If you hold US bonds, sell. The Fed wants to rob you to help the bankrupting US homeowners.

By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Limited

 

After resisting pressure for rate reduction for a month during the unfolding credit crisis, the Bernanke Fed did an about face and surprised the market by cutting the Fed funds rate by 50 bps to 4.75% on Sept 18.  The market was expecting 25 bps before the announcement. Moreover, the statement after the decision deemphasized inflation and emphasized the risk to growth from the credit crisis. This change of heart has far reaching consequences for how the US and the global economy would unfold in the coming months or even years. Judging from its meeting statement, the Fed is likely to cut interest rate to 4% by early 2008.  Two obvious consequences are higher inflation trajectory for the US economy and a weaker dollar. 

A byproduct of the Fed decision is that it would accelerate bubble expansion within the Chinese economy.  China is already experiencing a sizable bubble; the excess asset value is probably 100% of GDP now. To slow down the bubble expansion, China must make deposit rate higher than inflation rate, which implies 200-300 bps of rate hikes ahead. On the other hand, the Fed is cutting interest rate. The combination implies more hot money coming to China, which expands the bubble and increases inflation. China has been on a treadmill on its tightening policy-rate hikes are just not catching up with accelerating inflation. 

What is facing China is very similar to what Southeast Asia did 15 years ago. The Fed was cutting interest rate aggressively to stave off the impact of a property burst, which was called the Savings and Loans (or ‘S&L’) Crisis. At the time, Southeast Asia had an inflation problem, a nascent property bubble, and fixed exchange rates. The rate reductions by the Fed triggered a frenzy of lending to Southeast Asia.  It expanded its property bubble enormously. The bubble burst in 1997. 

Many argue that Southeast Asia should have appreciated their currencies aggressively to prevent the bubble from expanding. I am not sure about that. Japan nearly doubled its currency value after the 1985 Plaza Accord. It didn’t prevent its property bubble. If Southeast Asia had appreciated its currencies, it could have incited more speculation, as currency appreciation would be another factor for optimism, and drawn in more hot money. 

China cannot draw easy lessons from either Southeast Asia or Japan. It seems no country had successfully prevented bubbles during similar circumstances. I think China must use unconventional policies like administrative interventions to contain the bubble expansion. First, China must expand low-cost housing quickly and on a vast scale. A major support for the property bubble is the fear that the runaway price would make housing out of reach for majority of the people. Hence, many people ignore affordability and buy at any price. When people are confident that affordable housing will always be there, property demand would become rational, which would contain the property bubble, I believe. 

Second, China needs to increase barriers to hot money inflow. For example, over-invoicing of exports and under-invoicing of imports are significant factors in hot money inflow. China should stop offshore IPO’s completely. The mega fund raisings by property companies through offshore IPO’s don’t make sense for China.  It channels foreign money into the hottest bubble sector in the economy, totally contradictory to China’s national interest. 

Can China avoid the bubble path that Southeast Asia and Japan traveled before?  I am not optimistic.  Bubbles are so hard to prevent because so many benefit from them at the time. The beneficiaries are often influential and could stop effective prevention policies. I suspect that China’s bubble would expand enormously in the coming years. Even if a correction happens after the Olympics, the bubble may revive afterwards and become much bigger. It is possible that China’s bubble would become even bigger than Japan’s. 

Back to Bernanke, why the change of heart? It is hard for anyone to go against the crowd. I know! If Bernanke were to stick it out, the Wall Street wouldn’t like him, the politicians on the Capital Hill wouldn’t like him, and the sub-prime mortgage borrowers wouldn’t like him. When his job is up for renewal in four years, these people wouldn’t support him. He probably would lose his job and go back to Princeton to teach. He can forget about fat speech fees or mega contract for his memoir. All that for inflation?  Who represent inflation? Who would give him a medal for fighting inflation?  

The recent benign readings for inflation are about 2% annual rate. This is just temporary, I believe. I suspect Mr. Bernanke and his colleagues at the Fed agree. As Mr. Greenspan said recently, the Bernanke Fed faced a different inflation picture from what his did. I see four differences. 

