Abn Amro Letter Attacks Low Rates And Inflation

[El_Pirata]

From the FT:

Sir, Inflation has been surprisingly subdued in recent years as the correlation between inflation and commodity prices, unit labour costs and the domestic output gap has weakened. There are several reasons for this.

Globalisation, more transparent markets and the millions of people in emerging economies joining the global workforce are among the favourites. The question is whether this justifies sustained low real interest rates while asset prices are rising strongly.

Low interest rates are considered good because they foster economic growth, while high interest rates are seen as bad. This is a mistake. The price of money is arguably the single most important price in our economic system.

Price money wrongly and you cause serious distortions. Central banks that build popularity on sustained low interest rates are like parents who give their children ice cream instead of cod-liver oil. Remember how the Bundesbank was "disliked" in the good old days of stable money?

Central banks have been struggling with asset price inflation for some time. Most of them consider asset prices only in so far as they threaten price stability through wealth effects. It is unclear to me why asset price inflation is not simply considered inflation and dealt with accordingly.

There are two main reasons why inflation is bad. First, inflation impairs the signalling function of relative prices, leading to a sub-optimal allocation of resources across the economy. Asset price inflation does the same. Sharply rising asset prices attract disproportionate amounts of capital and sometimes brains.

Second, inflation leads to an unintended and undesirable redistribution of wealth. So does asset price inflation.

Some argue that property prices in countries such as Ireland, and perhaps other asset prices as well, are driven by structural factors, such as demography in the case of property, making such assets scarcer.

Their rising prices merely reflect a change in relative prices. I could accept this argument if I could also find a sufficient number of prices that are falling to offset the rise in these asset prices. If a change in relative prices consists only of some prices rising faster than others, then we have inflation, don't we?

Central banks are reluctant to include asset prices in monetary policy decision-making. They argue that they cannot determine the right level of asset prices any better than the market. Funny that, as central banks have no such reservations about their abilities when it comes to determining the price of money.

In addition, they are not sure how to fight asset price inflation. To me, it seems relatively simple. A combination of strong growth, modest consumer price index inflation, easy money, strong credit growth and strong asset price increases suggests that monetary conditions are too loose. The economy in the eurozone is recovering and growing at a rate close to its potential. In spite of two European Central Bank rate increases, real official interest rates are barely positive. This is asking for trouble.

As far as the eye can see, euribor futures contracts are pricing in money rates below 4 per cent. Assuming a 2 per cent inflation rate, that means rates will peak in this cycle well below their long-run average in real terms. If this happens, asset markets will continue to bubble. From time to time, those bubbles will inevitably pop.

Han de Jong,

Chief Economist,

ABN Amro Bank,

Amsterdam, The Netherlands

[RichM]

What a good letter. Thanks Pirata.

[jonpo]

well said....

[El_Pirata]

I am not generally much of a conspiracy-theorist, but letters like these do not get sent by people like Mr De Jong purely for the fun of it.

Add this to the general tone of the FT this week - a rash of special reports on inflation (why now when it is still not really showing up in data), the Spanish bubble, etc and it all looks a bit like "they" are preparing us for something.

[RichM]

I don't know how close the FT is to the establishment (i.e. New Labour etc) but maybe they have a feel for international factors in a way that the MPC/BoE don't?

[AFineMess]

As far as the eye can see, euribor futures contracts are pricing in money rates below 4 per cent. Assuming a 2 per cent inflation rate, that means rates will peak in this cycle well below their long-run average in real terms. If this happens, asset markets will continue to bubble. From time to time, those bubbles will inevitably pop.

Han de Jong,

Chief Economist,

ABN Amro Bank,

Amsterdam, The Netherlands

Well, that's very interesting. So euro banks expect money lending rates to be below 4%, despite the inflationary pressures on the economy identified by Mr. Jong and others. Does anyone have an explanation of this? Why does the market believe this? Are they all wrong, is it some kind of herd instinct, or do they know something we don't? Quite clearly it's not only HPC enthusiasts who think something is strange here, otherwise why would he write this letter.

[Time to raise the rents.]

Writen like a school boys assignment.

But I did like the point that rates will peak at lower than their long run average.

Aren't you lot convinced yet?

[CrashIsUnderWay]

the market is never wrong.

[Marina]

'Top economist' is an oxymoron.

When someone agrees with you - you think they're really clever, right on the money.

When they don't agree with you - you think they are a fool.

[geneer]

Writen like a school boys assignment.

But I did like the point that rates will peak at lower than their long run average.

Aren't you lot convinced yet?

irrelevant.

[El_Pirata]

But I did like the point that rates will peak at lower than their long run average.

I think you are missing the point. He is saying it would be a bad thing if they did. This and numerous articles elsewhere are making the case and preparing the public mindset for a bout of serious rate hiking.

