The European Central Bank has made up to €1bn in extra profits from crisis-related emergency lending, but its caution on unconventional policy measures has curbed potential earnings, analysts estimate. Extra liquidity pumped into the eurozone banking system since the collapse of Lehman Brothers last year has probably generated an extra €900m ($1.5bn, £780m) in profits so far, according to calculations by Goldman Sachs.

Some €300m of the total has been generated since June, when the ECB provided €442bn in one-year loans in its biggest liquidity providing operation. The extra profits are on top of the sums that the ECB normally makes on its market operations. Although the interest rate currently charged by the ECB – 1 per cent – was the lowest in its 11-year history, revenues “remain juicy because of the quantity of liquidity that banks keep hoarding”, said Natacha Valla, European economist at Goldman Sachs in Paris.

From last October the ECB has been meeting, in full, eurozone banks’ demand for liquidity. Ms Valla argued, however, that by sticking largely to using policy instruments already in its armoury the ECB had forgone potentially far higher margins.

Profits on the ECB’s programme to buy €60bn in covered bonds – low risk assets issued by banks and backed by public sector loans and mortgages – could be dwarfed by those on schemes launched by other central banks, which have involved higher risk. The Financial Times reported last month that the US Federal Reserve had made a $14bn profit on its crisis loan programmes, with its purchases of commercial paper among its most lucrative operations.

Instead, the ECB has created arbitrage opportunities for eurozone banks, which have used liquidity provided by the central bank to buy large amounts of government bonds, including from some of the smaller eurozone countries and riskier assets. These, in turn, can be used as collateral to raise fresh funds from the ECB. Eurozone banks’ holdings of euro-denominated government bonds have increased by more than €200bn since last year.

A synopsis of today's Industry Outlook is presented below. The full article can be read at http://at.zacks.com/?id=2678.

While the credit crunch and slower economic growth dampens private sector spending, fiscal expenditures appear ready to play a counter-cyclical role. China announced a rather large stimulus package in November.

Also, the U.S Congress passed a stimulus package that President Obama signed on Tuesday, February 17, 2009. The bill contains money that will flow into infrastructure spending. The only issue is the timeframe of the spending. For example, according to CBO estimates, of the $27.5 billion in the budget for highway spending (Title XII - Transportation and Housing and Urban Development Highway Construction), $9.625 billion will be spent by the end of FY2010. This equates to 35% in the first two (FY) years and the remaining portion realized through the (FY) years 2011-2016.

Amid the current global economic slowdown, there may be a silver lining. Central bankers have gone from raising interest rates and fighting inflation to slashing rates and flooding the system with liquidity. Specifically, the U.S Federal Reserve has engaged in quantitative easing (QE). In March, the FED announced it would spend over $1 trillion to buy mortgages-backed securities, agency debt and Treasury securities. In our view, these monetary conditions have helped to put a bid into commodity prices. We would become more constructive on commodity stocks, such as Freeport McMoRan (FCX), on signs reflation measures were sustainable into 2010.

Zacks "Profit from the Pros" e-mail newsletter provides highlights of the latest analysis from Zacks Equity Research. Subscribe to this free newsletter today by visiting: http://at.zacks.com/?id=2679.

About Zacks 

The performance of the Zacks Rank portfolios shown above for annual and year-to-date periods are the linked monthly total returns (price changes + dividends) of equal weighted hypothetical portfolios, consisting of those stocks with the indicated Zacks Rank, assuming monthly rebalancing and zero transaction costs. These are not the returns of actual portfolios. The hypothetical portfolios were created at the beginning of each month from Jan 1988 forward based on the values of the Zacks Rank available to Zacks' clients before the beginning of each month.

The portfolios created monthly from 1988 through September 2006 exclude ADRS and are comprised of stocks that have the indicated Zacks Rank and were covered by at least two analysts at the time of the stocks inclusion in the portfolio. Starting in October 2006 and going forward, the portfolios are comprised of all stocks with the indicated Zacks Rank and do not exclude ADRs, which is more reflective of the list of stocks that customers will find on the Zacks web sites. 2007 returns are for the period of Jan 1 - Jun 30, 2007. These performance numbers have been audited from 1995 through 2003 by Autschuler Melovan, a division of American Express Financial.

The year-ago level was about normal. In an economic boom, Dirk Van Dijk points out that capacity utilization gets up to about 85%, and historically a level of 75% indicates a very severe recession. We are in uncharted territory.

When looking at the global macro backdrop for industrial production and machinery orders amid weaker U.S consumption, we expect a continued slowdown in capital spending.

OPPORTUNITIES

While the credit crunch and slower economic growth dampens private sector spending, fiscal expenditures appear ready to play a counter-cyclical role. China announced a rather large stimulus package in November.

Also, the U.S Congress passed a stimulus package that President Obama signed on Tuesday, February 17, 2009. The bill contains money that will flow into infrastructure spending. The only issue is the timeframe of the spending. For example, according to CBO estimates, of the $27.5 billion in the budget for highway spending (Title XII - Transportation and Housing and Urban Development Highway Construction), $9.625 billion will be spent by the end of FY2010. This equates to 35% in the first two (FY) years and the remaining portion realized through the (FY) years 2011-2016.

Amid the current global economic slowdown, there may be a silver lining. Central bankers have gone from raising interest rates and fighting inflation to slashing rates and flooding the system with liquidity. Specifically, the U.S Federal Reserve has engaged in quantitative easing (QE). In March, the FED announced it would spend over $1 trillion to buy mortgages-backed securities, agency debt and Treasury securities. In our view, these monetary conditions have helped to put a bid into commodity prices. We would become more constructive on commodity stocks, such as Freeport McMoRan (FCX), on signs reflation measures were sustainable into 2010.

WEAKNESSES

We remain cautious on the U.S residential construction (& related) space. In our view, there is still too much existing and new home inventory to justify a new up-cycle in starts, which partially impacts the order flow of machinery companies that sell or lease equipment to the homebuilders. On the demand side, the combination of a weaker U.S labor market and the recent rise in mortgage rates (although from historically low levels) does not appear to add to the pool of available homebuyers.Zacks Investment Research

The year-ago level was about normal. In an economic boom, Dirk Van Dijk points out that capacity utilization gets up to about 85%, and historically a level of 75% indicates a very severe recession. We are in uncharted territory.

When looking at the global macro backdrop for industrial production and machinery orders amid weaker U.S consumption, we expect a continued slowdown in capital spending.

OPPORTUNITIES

While the credit crunch and slower economic growth dampens private sector spending, fiscal expenditures appear ready to play a counter-cyclical role. China announced a rather large stimulus package in November.

Also, the U.S Congress passed a stimulus package that President Obama signed on Tuesday, February 17, 2009. The bill contains money that will flow into infrastructure spending. The only issue is the timeframe of the spending. For example, according to CBO estimates, of the $27.5 billion in the budget for highway spending (Title XII - Transportation and Housing and Urban Development Highway Construction), $9.625 billion will be spent by the end of FY2010. This equates to 35% in the first two (FY) years and the remaining portion realized through the (FY) years 2011-2016.

