The Economist and the IMF are worried about what will happen to financial markets overseas when the Federal Reserve starts raising interest rates:
Posted by DeLong at April 10, 2004 07:56 PM | TrackBack | | Other weblogs commenting on this postEconomist.com | World markets: ...Flat yields in mature markets make emerging markets look good. But there is more to it than that. The ample liquidity sloshing around in the rich world is also an invitation to enter into the so-called “carry trade”. Carry traders borrow at low, short-term rates. They then invest the proceeds in higher-yield assets. Some simply buy long-dated American bonds. But the more adventurous look further afield, betting on richer-yielding emerging-market bonds with money borrowed at cheap rates in mature markets.
The problem is those cheap rates may not last much longer. Interest rates in Britain have already started rising. On Thursday April 8th, the Bank of England held rates steady at 4%, but it is expected to raise them another notch next month. When the Federal Reserve follows suit, the liquidity that lubricates the carry trade may dry up. A warning shot came late last week: America’s monthly jobs report was surprisingly strong—308,000 workers were added to the payrolls in March. That was followed up on Thursday by the news that the number of Americans making initial jobless claims fell to 328,000 in the week ending April 3rd, the lowest for more than three years. This gathering strength in the labour market threatens to remove the Fed’s last, best excuse for keeping interest rates at 45-year lows.
The market, of course, is not wholly unprepared—it knows the Fed will tighten monetary policy. But it does not know when, or by how much. Many analysts expect a rate rise before the summer is out. Others still maintain that the Fed will wait until after America’s November presidential election. When the Fed does finally get going, most assume it will take cautious, baby steps. But no one really knows how quickly it will move.
The IMF fears the bond market will be caught out in 2004, much as it was in 1994. Back then, markets were similarly bracing themselves for a gradual shift to a tighter monetary policy. Short-term interest rates were low and longer-term rates high, in anticipation of the economy reaching full strength. As a result, the “yield curve” at the beginning of 1994 was unusually steep—almost as steep, indeed, as at the start of this year.
Sure enough, in February 1994, the Fed started raising rates. But it went further and faster than anyone had anticipated: seven hikes in 12 months doubled the federal funds rate to 6%. As short-term rates caught up with long, the yield curve flattened out. The liquidity tap was turned off; the carry trade miscarried. Investors could no longer borrow cheap money to lavish on emerging markets. Emerging-market bond yields shot up. The result was Mexico’s “tequila” crisis, in which the country found itself with more debt than it could repay and a currency peg it could not defend.
This time might be different. In 1994, Alan Greenspan acted so precipitously because he was spooked by the prospect of inflation. But the spectre that haunted him then is no longer a worry: Mr Greenspan, if anything, thinks inflation today is too low. More importantly, few emerging markets are any longer in the business of defending unsustainable currency pegs, as Mexico was in 1994. If emerging markets do fall out of favour with foreign investors, their exchange rates can take some of the strain.
The IMF is still worried, however. “Valuations on emerging-market bonds, especially sub-investment grade bonds, appear vulnerable to an increase in underlying US treasury yields,” it says. As the Fund points out, the notion that this time it’s different has led many an over-optimistic soul to repeat this time exactly the same mistakes he made last time.
1) remember the intense pressure not to raise rates, particularly in a close political race...
2)otoh, the economist had an interesting article regarding the possible mis-measurement of gdp (the underreporting of intermediate imports) which would account for the non-existent job growth (because the economy has not grown at the pace previously indicated). any thoughts?
William Pesek Jr: Is Alan Greenspan Behind China's Bubble Too?
http://quote.bloomberg.com/apps/news?pid=10000039&sid=a5z8k14ECUoU&refer=columnist_pesek
Globalization is globalizing the Federal Reserve. It has 12 districts and acts based on U.S. events, but its influence has never been greater. It isn't far-fetched to think of Latin America as the 13th district, Southeast Asia the 14th, Russia the 15th, China the 16th, and so on.
Martin Wolf: The Fed is forced to fuel a global boom
http://www.talkaboutinvestments.com/group/misc.invest.stocks/messages/858491.html
You may think the Federal Reserve is the US central bank. But it is much more than that. It is the central bank of more than half the world. That explains much of what is happening in the world economy. Fed policies are driving the rest of the world quite as much as the US.
Posted by: rawls on April 10, 2004 10:51 PMIt's always different this time.
Posted by: big al on April 11, 2004 03:32 AMA too conventional and incorrect analysis.
The fed should measure the need to raise rates by the debt to asset ratios of the consumer and business, both of which are at historical highs.
Fed policy should be directed at reversing that trend, which can only come about through inflation of asset values.
Posted by: Moe Levine on April 11, 2004 06:04 AMlawrence makes the point that the Fed is a politically appointed body and that raising interest rates would be bucking intense political pressure.
Still, the determination of interest rates is perceived as an exercise of economics and one would hope that the Fed has a longer horizon than the political (4 yr) term. If the economic picture tells us that raising the interest rates is in our long range interests then I hope they would have the balls to buck the political pressure.