[FollowTheBear]

Writen like a school boys assignment.

But I did like the point that rates will peak at lower than their long run average.

Aren't you lot convinced yet?

If interest rates were only at 5.5% this is still 20% higher than today. House prices now reflect affordability at 4.5% (with just a little bubble blowing thrown in) and the lower interest rates are the more significant each small rise becomes.

And once prices start falling issues of affordability are irrelevant.

[brainclamp]

The key thing to know is that the targeting of CPI - (a fiddled with basket of nonsense, stripped of real unavoidable spending costs - utility bills, council taxes etc...) - which under-represents real inflation, is a very new manner of running moneytary policy.

Prior to these fake inflation targets, it wasn't inflation that was targeted, but the root cause of its horrors - the money supply. Thats because inflation targeting with a far more robust inflation measure than today, resulted in the horrific inflation of the 1970s, which eventually required massive increases in interest rates to restore the fabric of western civilisation.

New Zealand was the first country that adopted this lax inflation targetting regime. It set very low interest rates, giving immense amounts of credit from savers to borrowers, happly ignoring the subsequent huge asset price inflation. It settled on an watching an inflation measure which resulted in the inevitable blow up of all economic measures from a large torrent of newly printed money being poured into the economy.

New Zealand now looks like a basketcase economy. Property and land prices are in the stratosphere creating a huge wealth effect. People regularly spend 12% more than they earn. Its trade deficit is 10% of its annual output, its retail inflation rate - even with the fake measure, is shooting up well beyond 3%. Local taxation is rising by over 10% per year. Oh - yes its IR's are still far too low at 7.5% as real inflation is above this rate.

[OnlyMe]

Brainclamp,

Spot on - see my post on inflation/small shops.

[AFineMess]

Writen like a school boys assignment.

But I did like the point that rates will peak at lower than their long run average.

Aren't you lot convinced yet?

What a shame that ABN Amro Bank is so short sighted as to employ a schoolboy as their Chief Economist! Still they must have some pretty intelligent schoolboys in the Netherlands. I don't remember writing about inflation and money supply issues when I was at school. Ahem... (I assume that English is Mr. Jong's second language - and I thought it was pretty clearly expressed.)

But I'm convinced! Convinced that something isn't right, that is.

EDIT: come on TTRTR, let's have a quick essay from you too so we can see a master in action. In Dutch, of course.

Edited June 10, 2006 by AFineMess

[El_Pirata]

The question is, what does the banking sector as a whole want now?

Does it want ongoing low (in reality negative) rates that cause inflation go against its interests as a sector, as a net creditor? Does it want the risk spread to be continued to be squeezed, meaning it makes less and less money from investing in riskier assets?

I believe we've reached the stage in the cycle where low interests have ceased to benefit the sector, and behind the scenes there is lobbying for serious hikes going on. This of course will be resisted by politicians as it goes against their interests. Look at the tension between Trichet and European finance ministers. But at the end of the day the banks call the shots.

[RobertPaulson]

ABN AMRO owns Hollandse Bank Unie (HBU), which is the largest gold bank in the netherlands and is likely to have a big short on its books. Perhaps puts a different perspective on nervy letters to the FT from Chief Economists.

[AFineMess]

ABN AMRO owns Hollandse Bank Unie (HBU), which is the largest gold bank in the netherlands and is likely to have a big short on its books. Perhaps puts a different perspective on nervy letters to the FT from Chief Economists.

Very interesting too. I don't really remember how shorting works, but I take it you're saying it wouldn't be a very good thing for them right now.

How would you know if they had a big short on their books, or when would you find out?

[BandWagon]

The key thing to know is that the targeting of CPI - (a fiddled with basket of nonsense, stripped of real unavoidable spending costs - utility bills, council taxes etc...) - which under-represents real inflation, is a very new manner of running moneytary policy.

In the 70's unemployment was considered the most terrible social ill, and goverments tried to solve this by printing money.

They dumped the Bretton-Woods agreement and Inflation came roaring through.

Now we have inflation targeting, they found out the hard way that rampant inflation was even worse than high unemployment.

I just get the feeling the current idea of targeting retail inflation is just the latest in a long line of monetary and social experiments.

We're just going through the current "CPI" fad, which has helped cause this massive asset price distortion.

When this asset bubble has blown, what will be next?

[Immigrant]

Writen like a school boys assignment.

On the contrary, I am really impressed with his ability to express himself clearly and in plain English on a subject that is usually made very hard to understand.

Read any schoolboy essays lately? They are the complete opposite - pompous, confusing, puerile.

As Winston Churchill said: "Big men use small words, small men use big words" or something similar.

Sorry this is not relevant to the discussion but it is such a pleasure to see good plain English from an economist. I couldn't let your comment pass.