Amid the current global economic slowdown, there may be a silver lining. Central bankers have gone from raising interest rates and fighting inflation to slashing rates and flooding the system with liquidity. Specifically, the U.S Federal Reserve has engaged in quantitative easing (QE). In March, the FED announced it would spend over $1 trillion to buy mortgages-backed securities, agency debt and Treasury securities. In our view, these monetary conditions have helped to put a bid into commodity prices. We would become more constructive on commodity stocks, such as Freeport McMoRan (FCX), on signs reflation measures were sustainable into 2010.

WEAKNESSES

We remain cautious on the U.S residential construction (& related) space. In our view, there is still too much existing and new home inventory to justify a new up-cycle in starts, which partially impacts the order flow of machinery companies that sell or lease equipment to the homebuilders. On the demand side, the combination of a weaker U.S labor market and the recent rise in mortgage rates (although from historically low levels) does not appear to add to the pool of available homebuyers.Zacks Investment Research

The strength that early morning trade witnessed was in part due to Bank of America's (NYSE:BAC) successful sale of 1.25 million shares at an average price of $10.77 per share.  CEO Ken Lewis commented, "I think the worst is behind us."  During the morning session, investors also drew cheer from Treasury Secretary Geithner's comments who noted "indications that our financial system is starting to heal."

The US dollar declined to its lowest this year and oil prices went beyond $60. 

American Express (NYSE:AXP) declined 3.3%, as news of moves to regulate credit card rates and fees emerged.  However, not everything was gloomy on the Street as General Motors (NYSE:GM) shares jumped 14.2% after the company notified three offers for its German Opel unit. McDonald's (NYSE:MCD) added 4.4% after receiving analyst upgrades.

Oil prices jumped $1.94 to close at $62.04, a six-month high, after weekly inventory declined 2.1 million barrels.  The jump in prices was also attributed to a refinery fire earlier in the week and militant threats in Nigeria. Gold prices jumped to an eight-week high of $937.40, up $10.70.  US dollar declined to its lowest level of the year, off 1.2% against a basket of currencies.

On the upside, the FOMC minutes from last month's Fed meeting noted signs of stabilization on the consumer spending, housing and factory orders front; however, expectation for GDP was lowered sharply to -1.3% to 2% from -0.5% to -1.3%, and unemployment rate was raised to 9.2% to 9.6% by yearend. Deere (NYSE:DE), whose quarterly results were better than expectations, said, "The outlook for market conditions over the remainder of the year remains highly uncertain and the impact on company's sales and earnings is difficult to assess."

Today's data will cover weekly initial jobless claims (8:30 AM ET), expected to have declined to 625,000 from last week's 637,000. At 10:00 AM ET leading indicators are projected to gain traction with a 0.8% April rise versus a decline of 0.3% prior. Also at 10:00 the Philly Fed will report on manufacturing conditions for May, expected at a negative 18.0, but better than last month's negative 24.4 reading.

David Morris is chief executive of London-based Global Wealth Allocation Ltd., an asset management and research firm with around $3 billion in assets under management. He began his career by serving in economic development for the Canadian government in East Africa. In 1980, he took over as treasury manager for Xerox's Canadian operations. Then, six years later, he became treasurer for Campbell Soup in Canada. Morris later started a pension consultancy business. In 1992, he founded GWA.

Morris is probably best known for developing a series of 20 indexes that are sold worldwide in partnership with the FTSE Group. The benchmarks, which were created in 1996, are "wealth-weighted." GWA takes standard FTSE indexes and weights components based on three valuation measures: net profit, cash flow and book value.

IndexUniverse's Murray Coleman recently caught up with the economist-turned-index-developer to discuss his views on global corporate profits and market pricing of those assets.

IndexUniverse.com: Why do you focus on net profits and two other valuation metrics in creating indexes?

Morris: I didn't grow up, so to speak, as a fund manager. My education is as an economist and my work experience prior to GWA was as a treasurer in corporate finance. Most of my background has been focused on analyzing how corporations run their balance sheets—not modern portfolio theory. I look at how all of the tools, machines and equipment in society—the stock of capital—is used to produce a flow of goods and services. That is on a country-by-country, regional and global basis.

IU: What does your research tell you about current market conditions?

Morris: The limit to growth in the market, of course, is the amount of wealth being created at any given time. If we measure wealth consistent with economic macro theory, then we can look at the wealth in markets and compare that to current pricing levels. For example, in metals we're seeing a collapse in share prices underpinning the basic materials sector.

IU: Has that collapse been matched by a similar deterioration in the corporate profits?

Morris: No, global market prices for basic materials producers indicate that investors expect future wealth creation to decline materially by 35% or more in that sector. But the probabilities favor a recovery of prices rather than a further deterioration of wealth creation.

IU: What brings you to that conclusion?

Morris: We've just been told the Chinese are accumulating strategic materials now at a phenomenal rate. That will support the market pricing for metals. In effect, demand in China should put a floor on metals pricing going forward.

IU: So this is a significant new dynamic coming into play for basic materials and metals manufacturers?

Morris: Yes, considering that the bubble in metals prices that burst in 2007 was driven pretty much by economic development in China. For the decade ended in 2004, China's demand drove lead prices, for example, up almost five times greater than in the past decade. And copper prices expanded by over six times the previous decade's highest levels.

IU: When China's economic activity slowed in 2007, then demand and world metals prices dropped?

Morris: Yes, and they dropped by a large amount. Even though copper prices have rallied by 38% since December [2008], the market still doesn't seem to believe that demand has rebounded enough. But as we've just learned from recently released first-quarter [2009] data, China has purchased something like 20-25% of the world's total copper production. In that same time, copper prices went up about 45%.

IU: What do you see taking place in the financial sector?

Morris: Stock prices in developed markets for financials have dropped about 70% since July 2007. It's interesting to note that we've seen an almost identical deterioration in the sector's net profits and cash flow. In nonfinancials among developed markets, we've seen the same 70% erosion in prices. However, we haven't seen a similar deterioration in earnings. That indicates investors are punishing nonfinancials as much as financials. Today's market pricing is suggesting that investors expect another 50%-plus erosion in nonfinancial corporate profits from current levels. That would put corporate profits about at a level where they were a decade ago.

IU: How much have nonfinancial profits actually fallen?

Morris: Across global developed markets, nonfinancial prices have dropped about 15% off their peak levels. So broadly speaking, there's a huge gap between market pricing and actual corporate profits in those segments. More specifically, it appears that investors are punishing basic materials manufacturers especially hard.

IU: But you consider nonfinancial stocks to be priced fairly now, don't you?

Morris: Yes, and the 55% gap between how much prices have dropped for nonfinancials so far and the actual falloff in corporate profits signify the future for investors. In other words, that 55% gap represents the potential upside in nonfinancials going forward. But that's based on an assumption that no other significant material events will occur to cause a major contraction in corporate profits. But if that does happen, at this point, the downside seems limited because the market has already taken a 55% greater hit than actual earnings and cash flow measurements would justify.

