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“Most of us would assume that a contracting trade deficit is expansionary for the US economy and therefore a good thing. In that case fewer purchases of US dollar assets by the PBoC and other foreigners must also be a good thing because one is simply the obverse of the other.

“But it’s not necessarily a good thing. It depends how it happens. If the US trade deficit contracted because soaring US unemployment caused investment to collapse (i.e. faster than nominal savings decline), it would undoubtedly be very painful for the US. But if the US trade deficit contracted because Chinese consumers imported more US goods, I think everyone would be pretty pleased about it, and the interest rate consequences be damned.”
                                          Michael Pettis

Commentary & Analysis
Go long – they’re talking their book at the OECD

The Organization for Economic Cooperation and Development.

Here we are debating whether or not the Federal Reserve will follow the departure of QE with the commencement of QE3 or something similar. I’ve seen analysts peg a Fed interest rate hike at 2Q2012, at the earliest.

But the OECD has come out to tell us they expect what amounts to a full percentage point of rate hikes from the Fed over the rest of 2011. At the end of 2012 you ask? 2.25 percent.

Does someone know something I don’t (likely), or is the OECD covering their dollar shorts and going long?

They say the US central bank is more able to tighten monetary policy than the European Central Bank, which is currently watching the eurozone struggle with fiscal belt-tightening measures. Additionally, the OECD assumes a US economic recovery can persevere. But there have been some signs that growth is, to some extent, in jeopardy.

The OECD seems to think unemployment is the biggest challenge and biggest risk to their forecasts. Indeed, Ben Bernanke remains focused on unemployment as a reason for not moving on from easy-money policy.

The next measure will be durable goods, reported at 8:30 eastern time today. I’ve seen expectations of a negative print for the headline number due to sluggish auto sales.

On the other hand, loan activity might suggest a US recovery has reached sustainability territory. Willingness to lend to consumers has returned. Consumer credit is growing again. We are seeing commercial and industrial loan growth. Demand for business loans is growing. On most measures we have not regained pre-crisis levels, but the improvement in this arena has led economic recoveries in the past.

So … a 1% Fed Funds Rate after the next 7 months? And 2.25% after the next 19 months?

Consider this from Puru Saxena in a recent CNBC interview:

“Every one percentage point increase in the cost of the weighted capital for the government increases the annual interest burden by $140 billion.”

The debt ceiling and deficit spending issue has been hotly debated of late. But most parties have concluded that the US is not close to a possible default at the moment. So, is the Fed out to do the right thing for long-term economic sustainability? …Or long-term political sustainability?

I particularly think the OECD is ahead of itself on this call for Fed rate hikes. It may mean an end to easy money is closer than I thought, but I think 1% point of hikes by the end of the year is pushing it. But regardless of what I think, we need to gauge how the market responds to potential Fed normalization.