisis, he didn’t specifically criticize China’s outrageous currency policy.

But he didn’t have to: everyone got the subtext. China’s bad behavior is posing a growing threat to the rest of the world economy. The only question now is what the world — and, in particular, the United States — will do about it.

Yes indeed about not needing to say who the gorilla in the room is as the IMF has been for years talking about global imbalances and all along tip toeing around China. But is it really that surprising that China followed the examples of the Asian Newly Industrialized Countries {i.e. Four Asian Tigers of Hong Kong, Singapore, South Korea and Taiwan as well as Japan earilier} as well as the sound advice from development economists in pursuing an export led path to development? Krugman does acknowledge that none of China's policies were anything out of the ordinary and was logical for a developing country, but it has been noted that only a certain group can get on that development escalator at one time. It is possible that only a few NICs can in fact get on the escalator but not everyone at one time as Paul Collier mentions in his books.

The trick is to know when to change course and when the structure of an economy needs to adapt to the evolving world economy. The structural elements that allowed Japan to rise to second highest GDP are the same structural elements that led to the lost decade(s). Will China be able to adapt?

And that’s a particularly bad thing to do at a time when the world economy remains deeply depressed due to inadequate overall demand. By pursuing a weak-currency policy, China is siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere. The biggest victims, by the way, are probably workers in other poor countries. In normal times, I’d be among the first to reject claims that China is stealing other peoples’ jobs, but right now it’s the simple truth.

I too am skeptical about "stealing other peoples' jobs" but in the least it does make it hard for other countries to be able to get on the development escalator. And even for high income countries there is a need to adjust their economies in timely fashion instead of a complete schizophrenic economy.

The point is that with the world economy still in a precarious state, beggar-thy-neighbor policies by major players can’t be tolerated. Something must be done about China’s currency.

Yes a precarious place and yes China is a major player but "something must be done" might create more harm than good. Well one aspect that does not seem palatable is to allow the Chinese to buy US assets as the Japanese did in the 70s and 80s. It did not hurt the USA and in fact probably was a net gain for the USA. Another fine article about the global imbalances is from the CFR at: Global Imbalances, National Rebalancing, and the Political Economy of Recovery. It provides some background on a couple of previous global imbalances including the US-German situation in the 1920s. In addition to the quote below, I would recommend reading the whole piece especially the quote of FDR.

The German-American financial relationship rested on weak political foundations, as neither country was really prepared for the implications of the capital flows. The United States was not willing to provide an open market for German goods that would facilitate debt service, or any government measures to deal with eventual financial distress, and the Germans were unwilling or unable to make the sacrifices necessary to provide prompt debt service.

The US now has gone full circle and while we are not in the dire straights of the Germans we are faced with similar situations. Instead of increasing our savings rates we are still priming the pump of Fiscal Stimulus and increasing debt levels as much as we can.

Normally I am a harsh critic of Krugman even if he does have a Nobel Prize but because of his podium he does get scrutinized. The Economist.com blog starts off with questioning the USA Pushing China. Direct threats or retaliation is not likely to get much traction as they are already aware that other developing countries and the EU are not happy with the Chinese actions and the IMF has been hinting for a long time about the global imbalances. The Economist continues with another post that includes some thoughts from Scott Sumner at: An expansionary peg?

Mr Krugman implicitly argues that a recovery which allows imbalances to persist is no recovery at all. Mr Sumner obviously thinks that exchange rate levels are irrelevant to imbalances. And I suppose I'm struggling to square the two views.

Without being too technical, Sumner basically points out the savings rates differences, which he uses to conclude that exchange rates do not matter. But to get to the exact portion let me quote it here:

In 1933 FDR was not trying to depreciate the dollar against other currencies, he was trying to depreciate it against goods and services. Krugman and I agree that we should be trying to do the same today. But if the Chinese were to appreciate their currency they would be imposing deflationary monetary policy on their economy...

It is a mistake to think about exchange rate policy as trade policy, it is fundamentally a form of monetary policy. China’s current account surplus is driven by its high saving rate, and changing the nominal exchange rate won’t have any significant effect as long as the savings rate remains high...

