Global monetary policy

Bernanke's bind

The Fed, the dollar and commodities

THE spirit of St Augustine hovered over the Federal Reserve this week. “Oh Lord, let us stop cutting interest rates, but not yet,” is pretty much what America’s central bankers decided on Wednesday April 30th. The Fed’s governors cut their policy rate by another quarter-point, to 2%. But the accompanying statement gave a small hint that they may now pause.

There are plenty of reasons to stop cutting. Real interest rates are now firmly negative. Although the housing market continues to contract, the economy is limping rather than slumping. According to initial GDP estimates released on Wednesday, output grew at an annualised rate of 0.6% in the first three months of the year—the same pace as in the previous quarter and faster than most people expected. The mix of growth was not good. Final sales fell while firms built up their stocks, which bodes ill for future output. But with tax-rebate cheques arriving in the mail, a dose of fiscal stimulus is imminent.

A growing chorus worries that ever lower policy rates are adding to America’s problems. Some prominent economists have urged the central bank to stop. Fed cuts, they argue, are doing little to reduce borrowing costs but have sent commodity prices soaring—fuelling inflation and hitting Americans’ wallets hard.

Thanks to the credit crunch, Fed loosening plainly packs less punch than hitherto. But monetary policy has not been impotent. One route through which it has worked has been the weaker dollar. Although the greenback has been sliding for over five years, the pace of decline stepped up as the Fed slashed rates. Together with strong global growth, this weakness has cushioned and reoriented America’s economy. Strong foreign earnings have boosted corporate profits. Strong exports have countered the weakness in construction. Exclude oil, and America’s current-account deficit has shrunk to an eight-year low of 2.4% of GDP.

But oil—and other commodities—are the crux of the problem. In the past, economic weakness in America has usually pushed the price of oil and other commodities down. That relationship has weakened thanks to demand growth in big commodity-intensive emerging economies. But the recent surprise is that commodity prices have soared even as America’s economy has stalled and forecasts for global growth have been trimmed as well. Supply shocks are clearly part of the problem. But the fact that prices have soared across so many commodities suggests a common cause.

Could the culprit be the Fed? Advocates of this idea point to two channels. First, by slashing real interest rates, the Fed has encouraged speculation in commodities by reducing the cost of holding inventories. Second, by pushing down the dollar, Fed looseness is pushing up the price of dollar-denominated commodities.

Jeff Frankel, a Harvard economist, has long argued that low real interest rates lead to higher commodity prices. When real rates fall, he points out, commodity producers have more incentive to keep their asset—whether crude oil, gold or grain—in the ground or in a silo, than to sell today. Speculators, in turn, have more incentive to shift into commodities. There is no doubt that commodities have become an increasingly popular investment category—in fact they bear many of the hallmarks of a speculative bubble. But inventories for many commodities, particularly grains, are unusually low.

What about the dollar link? Chakib Khelil, president of the Organisation of Petroleum-Exporting Countries, argued this week that oil could reach $200 a barrel largely because the market was being driven by the dollar’s slide. Movements in the euro/dollar exchange rate and the price of oil have become extremely close (see chart). An analysis by Jens Nordvig and Jeffrey Currie of Goldman Sachs shows that the correlation between weekly changes in the oil price and the euro/dollar exchange rate has risen from 1% between 1999 and 2004 to 52% in the past six months.

That link is partly a matter of accounting. If the dollar falls, the dollar price of a commodity must rise for its overall price—in terms of a basket of global currencies—to remain stable. But commodity prices have risen even when priced in non-dollar currencies. And the correlation between changes in the price of oil and the euro/dollar exchange rate has risen even when oil is priced in a basket of currencies, such as the IMF’s special drawing rights.

So is the weaker dollar driving oil prices up or are high oil prices driving the dollar down? The Goldman analysts argue the latter because oil exporters import more from Europe than America and hold less of their oil revenues in dollars. A second factor lies with central banks. Because the Fed focuses on “core” inflation (which excludes food and fuel), whereas the ECB targets overall inflation, America’s central bank runs a looser policy in response to higher oil prices, thus pushing the dollar down.

