Michael Pettis on Rebalancing Through Wage Increases in China

In Michael Pettis' most recent private newsletter, from which I am only allowed to make excerpts, which arrived by email yesterday, he brings up in the beginning the question of what is going on in copper in China and comes to the same conclusions I did in my April 29 article, "China: Copper In, Copper Out".  He observes, "What is happening here in China is not that credit growth is too slow, but rather that infrastructure and real estate investment is so high that it has overwhelmed the available sources of credit ... Borrowers are resorting to some fairly convoluted and expensive ways of obtaining short-term credit largely because they cannot obtain financing from the local banks ... That doesn't mean there isn't liquidity in China.  There is tons of it, but much of the credit is being disintermediated because of constraints on bank lending ... So Chin's problem isn't that liquidity is tight --- how could it be with so much credit expansion and hot money inflow?  The problem is that much of the real investment growth seems to be funded outside the normal lending channels ... The weird distortions in the banking system, where credit isn't rationed by price but by quantity and hierarchy, has turned China, at least temporarily, into a revolving door for copper imports and exports."

In response to Jeremy Grantham's newsletter, on which I commented as part of my article, "Where Is the Global Economy Going?", he provides a revised set of tables comparing Chin's contribution to world GDP as opposed to its consumption of food and non-food commodities:

	Share of global GDP
China’s GDP	9.4%
China’s GDP (PPP basis)	13.6%

Non-food commodities	Share of global demand
Cement	53.2%
Iron Ore	47.7%
Coal	46.9%
Steel	45.4%
Lead	44.6%
Zinc	41.3%
Aluminum	40.6%
Copper	38.9%
Nickel	36.3%
Oil	10.3%

Food commodities	Share of global demand
Pigs	46.4%
Eggs	37.2%
Rice	28.1%
Soybeans	24.6%
Wheat	16.6%
Chickens	15.6%
Cattle	9.5%

He observes that these tables show "... the disproportion between China's share of global GDP and China's commodity consumption"  and "The tables give a very good sense of what might happen to global demand for various commodities as China rebalances."  If Chinese demand declines 10%, world global demand will decline nearly 5%.  However, he is stressing non-food commodities, because "... food consumption will continue rising as Chinese households move up the income scale."

He then asks is China currently rebalancing?  Rebalancing would have to consist of three segments: rising wages, appreciating currency, and interest rate hikes.  "... rebalancing means eliminating and reversing the wealth transfers from the household sector to the state and corporate sector.  The most important of these transfers has been the undervalued exchange rate, the lagging wage growth, and artificially low interest rates."  In the last year this has begun to reverse with the currency appreciating, interest rate hikes, and wages surging.  To the question of have we "... seen an improvement in the underlying economy caused by a rising consumption share", his answer is no.  He cites the most recent (April 2011) World Bank quarterly report on China from which he quotes a summary citing resilience in moving towards macroeconomic normalization with fiscal and monetary contribution, with which Pettis does not agree.  He does, however, think the rest of the quote about the slow down in consumption growth in 2011 is key.  The World Bank said, "Consumption growth slowed in early 2011. But overall domestic demand held up well, supported by still strong investment growth. Real estate investment has so far remained robust to measures to contain housing prices—a policy focus. Reducing inflation is the other policy priority, after inflation rose to 5.4%, largely on higher food prices."  For Pettis, "Growth has been propped up by what I think are very unhealthy increases in investment, and you can always increase growth in the short term by increasing investment, but its sustainability is really questionable."  It should be understood that "increasing investment" is referring to state owned enterprise (SOE) investment as opposed to private small companies.  This imbalance is creating an unsustainable situation which is causing a slow down in consumption growth that one would not expect (as shown by this World Bank graph) if rebalancing growth was taking place with GDP growth.

