Aurelia Butler

The writer is a former chair of the US Federal Deposit Insurance Corporation and a senior fellow at the Center for Financial StabilityUS Federal Reserve chair Jay Powell has expressed deep admiration for Paul Volcker, his legendary predecessor who defeated the high inflation that plagued the US economy from 1965 to 1982. Then, as now, Volcker was fighting more than a decade of loose monetary policy, combined with supply shocks stemming from geopolitical turmoil. But though he extols the man, Powell is deviating from Volcker’s methods. This is perhaps why inflation continues to accelerate, now topping 9 per cent in the US and spreading rapidly throughout the world.While Volcker fought inflation by restraining growth in money supply, Powell’s favoured approach is aggressive interest rate hikes. He also seems ready to lower rates if we enter recession. The recent bond rally and the Fed’s own stress tests of banks support this view. But Volcker had to keep monetary policy tight through two recessions to finally beat inflation. If he is to tame inflation expectations, Powell must strongly signal that he is prepared to do the same. Each year, the Fed puts the nation’s largest banks through stress tests to determine whether they can withstand adverse economic environments. The most severe scenario tested by the Fed this year assumed a deep recession that would cause consumer prices to drop from 8.25 per cent to 1.25 per cent, and short-term interest rates to go to zero. But the Fed did not try out the scenario that most concerns many experts: the economy plunges into a deep recession, but consumer prices and interest rates remain high. This was exactly the real-life “stagflation” scenario confronted by Volcker when he became Fed chair in 1979 and something that we should all be thinking about now. Volcker kept monetary policy tight through the recessions of 1980 and 1981-82, despite populist revolt, bipartisan demands for his firing, even a public call from the US Treasury secretary to ease money supply, which he famously dismissed as an “unusual communication”. During this time, unemployment rose to double digits, but he held firm until inflation finally fell, from more than 14.8 per cent in 1980 to less than 5 per cent by the end of 1982. His predecessors had pursued “stop and go” policies, continually raising rates when unemployment was falling and lowering them again when jobless levels rose. This had hurt the Fed’s credibility, whipsawed markets, and further entrenched inflation in the economy. Volcker wisely and bravely refused to revert to that tactic.Given this history, it would be folly for Powell and the Fed to embrace “stop and go” again today. They should also follow Volcker’s example by restraining money supply. Too much money chasing too few goods and services lies at the heart of this and every other inflationary moment. Regrettably, while the Fed started raising rates in March, it waited until June 1 to start draining excess cash from the system. It announced it would shrink its $8.4tn domestic portfolio by up to $47.5bn each month, but it had only declined by about $28bn as of July 13. Both Powell’s approach of raising rates and Volcker’s of restraining money supply lead to tighter monetary conditions. But the current approach involves the Fed, not the markets. The Fed sets rates and makes judgments about the size and pace of the increases. It then implements its policy by increasing the rate of interest it pays large financial institutions to keep their money with the central bank instead of lending it out. For banks, this means higher rates on their Fed reserve accounts. For other financial intermediaries such as money market funds, it means higher rates on certain short-term Treasury transactions called “reverse repos”. These institutions will be reluctant to lend unless their expected returns exceed the risk-free rate they are getting from the Fed. The Fed’s bill for this interest is high and growing. At the end of June, reverse repo balances were paying a rate of 1.55 per cent, while reserve balances paid 1.65 per cent. (if only we could all get those rates on our bank accounts). In contrast, to take money out of the system, the Fed simply sells some of its securities or lets them mature without reinvesting the proceeds. This leads to higher rates, as private investors become more dominant in markets from which the Fed is withdrawing. Importantly, the markets, not the government, drive the rate increases. This avoids the unseemly appearance and excessive cost of the Fed essentially paying institutions not to lend. For many years, the Fed has unwisely paid little attention to the huge volume of money its accommodative polices have created. It now needs to follow Volcker’s example and attack excess money supply head-on. It should replace the shock and awe of major interest rate hikes with new targets based on money supply, and aggressively shrink its portfolio, selling securities at a loss to do so, if necessary. It should also conduct new stress tests to assure the public that banks can withstand severe stagflation. We are fortunate that Powell is a courageous leader — now he must mirror Volcker’s strategic skilfulness as well. More

