A Rare Post Worth Reading

Asset manager, blogger and twitterer (?) Morally Bankrupt wrote some thoughts on the factors affecting US house prices over the next few years.

"With mortgage rates near record lows, due both to low inflation and negative real rates, the leveraged purchasing power of real wages is near historic maximums. Additionally, for the most part, it looks like the bottom is in for housing price declines. Does this make it a good time to buy leveraged real-estate to capture future price appreciation while financing it at low rates? I do not think it's as clear as many people think it is."

I encourage "housing analysts", both professional and amateur, (me being the latter) to read the post to understand why. One of the big takeaways is on how mortgage payments that vary linearly with debt amounts relate to changing rates that affect affordability geometrically:

"For home prices to sustainably exceed inflation, wage gains have to outpace inflation by more than the increase in rates over that same time period... [P]urchasing power increases at an increasing rate as rates decline... [A]t a fixed interest rate, purchasing power increases at a stable rate with payment. This means that for home prices to sustainably increase, growth in wages not only has to outpace inflation, but it has to outpace it by a margin wide enough to compensate for losses in purchasing power from any changes in the mortgage rate during that same period."

This has implications for the Canadian housing situation as well. The conclusion:

"Depressed real estate prices and low financing rates are leading many to see the current climate as a golden opportunity to buy leveraged real-estate, but price increases are not guaranteed, and the pay-out on a leveraged bet on housing is dependent many different factors. While affordability remains high and payments as % of income are near historic lows due to the Fed's extremely accommodating policy, an economic recovery can put an end to Fed accommodation and suspension of the Fed's MBS reinvestment program would be reflected on both, the risk-free interest rate and the spread at which MBS trade, turning a tailwind into a headwind for price appreciation. Leveraged buyers also run the risk of near-term price declines or inflation rates below the rate priced in by nominal rates. Leveraged real estate requires price appreciation and/or profits from rents to outpace the rate of inflation built-in to interest rates, which as we already saw, is not near lows. 

"I don't have an opinion on whether residential real-estate is a good or bad investment, it's not my line of work, but I think many investors are failing to see that a leveraged bet on real-estate price appreciation is, indirectly, a bet on inflation exceeding current inflation expectations and future wages increasing at a rate faster than inflation. Under an inflationary environment, increases in the real price level of real estate would require a mix of an increase in the % of income spent on housing and real wages in order to allow growth in outlays to outpace the loss in purchasing power created by any increase in real-rates, inflation expectations, or mortgage spreads."

Y U No Spend?

Bank of Canada governor Mark Carney is speaking again -- again -- this time to businesses, on how to pull Canada through what looks to be a period of uphill growth (emphasis mine):

Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup. 

Developments since 2008 have reduced our margin of manoeuvre. In an environment of low interest rates and a well functioning financial system, household debt has risen by another 13 percentage points, relative to income. Canadians are now more indebted than the Americans or the British. Our current account has also returned to deficit, meaning that foreign debt has begun to creep back up...

In other words, households are chasing diminishing returns and the point at which this debt will be impossible to properly service is a looming risk.

Our strong position gives us a window of opportunity to make the adjustments needed to continue to prosper in a deleveraging world. But opportunities are only valuable if seized.
First and foremost, that means reducing our economy’s reliance on debt-fuelled household expenditures. To this end, since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements in order to support the long-term stability of the Canadian housing market. Banks are also raising capital to comply with new regulations. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector. 

To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth. 

Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis. 

But Canadian companies, with their balance sheets in historically rude health, have the means to act—and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets.

This would be good for Canadian companies and good for Canada. Indeed, it is the only sustainable option available. A virtuous circle of increased investment and increased productivity would increase the debt-carrying capacity of all, through higher wages, greater profits and higher government revenues. This should be our common focus.

Carney is pleading with businesses to invest to make up for what household spending has done in the past 3 years (and longer), in part by expanding enterprises away from Europe and the United States where growth prospects look anaemic. It appears that increases in -- or even the maintenance of -- the average household debt-to-income ratio will be a trigger for further tightening of credit availability.

Carney has also provided confirmation that banks are increasing their capital reserves for household loans, which means less credit will be available going forward and banks will need to be more selective in the loans they make. It is unclear what criteria banks will use to ration their loans but may involve regional considerations, as was done by HCG earlier this year.

The Bank of Canada is trying, with the limited tools it has available, everything it can to get businesses to spend. If businesses do not spend the burden will be borne by households and governments and this, in Carney's view, is the outcome most likely to lead to subpar (or negative) economic growth. The federal government has been attempting to facilitate private investment through tax breaks and other investment programs, but now Carney, at least, is appealing to patriotism. That is a wonderful stance in principle.