If China is doing all of the right things --- raising wages, the exchange rate, and interest rates, Pettis asks, why isn't the economy rebalancing?  For Pettis, the key is the difference between real and nominal changes, because the nominal changes are not what matters.  Since last June the currency has appreciated approximately 5% since last June.  "On an annualized basis that's around 6% in currency appreciation since June.  But changes in a currency's real value reflect more than just changes in its nominal value.  They also depend crucially on inflation growth differentials and productivity growth differentials."  If Chinese inflation is higher than US inflation, then "... the RMB is appreciating in real terms even if its nominal exchange value hasn't changed.  Conversely, if US inflation is higher than Chinese inflation, then the RMB is depreciating in real terms."  Pettis then engages in an analysis of inflation in China and dismisses the argument that the higher inflation in China means is being appreciated by 8-9% annually by a combination of nominal appreciation and inflation and the 25% undervaluation of the renminbi could be eliminated in three years, because it would "... only be true if there were no differences in the productivity growth rates between the two countries."  But the Chinese worker productivity is growing faster than the American worker productivity and Chinese CPI inflation has not been in the tradable good sector but almost all in the food sector.  Pettis believes there has been relatively low inflation in the price inputs to both the US and Chinese tradable goods sector making the relevant price differential relatively small.  "In other words we can probably ignore the impact of inflation on the real changes in the currency." Pettis obviously disagrees with those who believe China's relatively high CPI means China's appreciation is not as low as it seems and is two or three percentage points higher. 

With respect to productivity growth differentials, Chinese worker productivity has been growing annually at two to three percent faster than US worker productivity and maybe even more depending on how one measures it.  This would mean the renminbi should nominally appreciate 2-3% just to keep from depreciating in real terms.  "Real appreciation, in other words, is less than nominal appreciation because of China's more rapid productivity growth."  He concludes there may have been some real appreciation against the US dollar but not very much.  Given the dollar is the world reserve currency and the renminbi is pegged to the dollar and the sharp depreciation of the dollar against the euro and other major currencies, the renminbi has also probably depreciated depending on the period at which you look.  "So what does this mean?  Just this: the claim that one of the key components of rebalancing --- an appreciating currency --- has been occurring may be vastly overstated or even simply wrong.  There has been little or no real appreciation of the RMB and there may actually have been some depreciation."

Just because interest rates have gone up since October does not mean rebalancing either.  While lending rates have gone up 100 basis points, depending on maturity rate, inflation has gone up 200-300 basis points, depending on the construction of the inflation index and focus on components.  "Real interest rates, in other words, have actually declined steeply.  Borrowers can obtain financing at lower real costs than ever, and depositors are suffering a significant and growing real loss on the money they leave in the banks.  This just increases the transfer of wealth from net depositors, who are households for the main part, to net borrowers, who are the state and corporate sector."  In fact, the imbalances from interest rates have been exacerbated.

With respect to wage growth, wages have been growing very quickly in the last year, but, given inflation, real wages have been growing less quickly than nominal wages.  Pettis believes that real wages have probably risen faster than productivity, which means that household wages have comprised a growing share of GDP.  Pettis' concern is the reason for the rising wages may be "... that demand for workers is driven primarily by unsustainable and unhealthy increases in the past two years in real estate and infrastructure development ..."  However unhealthy the reason, if it continues,  the problem of lagging wage growth to productivity growth may be eliminated and reversed.

Pettis summarizes that the undervalued exchange rate has not changed much and has not contributed to rebalancing, excessively low interest rates have gotten worse and significantly exacerbated the imbalances, and wage growth has gotten better and has contributed to rebalancing.  He sees no real way to compare the impact of these variables to judge the net effect.  He believes all one can do is look at household consumption, its relationship to GDP growth, and infer the net impact.  If, as the World bank suggests, household consumption is slowing, it might infer the imbalances are getting worse or it might mean there is a lag in the positive impact of rising wages and we will just have to wait until the end of 2011 to make an assessment.

