Richard Hoey
Chief Economist
November 12, 2008
The historic election of Barack Obama occurred at a specific cyclical inflection point and a specific secular inflection point. From a cyclical perspective, it occurred just as the financial crisis moved the U.S. recession, the G-7 recession and the global recession into an intensified stage of economic contraction. From a long-term secular perspective, it occurred just as the domestic savings and spending imbalances and the global trade and current account imbalances (resulting from debt-financed demand expansion in the G-7 and export-driven growth in emerging countries) have begun to correct.
Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.
After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.
In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.
The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.
We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.
In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.
After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.
What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.
We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.
In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.
The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.
Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.
We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.
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Jumat, 14 November 2008
Kamis, 13 November 2008
Economic Update
The historic election of Barack Obama occurred at a specific cyclical inflection point and a specific secular inflection point. From a cyclical perspective, it occurred just as the financial crisis moved the U.S. recession, the G-7 recession and the global recession into an intensified stage of economic contraction. From a long-term secular perspective, it occurred just as the domestic savings and spending imbalances and the global trade and current account imbalances (resulting from debt-financed demand expansion in the G-7 and export-driven growth in emerging countries) have begun to correct.
Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.
After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.
In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.
The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.
We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.
In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.
After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.
What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.
We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.
In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.
The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.
Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.
We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.
Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.
After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.
In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.
The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.
We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.
In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.
After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.
What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.
We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.
In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.
The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.
Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.
We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.
Selasa, 04 November 2008
Herd Behavior in Financial Markets: Theory and Evidence
Dr. Antonio Guarino
According to anecdotal evidence, herd behavior is diffused in financial markets. Some agents buy stocks simply "following the herd" in a bull market, or sell them in the wave of diffused pessimist in a bear market. While there is a large anecdotal evidence on herd behavior in financial markets, and the idea that traders herd is diffused among practitioners and market participants, our understanding of why herding can arise in the financial market is still limited. Furthermore, studies that have attempted to document and quantify the presence of herding in the market have obtained results that are far from conclusive. Most work remains to be done both at a theoretical and at an empirical level. My research activity is devoted to shed light on the phenomenon of herd behaviour in financial markets with a combination of theoretical, experimental and empirical work. Most of this work is a joint effort with Marco Cipriani , of George Washington University.
Herd behaviour is relevant for the financial market informational efficiency. Essentially, herd behaviour entails neglecting private information in trading a stock or a group of stocks, because of what previous traders have decided to do. Clearly, if an agent neglects private information and herds, the market will not be able to infer that private information from the choice of that agent, and the price will not be able to reflect it. If many traders herd, the stock price can be misaligned with respect to the true value of the stock. Cipriani and I have proven that, indeed, even if traders are perfectly rational Bayesian agents, herd behaviour occurs in the market because of traders' heterogeneity. Traders go to the market to exploit their private information and for non-informational (e.g., liquidity) motives. Over time, as trade proceeds, the informational reasons to trade become less important than the non-informational ones. At a certain point, all traders will neglect their private information and an "informational cascade" (i.e., a situation in which the traders' decisions are completely uninformative on the asset value) will arise. In a cascade the price does not react to the order flow and is stuck for ever. It may well be that the price remains stuck at a level far from the fundamental one. For instance, it may be that the value of a stock is high, but the price remains stuck at a low level, after a sequence of sell orders in the market. Therefore, herd behaviour can be a reason why we can observe a financial crisis even in an economy with sound fundamentals.