Bank of Canada Blows the Alarm on Housing Again

As the Eurozone crisis continues its slow impact with the current account iceberg, Canadian financiers, politicians, and technocrats (yes Canada has technocrats too) are planning for fallout (PDF). One key area of concern is the health of Canadian household finances. Below are excerpts from the risk analysis of Canada's housing market (emphasis mine):

The rising indebtedness of Canadian households in recent years has increased the possibility that a significant proportion of households would be unable to make debt payments in the event of an adverse economic shock. This growing vulnerability has heightened the risk that a deterioration in the credit quality of household loans would amplify the impact of the shock on the financial system. The resulting increase in loan-loss provisions for financial institutions and the reduced quality of the remaining loans would lead to tighter credit conditions and, in turn, to mutually reinforcing declines in real activity and in the overall health of the financial sector. 

The vulnerability to this risk remains elevated and is broadly unchanged since June. There are tentative signs that the sustained rise in the proportion of vulnerable households in recent years has moderated and credit growth has slowed noticeably over the past six months. Nonetheless, our simulation results suggest that household balance sheets remain vulnerable to adverse economic shocks... 

While the growth of household credit has slowed since early 2011, it has continued to increase more rapidly than income. As a result, the debt-to-income ratio of the Canadian household sector increased to a historical high of 149 per cent in the second quarter (Chart 23) and has been higher than the ratio in the United States since the start of 2011.

If recent trends persist, the ratio of household debt to income will continue to rise

Despite the rebound in the growth rate of mortgage credit in October, the Bank expects a gradual moderation in the underlying trend in household debt accumulation over the medium term as activity in the housing market slows and as lower commodity prices and heightened volatility in financial markets weigh on the wealth and confidence of Canadian households. Since the growth of personal disposable income is also projected to be moderate, the gap between credit and income growth is expected to narrow but remain positive, implying that further increases in the aggregate household debt-to-income ratio are likely. 

The overall financial situation of households remains strained  

Data for both individual households and the sector as a whole indicate that the financial situation of the household sector remains vulnerable. In particular, both the share of indebted households that have a debt-service ratio exceeding 40 per cent and the proportion of debt owed by these households remain above the 2000–2010 average.
The aggregate credit-to-GDP gap for Canada has fallen from its cyclical peak but remains high by historical standards, owing to the growth in household credit. International evidence has shown that this indicator is a useful guide for identifying a potential buildup of imbalances in the banking sector. 

Financial stress in the household sector has eased since the beginning of 2011, although it remains above pre-crisis levels: mortgage and consumer loans in arrears have moderated somewhat during 2011 but are nonetheless elevated. As well, the ratio of household debt to assets remains above its pre-crisis level, and household net worth declined modestly in the second quarter. Given negative returns across a broad range of assets since mid-year, net worth is expected to have declined further in the third quarter. 

Households are vulnerable to adverse shocks to the labour and housing markets 

Given the vulnerable state of their balance sheets, households would be less able to cope with the impact of significant adverse shocks. Two interrelated events to which Canadian household balance sheets are vulnerable are a significant decline in house prices and a sharp deterioration in labour  market conditions. 

Since high-ratio mortgages in Canada are insured, it is likely that a moderate fall in house prices would affect systemic risk primarily through the negative feedback loop with the real economy. In such a scenario, declines in house prices would lead to lower household net worth, reduced access to secured credit and lower employment in the housing-related sector. These factors would reduce consumer spending and increase strains on household balance sheets. 

Some measures of housing affordability suggest continued imbalances, owing to the robust performance of this market. In particular, house prices remain very high relative to income. Since the adverse impact of elevated residential property prices on affordability has been largely offset by low interest rates, affordability would be considerably curtailed if interest rates were closer to historical norms.

Certain areas of the national housing market may be more vulnerable to price declines, particularly the multiple-unit segment of the market, which is showing signs of disequilibrium: the supply of completed but unoccupied condominiums is elevated, which suggests a heightened risk of a correction in this market. 

A sharp and persistent increase in the unemployment rate would reduce aggregate income growth and make it more difficult for some households to make their debt payments. It would also have adverse knock-on effects on consumer confidence, the housing market and Canadian household net worth. 

The elevated debt loads of the household sector require continued vigilance

The Government of Canada has taken important measures in recent years to strengthen underwriting practices for government-backed insured mortgages. The most recent set of measures was implemented in March and April 2011, when the maximum amortization period was reduced from 35 to 30 years, the maximum loan-to-value ratio when refinancing a mortgage was lowered from 90 per cent to 85 per cent, and government-backed insurance on lines of credit secured by houses was withdrawn. These measures represented the continuation of a series of actions taken by the Government of Canada since 2008 to foster stability in the domestic mortgage market, and should help to moderate the future growth in household debt. Nonetheless, continued vigilance is warranted, since adverse debt dynamics remain in place. The Bank is co-operating closely with other federal authorities to continuously assess the risks arising from the financial situation of the household sector. 

