On Currency Misalignments

This week's Economist discusses the problem of trying to tell whether or not an exchange rate is "misaligned" - that is, far from some sort of underlying equilibrium exchange rate. As the piece below describes, discerning this is not as easy as it sounds:

Misleading misalignments

“MISALIGNMENT” is all the rage. A new bill introduced into America's Senate proposes to punish countries where the exchange rate is found to be “fundamentally misaligned”... The bill, which is clearly aimed at China, follows a flurry of China-bashing proposals over the past year. But this one is different: it has widespread support and is likely to be passed before the end of this year.

Congress is hoping that it will be much easier to show that a currency is misaligned than manipulated. On June 13th, the day that this legislation was introduced, the Treasury decided yet again not to brand China a currency “manipulator” in its semi-annual report on exchange rates, but confidently declared that the yuan was “undervalued”. And on June 18th the IMF also announced a new framework for monitoring countries' exchange-rate policies. It will track indicators such as heavy foreign-exchange intervention and “fundamental exchange rate misalignment” in order to identify countries that are unfairly manipulating their currencies.

This activity is based on the widespread assumption that the Chinese yuan is hugely undervalued against the dollar. Yet the awkward truth is that it is almost impossible to be sure when a currency is misaligned, let alone by how much.

...There are three main ways of determining the “correct” value for a currency. The oldest is based on the theory of purchasing-power parity (PPP): the idea that, in the long run, exchange rates should equalise prices across countries (The Economist's Big Mac index is a crude version of this).

...A more popular definition of the fair value of a currency is the exchange rate that corresponds to a trade position considered “sustainable”. Thus China's large and rising current-account surplus is seen as hard evidence that the yuan is severely undervalued.

...Stephen Jen of Morgan Stanley prefers a third method of calculating the fair value of a currency: the so-called behavioural equilibrium exchange rate. This does not attempt to define long-term economic equilibrium. Instead it analyses which economic variables, such as productivity growth, net foreign assets and the terms of trade, seem to have determined an exchange rate in the past, and then uses the current values of those variables to estimate a currency's correct value.

Morgan Stanley uses no fewer than 13 models to value currencies... [According to these models,] the yen might be anything between 18% overvalued and 29% undervalued, depending on which model you trust. But nine of the 13 models signal undervaluation, with the median value suggesting the yen is 15% too cheap—the weakest currency in the chart. What about the yuan? Morgan Stanley uses only four models to estimate the yuan's fair value, of which the median valuation suggests it is only 1% undervalued against the dollar—not the answer Congress wants. Another surprise is that most other emerging Asian currencies now look overvalued.

None of these numbers should be taken as precise, but two conclusions follow. The first is that, in theory at least, there is a stronger case for declaring Japan's currency to be misaligned than China's. It is bizarre that the weakest currency is the yen, when Japan is the world's largest net creditor and had faster GDP growth than either America or the euro area in the first quarter. The problem, says Mr Jen, is that traditional models for estimating the fair value of currencies still focus mainly on the real economy, but increased cross-border investment flows (based partly on nominal interest-rate differentials) are now much more important. The second awkward conclusion is that the highly subjective nature of assessing currency misalignment will make it very hard for America or the IMF to agree on whether a currency is out of line.

The extent of any existing yuan misalignment is indeed open to question, and reasonable people (and models) can disagree substantially. That's why to me it makes more sense to think about whether government intervention in the currency markets are acting to depress or prop up the value of a currency. If the current market value of a currency is only possible with government purchases or sales of the currency, then that is prima facie evidence that the current market exchange rate is somehow different from its free-market equilibrium rate.

That is slightly different from saying that it is different from some sort of "fundamental" or "fair" exchange rate, because market participants may still bid the price of a currency away from that underlying rate, but it's a lot easier to conceptualize and measure.

Rectifying Market Failures

This is interesting. It seems to be a case where government regulation has actually caused the market (in this case, the market in investment advice) to operate more efficiently.

Wall Street Analysts Proving More Bearish Than Ever

June 18 (Bloomberg) -- Never in the history of Wall Street have analysts been so bearish. The good news is they're also getting it right more often, helping make investors richer by betting against corporate America.

