Tuesday, September 01, 2009
Bouncing Along The Runway
Very interesting comments, which largely agreed with my observations. I think JM gets the Gold Palm Leaf of Peoetic Economics for the runway comment.
The sharp pop in input costs is going to be a problem for recovery, because manufacturing margins are too low for the most part as it stands. Further, there are going to be supplier problems in the event that we ever do manage to get up in the air. Also, while manufacturing is improving it is not improving enough to help employment trends.
But the bottom line is that input costs, which are largely commodity-related, are increasingly out of line with the ability of the consumer to pay for the products. This means that CPI is not going to inflate as much as PPI, which is the recipe for a manufacturing slowdown rather than a manufacturing expansion.
CF is skeptical of my claim that a couple of rate rises are needed this year. Ordinarily, I would agree with him.
Low rates make investment cheap, and boost the demand for stocks of companies that make things. As recessions wear on, the weaker competitors die out, and this increases effective demand for those left. The combination of low investment costs and a greater share of sales (even if overall sales are declining), plus the very low return on bonds, tends to divert investment into production. The likely return on such investments over a few years can be very high, because when final sales do increase, and the manufacturers have a large share of the market, investments in more efficient production may pay off hugely.
That's the theory. The reality here is that consumer demand is very slack. The slackness is related to real declines in incomes over a period of years, and a sudden rise in the costs of consumer credit, accompanied by a decrease in consumer credit for some segments of the population. It is also related to the demographics and consumption patterns of an aging population, which factor is quite intractable.
The consumer credit situation is structural, and also can't be modified by Fed actions. Changes in federal costs of funds are not going to move consumer credit rates substantially. Take a look at chargeoffs at commercial banks through June (NSA). Credit card chargeoffs are at 9.77%. Add servicing costs of 2.5-3% (usual allowance for securitizations), and we get to 12.77%. Then you need a margin, so if your cost of funds is 2%, and you want to make 3%, you need to charge the consumer 17.77%.
Servicing costs are much lower for home mortgages, but right now they are running high. Use 30 basis points (0.30%), plus current chargeoffs of 2.34%, plus a net margin of 3%, and mortgages should be well over 6%. Of course the theory is that the latest round of mortgages are going to be better underwritten, but if you look at the details a lot of them are going to have historically high default rates. And if you don't believe what I am writing here, take a look at real bank margins regardless of the fact that theoretically, the current rate situation is great for banks:
So the impact of raising fed rates on consumers is going to be minimal. Doing what is best for the overall economy will produce the best employment rate, and employment rates are going to have the most effect on final interest rates, because consumers who do not have jobs default on their loans. You try paying off your loans on unemployment. It ain't gonna happen. If the credit card company doesn't yank your credit quickly enough, you are going to ride through it on their coattails and then go BK.
Just for a reality check, the Q2 NSA bank chargeoff rate was 2.64% of all loans and leases. The previous high since 1985 was 1.90% in 1989, followed by 1.86% in 1991 during that recession. This is bad, and growing worse, which is why banks are toppling over. Nor is this just a matter of the small fry - the chargeoff rate for all loans and leases for the 100 largest banks was a stunning 2.91%, the credit card chargeoff rate was 9.87%, and the residential mortgage chargeoff rate was 2.66%. Yikes.
It is correct to say that we don't have monetary inflation. Just take a look at treasury yields, which dropped heavily this month after FRB governors announced that rates were going to be low, low, low for years to come as the Fed ensured we had a WalMart economy (new Fed logo, that little bouncy smiley face thingie that hops around on the prices and drops them). We began August with the 2 year at 1.18% and the 3 year at 1.72%. We ended August with the 2 year at 0.97% and the 3 year at 1.49%.
But nonetheless, commodity costs and manufacturing costs are rising. The reason for this is simple - the Fed has overswung in trying to push real rates down, and manufacturing is so slack that it cannot eat up the excess money. So although the Fed is controlling the the official rate, there are not enough places for investors to put their money with an acceptable return/risk ratio.
That is why you now see a remarkably high incidence of cash home sales, for example. Under normal conditions, investors can write off their interest plus depreciation plus maintenance costs, so it makes sense to borrow a good portion of the money. But now it makes sense just to dump the money in real estate - or in commodities. Banks and servicers are happy to take the money and run.
Thus, the Fed has rates so low that it is effectively shrinking the money supply, which is deflationary as all hell. It does not make sense for banks to lend or most borrowers to borrow. If banks were going to lend for a reasonable margin, they would have to factor in the risks of default and loss and lend at higher rates. There's less of a problem selling Treasuries than selling mortgages, so now the federal government is insuring a huge percentage of mortgages. This is stupid.
Oil is especially problematic. Natural gas prices keep collapsing, and oil usage is down by more than a decade's worth, even while supplies are consistently above the five year average range. There is absolutely no reason why oil should be priced the way it is, except that extremely low interest rates and extremely low rates of return on investment make it a good gamble. The government is holding rates so low in a high-risk environment that they are effectively paying investors to hold commodities or real estate. If people are worried about inflation, they'll be happy to hold a hard asset - but in an environment in which one is worried about real returns and deflating assets, the last thing you want is to borrow against that asset. Thus, credit constricts, velocity drops, expectations are reinforced, and moveable cash goes into the ground.