To test theoretical models of herd behaviour is difficult. As I said, herding, at least in our framework, means neglecting private information because of the observations of previous traders' decisions. Therefore, ideally, to test such models one would need data on private information, which is of course difficult to obtain for actually running markets. This difficulty can be overcome in an experimental study. In an experiment we can observe variables not available for actual markets, in particular, the private information that agents have when making their decisions. For this reason, Cipriani and I have run a series of experiments in which we test whether herding arises as theory predicts or not. In our laboratory market, subjects receive private information on the value of a security and observe the history of past trades. Given these two pieces of information, they choose, sequentially, if they want to sell, to buy or not to trade one unit of the asset. By observing the way in which they use their private information and react to the decisions of the previous traders, we can directly detect the occurrence of herding. Our experimental results are encouraging for the theory. Although the laboratory reveals some anomalies in subjects' behaviour, i.e., some deviations from equilibrium behaviour, overall what we observe in the laboratory is quite consistent with the theoretical predictions. In particular, in a frictionless financial market in which traders trade for informational reasons only, and the price is efficiently set by a market maker in response to the order flow, herd behaviour is very limited. This agrees with the theory, according to which we should not observe herding at all. Market frictions, instead, generate informational inefficiencies both theoretically and experimentally. Cipriani and I have studied a market in which such frictions take the form a trade cost. We have shown that such a cost impairs the process of information aggregation and an informational cascade occurs almost surely. A cascade occurs since, after some trades, the gain form trading becomes lower than the cost, and agents prefer to abstain from trading. Interestingly, such behaviour is not only a theoretical result, but also occurs in the laboratory. Indeed, our experimental results are very close to the theoretical prediction. Transactions costs can be due, for instance, to transaction taxes, like the Tobin Tax. Therefore, our work has also some policy implications on the introduction of such a tax.
In more recent work, Cipriani and I have extended our research on herd behaviour by estimating a theoretical model of herding with field data. While in previous work we have brought the model to the laboratory, in this work we have brought the model to the real financial market. We use data on many days of trade for some specific stocks. We estimate the parameters of a theoretical model that predicts herd buying (or selling) when a sufficiently high sequence of traders have decided to buy (or sell) the asset. In the market there is a market maker who efficiently sets the prices for a stock according to the orders flow, and a sequence of traders, who can buy or sell at those prices. Herd buying arises when all traders value the asset more than the price posted by market maker, even if they have negative private information. Similarly, herd selling arises when all traders value the asset less than the market maker, even if they have positive private information. After we have estimated the parameters of the model, we are able to track down the beliefs that the market maker (the notional prices) and the traders have during each day of trading. By comparing these beliefs, we can identify the periods of the trading day in which herding occurs or not.
The research activity described so far refers to the analysis of a single market (for instance, a single stock, or a single country). An important development of this research is to consider many markets at the same time. This allows to studying phenomena of "financial contagion" due to learning or herding across markets. Cipriani and I have already given some theoretical contribution on this topic, but much more work needs to be done. Future research (joint with Steffen Huck) will be focused on understanding financial contagion due to informational spillovers in the laboratory. This research project is kindly supported by the ESRC (program on the World Economy and Finance).
While most of this research project on herding and learning focuses on financial markets, part of it is devoted to more general issues of "social learning." Herd behaviour in financial markets is a possible outcome of the traders' learning process. Traders try to learn from the trading decisions of the agents who went first to the market: it may happen that this learning process makes them just neglect their private information. This is what can happen in different social contexts too. When we have to decide which car to buy or which restaurant to go to, we do observe the decisions of other agents, for instance of our neighbours. After observing them, we may well decide to change our mind and, for instance, imitate their decisions, neglecting our original private information. The process of learning from the actions of others is what we call social learning. I am investigating issues of social learning not strictly related to the financial market in a number of papers. In a joint paper with Steffen Huck, and Thomas Jeitschko, we experimentally investigated a model of Bayesian learning that predicts sudden changes in the behaviour of agents and sudden crashes in the market. In the laboratory these changes (information avalanches) do not take place since decision makers are prone to a "solipsism bias," i.e., they are unable to imagine that others who play the same game may make quite different experiences than they themselves. We conjecture that this solipsism bias is of relevance in many fields of human decision making. In another work with Steffen Huck and Heike Harmgart, we analyze how agents learn by observing the number of agents who have already made a decision. For instance, agents have to decide to which of two restaurants to go, and they can infer the quality of the restaurant by some private information and by observing how many other agents have already chosen to go to the two restaurants. The question is whether the aggregation of information is efficient in this context or whether informational inefficiencies can arise. This work, still in progress, is both theoretical and experimental. If you are interested in this work, you can also look at Steffen Huck's research on social learning . In another project with Antonella Ianni we analyze the process of social learning in an economy in which agents can only observe the actions of their neighbours. The question is whether local interaction leads to complete learning in the entire society and whether convergence is fast or slow.
