Wednesday, October 15, 2014

Germany, the Eurozone, and the Euro: Parity on Different Levels

The more I read about the dynamics of the German economy in relation to the rest of its Eurozone counterparts, the more it becomes clear that their ideological differences have extrapolated over time to create a competitive positioning versus one of co-ordination. Regardless, they find themselves in a monetary union at a time when the global economy is “re-evaluating” what works and what doesn’t work, and while this process is being sorted, slow growth and low inflation is presenting as normal.

Germany has built over time a trade surplus from exporting more than it imports [along with a few other smaller European economies], while most of the other larger Eurozone economies have been following the example of the US economy in running deficits and depending on foreign investments to grow.

Fast-forward to a post-crisis Europe, and foreign investors are no longer so eager to hand over their savings, and so we come to the first opportunity for parity. Germany has an option to draw down its trade surplus which stems mainly from exports to the rest of the Eurozone by investing in those same economies it trades with. This will bring Germany in line with the rest of the major Eurozone economies with running deficits to finance growth through investment. This is of course a means of buying time to allow domestic demand in the union to pick-up from the increased spending. Not likely in my opinion, since there are structural reforms that need to be made in Europe as a whole to boost competitiveness before investment and subsequent consumption demand can re-emerge.

This brings us to the other level of parity that can occur involving the Eurozone. To make Eurozone exports more competitive on the world market, the Euro needs to further devalue from its current levels. For there to be some meaningful and lasting effect on exports, parity to the US dollar may need to be reached in the foreign exchange market with the Euro. At these proposed levels the trade-weighted value of the Euro should have depreciated enough to stimulate foreign demand for Eurozone exports. This would also serve an additional benefit of increasing the prices of Eurozone imports. In short, inflation would be imported into the union, instead of generated internally.

This would give the European Central Bank (ECB) room to operate with more conventional monetary policy tools, and put the bank in a better position to manage long-term inflation expectations. Unfortunately, this would be at the detriment of the German savers, who would see their surpluses eroded away by the inflation, while the other major deficit carrying economies would see their deficits eroded away from getting to pay their debts with money that’s worth less than the money they initially borrowed.

If the German’s are willing to take one for the team, either in terms of handing over their hard-earned surpluses directly, or living with higher prices, and handing over their surpluses indirectly, the Eurozone may be able to survive its current bout with low growth from a drop-off in foreign investment, and low inflation [maybe even disinflation] from a drop-off in domestic demand. If Germany however, fails this test of altruism, then the alternative is Eurozone deflation, which will further push down wages and demand within the Eurozone, and leave German without its main export market. This will also push up the Euro which will make German exports to the world market even less competitive. At which point a German exit of the monetary union for the sake of the German economy will become the most politically appealing route.

Wednesday, October 1, 2014

Is the Federal Reserve Just That Good?

As the discussion of the persistently low inflation economic environment continues, the ideas, theories, and explanations continue to be formulated as to why this is the case. One argument that I found particularly interesting is the one for a market-neutral interest rate. The concept is basically the Federal Reserve aligning monetary policy with what is perceived [not empirically observable] to be an interest rate level that has a minimal effect on employment. This in theory, should allow monetary policy normalization to occur without slowing employment growth, and hence, GDP growth as well. If the Fed could indeed accomplish such a fete, then investors’ expectations of future inflation should remain anchored to the Fed’s long-term target of 2%.

Inflation expectations have also received its fair share of scrutiny as well. An interesting argument has also grabbed my attention on this topic. The argument poses that inflation expectations can be considered as the drag between real (time) economic activity and monetary policy. This is a fairly intuitive idea to internalize, as the Federal Open Market Committee (FOMC) along with investors and other market participants are basing their decision making on backward facing economic statistics when participating in market transactions. That disconnect between timely information and decision making is the alleged source of the expectations of higher future prices.

When we combine the two views, they paint a cohesive picture with one very important caveat; the Fed is extremely good at what it does. If the Fed is efficient at interpreting and re-acting to the real economy, then investor inflation expectations should remain well anchored. But, alas, as investors keep taking cues from the financial markets, while the Fed takes its cues from the macro-economy, a decoupling may occur between investor expectations and FOMC actions. This should [in theory] increase the drag between the real economy and monetary policy as market participants alter their real world investment decisions based on the evolving environment in the financial markets, which in turn affects the outcomes of monetary actions by the Fed.

Long story short, these theories and arguments are perfectly adequate until their underlying relationships breakdown. For the last five years, market participants have known what to expect from monetary policy because monetary policy has not changed in five years. All other FOMC actions have been isolated to the balance sheet relationship between the committee and the commercial banks. Somehow I believe that once the Fed starts its long road to normal, investors, academics, and pundits will be attempting to rationalize the dynamic economic environment that will result, and the underlying relationships that will be developing, in terms of inflation expectations and monetary policy evolution.