US Recession...

Here's some excellent analysis on the US business cycle by James Hamilton. The news is bad.....

China's inflation... good news or bad?

Is inflation procyclical or countercyclical? In China now, the inflation rate is too high so that some people predict it could be a sign of recession. Can you explain? -Amy

At it's base, increasing inflation can be good or bad. Thinking of the standard supply and demand diagram: prices rise when there is either too much demand or too little supply. Too much demand would tend to reflect a rapidly growing economy, which is good; too little supply would reflect a slowly growing (or even shrinking) economy, which is bad.

In the case of China, it's hard to tell. Yes, prices are increasing at the fastest pace for 12 years, and inflation now stands at over 7%. But prices have been pushed up partly by the recent bad weather, which reduced supplies. Now that the bad weather is passing, its effect on inflation should diminish as well.

But there's another sense in which China's inflation is bad. Much of China's recent growth has come from growing net exports. China, the "world's factory," has churned out huge quantities of manufactured goods for world markets, where demand has been growing based primarily on low prices.

But China will not be the lowest cost producer of these goods for much longer. Price inflation directly drives up the price of exports, and the increasing value of the RMB increases the price when converted to other currencies still further. Additionally, the cost of producing goods in China is increasing rapidly, with migrant wages increasing and workers able to be more particular about their working conditions.

But lets not overstate the threat here. The effects I've outlined above are likely to slow that rate of growth of the Mainland economy. In future, more of China's growth will have to come from producing higher valued products, as they will no longer be the world's cheapest source of manufactured goods. But don't expect the economy to completely stagnate anytime soon.

Zimbabwe inflation... again

Another in a continuing saga.... inflation in Zimbabwe officially hits 24,000%, although it may actually be far higher....

For the previous installment, see here.

Exchange Rate Appreciation and Inflation....

" China is reported to be accelerating the appreciation of the yuan to combat inflaton instead of increasing its interest rates, in part because of expectations of further cuts in US interest rates. How does appreciation combat inflation?" - Jane

That's an excellent question! There are a number of avenues available for the central bank to try to combat inflation. They've already tried price controls, that I've argued elsewhere will ultimately fail. They've also raised interest rates a number of times as well, an avenue that is more likely to be successful. But perhaps the most effective way to combat China's inflation rate is to allow the currency to appreciate more quickly.

How would that work? Well, as I wrote here, inflation ultimately results from demand exceeding supply within the Chinese economy. An increase in the value of the currency makes Chinese goods relatively more expensive and foreign-made goods relatively cheap. Thus demand for Chinese goods will fall, reducing demand and therefore inflation pressure in China.

There's a related effect as well. China is accumulating foreign reserves at a rapid rate, which means that it is buying foreign currency with domestic currency. To do this, it is expanding the domestic money supply. As Milton Friedman famously said, "Inflation is Always and Everywhere a Monetary Phenonemon." Increase the price of RMB and the demand for RMB will fall- reducing the need for Mainland authorities to increase the money supply.

Price Controls and Shortages...

One week ago, I discussed the likely consequences of the newly-introduced Mainland price controls here. I argued that "Price controls never have been, and in my view never will be, an effective policy to try to lower inflation." Previously, I've argued that price controls lead to shortages.

Well, guess what? From today's SCMP...

Worst-ever coal shortage sees stocks fall 40pc
Emergency measures taken as provinces ration electricity

The mainland has issued an emergency circular to ensure power supplies after an unexpected power shortage of nearly 70GW.
.....
In an effort to ease inflation, the State Council had announced this month that power producers would not be allowed to raise electricity prices in the short term, preventing them from passing on the rising cost of coal.
........
"It's a battle between power companies and the central government," said Great Wall Securities analyst Zhou Tao . "While coal prices are going up and an electricity price rise is ruled out by the government, the electricity companies are reluctant to buy much."

Electricity prices cannot be increased because of price controls, but the cost of generating electricity is rising due to rising coal prices. Profit maximising electricity producers respond by reducing the supply of electicity, resulting in power shortages.

