What next for the Fed...
One of the main function of the Federal Reserve is to adjust the interest rate according to current economic conditions. The members of the Fed get together on a regular basis, the first and third Monday of the month, unless they call for an emergency meeting, to decide if the discount rate should be changed or not. Since the 10th of May 2006, the discount rate has dropped from 6% right down to 2.25%(as at 1st of May 2008). There is no argument as to why the Fed had to decrease the rate at such a drastic level, but one big problem the Fed has to face now is the continuous rise in inflation and the slowing down of the America economy, in other words, stagflation has arrived.
On the one hand, the price of oil and food are rising non-stop. On the other, because of the credit crunch, lending has tightened and with confidence declining, investments will decrease and so will growth. The problem with changing the discount rate right now is that, there will always be a trade-off no matter what the Fed do. That is, if they decide to increase the rate, inflation should be checked and held at the same level for sometime, but the future of the economy will be even gloomier. But if the Fed opts for the alternative and decide to decrease the discount rate, inflation will rise even further. All this comes down to one question, what is the main concern for the central bank?
The European Central Bank's(ECB) priority was never in doubt, they decided that containing inflation is their main objective right from the beginning, that is why they never lowered their interest rate during the credit crisis. Of course, they had an advantage over the Fed, and that is the credit crunch didn't spread as much as they did in America, hence they only had to deal with the rise in prices of commodities. But as time goes on, Europe is starting to feel their economy slowing down, some odd countries are still maintaining high level of growth, like Germany, but the growth is slowing down as well. One big difference for the ECB, compared to the Fed, is that their interest rate is the same for all the members of the Euro. This means that even though some countries might be experiencing higher unemployment and lower growth than others, they will have to settle with the same interest rate and hence might not be as helpful if the interest rate is decided for that particular country.
Now back to the Fed, with the discount rate as low as it is right now, the US dollar is consequently low as well. This means that Americans will have to spend more than before to buy the same item. This is because, although low dollar means that American exports will be relatively cheaper, which should help curb the current account deficit as the amount of exports increase, imports will be more expensive than before and this is one of the reasons why inflation is getting higher. One might ask, "if imports are getting more expensive, won't that lower demand level?". The answer to that is yes, it will. But since Americans consume more than they could produce, in the case of oil and food and other commodities, they have no other options but to pay more to meet their needs. To counter this problem, the Fed can raise rates so that the dollar will rise again, compared to the other currencies, so things will be cheaper for the consumers. A downside to this though, as talked about earlier, is that increasing the rate will decrease borrowings and hence investments. With many people suggesting that the American economy is already recession, higher rates will only make the matter worse. Even though the rate at present is very low already, as a matter of fact, even lower than the rate of inflation. This means that even if I put money into my savings account, the interest I gain is still not enough to compensate for the higher price of the goods and services I consume.
If, however, the Fed decide that avoiding recession is a much more important issue, they might decide to maintain the discount rate at the current level or even lower it, which is highly unlikely. Given that most of the inflation is caused by oil and food, and the core inflation(inflation rate excluding oil and food lol) is actually quite stable, the Fed can bank on the fact that the rise in prices for oil and food is only temporary(this is supported by a lot of analysts, even by the newspaper I read). Even though the rise of price for oil and food is only for the short term, it doesn't mean there will be no harmful effects for consumers. Assuming that the Fed decided not to change the rate, inflation will definitely rise continuously as a result. This means that consumers will expect higher inflation in the future and therefore pursue for higher pay from their employers. Even if these businesses can pay higher wages, they will have to somehow pass on the extra costs to consumers, and the spiral goes on.
If we look back at the 1970s, we can see that the price of oil was rising non-stop, but after a while, the price started to drop again. This time however, is a bit different than the 70s, and that is the rise in demand of oil and commodities are mainly driven by the emerging countries like China and India and we also can expect that their demand will not curb as quickly as we might hope for. We also know from recent history(the dot-com bubble in 2001 and the crash of the Asian markets in 1997) that it takes a few years before an economy can recover to the state before the crisis, in this case, the credit crunch. Of course, we have to also consider the fact that the emerging markets are now relying less on the American economy, unlike those scenarios before, when the American economy represented the world economy. The chairman of the Fed, Ben Bernanke has suggested that there could be a possibility the discount rate will be raised at the end of this year, and we deduct from this that the Fed is trying to avoid both recession and inflation at the same time. It remains to be seen how much and how many times they will raise the rate, but the most important thing is that the ECB and the Fed should act in a coordinated fashion. This is because if the Fed chooses to avoid recession over inflation and the ECB decided to raise interest rates, the US economy will surely face even higher inflation, and things might start to get out of hand.