Given the robust pace of mortgage credit growth in recent years, the Office of the Superintendent of Financial Institutions has conducted focused research on retail lending products over the past 18 months. An advisory was recently released noting that additional analysis is planned in the coming months. Where appropriate, this analysis will build on international mortgage underwriting principles being developed by the Financial Stability Board. OSFI has reiterated that mortgage lenders are expected to have an established policy for mortgage underwriting that is supported through appropriate risk-management practices and internal controls.

Key points and comments:

• Household balance sheets are likely to deteriorate further in coming months, and potentially years, with current controls in place.
• The Bank of Canada sees high house prices relative to incomes as unsustainable in the long run.
• OSFI is concerned about a disconnect between bank lending practices and long-term economic stability.
• Curbs on lending in terms of implementing risk management measures and countercyclical buffers on mortage loans are likely in the works.
• Usually announcements of further tightening of mortgage credit are announced in the first two months of the year to allow for proper implementation before the brunt of the peak of Canada's spring selling season.

If the Bank of Canada feels the need to lower interest rates in early 2012, this paper suggests that they are seriously considering additional curbs on mortgage lending to offset any additional monetary stimulus. This may mean, in particular overheated regional markets (like Vancouver's), that OSFI will start enforcing measures more closely tied to regional price-income metrics. This means Vancouver homeowners may find credit availability tougher than other regions of the country.

This is an important report. I have been surmising that further curbs in mortgage lending are coming, but am still unsure what form they will take. It is still possible that curbs going forward will start delving into the low-ratio mortgage market -- if prices do start falling banks who are lending on terms incompatible with government-backed mortgage insurance will create a significant liability for Her Majesty's Government.

How Money is Created

I've been fascinated and somewhat confused of late by the concept of how money is created. Given certain developments recently involving the Swiss unilaterally instituting an exchange rate ceiling, summarized by Kash over at The Street Light, Canada's horror and dismay what we would do when "currencies go to war", and the general idea about how Canada "creates" money, I thought I'd link to some thoughts on the subject. This does not necessarily clarify much on the matter, but does indicate the Bank of Canada is somewhat of a black box and there is no ultimate online authority I was able to dig up.

Worthwhile: Currency, Interest, and Redeemability

Money as Debt (video)

Wiki: Fractional Reserve Banking

Gilligan's Corner: Canada’s Private Banks have no Reserve Requirements (read the comments too)

Steve Keen: The Roving Cavaliers of Credit

First year macro textbook chapters on money in Canada ch10 and ch11 (PDF)

MacroMania: Fractional Reserve Banking

When trying to get information on the basic functions of the banking system and currencies, I am reminded that the web has a few disagreements, and can make things seem rather complicated.

Roubini Global Economics - Will New Regulations Bring Continued Rebalancing for Canadian Housing?

By Tetiana Sears and Rachel Ziemba

Though Canada managed to avoid a U.S.-style housing crash, the Great White North may face its own set of difficulties, as the same ample credit extension, low interest rates and government incentives that helped the housing market rapidly recover the losses incurred during the 2008-09 downturn are contributing to increased household indebtedness, which we note in our latest North America Focus. The ratio of debt to disposable income reached a record high of 148% in Q3 2010. As underlying macroeconomic trends (e.g., the open output gap and weak core inflation) warrant an extended pause in the Bank of Canada’s tightening cycle, Canadian authorities have turned to regulatory means to dampen excessive credit practices and ultimately decrease households' vulnerability to rising debt service payments.

To this end, in January the Canadian Department of Finance announced new regulations for mortgages, including a reduction in the maximum amortization period to 30 from 35 years for government-insured mortgages with a loan-to-value ratio greater than 80% and a reduction in the maximum size of a home equity loan to 85% from 90% of the property value. The government also restricted its support for home equity lines of credit (HELOCs) to safeguard its balance sheet from any future problems with structured products. This course of action, which follows similar measures in early 2010, was taken to encourage Canadians to maintain equity in their homes and limit the creation of debt-backed products by keeping them off of the public balance sheet.

The shortening of the amortization will raise the qualifying income of those seeking mortgages approved by the Canada Mortgage and Housing Corporation (CMHC), and some homebuyers (mostly first-time) will be priced out of the market or will choose a more affordable house. The reduction in the HELOC should temper renovation activity and spending on durable goods, dampening consumption. Although the total impact of the new regulation will only be marginal, it will contribute to a decrease in housing demand through this year, along with slower job growth and higher debt-servicing costs. All in all, the softening of the housing market could be a drag on economic growth.