The safe returns on invested money are going to be less than the cost of borrowing, so it does not pay that cash buyer to put down 50% and finance 50%. Instead, the cash buyer is trying to maximize his future cash flow on that foreclosed home, because he expects it to deflate for a couple of years.
Now, CF is still right on the basic theory. We do need to keep rates quite low for an extended period of time. However, the only way to do it is to ratchet rates up into some sort of reasonable territory. The sooner you start, the likelier than you can get most of the adjustments occurring in the private economy.
I cannot emphasize enough that creating a situation in which invested money returns extremely low yields can be deflationary in a high-risk environment. You either pay people to compensate for risk, or you create a situation in which people don't want to borrow, banks get more "book" return for shrinking loan portfolios and taking back the associated ALLL than they do for lending, and everyone's worried about protecting future cash flow.
There is a reason for this seeming contradiction, and it is the condition of the banks. Bad previous underwriting combined with a really bad recession produces high default rates. Thus they keep having to put money aside for their ALLL (Allowance for Loan and Lease Loss), which is why effective margins are so low. The cost of credit lines boosts particularly, because if you have a line open that is discretionary (i.e. drawable at the debtor's behest), you really need to reserve on the whole line, but you may only be getting income on a very small portion. Thus it is greatly in the bank's interests (once they have their ALLL boosted) to gradually cut their lending, and it is greatly in the producers' interests to limit their need for credit accommodation, which cuts into their profits at an exceptionally high rate in times like these.
If I still haven't convinced you, here is the ratio of ALLL to assets (loans):
Many banks still have to increase their ratios. Treasuries are your safest return, but it should be obvious that when the US commercial bank ALLL ratio is above the yield on Treasuries, the wisest thing to do is to cut lending, which will render an even safer and higher return. And that is why loans and leases at banks are now beginning to decline (see H.8), whereas earlier in the recession they were still expanding. There is low demand for money, low return on money, and a much higher return for cancelling out debt. But this is deflationary, because it cuts into money circulation.
If this is not clear please tell me and I'll try again. When a person is so immersed in this stuff a person is often horribly bad at explaining it. I do have more time, and if kicked enough I can be lucid. It might take quite a bit of kicking, but I really do understand it, and it would not hurt me to learn to explain it.
PS: That last sounds arrogant. I don't mean that I understand macroeconomics any better than anyone else, but I really do understand the banking side, which is why lately I scream and run for the scrub brushes when I read call reports.
And I think your analysis is spot-on.
Those who think we are going to have severe inflation are not considering the fact that much of the effective money supply comes from the multiplicative effect of fractional reserve banking, which doesn't happen when the only borrowers banks are willing to lend to don't want to borrow.
On top of that, the operative formula is PQ = MV -- prices times quantities equals money supply times velocity -- and velocity is dropping, too.
So as you point out, the inflation we're seeing isn't really "monetary" inflation.
If the DPJ are able to accomplish the shift away from export orientation to domestic consumption which we are being told is their aim, the yen will rise and everything imported from Japan will become more expensive. Since manufacturers all over the world are heavily dependent on Japanese suppliers for high-value-added parts, their product costs will go up substantially if the yen rises from the current rate of 93 up to 80 or fewer per dollar*, the rate at which we last saw the trade balance start to mend. It's not only commodity inputs that manufacturers will find more expensive.
So the buying power of American consumers will be additionally impacted by rising prices that are not due to monetary inflation, and so not accompanied by wage increases. This will further decrease unit sales, with knock-on effects on the businesses of transporting, warehousing and retailing imported goods.
(Note that a large fraction of China's apparent trade surplus with us is in fact a hidden increment to the Japanese trade surplus vs the US, because high-value Japanese parts are a large component of Chinese product costs).
*Fewer yen per dollar means yen are more expensive.
On a macro scale those who are able paying off their principle; while those who are not defaulting seems a pretty bad place to be.
I'm reminded of the corvette scene in the Big Lebowski. Main street is pissed off and trashing the corvette of Bernanke, Geithner, Obama et al. (Oh yes, Obama, they'll be coming for your car too soon enough.)
I also think I figured out a back-of-the-envelope model for the Latin American monetary disease. The consistency between Argentina and the U.S. is market-specific inflation of one of two pegged currencies in a globally deflationary environment, which eventually forces the abandonment of the peg. I suspect, though, that the trade and debt imbalance resulting from the peg is a necessary pre-condition to the crisis.
Argentina forced a dollar peg and used the resulting monetary stability to leverage their governmental budget. When Greenspan tried to gracefully deflate the tech bubble by raising rates, Buenos Aires couldn't cover the financing and had to abandon the peg; all those years of fiscal mis-management caught up to them in spiking import prices and the inability to borrow to cover their cost of government.
In our case China forced a dollar peg in order to make it easy for us to leverage our consumer AND governmental budgets to buy their exports. This disguised the true cost of U.S. debt, and allowed a debt bubble to build up. For many reasons, we are now faced with a globally deflationary environment. Up to now, at least, China has continued to finance our government for their own purposes.
