"Kee" Points with Jim Kee, Ph.D.

Markets versus economists? According to the Chicago Mercantile Exchange, Federal funds futures indicate a 23% likelihood that the Fed will raise rates this week during its September FOMC meetings. CME futures contracts (as they are called) reflect bets by investors and traders on central bank policy, and are used to hedge exposure to interest rate changes. The 23% likelihood reflects a big decline in rate hike expectations, as it was 45% only a month ago. Interestingly, the latest Wall Street Journal monthly survey of economists puts the odds of a September hike around 46%, which is down from 82% in August. That’s about where I am – a coin toss – but I also like markets (CME futures) over economists (WSJ survey). That suggests that the CME futures will be right and that there won’t be a hike this week. Futures markets aren’t perfect though, so it will be interesting to see if they get it right on this one. If the Fed raises rates, I’ll give the win to the economists. If the Fed stands I’ll give the win to the futures market.


The reason that the Fed might hold off, in addition to the fact that US economic data and inflation data are well below previous rate-hike levels, is concern over slowing in China. There is uncertainty over China’s impact on emerging markets, and of the impact of emerging markets on global and US growth. That is what’s creating the Fed’s quandary. Back in the late 1990s, during the ‘Asia meltdown,’ I was confident that emerging markets couldn’t pull the rest-of-the world into recession (it was always the other way around). I feel that way today, but with less confidence, both because emerging markets are a larger share of global output, and because US growth is below average. The fact is that to date we have never had an emerging markets-led recession. Emerging markets have been one of the big landmines for investors this year, the others being Puerto Rican bonds (and the funds that hold them) and energy. If you have been following Kee Points, you know that we at STMM have had no direct exposure to emerging markets or to Puerto Rican bonds, and we have been cautious on energy investments for some time.


Budget note: A big issue in the press lately has been the declining US budget deficit (excess of expenses over revenues), which now stands at 2.4% of GDP, down from last year’s 2.9% (it peaked at 9.8% of GDP in 2010). Revenue growth has outstripped the growth of outlays in recent years, but a lot of the decline can also be attributed to low interest rates and hence ultra-low (WSJ) borrowing costs. The late James Buchanan, who won the Nobel Prize in economics for his work in “public economics” (the study of governments), used to argue that when it came to borrowing, what’s true for individuals is true for governments. Specifically, whether or not incurring a debt leads to a reduction in wealth depends upon whether the debt (borrowing) is used to create an off-setting asset to service the debt. For example, if an individual borrows $10,000 and just spends it all in Las Vegas, his or her net worth has declined by $10,000 because a debt or liability has been incurred with no off-setting asset. On the other hand, if the $10,000 was used to start a business (or learn software coding, or buy a pizza oven, etc.) then an asset has been created to service the debt. And so it is with governments, argued Buchanan. The point is that it is not debts and deficits that matter per se, but rather how those borrowed funds are used.


So borrowing to finance consumption spending is different from borrowing to finance investment. That is why so many desired government spending programs are called investment programs. And many are, particularly “infrastructure” projects like roads and bridges and power grids. But it is not that simple, because sometimes the same asset can vary dramatically in cost. That was the conclusion of a study produced by the non-partisan Common Good organization and cited in last week’s Wall Street Journal. The report, “Two Years, Not Ten Years: Redesigning Infrastructure Approvals,” concluded that permitting delays cost the country over $3.7 trillion, or twice the $1.7 trillion needed to modernize the country’s infrastructure. The point is that every dollar spent on infrastructure isn’t always buying a dollar’s worth of investment or creating an asset worth a dollar. That makes the evaluation of government debts and deficits a lot harder. From a political perspective, transferring income for consumption spending results, conceptually, in perhaps a smaller pie but a more equitable distribution of income. Investment spending results in a larger pie but perhaps a less equitable distribution of income. That, in my opinion, is the 2016 election battle in a nutshell.


Finally, in prior Kee Points I have talked about China’s exchange rate policy, which went from being fixed to the dollar to pegged to the dollar within a certain range or band (often called a “crawling peg” – China also had an interim ‘managed float period from 2005-2008). Markets like certainty, which they get with a fixed exchange rate and to some extent from a free or floating exchange rate, which adjusts to market forces rather than to the discretion of monetary authorities. But pegged rates create uncertainty, as markets always have to guess when and if the peg will change. China is transitioning from a fixed rate to a flexible rate and, during the transition, finds itself in the undesirable middle. Since it “widened the band” around which the yuan would trade relative to the dollar in August (yuan are now worth fewer dollars), it has had to spend a lot of its foreign exchange reserves (namely dollars) in order to prevent its currency from falling even more dramatically against the dollar. The Financial Times summed it up well last week:


“They (China) have gone from a credible peg that cost them almost nothing to a weak peg that nobody believes and that is costing them more than $10 billion a day to defend – they’re paying huge sums for something they had for free just a few weeks ago.”


Of course, China figured that its strong currency was costing it money in terms of lost exports, so the move to widen the trading band is not as irrational as is often reported…assuming they can regain credibility!