O'Neill showed us the way, no?
I agree ( with rawls) that given the imbalance of American consumption in the global picture, the Fed is much more than a central bank. Raising the US interest rate would not only have immediate effects on the domestic economy but also the foreign economies that are overly dependent on their exports to the US. Roach, who never tires of telling us about this "imbalance", is adamant about a 2% interest hike. (In his view, sooner is better than later and a sizeable dose is better than a gradual approach. And to do nothing is a case of denial.) Correction before catastrophe.
"Its (always) different this time" propels not only the overly-optimistic but the overly-pessimistic as well.
That might be Roach and it might not --depending on how one sees the differences.
lawrence rocke wrote, "the economist had an interesting article regarding the possible mis-measurement of gdp (the underreporting of intermediate imports)..."
That's interesting. Got a URL for that?
Posted by: liberal on April 11, 2004 11:09 AMA propos "carry trades", there is an old saying: "carry traders are often carried out of the building".
Posted by: Mats on April 11, 2004 11:59 AM"Got a URL for that?"
GDP Growth: Are The Numbers Too Rosy?
http://www.businessweek.com/magazine/content/04_14/b3877044.htm
'Forget faulty jobs data. An overstated GDP may help explain the economic reality gap'
also... Where Wealth Lives
http://businessweek.com/magazine/content/04_16/b3879051.htm
'The productivity boom has made asset owners rich -- and left many wage-earners behind'
Don't forget that the world's largest gov't debt market is Japan, where long-term interest rates are hovering around 2%, with the Postal System there (where most of the population keeps its retirement savings) taking on most of the interest rate risk. The Fed isn't the only CB having to carefully negotiate, as Paul McCulley has termed it, an "exit strategy" from very low interest rates -- 'ZIRP' in Japan.
Doctor, My Eyes
http://www.pimco.com/LeftNav/Late+Breaking+Commentary/FF/2004/ff_04_04.htm
'...once reflationary policies beget reflationary consequences, it will be time for the Fed to dilute the ink supply for its reflationary printing press. Such a change will ineluctably involve bursting of asset price bubbles, as those who have bet that the Fed would fail in its reflationary efforts are compelled to reduce portfolio risk and leverage. This is the biggest challenge presently confronting the Fed: the exit strategy from a 1% Fed funds rate, when it is no longer prudent.'
I have the impression that Greenspan and company are trying to talk their way out of the sort of eruption that came about in February 1994. Fed officials have been saying two things. One is that rates are going to have to rise - those in carry trades are to understand that the party will be ending. The other point Fed officials have been making is that they don't have to hurry. This may mean they don't have to hurry to get rate hikes underway, but it may also mean they don't have to hurry once rate hikes are underway. In the latter case, the massive "rush for the door" that was seen in February of 1994, when bond yields rose 75 bps in response to a 25 bp hike in the funds rate, may be avoided. Carry trades will become less lucrative, but Fed assurances of patience may reduce the urge to get out all at once.
Posted by: K Harris on April 11, 2004 06:37 PMThere are many reasons for the Democratic electoral debacle in 1994, including the mostly self-inflicted health reform fiasco. Nevertheless, the Fed by so rapidly tightening interests rates also played a part. Despite this, Clinton never publically criticized Greenspan. This makes Greenspan's post-2000 behavior even more despicable. Surely, he knew the differnce between a CBO baseline and an actual prediction about what future budget surpluses would be.
Posted by: Vadranor on April 11, 2004 08:45 PMI had trouble with the Economist article that
growth may be overstated. They compare industrial production to goods output -- but the issue is if outsourcing is causing services
output to be overstated so the comparison they make is not too the point.
I looked into this issue several months ago and came to the conclusion that we probably are overstating service output because we are missing service imports in the data collection,
but it is not big enough to explain the divergence between income growth and output growth.
It is like the claims you hear that the US gets more jobs from insourcing than we lose from outsourcing. I'M seing this reported several times recently -- including in the Lexington article in the economist last week-- but it just does not make sense. People are claiming that the jobs from direct foreign investment is evidence. But that makes no sense at all. US firms employee 9 M people aboadd and foreign firms employee 6.4 M
in the US. US firms employment abroad is 150% of US jobs in foreign firms. Logic would suggest that the outsourcing ratio shuld be similiar -- not the opposite. You get the same ratio if you compare imports to exports. If we have a massive goods trade deficit it would be logical to haqve a large "outsorcing" deficit.
Has anyone seen the original source for the argument that the US has more insourced jobs than outsourced jobs that is now being spouted by some?
Are they really worried or is this just another facet of the relentless Economist drumbeat for raising interest rates? They just take a page from Fox News and analyse the effects of the policy they advocate as if its implementation were a forgone conclusion.
Posted by: Retief on April 12, 2004 09:49 AMAre they really worried or is this just another facet of the relentless Economist drumbeat for raising interest rates? They just take a page from Fox News and analyse the effects of the policy they advocate as if its implementation were a forgone conclusion.
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