The key question is the same as always: at what point, if any, does the global appetite for Treasury debt diminish to the point of forcing China to drop the peg? We can probably drag this limbo state out for a decade or two, if China maintains the peg. If they don't, well, Don't Cry for Me....
Two far leftist presidents were elected - Salvador Allende in Chile and Allan Garcia in Peru. Both instituted sweeping socialistic "reforms" requiring much deficit spending. Within two years both countries experienced runaway inflation of up to 650%. Allende was deposed in a military coups but Garcia was defeated in an election by Alberto Fujimora, a Japanese-Peruvian. Fujimora reformed the economy and defeated the Maoist guerrilla group known as the Shining Path. However, the leftistys managed to catch Fujimora's security chief bribing someone. Fujimora resigned and left Peru, but the leftists could nopt forgive him for saving the economy. Fujimora is now in prison for life on charges of excessive cruelty in dealing with the Shining Path.
Chile was returned to economic normalcy over a period of years by Gen'l Augusto Pinochet, a militarty dictator. However, after after a period of ten years elections and prosperity returned to Chile. But Chile recently elected Michelle Bachelet, another socialist who is trying to institute socialist programs again. Also, Chile, lke Peru, had a leftist group that could not forgive Pinochet for reforming the economy. Eventually they tried Pinochet for crimes against humanity after he left office. He died before the trial concluded.
Is Obama our Allende or Garcia? I realize the U.S. economy is much stronger and more diversified than Peru or Chille, but are we going to face ruinous inflation at some point because of deficit spending and profligate money creation? I don't know the answer, but I'm very concerned and, though we have deflation now, it could change quickly if the dollar continues to sink.
My question to you is, ppl think deflation and they think "price of everything goes down".
What you seem to be saying is that we are going to get selective price increases in commodities and real estate because ppl have nowhere to put their cash.
However, if returns are negative, why not just hold cash and not commodities or real estate? Are you saying that those holding real estate are wrong? (because they think inflation is coming)?
Also, Japan had a huge trade surplus and a healthy balance sheet. the US does not. I am uncertain where that leads us, and makes me think that longer term, inflation is a better course for helping pay that debt off. Do you see us playing out differently b/c of our worse fiscal position?
Very much enjoy your posts. In fact, I really look forward to them--probably in the same way other people look forward to their favorite weekly tv show.
LTR - Cash is producing very low income flows, and most people believe inflation will resume. In a lot of ways, buying hard assets serves as a hedge for an individual investor. And don't forget taxes!
AllanF - but in a lot of ways, being debt-free is by far the best investment for most people right now. And for many businesses! If you are paying 5-17% on your loans, and your risk-free returns are much lower, paying off debt is a very good strategy.
As I pointed out, accommodation credit (letters of credit, discretionary credit lines, etc) come at a high price right now. Therefore it makes sense for businesses to build up a cash reserve instead of using such credit, and it makes sense for most people who may be paying 13% at best on their CCs to pay that debt down. Nor do CCs and lines have as much appeal to the individual as before, because by now people grasp the idea that they may disappear or become terribly high-cost just when you truly need them.
But there is no question that the US has backed itself into a situation which is rather similar to Japan's. The chief difference is that our balance of trade is far worse. We are certainly rapidly pursuing Japanese-like levels of public debt.
There is one strong difference, and that is cultural attitudes toward debt. In Japan, a lot of businesses and individuals struggled onward paying off debt that was wildly out of line with the underlying asset. That is going to be less true in the US.
My point was our betters have overplayed their hand by ignoring the amount of debt folks have to pay down. They want us to spend and take on more debt. They've done everything they can to disincentive saving by lowering the Fed rate to 0, with savings accnts, CD's, and Money Markets following. However, the retail cost to borrow has not followed because banks are trying to recover their poor underwriting from the bubble years. I suppose from a business standpoint on the part of banks they have to do this, but the public doesn't have to be a party to it. They can simply keep paying down their debt instead. So the unintended consequence of 0% interest rates to screw savers is that debtors (those that are able) choose to pay down debt. And those that are not able, choose to default.
Long story short, I agree raising interest rates this year would probably be a good thing to get risk-averse people to loosen up a little bit.
I think you are addressing some of the reasons why banking regulation is necessary to prevent these extremes from occurring. As we can now see, the "too big to fail" structures turn into a lead weight on the economic ankles. The 1990s-era banking and finance proposals have turned in an epic fail.
The big disconnect I have is the price of Commodities, as you say. Gold at $1,000/oz? Oil at $70/bbl? Copper at 287/oz? Not consistent with 16% unemployment, 68% Cap U, Recession. To the extent w/ 0% interest rates it's cheap to carry the physical long, I guess that's plausable. Perhaps it has more to do with the low rates making the dollar cheaper, pushing up the raw material prices. Agree a higher Fed Funds rate will make the dollar more attractive, push prices down and not feed much into consumer rates. It will however eat into the Company margins, and be especially hard on small business. I dunno. Complicated.
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