IU: The majority of downside risk for investors globally will continue to come in financial sectors then, won't it?

Morris: Yes, going forward there could be some real nasty surprises. But that's likely to hurt financial balance sheets much more than nonfinancials, considering that financials have fallen by so much at this point. And the limit to that risk is the positive yield curve that is benefiting banks right now.

IU: How do you see bond yields impacting the profit picture for banks across the developed world?

Morris: With 90-day Treasuries yielding around 11 basis points today, and 30-year Treasuries yielding about 400 basis points, financial institutions can borrow at short-term rates—that is, take deposits—while lending at longer-term rates. So they've got a built-in profit margin right now in the lending business. 

IU: But banks are being criticized for not lending enough, aren't they?

Morris: We keep reading that. But the total assets in the world banking system are just under [U.S.] $60 trillion. So even if bank lending shrinks a little, that positive yield curve is still working with an enormous base of assets.

IU: So as long as yield curves remain positive, that will act as a floor to losses in the financial sector?

Morris: Yes, that would seem to be the case. Remember that when the credit crisis began in the summer of 2007, the yield curve was inverted almost everywhere in the world. You can debate the merits of Ben Bernanke's short reign as chairman of the U.S. Federal Reserve's board. But give him credit—he did manage to get the yield curve to turn positive in the span of a little more than 18 months. Consider that in June 2007, 90-day Treasury notes were yielding 480 basis points, and 30-Year Treasury notes were around 505 basis points. So that put a huge squeeze on bank profits. That situation has been turned around and will prove to be a significant factor in the performance of financials as a whole in coming quarters.

David Morris is chief executive of London-based Global Wealth Allocation Ltd., an asset management and research firm with around $3 billion in assets under management. He began his career by serving in economic development for the Canadian government in East Africa. In 1980, he took over as treasury manager for Xerox's Canadian operations. Then, six years later, he became treasurer for Campbell Soup in Canada. Morris later started a pension consultancy business. In 1992, he founded GWA.

Morris is probably best known for developing a series of 20 indexes that are sold worldwide in partnership with the FTSE Group. The benchmarks, which were created in 1996, are "wealth-weighted." GWA takes standard FTSE indexes and weights components based on three valuation measures: net profit, cash flow and book value.

IndexUniverse's Murray Coleman recently caught up with the economist-turned-index-developer to discuss his views on global corporate profits and market pricing of those assets.

IndexUniverse.com: Why do you focus on net profits and two other valuation metrics in creating indexes?

Morris: I didn't grow up, so to speak, as a fund manager. My education is as an economist and my work experience prior to GWA was as a treasurer in corporate finance. Most of my background has been focused on analyzing how corporations run their balance sheets—not modern portfolio theory. I look at how all of the tools, machines and equipment in society—the stock of capital—is used to produce a flow of goods and services. That is on a country-by-country, regional and global basis.

IU: What does your research tell you about current market conditions?

Morris: The limit to growth in the market, of course, is the amount of wealth being created at any given time. If we measure wealth consistent with economic macro theory, then we can look at the wealth in markets and compare that to current pricing levels. For example, in metals we're seeing a collapse in share prices underpinning the basic materials sector.

IU: Has that collapse been matched by a similar deterioration in the corporate profits?

Morris: No, global market prices for basic materials producers indicate that investors expect future wealth creation to decline materially by 35% or more in that sector. But the probabilities favor a recovery of prices rather than a further deterioration of wealth creation.

IU: What brings you to that conclusion?

Morris: We've just been told the Chinese are accumulating strategic materials now at a phenomenal rate. That will support the market pricing for metals. In effect, demand in China should put a floor on metals pricing going forward.

IU: So this is a significant new dynamic coming into play for basic materials and metals manufacturers?

Morris: Yes, considering that the bubble in metals prices that burst in 2007 was driven pretty much by economic development in China. For the decade ended in 2004, China's demand drove lead prices, for example, up almost five times greater than in the past decade. And copper prices expanded by over six times the previous decade's highest levels.

IU: When China's economic activity slowed in 2007, then demand and world metals prices dropped?

Morris: Yes, and they dropped by a large amount. Even though copper prices have rallied by 38% since December [2008], the market still doesn't seem to believe that demand has rebounded enough. But as we've just learned from recently released first-quarter [2009] data, China has purchased something like 20-25% of the world's total copper production. In that same time, copper prices went up about 45%.

IU: What do you see taking place in the financial sector?

Morris: Stock prices in developed markets for financials have dropped about 70% since July 2007. It's interesting to note that we've seen an almost identical deterioration in the sector's net profits and cash flow. In nonfinancials among developed markets, we've seen the same 70% erosion in prices. However, we haven't seen a similar deterioration in earnings. That indicates investors are punishing nonfinancials as much as financials. Today's market pricing is suggesting that investors expect another 50%-plus erosion in nonfinancial corporate profits from current levels. That would put corporate profits about at a level where they were a decade ago.

IU: How much have nonfinancial profits actually fallen?

Morris: Across global developed markets, nonfinancial prices have dropped about 15% off their peak levels. So broadly speaking, there's a huge gap between market pricing and actual corporate profits in those segments. More specifically, it appears that investors are punishing basic materials manufacturers especially hard.

IU: But you consider nonfinancial stocks to be priced fairly now, don't you?

Morris: Yes, and the 55% gap between how much prices have dropped for nonfinancials so far and the actual falloff in corporate profits signify the future for investors. In other words, that 55% gap represents the potential upside in nonfinancials going forward. But that's based on an assumption that no other significant material events will occur to cause a major contraction in corporate profits. But if that does happen, at this point, the downside seems limited because the market has already taken a 55% greater hit than actual earnings and cash flow measurements would justify.

IU: The majority of downside risk for investors globally will continue to come in financial sectors then, won't it?

Morris: Yes, going forward there could be some real nasty surprises. But that's likely to hurt financial balance sheets much more than nonfinancials, considering that financials have fallen by so much at this point. And the limit to that risk is the positive yield curve that is benefiting banks right now.

IU: How do you see bond yields impacting the profit picture for banks across the developed world?

Morris: With 90-day Treasuries yielding around 11 basis points today, and 30-year Treasuries yielding about 400 basis points, financial institutions can borrow at short-term rates—that is, take deposits—while lending at longer-term rates. So they've got a built-in profit margin right now in the lending business. 

IU: But banks are being criticized for not lending enough, aren't they?

Morris: We keep reading that. But the total assets in the world banking system are just under [U.S.] $60 trillion. So even if bank lending shrinks a little, that positive yield curve is still working with an enormous base of assets.

IU: So as long as yield curves remain positive, that will act as a floor to losses in the financial sector?