Another reason to suspect that the Fed is more than a bit player is that American interest-rate decisions have a disproportionate effect on global monetary conditions. Some emerging economies still peg their currencies to the dollar; many others have been reluctant to let their exchange rates rise enough to make up for the dollar’s decline. As a result, monetary conditions in many emerging markets remain too loose. This fuels domestic demand, pushing up pressure on prices, particularly of commodities. All of which suggests that the Fed’s decisions are propagated widely through the dollar.

The most recent circumstantial evidence also suggests that the Fed may bear some responsibility for the commodities boom. As investors speculated that it was putting short-term interest rates on hold for a while, the dollar rallied against the euro during European trading hours on Thursday. In turn, oil, gold and other commodities fell. Whatever the role of the Fed, if those trends persist, its policymakers will heave a sigh of relief.

Clinton Caught in Time Warp With Windfall Oil Tax: Amity Shlaes

Commentary by Amity Shlaes

May 2 (Bloomberg) -- Jimmy Carter's in the news again. The former president wants a windfall-profits tax. No wait, he wants the U.S. to recognize Hamas. Hillary Clinton is the one who wants a windfall-profits tax.

It seems that every year, usually just around the time Memorial Day comes into view, a politician demands a tax on oil profits. Richard Nixon's economists offered one up in 1973, arguing, almost vindictively, that they were justified in imposing a stiff levy because the tax would ``make up in some degree for windfalls which have occurred in the past.''

Carter proposed one in 1977, saying his administration ``will ask private companies to sacrifice just as private citizens do.'' A few years ago Senator Charles Schumer of New York put forward a tax in the name of funding a $100-per-family income tax credit.

Senator Clinton has couched her support in terms of the hunt for revenue: ``I'm the only one with a plan,'' she said earlier this week. And lots of other Americans, not just Democrats, are eager for a break at the pump.

What to make of it? Insanity has been defined as doing the same thing over and over again, and each time expecting a different result. By this definition, a new windfall-profits tax would suggest a sort of collective insanity. For, as our country's history with the great Windfall-Profit Tax of 1980 amply demonstrates, there are lots of reasons to oppose it.

Not Much Revenue

The first is that such taxes tend to yield disappointing revenue. Back in 1980, lawmakers were riled over the news of Arab Light hitting $36 a barrel, up from just $14 in 1978.

Congress, the world's worst economic forecaster, began to envision an endless increase in the price of oil and an endless gusher of revenue. Lawmakers imposed a levy of as much as 70 percent based on a per-barrel increase over a designated base price.

Carter wasn't necessarily comfortable with the recent ending of price controls. And he knew that Mobil Oil Corp. and other oil companies were excited about future discoveries.

Now he consoled himself with the thought that this windfall tax would take the profit of such discoveries from such irritating petrocrats.

Of course, oil prices didn't surge -- in fact, they dropped. There was something at work that lawmakers hadn't thought of. The oil-price increases had been partly a monetary event, reflecting the inflation that the new Federal Reserve Chairman, Paul Volcker, was then vanquishing.

Quiet Death

Some would argue that inflation plays the same role in goosing commodity futures prices today. By 1986 oil prices had collapsed. Disappointing windfall tax revenue reflected that.

At the Cato Institute, authors Jerry Taylor and Peter van Doren reckon that the windfall profits tax generated $40 billion or so, instead of the $175 billion once projected. By 1988, embarrassed lawmakers allowed the tax to die a quiet death.

But in the course of its life, the tax did plenty of damage. As a Congressional Budget Office paper from 1983 pointed out, the levy early on proved itself an administrative nightmare since it effectively required the collection of ``detailed information on each individual oil-producing property in the United States.''

What's more, the tax so depressed business activity that it had an effect on the general economy.

Experts Baffled

But in 1980 the economy's refusal to recover was baffling some economists. One of their conclusions, published in the New York Times, was that the windfall-profits tax was being passed along to consumers, reducing disposable income and so demand. In other words, it was doing the opposite of what the tax-rebate checks are supposed to be doing this month and next.