If what you have read so far seems interesting to you, and you want to know more, please visit the ELSE Working Papers Archive and my Personal Webpage, where you can find updated versions of my papers. adapted from http://else.econ.ucl.ac.uk/newweb/research/blurb1.php
According to anecdotal evidence, herd behavior is diffused in financial markets. Some agents buy stocks simply "following the herd" in a bull market, or sell them in the wave of diffused pessimist in a bear market. While there is a large anecdotal evidence on herd behavior in financial markets, and the idea that traders herd is diffused among practitioners and market participants, our understanding of why herding can arise in the financial market is still limited. Furthermore, studies that have attempted to document and quantify the presence of herding in the market have obtained results that are far from conclusive. Most work remains to be done both at a theoretical and at an empirical level. My research activity is devoted to shed light on the phenomenon of herd behaviour in financial markets with a combination of theoretical, experimental and empirical work. Most of this work is a joint effort with Marco Cipriani , of George Washington University.
Herd behaviour is relevant for the financial market informational efficiency. Essentially, herd behaviour entails neglecting private information in trading a stock or a group of stocks, because of what previous traders have decided to do. Clearly, if an agent neglects private information and herds, the market will not be able to infer that private information from the choice of that agent, and the price will not be able to reflect it. If many traders herd, the stock price can be misaligned with respect to the true value of the stock. Cipriani and I have proven that, indeed, even if traders are perfectly rational Bayesian agents, herd behaviour occurs in the market because of traders' heterogeneity. Traders go to the market to exploit their private information and for non-informational (e.g., liquidity) motives. Over time, as trade proceeds, the informational reasons to trade become less important than the non-informational ones. At a certain point, all traders will neglect their private information and an "informational cascade" (i.e., a situation in which the traders' decisions are completely uninformative on the asset value) will arise. In a cascade the price does not react to the order flow and is stuck for ever. It may well be that the price remains stuck at a level far from the fundamental one. For instance, it may be that the value of a stock is high, but the price remains stuck at a low level, after a sequence of sell orders in the market. Therefore, herd behaviour can be a reason why we can observe a financial crisis even in an economy with sound fundamentals.
To test theoretical models of herd behaviour is difficult. As I said, herding, at least in our framework, means neglecting private information because of the observations of previous traders' decisions. Therefore, ideally, to test such models one would need data on private information, which is of course difficult to obtain for actually running markets. This difficulty can be overcome in an experimental study. In an experiment we can observe variables not available for actual markets, in particular, the private information that agents have when making their decisions. For this reason, Cipriani and I have run a series of experiments in which we test whether herding arises as theory predicts or not. In our laboratory market, subjects receive private information on the value of a security and observe the history of past trades. Given these two pieces of information, they choose, sequentially, if they want to sell, to buy or not to trade one unit of the asset. By observing the way in which they use their private information and react to the decisions of the previous traders, we can directly detect the occurrence of herding. Our experimental results are encouraging for the theory. Although the laboratory reveals some anomalies in subjects' behaviour, i.e., some deviations from equilibrium behaviour, overall what we observe in the laboratory is quite consistent with the theoretical predictions. In particular, in a frictionless financial market in which traders trade for informational reasons only, and the price is efficiently set by a market maker in response to the order flow, herd behaviour is very limited. This agrees with the theory, according to which we should not observe herding at all. Market frictions, instead, generate informational inefficiencies both theoretically and experimentally. Cipriani and I have studied a market in which such frictions take the form a trade cost. We have shown that such a cost impairs the process of information aggregation and an informational cascade occurs almost surely. A cascade occurs since, after some trades, the gain form trading becomes lower than the cost, and agents prefer to abstain from trading. Interestingly, such behaviour is not only a theoretical result, but also occurs in the laboratory. Indeed, our experimental results are very close to the theoretical prediction. Transactions costs can be due, for instance, to transaction taxes, like the Tobin Tax. Therefore, our work has also some policy implications on the introduction of such a tax.