The best response? Deregulate electricity prices, allowing these to move with the cost of production. The most likely response? Regulate coal prices, to reduce the cost of electricity generation. But this would not work: it'll merely result in shortages of both electricity AND coal, as profit maximizing coal producers respond to decreasing profit margins by decreasing the supply of coal.

I repeat: PRICE CONTROLS DO NOT WORK.

Negative Real Interest Rates...

From today's SCMP:

"HK slips into negative interest rates. With local lenders responding to Fed cut, prime drops below inflation level of 3.8pc.
....
The result is a negative interest-rate scenario, reminiscent of the mortgage rate from 1991 to 1994. At 4 percentage points below prime, the mortgage rate now stands at between 3.1 per cent and 3.25 per cent, below the inflation rate measured at 3.8 per cent last month."

Effectively, if you have a mortgage, the Bank is now paying you, rather than the other way around! That is, you will pay back your loan in future, inclusive of interest, with less real money than the loan is worth today. And the likely result?

"Property agents said negative mortgage interest rates would help bring the market back to 1997's peak levels faster....."

Does that mean you should buy property? Not necessarily. First there are the transaction costs, that amount to about 5% of the value of the property, and then there is the risk of future property price movements. IF the US recession spreads to Asia, expect property prices to decline significantly, which would wipe out any gain from negative real interest rates many times over.

Zimbabwe Inflation, again....

On the continuing saga of Zimbabwe hyper-inflation, there is now a $10m banknote, which is about enough to buy one drink in a bar- see more at the Undercover Economist here. For my previous take on the causes and consequences of Zimbabwe inflation, click here.

Hong Kong Inflation

Inflation in the CPI is up to 3.8% in Hong Kong, according to the Census and Statistics Department. That is, the average price that consumers paid for consumer goods in December 2007 was 3.8% higher than than in December 2006. This is the highest level of consumer inflation since June 1998, almost 10 years ago!

The driving force behind Hong Kong's inflation is rapid growth across the border in Mainland China fueling increased demand here. As long as China's rapid develop continues, coupled with an appreciating RMB, increased demand for Hong Kong produced goods and services will put positive pressure on Hong Kong prices.

But now there is another force putting upward pressure on Hong Kong prices. Yesterday the US central bank cut interest rates by 75 basis points, or 0.75% (for an analysis of the rate cut, see James Hamilton's comments here). This implies that interest rates in Hong Kong will drop as well, as a result of Hong Kong's currency board system that effectively fixes the exchange rate between Hong Kong and the United States. (See earlier posts here and here to understand why).

These lower nominal interest rates imply cheaper mortgages and loans in Hong Kong, which will likely fuel further increased demand and therefore inflation in Hong Kong.

The bottom line: expect price increases in Hong Kong to accelerate further in the short run.

Chinese Price Controls...

Prices are going up in Mainland China, so the Government has enacted price controls. From today's SCMP editorial...

"The tough measures introduced yesterday to cap soaring food prices on the mainland clearly signal that Beijing is seriously concerned about inflation - and determined to combat the problem. These are the most stringent controls on the prices of basic necessities for 15 years. Their introduction shows that even as the mainland continues to move ahead with free-market reforms, the government is not afraid to use tough administrative measures when it believes they are necessary."

The tone of the editorial suggests that price controls represent a difficult, but ultimately effective, policy to combat increasing inflation. I'm far more sanguine. Price controls never have been, and in my view never will be, an effective policy to try to lower inflation- see my earlier posts here and here for more.

The Zimbabwe CPI is now Undefined....

According to this article, the Zimbabwe state statistical agency is no longer calculating the CPI, as there are too many empty shelves, and not enough goods left to include in the calculation.

Following from my earlier discussions of Zimbabwe's inflation (the latest being here), I think this new development highlights a potential bias in the CPI that I haven't seen discussed elsewhere. What is the price of a good that is no longer available at any price? The only answer to this question is that it is undefined, or infinite. If even one component of the CPI is no longer available at any price, then regardless of how trivial that component is within the CPI, Zimbabwe inflation now equals infinity!

(This is part of the reason why price controls are such a bad idea: they lower the prices for some consumers but inevitably create shortages, and therefore infinite prices, for others).