To myself that implies that incentives do not matter. That exchange rates have no effect on the economy. Then how did the low savings rates in the US come about? The mechanism is through the relative costs of tradable vs. non-tradable goods. As the Chinese currency appreciates then tradables become less expensive from abroad as well as the raw materials going into manufacturing.

Another way to look at this situation is through the absorption approach to the balance of payments {Laursen-Metzler effect}. Looking at it in the context of revaluations this would tell us that the income effect would increase Chinese consumption as they in effect have more disposable income {lowered prices of foreign products}, and the substitution effect would be to substitute domestic consumption that prices rose relatively for more external goods and services that became relatively less expensive.

Even if as Sumner states that "changing the nominal exchange rate won’t have any significant effect as long as the savings rate remains high" is correct, that considers that all actions by the central bank is in isolation. The Chinese may be looking to increase absorption {i.e. reduce savings rates} as well as reduce demands on export led development which will have effects on the current account balances.

Krugman comes back with a response and in his usual tone {"certain zombie fallacies — ideas that you kill repeatedly, but refuse to die —"} at: Adjustment and the dollar. While I agree with Krugman on most of his major points, the only question, as others have raised, is what can the USA insist on with-in reasonable expectations. I know of no one that wants a trade war now.


Links:
The Chinese Disconnect By PAUL KRUGMAN
An expansionary peg?
Adjustment and the dollar
Please China, keep “beggaring your neighbors.”
Pushing China Posted by: Economist.com | WASHINGTON

South-South Trade Tensions

FRBSF Economic Letter: Recent Developments in Mortgage Finance (2009-33, 10/26/2009)

***Two Views: Blame It on Beijing Redux, or Joint Determination
A New Meme: Blame It on Beijing (and Seoul, and Riyadh...)
Dollar Demise and Double Dip: Latest Forecasts
Guest Contribution: East Asian Production Networks, Global Imbalances, and Exchange Rate Coordination
Evaluating the new tools of monetary policy

Reports of the dollar's death are exaggerated By BARRY EICHENGREEN

Global Imbalances, National Rebalancing, and the Political Economy of Recovery
HT to EconBrowser:The Political Economy of Recovery and Rebalancing

Don't Let U.S. Capitalism Go the Italian Route
http://faculty.chicagobooth.edu/luigi.zingales/research/papers/capitalism_after_the_crisis.pdf

The growing case for a jobless recovery

Sensible

These are but two examples of Bartlett's revolutionary opinions that tax cuts don't pay for themselves and that taxation is not cyanide for job growth.

The Capital Spectator: DIVING INTO THE NUMBERS
THE CHALLENGE AHEAD

At the same time, it may be dawning on the crowd that the recovery, while looking intact for the moment, is set to be increasingly boring. The excitement of the past six months or so is on track for the dull business of looking forward, finding challenges and formulating responses. That's quite different from weighing the data du jour, looking backward and cheering that we've sidestepped a larger disaster.

The future, to put it bluntly, looks rather tedious from our perch.

China discloses currency basket composition
Composition of currency basket revealed

Zhou did not give details of the weightings of individual currencies in the basket.

China discloses currency basket composition

Misc. not needed links:
Dollar Rise Squeezes ETFs and Indexes

Dollar Rises and Sends Indexes Down Sharply

Global Financial Stability Report Navigating the Financial Challenges Ahead October 2009

IMF: "Risks to financial stability have intensified"

"Reserve Accumulation and Easy Money Helped to Cause the Subprime Crisis"

Unemployment and inflation

William Brock, Cars Hommes and Florian Wagener show how hedging instruments can destabilize markets.
http://www1.fee.uva.nl/cendef/publications/papers/arrowabridged.pdf

Watching America   :   » The China–U.S. Exchange Rate War

A Longer View of the Markets...

We at Sabrient are "market relative" meaning our buy rating equities outperform the market and our sell rated equities under-perform the market compared to its relative benchmark. In addition we do not try to time the market or even try to give more weights to up or down markets, but it is always with open eyes we need to see the current events and macroeconomic events with full knowledge. We understand that to win in markets it takes long term investment strategies like New York University economist Nouriel Roubini that so succinctly predicted the current crisis stated in Money magazine:

...Roubini himself hasn't bought or sold a thing in response to his own forecasts: He has all of his money in a diversified portfolio of index funds. "That's how I've invested for the past 20 years and how I'll invest for the next 20," he says. "I take the long-term view."