In more recent work, Cipriani and I have extended our research on herd behaviour by estimating a theoretical model of herding with field data. While in previous work we have brought the model to the laboratory, in this work we have brought the model to the real financial market. We use data on many days of trade for some specific stocks. We estimate the parameters of a theoretical model that predicts herd buying (or selling) when a sufficiently high sequence of traders have decided to buy (or sell) the asset. In the market there is a market maker who efficiently sets the prices for a stock according to the orders flow, and a sequence of traders, who can buy or sell at those prices. Herd buying arises when all traders value the asset more than the price posted by market maker, even if they have negative private information. Similarly, herd selling arises when all traders value the asset less than the market maker, even if they have positive private information. After we have estimated the parameters of the model, we are able to track down the beliefs that the market maker (the notional prices) and the traders have during each day of trading. By comparing these beliefs, we can identify the periods of the trading day in which herding occurs or not.
The research activity described so far refers to the analysis of a single market (for instance, a single stock, or a single country). An important development of this research is to consider many markets at the same time. This allows to studying phenomena of "financial contagion" due to learning or herding across markets. Cipriani and I have already given some theoretical contribution on this topic, but much more work needs to be done. Future research (joint with Steffen Huck) will be focused on understanding financial contagion due to informational spillovers in the laboratory. This research project is kindly supported by the ESRC (program on the World Economy and Finance).
While most of this research project on herding and learning focuses on financial markets, part of it is devoted to more general issues of "social learning." Herd behaviour in financial markets is a possible outcome of the traders' learning process. Traders try to learn from the trading decisions of the agents who went first to the market: it may happen that this learning process makes them just neglect their private information. This is what can happen in different social contexts too. When we have to decide which car to buy or which restaurant to go to, we do observe the decisions of other agents, for instance of our neighbours. After observing them, we may well decide to change our mind and, for instance, imitate their decisions, neglecting our original private information. The process of learning from the actions of others is what we call social learning. I am investigating issues of social learning not strictly related to the financial market in a number of papers. In a joint paper with Steffen Huck, and Thomas Jeitschko, we experimentally investigated a model of Bayesian learning that predicts sudden changes in the behaviour of agents and sudden crashes in the market. In the laboratory these changes (information avalanches) do not take place since decision makers are prone to a "solipsism bias," i.e., they are unable to imagine that others who play the same game may make quite different experiences than they themselves. We conjecture that this solipsism bias is of relevance in many fields of human decision making. In another work with Steffen Huck and Heike Harmgart, we analyze how agents learn by observing the number of agents who have already made a decision. For instance, agents have to decide to which of two restaurants to go, and they can infer the quality of the restaurant by some private information and by observing how many other agents have already chosen to go to the two restaurants. The question is whether the aggregation of information is efficient in this context or whether informational inefficiencies can arise. This work, still in progress, is both theoretical and experimental. If you are interested in this work, you can also look at Steffen Huck's research on social learning . In another project with Antonella Ianni we analyze the process of social learning in an economy in which agents can only observe the actions of their neighbours. The question is whether local interaction leads to complete learning in the entire society and whether convergence is fast or slow.
If what you have read so far seems interesting to you, and you want to know more, please visit the ELSE Working Papers Archive and my Personal Webpage, where you can find updated versions of my papers. adapted from http://else.econ.ucl.ac.uk/newweb/research/blurb1.php
Minggu, 02 November 2008
India feels crisis, Brown seeks cash for IMF
RIYADH: British Prime Minister Gordon Brown on Sunday called for billions of dollars in extra funding for the International Monetary Fund to prop
up struggling economies, while Chinese Premier Wen Jiabao said maintaining China's strong domestic growth was his priority.