Specifically, the Windfall Tax made investment and production at domestic oil companies more expensive. Mobil was right. You needed incentives to want to drill. That deterrent slowed the sort of research that might have made energy less expensive earlier.

A Congressional Research Service paper suggested that the 1980 law actually increased foreign imports relative to domestic production.

So where we are now is that Clinton and her colleagues are backing a move that would strengthen the position of Middle Eastern OPEC members and Hugo Chavez of Venezuela.

No Free Trade

That's certainly consistent with her perverse refusal to help save Colombia from the arms of Hugo by rejecting the Colombian-American free trade agreement. But it's not exactly a position that leads to U.S. energy independence or suits our country's green ambitions.

Clinton argues that the windfall tax is valuable because it will subsidize a summer gas tax holiday for drivers. Senator John McCain, the presumptive Republican presidential nominee, has also endorsed a gas tax holiday. Such a break will feel good, but like the windfall tax, may prove counterproductive.

As economists such as Harvard's Greg Mankiw have pointed out, if you want domestic innovation, it would make more sense at this point to raise the gas tax and let the companies keep the rest of their resources. Then they would work on green technology. And of course, do the most important thing of all: drill.

All these missteps by his opponents actually leave Senator Barack Obama looking pretty good. He commented recently on the gas tax holiday, saying ``this isn't an idea designed to get you through the summer. It's designed to get you through the election.''

He's right. In her energy plans, Clinton believes she's found a political windfall. But those plans are so poorly crafted they may prove to be what wipes her out.

U.S. Stocks Rally on Better-Than-Forecast Jobs Data, Fed Loans

May 2 (Bloomberg) -- U.S. stocks gained, bringing the market to its first three-week advance since October, as a better-than-forecast jobs report boosted optimism that the economy won't get much worse.

Eight of 10 industry groups in the Standard & Poor's 500 Index climbed after the government said payrolls shrank by 20,000 workers in April, almost three-quarters less than economists had projected. Citigroup Inc. led financial shares to their highest level since February as the Federal Reserve increased a cash-loan program. Sun Microsystems Inc. tumbled the most since 2002, dragging technology shares lower, after posting a surprise loss.

The S&P 500 added 7.09, or 0.5 percent, to 1,416.43 at 11:25 a.m. in New York. The Dow Jones Industrial Average rose 56.51, or 0.4 percent, to 13,066.51. The Nasdaq decreased 2.81 to 2,477.9. Asian and European shares rose, sending the MSCI World Index to an almost four-month high.

``This is good news because consumer spending depends on job security,'' said Edgar Peters, chief investment officer at PanAgora Asset Management in Boston, who has been buying more equities in the last six weeks on speculation a U.S. contraction would be ``mild.'' PanAgora oversees $25 billion. ``All the talk of recession had people being as crazy as saying `This will be like the Great Depression.' If the job losses are limited to Wall Street, it's not going to bother Main Street.''

The S&P 500's 2.2 percent climb over the past two days pushed the index up 11.2 percent from its 19-month low March 10 and pared its 2008 loss to 3.5 percent. The Dow average has reduced its year-to-date decline to 1.5 percent.

Bullish Chart

The jump in the S&P 500 above 1,400 yesterday for the first time since January indicates U.S. stocks may extend their rally, say analysts who make predictions based on trading patterns. The gains sent the benchmark index for American equities closer to its 200-day moving average than at anytime this year.

More than three stocks gained for every two that fell today on the New York Stock Exchange. The Morgan Stanley Cyclical Index, designed to measure the performance of stocks closely tied to the health of the economy, rose 0.6 percent.

Citigroup increased 75 cents, or 2.9 percent, to $26.74. Bank of America Corp., the second-biggest U.S. bank, rose 61 cents to $40. The S&P 500 Financials Index climbed 1.1 percent to the highest level since Feb. 4.