The most recent Canadian housing data (housing starts for January and building permits for December) suggest that Canadian homebuilding activity is stabilizing at the levels of late 2010 as domestic, U.S. and global momentum combine to help bring the market in for a soft landing. This week’s data on new-home construction continued to build on our base case scenario, given stricter lending standards and mortgage origination rules in Canada. Although we don’t see any evidence of a sharp correction, there are risks of some volatility in the housing market in coming months as new mortgage regulations are implemented in March. Despite this likely transitory increase in mortgage applications, the broader trend of cooling housing market activity appears to be well entrenched. Although both new and existing home sales picked up in Q4 2010, the overall pace has notably moderated from late 2009-early 2010. Higher prices, rising debt and slow growth in wages will keep trends modest.

Canada’s growth momentum picked up in late 2010, along with growth south of the border, as exports and mining demand and services picked up. Labor market data, a lagging indicator, suggest that this stronger momentum could carry into Q1, posing upside risks to RGE’s current forecast of 2.3% growth for 2011. Should economic growth surprise on the upside, housing market activity could be more resilient.

Stronger growth would remove support for the central bank’s dovish bias and suggests that the gradual increase in benchmark and long-term interest rates would boost debt service costs. On balance, rising debt payments will be only partly offset by income growth as debt is outpacing wage growth, and we expect that January’s job gains are not sustainable. As the Canadian economy faces these opposing forces, housing market activity should continue to rebalance and is likely to stabilize in the latter part of 2011 at a pace of growth lower than that of 2010. Regulators have to hope the pace remains gradual.

Canadian policy makers are by no means the only ones struggling with the dilemma of whether to worry about frothy asset markets. Capital flows into many emerging market economies, particularly in Asia, have stoked domestic housing markets—with dollar-pegged and RMB offshoring epicenter Hong Kong particularly affected. Other advanced economies, like the Nordics and Switzerland (which have stronger balance sheets than the eurozone periphery) have also experienced strong housing price appreciation, as RGE noted in a recent Europe Focus. They have attracted significant capital inflows during the economic recovery, and the well-capitalized banks took advantage of low interest rates to increase lending, supporting the recovery of the housing market and domestic demand.

Optimal Monetary Policy during Endogenous Housing-Market Boom-Bust Cycles

This paper uses a small-open economy model for the Canadian economy to examine the optimal Taylor-type monetary policy rule that stabilizes output and inflation in an environment where endogenous boom-bust cycles in house prices can occur.

The model shows that boom-bust cycles in house prices emerge when credit-constrained mortgage borrowers expect that future house prices will rise and this expectation is neither shared by savers nor realized ex-post. These boom-bust cycles replicate the stylized features of housing-market boom-bust cycles in industrialized countries. In an environment where mortgage borrowers are occasionally over-optimistic, the central bank should be less responsive to inflation, more responsive to output, and slower to adjust the nominal policy interest rate.

This optimal monetary policy rule dampens endogenous boom-bust cycles in house prices, but prolongs inflation target horizons due to weak policy reactions to inflation fluctuations after fundamental shocks.

TD Economics - Real Estate Trends Could Impact Future Path Of Canadian Monetary Policy

I suggest you read this TD Economics report released today. It contains some interesting thoughts about monetary policy and the real estate market across Canada.

Bank of Canada cuts lending rate to record low of 1%

From CBC:

The Bank of Canada on Tuesday cut borrowing costs to a record low as it warned the economy will shrink this year. In a further move to bolster the sagging economy, the bank reduced its key overnight rate by half a percentage point to one per cent. The bank has now trimmed 3.5 percentage points from the overnight rate since it started its latest cycle of cuts.Tuesday's cut reduced borrowing costs below 1.12 per cent, which had been the lowest point set back in 1958.

More rate reductions may also be in the offing, as the Bank of Canada said more stimulus could be needed to boost the sagging economy."Major advanced economies, including Canada's, are now in recession and emerging-market economies are increasingly affected," the bank said."Canadian exports are down sharply, and domestic demand is shrinking as a result of declines in real income, household wealth, and consumer and business confidence."

Bank sees recovery in 2010

The Canadian economy is expected to contract by 1.2 per cent in 2009, but the bank sees a recovery in 2010, when the economy is projected to expand by 3.8 per cent.Back in October, the bank projected growth of 0.6 per cent in 2009, and 3.4 per cent in 2010.The bank will provide more details on its outlook for the economy on Thursday, when it releases its Monetary Policy Update.

The bank also signalled that inflation fears have abated. The so-called core inflation rate is expected to fall to 1.1 per cent in the fourth quarter of this year, while the overall inflation rate is expected to dip below zero for two quarters in 2009 because of lower energy prices."With inflation expectations well-anchored, total and core inflation should return to the two per cent target in the first half of 2011 as the economy returns to potential," the bank said.

The major Canadian banks quickly moved to reduce their prime rates to three per cent. That differed from some of the past moves by the Bank Canada, when the big banks either delayed lowering their prime rates or did not pass along the full cut. The banks cited the tight credit markets as the reason why they were not passing along the cuts to customer borrowing rates.