Mixed Signals or Structural Changes?
This blog post will center around the article from the Federal Reserve Bank of Dallas entitled: National Economic Update|October 8, 2009|Optimism Amid Uncertainty. That is definitely a theme that the newsletters from Sabrient ‘What the Market Wants’ has brought up. First the opening statement:

As we enter the final quarter of 2009, a number of important indicators are beginning to show expansion, suggesting that the trough of the current contraction may have come in the second quarter of this year. However, not all incoming information has been positive. Some data suggest that any optimism should be tempered, that this fledgling recovery has a long way to go before the economy achieves stability, and that the key word moving forward is “uncertainty.”

Uncertainty? Most certainly! Most recoveries also are marked by mixed signals as some of the signals may be sectors that are shrinking in overall importance and have more to do with changes in the structure of the economy than the marked level of growth. I already noted that there were some Shoots of Recovery??? in the late part of August and since then we have had more positive signals.

Manufacturing Up, but Job Losses Give Reason for Pause
An example of recent growth is the Institute for Supply Management’s Purchasing Managers Index for Manufacturing. In August, this indicator crossed the critical threshold of 50 for the first time since January 2008. And it remained above 50 during September with a value of 52.6. This typically signals expansion in the manufacturing sector. The ISM’s nonmanufacturing indicator also rose into expansion territory for the first time in a year, to a value of 50.9

Very good but manufacturing has not been a source of job growth from recoveries and the long term trends are down for employment in manufacturing. But this is not to say that manufacturing is dead in the USA like many pundits on TV state. An idea I have also had to try to correct in people's minds. But let us look at what the trend is with regard to the manufacturing sector which could be one of the shrinking sectors as sectoral shifts happen. The chart below tracks the Industrial Production Index (IPMFG) from January 2000 until August 2009 which would mark almost one decade. Data from Chicago Fed Midwest Manufacturing Index and U.S. Industrial Production.

{X-axis is months starting at January 2000 and Y-axis is the index measurement.} It clearly shows that the US will not get back to the level at the beginning of 2000 even if we are starting to see a positive numbers the last two months. It is worth noting that the index had a local high of 104.5 for July-August 2000 which took until May 2004 to recover from the recession and the 9-11 events. The index then had a nice steady growth spurt during which it reached a peak of 114.8 in December 2007 which marked the first signals of banking problems. Basically, a lost decade as far as manufacturing is concered. If you look the data more you can see that every decade was marked by increased levels of manufacturing even as far back as the 40s.

A Lost Decade for Manufacturing... What about employment?

Conversely, the job picture in September is no cause for excitement. During the month, the economy shed 263,000 jobs, and the unemployment rate rose to 9.8 percent (Chart 2). The story becomes somewhat more worrisome when looking at only private-sector jobs. As of September, the number of nongovernment jobs was just below that seen in June 1999, leaving the impression that 10 years of private sector progress has been lost through 21 months of labor market downturn.

Yes another signal of a lost decade and similar time frame for the losses noted above in manufacturing. Anyone follow the DJIA also? November 1, 1999 opened at 10,731.

There is some optimism to be found in the job market, however. Job losses in housing-related industries are now tapering off at about the same pace as in nonhousing-related activities, suggesting that the structural adjustment that this sector has been undergoing since roughly 2005 may be coming to an end.

Is Housing Spelled with a W?

Housing Market Hints at Steps Toward Normalcy
Taken together, existing-home sales and new housing starts give the impression that the housing market may have finally bottomed out (Chart 3). It’s possible that the apparent stabilization has been artificially induced, in part, by the temporary tax credit for first-time homebuyers, something that will become clearer when the tax credit expires in December. Even so, the improvement in housing market conditions is apparent in the flattening of home prices during the three months of second quarter 2009—the first time in six quarters that prices have declined by less than 3 percent. Unfortunately, this too could give way to additional price declines once the large foreclosure inventory on banks’ balance sheets hits the market.

Good news about the job market as well as the glut of houses that were foreclosed to have been absorbed into the market including the new homeowners that took advantage of the tax credits. But that could all be for naught if the rumors of the vast amounts of foreclosed homes may come on the market in another wave. I won't go into all the nuances here but this article seems to cover most of the important ones. Letter of the day? W Housing could take double dip down in 2010. And now back to the National Economic Update article.