Eurozone business activity has gone into reverse for the first time since February 2021 after companies were hit by falling orders and rising prices, fuelling economists’ expectations of a recession this year.Fears that the 19-country single currency zone is heading for a sharp downturn were reinforced by S&P Global’s flash eurozone composite purchasing managers’ index for July, which on Friday showed output and new orders both fell for the first time since coronavirus lockdowns in early 2021.The outlook for the eurozone has worsened in recent weeks after the European Central Bank raised interest rates more than expected on Thursday, while Russia is squeezing natural gas supplies to Europe, Italy is in the grip of a political crisis and record inflation is eroding household spending.The composite PMI, which measures activity at both services and manufacturing companies across the eurozone, fell to a 17-month low of 49.4, down from 52 in June. Economists polled by Reuters had expected a reading of 51.It is the first time the index has fallen below the crucial 50 mark that separates growth from contraction since February 2021, when businesses were still grappling with Covid-19 restrictions.The euro slipped on the report, down 0.7 per cent against the US dollar to $1.015. German 10-year bond yields also fell to 1.07 per cent, their lowest since May, on growing expectations that a recession will cause the ECB to stop raising rates sooner than expected. Italy’s 10-year bond yield also fell, but the spread with Germany widened to 2.3 percentage points, close to last month’s three-year high.Melanie Debono, an economist at Pantheon Macroeconomics, said: “An economic slowdown could well mean that the central bank lifts rates by less than markets expect, but further hikes are coming, all the same.”The PMI score for the eurozone manufacturing sector fell more than expected to 49.6, while the reading for the larger services sector indicated that it managed to cling on to slight growth with a reading of 50.6.“The eurozone economy looks set to contract in the third quarter as business activity slipped into decline in July and forward-looking indicators hint at worse to come in the months ahead,” said Chris Williamson, chief business economist at S&P Global Market Intelligence.Factories cut back on procurement after they experienced “the largest build-up of unsold finished goods ever recorded by the survey”, caused by lower than expected sales and weaker order books, S&P Global said. It added: “Consumer-oriented services such as tourism and recreation, media and transportation saw either stalled growth or outright declines.”Companies took a more cautious approach to hiring staff and business expectations for the year ahead fell to their lowest level since May 2020. Input inflation pressures and supply bottlenecks eased, but companies continued to increase their prices sharply.The ECB published its survey of professional forecasters on Friday, showing they had cut their eurozone growth expectations and raised them for inflation. The 56 respondents predicted growth in gross domestic product of 1.5 per cent next year, down from a forecast of 2.3 per cent in April. Their prediction of 2.8 per cent growth for this year was down 0.1 percentage point from their previous forecast.They expected inflation to peak at 7.3 per cent this year and remain above the ECB’s 2 per cent target for the next two years, while raising their long-term forecast of price growth from 2.1 to 2.2 per cent. Analysts said this was likely to have contributed to the ECB’s 50 basis point rise.Consumer confidence in the bloc fell to a record low this month as households confronted soaring energy and food prices, according to the European Commission’s latest survey published on Wednesday. More