Morris: Yes, that would seem to be the case. Remember that when the credit crisis began in the summer of 2007, the yield curve was inverted almost everywhere in the world. You can debate the merits of Ben Bernanke's short reign as chairman of the U.S. Federal Reserve's board. But give him credit—he did manage to get the yield curve to turn positive in the span of a little more than 18 months. Consider that in June 2007, 90-day Treasury notes were yielding 480 basis points, and 30-Year Treasury notes were around 505 basis points. So that put a huge squeeze on bank profits. That situation has been turned around and will prove to be a significant factor in the performance of financials as a whole in coming quarters.

In a marketplace given to looking forward six months or so, investors did not have enough reason to rejoice as the latest growth data showed GDP fell at an annual rate of 6.1% from January through March.  Nevertheless, investors looking for reassuring signs did find consumer data somewhat comfortable.  And U.S. Federal Reserve's observation that the rate of economic contraction was "somewhat slower" was an added relief.  Markets shrugged off reports suggesting Chrysler's imminent bankruptcy and media reports that at least one-third of the stress-test banks may require additional capital.  At the end of the day, the DJIA closed up 2.1% to its highest since February 9, the tech-heavy NASDAQ was up 2.3% to its highest since November 4, and the S&P up 2.2% to its highest since January 28. 

The NASDAQ has now surged 25% from February 27, for its best two-month run since 2002, and is up 34.9% from its March 9 closing low. The S&P has gained 29.1% and the DJIA 25% from March 9 levels. Also, the CBOE Vix "fear factor" index fell 4.9% in yesterday's trading to 36.08, signaling a less volatile environment. Exxon Mobil (NYSE:XOM) joined IBM (NYSE:IBM) in declaring a dividend hike, lifting its quarterly payout by 5% to 42 cents. Despite flu-related worries, a weak GDP report and a huge inventory build up, crude prices rallied 2.2% to $51. As investors took to risk assumption, the prices of Treasuries continued lower, with the 2-year off 0/32 to a yield of 0.954%, and the 10-year off 26/32 to a yield of 3.107%.

Among the ten S&P sectors, nine moved higher Wednesday, with only telecom stocks heading southwards, with a 0.3% drop.  Financial shares led the advance with a 4.6% gain. On the DJIA, banking stocks also topped the list of advancing issues, with Citigroup (NYSE:C) advancing 8.0%, Bank of America (NYSE:BAC) rising 6.5%, and JP Morgan (NYSE:JPM) recording a 5.2% gain. News that shareholders had stripped Bank of America's (NYSE:BAC) CEO Lewis of his Chairman title failed to dampen spirits, with the stock rising 6% in premarket trading. Last night's First 100 Days news conference revealed Obama anxious to lose the mantle of government involvement with the banking industry, ameliorating fears of a backdoor-entrance into banking nationalization.

Yesterday's earnings news also surprised on the upside with better-than-expected earnings from Aetna (NYSE:AET), Baker Hughes (NYSE:BHI), General Dynamics (NYSE:GD), Hess (NYSE:HES), Starbucks (NASDAQ:SBUX), Time Warner (NYSE:TWX), Visa (NYSE:V), Waste Management (NYSE:WMI), and Wyeth (NYSE:WYE).

Wednesday's economic posts indicated advance US GDP fell a worse-than-expected 6.1% during the first quarter, following the fourth quarter's 6.3% drop.  The decline widely missed the expected 4.7% drop. However, the data revealed businesses cut inventory levels at the fastest pace in the past decade, lifting hopes of a turnaround on future builds. Moreover, the key ingredient of consumer spending rose 2.2%, following a 4.3% fourth quarter drop, signaling resiliency in the segment, which represents 70% of the total economy. Wal-Mart (NYSE:WMT) added to such hopes, noting increased consumer purchasing of non-essentials such as sporting goods and bedding.

The FOMC monthly interest rate decision provided the as-expected news that the Fed plans to keep key interest rate levels at 0.00%-0.25% for an extended period as the fragile recovery gains footing.

Today's data include weekly initial claims, expected to show continued gains, with jobless claims up 5,000 to 645,000 from 640,000 the previous week. March personal income is expected to match the prior month's 0.2% decline; personal spending is expected to show an 0.1% drop versus February's 0.2% advance. The Chicago Purchasing Managers Index is likely to show an increase to 34.0 in April from 31.4.

Japan's Nikkei 225 stock average closed up 108.09 points, or 1.2%, to 8,857.93, while Hong Kong's Hang Seng jumped 452.35 points, or 3.1%, to close at 14,998.04. South Korea's Kospi advanced 1.1% to 1,297.85.

Oil prices rose by almost $1 per barrel on hopes of economic recovery. US premarket futures suggest a continuation of equity interest this week, even as a dismal quarter for corporate results is anticipated.

Last week saw the DJIA registering a 3.1% advance on the week.   The index, which is now up 21.5% since March 6, recorded its best four weeks of gains since 1933.  The S&P 500, which rose 3.3% last week, has advanced 23.2% from its March 6 lows. And the tech-heavy NASDAQ jumped 5% for the week, with a 25.3% surge from its March lows. The CBOE Vix, the Chicago Board Options Exchange Volatility Index, closed below 40 on Friday for the first time since January.

Gold prices went below $900, off $11.60 on Friday as risk-appetite grew, resulting in shares of Harmony Gold (NYSE:HMY) to drop 13.9% on the week.  Rangold Resources (NASDAQ:GOLD) declined 5.4%.

Last week all but one of the S&P sectors recorded gains, led by a 7% advance among financials, and 6% increases in technology and basic material sector shares. Lagging the S&P sector action were health care stocks, which declined 1.9% during the week. Among financials, SLM Corp (NYSE:SLM) jumped 19.7%; Huntington Bancshares (NASDAQ:HBAN) 19.6%; ING Corp (NYSE:ING) 19.3%; and Friedman Billings and Ramsey (NYSE:FBR) 19.1%. On the DJIA, Citigroup (NYSE:C) rose 8.8% during the week, while JP Morgan (NYSE:JPM) jumped 6.9%, and American Express (NYSE:AXP) was up 6.1%.  Even though expected, FASB's moves to relax accounting standards for treatment of toxic assets were interpreted as likely to improve near-term results.

Commodity markets also jumped on hopes of economic recovery. Copper prices went above $4,000 per ton. Basic materials sector gains were led by a 22.8% weekly gain in Dow Chemical (NYSE:DOW), 21.7% in Arcelor Mittal (NYSE:MT), 21.1% in PPG Industries (NYSE:PPG), 16.1% in AK Steel (NYSE:AKS) and 15.1% in Celanese (NYSE:CE).

Technology shares, driven by increased risk appetites, advanced 6% during the week, led by a 32% jump in shares of Research in Motion (NASDAQ:RIMM), which reported better-than-expected results for the quarter on record revenues. Corning (NYSE:GLW) jumped 17.7% after several analysts' increased 2009 profit estimates and increased price targets, and in advance of a Barron's article noting a 39% increase in February flat-panel TV sales. Fairchild Semiconductor (NYSE:FCS) rose 14.4% and National Semiconductor (NYSE:NSM) gained 13.8%. 

