The Forex Market

Menzie Chinn at Econbrowser points us to the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. Among other things, this report shows the amount of forex transactions as well as the currency distribution of forex transactions. The table below shows on average $3.2 trillion of forex traded per day!




This next table shows the currency distribution of forex transactions. The dollar makes up 86.3% in 2007.




Very interesting reading...

William White on Benign Deflation

I have discussed in this blog the difference between malign and benign deflation and why it matters to macroeconomic stability. I have also posted some of Andy Xie's (formerly of Morgan Stanley) work who makes this same argument. Here is an excerpt from another voice making this same point:

Is Price Stability Enough?
William White , Bank for International Settlements

"One implication of positive supply side shocks is that they call into question whether monetary policy should continue to pursue the near-term [monetary policy] target of a low positive inflation rate... Failure to adjust the [monetary policy] target downward (whether explicitly or implicitly) in the face of positive supply shocks would result in lower policy rates than would otherwise be the case... Paradoxically, taking out insurance against a benign deflation might over an extended period increase the probability of the process eventually culminating in a “bad” or even “ugly” one. "

Yes, I have provided a link to this article before, but I after looking at it again today I thought it was worth another plug on my blog. Read the entire article.

Daniel Gross is Scratching His Head...

Mark Thoma and David Altig do a good job explaining why it is appropriate for the Fed to look at core measures of inflation when conducting monetary policy. Their argument is essentially that core inflation (or trimmed-mean PCE) does a better job predicting future overall inflation. Many observers are critical of this approach and say that it runs against reality. Here is one such observer:

Gross: There's No Inflation (If You Ignore Facts)
By Daniel Gross
Newsweek

Oct. 8, 2007 issue - Imagine that a cardiologist told you that aside from the irregular heartbeat, the stratospheric cholesterol count and a little blockage in your aorta, your core heart functions are just fine. That's precisely what the government's cardiologist—Ben Bernanke, chairman of the Federal Reserve—has just done. The central bank is supposed to make sure the economy grows fast enough to create jobs and make everybody richer, but not so fast that it produces inflation, which makes everybody poorer. "Readings on core inflation have improved modestly this year," the Federal Open Market Committee said in justifying its 50-basis-point interest-rate cut last month, while conceding that "some inflation risks remain."

Catch that bit about "core inflation"? That's Fedspeak for: inflation is under control, unless you look at the costs of things that are going up. The core rate excludes the prices of food and energy, which can be volatile from month to month. Factor them in, and inflation is about as moderate as Newt Gingrich. In the first eight months of 2007, the consumer price index—the main gauge of inflation—rose at a 3.7 percent annual rate. That's more than 50 percent higher than the mild 2.3 percent core rate. The prices of energy and food are soaring, at 12.7 percent and 5.6 percent annual rates, respectively, and have been doing so for years. As a result, the CPI—including food and energy—has risen 12.6 percent since July 2003, for a compound rate of about 3 percent.

Signs of inflation are evident throughout the economy. When investors fear a rising inflationary tide, they latch onto the driftwood of gold. The day Bernanke cut rates, the price of the precious metal soared to heights not seen since 1980, when inflation ran at nearly 12 percent! I read about this in The Wall Street Journal (whose newsstand price rose 50 percent in July), which I picked up in the lobby of a New York hotel (where the average nightly rate soared 12.5 percent in the first seven months of 2007 from 2006, according to PKF Consulting) while sipping on a Starbucks Frappuccino (whose price has risen twice since last October).

There are sound macro-economic reasons to believe higher inflation may be a fact of economic life, according to former Federal Reserve chairman Alan Greenspan, who discusses the topic in his new memoir, "The Age of Turbulence." (Apparently, the editors killed the original title: "The Dotcom Bubble Wasn't My Fault. Nor Was the Housing Bubble.") Greenspan notes that vast anti-inflationary forces in the 1990s—especially China's emergence as a low-cost producer of goods—helped tamp down prices. But China's rampant growth and rising living standards could encourage inflation. "China's wage-rate growth should mount, as should its rate of inflation," he writes.

In a recent paper, Albert Keidel of the Carnegie Endowment for International Peace warns of China's "gathering inflation storm," powered in part by "explosive price increases in key consumer categories" like noodles and pork... China is bound to export its inflation—it exports everything else, after all—either in the form of higher prices for toys, or in the form of higher global prices for the commodities it consumes in increasingly huge gulps.

In the United States, companies are passing along high-er commodity and fuel costs by boosting prices, slashing portions and tacking fuel surcharges onto things ranging from deliveries to lawn service. And because food and energy prices are so visible—the prices are posted in public, and consumers buy these goods frequently—price increases have a disproportionate impact on perceptions of inflation.