Perhaps the most persuasive evidence that the housing downturn has halted comes from the indicator of five-month-moving-average, single-family housing permits, which we use in gauging the housing cycle. According to this indicator, the housing downturn that started in December 2005 may have ended in April of this year, making it the deepest in magnitude and the third-longest on record (Chart 4).

Just because it has been deeper and longer than most others, does not indicate that it may last even longer and deeper. It may also be marked by the double dipping in the W shape as noted above. The worst position to be in would be a vicious cycle of rising unemployment leading to further weakening of the housing market caused by increases in foreclosures as the article Mountain of modifications Industry tries to keep up with avalanche of troubled mortgages indicates.

What Factors Lead to the Housing Crisis?
The last section brought up the issues of what caused the housing meltdown at least with regard to macroeconomic factors. Maurice Obstfeld and Kenneth Rogoff provide some insights into these factors in the PDF paper "Global Imbalances and the Financial Crisis:Products of Common Causes" and a portion of their introduction:

This apparently favorable equilibrium {strong economic performance} was underpinned, however, by three trends that appeared increasingly unsustainable as time went by. First, real estate values were rising at a high rate in many countries, including the world’s largest economy, the United States. Second, a number of countries were simultaneously running high and rising current account deficits, including the world’s largest economy, the United States. Third, leverage had built up to extraordinary levels in many sectors across the globe, notably among consumers in the United States and Britain and financial entities in many countries. Indeed, we ourselves began pointing to the potential risks of the “global imbalances” in a series of papers beginning in 2001.2 As we will argue, the global imbalances did not cause the leverage and housing bubbles, but they were a critically important codeterminant.

What about some more good news and how are consumers doing?
Before getting back to National Economic Update article let me provide a few more shoots of recovery:
U.S. CPI up 0.4% in August on higher gasoline prices Core inflation rate rising at slowest pace in five years
U.S. Q2 GDP down 0.7% vs 1.0 prev est
Spending soars to highest in eight years on clunkers' Real disposable incomes off 0.2%, marking third monthly decline in a row
U.S. Sept. ISM services highest since May 2008
Trade gap narrows on drop in crude imports
Consumer prices rise 0.2% in September Home-ownership costs fall for first time since early 1990s
Except for autos, U.S. Sept. retail sales healthy
U.S. Sept. industrial production up 0.7%

Consumer Fears Ease and Prices Remain Subdued
The pervading unease that has typified consumer spending seems to be gradually lifting as well. Headline retail sales climbed 2.7 percent in August, the biggest monthly advance since January 2006. The monthly gain remained solid—1.1 percent—even after excluding products benefiting from the cash-for-clunkers program. In addition, the University of Michigan’s indexed consumer confidence indicator has risen 15 points since the end of last year, when it hit low levels comparable with those seen in the first- to third-quarter 1980 downturn.

Finally, changes in prices have remained relatively subdued. In both July and August, year-over-year CPI inflation was between –1.4 and –1.9 percent, while core CPI inflation remained about one point below its average over the past decade. Long-term inflation expectations, as implied by forward rates, similarly remain close to historical levels.

The positive aspect throughout the crisis has been that inflation has always maintained low levels. Even when food and gas prices were rising which caused the headline inflation rates to increase, core CPI numbers stayed low. The pundits were dead wrong about stagflation.

Hot Money Flows into {out of} the USA?

Financial Indicators Provide Market Optimism
On the financial side, a host of indicators used to assess the stress of credit and securities markets are returning to historical levels, reinforcing the view that markets are beginning to heal. That is certainly the message coming from the three-month LIBOR–OIS spread. After a period of uncharacteristic elevation, the spread is quickly approaching levels seen well before the current downturn started (Chart 5).

That is very much indeed positive signs and no geopolitical tensions has changed this recently. But this spread could easily widen if there is greater uncertainty perceived or real in the global economy including how the global imbalances become resolved.