However, health care sector remained the weak group, declining 1.9% on the week. Shares losing ground included Amgen (NASDAQ:AMGN), off 9.8% and Abbott Labs (NYSE:ABT), down 5.3%. Friday losses hit Bristol Myers (NYSE:BMY) shares, off 5.4% as analysts lowered expectations the company was a takeover candidate, and Humana (NYSE:HUM), off 5.7%, on analyst warnings that earnings would be hurt by changes in the US Medicare Advantage Program.

This week will indicate the market's ability to push beyond its month-long rally in the face of an earnings season likely to suffer first quarter declines of 36.9% from year ago levels, according to Thomson Reuters (NYSE:TRI), with a record nine straight quarterly declines. All S&P sectors are expected to post declines, led by a 97.4% drop in consumer discretionary earnings due to losses at General Motors (NYSE:GM) and Ford (NYSE:F). Material sector earnings are expected to have fell 74.9%, energy 56.7%, and financial firms - no longer at the top of the list - are projected down 33% according to FactSet. Alcoa (NYSE:AA) kicks off earnings season on Tuesday, with key corporate results also due out from Bed Bath & Beyond (NASDAQ:BBBY), Mosaic (NYSE:MOS), Constellation Brands (NYSE:STZ), Family Dollar (NYSE:FDO) and Pep Boys (NYSE:PBY).

Among key economic posts, February consumer credit is slated for Tuesday, February wholesale inventory data and the Fed minutes from the March 17-18 FOMC meeting on Wednesday, and weekly jobless claims and key February trade balance figures on Thursday. Fed Governor Warsh speaks on financial markets today at 5:00 PM ET, with Minneapolis Fed President Stern and Kansas City Fed President Hoenig speaking on Thursday.

World real GDP increased by 9.4% between 2003 and 2005. That growth in world income was the primary cause behind an increase in world petroleum consumption of 5 million barrels per day between 2003 and 2005, a 6% increase over the two years. The next two years (2006 and 2007) saw even faster economic growth (10.1% cumulative two-year growth), with Chinese oil consumption alone increasing 870,000 barrels per day. Yet between 2005 and 2007, global oil production stagnated.

Thin line. Monthly global crude oil production, including lease condensate, natural gas plant liquids, other liquids, and refinery processing gain, in millions of barrels per day, 2003:M1-2008:M10. Data source: EIA. Bold line: 12-month moving average of values from thin line centered at indicated date..

What persuaded residents outside of China to reduce petroleum consumption in the face of booming levels of income? The answer is that the price of oil had to increase. How much the price should have risen depends on the price elasticity of demand. Consider the following illustrative calculations. It seems reasonable to maintain that the economic growth in 2006 and 2007 would have resulted in at least as big a shift of the demand curve as resulted from the slightly weaker GDP growth of 2004 and 2005. Adding in the first half of 2008 (when global GDP continued to rise), consider then the consequences of a rightward shift of the demand curve of 5.5 million barrels per day. With production only increasing by 0.5 mb/d over this period, a demand elasticity of ε = 0.06 would imply that the price should have risen from $55/barrel in 2005 to $142/barrel in 2008:H1.

Illustrative price effects of 5.5 mb/d rightward shift of demand curve and 0.5 mb/d rightward shift of supply curve between 2005 and 2008:H1 assuming price elasticity of 0.06. Source: Hamilton (2009).

A short-run elasticity of 0.06 for crude petroleum demand could certainly be defended on the basis of estimates in the literature, though so could a higher or lower value. I offer the above calculation simply as an illustration that the observed price behavior could be fully reconciled with reasonable assumptions about supply and demand.

But why then did the price subsequently collapse even more dramatically? A shift of the demand curve back to the left as a result of the impressive global economic downturn is certainly part of the answer. Note, however, that even if global real GDP were to fall by more than 10%-- which so far fortunately it has not-- that would only put us back to where we were in 2005 (at $55 a barrel), and the price was observed to fall even more than this. We therefore would need to postulate a second factor behind the price decline of 2008:H2, namely, an increase in the price elasticity of demand as consumers had time to make adjustments. Again such a hypothesis is consistent with previous experience, and in particular, between 2007:Q3 and 2008:Q3, U.S. petroleum consumption fell by 8.8%. That drop in U.S. petroleum consumption unambiguously represented the combined effects of lower income and price-induced changes in use.

If we say that one elasticity (0.06) is to be used to account for the 2008:H1 price and another higher elasticity for 2008:H2, there is an implicit claim that market participants were learning imperfectly about the price elasticity of demand. There was a surprisingly long period in which demand responded less than some might have expected to the oil price increases (i.e., consistent with an elasticity of 0.06), and then a very dramatic drop in oil use as a result of the combined influence of falling incomes and changing consumption habits.

My paper also has an extensive examination of an alternative explanation based on a speculative bubble in the price of oil. I will not attempt to reproduce much of that analysis here, but only note the bottom line: in order to reconcile a proposed speculative bubble story with the observed behavior of the physical quantities demanded, supplied, and going into inventories, it is necessary to postulate a very low price elasticity of demand through 2008:H1-- precisely the same conditions one would need in order to attribute the price moves entirely to fundamentals.

In terms of policy implications, the paper suggests that sales out of the Strategic Petroleum Reserve could have been explored as a possible tool for curbing excessive speculation, and proposes that the U.S. Federal Reserve needs to take account of possible consequences of its actions for relative prices of commodities. My bottom line was nevertheless the following:

But while the question of the possible contribution of speculators and the Fed is a very interesting one, it should not distract us from the broader fact: some degree of significant oil price appreciation during 2007-08 was an inevitable consequence of booming demand and stagnant production. It is worth emphasizing that this is fundamentally a long-run problem, which has been resolved rather spectacularly for the time being by a collapse in the world economy. However, the economic collapse will hopefully prove to be a short-run cure for the problem of excess energy demand. If growth in the newly industrialized countries resumes at its former pace, it would not be too many more years before we find ourselves back in the kind of calculus that was the driving factor behind the problem in the first place. Policy-makers would be wise to focus on real options for addressing those long-run challenges, rather than blame what happened last year entirely on a market aberration.

Technorati Tags: oil, oil prices, oil shocks

I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.

Assets of the Federal Reserve, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward. Apart from that general unease, I have a particular concern about the motivation for the Term Asset-Backed Securities Loan Facility, whose goal is to generate up to $1 trillion of lending for businesses and households by catalyzing a revival of loan securitization. I grant that securitization was an enormously successful device for funneling vast sums into sundry loans. For example, securitization successfully turned 80% of quite shaky subprime loans into Aaa-rated assets. To put that in perspective, only five U.S. companies currently have the ability to issue Aaa-rated debt. So yes, a device that transformed weak loans into Aaa-rated debt was marvelously successful at attracting capital from all over the world into U.S. private lending.

