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!