Obstfeld and Rogoff stated that China "has plenty of room to take the lead and should." But it was noted that there is a lack of incentives for the individual players and nations to change their policies in the short run that leads to longer term lack of changes. I find it hard see much "hot money flows" entering the USA right now or more broadly as a rising exchange rate for the US dollar as was experienced between April 2008 to March 2009 with a 16.4 % increase.

They also note that the "The dollar is likely to depreciate quite a bit further as adjustment proceeds, although the process will be slower to the extent that major U.S. trading partners, notably China, resist the appreciation of their own currencies." One more passage from Obstfeld and Rogoff:

Are today’s somewhat compressed external imbalances still a problem? Perhaps one could hope that the current pattern is sustainable and will require little further adjustment. A number of considerations suggest, however, that global imbalances remain problematic, both for the U.S. and the world:
• The large private foreign purchases of U.S. assets that helped finance the U.S. deficit in past years have, for the moment, contracted sharply. Given the prospect of much larger U.S. public-sector deficits down the road, with no clear and credible timetable for their reduction, U.S. external borrowing will be prolonged and investor faith in the dollar cannot be taken for granted. Recent research on crises suggests several avenues of vulnerability as U.S. government deficits and debt grow, including self-fulfilling funding crises and currency collapses once fiscal fundamentals enter a danger zone. Given the multiple equilibria involved, the timing of such events is inherently impossible to predict. It is even conceivable, if the fiscal regime comes to be perceived as non-Ricardian and therefore not self-financing over time, that inflation expectations lose their customary monetary anchor, thereby making inflation control by the Fed more difficult.35 In short, the prospect of dollar instability remains.

Most recent developments.
The equity markets and currency markets got a little choppy as the news of the PPI and housing starts figures were released including the Euro reached a high vs. the dollar since August 2008.

Dollar moves choppy after weak U.S. PPI/Housing data
U.S. PPI has declined 0.6% from August to September, while it dropped 4.8% sin the last twelve months, a well larger decline than the -0.2% monthly and -4.1% yearly drop expected by the analysts. Excluding food and energy, the Core PPI Index edged down 0.1% in September, and rose 1.8% year on year.

Furthermore, U.S. housing Starts increased 0.5% in September to a seasonally adjusted annual rate of 590,000 units, too short of the 2.0% increase forecasted by market analysts.

The drop in PPI is significant and the markets reacted in knee jerk fashion but the Core PPI is something that needs to be looked at even more closely. In this case the last month was down but only slightly and the past years numbers are quite in line with maintaining low but positive inflation levels which is good for strong economic growth going forward.

Housing and construction in general also does not seem to be sector that will lead the USA out of high unemployment as the overhang of foreclosed homes and resets mortgages may create a huge surplus of housing units on the market.

What does this mean?
I think I still come back to what Max Lichtenstein and Jessica Renier entitled their National Economic Update as "Optimism Amid Uncertainty". But along the way, we have explored some issues including the insightful paper by Obstfeld and Rogoff about the convergence of factors that lead to the financial crisis caused by the housing sector. And whether some of these sectors could be the impetus for a bain or boon going forward. We also looked at some data that showed a "lost decade" in both employment and the manufacturing sector.

Obstfeld and Rogoff ask what will happen "if the U.S. is no longer the world’s borrower of last resort." But for the mean time, do not expect the global imbalances to be corrected...

Euro touches $1.50 vs. dollar for 1st time since August 2008
Henri Guaino, a top aide to French President Nicolas Sarkozy on Tuesday, said the euro at $1.50 "is a disaster for European industry and the economy," Reuters reported.

A day earlier, French Finance Minister Christine Lagarde, speaking to reporters after a meeting in Luxembourg of euro-zone finance ministers, said officials needed to remain "disciplined" in their message calling for a stronger U.S. currency.

"We want a strong dollar; we need a strong dollar," she said, according to news reports.

And European Central Bank President Jean-Claude Trichet on Tuesday repeated his endorsement of calls by U.S. officials for a strong dollar.

Random Thoughts on the Economy I

We understand that to win in markets it takes long term investment strategies like New York University economist Nouriel Roubini that so succinctly predicted the current crisis stated in Money magazine:

...Roubini himself hasn't bought or sold a thing in response to his own forecasts: He has all of his money in a diversified portfolio of index funds. "That's how I've invested for the past 20 years and how I'll invest for the next 20," he says. "I take the long-term view."