First, inflation outlook is up rather than down. The Greenspan years were marked by continuing downward trend of inflation due to globalization and information technology. The two factors decreased labor’s bargaining power against capital. The US-based manufacturing companies were moving factories first to Southeast Asia and then China to cut labor costs. The outsourcing was a headwind against labor demand. 

IT technology was able to replace labor with capital and increase productivity at the same time. It revolutionized the retail sector-the largest but the lowest productivity sector in a service-centric economy.  The rise of big-box retailers, probably the most important retail innovation in a century, dramatically decreased the cost of distribution between goods manufacturers and consumers. It was made possible by the use of IT to manage vast flows of goods across the world within a single company. As big box retailers concentrated distribution channels, they were able to bargain down the ex-factory prices from the fragmented manufacturing sector, which was an extra benefit for them and their customers. Both the declining costs of distribution and the declining ex-factory prices of goods kept inflation down. 

Outsourcing and IT changed the relationship between employment and wage. When unemployment rate is low, wage tends to rise, as workers have more choices and businesses have less. This is why economists believe in the concept of nairu-Non-Accelerating Inflation Rate of Unemployment, i.e., when unemployment rate is below certain level, wage rise accelerates, which forces producers to raise prices to pass on the cost increase. When businesses have alternatives like moving factories abroad or installing computers to replace labor, they are in a stronger position to resist wage pressure. Hence, nairu is lower.  This allows the Fed to keep interest rate low even during a tight labor market. 

The benefits from globalization and IT have been mostly absorbed. Factories for manufacturing consumer products are already optimally distributed around the world.  IT has become fully integrated into distribution and production.  Further productivity gains from both are likely to be limited and slow to come. The current US unemployment rate at 4.6% is quite low by historical standard. Even as it rises a bit in a slowing economy, wage pressure could remain high due to rising nairu. 

Slowing productivity is a related factor. Globalization and IT decreased labor demand and allowed US labor to shift to higher productivity activities. This redistribution was an important factor for the pickup of one percentage point in labor productivity growth rate between 1996-2006. As the benefits of globalization and IT are fully absorbed, labor productivity could slow back to 1.5%. 

The combination of rising nairu and slowing productivity is an inflation nightmare for a central bank. It severely limits its ability to use monetary policy to stimulate demand. Even as the economy slows down and unemployment rate rises, inflationary pressure may intensify. 

Second, global economy is experiencing rising inflation. During the Greenspan years, emerging economies were constantly in crisis.  The Latin debt crisis of the 1980s, the Mexican peso crisis in 1994, the Asian Financial Crisis in 1997, the Russian debt crisis in 1998, etc., served as deflation shocks to the US economy.  It severely depressed commodity prices like oil and decreased import prices in general as emerging economies devalued to boost exports. 

The picture for emerging economies today is the opposite. After years of trade surpluses, they are awash with cash. The excess liquidity has caused buoyant asset markets at home, which has boosted domestic demand.  As they have put trillions of dollars on the side for rainy days, they can continue to spend even if their exports to the US slow down. They are not likely to cut export prices when exports weaken.  Indeed, buoyant domestic demand has so stretched their production capacity that they are raising export prices. Hence, the US will not experience reduction in import prices during the current economic downturn.  

Third, dollar is 20% off its 2002 peak.  Its inflationary pressure is yet to be fully absorbed. If the Fed turns aggressive in cutting interest rate, it would weaken the dollar and increase inflationary pressure further.  The US import price has not fully reflected the weak dollar, as the US demand is so vast and could pressure their suppliers. For example, some Chinese exporters fear losing their US buyers and have been compromising qualities to keep prices down. As the quality problems surface, the US import prices would catch up with the weak dollar. As the Fed cuts interest rate, the dollar will weaken further. It adds to inflationary pressure. Fourth, commodity prices remain high. The US credit crisis should have depressed commodity prices as it would lead to a weaker US economy and less demand for commodities. Instead, commodity prices rose.  The reason, I believe, is liquidity coming out of credit market into commodity market. That explains the recent and perverse correlation between the two markets. 

