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Once again, our friends across the Atlantic are better analysts than their American counterparts. There is a great deal of confusion in the marketplace surrounding whether we have passed the worst of this recession or, indeed, if we are suffering a recession at all.

It is clear to most people in the trenches that we are suffering a fairly steep recession. Housing prices are down across the entire country. The mortgage “meltdown” shows no sign of abating - indeed, mortgage foreclosures are projected to increase for at least the balance of 2008. Oil prices continue to sky rocket with major consequences for all our transportation companies.

Although technically the economy grew at a .6% clip for the last two quarters, that was mostly inventory build-up (see “Ben’s Bind”in the THE ECONOMIST , May 3, 2008 issue).

It is clearly “Too Soon to Relax” (THE ECONOMIST , May 3, 2008). Higher fuel prices are bankrupting airlines right and left. Higher food prices are hitting the consumer in the pocketbook on a daily basis. Reduced credit is dampening prospects to both corporate and real estate deals. Transactional lawyers are being laid-off by the hundreds in New York and other major business centers of the United States.

These developments on the ground, add up to a seriously negative economic situation. (If not actually a recession by name)

What you can do to weather this economy:

Cash is king. So keep your cash flow ready for the deals that will come early next year.

Refinance your commercial real estate while interest rates are again at historic lows. A Democratic administration will likely increase interest rates after November, 2008.

If you are a small to medium size company, pare your staff of as much “dead weight” as you can. Productivity is key to surviving this recession.

Have faith. Things will get better. It is only a matter of time. --Edward E. Klein

Ben's Bind
Global Monetary Policy


THE spirit of St Augustine hovered over the Federal Reserve this week. “Oh Lord, let us stop cutting interest rates, but not yet,” is pretty much what America's central bankers decided on April 30th. The Fed's governors cut their policy rate by another quarter-point, to 2%. But the accompanying statement gave a small hint that they may now pause.

There are plenty of reasons to stop cutting. Real interest rates are now firmly negative. Although the housing market continues to contract—the latest figures show sales falling, prices tumbling and the number of vacant homes soaring—the economy is limping rather than slumping. According to initial GDP estimates released on April 30th, output grew at an annualised rate of 0.6% in the first three months of the year—the same pace as in the previous quarter and faster than most people expected. The mix of growth was not good. Final sales fell while firms built up their stocks, which bodes ill for future output. But with tax-rebate cheques arriving in the mail, a dose of fiscal stimulus is imminent.

A growing chorus worries that ever lower policy rates are adding to America's problems. Some prominent economists, including Martin Feldstein of Harvard University and Bill Gross of PIMCO, a big money-management firm, have urged the central bank to stop. Fed cuts, they argue, are doing little to reduce borrowing costs but have sent commodity prices soaring—fuelling inflation and hitting Americans' wallets hard.

Thanks to the credit crunch, Fed loosening plainly packs less punch than hitherto. Lending standards are tightening across the board. The cost of a 30-year mortgage has risen over the past six months, even as short-term rates have tumbled. But monetary policy has not been impotent. One route through which it has worked has been the weaker dollar. Although the greenback has been sliding for over five years, the pace of decline stepped up as the Fed slashed rates. Since August the dollar has fallen by 7% against a broad basket of currencies and 13% against the euro. Together with strong global growth, this weakness has cushioned and reoriented America's economy. Strong foreign earnings have boosted corporate profits. Strong exports have countered the weakness in construction. Exclude oil, and America's current-account deficit has shrunk to an eight-year low of 2.4% of GDP.

But oil—and other commodities—are the crux of the problem. In the past, economic weakness in America has usually pushed the price of oil and other commodities down. That relationship has weakened thanks to demand growth in big commodity-intensive emerging economies. But the recent surprise is that commodity prices have soared even as America's economy has stalled and forecasts for global growth have been trimmed as well. No one expects global growth to accelerate this year, yet the price of crude oil is up 20% since the beginning of the year, The Economist's overall commodity-price index is up 18%, the metals index is up 24%, and the food-price index is up 18%. Supply shocks—from drought in Australia to strikes at Nigerian oil wells—are clearly part of the problem. But the fact that prices have soared across so many commodities suggests a common cause.

Could the culprit be the Fed? Advocates of this idea point to two channels. First, by slashing real interest rates, the Fed has encouraged speculation in commodities by reducing the cost of holding inventories. Second, by pushing down the dollar, Fed looseness is pushing up the price of dollar-denominated commodities.

Jeff Frankel, a Harvard economist, has long argued that low real interest rates lead to higher commodity prices. When real rates fall, he points out, commodity producers have more incentive to keep their asset—whether crude oil, gold or grain—in the ground or in a silo, than to sell today. Speculators, in turn, have more incentive to shift into commodities. There is no doubt that commodities have become an increasingly popular investment category—in fact they bear many of the hallmarks of a speculative bubble. But inventories for many commodities, particularly grains, are unusually low.