Mixed Signals or Structural Changes?
This blog post will center around the article from the Federal Reserve Bank of Dallas entitled: National Economic Update|October 8, 2009|Optimism Amid Uncertainty. That is definitely a theme that the newsletters from Sabrient ‘What the Market Wants’ has brought up. First the opening statement:

As we enter the final quarter of 2009, a number of important indicators are beginning to show expansion, suggesting that the trough of the current contraction may have come in the second quarter of this year. However, not all incoming information has been positive. Some data suggest that any optimism should be tempered, that this fledgling recovery has a long way to go before the economy achieves stability, and that the key word moving forward is “uncertainty.”

Uncertainty? Most certainly! Most recoveries also are marked by mixed signals as some of the signals may be sectors that are shrinking in overall importance and have more to do with changes in the structure of the economy than the marked level of growth. I already noted that there were some Shoots of Recovery??? in the late part of August and since then we have had more positive signals.

Manufacturing Up, but Job Losses Give Reason for Pause
An example of recent growth is the Institute for Supply Management’s Purchasing Managers Index for Manufacturing. In August, this indicator crossed the critical threshold of 50 for the first time since January 2008. And it remained above 50 during September with a value of 52.6. This typically signals expansion in the manufacturing sector. The ISM’s nonmanufacturing indicator also rose into expansion territory for the first time in a year, to a value of 50.9

Very good but manufacturing has not been a source of job growth from recoveries and the long term trends are down for employment in manufacturing. But this is not to say that manufacturing is dead in the USA like many pundits on TV state. An idea I have also had to try to correct in people's minds. But let us look at what the trend is with regard to the manufacturing sector which could be one of the shrinking sectors as sectoral shifts happen. The chart below tracks the Industrial Production Index (IPMFG) from January 2000 until August 2009 which would mark almost one decade. Data from Chicago Fed Midwest Manufacturing Index and U.S. Industrial Production.

{X-axis is months starting at January 2000 and Y-axis is the index measurement.} It clearly shows that the US will not get back to the level at the beginning of 2000 even if we are starting to see a positive numbers the last two months. It is worth noting that the index had a local high of 104.5 for July-August 2000 which took until May 2004 to recover from the recession and the 9-11 events. The index then had a nice steady growth spurt during which it reached a peak of 114.8 in December 2007 which marked the first signals of banking problems. Basically, a lost decade as far as manufacturing is concered. If you look the data more you can see that every decade was marked by increased levels of manufacturing even as far back as the 40s.

A Lost Decade for Manufacturing... What about employment?

Conversely, the job picture in September is no cause for excitement. During the month, the economy shed 263,000 jobs, and the unemployment rate rose to 9.8 percent (Chart 2). The story becomes somewhat more worrisome when looking at only private-sector jobs. As of September, the number of nongovernment jobs was just below that seen in June 1999, leaving the impression that 10 years of private sector progress has been lost through 21 months of labor market downturn.

Yes another signal of a lost decade and similar time frame for the losses noted above in manufacturing. Anyone follow the DJIA also? November 1, 1999 opened at 10,731.

There is some optimism to be found in the job market, however. Job losses in housing-related industries are now tapering off at about the same pace as in nonhousing-related activities, suggesting that the structural adjustment that this sector has been undergoing since roughly 2005 may be coming to an end.

Is Housing Spelled with a W?

Housing Market Hints at Steps Toward Normalcy
Taken together, existing-home sales and new housing starts give the impression that the housing market may have finally bottomed out (Chart 3). It’s possible that the apparent stabilization has been artificially induced, in part, by the temporary tax credit for first-time homebuyers, something that will become clearer when the tax credit expires in December. Even so, the improvement in housing market conditions is apparent in the flattening of home prices during the three months of second quarter 2009—the first time in six quarters that prices have declined by less than 3 percent. Unfortunately, this too could give way to additional price declines once the large foreclosure inventory on banks’ balance sheets hits the market.

Good news about the job market as well as the glut of houses that were foreclosed to have been absorbed into the market including the new homeowners that took advantage of the tax credits. But that could all be for naught if the rumors of the vast amounts of foreclosed homes may come on the market in another wave. I won't go into all the nuances here but this article seems to cover most of the important ones. Letter of the day? W Housing could take double dip down in 2010. And now back to the National Economic Update article.