Pettis has more surety in knowing, if wages are rising and interest rates are declining, there would be more real wealth transfers within the economy from corporates to households in the form of wages and from households to corporates in the form of lower interest rates.  This "... means that labor-intensive industries are bearing more than the full cost of whatever adjustment may be happening and capital-intensive industries are bearing a negative cost."  he then anecdotally relates he is hearing from his students, many of whom are the children of the owners of SME (small and medium enterprises), which tend to be labor intensive, that they are raising wages as fast as they can and still losing workers to the SOE's, which are capital intensive.  For SME's, wages are a significant portion of the business expenses, particularly if the cost of borrowing is declining.  It is Pettis' position the small businesses have driven real and sustainable growth in China, while SOE's and government investment have promoted growth by pumping wasteful levels of unsustainable investment.  For me, this brings up the question of why the SMEs and SOE's are competing for the same workers given the unemployment problem in China and the use of infrastructure projects to put people to work.  I am just surmising, but it would appear the SOE's may be raising wages faster than the SME's, leaving the SME's the job of training new employees.  If that is so, then government infrastructure projects are not hiring the unemployed and training them as much as such projects would warrant.  All of which goes back to Pettis' problem with the SOE's privileged existence.

For Pettis, the hope is not for smaller companies to grow faster to facilitate the reduction of investment growth, but the necessity to engineer the reduction of investment growth.  "The more important the capital-intensive sector is to the economy, and the more addicted these companies become to cheap capital that can be flung into wasteful projects, the harder it will be to rebalance the economy."  It will only make rebalancing transfers more difficult.

It is clear to Pettis that China is not rebalancing.  Beijing's growth model implies to Pettis that rebalancing cannot happen in theory except with a sharp contraction of investment growth.  It is not happening.  Pettis thinks, if there is another year or two of stagnant consumption as a share of GDP, maybe policymakers will wake up.  Until then do not expect the SME sector to prosper.  You can expect more of the same.

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ECB's Trichet Less Inflation Hawkish

In a press conference today, Trichet indicated the ECB is still concerned and watching headline inflation, but there would be no increase in the interest rate since the 25 bps increase in April.  In his introductory statement, this was a key paragraph:


"To sum up, based on its regular economic and monetary analyses, the Governing Council decided to keep the key ECB interest rates unchanged following the 25-basis point increase on 7 April 2011. The information that has become available since then confirms our assessment that an adjustment of the very accommodative monetary policy stance was warranted. We continue to see upward pressure on overall inflation, mainly owing to energy and commodity prices. A cross-check with the signals coming from our monetary analysis indicates that, while the underlying pace of monetary expansion is still moderate, monetary liquidity remains ample and may facilitate the accommodation of price pressures. Furthermore, recent economic data confirm the positive underlying momentum of economic activity in the euro area, with uncertainty continuing to be elevated. All in all, it is essential that recent price developments do not give rise to broad-based inflationary pressures. Inflation expectations in the euro area must remain firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Such anchoring is a prerequisite for monetary policy to make an ongoing contribution towards supporting economic growth and job creation in the euro area. With interest rates across the entire maturity spectrum remaining low and the monetary policy stance still accommodative, we will continue to monitor very closely all developments with respect to upside risks to price stability. Maintaining price stability over the medium term is our guiding principle, which we apply when assessing new information, forming our judgements and deciding on any further adjustment of the accommodative stance of monetary policy."

The full video of the statement and Q & A are here.


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United States in Housing Double Dip

Clear Capital reported today that their Home Price Index shows prices nationally have double dip to .7% below prior lows experienced in March 2009.  Calculated Risk is showing that the REO properties are increasing pressuring housing prices down.  FHA inventory of REO property has increased over 67% since December 2009.  In 2009, there was an economic stimulus, which was inadequate in scope, duration, focus, and amount, which helped counter falling housing prices while leaving continuing high unemployment.  The home buyer credit helped pump up housing sales.  One-third of national home sales are REO.  More than a quarter of home owners nationally still have negative home equity, because the programs put forward have been inadequate and poorly executed by the banks and mortgage servicers as well as inadequately monitored by Federal Government regulators.

You should also be aware that the ISM service sector index was down in April to 52.8 from 57.3 in March and the employment segment was down to 51.9 from 53.7.  While over 50 indicates expansion, this report shows growth is sharply slowing. 

Weekly jobless claims were sharply up 43,000 to 474,000; 4 week moving average was up 22,250 to 431,000, and continuing was up (for first time in several weeks since many people dropping off with expiration of benefits) 74,000 to 3,733,000.  There may be auto and school employee layoffs in this.


If you have been reading the last few posts in this Blog, this further evidence of economic slow down should not surprise you.