Tuesday, July 1, 2008
Sunday, June 15, 2008
A barrel a month, keeps your money away
With the price of oil getting higher and higher, consumers' budgets get tighter and tighter. This week, we have seen another record high for the price of oil, we have also seen the price of oil jumped from $127 to $138 in a single day. Now Goldman Sachs is predicting that the price will go up to $150 a barrel. Russia's Gazprom even said that the price of oil will increase to $250 a barrel next year. One might ask, "why is this happening?".
A lot of consumers think that the reason for this hike is because oil companies are getting greedier and because these companies know that the demand for oil is very inelastic, they can increase the price to as high as they would like. We also have people blaming the speculators for the problem, so what is the main reason for the price of oil that seem to have no limit?
There is no one main reason for this, rather, it's a series of unfortunate events that created it. I will try to break them down one by one, I will also talk about those that I think played no factor in the rise. First up, and I will go for the easy one, and that is the oil companies and if they are just getting hungrier for money. Many consumers think that these companies are like monsters that eat into people's pockets and their appetite is getting larger by the day. So, if this theory stands true, why does the oil price go down? It's quite obvious that this is not the main problem.
Then, there's those speculators. For those of you who don't know what speculators are, they are people that trade the futures of oil, in other words, they gamble if the price of oil will rise or fall. All they do is by trading papers and when they mature, they can settle them with a cash payment or sell them on to genuine consumers. One funny thing about economics is that, people do business solely by using their own expectations about the future, which are informations that were picked up from the market. Because of this, when speculators buy contracts that say the price of oil will be $200 in six months time, the demand at this moment will shoot up. This might be confusing at first, but if we look at it this way, say that today's price of oil is $150, and if a person buys a barrel right now, and sell it six months later, he would have made a profit of $50. Where I am going with this is that, as more and more people believe that the price of oil will keep on rising, and we know that supply will remain the same in the short term, demand will increase as people fear they will have to pay a lot more in the future.
All these come to a conclusion, the price of oil is the direct result of the mechanism of the basic economic model of supply and demand. During the last few years, the supply has grown by a little. On the other hand, the increase in demand, especially from the developing countries, has been outweighing the increase in supply. So why don't the refineries build new equipments or develop new oilfields to make the extraction of oil more efficient? It's because investing in the extraction of oil is time draining and requires a lot of capital. Also, since each refinery can be used for decades, these firms will have to be prudent in making decisions to invest. Moreover, it is also difficult to get the right permits to start construction. The cost of developing new fields has risen even faster, plus, we have these environmentalists protesting every now and then about the pollution these refineries produce. Although many geologists believe that there are still a lot of oil to be discovered in the Middle-East and the former Soviet Union, the regions' governments, as well all know, can be stubborn at times in allowing outsiders to have access.
If the economic model stands correct, that when the price increase, demand decreases, why do we see so little downward movement in the level of demand? Although demand in rich countries has been dropping for the past two and a half years, the thirst for oil in developing countries like China, India and Brazil has overshadowed the drop. But it is still weird that the rise in consumption in these countries(though at a slower pace) don't fall as much as we might have expected. This is partly because their economies are growing faster, but also, for countries like China, India, Malaysia etc. their consumers do not feel the rise in the price of oil through subsidies from their governments. This means that in some parts of the world, petrol is not sold at the market price. According to the newspaper I read, the cheapest petrol is in Venezuela, at 5 cents(US dollars) per litre, and China's price is at 79 cents, and then we compare that to United States' $1.04 per litre. With the price of oil rising each and every day, the cost of subsidies must rise too, and sooner or later, governments will have to lift prices. The main reason they need to subsidies oil is because if they had not done so, these countries' inflation would have been pushed through the roof. In order to keep their economies going at full speed and to avoid their consumers protesting and rioting(We have to remember that these countries' political situation are all not very stable, the only thing that keeps them quiet is by increasing their wealth and lowering their cost of living, or by force) like those truckers in Spain, they had to shield their consumers from the rising cost of fuel. Some governments believe that by capping the price of oil, they can in turn help the poor. What they did not consider is the fact that the poor cannot afford oil in the first place, if they never had a car, how are they going to consume petrol. Rather, this only helps the rich and industries that are energy intensive.
These problems cannot be fixed in the short term, as mentioned earlier, demand and supply for oil is quite inelastic. People need time to replace their old cars with new hybrid ones, or to move to more urban areas where they can easily have access to public transport. Also, it takes a long time to develop a new oil field after discovery. In the long term, the level of supply will rise and demand will drop. But for us, the consumers, the near future does not look so bright.