Perhaps the most persuasive evidence that the housing downturn has halted comes from the indicator of five-month-moving-average, single-family housing permits, which we use in gauging the housing cycle. According to this indicator, the housing downturn that started in December 2005 may have ended in April of this year, making it the deepest in magnitude and the third-longest on record (Chart 4).

Just because it has been deeper and longer than most others, does not indicate that it may last even longer and deeper. It may also be marked by the double dipping in the W shape as noted above. The worst position to be in would be a vicious cycle of rising unemployment leading to further weakening of the housing market caused by increases in foreclosures as the article Mountain of modifications Industry tries to keep up with avalanche of troubled mortgages indicates.

What Factors Lead to the Housing Crisis?
The last section brought up the issues of what caused the housing meltdown at least with regard to macroeconomic factors. Maurice Obstfeld and Kenneth Rogoff provide some insights into these factors in the PDF paper "Global Imbalances and the Financial Crisis:Products of Common Causes" and a portion of their introduction:

This apparently favorable equilibrium {strong economic performance} was underpinned, however, by three trends that appeared increasingly unsustainable as time went by. First, real estate values were rising at a high rate in many countries, including the world’s largest economy, the United States. Second, a number of countries were simultaneously running high and rising current account deficits, including the world’s largest economy, the United States. Third, leverage had built up to extraordinary levels in many sectors across the globe, notably among consumers in the United States and Britain and financial entities in many countries. Indeed, we ourselves began pointing to the potential risks of the “global imbalances” in a series of papers beginning in 2001.2 As we will argue, the global imbalances did not cause the leverage and housing bubbles, but they were a critically important codeterminant.

What about some more good news and how are consumers doing?
Before getting back to National Economic Update article let me provide a few more shoots of recovery:
U.S. CPI up 0.4% in August on higher gasoline prices Core inflation rate rising at slowest pace in five years
U.S. Q2 GDP down 0.7% vs 1.0 prev est
Spending soars to highest in eight years on clunkers' Real disposable incomes off 0.2%, marking third monthly decline in a row
U.S. Sept. ISM services highest since May 2008
Trade gap narrows on drop in crude imports
Consumer prices rise 0.2% in September Home-ownership costs fall for first time since early 1990s
Except for autos, U.S. Sept. retail sales healthy
U.S. Sept. industrial production up 0.7%

Consumer Fears Ease and Prices Remain Subdued
The pervading unease that has typified consumer spending seems to be gradually lifting as well. Headline retail sales climbed 2.7 percent in August, the biggest monthly advance since January 2006. The monthly gain remained solid—1.1 percent—even after excluding products benefiting from the cash-for-clunkers program. In addition, the University of Michigan’s indexed consumer confidence indicator has risen 15 points since the end of last year, when it hit low levels comparable with those seen in the first- to third-quarter 1980 downturn.

Finally, changes in prices have remained relatively subdued. In both July and August, year-over-year CPI inflation was between –1.4 and –1.9 percent, while core CPI inflation remained about one point below its average over the past decade. Long-term inflation expectations, as implied by forward rates, similarly remain close to historical levels.

The positive aspect throughout the crisis has been that inflation has always maintained low levels. Even when food and gas prices were rising which caused the headline inflation rates to increase, core CPI numbers stayed low. The pundits were dead wrong about stagflation.

Hot Money Flows into {out of} the USA?

Financial Indicators Provide Market Optimism
On the financial side, a host of indicators used to assess the stress of credit and securities markets are returning to historical levels, reinforcing the view that markets are beginning to heal. That is certainly the message coming from the three-month LIBOR–OIS spread. After a period of uncharacteristic elevation, the spread is quickly approaching levels seen well before the current downturn started (Chart 5).

That is very much indeed positive signs and no geopolitical tensions has changed this recently. But this spread could easily widen if there is greater uncertainty perceived or real in the global economy including how the global imbalances become resolved.

Obstfeld and Rogoff stated that China "has plenty of room to take the lead and should." But it was noted that there is a lack of incentives for the individual players and nations to change their policies in the short run that leads to longer term lack of changes. I find it hard see much "hot money flows" entering the USA right now or more broadly as a rising exchange rate for the US dollar as was experienced between April 2008 to March 2009 with a 16.4 % increase.

