Initial Claims

I'm looking for 465,000 this week, a shade above the consensus of 460,000. Between the recent jobless claims and the weather, February's payroll report could be nasty.

What to Make of the Discount Rate Increase?

Markets were surprised by the Fed's increase of the discount rate yesterday. They are debating to what extent this means the Fed will raise rates sooner rather than later. My view: this is liquidity policy, not monetary policy.

Together with raising the discount rate, the Fed also raised the minimum bid rate on the TAF. In other words, the Fed is making it more painful for banks to rely on the authorities for lending instead of going to the market. This is likely to be especially difficult for less healthy banks, as it should be.

In short, monetary policy is about managing demand in the economy. Liquidity policy is about ensuring the stability of the financial sector. The Fed's discount window is about ensuring stability for banks, and raising this rate is about pushing the banking sector off of public support, rather than managing the economy.

Initial Claims Number

I forecast 467,000, in line with consensus of 465,000 and a decrease of 13,000 from last week.

More on European Interbank Lending

I've done a bit more digging into what's going on in the European bank funding market. Apparently, the issue is not so much that the banks bidding for ECB funds can't borrow at Euribor, but that they cannot do so in size. This is because banks still have tight counterparty exposure limits, and also because their balance sheets remain constrained.

The counterparty exposure issue is that Bank A's risk managers have set a limit on the maximum it can lend to Bank B. These limits are currently small in historical terms. So even if Bank B wants to borrow more, and Bank A's traders want to lend, they are constrained from doing so by Bank A's risk policies. As a result, Bank A is forced to put excess funds on deposit with the ECB at 0.25%, rather than lend it to Bank B at 0.35%.

The balance sheet issue is that making loans in the interbank market requires banks to hold capital against those loans, and that capital is still quite constrained. So while banks are awash in liquidity, they are unable to put that liquidity to work because they are unwilling to use the capital necessary to support the lending.

The result is that banks that are short of funds have tapped out their private credit capacities and must borrow the balance at the ECB at 1%. Meanwhile, banks with excess funds have hit their risk limits and must lend the balance to the ECB at 0.25%.

ECB Monetary Policy

I've been looking at interest rates in Europe over the past few days, and there's an interesting dynamic going on. "Interest rates" in Europe, meaning the European Central Bank's policy rate, are 1%. But money market rates for interbank lending, i.e., the European equivalent of the Fed Funds rate, are much lower. In effect, the ECB is running a zero-interest-rate policy by stealth.

First, some background on how the ECB conducts monetary policy.

The vast majority of the euros in circulation are lent to the European banking sector for a 1-week term against high-quality, euro-denominated collateral. The lending is carried out at the ECB policy rate, which is currently 1%. Money is lent to any bank that bids for funds, and no bank is forced to do so.

Banks will only borrow from the ECB in this way if it is their cheapest source of funding. But right now, it isn't. 1-week Euribor, which is the rate the best banks charge each other for loans, without collateral, is about 0.35%. So, if you're a financially secure European bank, you have the choice of borrowing at 1% from the ECB and having to post collateral, or borrowing at 0.35% on the market without collateral. This choice is a no-brainer! You're going to borrow on the market.

However, somebody has to be borrowing from the ECB at 1%, because this is the only way that euros get into circulation. If nobody did, all the euros would be stuck at the ECB and there would be no money in the economy! Clearly, this is not happening. So who is borrowing at the policy rate? Most likely, it's the weaker banks in countries like Spain and Greece that can't get funding on attractive terms in the market.

Usually, when weaker banks that can't get good funding in the market borrow from the central bank, they do so by accessing the so-called "discount window," and at a penalty rate. But in Europe, because only "bad" banks borrow at the policy rate, the policy rate of 1% is the penalty rate, while the good credits borrow at 0.35% on the open market.

This 0.35% is the "true" interest rate in Europe, and it offers a different perspective on whether the ECB's policies are actually so different from the Fed's.