Borrowing is getting cheaper if you can qualify and you are willing. It doesn't seem like the willing qualify these days and the qualified seem unwilling!

US Financials Falling Like Dominoes

Sept. 14 (Bloomberg) -- Lehman Brothers Holdings Inc. prepared to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the U.S. securities firm and Wall Street prepared for its possible liquidation.

Lehman and its lawyers are getting ready to file the documents for bankruptcy protection tonight, said a person with direct knowledge of the firm's plans. A final decision hasn't been made, though none of the other options being considered appeared likely, the person said, declining to be identified because the discussions haven't been made public.

Sept. 14 (Bloomberg) -- Bank of America Corp. agreed to buy Merrill Lynch & Co. for about $44 billion, a person with knowledge of the deal said, after shares of the third-biggest U.S. securities firm fell by more than 35 percent last week and smaller rival Lehman Brothers Holdings Inc. neared bankruptcy.

Bank of America and Merrill reached a deal in principle, according to the person, who declined to be identified because the deliberations were private. A final merger agreement hasn't been signed yet, the person said. The boards of Merrill and Bank of America approved the transaction this evening, the Wall Street Journal reported, citing unidentified people familiar with the matter.

Sept. 14 (Bloomberg) -- American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking a $40 billion bridge loan from the Federal Reserve as it tries to sell assets, the New York Times reported.

The insurer has turned down a private-equity investment because it would have meant handing over control of the company, the Wall Street Journal said on its Web site, citing unnamed people. AIG may get access to the Fed's borrowing window in an ``extreme liquidity scare,'' Citigroup Inc. analyst Joshua Shanker said in a Sept. 12 research note.

Behind the Food-Price Riots

From the Wall Street Journal: By VINCENT REINHART, April 18, 2008

With a dramatic rise in the prices of foodstuffs, riots have flared up in dozens of hotspots around the world. Panicky politicians are responding with precisely the wrong policies, including production subsidies and trade controls.

The problem is clear enough: According to the International Monetary Fund, food and beverage prices have risen 60% in the past three years, and more than doubled since 2001. Even in the U.S., increases in the food-price component of producer- and consumer-price indexes over the last 12 months have been in the neighborhood of 5%.

What is going on? We can discern four forces at work today pushing up food prices – forces that were also at work in the 1970s, the last time food prices increased so rapidly on a sustained basis:

- Monetary policy in overdrive. Consider the real federal funds rate – that is, the nominal funds rate less inflation. A low real fed funds rate both encourages interest-rate sensitive spending, such as business investment, and discourages global investors from supporting the dollar on foreign exchange markets. At 2.25%, the nominal fed funds rate is now below the prevailing rate of consumer price inflation.

The last time the real fed funds rate was negative for a prolonged period was the mid-1970s. This was also a period when overstimulated demand pushed food prices up and the dollar depreciated sharply. In the end, economic growth suffered as well. Remember stagflation?

- Exchange-rate arrangements in disarray. The 1970s were also noted for turmoil in exchange markets, following the breakdown of the Bretton Woods system. The schism today is that some exchange rates move too little and others too much.

The exchange rates that are moving too little are those of emerging market economies and oil producers. China, India, Korea and Taiwan, and key oil producers such as Saudi Arabia, have been preventing their exchange rates from appreciating significantly by rapidly accumulating international reserves.

They've also effectively adopted the monetary policy of the Federal Reserve by keeping their domestic interest rates close to the fed funds rate. That way, no interest-rate wedge opens between their markets and our own that would otherwise put pressure on their exchange rate. As a consequence, they are following an accommodative monetary policy strategy totally unsuited to their already overheated domestic economies. Higher inflation has followed.

With exchange-rate movements capped by policy makers in so many parts of the world, the burden of adjustment falls more heavily on the nations that allow their currencies to float freely, such as Canada, those in the Euro area, and Japan. The depreciation of the dollar against these currencies is yet another reminder of the 1970s. As a result of these exchange-rate changes, the purchasing power of these regions for any internationally traded good denominated in dollars has gone up. Hence, it is no accident that the dollar price of food is up sharply.

- Unsound market interventions. Policy makers flailed about in the 1970s, enacting environmental legislation without due deference to the costs imposed on industry. They also tried to impede market forces with gasoline rationing and a brief flirtation with outright price controls.

This time round, our government has been force-feeding the inefficient production of ethanol. The result: Corn prices have more than doubled over the past three years, adding to price pressures on commodities that are close substitutes, or which use corn as an input to production.
Meanwhile, policy makers in emerging market economies have bent under the weight of popular unrest to raise food subsidies. This strains their budgets. They are also imposing restraints on exports, thereby losing gains from trade.