FRANKFURT/HELSINKI/BERLIN (Reuters) – Uniper on Friday received a 15 billion euros ($15.2 billion) bailout from the German government to save the gas importer that is the biggest casualty of Europe’s energy crisis so far.The state rescue caps weeks of negotiations between Germany and Finland, which controls Uniper’s majority shareholder Fortum. It provides a lifeline after falling Russian gas supplies drained the company’s finances.Uniper shares fell 18% following the announcement. Fortum shares were 1% lower.As part of the deal, the German government will take a 30% stake in Uniper. Fortum’s stake in Uniper will be diluted to 56%, down from around 80% currently as a result.”We are living through an unprecedented energy crisis that requires robust measures,” Fortum CEO Markus Rauramo said, adding the deal reflected the interests of all parties. “We were driven by urgency and the need to protect Europe’s security of supply in a time of war.”Under the agreement, Germany will buy 157 million new ordinary Uniper shares for 267 million euros and make available capital of up to 7.7 billion against issuance of mandatory convertible instruments.In addition, state-lender KfW will raise an existing credit line by 7 billion euros to 9 billion in total.The package still needs approval from the European Commission, and requires confirmation of Uniper’s investment grade rating by agency S&P. The deal also needs approval by Uniper shareholders.It also carries certain conditions, including Uniper withdrawing a lawsuit against the Netherlands over its coal phase-out as well as a commitment by the Duesseldorf-based group to not pay dividends for the duration of its stabilisation period.Following the rescue, Uniper, Fortum and the German government will work on a long-term solution to reform the company’s wholesale gas contract architecture, which has exposed the group to billions in losses.The parties intend to agree on the longer-term solution by the end of 2023, they said.A drop in Russian gas supplies meant that, rather than being able to rely on long-term price agreements, Uniper had to buy expensive gas on the spot market to make up for the shortfall.Friday’s agreement will allow Uniper to pass on higher gas prices, which have risen eight-fold as a result of Moscow cutting supplies, to customers, but German Chancellor Olaf Scholz said the government was looking at relief measures.($1 = 0.9847 euros) More

It was the fourth cut this year. In the immediate aftermath of Moscow’s despatch of armed forces into Ukraine on Feb. 24, the central bank had hiked its key rate to 20% from 9.5% in order to reverse a plunge in the value of the rouble. In a Reuters poll earlier this week, most analysts had expected a smaller cut of 50 basis points from 9.5%.”The Bank of Russia will consider the necessity of a key rate reduction in the second half of 2022,” it said in a statement.The rouble extended losses, sliding to 58.13 against the dollar minutes after the rate decision, from 57.57 seen shortly before.”Apparently the regulator has decided to act more aggressively than previously thought, as inflation is falling faster than in forecasts,” analysts at Promsvyazbank said.Annual inflation slowed to 15.5% as of July 15, the central bank said, lowering its 2022 inflation forecast to 12-15% from its previous assessment of 14-17%. It reiterated its hope that inflation would fall to its 4% target in 2024.High inflation dents living standards and has for years been one of Russians’ main concerns, but the economy needs stimulation in the form of cheaper credit to address the negative effects of sweeping Western sanctions.The central bank revised its economic forecasts for this year, saying gross domestic product would contract 4-6%. In late April, it had said GDP would shrink 8-10%.”The external environment for the Russian economy remains challenging and continues to significantly constrain economic activity,” the central bank said.”Consumer activity remains subdued, but is beginning to recover, including amid a gradual increase in imports of consumer goods.”In 2023, the economy will contract by 1-4%, the central bank said, revising its earlier forecast that the economy would shrink by up to 3% next year. Central Bank Governor Elvira Nabiullina will shed more light on the bank’s forecasts and policy in a media briefing at 1200 GMT.    The next rate-setting meeting is scheduled for Sept. 16. More