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Commodities, Global Growth, and U.S. Inflation

Today, 5/4/2011, commodities are falling.  In looking at a short list of commodities, I only see corn and ethanol up.  I have done a series of most recent posts on just these subjects: copper, growth and inflation in the U.S., is it time to sell gold and silver, and the global economy and commodities direction.  Consequently, what is happening today should not surprise.

James Hamilton on the Econbrowser has an interesting post today on the relation of a surge in oil prices and the beginning of recessions in ten of the last eleven recessions.  Such surges have an impact on auto sales (as demonstrated in 2008), and I have seen anecdotal information that auto sales of fuel efficient vehicles are up and retail sales are down.  We have previously noted that retail sales in Germany were down 2.1% in March on lower food and clothing purchases.  Hamilton expects a smaller response now, because the public did not revert to larger vehicles after 2008 and the high prices of less than three years ago have not yet been reached.  Yet, prices here in central Illinois are up to $4.29 per gallon, which means it is higher in urban areas.  Hamilton is in San Diego.  He does not see the non-linear relationship have yet reached the level necessary to predict a recession.


Via Mark Thoma at Economist's View, there is an article that posits high commodity prices are reflective of less productivity, which may be from bad weather, but the author believes that it may be a longer run phenomenon.  If you remember, in our most recent post, Jeremy Grantham is predicting a decline in commodities and we are seeing a broad sell off today.  In a more recent article by Michael Roberts at Greed, Green and Grains, he shows data that the heat in 2010 in the U.S. was not as hot as expected and the crop yield was consistent with the heat levels.  If 2011 is cool, it should be better.  Here in Central Illinois planting is only about 10% completed as it is being delayed by more rain than usual.

Oil shed 2.6% yesterday and is down again today.   The EIA weekly petroleum supplies report came in today worse than expected with oil supplies up 3.4 million barrels, gas supplies down 1 million barrels, and distillate supplies down 1.4 million barrels.  Part of the decline in oil is being attributed to fear the global economy is slowing down based on the different sales and manufacturing reports which have come out this week and last.

A St. Louis Federal Reserve paper is placing the blame for headline inflation on fuel prices rather than fuel and food.  We have already commented on the over reaction of the Federal Reserve to headline inflation and that inflation is actually well contained.  With the Federal Reserve over reacting to inflation expectations, it is almost as if, rather than having an inflation target (which we are below), the Federal Reserve has created an inflation ceiling which could negatively affect economic growth.

Yesterday, Marshall Auerback had an excellent article on how global growth is slowing, although as Tom Duy has observed that the Fed will not be doing a QE3, I respectfully disagree (because I understand his reasoning with respect to QE2) with Marshall Auerback that the Fed will continue its weak dollar and loose monetary policies.  Bernanke clearly communicated a growing concern with inflation (headline not core although core is trending up to the target 2%).  As commodities have fallen today and the prior two days, the dollar is stronger.  As I would expect, Auerback correctly sees the asinine problem of focusing on a debt limit, the potential implosion of the eurozone, declining retail sales in Germany and Spain, the tragic drama of Ireland (as compared to Iceland) as the European monetary Union debates whether it should act in its own best (banking sector) interest and truly support Ireland's economic recovery, and China's tightening and the direct effect on investment in GDP --- all of which we have also written.  Auerback also correctly adds the destructive IMF deficit thinking in Japan which may cause Japan to curtail and delay necessary reconstruction.  Edward Hugh believes that Japan is in a recession, as we have already written in our last post, and that reconstruction will spur a pick up in the second half of the year, but he is not convinced that reconstruction will be the spurt of economic growth for Japan as it has historically been for other economies.  On the other hand, the Australian economist Bill Mitchell maintains (and I have every reason to believe Marshall Auerback is in agreement with him) that economic growth through reconstruction in Japan is merely a matter of proper fiscal policy.  Global growth is slow, but we do not need to beat the slow horse dead with destructive austerity and deficit fear when it is the job of government to respond to aggregate demand when the private sector does not or cannot and/or the external sector contribution is not sufficient.  The choice in Japan, the United States with it continuing high unemployment, and the eurozone credit crisis is the choice between recession and economic growth. 



