Expectations Of Inflation Are Growing

It appears that neither deflation nor inflation are currently a problem with the consumer price index barely moving in either direction. However, the outlook for inflation based on the daily yield spread is growing, which when considered with rising gold and declining dollar, is raising market expectations of future inflation. See the following post from The Capital Spectator.
One of the supporting pillars in the recent rally is the recognition that inflation isn't a problem. Last year's financial crisis knocked the stuffing out of the system's tendency to devalue the purchasing power of fiat currencies over time. The net result is an unusual level of economic cover for keeping interest rates low--really low. Indeed, the primary goal of the Federal Reserve and its counterparts around the world over the past year has been the unbridled pursuit of higher inflation, though not necessarily high inflation.

In the depths of the crisis, the immediate objective was simply to deliver some level of inflation, which is to say something other than deflation. Allowing deflation to fester is simply too great a threat. The basic prescription has been printing money. How's it working?

The good news is that deflation is no longer a clear and present danger, as it appeared to be late last year and into early 2009. Measured by the consumer price index (CPI), the official benchmark of inflation in the U.S., the last monthly decline in consumer prices overall was in March. There have been two months with flat prices, but the general trend since the spring is up, if only marginally. In September (the last reported month), CPI advanced 0.2%, down from August's 0.4% rise, the Labor Department reported. The latest CPI reading shows that consumer prices fell on a year-over-year basis, but that statistical quirk will soon fall away as we move beyond the events of 2008.

The October update on CPI arrives next week (November 18), and the consensus forecast is looking for a 0.2% rise, according to Briefing.com—unchanged from September.

Meantime, the Treasury market's outlook for inflation is climbing. As our chart below shows, the implied outlook for inflation based on the spread between nominal and inflation-indexed 10-year Treasuries is now above 2%. This is the first sustained move above 2% since the financial crisis of 2008, save for a brief rise over this level back in June.



A 2% inflation rate is hardly the end of the world, of course, assuming the forecast proves accurate. Indeed, before last year's crisis, the Treasury market was consistently predicting inflation in the 2.5% range. By that benchmark, the inflation outlook remains muted. Much of the recent rise is simply a return to levels that prevailed under less extraordinary times.

But expected inflation is a slippery concept, as is all other efforts at divining the future. What's more, there's no lone methodology for forecasting inflation, much less one that's persistently accurate. Rather, the crowd is constantly reassessing the future and making guesstimates about what's coming. But while we can debate exactly what constitutes a fair outlook for pricing pressures, the general trend is clear, as the chart above shows. Slowly but surely the market is raising its inflation expectation.

There's some corroborating evidence that this is more than rank speculation. The gold market, for instance, has been pushing higher too. An ounce of gold now trades for roughly $1,100, a roughly 50% rise from a year ago. Meantime, the U.S. dollar has weakened over the past year. The twin trends suggest that inflation is on the rise, if only marginally.

That's no surprise, given the Fed's instinct and decisions over the past year. But in pulling the levers that engineer a higher level of inflation, the great question is whether Bernanke and company can slow and/or turn off the upward momentum in pricing pressure at the appointed time?

One of the Fed's own, James Bullard, president of the St. Louis Fed, tells FT yesterday that for the foreseeable future “you have inflation that will be possibly substantially above target over a horizon of two to four years, and that, I think, is because of the combination of very large fiscal deficits in the US with very easy monetary policy.”

We keep hearing that the central bank shouldn't repeat the mistake of the 1930s, when the Fed started raising interest rates too early, which derailed the nascent recovery. But it's becoming clear that the problems of the moment don't constitute another Great Depression. There are still huge challenges ahead, but they're different challenges than those that confronted policymakers in the mid-to-late 1930s. Nor is it clear that interest rates just above zero are the magic solution to what ails us now.

One can make a case that it was easy money that got us into the current mess and that easy money isn't necessarily going to get us out of the hole this time, as it seemed to in past business cycles. Yes, stabilizing the system was a priority over the past year, starting with preventing deflation. That battle seems to be won. Deciding what comes next, and what it means for portfolio strategy, is now the topic du jour, and it's only just begun. Unfortunately, easy answers aren't forthcoming.

As the FT story on Bullard advises,

Mr Bullard said historically the Fed had waited until two-and-a-half to three years after a recession ended before raising rates. That, he said, “would put you in the first half of 2012”. But the committee might take into account a wider set of factors this time, including the danger that ultra-low rates could fuel asset price bubbles.

“What is different this time is that the argument about staying too low for too long is going to weigh pretty heavily on the committee. It is more than just: ‘What does the output gap look like; what does inflation look like?’”