What about the dollar link? Chakib Khelil, president of the Organisation of Petroleum-Exporting Countries, argued this week that oil could reach $200 a barrel largely because the market was being driven by the dollar's slide. Movements in the euro/dollar exchange rate and the price of oil have become extremely close (see chart). An analysis by Jens Nordvig and Jeffrey Currie of Goldman Sachs shows that the correlation between weekly changes in the oil price and the euro/dollar exchange rate has risen from 1% between 1999 and 2004 to 52% in the past six months.

That link is partly a matter of accounting. If the dollar falls, the dollar price of a commodity must rise for its overall price—in terms of a basket of global currencies—to remain stable. But commodity prices have risen even when priced in non-dollar currencies. And the correlation between changes in the price of oil and the euro/dollar exchange rate has risen even when oil is priced in a basket of currencies, such as the IMF's special drawing rights.

So is the weaker dollar driving oil prices up or are high oil prices driving the dollar down? The Goldman analysts argue the latter. Dearer oil is pushing the dollar down, they claim, because oil exporters import more from Europe than America and hold less of their oil revenues in dollars. A second factor lies with central banks. Because the Fed focuses on “core” inflation (which excludes food and fuel), whereas the ECB targets overall inflation, America's central bank runs a looser policy in response to higher oil prices, thus pushing the dollar down.

Another reason to suspect that the Fed is more than a bit player is that American interest-rate decisions have a disproportionate effect on global monetary conditions. Some emerging economies still peg their currencies to the dollar; many others have been reluctant to let their exchange rates rise enough to make up for the dollar's decline. As a result, monetary conditions in many emerging markets remain too loose. This fuels domestic demand, pushing up pressure on prices, particularly of commodities. All of which suggests that the Fed's decisions are propagated widely through the dollar.

The most recent circumstantial evidence also suggests that the Fed may bear some responsibility for the commodities boom. The dollar slipped after the Fed's rate-cut decision as investors reacted to its doveish tone, though at $1.56 per euro, it was still up 2.6% from its low of $1.60 on April 22nd. The price of oil, after hitting a record high of almost $120 a barrel on April 28th, had tumbled to $113 on April 30th. But the price of crude and other commodities rose afterwards. If those reactions persist, America's central bankers may have to reflect carefully.

Copyright THE ECONOMIST 2008

Too Soon to Relax
Credit Crunch


IS IT really over? In the middle of March investors were worried that the financial system was going to hell in a handcart. Analysts competed to produce the highest possible forecast for losses from the credit crunch. Just six weeks later, everything seems a lot calmer. Stockmarkets have stabilised and corporate credit spreads (the excess interest rates paid by risky borrowers) have come down sharply. Gold is cheaper. Bankers talk about having put the worst behind them. This week the Bank of England's twice-yearly Financial Stability Report was cautiously optimistic (see article) and America's Federal Reserve was relaxed enough to cut the pace of its monetary easing (see article). Rates may even have reached the bottom.

Optimists can point to one big relief. When the Fed helped JPMorgan Chase to rescue Bear Stearns, it sent a signal to the markets—a kind of “No Bank Left Behind” Act. If the Fed was willing to save an investment bank, without any retail depositors, then the system would not be brought down by a “plumbing problem”, such as the collapse of a counterparty in the derivatives market. The boost to confidence has helped banks to repair their balance sheets by raising large sums from both shareholders and the bond markets. Maybe financial Armageddon had been avoided.

Maybe. But the fight ahead still looks bloody. Although the system as a whole is safer, plenty of problems remain for particular banks. In the money markets, the banks are still having to pay a high margin over official rates to borrow short-term money, despite the ingenious efforts of the Bank of England, European Central Bank and America's Fed. Investors are still worried that banks could get into trouble. There is probably more troubling news to come on write-offs; declared losses so far are well short of the $945 billion that the IMF estimated were the global losses from the crisis, much of it outside the banking system.

The malaise that started the crisis—the American housing market—is still getting worse. The month-on-month decline in the Case-Shiller index of house prices in 20 large cities is accelerating; on the latest reckoning, it was down by 12.7% over the 12 months to February 29th. As the decline continues, more homeowners will default on their loans.

And losses are now emerging in areas other than housing. After a long period with scarcely any bond defaults by companies, there have been 21 failures this year, according to Standard & Poor's, a rating agency; some 122 issuers, with debt of around $102 billion, are deemed vulnerable to default. Ominously, corporate debt is the shaky foundation for trillions of dollars of derivative contracts.

Consumers round the world are grappling with higher food and fuel prices. British house prices are now showing annual declines. Europe's economies seem to be deteriorating. In April the Belgian business confidence indicator, a good gauge of the continent's conditions, suffered the biggest decline in its 28-year history. Commercial property looks vulnerable, as do some emerging markets, especially in central and eastern Europe. And things are shaky in Japan, where industrial production declined more than 3% in the latest month.

Imagine that you had fallen asleep last July and that you had been spared the dread words “credit crunch” and “Bear Stearns”. On waking today, you would be astonished at how low American interest rates had fallen (especially in the light of headline inflation). But you would still be alarmed at the state of housing markets, the prospects for consumer spending and the trend in forecasts of economic growth. You would not assume that the worst was over. Nor should investors, just because they have had to live through it all.

Copyright THE ECONOMIST 2008



By: Brian J. Markowitz
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By: Brian J. Markowitz
More Info

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