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Where Is The Global Economy Going?

Let's take a look at some economic data, which we have not previously posted, from last week and this week though today (5/3/2011).


U.S. Federal Reserve Texas Manufacturing Survey down to 8 from 24 the prior month.

Brazil is worried about 6.44% inflation through mid-April.

China tells (unofficial report) three largest banks to raise capital adequacy ration to 11.8% and fourth to raise it to 11.7%.

U.S. Case-Schiller (3 month average) 20 City Housing Price Index down 3.3% March.

U.S. Federal Reserve (Richmond) manufacturing survey down to 10 from 20 in prior month.

UK GDP Q1 2011 up 5 tenths of a percent.

U.S. durable goods new orders up 2.5% March (exp 2.0), ex transportation up 1.3%, capital goods non-defense new orders up 2.1%, inventory up 1.3%.

Eurozone banks tighten lending standards.

U.S. GDP Q1 up 1.8% (exp 1.9).

Spain unemployment up top 21.3%; March retail sales down 8.6% year on year, CPI up 3.5% EU harmonized April year on year, national CPI up to 3.8% (2.7% annualized).

Bank of Japan said economy likely fell into recession in March; Japanese industrial production down 15.3% March (earthquake/tsunami) vs February, consumer spending down 5%.

German unemployment down 37,000 to 2.97 million (lowest since June 2009) -- fear of wage demands.

Eurozone inflation up to 2.8% April vs year ago (March was 2.7%)

German retail sales down 2.1% in March, down 3.5% vs year ago on lower food and clothing purchases.

U.S. ECRI Weekly Leading Index down to 7.5% from 7.7%

U.S. Federal Reserve (Chicago) economic activity up to .26 march from .16 February but 3 month moving average down to .20 from .27.

U.S. ISM manufacturing index down to 60.4 April from 61.2, inventory up to 53.6 from 47.4, new orders down to 61.7 from 63.3, prices up to 85.5 from 85, exports up to 62.0 from 52.5, imports down 1.0 to 55.5, employment down 3 tenths to 62.7.  On the whole this is actually very mixed results and trending negative despite exports/imports.

Eurozone manufacturing growth up to 58 April from 57.5

India raised its interest rate 50 bps with the repo rate at 7.25% and from now on pegging the reverse repo at 1% below the repo to fight inflation; headline inflation nearly 9% in March, GDP Q1 estimated at 8.6%.

U.S. factory new orders up 3% (exp 1.9) March and February revised from <.1> to up 7 tenths, ex transportation up 2.6%, non-defense new orders up 4.1%.

Eurozone PPI March up 6.7% vs year ago -- fastest since September 2008 --- driven by energy input prices up 13% (up 31% vs year ago).

China April PMI manufacturing down to 52.9 from 53.4 (exp up to 53.9).

UK PMI manufacturing April down to 54.6 from 56.7 for a 7 month low.

Doug Short is showing charts for the Q ratio at 1.18 with a arithmetic mean of 67%, a geometric mean of 81%, and he is using the Vanguard Total Market ETF (VTI) to adjust the quarterly Flow of Funds report monthly.  This showing the market is significantly over valued.

John Hussman continues to find the market over valued and over bought:

It's clear that present conditions are among the most extreme in history. In fact, to capture instances other than today, 1987 and 2007, we have to broaden the criteria. The following are sufficient for purposes of discussion:

"1) Overvalued: Shiller P/E over 18 (presently, the multiple is over 24)

"2) Overbought: S&P 500 within 1% of its upper Bollinger band on a daily, weekly and monthly resolution (20 periods, upper band 2 standard deviations above the moving average), and S&P 500 at least 20% above its 52-week low.

"3) Overbullish: Investors Intelligence bullish sentiment at least 45% and bearish sentiment less than 25% (presently, we have 54.3% bulls and 18.5% bears).

"4) Rising yields: Yields on the 10-year Treasury and the Dow 30 Corporate Bond Average above their levels of 6 months earlier.