This post has been republished from James Picerno's blog, The Capital Spectator.

Inflation Of Domestic Versus Overseas Goods And Services

Tim Iacono from The Mess That Greenspan Made, breaks down inflation into domestic inflation and imported inflation and comes to an interesting conclusion. The deflation of goods and services from overseas has made overall inflation appear lower than it really is. If you look at domestic inflation in isolation, it shows much higher inflation than the public has been led to believe.

For some time now, the disparity between price increases for imported goods and price increases for domestic goods and services has been of great interest to me and, after working through all of the applicable Labor Department data on this subject, it quickly becomes clear that there is an interesting story to tell here about two very different types of U.S. inflation in recent years - domestic inflation and imported inflation.



The data in the graphic above will be detailed in the paragraphs ahead because it is deserving of close inspection. To be sure, it is a quite fascinating subject for those not familiar with how dramatically inflation in the U.S. has changed over the years.

But, the more important point to be made here first is that this disparity between domestic and imported inflation was one of the primary reasons why central bank policy in the U.S. had been steering us on a wayward course for so many years. Clearly, two of the major factors that enabled the nation's "easy money" policies for the past two decades have been:

1. The fixation on consumer prices (while ignoring asset prices)
2. The irrational fear of falling prices (today and in 2002-2003)

To a large extent, the Holy Grail of benign inflation and the threat of deflation were not what they appeared to be. In short, the deceptive combination of sharply rising domestic prices combined with falling prices for imported goods has been a major contributor to policy mistakes by the central bank, one of many policy mistakes made over the years that have now come home to roost.

Breaking the Consumer Price Index Apart

The Labor Department breaks consumer prices down into eight major categories, weighted as shown below. This composition is intended to represent a "basket of goods" that consumers purchase and the overall, weighted increases in prices are intended to represent the "rate of inflation" in the U.S.



For the purposes of this discussion and as the source for all the charts that appear here, only original Labor Department data is used and all issues related to such things as hedonic adjustments, geometric weighting, and other factors that contribute to the "reported" rate of inflation almost always coming in lower than the rate of inflation experienced in the "real" world will be ignored.

Importantly, lower "reported" inflation goes a long way in limiting government liabilities for such things as cost of living adjustments and makes central bankers, the stewards of American fiat money, look better than they otherwise might, so, this is not a subject that should be dismissed as inconsequential because, clearly, it is not.

It just won't be part of this discussion.

As for separating the consumer price index (CPI) into "domestic" and "imported" components, in looking at the top-level categories above, one can clearly spot a few that are predominantly domestic - education/communication, food/beverages, and medical care - and, while there are surely some imported goods in each of these groups (e.g., the 0.214 percent weighting for personal computers within the first group), it can safely be said that the "domestic" label fits all three.

Similarly, since the U.S. essentially stopped making their own clothes years ago, it can safely be said that the apparel category consists of primarily imported goods.

But, after that, things get a little trickier.

Making Sense of the Housing and Other Categories

The housing category breaks down as shown below and, as noted here many times before, probably the single biggest blunder of all regarding the consumer price index was the substitution of "owners' equivalent rent" for the cost of homeownership back in 1983.


As far as monetary policy is concerned, this was one of the major "enablers" for the late great housing bubble and its subsequent bursting since there would have been little chance of short-term lending rates resting at one percent back in 2003 and 2004 if home prices that were rising at an annual the rate of eight to ten percent nationally had been included in the calculation of consumer prices rather than the dubious measure of what homeowners think their place might rent for.

In fact, owners' equivalent rent has so distorted consumer prices in the U.S. that they, along with rental costs within the "Shelter" subcategory of the CPI, are completely excluded from the domestic/imported inflation discussion here.

[Note: For a complete breakdown of the CPI categories see this item at the BLS.]

With rents excluded from this list you are left with one sub-category of goods that is mostly imported - household furnishings - and the rest can be safely categorized as domestic.

Moving on to the transportation category we find cars, trucks, and the fuel that is required to run them and, while these are clearly both domestic and imported goods, the task of separating the two is nearly impossible. Since they are primarily made in the U.S., for the purposes of this discussion they are considered domestic.

Similarly, the recreation and other goods and services categories contain a mix of products, however, here they can be easily segregated. For example, nearly all cameras and audio equipment are imported while movie tickets and film processing are domestic services. And in the final "other"category, tobacco products are clearly home grown while personal care products are largely imported.