With the price of oil getting higher and higher, consumers' budgets get tighter and tighter. This week, we have seen another record high for the price of oil, we have also seen the price of oil jumped from $127 to $138 in a single day. Now Goldman Sachs is predicting that the price will go up to $150 a barrel. Russia's Gazprom even said that the price of oil will increase to $250 a barrel next year. One might ask, "why is this happening?".
A lot of consumers think that the reason for this hike is because oil companies are getting greedier and because these companies know that the demand for oil is very inelastic, they can increase the price to as high as they would like. We also have people blaming the speculators for the problem, so what is the main reason for the price of oil that seem to have no limit?
There is no one main reason for this, rather, it's a series of unfortunate events that created it. I will try to break them down one by one, I will also talk about those that I think played no factor in the rise. First up, and I will go for the easy one, and that is the oil companies and if they are just getting hungrier for money. Many consumers think that these companies are like monsters that eat into people's pockets and their appetite is getting larger by the day. So, if this theory stands true, why does the oil price go down? It's quite obvious that this is not the main problem.
Then, there's those speculators. For those of you who don't know what speculators are, they are people that trade the futures of oil, in other words, they gamble if the price of oil will rise or fall. All they do is by trading papers and when they mature, they can settle them with a cash payment or sell them on to genuine consumers. One funny thing about economics is that, people do business solely by using their own expectations about the future, which are informations that were picked up from the market. Because of this, when speculators buy contracts that say the price of oil will be $200 in six months time, the demand at this moment will shoot up. This might be confusing at first, but if we look at it this way, say that today's price of oil is $150, and if a person buys a barrel right now, and sell it six months later, he would have made a profit of $50. Where I am going with this is that, as more and more people believe that the price of oil will keep on rising, and we know that supply will remain the same in the short term, demand will increase as people fear they will have to pay a lot more in the future.
All these come to a conclusion, the price of oil is the direct result of the mechanism of the basic economic model of supply and demand. During the last few years, the supply has grown by a little. On the other hand, the increase in demand, especially from the developing countries, has been outweighing the increase in supply. So why don't the refineries build new equipments or develop new oilfields to make the extraction of oil more efficient? It's because investing in the extraction of oil is time draining and requires a lot of capital. Also, since each refinery can be used for decades, these firms will have to be prudent in making decisions to invest. Moreover, it is also difficult to get the right permits to start construction. The cost of developing new fields has risen even faster, plus, we have these environmentalists protesting every now and then about the pollution these refineries produce. Although many geologists believe that there are still a lot of oil to be discovered in the Middle-East and the former Soviet Union, the regions' governments, as well all know, can be stubborn at times in allowing outsiders to have access.
If the economic model stands correct, that when the price increase, demand decreases, why do we see so little downward movement in the level of demand? Although demand in rich countries has been dropping for the past two and a half years, the thirst for oil in developing countries like China, India and Brazil has overshadowed the drop. But it is still weird that the rise in consumption in these countries(though at a slower pace) don't fall as much as we might have expected. This is partly because their economies are growing faster, but also, for countries like China, India, Malaysia etc. their consumers do not feel the rise in the price of oil through subsidies from their governments. This means that in some parts of the world, petrol is not sold at the market price. According to the newspaper I read, the cheapest petrol is in Venezuela, at 5 cents(US dollars) per litre, and China's price is at 79 cents, and then we compare that to United States' $1.04 per litre. With the price of oil rising each and every day, the cost of subsidies must rise too, and sooner or later, governments will have to lift prices. The main reason they need to subsidies oil is because if they had not done so, these countries' inflation would have been pushed through the roof. In order to keep their economies going at full speed and to avoid their consumers protesting and rioting(We have to remember that these countries' political situation are all not very stable, the only thing that keeps them quiet is by increasing their wealth and lowering their cost of living, or by force) like those truckers in Spain, they had to shield their consumers from the rising cost of fuel. Some governments believe that by capping the price of oil, they can in turn help the poor. What they did not consider is the fact that the poor cannot afford oil in the first place, if they never had a car, how are they going to consume petrol. Rather, this only helps the rich and industries that are energy intensive.
These problems cannot be fixed in the short term, as mentioned earlier, demand and supply for oil is quite inelastic. People need time to replace their old cars with new hybrid ones, or to move to more urban areas where they can easily have access to public transport. Also, it takes a long time to develop a new oil field after discovery. In the long term, the level of supply will rise and demand will drop. But for us, the consumers, the near future does not look so bright.
Sunday, June 8, 2008
Why a chocolate bar turned sour and umm, not so crunchy anymore...
