More Risk Ahead?

Another Financial Times' report notes a warning from BIS, Bank for International Settlements:

Interest rates in the world’s leading economies should rise while conditions are good to avert the twin risks of rising inflation and trade imbalances that could destroy the remarkable strength of the world economy, the Bank for International Settlements has warned.

The central banker’s bank, based in Basel, Switzerland, also says that financial innovation may be dangerous, especially the wider distribution of credit risk using asset-backed securities. “More scepticism might be expressed about some of the purported benefits of having new players, new instruments and new business models,” it says in its annual report.

More Euros in Circulation

Financial Times' Ralph Atkins reports from Frankfurt (home of ECB) that there are now more euors in circulation than dollars.

Banknote holdings per person are almost twice as high in the 13-country eurozone as in the US, the study shows, while eurozone citizens typically withdraw 50 per cent more each time they use a cash machine.

Net shipments of euro notes to outside the eurozone are declining, says the report. Only 10-15 per cent of euros in circulation are held abroad. About 60 per cent of US dollars in circulation are held overseas.

One explanation for Europe's cash addiction could be that the use of payment cards is less developed in many eurozone states than in the US. The ECB believes low inflation and interest rates have increased the attraction of holding cash, while euros are available in higher-denomination notes than dollars. Demand for €500 ($674, £337) notes has shown a particular rise.

Excluding notes held abroad, per capita holdings in the US were worth the equivalent of about €870. For the eurozone, the figure was more than €1,600.

People Eat and They Drive

The Economist knows the difference between the headline inflation and core consumer price index, and understands the importance of the former as an inflation indicator:

What the markets blithely ignored was the day's bad news. Headline consumer prices rose by 0.7%, the biggest monthly increase for nearly two years. Unlike core inflation, the headline measure includes fuel costs, which rose sharply, as well as food prices. For bond prices to rise on such a big jump in inflation, markets must be placing a great deal of faith in the core index as the true gauge of price pressures. Is that wise?

The cold-and-hungry index

The lure of core inflation as a barometer is that headline inflation rates tend to be volatile. Last June the annual headline rate in America, pushed up by soaring oil prices, was as high as 4.3%, but by October it had plunged to 1.3%. The rationale for excluding food and fuel is to filter out prices that jump around for temporary reasons, such as the vagaries of the weather or the messy politics of the Middle East. A good core index excludes this noise, leaving only the enduring part of inflation that reflects the weight of spending in the economy.

Money Supply

Despite the recent correction to the falling prices and rising yields of U.S. treasuries, I've been wondering how the Federal Reserve might react in the coming months as the bond market remains jittery. The talk to beat inflation was tough when the new chair took his place. However, if money is tightened to reduce inflation, interest rates will have to rise even more, furthering the slump in the housing market already suffering from the recent subprime melt-down. This course of action will lead to serious unhappiness among those owning property. If the Fed decides on merely talking about beating the inflation while letting money loose, interest rates will remain less volatile and inflation will rise but perhaps at a slower rate than would cause a shock. If I were to bet, I would bet that the Fed will choose the latter coure of action. It is the politically "prudent" course although many who earn wages and have little property to own may suffer more than others.

From an entirely different perspective ...

If they fight inflation too hard, interest rates will go higher, more adjustable rate mortgages will go into default, and fewer people will be able to afford a first home. If they don't fight inflation, adjustable rate mortgages do not need to go up too high. Instead, salaries will eventually go higher with inflation (there's always a delay with salaries) ... but this course of action devalues outstanding debt. In other words, those who have given their money into debt will be earning lower, real interest rates (real interest rate = nominal interest rate minus inflation rate) ...

So, they need to side either with people that owe (mortgages or other debt) and let inflation rise or with those who lend and let interest rates rise.

Bond Sell-off

As 10, 20 and 30 - year treasury prices go down, their yeild goes up, putting upward pressure on interest rates. Thus, reports Krishna Guha of Financial Times:

The spectacular sell-off in the US bond market this week is a macroeconomic event not just a financial market event, with consequences for the rate and composition of US growth and the conduct of monetary policy.

The sharp increase in yields on 10, 20 and 30-year Treasuries will push up mortgage rates and put renewed pressure on a still-weak housing market, with potential spill-over effects on US consumer spending.

In a second FT report, Richard Beales and Joanna Chung, describe how the rise in yeilds relate to expectations:

Investors sold bonds heavily on Thursday following growing concerns over rising interest rates and the sustainability of easy credit conditions.

Coffee Economics

Coffee ... the world's second most widely sold commodity, after oil .... (Harvard Business Review, October 2006)