The Fed, which has reduced its benchmark interest rate by 3.25 percentage points since September, today expanded its cash- loan auctions for banks by 50 percent to $75 billion each after higher borrowing costs blunted the impact of the four-month-old program. Fed Chairman Ben S. Bernanke created the Term Auction Facility and two other programs to reverse a decline in liquidity stemming from the subprime mortgage-market's collapse. Today's move may reduce loan payments for some companies and homeowners with variable-rate mortgages.

`Interesting Activity'

``I just got to the conclusion that this is the time to actually start increasing our weight in financials because the system is trying to be fixed, and in fact, is being fixed right now,'' Kevin Rendino, a senior fund manager at BlackRock Inc. in Plainsboro, New Jersey, said in an interview on Bloomberg Television. Rendino helps oversee about $15 billion. ``You cannot ignore what the Fed has done. All of the interesting activity they have done speaks to a better environment for the financials.''

Yahoo! Inc. gained $1.01 to $27.82 on speculation Microsoft Corp. may boost its bid for the operator of the second-most popular search engine. Microsoft is leaning toward a hostile bid and may make an announcement as early as today, the Wall Street Journal reported, citing people familiar with the matter. Microsoft declined to comment on its plans to the Journal. Microsoft lost 4 cents to $29.36.

Energy Rebound

Energy shares gained as crude oil rose for the first time in four days, gaining $1.25 to $113.77 a barrel as Turkey renewed its offensive against Kurdish rebels in Iraq, holder of the world's third-biggest oil reserves.

Exxon Mobil Corp., the biggest U.S. energy company, added 23 cents to $89.93. Schlumberger Ltd., the largest oilfield services company, climbed $1.54 to $99.89.

Chevron Corp. added 30 cents to $95.24. The second-largest U.S. oil company said first-quarter profit rose 9.5 percent amid record global demand for oil. Per-share profit was 8 cents higher than the average of 18 analyst estimates compiled by Bloomberg.

U.S. oil futures averaged $97.82 a barrel in the quarter, up almost $30, on their way to touching a record at $119.93 this week. Each $5 increase in crude prices boosts Chevron's earnings per share by more than 6 percent, according to Erik Mielke, an analyst at Merrill Lynch & Co. in New York.

Sun Microsystems Inc., the fourth-largest maker of server computers, dropped the most since July 2002 after a surprise loss, stagnant sales and another round of job cuts raised concern that Chief Executive Officer Jonathan Schwartz's growth plan isn't working. Sun slid $3.25, or 20 percent, to $13.08 for the steepest retreat in the S&P 500.

U.S. Economy: Employers Lose 20,000 Jobs, Less Than Anticipated

May 2 (Bloomberg) -- The U.S. lost fewer jobs than forecast in April, and the unemployment rate dropped, signaling that the economic slowdown may be milder than the 2001 recession.

Payrolls shrank by 20,000 workers, following a revised 81,000 drop in March that was larger than previously estimated, the Labor Department said today in Washington. The jobless rate fell to 5 percent, from 5.1 percent in March.

``We are in a recession, this report doesn't change that,'' said Ellen Zentner, an economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, who had forecast a payrolls cut of 25,000. ``What it does is support the idea that the downturn will be mild. Consumer spending isn't going to tank.''

Treasury notes fell, while stocks and the dollar rallied on speculation the Federal Reserve will refrain from lowering interest rates next month after seven cuts since September. An average of 121,000 jobs a month were eliminated in the first four months of the 2001 recession, compared with an average of 65,000 this year. A separate report from the Fed showed factory orders rose more than anticipated in March.

``Obviously a negative number is still negative,'' said Bill Cheney, chief economist at John Hancock Financial Services in Boston, in an interview with Bloomberg Television. ``But it is still so close to zero that essentially it means flat,'' just as government tax-rebate checks are being mailed, which will be ``almost guaranteed'' to boost job growth.

Economists forecast payrolls would fall by 75,000 in April after a previously reported 80,000 decline the previous month, according to the median of 82 projections in a Bloomberg News survey.

Further Fed Steps

Minutes before the jobs figures were published, the Fed said it will increase its auctions of cash to banks and expanded the collateral it takes on from bond dealers. The steps are aimed at alleviating strains in credit markets.