We all know that around one and a half years ago, there was a large amount of defaults of mortgages in America which led to a thing called credit crunch, and these mortgages were mostly subprime. But for many of us, it is not clear what caused this and why it has led to such devastation in the financial markets.
A few years ago, when every country's market were all going very well, everyone was making their money, when there was nothing to worry about, and then all of a sudden, an eruption of foreclosures brought a lot of banks and lenders to their knees and eventually bankruptcy. But why? I remember one of my ex-colleagues saying "Oh, the reason the subprime mortgages turned so bad was because all the banks did not want to have them on their balance sheets and so they had to pass it around to other banks and financial institutes, hence the spread of the disaster." I thought to myself, and why is it that you think the banks took it onto their own balance sheet in the first place? Just for the sake of taking more risk and look like a hero?
When the times are good, you seem to take the pedal off and lose your concentration and allow yourself to take more risks. These banks and institutes obviously thought that it was fine to bear these extra risks as they would yield higher returns. But here comes another question, if everything was going so great, why did these borrowers had no other choice but to default their mortgages (remember these are subprime, it means that these borrowers have a bad credit history)? These mortgages all had a term, and that is, at a specific date, the interest rate will reset to a higher point. These borrowers obviously could not handle these repayments and had to default the mortgages. Banks had no alternatives but to write-off these so called "assets" from the balance sheet and moreover, their reputation and trust for each other deteriorated and this stopped them lending to each other and hence the credit crunch.
You might ask, even though the banks had to write off these mortgages, how did it spread from the banking sector to the whole of the financial market? We don't call these people pros for nothing, they somehow, using some very complicated financial manipulation, repackaged these mortgages, link them into some other type of investments, and made them into attractive looking investing vehicles for other investors like the hedge funds, pension funds to buy. So from the bank sector, the virus spread to the normally safe hedge funds and pension funds and this caused major chaos and shock into literally everyone in the markets and as the level of lending decreases, growth also slows, add that together with inflation, we come to a situation called stagflation.
When white chocolate collides with dark chocolate
How can I say this blog is about politics without writing about America's hottest topic ? It's the lovely Ms. Hillary Clinton and the charming Mr. Barack Obama. Now, we all know that Mr. Obama has finally clinched the Democratic Party's nomination, so I am not going to talk about what happened before. What I am going to talk about is what comes next for him.
Recently, a lot of people have discussed the possibility that Mr. Obama will pick Ms. Clinton as his running mate, and this will help him gather some of her votes, especially white-collar voters. But what he lacks mainly and is often attacked by critics for, is the lack of experience at the age of forty six. In November, he will be up against a man who is seventy one years old, who not only have served in the Vietnam War, but during that time, he has been shot, captured and tortured. Just by talking about this, Mr. John McCain will be streets ahead if the election was decided on experience.
What we have to remember is, American is tired of both the Bush administration and the Republicans, although Mr. McCain is trying very hard to distance himself from President Bush, he is a Republican no matter what. On the other hand, Mr. Obama has this ability to convince voters that he will be able to carry out reform to both the economy and foreign policies for America. One of his main point in his campaign would be to cease free-trade agreements with other countries, and as we all know, this will do a lot more harm than good(if any).
Now, about the possible alliance with Ms. Clinton. Although he could bring some of Ms. Clinton's voters to his side, it might not be a wise idea to do so. One of the main reasons for this is because, with Ms. Clinton as his running mate, and a possible future vice-president, they do not have this aura of authority, and certainly not enough for a commander-in-chief(America's president is the commander-in-chief). Both of them have literally no experience in the fields, or put it this way, not even anywhere close to the fields. I remember reading one of Ms. Clinton's speeches saying "I remember landing under sniper fire (in Bosnia, 1996)" and "running with our heads down to our vehicles." I found it extremely amusing when I read from a newspaper reporting that the site she was in was actually safely secured by the military. If Mr. Obama really wants to compensate his weakness in these areas, he would have to choose a person that has experience in the military, and has much more experience in politics(Like Mr. Jim Webb, Virginia's junior senator, a former secretary of the navy).
What we have to remember though, is that Mr. Obama is going off the charts with his fund-raising for his campaign, so he surely has no problems there. On the other hand, Mr. McCain is a little bit behind in the financial aspect, and also, some people criticize him for his age, but he would counter and say that he has a lot of experience. Plus, Ronald Reagan was elected when he was at the age of 70.
My personal choice would be Mr. McCain, mostly because of his economic views and of course his experience, and plus, I don't really agree with Mr. Obama's way of changing the policies in America, put it frankly, I just think it's the wrong way to go.
