by Calculated Risk on 1/03/2010 09:41:00 PM

From PIMCO's Paul McCulley: PIMCO’s Cyclical 2010 Outlook

The first issue is the peg between the Chinese yuan and the U.S. dollar, which essentially gives us a one-size-fits-all monetary policy in a very differentiated world. Progress, or lack of progress, on this issue could lead to several outcomes. If China were to let its currency appreciate, it could regain a degree of monetary policy autonomy and a better ability to manage the risk of overheating and asset price inflation. Another outcome, however, is that China refuses to let the yuan appreciate, essentially maintaining too easy of a monetary policy for itself and the developing countries that shadow Chinese policies. This would create bubble risk, particularly for assets such as emerging market (EM) equities and commodities.

The second major uncertainty is what will happen when the Fed completes its mortgage-backed securities (MBS) buying programs. We know that it will have an unfriendly effect on the interest rate markets, but we don’t know the magnitude, because it’s too hard to isolate the supply and demand dynamics between fundamentals and the stimulus programs. ...

The third uncertainty is any change in the Fed’s pre-commitment language, which is currently committed to keeping the fed funds rate exceptionally low for an “extended period.” We don’t think the Fed is going to tighten any time in 2010, but long before the FOMC (Federal Open Market Committee) actually does the deed, it will have to change its language. That could very well happen in 2010, and there is genuine uncertainty over how quickly and strongly the market will anticipate a tightening process. Our gut feeling is that the moment the Fed changes any one of its words, it’s going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination. The most important book at the Fed right now is a thesaurus, and it’s probably sitting on top of Paul Samuelson’s Foundations of Economic Analysis.
emphasis added

Professor Krugman discussed the Chinese peg a few days ago: Chinese New Year

China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.
...
My back-of-the-envelope calculations suggest that for the next couple of years Chinese mercantilism may end up reducing U.S. employment by around 1.4 million jobs.

And the Fed MBS purchase program is just one of several government housing support programs that is scheduled to end in the next six months (the MBS program is scheduled to be complete by the end of Q1). My estimate is mortgage rates will rise by about 35 to 50 bps relative to the Ten Year treasury yield when the Fed stops buying MBS.

And on the Fed Funds rate, it is very unlikely that the Fed will raise rates in 2010. However McCulley thinks the Fed might change the wording of the statement - and he believes "it’s going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination".

I think jobs and the housing market (prices, supply and demand) are the two biggest economic issues in the U.S. this year.