Thank the regulatory hammer of former New York Attorney General Eliot Spitzer. In 2003 he forced 10 big firms to separate investment banking from research to avoid the conflicts of interest that tempted analysts to keep their reports upbeat.

"The industry has changed: you're not anathematized if you come out with a negative opinion," said Robert Stovall, whose work on Wall Street the past five decades included stints as a strategist at the securities unit of Newark, New Jersey-based Prudential Financial Inc. and research director at Nuveen Corp. in New York. "It used to be that sell recommendations were frowned upon. I even worked at firms where the CEO said, 'I never want to see a bearish word on my stationery.'"

That transformation has helped investors following analysts' advice to beat the market. Nine of those 10 firms have been accurate the past two years, according to Investars, which tracks analysts' performance.

It's old news that government intervention can help remedy market failures. But the fact that this principle seems to hold true even on Wall Street - the emotional center of the laissez-faire economic world-view - is fascinating, and carries important implications for markets where market-failures are much more obvious.

Oh, and in case you were wondering: Yes, I'm thinking about health care.

New Economic Data

There was a lot of new economic data released today. The two most widely anticipated were the news releases on Consumer Prices and Industrial Production.

The first picture shown below sums up the story as far as consumer prices go. Energy prices have gone up a lot, so the overall CPI looks bad, rising at a 5.5% annualized rate over the past six months - the fastest rate of inflation since the oil-price spike in the fall of 2005, following hurricanes Ivan and Katrina. So far, that inflation has not fed through into faster inflation in non-energy products, but recent history suggests that we should probably expect an uptick in core inflation in coming months.



Industrial production data also tells a somewhat unsettling story, illustrated below.



Real output by US industry stagnated last fall, and has failed to resume regular growth since then. Over the past three months production has been growing at a meager 0.6% annualized rate; as a result, capacity utilization remains only moderate. That's good news for inflation pressures, but bad news for the job market and future business expansion.

More Care, Not Better Care

This article contains nothing that is the slightest bit surprising, but it still provides a nice illustration of some of the problems with the US's health care system:

In Health Care, Cost Isn’t Proof of High Quality

In a Pennsylvania government survey of the state’s 60 hospitals that perform heart bypass surgery, the best-paid hospital received nearly $100,000, on average, for the operation while the least-paid got less than $20,000. At both, patients had comparable lengths of stay and death rates.

But the best part of the article is a single sentence that comes about half-way through the piece. It is the sentence that cleanly and concisely encapsulates the biggest structural flaw in the US health care system:

[S]o hospitals are rewarded for providing more care, not better care.

I can't sum it up any better than that.

Action in Long-Term Interest Rates

Long-term interest rates have been in the news in the US financial world in recent days. For example:

Bond Yields Soar, Driving Shares Down

The cost of borrowing headed higher yesterday and drove the stock market down sharply.

Yields on the 10-year Treasury note — a key benchmark that influences nearly all long-term interest rates, including home mortgages — hit a five-year high, climbing to 5.248 percent yesterday, up from 5.154 percent late Monday as investors sold off notes and bonds.

Treasury yields, which have been rising steadily since the end of April and have started to weigh on the stock market, quashed an early afternoon stock rally. The Standard & Poor’s 500-stock index, a broad gauge of the market, closed down 1.07 percent, or 16.12 points, to 1,493 points; and the Dow Jones industrial average dropped 1 percent, or 129.95, to 13,295.01 points.

First, a little perspective. Yes, the rise in long-term interest rates in recent weeks has been fairly impressive. But as the following chart illustrates, this sell-off in the bond market is not much different (so far) from a number of previous short-lived surges in interest rates, and could just as easily be reversed over the coming months. In the grand scheme of things, long-term interest rates in the US are still substantially below where they were during the last economic expansion.



That said, there are a couple of interesting things to note about the current phenomenon. First of all, the recent rise in long-term rates - together with a bit of a fall recently in short-term rates - means that the yield curve has abruptly become "un-inverted". In other words, short-term interest rates are now no longer higher than long-term rates, in contrast to the situation for most of the past year. There are a number of different possible interpretations for this change, including the possibly contradictory beliefs that the Fed is soon going to have to start reducing interest rates to prop up economic growth, or that the economy is poised for a rebound that would increase the demand for loanable funds.