- Oil prices on the rise. The lines stretching around filling stations in the 1970s should remind us that large energy-price increases are disruptive. And we have had a large one: Crude prices have more than quadrupled since 2001. Any industry dependent on energy will feel those cost pressures, and modern agriculture, with its oil-based fertilizers and large machinery, is no exception.

But there is an important difference between our troubles today and those of the 1970s. In that decade, aggregate supply sagged as oil producers scaled back production and anchovies disappeared off the coast of Peru. The 2000s have been about demand expansion. Millions of workers in China, India and Vietnam, among others, have joined the world trading system. Beginning from a point close to subsistence, most of their additional income is being spent on food. Thus, the price of food relative to other goods and services has risen.

The good news is that producers respond to relative prices, although it can take some time. Already, the acreage in which corn is planted in the United States is back to levels of the 1940s. More of a production response should follow in other areas as well.

Challenges abound as supply catches up with higher global demand. The Federal Reserve has to be sensitive not to stoke inflation pressures, and to monitor inflation expectations closely. The subsidies proffered to corn producers have to be trimmed, in part to set a new standard for emerging market economies to emulate. And the gains from an open trading system have to be protected to keep our economy efficient.

Mr. Reinhart, a resident scholar at the American Enterprise Institute, was director of the Division of Monetary Affairs at the Federal Reserve.

Here is a Canadian perspective on inflation.

Wall Street Owns Federal Reserve

In a move that basically puts central bank interest rates below the rate of inflation, the US Federal Reserve lowered their prime rate 75 basis points to 3.5% before markets opened this morning.

Just a reminder to everyone out there, this is exactly the stupid type of move that got us into the whole mortgage mess, housing bubble, credit crisis. Look for the next bubble to start anytime now with even more interest rate cuts left to come with the inflation beast lurking and about to be let out into the street.

What is your bet on the next bubble?

Here is my short list of candidates:

Infrastructure
Agriculture
Alternative Energy

Cash Injection - Hello Inflation

By HEATHER SCOFFIELD Globe and Mail Update December 12, 2007 at 12:29 PM EST

OTTAWA — The world's major central banks, including the Bank of Canada, are launching a rare coordinated action to calm global credit markets and smooth out transactions over the end of the year.

The Bank of Canada, the U.S. Federal Reserve, the European Central Bank, the Bank of England and Switzerland's central bank made a joint announcement Wednesday, saying they were taking coordinated measures “designed to address elevated pressures in short-term funding markets.”

Investors applauded what was yet another step to deal with a severe credit crunch stemming from the tightening of bank lending standards. The Dow Jones industrial average was up by more than 100 points in midday trading, after rising more than 270 points in early trading, while the S&P/TSX composite index gained more than 120 points.

“At the very least these measures should tide the markets over the potentially awkward New Year period, and hopefully well into 2008 as well,” Capital Economics said in a research note. “They do not address the underlying imbalances threatening the world economy – notably the impact the U.S. housing slump will still have via conventional economic channels – but they should at least reduce the risk that the credit crunch tips economies into recession.”

For its part, the Bank of Canada will inject liquidity into short-term money markets, something it has resisted doing over the past few months despite widening spreads in short-term debt markets.

To date, the Canadian central bank has only concentrated on injecting liquidity into the overnight market to defend its target interest rate, which stands at 4.25 per cent. But spreads on credit for terms longer than overnight have been high and widening recently.

The central bank will enter into purchase and resale agreements with banks Thursday to the tune of $2 billion, followed by a minimum of $1 billion next Tuesday.

The Bank of Canada will also expand its list of collateral, something financial institutions have been begging the central bank to do for months.

Acceptable collateral for the term liquidity includes Government of Canada bonds and bonds guaranteed by the government, such as Canada Mortgage Bonds and securities backed by provincial governments, and bankers' acceptances and bearer deposit notes.

The Bank of Canada also said it would begin in March to accept some kinds of asset-backed commercial paper, or ABCP, as collateral for borrowing from its standing liquidity function, a pool from which banks can borrow at the bank rate, on an overnight basis, to help deal with temporary liquidity problems in their settlements.

To be accepted as collateral, the ABCP can not be the type that froze Canadian markets in August. Rather, it must be backstopped under global rules, not looser Canadian rules, the central bank said.

The fact that the Canadian central bank is taking measures it has resisted to date — making plans to accept ABCP as collateral, getting involved in term lending, and being more lenient in the collateral it accepts – suggests grave and urgent concern on the part of the central bank.

And the fact that it is coordinating credit-oriented action with other central banks suggests problems are deep and widespread, heading to a climax as the year draws to a close and demand for liquid cash spikes.

The liquidity measures are aimed at flooding money markets with extra readily-available cash at a price lower than the market is demanding now. The measures are meant to drag spreads back to more normal levels, and instill confidence in the markets.

While each central bank's measures may seem modest taken on their own, they are impressive if taken together and should be effective, said Mark Chandler, fixed income strategist at RBC Capital Markets.