Leaders from Mumbai to Moscow and Berlin moved to support their own economies on Saturday, with India's central bank cutting interest rates for the second time in two weeks, Russia putting 170 billion roubles ($6.4 billion) into a state bank and German Chancellor Angela Merkel pledging support for a big investment package to boost Europe's largest economy.
Brown, speaking in Riyadh, said oil-producing Gulf States and China should contribute money for the IMF to lend to countries at risk of financial collapse.
"If we are to stop the spread of the financial crisis, we need a better global insurance policy to help distressed economies," Brown said.
Chinese Premier Wen, writing in the ruling Communist Party's ideological journal, warned of growing domestic social risks from a global economic downturn.
"Against the current international financial and economic turmoil, we must must give even greater priority to maintaining our country's steady and relatively fast economic development," Wen wrote.
"We must be crystal-clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues and social development...and factors damaging social stability will grow."
China cut interest rates on Wednesday for the third time in six weeks to help the world's fourth-largest economy ride out the reverberations of the global financial crisis.
In India -- like China, a magnet for foreign investment in recent years as their economies roared -- the central bank on Saturday cut its main lending rate for the second time in as many weeks to ease a cash squeeze and spur economic growth.
INDIA WAS GETTING WORSE
Analysts said the surprise move showed Indian concern that strains on its economy were quickly becoming more severe.
"These actions were necessary (and had) to be taken on the liquidity front...the situation was getting worse," said Vikas Agarwal, a strategist at JP Morgan.
The central bank cut the repo rate, its main short-term lending rate, by 0.5 percentage point to 7.5 per cent and banks' cash reserve requirements by 1 percentage point to 5.5 per cent.
Policymakers around the world have slashed interest rates in recent weeks and injected huge amounts into their banking systems to try to combat the spillover effects of the global crisis, which has caused credit markets to freeze up and threatens to plunge the world economy into recession.
adapted from http://economictimes.indiatimes.com/
up struggling economies, while Chinese Premier Wen Jiabao said maintaining China's strong domestic growth was his priority.
Leaders from Mumbai to Moscow and Berlin moved to support their own economies on Saturday, with India's central bank cutting interest rates for the second time in two weeks, Russia putting 170 billion roubles ($6.4 billion) into a state bank and German Chancellor Angela Merkel pledging support for a big investment package to boost Europe's largest economy.
Brown, speaking in Riyadh, said oil-producing Gulf States and China should contribute money for the IMF to lend to countries at risk of financial collapse.
"If we are to stop the spread of the financial crisis, we need a better global insurance policy to help distressed economies," Brown said.
Chinese Premier Wen, writing in the ruling Communist Party's ideological journal, warned of growing domestic social risks from a global economic downturn.
"Against the current international financial and economic turmoil, we must must give even greater priority to maintaining our country's steady and relatively fast economic development," Wen wrote.
"We must be crystal-clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues and social development...and factors damaging social stability will grow."
China cut interest rates on Wednesday for the third time in six weeks to help the world's fourth-largest economy ride out the reverberations of the global financial crisis.
In India -- like China, a magnet for foreign investment in recent years as their economies roared -- the central bank on Saturday cut its main lending rate for the second time in as many weeks to ease a cash squeeze and spur economic growth.
INDIA WAS GETTING WORSE
Analysts said the surprise move showed Indian concern that strains on its economy were quickly becoming more severe.
"These actions were necessary (and had) to be taken on the liquidity front...the situation was getting worse," said Vikas Agarwal, a strategist at JP Morgan.
The central bank cut the repo rate, its main short-term lending rate, by 0.5 percentage point to 7.5 per cent and banks' cash reserve requirements by 1 percentage point to 5.5 per cent.
Policymakers around the world have slashed interest rates in recent weeks and injected huge amounts into their banking systems to try to combat the spillover effects of the global crisis, which has caused credit markets to freeze up and threatens to plunge the world economy into recession.
adapted from http://economictimes.indiatimes.com/
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