"I should note that while present conditions easily fit into the foregoing criteria, we generally use a somewhat less restrictive criteria to define an "overvalued, overbought, overbullish, rising-yields syndrome in practice, in order to capture a larger number of important but less extreme periods of risk. The foregoing set of conditions isn't observed often, but the historical instances satisfying these criteria in post-war data are instructive. Here an exhaustive list of them:

"August 1972, November-December 1972: The S&P 500 quickly retreated about 5% from its August peak, then advanced again into to its bull market peak near year-end (about 6% above the August peak). The Dow then toppled -12.3% over the next 50 trading days, and collapsed to half its value over the following 22 months.

"August 1987: The market advanced about 6% from its initial signal into late August. The S&P 500 then lost a third of its value within 8 weeks.

"June 1997: The only mixed outcome, during the strongest segment of the late 1990's tech bubble. The S&P 500 advanced another 10% over the following 8 weeks, surrendered 4%, followed with a strong advance for several months, surrendered it during the 1998 Asian crisis, and then reasserted the bubble advance. Over a 5-year period, the overvaluation ultimately took its toll, as the the S&P 500 would eventually trade 10% below its June 1997 level by the end of the 2000-2002 bear market. Still, the emergence of the internet, booming capital spending, strong economic growth and job creation, rapidly falling inflation, and dot-com enthusiasm evidently combined to overwhelm the negative short- and intermediate-term implications of this signal.

"July 1999: The S&P 500 advanced by 3% over the next two weeks, then declined by about 12% through mid-October, and after a recovery to the March 2000 bull market high, the S&P 500 fell far below its July 1999 level by 2002.

"March 2000: The peak of the bubble - the S&P 500 lost 11% over the following three weeks, recovered much of that initial loss by September, and then lost half its value by October 2002.

"May/June 2007, July 2007: The S&P 500 gained 1% from the late-May/early-June signal to the July signal, then lost about 10% through August 2007, recovered to a marginal new high of 1565.15 by October (about 1% beyond the August peak), and then lost well over half of its value into the March 2009 low.

"February 2011, April 2011: A cluster of signals in the 2-week period between February 8-22 immediately followed by a decline of about 7% over the next 3 weeks. As of Friday, the market has recovered to a marginal new high about 1.5% above the February peak.

"So not including the cluster of signals we've observed in recent months, we've seen 6 clusters of instances in post-war data (we're taking the 1997, 1999 and 2000 cases as separate events since they were more than a few months apart). Four of them closely preceded the four worst market losses in post-war data, one was quickly followed by a 12% market decline, and one was a false signal over the short- and intermediate-term, yet the S&P 500 was still trading at a lower level 5 years later. The red bars indicate instances of this syndrome since 1970, plotted over the S&P 500 (log-scale).

"Examining this set of instances, it's clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several percent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes" 

Jeremy Grantham, in his quarterly letter, believes the world is at a paradigm shift in which we having a growing population with less available land and commodity prices have been going up. However, he expects commodities may go down in the next year and, if China stumbles economically (1 in 4 chance) and/or the weather is better than expected (80% probability), they may collapse causing a global crisis.  Given that we have been seeing droughts and catastrophes, it is very possible the overall weather will be better going forward.  In his view, abundant resources and falling prices are a concept of the past.  Energy and finite natural resources will have great difficulty meeting future demands without significant technological changes.

We have already written about copper, gold, and silver, but you can see possible problems with corn, wheat, cotton, cocoa, coffee, etc in the current market despite year to date returns.

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Inflation & Economic Recovery: Is It Time to Sell Gold and Silver?

I wrote in my recent article  about the confusion of core inflation and headline inflation which exists in many minds.  David Andolfatto, who is a Canadian economist who works for the St. Louis Federal Reserve, has written an explanatory piece on how the measurement of inflation is meant to have practical policy meaning and, if the purpose of core inflation is to approximate a trend, then why not calculate an inflation trend.  He shows how a trend line of inflation would look compared to headline and core:

 

At the same time, as my article Bernanke's press briefing indicated, the Fed appears to be overly concerned with inflation expectations as opposed to actual inflation.  Tom Duy believes the Fed will end QE2 and begin tightening to fight an inflation that does not appear to exist in reality given poor retail final sales, a very depressing continuing output gap in a "recovery", and slow GDP growth reflective of stagnating employment.  Tom Duy compares the 1982 recession recovery retail final sales chart with the current recovery retail final sales current figures chart showing the current recovery is pitiful in comparison.  He also shows in graph form that inflation is well contained.