China's government is trying to deal with its inflation in predictably Orwellian fashion. "Beijing has instructed local provincial and urban statistical bureaus in a subtle form of denial—they are not to use the word 'inflation' to describe what is happening," notes Keidel. It's easy to mock Beijing's clumsy bureaucrats. But by focusing on core inflation, the Federal Reserve—along with the legions of investors who reacted ecstatically to the interest-rate cut—is practicing its own subtle form of denial.

George Selgin and Monetary Policy Today

Here is an article by George Selgin from August 31 that takes a similar view to mine (see here and here) on the role U.S. monetary policy has played in the housing boom-bust cycle that now plagues the U.S. economy. (This is the same George Selgin to whom I referenced in an earlier posting about the Productivity Norm rule for monetary policy.)

Federal Reserve should resist tinkering
"When the Federal Reserve slashed its discount rate by a half-percentage point earlier this month, it was trying to add a little lubricant to a credit market that seemed on the verge of seizing up. But by giving weary investors a chance to catch their breath, the move also gave them an opportunity for finger pointing – at avaricious mortgage lenders, at naive borrowers, and at rating agencies.

One culprit, though, has not only avoided blame but has come across as the episode's hero. And that culprit is the Federal Reserve itself. Like some renegade fireman, though unwittingly, the Fed played a part in igniting the conflagration it's now trying to smother.

Because the disaster was kindled years ago, responsibility for it belongs not to the current Fed board but to Alan Greenspan and his team of monetary policymakers. The fundamental problem, however, transcends the actions of any Fed chairman. Indeed, the Fed as it's presently managed can hardly help causing sometimes ruinous market distortions.

Why did mortgage lenders earlier this decade start showering credit as if it were spewing from a public fountain? The answer is that credit was spewing from a public fountain – and that fountain was the Fed. In December 2000, the Fed began an unprecedented year-long series of rate cuts, reducing the federal funds rate from over 6 percent to just 1-3/4 percent – a level last seen in the 1950s. By mid-2003, two further cuts had reduced the rate to just 1 percent.

The general aim of these cuts was to keep a mild growth slowdown from getting worse. But they had the quite unintended effect of generating euphoria in the mortgage market by flooding it with funds. Lenders dramatically lowered mortgage rates and kissed old-fashioned lending standards goodbye. Buying property was never easier. As one jubilant industry insider put it, "Who could ask for anything more?"

The sad sequel is grist for the mill of monetary economists long critical of central banks' attempts at fine-tuning. It illustrates the late Milton Friedman's claim that the full effects of monetary policy changes happen only after "long and variable lags," when conditions that motivated the changes have passed into history. The result is that fine-tuning often ends up promoting business cycles instead of dampening them.

The subprime lending crisis also shows that, while central banks certainly have the power to expand a nation's spending power, they can't guarantee that the extra power gets used as intended, namely, to give a roughly uniform boost to the overall demand for goods. On the contrary: The crisis supports the argument, first developed by Austrian-school economists Ludwig von Mises and Friedrich Hayek, that the techniques central banks employ to increase spending power are bound to distort spending patterns by driving lending rates below their sustainable, "natural" levels.

By injecting the new money they create into credit markets, central banks create an artificially high demand for long-term investments, such as real estate, in which interest costs loom large. Think back a few years. Even your auto mechanic was bragging about "flipping" condos with easy credit. That's a natural consequence of the way central banks distort spending patterns. The trouble, however, is that the new money does eventually swell overall demand, including the demand for credit. Interest rates soon rise, ending the investment boom. Regrets multiply.
That's exactly what happened last year, when the federal funds rate climbed back above 5 percent.

In hindsight, it's easy to say that the Fed blundered. But avoiding similar blunders in the future is another matter. The truth is that the Fed, as presently constituted, faces an impossible task: It can't tell whether its targeted rates are "natural" (and therefore sustainable) except in retrospect, when it's too late; and it will always be tempted to engage in fine-tuning, both because the Humphrey-Hawkins Act of 1978 calls for it to do so, and because a myopic and inadequately informed public rewards Fed bureaucrats for "doing something" even when they ought to stand pat.

Only institutional reform can get us out of this predicament. The Fed must be taken out of the fine-tuning business. Instead, it must observe a strict and unambiguous monetary rule, such as one calling for the Fed to announce and stick to an inflation-rate target. As it happens, chairman Ben Bernanke favors such a rule. If Congress gives him what he wants, the Fed may be spared some future finger pointing; and the public may be spared further crises."

• George Selgin is a professor of economics at the University of Georgia's Terry College of Business.

Another Critique of the Saving Glut Theory

Over at Brad Sester's blog, Michael Pettis (guest blogging for Brad) is leading a discussion on whether there really has been a global saving glut. I have expressed my reservations about the use of saving glut theory to make sense of the global economic imbalances here, here, here, and here. Micheal Pettis does us favor by pointing us to an interesting Stephen Roach article. There is no direct link to the article, but I have pulled portions of it from a posting at the International Political Economy Blog.