They also note that the "The dollar is likely to depreciate quite a bit further as adjustment proceeds, although the process will be slower to the extent that major U.S. trading partners, notably China, resist the appreciation of their own currencies." One more passage from Obstfeld and Rogoff:

Are today’s somewhat compressed external imbalances still a problem? Perhaps one could hope that the current pattern is sustainable and will require little further adjustment. A number of considerations suggest, however, that global imbalances remain problematic, both for the U.S. and the world:
• The large private foreign purchases of U.S. assets that helped finance the U.S. deficit in past years have, for the moment, contracted sharply. Given the prospect of much larger U.S. public-sector deficits down the road, with no clear and credible timetable for their reduction, U.S. external borrowing will be prolonged and investor faith in the dollar cannot be taken for granted. Recent research on crises suggests several avenues of vulnerability as U.S. government deficits and debt grow, including self-fulfilling funding crises and currency collapses once fiscal fundamentals enter a danger zone. Given the multiple equilibria involved, the timing of such events is inherently impossible to predict. It is even conceivable, if the fiscal regime comes to be perceived as non-Ricardian and therefore not self-financing over time, that inflation expectations lose their customary monetary anchor, thereby making inflation control by the Fed more difficult.35 In short, the prospect of dollar instability remains.

Most recent developments.
The equity markets and currency markets got a little choppy as the news of the PPI and housing starts figures were released including the Euro reached a high vs. the dollar since August 2008.

Dollar moves choppy after weak U.S. PPI/Housing data
U.S. PPI has declined 0.6% from August to September, while it dropped 4.8% sin the last twelve months, a well larger decline than the -0.2% monthly and -4.1% yearly drop expected by the analysts. Excluding food and energy, the Core PPI Index edged down 0.1% in September, and rose 1.8% year on year.

Furthermore, U.S. housing Starts increased 0.5% in September to a seasonally adjusted annual rate of 590,000 units, too short of the 2.0% increase forecasted by market analysts.

The drop in PPI is significant and the markets reacted in knee jerk fashion but the Core PPI is something that needs to be looked at even more closely. In this case the last month was down but only slightly and the past years numbers are quite in line with maintaining low but positive inflation levels which is good for strong economic growth going forward.

Housing and construction in general also does not seem to be sector that will lead the USA out of high unemployment as the overhang of foreclosed homes and resets mortgages may create a huge surplus of housing units on the market.

What does this mean?
I think I still come back to what Max Lichtenstein and Jessica Renier entitled their National Economic Update as "Optimism Amid Uncertainty". But along the way, we have explored some issues including the insightful paper by Obstfeld and Rogoff about the convergence of factors that lead to the financial crisis caused by the housing sector. And whether some of these sectors could be the impetus for a bain or boon going forward. We also looked at some data that showed a "lost decade" in both employment and the manufacturing sector.

Obstfeld and Rogoff ask what will happen "if the U.S. is no longer the world’s borrower of last resort." But for the mean time, do not expect the global imbalances to be corrected...

Euro touches $1.50 vs. dollar for 1st time since August 2008
Henri Guaino, a top aide to French President Nicolas Sarkozy on Tuesday, said the euro at $1.50 "is a disaster for European industry and the economy," Reuters reported.

A day earlier, French Finance Minister Christine Lagarde, speaking to reporters after a meeting in Luxembourg of euro-zone finance ministers, said officials needed to remain "disciplined" in their message calling for a stronger U.S. currency.

"We want a strong dollar; we need a strong dollar," she said, according to news reports.

And European Central Bank President Jean-Claude Trichet on Tuesday repeated his endorsement of calls by U.S. officials for a strong dollar.

Misc. Links:
Who’s afraid of the big, bad market?

On the measurability of offshorability Alan S. Blinder

Present at the Trade Wars

DOW 10,000!!!! Oh Wait, Make That 7,537

Series: TWEXB, Trade Weighted Exchange Index: Broad

Mountain of modifications Industry tries to keep up with avalanche of troubled mortgages

"Something is Wrong with Wall Street"

Implications of a Doomed Dollar