The Australian economist Bill Mitchell continues his criticism of American economic policy with asinine public debate on the need to raise the debt ceiling, citing even Warren Buffet as stating that is the failure to raise the debt limit would be the most "asinine act" and that there should not be a debt limit in the first place.  Mitchell then looks at the slow U.S. GDP growth, continuing high unemployment, and continuing low inflation and finds the U. S. government's failure to provide sufficient economic stimulus in the form of fiscal spending to increase employment economically inappropriate and unconscionable.

David Andolfatto wrote an article after the Fed press briefing about inflation , money supply , and gold prices and dismisses the argument of currency substitution and transitory commodity prices.  In the process he shows a 20 year chart of money supply compared to the price of gold, which finds, as anyone familiar with historical inflation and gold prices already knows, that gold prices rise and fall and does not keep pace with inflation.

Given the Fed policy of a weak dollar, based on the weekly charts, the price of gold may not be going down immediately while it continues to test resistance levels, but if you have a basis of, say, $400 an ounce in gold and it is now over $1550, why would you not be locking in profits and continuing your original investment amount if you think it will still continue to rise and not fall?  Hyperinflation is not going to happen.  If the economy tanks and the dollar is worth little, how many bullets will it take to appropriate your gold?  On the other hand silver does appear to be peaking or approaching a peak with a significantly growing short position.  In just one weekend since the weekly charts above, silver went down 12% (the chart is ugly) with a low of $42.19 closing at $44.93 on Sunday (5/1/2011) trading and the COMEX may be facing a major default in a TBTF as there is supposition that J. P. Morgan, as the money maker for silver, was on the wrong end of the trade.  If you have an over 200% profit in silver, as I do in the personal (designed for use by an individual investor on their own) "hedge" fund portfolio model I have designed, or any 20% or better profit, why not lock in the profit while you have it?  It may not yet be the time to sell gold, but, in my personal opinion, it sure looks like a decent, prudent time to sell silver before the rush.  If you are in commodity ETFs, do not panic, but do not be complacent.  Make sure you have your stop loss or stop loss limit orders in place to limit losses and protect gains.  If you are in bullion or coins, you are hopefully near a reputable dealer.

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U.S. Treasury Market Says Nuts to S&P Warning

In last weeks Treasury auctions, which was the first full week since the S&P warned on the U.S. deficit, the U.S. Treasury auctioned 2 year, five year, and 7 year Treasury bonds.  All sold with healthy bid-to-cover ratios at yields lower than the prior month auctions for the same bonds.

2 yr. Treasury, $35 billion, yield .673% (last month .789%), bid-to-cover 3.07, foreign purchasers 37.9%, direct 13.4%.

5 year Treasury, $35 billion, yield 2.124% ( last month 2.269%), bid-to-cover 2.78, foreign 40.0%, direct 11.2%.

7 year Treasury, $29 billion, yield 2.712% (last month 2.895%), bid-to-cover 2.63, foreign 39.1%, direct 7.85%.



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Economic Growth & Inflation in the United States

 Earlier in the week, the economist Tom Duy wrote that he expected Bernanke on Wednesday to address growing inflation expectations while maintaining an unchanged monetary policy.  Most people have a very difficult time distinguishing between transitory headline inflation (which hits the wallet hard) and core, sticky inflation which consists of continuing price increases which impact prices and wages throughout the economy.  This is why inflation expectations can be an economic problem when transitory inflation exists, because people start expecting real core inflation and saving, which can slow the economy.  We have already written that Duy and others were very disappointed in Bernanke's over reaction to inflation expectations as opposed to real core inflation in his remarks and his failure to sufficiently address labor costs and unemployment.