Stephen Roach:

"There is no glut of global saving. Yes, global saving has risen steadily over the past several decades, but contrary to widespread belief, the rise in recent years has been no faster than the expansion of world GDP. In fact, the overall global saving rate stood at 22.8% of world GDP in 2006 – basically unchanged from the 23.0% reading in 1990. At the same time, there has been an important shift in the mix of global saving – away from the rich countries of the developed world toward the poor countries of the developing world. This development, rather than overall trends in global saving, is likely to remain a critical issue for the world economy and financial markets in the years ahead.

There can be no mistaking the dramatic shift in the mix of global saving in recent years. A particularly stunning change has occurred in just the past decade. According to IMF statistics, in 1996 the advanced countries of the developed world accounted for 78% of total global saving. By 2006, that share had fallen to 65%. Over the same decade, the developing world’s share of global saving has risen from 22% in 1996 to 36% in 2006. Put another way, the rich countries of the developed world – which made up 80% of world GDP in 1996 – accounted for just 43% of the cumulative increase in global saving over the past decade. By contrast, the poor countries of the developing world – which made up only 19% of world GDP in 1996 – accounted for fully 58% of the cumulative increase in global saving over the 1996 to 2006 period, or approximately three times their weight in the world economy. This wealth transfer from the poor to the rich – the exact opposite of that which occurred in the first globalization of the early 20th century – is one of the most extraordinary developments in the modern history of the global economy.

The United States, of course, stands out for extreme negligence on the saving front. By 2006, America’s gross national saving rate – the combined saving of individuals, businesses, and the government sector – stood at just 13.7%. That’s down from the 16.5% rate of a decade earlier and, by far, the lowest domestic saving rate of any major economy in the developed world. Adjusted for depreciation – a calculation which provides a proxy for the domestic saving that is left over after funding the wear and tear on aging capacity – the US net national saving rate averaged just 1% over the past three years, a record low by any standards. Over the 1996–2006 period, the US accounted for a mere 12% of the total growth in worldwide saving – less than half its 26% share in global economy as of 1996. Elsewhere in the developed world, it has been more of a mixed picture. The Japanese saving rate, while a good deal higher than that of the US, fell from 30.4% in 1996 to 28.0% in 2006. By contrast, gross saving in the Euro Area held steady at around 21.0% over the past 10 years...

The dramatic shift in the mix of global saving over the past decade is a big deal. It drives the equally unprecedented disparity between current account surpluses and deficits – the crux of the global imbalances debate. It also accounts for the gap between trade deficits and surpluses that is shaping the current protectionist debate in the US Congress. In theory, of course, this shift in the mix of saving also has the potential to shape relative asset prices between debtor and lender nations. Although those impacts have yet to take on serious proportions, I continue to suspect the risk of such a possibility is a good deal higher than that envisioned by the broad consensus of global investors.

From the start, the concept of the global saving glut was very much a US-centric vision (see the March 10, 2005, speech of then Federal Reserve Board Governor Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit”). From America’s myopic point of view, it believes it is doing the world a huge favor by consuming a slice of under-utilized saving generated largely by poor developing economies. But this is a very different phenomenon than a glut of worldwide saving that is sloshing around for the asking. The story, instead, is that of a shifting mix in the composition of global saving – and the tradeoffs associated with the alternative uses of such funds. I suspect those tradeoffs are now in the process of changing – an outcome that is likely to put downward pressure on the US dollar and upward pressure on long-term US real interest rates. If the borrower turns protectionist – one of the stranger potential twists of modern economic history – those pressures could well intensify. Don’t count on the saving glut that never was to forestall these outcomes."

This Yield Curve Paper Sounds Familiar...

Charles Goodhart and Luca Benati have a new paper on the yield curve where they "have investigated why the yield curve has appeared to have had such predictive power for future output growth at times in the past, but also why this may now have largely disappeared. [They] examine the relationship... for the US and the UK since the Gold Standard era, and for the Eurozone, Canada and Australia in the Post-WWII period... [their] results suggest that, historically, the additional predictive power of the spread for future output growth –over and above that already encoded in other macroeconomic variables – often appeared during periods of uncertainty about the underlying monetary regime."

So the yield curve's predictive power is contingent on the uncertainty of the underlying monetary regime. This finding is consistent with what Michael Bordo and Joseph Haubrich found in their paper, The Yield Curve, Recessions and the Credibility of the Monetary Regime: Long Run Evidence 1875-1997 (with Joseph G Haubrich) NBER Working Paper No10431, 2004. Here is the abstract:

"This paper brings historical evidence to bear on the stylized fact that the yield curve predicts future growth. The spread between corporate bonds and commercial paper reliably predicts future growth over the period 1875-1997. This predictability varies over time, however, particularly across different monetary regimes. In accord with our proposed theory, regimes with low credibility (high persistence of inflation) tend to have better predictability."

Ben Bernanke Has a Blog!

Do you want to know what Ben Bernanke is really thinking? Do you want know Fed actions before they occur? If so, then check out the Ben Bernanke Blog.