“It's coordinated with monetary policy and it's coordinated with central banks, and it shows that they're listening,” he said.

Markets balked yesterday when the U.S. Federal Reserve cut its key rate by just a quarter of a percentage point, feeling the Fed was not sufficiently recognizing the pain felt from the credit crunch.

The Fed's response makes more sense now, with the news that it is coordinating with central banks to inject liquidity, Mr. Chandler said.

The action comes alongside interest rate cuts by the Fed, the Bank of Canada and the Bank of England, he pointed out, and as a package should ease problems in debt markets.

Mr. Chandler said it is wise for central banks to work together, since the problem of widening spreads in credit markets is globalized – more expensive borrowing conditions in one country has sent borrowers scurrying to other countries in search of better rates. But the pressure of their demand made for more expensive borrowing in other countries too.

So a problem in England quickly became a problem in Canada and the United States.
“We've all been fighting for the same thing, which is a pool of liquidity,” Mr. Chandler said.
That pool is now larger and easier to access.

In a statement timed to occur before the start of trading, the Fed said it planned to offer $40 billion (U.S.) in emergency funds to banks next week through an auction process.

The Fed said that it was creating a temporary auction facility to make funds available to banks and was also setting up lines of credit with the European Central Bank and the Swiss Central Bank that could be used for additional resources.

The first two auctions of $20 billion each will be next week on Dec. 17 and Dec. 20.
Analysts said the use of auctions to try to get more money into the banking system was an acknowledgment that efforts to spur direct loans from the Fed to banks through the Fed's discount window had not worked as well as hoped because of banks' fears that investors could become worried if they started utilizing the Fed's discount window to any large extent.

The Fed said it was also setting up lines of credit with the European Central Bank and Swiss Central Bank that could be used for additional resources.

The Fed said the new auction process should “help promote the efficient dissemination of liquidity” when other lines of credit were “under stress.”

It said that the temporary swap arrangements being set up would provide up to $20 billion in reserves for the European Central Bank and up to $4 billion for the Swiss National Bank. The reserves would be available for up to six months.

Since the global credit crunch hit with force in August, central banks have been injecting massive amounts of money into the banking system in an effort to keep credit flowing.

However, those efforts have only been partially successful. Many businesses and consumers report rising trouble in obtaining loans as banks become more fearful about extending credit in the wake of a surge in bad loans stemming from the U.S. housing crisis.

But I thougth these problems were contained to the United States and only affected a few deadbeat borrowers called subprime!?!?!

Check out Calculated Risk on this topic.
Or Floyd Norris' comments at the NY Times.

Central Banking

The video is an interesting history lesson with some controversial conclusions.

And here in Canada - - - all is (not) well.

OTTAWA (Reuters) - The Bank of Canada may have overstepped its legal powers during the summer credit crunch and legislative changes are needed to clarify its role in future financial market crises, an independent report said on Tuesday.

From August 15 to September 7, the central bank temporarily expanded its list of collateral used when conducting open-market operations to boost liquidity and reinforce its target for the overnight interest rate.

The bank stepped into "questionable legal territory" when it began accepting commercial paper, foreign bonds and corporate bonds in addition to the usual government securities, bills of exchange and promissory notes, argued John-Paul Koning of the C.D. Howe Institute, a think tank.

"The bank's actions may have exceeded its statutory authority and, if Parliament believes it necessary that the bank should have the scope to act as it did, legislative changes are needed," Koning wrote.

The law governing the Bank of Canada says that only government-issued and guaranteed securities may be used as collateral for central bank operations designed to influence the overnight lending rate. These include the Special Purchase and Resale Agreements, whereby it buys securities with the agreement to sell them back the next business day.

The list of collateral is less restrictive for lending through the Bank of Canada's Standard Liquidity Facility. It was this list that the bank adopted temporarily for its purchase and sale operations in the market.

The law gives the central bank extended buying and selling powers in times of financial emergency but only if the governor publicly states that an emergency exists, something Bank of Canada Governor David Dodge did not do in August.

Lawmakers should decide whether they want to give the Bank of Canada the power to use private sector debt as collateral when ensuring short-term financing in times of financial market difficulty, Koning said.

"The Bank of Canada should offer Canadians a comment on its actions of this past August. Policymakers should also revisit the thinking behind certain sections of the Bank of Canada Act," he said.

"Failure to do so could hamper the bank's response the next time the financial system runs into trouble."

Dodge signaled on October 21 that he was mulling possible changes to the bank's liquidity provisions. In a speech in Washington, he floated the idea of a new central bank facility that would provide liquidity to banks at terms longer than overnight, collateralized with a possibly wider range of securities.

Deputy Governor Pierre Duguay repeated the idea in a November 20 speech. "The types of market failure that such a facility would be designed to deal with would obviously need to be very carefully considered to avoid weakening the incentive for preventive risk and liquidity management by market participants," he said.