BRASILIA (Reuters) – Brazilian fixed-income markets are pricing in the highest risk levels in years, raising red flags among investors and government officials who see little relief in sight.While global interest rate hikes and recession risks have put all emerging markets under pressure, Brazil faces special scrutiny after Congress cracked open a constitutional spending cap to allow a burst of election-year expenditures.”The problem is the change in the spending cap,” said an Economy Ministry official, who requested anonymity to discuss the situation openly. “It weakens the reading that the fiscal situation will be under control in the coming years.”Even with positive surprises such as strong June tax revenue data on Thursday, the official said Brazil’s yield curve remains under pressure as investors brace for the worst.Both major presidential candidates on the ballot in October – leftist former President Luiz Inacio Lula da Silva and right-wing incumbent Jair Bolsonaro – have signaled they plan to extend this year’s boost in social spending into next year.”It’s a fiscal bomb,” said Sergio Goldenstein, chief strategist at Renascença DTVM. “Risk premiums look high, but there is little room for a relevant drop.”The real rate for inflation-linked government bonds has been running at the highest level since late 2016, while Brazil’s five-year credit default swaps are at highs last seen at the beginning of the pandemic in March 2020. (GRAPHIC: Yields climb for Brazil gov’t inflation-linked bonds – https://fingfx.thomsonreuters.com/gfx/mkt/klpykyjrgpg/juro%20real%205%20anos%20ntnb.PNG) Concerns about Brazil’s credit profile come as commodity shocks from the war in Ukraine rattle the global economy and contribute to inflation, prompting rich nations to start raising interest rates.”All the credit spreads in the world are opening, our bonds are not immune to that,” said Ronaldo Patah, chief strategist at UBS Consenso.In fact, Brazil’s strong exports of grains, oil and iron ore give it some advantages compared to other emerging markets riding out the current surge in commodity prices, independent of the political risks in Brasilia now rattling investors.Brazil’s central bank also got an early start hiking rates compared to most peers, raising its benchmark interest rate from a record low 2% in March 2021 to 13.25% currently, with another hike penciled in for August to curb double-digit inflation. Most of the market has therefore been betting on rate cuts supporting growth from the middle of next year. However, risk premiums now point to rates above 13% in the yield curve for maturities ranging from 2024 to 2033, while mid-2023 vertices indicate an accumulated rate above 14%. “I am struck by this process of (yield curve) flattening that we are seeing at a very high level”, said the chief economist at Ativa Investimentos Etore Sanchez. (GRAPHIC: Brazil rate curve flattening – https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrbqmapm/inclinacao%2027%2023.PNG) Roberto Dumas, chief strategist at Banco Voiter, said Brazil is caught between a central bank tightening rates while the government is finding new ways to boost spending. “The more one accelerates, the more the other needs to step on the brakes. Everyone is projecting more and more that the Selic will rise more than expected”, said Dumas, who foresees the benchmark rate at 14.25% at the end of this year. More

According to Refinitiv Lipper, investors offloaded a net $13.79 billion worth of global equity funds, marking the biggest weekly outflow since June 15. (GRAPHIC: Fund flows- Global equities bonds and money market – https://fingfx.thomsonreuters.com/gfx/mkt/zgvomxlryvd/Fund%20flows-%20Global%20equities%20bonds%20and%20money%20market.jpg) The European Central Bank raised its benchmark deposit rate by 50 basis points, above its own guidance of a 25-basis-point hike, to rein in soaring inflation levels in the region.The U.S. Federal Reserve is also expected to raise policy rates by another 75 basis points at its meeting next week as it seeks to balance the risks of a stubbornly high inflation and the likelihood of a recession.U.S. and European equities funds booked withdrawals of $8.45 billion and $5.6 billion, respectively, although investors poured about $740 million in Asian equity funds.Sectoral data showed financial, consumer discretionary and metals and mining funds witnessed outflows of $995 million, $445 million and $416 million, respectively, but healthcare gained $511 million in inflows. (GRAPHIC: Fund flows: Global equity sectors – https://fingfx.thomsonreuters.com/gfx/mkt/mypmnlyaovr/Fund%20flows-%20Global%20equity%20sectors.jpg) Selling continued for a second week in global bonds funds as investors unwind $6.9 billion worth of holdings.Government