Twenty Third Floor
Technical Business Advantage

Looks like my money is safe – Reserve Bank cut rates as predicted. Thinking about trying to predict for each MPC meeting then tracking my performance over time so I can be held accountable. Will mull over this first I am not that sure I’ll be sufficiently confident to stick my neck out in future!

It’s clear some people just don’t get that deflation is catastrophic from an economic perspective. You would have though that Japan’s lost decade (is it still only a decade?) would be sufficient warning.

Michael Pento from Euro Pacific capital writes about the options open Bernanke to stimulate the US economy through open market purchases given that interest rates are up against the zero bound.

He’s right about the options, but horribly misguided when it comes to wishing for deflation:

By keeping prices from falling more that they would have naturally, Fed intervention has created a burden.

The US public (and private) debt is such a significant portion of GDP, the correct answer cannot be to increase it as a percentage of GDP by deflating prices and keeping the nominal value of outstanding debt the same. Moreover, what the US needs is economic activity; encouraging everyone to leave their money in the bank because it increase in value every day and “nobody else is spending so deflation will continue” doesn’t sound like a success story to me. Downward price stickiness, particularly with wages (yes, even in the US) would add to the catastrophe.

Pent also raises the risk of hyperinflation:

…investors would be forced to once again abandon savings and chase runaway prices.

I don’t know how we went from fears of deflation to “runaway prices”. The challenge with this policy is to credibly promise moderate inflation for several years (depending on how strong your Ricardian views are).

Runaway prices are much easier to control than deflation. With inflation, we actually have a range of tools to use.

It’s unreal how many people have views on the economy that aren’t rooted in any economic theory at all.

From Stats SA

The headline inflation rate in July 2010 (i.e. the Consumer Price Index for all urban areas in July 2010 compared with that at July 2009) was 3,7%

The official inflation rate (i.e. the percentage change in the CPI for all urban areas in July 2010 compared with that in July 2009) was 3,7% at July 2010. This rate was 0,5 of a percentage point lower than the corresponding annual rate of 4,2% in June 2010 (i.e. the Consumer Price Index for all urban areas in June 2010 compared with that in June 2009).

From June 2010 to July 2010 the Consumer Price Index for all urban increased by 0,6%

CPI Headline July 2010 = 3,7%

So this is close to the bottom of our 3% to 6% inflation targeting range. Economic growth is struggling, unemployment is high, but we haven’t reduced interest rates? Something here is a little odd.

I’ll put another $100 in Kiva, to be “microlent” to businesses and people across the world, if the next monetary policy committee meeting doesn’t cut interest rates.

I blogged recently about why I park on the fourth floor of the Cape Town airport parkade, and also about understanding and utilising unlikely but extreme events to your advantage. There is actually a link between these two posts.

Parking on the top floor does have a cost. It takes longer to drive up all the ramps and does, perhaps, on average take longer than parking on the most convenient floor every time. This extra time is a premium I pay to reduce the potential for really bad outcomes and thus optimising the parking problem. For example:

• I avoid the situation of attempting to park on a lower floor (trusting the untrustworthy electronic vehicle counter) and, after driving around for a while trying to find parking, having to give up and try a different floor. This much longer time, even if it only happens rarely, is a much worse outcome than 30 seconds on every flight. It can easily be the difference between making and missing a flight.
• I don’t have to worry about remembering where I parked my car. I don’t know that I am more forgetful than the average traveller, but travelling almost every week makes each trip blur into the next. I don’t waste headspace on trying to remember where I parked my car, and I don’t worry about forgetting. I have the peace of mind from having purchased a time of insurance against the risk of forgetting where I parked.

I get no value out of successfully memorising my car location, but gain from removing this risk and this worry from my routine.

If your company has a foreign currency exposure due to imported input components, this is a risk and a worry over which you have no control. Your energies are better expended elsewhere, on the operational and sales issues that you can effectively change. Get rid of these risks and get on with your real business.

A friend “volunteered” me to answer an insurance question from Aardvark on allocating economic capital across different insurance products. After writing a short response, I received the frighteningly useful message: “Error”.

Having written a brief summary of the different techniques used in this really important area, I thought I should use it as a blog post. Maybe “Daan d.” from Cape Town will stumble across this answer eventually.

The question:

What is the standard practice to allow for diversification benefits when allocating capital required between different insurance products?

My brief answer (this is a huge topic!):

There is no standard practice. It’s one of the more irritating and subjective aspects of allocating capital between imperfectly correlated product

Economic Capital doesn’t have to be calculated as VaR, but I will use VaR below as a generalisation. Banks are typically slightly more mature in their capital allocation processes so what I’m describing below is often used in the banking world, but applies equally to insurance (life and non-life / P&C).

Splitting the capital in proportion to the sum of the components is frequently used, but is flawed and usually doesn’t give good results unless speed and simplicity are primary objectives. (more…)

Consumer prices in the US are now lower than they were a year ago.

photo credit: TheTruthAbout…

This is the first time this has happened since 1955. On the one hand, this reiterates that this recession is much worse than those in recent times. On the other hand, it shows how how asset prices had become in the final years of the credit-bubble. A large cause of the declining prices was the effect of oil and energy costs. The high base from high oil prices makes it easier for prices to move backwards.

This isn’t yet enough to introduce stubborn deflation. The oil price effect is a particular feature of the data and not all components of the consumer price index are declining. Real interest rates are still positive, and with declining prices (if these were to persist) there is not way through interest rate policy to change this.

The much-feared, poorly understood “quantitative easing” may be required to boost the money supply and encourage some inflation.

While serious deflation is probably not a major risk, the risk of massive inflation arising out of overdone quantitative easy, government spending and low interest rates should still be a concern for the dollar in the medium term.

I blogged before about some medium-term concerns I have around Lebanon’s currency stability. A story I saw today shows an opposite view, so I’m linking it here.  Moody’s have upgraded Lebanon’s bond ratings due to improved external liquidity.

My original post was to temper the irrational optimism around the currency peg, rather than to say there is bad news around the corner. However, I still feel Moody’s may be slightly optimistic, upgrading a small country’s bonds when the extent of the global recession is not clear.

In my previous post I discussed some of the risks to various currencies.

Now what happens if your local currency is pegged to the US Dollar as it is in Lebanon? Speaking to Lebanese bankers and insurers there seems to be a devout belief  that the peg is rock solid.  This is surprising given the history of the Lebanese Pound (LBP) over the last 30 years. Decades of civil war and hyperinflation decimate a currency.

photo credit: austinevan

Now if you offer insurance policies denominated in USD or LBP, accepting premiums and paying benefit in currencies assumed always to be pegged at a fixed  rate you might want to consider what assets you have backing those policies. USD policies backed with assets in LBP (and LBP policies backed with USD assets) are a massive currency risk. The probability of a break in the peg may be small, but the result could be catastrophic.

Unfortunately, it is arguably worse. Even if the USD policies are backed with USD deposits and bonds at Lebanese banks, how will the banks fare if the currency is devalued? How about if the USD does plummet on the back of inflation concerns in the US economy and the LBP is forced to be revalued upwards? Unless the banks are managing this currency risk themselves and are appropriate matched the contagion of currency problems will flow through banks and straight to insurance companies.

Now is not the time to assume that artificial links will remain no matter what happens to the global economy. This is a massive currency risk.