We all know that around one and a half years ago, there was a large amount of defaults of mortgages in America which led to a thing called credit crunch, and these mortgages were mostly subprime. But for many of us, it is not clear what caused this and why it has led to such devastation in the financial markets.
A few years ago, when every country's market were all going very well, everyone was making their money, when there was nothing to worry about, and then all of a sudden, an eruption of foreclosures brought a lot of banks and lenders to their knees and eventually bankruptcy. But why? I remember one of my ex-colleagues saying "Oh, the reason the subprime mortgages turned so bad was because all the banks did not want to have them on their balance sheets and so they had to pass it around to other banks and financial institutes, hence the spread of the disaster." I thought to myself, and why is it that you think the banks took it onto their own balance sheet in the first place? Just for the sake of taking more risk and look like a hero?
When the times are good, you seem to take the pedal off and lose your concentration and allow yourself to take more risks. These banks and institutes obviously thought that it was fine to bear these extra risks as they would yield higher returns. But here comes another question, if everything was going so great, why did these borrowers had no other choice but to default their mortgages (remember these are subprime, it means that these borrowers have a bad credit history)? These mortgages all had a term, and that is, at a specific date, the interest rate will reset to a higher point. These borrowers obviously could not handle these repayments and had to default the mortgages. Banks had no alternatives but to write-off these so called "assets" from the balance sheet and moreover, their reputation and trust for each other deteriorated and this stopped them lending to each other and hence the credit crunch.
You might ask, even though the banks had to write off these mortgages, how did it spread from the banking sector to the whole of the financial market? We don't call these people pros for nothing, they somehow, using some very complicated financial manipulation, repackaged these mortgages, link them into some other type of investments, and made them into attractive looking investing vehicles for other investors like the hedge funds, pension funds to buy. So from the bank sector, the virus spread to the normally safe hedge funds and pension funds and this caused major chaos and shock into literally everyone in the markets and as the level of lending decreases, growth also slows, add that together with inflation, we come to a situation called stagflation.
When white chocolate collides with dark chocolate
How can I say this blog is about politics without writing about America's hottest topic ? It's the lovely Ms. Hillary Clinton and the charming Mr. Barack Obama. Now, we all know that Mr. Obama has finally clinched the Democratic Party's nomination, so I am not going to talk about what happened before. What I am going to talk about is what comes next for him.
Recently, a lot of people have discussed the possibility that Mr. Obama will pick Ms. Clinton as his running mate, and this will help him gather some of her votes, especially white-collar voters. But what he lacks mainly and is often attacked by critics for, is the lack of experience at the age of forty six. In November, he will be up against a man who is seventy one years old, who not only have served in the Vietnam War, but during that time, he has been shot, captured and tortured. Just by talking about this, Mr. John McCain will be streets ahead if the election was decided on experience.
What we have to remember is, American is tired of both the Bush administration and the Republicans, although Mr. McCain is trying very hard to distance himself from President Bush, he is a Republican no matter what. On the other hand, Mr. Obama has this ability to convince voters that he will be able to carry out reform to both the economy and foreign policies for America. One of his main point in his campaign would be to cease free-trade agreements with other countries, and as we all know, this will do a lot more harm than good(if any).
Now, about the possible alliance with Ms. Clinton. Although he could bring some of Ms. Clinton's voters to his side, it might not be a wise idea to do so. One of the main reasons for this is because, with Ms. Clinton as his running mate, and a possible future vice-president, they do not have this aura of authority, and certainly not enough for a commander-in-chief(America's president is the commander-in-chief). Both of them have literally no experience in the fields, or put it this way, not even anywhere close to the fields. I remember reading one of Ms. Clinton's speeches saying "I remember landing under sniper fire (in Bosnia, 1996)" and "running with our heads down to our vehicles." I found it extremely amusing when I read from a newspaper reporting that the site she was in was actually safely secured by the military. If Mr. Obama really wants to compensate his weakness in these areas, he would have to choose a person that has experience in the military, and has much more experience in politics(Like Mr. Jim Webb, Virginia's junior senator, a former secretary of the navy).
What we have to remember though, is that Mr. Obama is going off the charts with his fund-raising for his campaign, so he surely has no problems there. On the other hand, Mr. McCain is a little bit behind in the financial aspect, and also, some people criticize him for his age, but he would counter and say that he has a lot of experience. Plus, Ronald Reagan was elected when he was at the age of 70.
My personal choice would be Mr. McCain, mostly because of his economic views and of course his experience, and plus, I don't really agree with Mr. Obama's way of changing the policies in America, put it frankly, I just think it's the wrong way to go.
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