Ratio of total mortgage debt (from Table L.2 of Flow of Funds Accounts) to nominal GDP (from BEA Table 1.1.5).

But the whole premise behind those Aaa ratings-- that securitization could isolate a "safe" component of a pool of fundamentally risky loans-- was deeply flawed. It is impossible to diversify away aggregate or systemic risk. All that the device did was to mislead investors into thinking they were protected from those nondiversifiable risks and push those risks onto the taxpayers and the Fed. Before we decide that securitization is the road out of our present difficulties, I would like a detailed and convincing explanation of why the past mistakes are not going to be repeated again.

A second concern I have with the new Fed balance sheet is that it has seriously compromised the independence of the central bank. To my knowledge, every hyperinflation in history has had two key ingredients: (1) budget deficits that could not be resolved politically, and (2) a central bank that assumed the obligations that the fiscal authority could not.

In the U.S. today, there is little question in my mind that repaying the projected deficits with tax increases or spending cuts will be extremely difficult politically. Each additional trillion dollars would roughly require doubling the personal income tax rate on all Americans for one year, something I cannot see the political process delivering. There is enormous pressure in the current situation to defer solutions and look for temporary fixes with off-balance-sheet measures. The reason that the Fed is sought as a partner for the Treasury in all these new actions is because the Fed is perceived to have deeper pockets than the Treasury. This is not a situation that a self-respecting central bank should let itself get into.

My third concern is that the new Fed balance sheet has handicapped the Fed's ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation. Which of the Fed's new assets would it sell off when it needs to absorb back in the huge volume of reserves it has recently created? The Fed's hoped-for scenario is that the reserves won't need to be called back in until the situation has stabilized and the facilities are no longer needed. But I am concerned instead about the possibility of a dramatic shift in the perceptions of foreign lenders, in which case inflationary pressures could emerge in a situation that is far more chaotic than the one we currently face.

I recommend instead that the Fed should be buying Treasury Inflation-Protected Securities in the current situation. Tim Iacono says that's like the Mafia buying "protection" from itself. But my point is that TIPS represent an asset that would gain in value at a time the Fed needs to sell them, meaning that the logistical ability of the Fed to drain reserves quickly in such circumstances is without question.

What we need in the current situation is a central bank that is a bulwark of stability. A profound lack of confidence in the U.S. government itself would make our current problems look like a walk in the park. If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.

But it's not clear the Fed has either the means or the credibility.

Technorati Tags: macroeconomics, economics, Federal Reserve, deflation, inflation, credit crunch

Let's start with the Fed's summary of current conditions:

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The second paragraph is similar to the wording that the Fed introduced in its previous January statement. The Fed is trying to communicate that it sees the very low inflation rates (and threatened deflation) of recent months as unhealthy for the economy and something it intends to prevent. The Fed is very mindful of the role of expectations in the current setting, and wants with this statement to communicate clearly to the public that it's not going to allow deflation.

What's new in yesterday's statement is what the Fed says it's going to do about it.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

What's with all these numbers appearing in the statement? Traditionally the key number that the members of the FOMC would vote on and that the Fed would communicate to the public with a statement like this would be a target interest rate that the Fed had settled on for the fed funds rate, an interest rate charged on overnight interbank loans. But that traditional policy tool has been fundamentally irrelevant for months now, as the fed funds rate scraped along the zero lower bound. The Fed has accordingly finally settled on an alternative way of framing its quantitative strategy in terms of specific quantitative expansions it intends to implement.

This is what I have been urging the Fed to do. Personally I would have focused more on purchasing long-term Treasuries (particularly TIPS) rather than the agency issues, but this should get the job done. And the job, in my mind, is to make sure that the Fed prevents deflation.

Let me be very clear that I am using the term "deflation" here in a very specific and narrow way. I am defining deflation (as do most academic economists) as an increase in the real purchasing power of each dollar bill outstanding, as measured by a decrease in the level of a broad price index such as the CPI or PCE deflator. I think that deflation is an important condition for the Fed to avoid because deflation magnifies and aggravates the real burdens of debtors (dollar sums owed become an even bigger real burden), which would drive us even deeper into our current problems.

There's a second reason why I believe achieving a modest rate of inflation (my number is 3%) should be job 1 for the Fed. The goal of fiscal stimulus is to increase aggregate nominal demand. The notion is that there is sufficient slack in the economy that we could increase nominal GDP without causing nominal prices to increase, and thus generate an increase in real incomes. Once we get to the point where that stimulus starts to produce inflation, we know we've done all we can with the policy of demand stimulus.

I have favored federal fiscal stimulus as the preferred policy tool for purposes of investment in infrastructure that could be justified on the basis of the direct productivity of the projects themselves and preventing fiscal contraction at the state and local level. However, monetary policy to me makes more sense as the tool to use for the goal of increasing total nominal spending beyond the level achieved by those first two categories of fiscal stimulus. And I frankly have never understood the position of those who claim that policies such as that adopted by the Fed yesterday will have no consequences for the purchasing power of a dollar.

I emphasize that I am decidedly not suggesting that either fiscal or monetary policy stimulus are capable of solving all of our problems. Real debt imbalances, both domestic and international, frictions in moving resources out of housing and autos and into other sectors, and the profound problems with our financial system all place important physical constraints on what any stimulus package, monetary or fiscal, is capable of achieving. Once we get to 3% inflation, that to me will be a clear indication that we've accomplished all we can with tools to stimulate aggregate demand.

I would also like to say a word about the short-run versus the long-run outlook for inflation. I am fully in agreement with those who worry that the prospective new debt issue by the U.S. Treasury and risky asset position of the Federal Reserve put in play some powerful forces for inflation over the longer run that may prove quite difficult to contain. But while I agree that this is quite an important issue, I believe it would be dead wrong to interpret yesterday's statement from the Fed as confirmation that we are now starting down that path. The actions by the FOMC yesterday were, in my opinion, not influenced in the slightest by those long-run pressures, but instead were motivated entirely by the short-run concerns I outlined above. I believe the Fed shares my goal that what we want to see is 3% inflation, no more, and that when we get there, they'll stop.

What will be the indication that we've done all we can with this tool? I would urge the Fed to be watching the exchange rate and commodity prices quite closely for an indication that the deflation tide has turned.

The Fed has declared pretty loud and clear that it is not going to allow deflation. So here's my personal investment advice: don't bet against the Fed.

Technorati Tags: macroeconomics, economics, Federal Reserve, deflation, inflation

Obviously, the discussion which we hope to initiate here comes in two phases. First, there is the question of whether or not the ECB should be considering QE at all? I am sure that there is plenty of people out there disagreeing with the sentiments expressed below. Secondly, there is then the issue of how exactly the ECB would conduct QE. Once again, I should warn you; this is a bugger and, at times, also somewhat technical.

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Most sports coaches - irrespective of whether they work in soccer, baseball, rugby or even American football - have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.