The speculative forces in the global financial system severely complicate the Fed’s task. Like in the currency market, any weakness in its inflation fighting resolve would lead to escalation of speculation in the commodity market, which would increase inflationary pressure. 

In the US economy today, the only factor that depresses inflationary pressure is weakening consumer demand due to the credit crisis.  Retailers tend to cut prices to boost sales when demand weakens, because they need to clear inventory.  This is why the current inflation numbers look good.  But, when the inventories are gone, they will order less and don’t need to cut prices anymore. 

But, does it hurt to have a bit more inflation? In one sense, it is good for the US. Foreigners hold US financial assets over 100% of its GDP. The salesmanship of the Wall Street is the reason that foreigners hold such a vast amount of the US financial assets. A bit more inflation means a weaker dollar, which costs foreigners.  Of course, a big part is the securitized sub-prime mortgages. So far, such securities have depreciated as some US sub-prime mortgage borrowers have defaulted and the properties they leave behind are worth less than the debt value. Hence, the market prices for such securities have depreciated to reflect the gap between debt outstanding and property value.  Inflation would be another cost for the investors in the sub-prime securities. 

The beneficiaries of the inflation are the US mortgage borrowers whose debts depreciate in real value and the hedge fund investors in the equity portion of the securitized debt. For non specialists, it is a big puzzle that a big chunk of high risk debts like sub-prime mortgages could be rated at AAA by rating agencies. The trick is to classify investors into different classes according to their income seniority. As some homeowners default, the investors who own the lowest seniority portion, the equity portion or more commonly known as toxic waste, lose everything.  Some hedge funds who went from 100 to zero in days invested in such assets. The hedge funds that haven’t gone under may get lucky if inflation bails out homeowners. 

What’s at stake is who would pay for the consequences of the property burst. The property holdings of the US household and non-profit organizations reached 168% of GDP in the second quarter of 2007 compared to the historical average of about 100%. In the previous property bubble, this ratio never surpassed 140%. If the normalization unfolds over three years and nominal GDP grows by 6% per annum (2% real and 4% inflation), property price still needs to decline by 30% for the property value to revert to 100% of GDP.  4% inflation couldn’t save American mortgage borrowers. The Fed may tolerate even more inflation, possibly double-digit rate inflation. 

At the 2006 IMF/World Bank conference, I predicted that the US economy would experience a recession in 2008 and mild stagflation-2% growth rate and 3% inflation rate for three years. It seems I gave too much to the Fed then. A recession in 2008 is still likely. The housing market is too heavy to be reversed quickly. The stagflation would be more serious than I anticipated. 5% inflation is quite likely.  Indeed, double-digit inflation like in the 1970s cannot be ruled out. 

In a closed economy, inflation is a zero-sum game in wealth redistribution. Investors in fixed income lose and borrowers win. As the US owes so much to foreigners, inflation, at least the unexpected part, adds value to the US economy. It does give the Fed incentives to tolerate more inflation. Why then it just lets it all out and inflates away all the foreign debts? The problem is that foreigners may see what’s coming and sell everything right away. It would trigger the US bond market to collapse, which would wreck havoc on the US economy. Hence, inflation benefits the US only if foreigners can be fooled before it happens. The Fed is still paying lip service to inflation for that purpose. 

You probably know what I am getting at. If you hold US bonds, sell. The Fed wants to rob you to help the bankrupting US homeowners. My hunch is that the US inflation would rise to above 4% next year and higher afterwards.  Foreigners own 40% of the US treasuries, mostly central banks. They should sell now to demonstrate they wouldn’t accept the broad daylight robbery by the Fed. The selling would cause the treasury yield to skyrocket, which would offset the stimulus from the rate cut by the Fed. The Fed may have to change policy to appease foreigners when it sees the rebellion. 

If foreigners don’t act and lay there like lambs, they deserve to be slaughtered.