Today's report also showed that income growth slowed last month as the economy stalled. The economy's 0.6 percent expansion rate over the six months through March was the weakest performance since the 2001 slump.

Factory payrolls slumped by 46,000 workers, Labor said. Economists surveyed by Bloomberg had forecast a decline of 35,000. In the construction industry, employers cut 61,000 jobs, the most since February 2007.

General Motors Corp., the world's largest automaker, said April 28 it's reducing production of large pickup trucks and sport-utility vehicles this year at four plants in the U.S. and Canada because of slowing sales. The plan affects 3,550 workers.

Car Sales

Industry figures released yesterday showed that autos sold at a lower-than-forecast 14.4 million annual pace in April, the fewest since 1998.

Service industries, which include banks, insurance companies, restaurants and retailers, added 90,000 workers last month, the most this year, after an increase of 7,000 in March, today's report showed. The advance was led by business and professional services, along with education and health jobs.

Accenture Ltd., the world's second-largest technology- consulting company, will hire 60,000 people worldwide, Chief Executive Officer William Green told reporters on April 22. The company hasn't seen a drop or delay in orders from banks and financial companies, he said.

Retail payrolls declined by 26,800 after falling 19,300 a month earlier.

Home Depot Inc., the world's biggest home-improvement retailer, said May 1 it will close 15 stores and scrap plans for 50 more because the U.S. housing slump is hurting sales. The company will eliminate or move 1,300 jobs because of the closings.

Bank Hiring

Payrolls at financial firms increased by 3,000 jobs, after dropping 4,000 the prior month, Labor said. The gain, the first since July, is a surprise after figures from the Securities Industry and Financial Markets Association showed that Wall Street banks and securities firms, hit by $309 billion of mortgage losses and writedowns, slashed 48,000 jobs in the past 10 months.

Federal Reserve policy makers this week lowered the benchmark overnight lending rate between banks by a quarter percentage point, to 2 percent, in a bid to revive the economy. The government also started sending out tax rebate checks that were part of its fiscal stimulus plan.

``Household and business spending has been subdued and labor markets have softened further,'' the central bank said April 30 in announcing its decision. It also said that the easing that has taken place since last year, along with efforts to stabilize financial markets ``should help to promote growth over time.''

GDP Growth

The U.S. economy expanded at a 0.6 percent annual pace in the first quarter, the Commerce Department said on April 30, as inventories increased because consumer spending slowed and business investment dropped. The rise in stockpiles, along with smallest gain in household spending in seven years, indicates the economy will weaken further in coming months.

The average work week declined to 33.7 hours from 33.8 hours, according to today's report. Average weekly hours worked by factory workers decreased to 40.9 from 41.2, while overtime fell to 3.9 hours from 4.0 hours. That brought average weekly earnings down by $1.45 to $602.56 last month.

Workers' average hourly earnings rose by 1 cent, or 0.1 percent, the least since October, to $17.88 in April. That compares with a 0.3 percent gain forecast by economists in the Bloomberg survey.

Hourly earnings were 3.4 percent higher than a year earlier, the smallest gain since January 2006.

Job losses and higher food and energy costs are making consumers anxious. The Conference Board's confidence index for April fell to 62.3, a five-year low. The share of respondents who expected their incomes to rise over the next six months was a record-low.

Fed Raises Cash Auctions to Ease Bank Borrowing Costs (Update5)

May 2 (Bloomberg) -- The Federal Reserve increased its auctions of cash to banks and expanded the collateral it takes on from bond dealers, acting in concert with European central banks to alleviate persistent strains in credit markets.

The Fed boosted its biweekly Term Auction Facility operations by 50 percent to $75 billion. It also raised the amount of dollars it makes available to the European Central Bank and Swiss National Bank through swap lines to a combined $62 billion from $36 billion.

Today's actions follow a jump in banks' borrowing costs of as much as 0.38 percentage point since the Fed's March meeting that had blunted the impact of the cash injections that began in December. An index of U.S. financial stocks climbed to the highest level in three months after the announcements.