Dodge and Senior Deputy Governor Paul Jenkins will be answering questions from the Senate Banking Committee on Thursday and the incoming governor, Mark Carney, appears before the House of Commons finance committee on Wednesday afternoon.

(Reporting by Louise Egan; Editing by Peter Galloway)

Bank of Canada releases Monetary Policy Report

OTTAWA – The Bank of Canada today released its October Monetary Policy Report, which discusses current economic and financial trends in the context of Canada's inflation-control strategy.

Here are some highlights:

Implementing Monetary Policy: Targeting the Overnight Rate
The Bank of Canada’s monetary policy implementation framework centres on keeping the overnight rate close to its target.1 The Bank’s primary influence on the overnight rate is through the 50-basis-point operating band, reinforced through its standing facilities for loans and deposits. In order to reinforce the target when the overnight rate deviates from it, the Bank uses open market buyback operations and changes in the level of settlement balances provided to the financial system. If the overnight rate is generally trading above the target rate, the Bank will intervene with special purchase and resale agreements (SPRAs). If the overnight rate is generally trading below the target rate, the Bank will intervene with sale and repurchase agreements (SRAs). In addition, to influence the overnight rate, the Bank can adjust the targeted level of settlement balances higher or lower than the typical $25 million setting. SPRAs are routinely conducted around month-, quarter-, and year-end periods, and when large payment flows are going through the system. The Bank used SPRAs, SRAs, and adjustments to settlement balances, as appropriate, during episodes in 1999, during the transition to the Large Value Transfer System (LVTS), and in early 2006, when there was persistent downward pressure on the overnight rate.

Since early August, the Bank has again been using these tools to counter upward pressure on the overnight rate and keep it close to target.


The Cost and Availability of Credit in Canada
Credit conditions in Canada have tightened since late July, reflecting a repricing of risk as investors have become less willing to hold a wide variety of private sector securities, most notably asset-backed commercial paper (ABCP). The degree of tightening in terms of changes in the availability and cost of financing for financial institutions, firms, and households is difficult to estimate. Since the situation is still evolving, estimates are subject to a high degree of uncertainty. But what is clear is that the costs of borrowing from the market or from banks has increased, and credit conditions have tightened.

The cost of funding for Canadian banks through various market instruments has risen 10 to 35 basis points relative to the rates observed at the end of July. Increases in the costs of deposits have been more modest. Some borrowing rates posted by financial institutions have increased over the past few months. Effective borrowing rates for both business and consumers have also increased as the extent to which discounts on posted rates offered to households and businesses, such as the prime rate, have diminished. In addition, some financial institutions have increased covenants on new loans, and others have indicated some reduction in new loan originations. All told, the effective costs of household and business loans from financial institutions are estimated to have increased by about 20 to 35 basis points.

Businesses’ cost of borrowing through financial markets has also increased somewhat since July. The overall cost of issuing short-term market debt is estimated to have increased by roughly 20 to 30 basis points. Based on observed prices, the cost of long-term debt is estimated to have remained largely unchanged, but the actual amount of issuance has been relatively small and remains limited to investment-grade borrowers.1 As a result, observed prices likely do not fully reflect actual borrowing conditions. When the different components of bank and market borrowing are aggregated, the weighted average cost of borrowing for non-financial firms has increased by at least 15 to 25 basis points.

Overall, the cost of borrowing for households and businesses is estimated to be about 25 basis points higher, relative to the overnight rate, than it was prior to the summer developments, and availability and terms of credit have tightened modestly.

Bank of Canada Intervention

OTTAWA, Oct 1 (Reuters) - The Bank of Canada has now injected a total of C$890 million ($899 million) in overnight money into the markets on Monday to lower the overnight interest rate toward the central bank's target and improve liquidity.

Earlier on Monday, the bank injected C$530 million and has now increased that total. The bank intervened regularly in August during a credit crunch, but stayed out of the market from mid-August until late September.

It operates through Special Purchase and Resale Agreements, buying securities with the agreement to sell them back the next business day.

What are "Special purchase and resale agreements (SPRAs)"
Repo-type operations in which the Bank of Canada offers to purchase short-term Government of Canada securities from jobbers (investment dealers) with an agreement to sell them back the next business day. They are initiated by the Bank to prevent the overnight rate from moving above the upper limit of the operating band or to signal a change in the band.

For more information on how the Bank of Canada implements this policy check out these links:

http://www.bankofcanada.ca/en/review/1998/r981b.pdf
http://www.bankofcanada.ca/en/lvts/lvtsmp3.pdf
http://www.bankofcanada.ca/en/financial/lvts_neville.pdf

UPDATE: Reader /Dev/Null sent me a link to this article, which, upon reading made me want to go out and buy canned goods, gold, and ammo.