Interest Rates & Consumer Price Infaltion - US & EU

Interest rates in the US remain 2 1/4 points lower than those in the EU, despite greater consumer price inflation in the US. The Federal Reserve in the US is charged with both keeping inflation under control and stimulating the economy, while the EU central bank's mandate is only to keep inflation in check.

Interest Rate and Consumer Price Inflation Trends - US & EU

Source: WSJ

"It Was Leverage Killed the Beast"

Police Lieutenant: Well, Denham, the airplanes got him.
Carl Denham: Oh no, it wasn't the airplanes. It was beauty killed the beast.

--- Last lines, King Kong (1933) ---

Morgan Stanley and Goldman Sachs Group, the remaining independent Wall Street brokerages, threw in the towel today and converted to traditional bank holding companies, placing themselves under the regulatory supervision of numerous federal regulatory agencies. Instead of being overseen just by the Securities and Exchange Commission, Goldman Sachs and Morgan Stanley will now face much stricter oversight from numerous federal agencies. The Federal Reserve will regulate the parent companies, the Comptroller of the Currency will oversee the national bank charters, and the Federal Deposit Insurance Corp. will likely play a bigger role because the companies are expected to seek much higher volumes of federally backed deposits, and the entities may seek to take customer deposits, instead of depending on short-term borrowing to finance their investments.

The firms will reduce their leverage ratios -- a measure of a firm's risk in relation to the equity on its balance sheet -- over the next two years from current levels to something more in line with that at commercial banks. Investment bank ratios now stand above 20, with commercial banks closer to 10. The combination of easy money, interest rates kept lower than the real inflation rate by the Fed after the dot com bust, Fannie Mae and Freddie Mac incentives to make housing affordable to more Americans, and finally the housing bubble burst, at the core of the problems, that all contributed to the rapid deleveraging of investment banks as their underlying assets crashed in value.

Quarterly Leverage Ratios Trend for Morgan Stanley, Goldman Sachs, Lehman Brothers

Morgan Stanley and Lehman Brothers had leverage ratios above 30 in Q1 2008, while Goldman Sachs had a leverage ratio of 27. For comparison purposes, Bank of America has a leverage ratio of 11, giving it far more assets to back up any troubled investments it makes. Having more assets on their balance sheets allowed the commercial banks to ride out the storm, since they had more resources to fall back on, without having to raise more capital, as their investments declined in value. Much of the investments banks out-sized profits came from this leverage - investing borrowed money in the hopes of getting a great return before having to pay it back. This fueled the out-sized returns of the investment banks during their salad day, and fuled their death pyres during the housing crash. They will be safer in the future, but also have smaller returns, as their ability to bet large amounts of someone else's money has now come a'cropper.

The Inflation Story

The producer price index (PPI) is up 8.8% year over year, partly due to higher energy and higher commodity prices. But consumer prices are up only 4% on all items and 2.2%, excluding energy and food. This means that producers have been eating about 5% in gross margins to keep prices low. Discount retailers have been holding the line on prices as well, reluctant to give ground to any competitor. But if the PPI continues at this level or higher, eventually manufacturers and retailers will have to cave, accelerating the growth of inflation even more.

Producer Price Index is up 8.8% this year (8-19-08)

Core Inflation and Consumer Price Index through August 2008

At the same time, union membership has been falling steadily for the past two decades and outsourcing of white-collar information worker jobs gives workers less room to negotiate higher wages and salaries.

Partially offsetting the rise in prices, the dollar has been rising against foreign currencies, mostly due to their weakness, rather than the strength of the US economy. This makes imports cheaper and helps hold the line on inflation.

The Dollar Exchange Rate vs the Yen and Euro

All told, at the end of four years a 4% inflation rate, where the overall consumer price index is today, results in a $100,000 salary being worth only $80,000.

The Fed will have to turn its attention to this issue sooner rather than later if it wants to avoid a repeat of the stagflations of the late '70s and early '80s.

Bullish on the US Dollar - Exchange Rate vs Euro, Yen, British Pound

The dollar enjoyed its best one day performance in six years (on August 8, 2008). Fears that Europe's economic woes are just beginning and that Japan may be entering another recession prompted some analysts to say, "The dollar bear market is over. A multiyear bull market for the dollar has just begun." - Marc Chandler, currency strategist at Brown Brothers Harriman, New York.

Since July 1, 2008, the dollar is up 3.5% against the pound, 3.6% against the yen, and 6.0% against the euro.

US Dollar to Euro Exchange Rate 2005 - 08/08/08Source: http://www.oanda.com/convert/fxhistory


U.S. Dollar to Yen Exchange Rate 2005 - 08/08/08
Source: http://www.oanda.com/convert/fxhistory

US Dollar to British Pound Exchange Rate 2005 - 08/08/08Source: http://www.oanda.com/convert/fxhistory

See: Dollar's Best Gain in Six Years Powers Stocks

Suffering from a $1.9 Trillion Dollar Shortage in Credit

The Fed has cut its target interest rate 3.25 percent since last September, but interest rates remain stubbornly high. Rates on 30 year mortgages went for 6.6% last week, compared with 6.4% on the day the Fed started cutting rates. Corporate borrowing rates have risen to 6.1% from 5.9%. The Wall Street Journal quotes David Rosenberg, Merrill Lynch's bearish chief North American economist saying in a note to clients, "In over two decades of experience on the Street, let's just say I have never seen this condition before, and [Ben] Bernanke has only read about it."

Why this divergence? The biggest reason is the credit crunch. Says the WSJ:

Banks have lost roughly $480 billion in the past year, but have raised only about $345 billion in new capital, estimates James Bianco, president of Bianco Research. Assuming they weren't overcapitalized before, that leaves them about $135 billion undercapitalized.

With leverage, that capital translates into roughly $1.9 trillion in lending capacity now off the market, he estimates.

In short, Supply and Demand: an absence of $1.9 trillion in lending supply has driven up the price of borrowing, despite the federal funds rate.

Key Interest Rates Diverge, Wall Street Journal

The Shape of the Price of Oil

The price of oil from 1976-2007, both adjusted for inflation and not adjusted for inflation:


Oil and the Federal Funds Rate, July 2007 - July 2008, after all of the conspiracy theories, a simple reason fot the rise in the price of oil?