``The world is awash in liquidity, it just isn't reaching the right financial borrowers,'' said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``Today's action from the central banks is another strong dose of medicine that will help cure what ails the credit markets.''

Fed officials also expanded the collateral they accept under the Term Securities Lending Facility to include AAA rated asset- backed investments. That includes some bonds backed by student loans, which Democrats in Congress had pushed Chairman Ben S. Bernanke to take on the central bank's balance sheet.

Stocks Rally

The Standard & Poor's 500 Financials index gained 1.1 percent to 373.68 at 10:50 a.m. in New York. Stocks also climbed after a Labor Department report today showed employers cut fewer workers than forecast in April, and the unemployment rate unexpectedly dropped to 5 percent.

The Fed created the TAF and two other programs to reverse a decline in liquidity that began last year with the collapse in the market for subprime mortgages. Today's announcement may reduce loan payments for some companies and homeowners with variable-rate mortgages.

Today's actions were taken ``in view of the persistent liquidity pressures in some term funding markets,'' the Fed said in a statement.

A gauge of bank funding costs, a premium on three-month bank loans over the overnight indexed swap rate, which is a measure of what traders expect for the Fed's benchmark rate, reached 87 basis points on April 21. That was the highest since the Fed announced the TAF on Dec. 12.

Speculation had risen among Fed watchers this week that the central bank would increase the size of the TAF operations after borrowing costs increased. Some had also anticipated an extension in the term of the loans beyond 28 days.

`Tremendous Reluctance'

``It was a relatively conservative measure'' because the duration remains unchanged, Richard Iley, senior economist at BNP Paribas SA in New York, said in an interview with Bloomberg Television. ``Evidence thus far is that these auctions have had very limited impact in bringing down these still-elevated credit spreads. There still remains a tremendous reluctance on the part of financial institutions to lend to one another.''

Today's decision comes two days after the Fed's interest- rate setting Open Market Committee lowered its benchmark rate for a seventh time since September, while signaling it's ready to hold off on further cuts.

In its statement, the Fed removed a previous reference to ``downside'' risks to growth, while noting that past federal funds rate reductions and ``ongoing'' liquidity measures should help spur a recovery in economic growth.

Fed Strategy

``They're looking for ways to provide liquidity other than through cutting the federal funds rate,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina. With today's actions, ``they're trying to prevent the strains from building up,'' he added.

The TAF, which provides 28-day loans to commercial banks, will sell $75 billion in auctions every two weeks, starting with the May 5 operation, the Fed said in the statement. The decision will increase the amount outstanding under the auctions to $150 billion from $100 billion.

It's the third increase since the program started in December at $40 billion per month.

The expanded collateral under the TSLF will take effect with the sale to be announced May 7 and settle on May 9, the Fed said. The Fed announced the program in March, auctioning as much as $200 billion in Treasuries. In several of the sales, the Fed has failed to attract enough bids to cover the securities at auction.

Loan Collateral

The Fed already accepts residential and commercial mortgage- backed securities and agency collateralized mortgage obligations through the TSLF.

``The wider pool of collateral should promote improved financing conditions in a broader range of financial markets,'' the Fed said.

Along with the TAF and TSLF, the Fed in March started direct lending to investment banks at the same rate as to commercial banks, currently a premium of a quarter-point over the benchmark federal funds rate. The central bank also provided $29 billion of financing to secure JPMorgan Chase & Co.'s takeover of Bear Stearns Cos.

Investors have responded, buying a record $45.3 billion of corporate bonds last week and spurring a rebound in the Standard & Poor's 500 stock index from the year's low in March.

Today's decision comes after criticism from Stanford University economist John Taylor, who wrote in a study last month that there is ``no empirical evidence'' the TAF has reduced the premium that banks charge each other to lend cash for three months.

Fed Governor Frederic Mishkin said in a Feb. 15 speech that there was ``some evidence that the TAF may have had significant beneficial effects on financial markets.'' Mishkin included the caveat that ``isolating the impact of the TAF on financial markets is not easy.''