A second point of interest is that the current run-up in long-term interest rates is entirely due to a rise in real interest rates, rather than a rise in inflation expectations. Using the 10-year inflation-indexed bond to serve as an estimate of the real interest rate, we can estimate inflation expectations as the difference between that real interest rate and the nominal bond yield (a procedure that has a few minor problems with it due to liquidity issues in the TIPS market, etc., but one that still conveys the general idea). Doing that reveals that financial market participants still (on average) expect inflation over the next 10 years to be in the neighborhood of 2.3%-2.5% - right where those expectations have been for years. The real interest rate, on the other hand, has jumped by almost three-quarters of a percentage point in the past few weeks, as the following chart shows.



One big question on a lot of people's minds is how big the China factor may be. If this movement in US interest rates is indeed being driven largely by concerns about China's economy, then this could be an important moment in US financial history, i.e. the point in time when we really started seeing China's direct influence on US interest rates. Of course, given how difficult to gauge why financial market participants are doing the things that they're doing, we may never know for sure if that's the case.

Inflation in China

This news story is making headlines in the business press this morning:

China's Inflation Accelerates, Adding Rates Pressure

June 12 (Bloomberg) -- China's inflation accelerated at the fastest pace in more than two years in May as pork prices soared, increasing the likelihood that interest rates will be raised.

Consumer prices rose 3.4 percent from a year earlier, the National Bureau of Statistics said today. That was more than the 3.3 percent expected by economists. April's inflation rate was 3 percent, matching the central bank's 2007 target.

Meat prices surged 26.5 percent, helping to push inflation above the target and adding to concern that the world's fastest- growing major economy may overheat. Inflation is outpacing returns on bank deposits, encouraging households to put money into a stock market that the government is trying to cool.

"Today's number and the stock market for the past few days make a stronger case for a rate hike," said Wang Qing, chief China economist at Morgan Stanley in Hong Kong.

The reason that this news is of such interest to the US is because of the implications it holds for China's monetary policy, which faces increasing pressure to cool down the Chinese economy. The classic ways to do that would be to raise domestic interest rates, and/or to allow the currency to appreciate against the dollar. Either of these steps could cause a reduction in official Chinese purchases of US bonds, thus contributing to a rise in interest rates in the US.

On the other hand, in the past the Chinese authorities have used more quantitative means to control the speed of the economy - i.e. urging (commanding?) more or less lending by the banking sector. That route implies a smaller impact on the US economy (US interest rates would be less directly impacted), which is why observers in the US have been paying close attention to every move by the Chinese monetary authorities.

One thing is for sure, though: month by month, it seems increasingly clear that China's government will need to take bigger steps to cool the economy than they have so far.

Update on Housing Prices

Last week (while I was away on vacation) the OFHEO released their quarterly estimates of housing prices in the US. While it isn't a perfect measure of house prices, I think it's a pretty good one. Since it tries to track what happens to the price of the same house over time as it is bought and sold, it avoids some of the problems of prices measured by the median sales price. Furthermore, it is separately calculated for each Metropolitan Statistical Area (MSA), which provides a lot of texture to our analyses of the housing market.

At any rate, here's a picture of what the most recent data shows for some of the US's largest coastal cities - the ones the enjoyed the biggest price appreciations during the period 2000-05.



In a rather remarkable display of synchronization, all of these cities are showing rapidly falling rates of price appreciation. Boston, San Diego, and San Francisco are now registering negative year-over-year real price changes, and it seems likely that in three months we'll be able to add New York, L.A., and Washington DC to that list. Note that the states that contain these particular MSAs account for about 40% of the population of the US.

On the other hand, there is another 60% of the US that lives in interior states that did not go through the most recent big price appreciation. Unfortunately, it seems that house prices are leveling off - and in some cases, falling - in those places, too.

And as for the longer view: the last picture shows the 2-year price change (to better smooth out some quarterly variability) in major coastal cities of the US over the past twenty years.



Based on past experience, it seems very reasonable to think that we're only in the very early stages of a many-year-long price correction. Don't think about the housing market turning around in 6 months, or even in a year or two; I'd suggest that you think about it gradually falling and leveling off over the course of the next 5-7 years or so. So be patient.