Prices for Imported Goods are Falling Faster Than you Think

Lo and behold, when only looking at products that are imported (mostly from Asia), one sees that we've had "deflation" for quite a few years now and not just the "one-off" variety where readings come in at minus one percent and persist for only a month at a time.

For example, the apparel category has posted year-over-year price declines in 13 of the last 14 years and clothes cost a cumulative 15 percent less than they did in the 1990s.



Now that's what I call "deflation", though, it has more to do with cheap labor and fixed exchanged rates in Asia than it does with anything else.

Prices for most imported goods have been declining consistently over the last decade, however, you don't hear too much about this as most news reports and analysts cite the headline inflation numbers or, worse, "core" inflation, excluding food and energy.

Falling prices for imported goods have been a key factor in being able to report overall "moderate" rates of inflation in recent years.

Prices for Domestic Goods and Services are Quite High

On the domestic side, when looking past the volatility that somewhat obscures the underlying pattern in the chart below, prices are clearly rising much faster than headline inflation has been indicating, particularly since the turn of the century.

[Note: The scales are the same for the chart below and the one in the previous section in order that the magnitudes can be more easily compared.]



While food price have been rising only modestly up until last year, it probably won't come as a surprise to anyone to learn that medical services costs have more than doubled over the same period of time that apparel prices have plunged, as noted in the previous section.

It is not until you look closely at the individual components of the consumer price index that you realize we really have been living in a world of "two inflations" - tumbling prices for imported goods and rapidly rising prices for domestic goods and services.

Combine these two inflations and throw in the huge "shelter" component that neither rises nor falls much as home prices soar and then plunge and the result is "benign" inflation.

What Does this all Mean?

For years, persistently low and falling prices for imported goods such as electronics and apparel have been masking much higher levels of domestic inflation in areas such as medical services and household energy.

Any economist with a spreadsheet and a web browser could have confirmed that.

But, what is significant about this is that this phenomenon should have been factored into monetary policy over the last decade or so but it wasn't.

Low inflation, regardless of its source, was used as a justification for keeping interest rates too low for too long and the unfounded fear of "de-flation" was the reason cited for keeping rates at "freakishly" low levels for several years in this decade.

Yes, pegged currencies in Asia play a role here, but surely the folks at the Federal Reserve, even with their misguided focus on consumer prices to the exclusion of nearly all other considerations, could have seen that inflation in the U.S. was only as low as it was because of cheap imports.

Had this been understood and had interest rates been kept higher over the last ten years, we probably wouldn't have near the number of problems that we've seen in the last year or two.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

How The Inflation Monster Could Spoil The Party

The stock market has rallied, job losses are cooling down, and housing prices swung higher this summer. Just when it seemed like we might make it out of the recession, the inflation monster may arrive with a vengeance. Tim Iacono explains why multiple factors may conspire to summon the inflation monster in the not-so-distant future.

You hear a lot of talk these days about what could possibly stop the current stock market rally given that we've clearly passed the "acute" phase of the financial crisis and, quite literally, there is no place to go but up for many economic indicators.

The term "statistical recovery" is bandied about quite a bit by doubters of the recent move up for equities and for many very good reasons such as the following:

• home prices seem to be going up when they're probably really still going down
• consumers have dramatically cut back on their spending but no one seems to care
• current quarter GDP will print at +2 or +3 percent but it is completely unsustainable
• bank balance sheets appear healthy when they are really still loaded with bad loans

But, none of this really seems to matter when you have a chart that looks like this.




A 50+ percent move up over a period of five-and-a-half months will eventually make a believer out of almost anyone, a point that is proven again and again, day after day.

But, aside from some big new financial market brush fire developing somewhere that, having learned the lessons of 2008 well, the Treasury Department and Federal Reserve will no doubt quickly hose down with another few hundred billion dollars in money and credit (more if needed), is there anything out there on the horizon that might dampen the enthusiasm of the stock-buying public?

Well, the obvious one is housing.

While a growing number of pundits have all but declared the housing market healed, the latest evidence being offered the other day in the S&P Case Shiller Home Price Index, there is still clearly a ways to go before real estate stops being a drag on consumer psyches and far too many still believe that, somehow, we'll revert to our 2005 spendthrift ways.

There are millions of foreclosures still to come over the next year or two and most people seem all too willing to take their $8,000 tax credit and bid on a property, not seeming to know or care that home price bottoms are long drawn out affairs and that five percent 30-year fixed rates are the exception, not the rule.

As for the Case Shiller Home Price Index, as noted here previously, there's a pretty good chance that seasonal factors will result in the resumption of negative monthly price changes in another few months, though, with the sea-change in prices recently, anything could happen.