So what has all this waffle about football, baseball and whatever got to do with the ECB and how it should respond to the Eurozone's "fluid and evolving" economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) they do not seem to have included a section on what to do when interest rates finally hit the zero bound (not this month evidently, but maybe, or possibly the one after....as Bank President Trichet said after today's decision to reduce the rate to 1.5%: “We didn’t decide ex-ante that this was the lowest point that we could attain” ). Nor do the ECB seem to have a page which explicitly handles the currently fashionable state of the art set of tools known collectively as quantitative easing. And this omission may, as the zero bound looms and outright deflation threatens, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or even when) the Eurozone as a whole enters a deflationary rather than a disinflationary dynamic, and even more importantly, what happens if price movements fall into deflation mode and stay there?

 But before we get ahead of ourselves, let's go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing all this time in order to alleviate the credit crunch and reverse that depressing cycle of decline and deterioration which currently seems to hold the Eurozone economies so tightly in its grip. Speaking at the European American Press Club on the 20^th of February ECB President Jean Claude Trichet laid out in some detail the considerable variety of measures the bank has been taking since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the eye, and depending on your point of view the omission is a more or less disturbing one.

The fact of the matter is that at no point in his entire speech does the Central Bank President get to mention (not even once) the effects the crisis has been having on the real economy. His entire attention is focused on measures that the bank has been taking in order to ease the crunch by improving funding conditions in the interbank market, and in particular he enumerates in some considerable detail all the various classes of credit the ECB has been making available to Europe's banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about the state of the European economy, but rather about the steps the bank was taking to address the impact of the financial crisis and the credit crunch. But this would be precisely the point, since at the present moment in time the two are inextricably intertwined, with the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels.

This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, with the impression being given that Trichet by and large believes the ECB has things nicely under control with a nominal interest rate (then) running at 2% and that despite the awkward hurdles which may still lie out there in front of us, no extraordinary measures are needed. If this is the case, maybe someone needs to pick up the phone and give the gentlemen in Frankfurt Ivory Tower a call suggesting they take a long hard look out of their window to see just what is happening in the world that lies beyond.

Possibly some may feel that the dichotomy being made here is a false one since the ECB always held that the measures it was taking to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument in the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.

The facts of the matter are all now pretty much unequivocal, and really speak for themselves (or at least they should do).

• In the first place the problem in the banking sector and the wholesale money markets was never really the main issue. This, undoubtedly real, problem was merely the outward and evident symptom of a much deeper structural problem concerning how the whole (global) economy needed to deleverage, and how the systemic character of the money market breakdown would ultimately require government and institutional intervention on a large scale.

• Secondly the crisis has now very much become an economic and not simply a financial one. We won't belabour the reader here with all the gory economic details which you are all already so familiar with, but we would like to stress that it is now pretty evident that the global economy is taking a hit on the scale that has not been seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is not a matter to take lightly, even if some economies are hit worse than others. We should also not fail to take notice of the fact that, despite many early assurances to the contrary, while the United States is certainly busily fighting its own private economic demons, the locus of the crisis has now slowly but surely moved in Europe's direction, first via the Southern and Eastern periphery and then entering into that very bastion of the Eurozone itself - the German economy.


• This is not either the time or the place to examine all the chain-links and mechanisms through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such that the very foundations of our common economic edifice - of the Eurozone and even the European Union - are now at risk. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future stability of a currency) becomes (and by some multiples) a potentially more profitable investment opportunity than building a factory and creating employment then the seeds of financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and that something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, by stimulating growth possibilities, and above all by encouraging a return of confidence to our somewhat battered and beaten economic system.

In order to address the rather urgent task which now faces us we should not, in principal, exclude the use of extraordinary action and recourse to what have come to be known as "unconventional tools" on the part of the ECB. Indeed in the difficult battle which now confronts us, no door should be closed, and no stone left unturned. Yet, all of this still remains on the level of "in principle" and in theory. Since despite all the evidence, indeed the facts on the ground speak for themselves, which strongly suggests that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here) we are still wallowing around in hypothetical discussions with no one actually prepared to strongly push for a very rapid biting of the most badly needed bullet. Furthermore, a new problem now presents itself, since the wreckage which is rapidly piling up in Eastern Europe risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which have already been beaten to pulp by equity losses and debt defaults in one corner of the globe after another.

Indeed, some of us would claim that once the wheels of the present train crash were set in motion a year or so ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe, and in this fashion would arrive beating and hammering at the doors of the ECB in the form of both a severe Eurozone recession and a near-systemic collapse in the economies of Eastern Europe. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was always going to be in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.

However, if we come to look at the responses to date from the ECB, we find that these have in no way been either as drastic or as urgent as those initiated by counterparts like the Bank of Japan and the US Federal Reserve (or even, come to that, by the Bank of England and the Swedish Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns about the dangers of letting interest rates drop too low too quickly, and even warned of the dangers of reproducing yet more bubbles. This "conjuring of demons" seems to us to be soo terribly Japan in the 1990s-ish.

In fact the whole crisis reponse and reaction process seems to have revealed more a feeling of confusion and disarray, than one of order and "everything under control". Back in December 2008, the councils self-proclaimed hawk, Axel Weber, was busy worrying us all with his discovery of the "horrifying fact" that lowering interest rates below 2% would have implied the application of negative real interest rates (citing the fact that inflation expectations at that point for the medium-to-short term were themselves hovering at around 2%. He seemed to be blissfully unaware that with economies like the German and Spanish ones registering annual contraction rates in the 5% region, negative interest rates might be just the recipe the doctor was ordering. Just over a month ago Greek council member George Provopoulos added his voice to the chorus, cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone economy would begin to recover by the time we reached 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%.

This view was reiterated some weeks later by Luxembourg's representative on the Council, Yves Mersch, when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the "usual suspects" - namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggressive monetary policy.

Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of unease and bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of what we are up against. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that, in his view, there were no taboos whatsoever. Such statements certainly constitute a starting point, but still perpetually create the feeling of "too little too late", and in fact have done little to persuade financial markets that the ECB is actually in control of the situation.

This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usual charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not see fit (at that point) to go further, and elaborate on what he thought these were. The markets responded as might have been expected to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the then prevailing "zeitgeist" was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we needed given the strength of the contraction.

As BNP Paribas's senior economist in London, Ken Wattret, said at the time:

“We’re desperately spinning around to get a proper handle on the issue,” (...) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”

Part of the problem here, of course and as ever, is that there is far from unanimity on the ECB Governing Council. With the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily be let to utter that famous "would the real spokesperson for the ECB now stand up"! The latest "dissenter" in the long line who have been queuing up to expound on their "nuanced view" was Athanasios Orphanides, Governor of the Bank of Cyprus, who in a speech the 28th of January made plain his opinion that:

The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.