U.S. GDP for Q1 was announced this week at 1.8% (analysts had expected 1.9%).  If you take a look at the different segments of GDP and their contribution to the total number, you will see an increase in imports and decrease in government spending which have a negative impact which far outweigh increases in exports and inventories which have a positive impact.  Growth this slow can often mean higher unemployment.  Until housing (which is on the edge of double dipping) and business investment improve, the trend of economic growth will continue to be slow and disappointing.

One guest writer at dshort.com did a chart on GDP with and without government spending included which, not unsurprisingly, showed that the number of years since 1960 with negative GDP growth more than doubled.  The proper purpose of government national deficits is a response to aggregate demand, as we have written, and its resulting in economic growth when there would have been negative growth it what it should do.  The dshort.com guest writer is concerned about the resulting debt when it should be the private sector growing, but he appears more concerned about deficit than why the private sector was not otherwise stimulated.

The U.S. also released this week its Personal Income and Outlays report for March which showed personal consumption expenditures (PCE) going up 6 tenths of a percent in March from February on the increase in food and fuel.  Personal income rose 5 tenths of a percent, but disposable income only rose one tenth of a percent.  Doug Short at dshort.com did updated charts on headline and core CPI and core and headline PCE and comparing core PCE and CPI against each other for two different time periods.  While we mere mortals cannot eliminate food and fuel from our consumption, the transitory volatility of food and fuel prices can be misleading in actual sticky inflation.  The price increases have to be continuous and impact production prices and wages to be core inflation.

This is also why I pay only passing attention to consumer sentiment, because it is such lagging, old information, which is why while inflation expectations are increasing right now, the consumer sentiment survey showed increased optimism.  Transitory inflation hurts, but, if inflation became sticky, the real pain sets in.  It is like a child becoming mildly sick but playing to sympathy and the parent does not sort the symptoms and behavior out and over reacts.  Going to the doctor, when it serves no good purpose, makes life all that more expensive.

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China: Copper In, Copper Out

We have written on several occasions how copper is being imported into China, placed in bonded warehouses, and used as collateral to gain access to credit.  This has led to a significant rise in copper prices.

The bonded warehouse inventories of copper are actually up despite less copper imports in China.  This means there may be no real demand for the copper other than as collateral and that it could constitute an oversupply which could negatively affect prices with destocking.  It appears that a variety of Chinese businesses, including possibly property developers, have been using copper in bonded warehouses for collateral.

As the holders of these copper inventories find it harder to rollover financing, they are responding by re-exporting copper in larger quantities to the extent that copper exports surged to 36,800 tons in March.  The two most popular countries to which the exports are sent are Singapore and South Korea, both of which have LME warehouses.  Rather than meeting Chinese productive demand, it appears much of the imported copper is being re-exported after a monetization pit stop in Chinese bonded warehouses.  Since it was never sold to a mainland buyer no VAT applied and the import - export transaction is tax neutral.

If the copper is not to meet internal demand which has remained price resistant, this has a direct effect on analysts projections of GDP and on the market price of copper if the import - pit stop for loans - export cycle continues to trend towards less import and larger exports.

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Bernanke Press Briefing

Some people have asked what Bernanke said today at the first ever Federal Reserve Chairman's press conference after a FOMC meeting.  The statement of the FOMC meeting had no surprises and even included the "extended period" phrase and sees inflation and unemployment as transitory.

The press conference began with a reprise of the statement and of economic projections.  In answering questions, Bernanke always focused on the "medium term".  Nothing surprising but it does reiterate his view of the economy and recovery from th4e financial crisis.

The full press conference including questions and answers can be watched and heard in full here.

Update 4/28/2011:  The economist Tom Duy takes Bernanke to task for too much emphasis on inflation and little regard for unemployment.

CalculatedRisk sees QE2 as just ending not tapering off, no chance of QE3 with the statements on inflation and unemployment, and interest rates not likely to go up until middle of 2012.

Krugman dismisses Bernanke's concerns about inflation and questions Bernanke's understanding of how serious the unemployment problem is.

Marshall Auerback provides an assessment of QE2 as counterproductive and destructive of the Middle Class.

The Australian economist Bill Mitchell rips Bernanke for his inflation fears, agreement with the S&P deficit warning, and finds the unemployment projections, despite remaining high, as optimistically unrealistic.

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