But life is not actually quite as bad as infinite inflation would imply. Recall that we often use the CPI as a measure of the "cost of living." To an economist, the cost of living is the lowest cost of attaining a given standard of living, or utility. The CPI is an imperfect measure of this because it ignores substitution effects (consumers substitute away from relatively expensive goods towards cheaper ones), new goods (the weights are only updated occasionally, so ignores the rapid price declines usually associated with new goods), and improvements in quality over time. These three biases tend to result in the CPI overstating rises in the true cost of living.

If we ignore goods that are no longer available at any price due to a collapsing, corrupt, crime-ridden economy, then that introduces a bias that works the other way. It will not in fact result in infinite inflation (since a rational consumer would substitute away from the unavailable goods to those that are still available), but in the case of Zimbabwe is likely to result in measured inflation significantly understating the true rise in the cost of living. True infinite inflation can only arise when there is nothing left available for sale at any price.

So the poor people of Zimbabwe who have been arguing that the prices they pay are rising faster than official CPI figures indicate have a point.

And what is the source of this hyper-inflation? The money supply is growing at 18000% per year! as Friedman said, "Inflation is always and everywhere a monetary phenomena."

Oil, Gold, Exchange Rates, and Inflation....

Does the rapid appreciation of the price of oil and gold signify increased inflation? Here's a careful analysis by James Hamilton on Econbrowser.

Japan's Phillip's Curve....

.... looks like Japan. That's from my former PhD Supervisor and co-author, Professor Gregor Smith of Queen's University. The same is apparently true of the Marshal Islands, the Netherlands, and the Czech Republic (see the links on Smith's homepage). It's not true for HK.... I checked.

Has the Fed lost the plot?

"I am afraid that the Fed Reserve, which regards its loose monetary policy can overcome potential recession, has missed the point. The underlying problem with US' economy is the unbelievable deficit! With high deficit and high oil price, I am reminded of the stagflation of 1970s. What do you think?" - Wallace

The Federal Reserve is in a tight spot. Their objective is to try to ensure that the US economy grows as fast as possible without generating excessive inflation. If the economy starts to slow, they cut interest rates, while if the economy grows too fast, they raise rates.

That's the theory, in the simplest possible terms. But the reality is much more complicated. We can think of the economy as consisting of many different key indicators, that all suggest different monetary policy responses. For example, if we were to focus on the latest employment numbers, GDP release, or inflation data, they were relatively strong, suggesting that a reduction in interest rates is definitely not required at the current point in time, and runs the risk of fueling further increases in the inflation rate. In sharp contrast, if we focus on one key aspect of the economy, the stock of wealth tied up in housing, this is dropping in value very quickly, and will most likely lead to a significant drop in consumption and a recession in the coming months. (I know I've been making this argument for some time now, but I still believe it to be true!).

Add to the mixture the fact the monetary policy acts on the real economy (e.g. GDP) with a lag of 6-12 months, and on the nominal economy (i.e. inflation) with a lag of 12-18 months, and you end up with a central bank that has to worry about what is going to happen in the future, rather than the present.

And just to make things even more confusing, the current subprime mortgage meltdown has effectively tightened monetary policy, as banks require higher interest rates to offset their increased risk aversion as a large part of their portfolio has gone up in smoke. To some extent, the cuts in interest rates have simply offset this recent phenomena. To illustrate this, consider the following graph, containing the prime rate, the effective federal funds rate, and the yield on BBA-rated bonds (all data taken from FRED). While the first two series have seen falls in interest rates since May of 50 basis points, the BBA yields are actually higher!



So coming back to the question, I think there is a risk of stagflation (when the economy's growth rate slows and inflation increases) if the central bank cuts rates too much, but there's also a risk of a serious recession (if house prices continue to fall dramatically, and consumers cut back on their consumption). On balance, we could argue about whether the central bank has done too little or too much, but we will never know for sure until after the fact, and by then it is too late to do anything about it!

On the real issue being the budget deficit, this is indeed a problem going forward for the United States, but not directly related to the monetary policy dilemma that the Federal Reserve faces. (In the margin, an expansionary fiscal policy requires a relatively contractionary monetary policy to offset its inflationary effects). And of course, moving to a contractionary fiscal policy would only make matters worse if the US economy does enter a recession.