Initial Claims Number

I project 465,000, compared with consensus of 455,000.

What's Happening to American Manufacturing?

Today's Wall Street Journal has a wonderful article on the seismic shifts in US manufacturing. Despite (or perhaps the cause of) the long-term decline in manufacturing employment in the US, productivity growth has been very strong. Higher-tech parts of the sector have been expanding capacity, even during the recession, while parts of the sector that are not at the technological frontier have been contracting very quickly and/or moving abroad, as the WSJ's chart shows. Production, however, remains broadly weak.

While the process of structural adjustment can be painful, it is encouraging that the US remains a center for high-tech, high-value-added production. Now the key is maintaining the appropriate workforce!

Communism and Economic Structure

Yesterday's New York Times has a wonderful article on McDonald's two-decade drive to build a supply chain in the communist Soviet Union and then Russia, which they have finally just completed.

Read it here:
http://www.nytimes.com/2010/02/02/business/global/02mcdonalds.html?hp

Strong Dollar

Aside from some short-term notes from the Wall Street analysts, there's been a consensus for a while now that the dollar needs to weaken significantly to eliminate the global imbalances in the economic system. Generally, the argument goes that America has a large and unsustainable trade deficit, which foreign central banks are financing by buying US Treasury bonds. If the foreigners tire of financing our trade deficits (the 2007 version is "profligate consumption" but this seems not to apply so much anymore), they will dump US assets and the dollar will weaken. The only way to bring things back into balance is for the dollar to weaken in order to make US goods more competitive on the global market. Exploding US budget deficits only increase the required adjustment. I don't think it's going to happen this way.

In the near term, it's true, as many Wall Street analysts have pointed out, that a renewed downturn in the global economy could lead to dollar strength when investors flock to quality assets such as US Treasurys. But this isn't what I have in mind. Instead, I think we're going to see a new secular trend of dollar strength combined with narrowing global imbalances, for a number of reasons.

1. Rising U.S. savings. American households are tapped out debt-wise. Corporations don't want to borrow to invest because they have so much spare capacity. That means Americans want to buy US securities instead of importing foreign goods and energy. So this is a large new source of demand for dollars -- if the personal savings rate rises from 0% to 10% this is $1 trillion in extra annual demand for dollar securities right there. Not all of this is new demand for dollars since some of it is replacing demand for US goods, but a lot of it is.
2. Fiscal issues are worse other places. Sure, the US needs to get its fiscal house in order. But the budgetary and demographic situation in Europe and Japan is *far* worse than it is in the US. Let's face it, a basket of AUD, CAD and BRL is simply not going to become the world's new reserve currency, and neither is the yuan. China is a country that is not so politically stable and has had two revolutions, a civil war, and an occupation by a foreign power in the last century. The legal system is not exactly conducive to foreigners enforcing their property rights. In the nightmare scenario, do you want to have your money in renminbi?
3. Demographics mean foreign savings rates will fall. At the vanguard of this movement is Japan, where the savings rate has already fallen into the low single digits as the population ages. As this continues, Japanese retirees will liquidate their savings to purchase imported goods, and Japan will become a trade-deficit country, reversing a half-century trend. Europe is not far behind. The emerging economies have a different issue: as they catch up to the West, they will want to consume more and save and invest less. That will lead to a preferences-driven increased taste for imports, weakening their currencies.
4. Deflation or disinflation in the US. The US is in a balance sheet recession. (Read "The Holy Grail of Macroeconomics" by Richard Koo if you don't know what I'm talking about.) A long period of weak demand growth will lead to subdued inflation or perhaps even outright deflation. That will keep a floor under the dollar.
5. The dollar is already cheap by PPP standards. There's only so far it can go before Toyota and Mercedes start opening factories in the US instead of abroad -- oh, wait, they already have!

I hope to post a lot more on this theme in the future. But we shouldn't be surprised if several years from now, dollar-euro trades at parity and the yen is back in the 130-140 range. Only sterling is about right at $1.60 to the pound.