That this sounds vaguely reminiscent of the message which has long been coming across from the other side of the pond should not surprise us too much, since as Bloomberg reporter Ben Sils has pointed out, he is in fact a former Federal Reserve economist (who made a name for himself, apparently, by telling his superiors they were wrong, go to it Athanasios). Sils suggests that events are now moving rapidly on the Council (although not that rapidly, judging by this week's outcome), and that Orphanides might actually be the one emerging with the upper hand in the near term. And don't for a minute believe Orphanides is merely doing a bit of headline grabbing. There is a real theoretical argument behind his position, one which he, himself, elaborates in this paper which discusses how, in a deflationary situation, the central bank should attempt to steer expectations towards inflation by "promising" very low interest rates for an extended period of time. (For some considerably more wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry's IMF paper on the importance of communicating clearly when you want to make a "credible threat of irresponsibility").

What are Others Doing Then?

With the ECB being so cautious and unsure about whether or not to engage in what has now become known as Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) why don't we take a look and see just what the rest of them are doing.

Morgan Stanley's Stephen Jen had a very useful piece on the Federal Reserves' entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these will now need to be collapsed into one here in Europe given the looming deflation threat). The first stage is to attack the credit crunch, and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the "lower bound") based on a division of labour between the bank (which has ballooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to "steer" inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.

• Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of "monetising" the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say something similar about their European equivalents, who, it seems to us, are gradually being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.


• The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point. One significant way in which this can work is, as Kemp notes, by matching increased lending to financial institutions with an increase in deposits these same financial institutions hold with the Fed (a bit wonkish, but still).


• A central bank can also alter the composition of its balance sheet by purchasing securities in an attempt to directly affect the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. In fact, the ECB has already doing something like this for some time now, since it is not at all clear just how many of those assets currently parked over in Frankfurt (and which have been exchanged for liquidity) will ever actually get to leave again. In a general sense, there also seems to have been a rather radical change with respect to the kind of assets the central banks have been willing to accept as collateral for liquidity.

One of the basic cornerstones of QE that has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US' case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the "traditional" QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to "manage" the yield curve on the short end and thus allow the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks at positive interest rates.

So, What should and could the ECB do?

Well the answer to this question clearly depends on where you think the Eurozone's real economy is at right now. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggressive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet's recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of everything we have on the table in terms of economic data, and that we are still a long way from doing the necessary.

However, and in fairness to their point of view, we might start by taking a look at the various reasons which have been offered attempting to argue why it would be inappropriate for the ECB to engage in QE and why some continue to argue that the risk of inflation is still imminent. In order to get to grips with such arguments there is, of course, no better route than by listening to the ECB itself, but since its council members all too often simply offer us their own highly distinct form of newspeak, the following pieces (one by Robert Ophèle Deputy Director at La Banque de France, the other from Sylvester Eijffinger, professor at Tilburg University) are quite useful.

Ophèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.

Ophèle uses two arguments in defence of the idea that what we may currently be experiencing is disinflation and not deflation. The first is the fact that the current sharp drop in price levels mainly comes from energy and food prices, and are thus largely giving back the price gains that were so instrumental in driving global monetary policy only a year ago. The second is a much trickier issue, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.

This is an extraordinarily powerful and, as it were, convenient argument for those who would defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects as energy prices shot up ever higher and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. However, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.

However this argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:

We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.

Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can't deflate because households don't expect them to, and households don't expect them to because they are running at x% a year), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because one expects inflation does not mean that you are going to get it and furthermore, expectations may change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don't get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.

As ever when we have this discussion of expectations the time horizon is the problem. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.

Turning to the case made by Sylvester Eijffinger, an even stronger argument is fielded against the deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity citing as authority European Union economy and Finance Commissioner Joaquim Almunia who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument would seem to us to be a self defeating one, since if it is valid the future of countries liike Spain, Ireland and Greece within the Eurozone must come under an immediate question mark, since without such downward corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and thew consequent drop in demand only serves accelerate deflation rather than avoid it. That it, this kind of argument, in a major recession like the one we have now, is totally and thoroughly false.

Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal policy not to mention a unified treasury. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it is strictly forbidden according to the ECB's own rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?

But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce of the same of those bonds were to be deployed by the commission across the Union to fulfil pre agreed objectives. But wouldn't those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.

Time to Add More Pages to the Playbook?

We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obviously have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an initial tentative sketch of what the ECB might do to move forward towards a process of quantitative easing and we have offered some suggestions about how to do this. Clearly, not everyone will be ready to agree with the initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready to entertain the idea. As such we hope the ideas here expressed may contribute to a wider ongoing debate about what to do about Europe's present economic and financial crisis, and what kind of measures and tools we have available to deal with it.

Unfortunately, the ECB, and most recently and specifically bank President Jean-Claude Trichet, have been ardently defending a viewpoint based on the non-existence of deflation risk. Today's, decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bold move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by its peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs "originality" is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credibility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries in its charge into a negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun.

One of Bernanke's goals was to reassure the public that the many new loans that the Fed is extending and assets it is purchasing do not pose a significant risk to taxpayers. From Bernanke's remarks:

Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers.

Left unsaid here is the fact any private lender could equally well have also extended said overcollateralized loans to these same borrowing institutions, but decided that the compensation for absorbing such a risk was inadequate. Bernanke's core assumption is thus that private lenders are currently mispricing risk, but the Fed can do it correctly. I'm prepared to believe that's true-- there is some degree of overcollateralization that might be inadequate for markets but should be sufficient for the Fed, but what is it? Are the underlying assets really worth 99 cents, 90 cents, or 50 cents on the dollar? Should the overcollateralization therefore be 1%? 10%? 100%? The devil is in the details, and whatever details we know about this aren't coming from the Fed.

Nor do I take comfort in Bernanke's observation that the Fed hasn't lost any money on the new facilities-- yet. Didn't the buyers of subprime MBS say the same thing? It was the wrong answer then for the same reason it's the wrong answer now-- when you drastically change the scale and rules of the game, you can't base your risk assessment on historical performance. The one thing of which we should be confident at the moment is that the future won't look like the past.

Bernanke also discussed some of the Fed's new plans:

In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve's credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a "haircut" and the Treasury is providing $20 billion of capital as supplementary loss protection. We expect this facility to be operational next month.

Here at least we have a number-- $20 billion-- that will give us some idea of what Bernanke assesses the ballpark risks to be. If, for example, we see that the Fed lends $100 billion in this program, I'd take that to mean he's thinking the underlying assets are really worth at least 80 cents on the dollar; if $200 billion, we're talking about 90 cents on the dollar. If this gets into the hundreds of billions, it's hard to see how $20 billion would be regarded as a significant equity cushion.

Bernanke also addressed the question of what's the exit plan for bringing the Fed's balance sheet back to normal size and safety:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities....

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds-- including loans to financial institutions, currency swaps, and purchases of commercial paper-- are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy-- namely, by setting a target for the federal funds rate.

That sounds to me like an exit strategy for how to get out of this if everything works out just right and the problems all go away.

And what's the exit strategy if it doesn't work? I suppose more lending facilities.

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