Pressure on the HKD peg...

The HKMA has been intervening regularly lately to maintain the HKD peg. The currency is nominally fixed at 7.80 HKD per USD, but allowed to fluctuate between 7.75 and 7.85. When it hits the weak side of the band (7.85), the HKMA is obliged to buy HKD in exchange for USD. And when it hits the strong side, the HKMA sells HKD in exchange for USD.

Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).

However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.

But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.

Price Controls make a Comeback...

Price controls are making a comeback, in Argentina, Russia, and China. as I've argued before this is a bad idea. Let me recount my two main objections briefly.

First, price controls do not generally work. If they succeed in preventing prices from rising, then shortages will inevitably result. I'd rather pay "too much" for a good or service than fail to be able to buy it at all because the supplier has run out! (If a supplier runs out of a product, the effective price is infinity- which can hardly be thought of as successful if your objective was to prevent prices from rising! Normally, however, the black market ensures that one can still purchase price controlled goods- perhaps at an inflated price- even when shortages result).

Second, even if they did "work" by prevening prices from rising, they do so from distorting the price signals that are essential for efficient resource allocation.

In the end, too high inflation results from one and only one cause: too lax monetary policy. As Milton Friedman famously said "Inflation is always and everywhere a monetary phenomenom." Indeed, for high inflation countries there is approximately a 1-for-1 relationship between money supply growth and inflation, although the link is less than proportional for lower inflation economies.

See my earlier post for more.

Froth and Bubbles....

"What should China do to try to reduce excess liquidity and inflation" - Qin

China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.

What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.

That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.

My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.

Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.

Understanding Hyperinflation

Zimbabwe has the highest inflation rate in the world today, and provides an illustration of the effects of inflation. Consider this news article on CNN on inflation in Zimbabwe, which has picked back up to 7982% in the year ended September.

Relatedly, the Government recently devalued the official exchange rate from 250 Zimbabwe Dollars per USD to 30,000. At the time, commentators mentioned that this was not enough, as the underlying black market rate was closer to 250,000 ZimD per USD. Well now, just one month later, the black market rate has deteriorated to close to 1million ZimD per USD. And that was on October 18.

To understand what 7982% inflation means, that implies a daily compounding inflation rate of 1.21%. (That is, (1+0.0121)^365=(1+79.82)) That's about Hong Kong's annual inflation rate every day, compounding! Put another way, prices double every 57 days ((1+0.0121)^57=2), or about every 2 months. Every 4 months, they quadruple, etc. Based on this back-of-the-envelope calculation, in the unlikely event that you hold some ZimD, sell them fast- the value of the ZimD will be falling approximately proportionally with the inverse of the price level. Since the news story I linked to above was published 11 days ago, the black market rate has likely fallen to about 1.14 million ZimD per USD already!

The HKMA is On Top of Things....

The Hong Kong Monetary Authority, Hong Kong's de facto Central Bank, is on top of things... literally! In fact, being housed in the top 11 floors of IFC2, the world's 7th tallest building (and Hong Kong's tallest.... at least until the new ICC building going up across the harbour adds a few more floors).

Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.

Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.





The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.

And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).

Sky High Oil....

So the oil price is at all time high levels- as the following graph shows (although this data series stops in March 2007: the price is now over $80/Barrel).




But is it really? First, here's the real price of oil- still significantly below the level attained in 1980, shortly after the Iranian Revolution.




But there's another reason to downplay the massive growth in the price of oil. It just happens to be reported in US dollars, which have been losing value against almost all other currencies in recent months.

Here is the real price of oil faced by consumers in the United Kingdom, by comparison. Yes, the price of oil is up, but hardly by the spectacular levels we'd imagine when we read the headline figures- especially for countries with exchange rates that have appreciated against the USD. in fact, because oil happens to be priced in USD, a fall in the value of the greenback will naturally increase the price of oil irrespective of the supply and demand for "black gold."

How Does a Central Bank Create Money?

James Hamilton of UC San Diego and prolific blogger at Econbrowser provides an excellent explanation of the process by which the Federal Reserve creates money here. While the labels and details vary, any economy with an independent central bank follows a similar process.