funds saw outflows of $2.49 billion after 15 weeks of inflows, while net selling in short- and medium-term bond funds eased to a 15-week low of $1.88 billion. (GRAPHIC: Global bond fund flows in the week ended July 20 – https://fingfx.thomsonreuters.com/gfx/mkt/gkplgyklxvb/Global%20bond%20fund%20flows%20in%20the%20week%20ended%20July%2020.jpg) Meanwhile, investors sold money market funds worth $1.34 billion after two weeks of purchases.In the commodities space, net selling in gold and precious metal funds stood at $1.1 billion, a 63% bigger outflow than the previous week, while energy funds posted a fourth weekly outflow, valued at $180 million.An analysis of 24,388 emerging market funds showed investors jettisoned equity fund worth 2.04 billion, the biggest outflow in 10 weeks, while bond funds suffered a sixth weekly outflow of $2.13 billion. (GRAPHIC: Fund flows: EM equities and bonds – https://fingfx.thomsonreuters.com/gfx/mkt/mopanaoqlva/Fund%20flows-%20EM%20equities%20and%20bonds.jpg) More

OTTAWA (Reuters) – Canadian home prices are dropping fast after surging during the coronavirus pandemic, but that is offering little relief for consumers who face sky-rocketing rents and fading buying power as interest rates rise.Desperate would-be buyers found themselves caught in a frenzy of bidding wars for real estate during the pandemic, when home prices in Canada rose more than 50% in just two years. Now the competition has moved to rentals, with landlords demanding months of rent upfront and at times, even pitting tenants against one another to see who will pay more, according to real estate agents and media reports.The average rent on a 1-bedroom apartment in Canada is up 13.7% from the start of the year, data from Rentals.ca shows, with year-on-year rents surging 18.5% in Toronto and 19.2% in Vancouver. (GRAPHIC: Canada rents up sharply so far this year – https://graphics.reuters.com/CANADA-ECONOMY/RENT/gkvlgyqylpb/chart.png) The shift from frantic demand for homes-to-buy to homes-to-rent makes plain a broader issue with Canadian housing: that there simply is not enough of it, said Dan Scarrow, president of Macdonald Realty in Vancouver.”Higher (interest) rates are not destroying demand for housing, it’s just shifting the demand from buying to renting,” he said. “The demand just sloshes between renters and buyers, depending on where rates are so long as you have constrained supply.”The Bank of Canada has raised its policy interest rate to 2.5% now from 0.25% at the start of the year to fight inflation, which hit a near 40-year high of 8.1% in June. The rapid rise in borrowing cost has chilled the real estate market, pulling down Canada’s average home price by 18.5% from its February peak, according to data from the Canadian Real Estate Association.But softer prices do not appear to be helping would-be buyers, who now can’t get loans due to far higher mortgage qualifying rates. And that, in turn, is driving up rental demand.”Rents have gone insane because people have to have a place to live,” said Paul Eviston, a Vancouver-based real estate agent. “Demand on the rental market has really taken off as a lot of people that were would-be buyers are now forced to rent.”That hot rental demand has put a floor under condo prices in large cities, real estate agents said, with investors feeling confident enough to wait out price dips and some even looking to snap up more investment properties.Toronto agent Imran Khan just sold a loft apartment to an investor who was able to lease it out within days of closing. “I’ve listed properties for rent … and we get multiple offers, right. Like right away,” said Khan.Rising immigration and a post-pandemic return to urban centers will further bolster demand for city condos, said Khan. Landlords, for their part, are pushing for higher rents when units turn over, agents said.The shift from owned-homes to rental-homes is also starting to show up in Canada’s inflation data, with homeowners’ replacement cost increases easing sharply to 10% from 13% in April, while rent inflation remains near the 32-year high hit in April.Mortgage interest costs, which fell sharply as the pandemic took hold and rates were slashed, are now surging. Homeowners who took out variable loans or those with mortgages coming up for renewal are feeling the most pinch. “Right now is actually one of those unique moments where buyers, sellers, and renters are probably all struggling,” said Scarrow. “Usually, there is a winner. But I think this time it’s a struggle really for everyone.” More