The reversal in home prices from a February-March decline of more than two percent to a May-June gain of almost 1.5 percent was the largest three-month swing in more than 20 years of data for the 10-city index - more than double the previous record.

Is that what's really happening in the housing market and, if so, how long can that possibly continue with the deluge of sellers that will now be entering the market, most importantly banks with their huge inventory of foreclosed homes?

Another month or two of rising home prices and then a swift return to negative numbers could dampen confidence very quickly later this year and millions of shareholders might realize that home prices have not yet hit bottom, despite the optimism everyone felt over the summer.

Turning to the labor market picture, it remains a bleak outpost where stock market bears can still gather to compare notes, however, it is not likely to scare off any bulls at this point.

Who would have thought that we'd ever "cheer" a quarter of a million jobs lost in just one month? But, that's what happened last month and it might happen again next week.

There is much more pain to come in the labor market but, from here on out, except for the low-profile, long-term unemployment statistics, it will continue to be a case of being "less bad" than what we've already seen.

In a world where "less bad is the new good", that's reason alone to bid stocks higher.

There is one thing, however, that could put the kibosh on investors' enthusiasm a few months down the road - inflation.

Inflation?

Hasn't inflation morphed into deflation - an annual rate of minus 2.1 percent as of July - and isn't everyone looking for consumer prices to be tame for the next year or two if, as it appears now, we are lucky enough to avoid that dreaded Great Depression malady of "de-flation"?

Surely, the now-docile CPI won't be spooking any shareholders this year.

Well, maybe it will...

Here's why.

Recall that the consumer price index breaks down into eight major categories as shown below, the two categories that contain energy costs - housing and transportation - both broken out into energy and non-energy components.

Here's the way things stand today, energy prices being the clear driver in the current negative annual rate of inflation which reached a 50+ year low last month.



Notice that, even through the distortion of hedonic adjustments and other nefarious measures that the Bureau of Labor Statistics uses to ensure that prices don't rise too much, nearly all non-energy categories are still up from a year ago, some of them a lot.

Though economists may still favor the dubious "core rate" of inflation, it is the year-over-year change in the "overall" rate of inflation that garners all the headlines and elicits concerned looks from investors of all stripes.

So, what happens later this year when, instead of comparing energy prices against $140 crude oil or even $100 crude oil, energy costs are compared to $40 or $50 crude oil?

Well, it may not be pretty.

Even though all energy components account for less than eight percent of the overall index, they have quite a large impact on the headline figure when you get changes of 30, 40, 50 percent or more and, importantly, this works in both directions.

According to Energy Department data, U.S. gasoline prices reached a low at about $1.61 a gallon last December and stayed below $2 a gallon until the spring. Today's average retail price of $2.62 represents a whopping 63 percent increase over last year's low, a full 30 percent above the two dollar mark. With the prospect that crude oil prices may not go down and, perhaps, might just head toward $100 a barrel between now and the end of the year, this sets the stage for some surprisingly high inflation rates.

Keeping all other categories in the CPI unchanged from year-over-year readings and throwing in a healthy increase for heating oil, piped gas, and electricity (which is something of a stretch for natural gas prices, but, anything's possible these days), all of a sudden you come up with three or four percent inflation again before Christmas, perhaps higher.



After the huge success of the Cash for Clunkers program, many now expect car prices to rise which could push that last red bar hanging below the x-axis into positive territory.

Now, I don't know about you, but it seems to me that inflation rates this high might set off all sorts of chain reactions in financial markets, especially with interest rates at zero percent and the Fed printing money furiously, and none of this is likely to be good for equity markets.

As the world learned painfully in the 1970s, stocks and inflation don't get along too well together and, while this surge in consumer prices might only last four or five months, it will nonetheless have the media talking about inflation again and those poor seniors who are getting no cost of living adjustments in their Social Security checks will again be calling their Congressmen to complain.

Believe it or not, a curve like the one you see below is quite possible as we enter 2010.



Now, the really bad news here is that, since the recent wave of liquidity has pumped up nearly every asset class, the price of oil is not likely to go down (making for tame inflation later this year) unless stock prices go down.

But, based on the much higher year-over-year rates of inflation that will show up later this year if oil prices do not go down, that, in itself may be enough to send the price of stocks down.

Either way, it looks like something has to go down.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Deflation Risk Averted But Could Massive Inflation Be Around The Corner?

By creating nearly $4 trillion in new money and credit, representing the largest increase by the American federal government since the country's Civil War, the monetary system has been repaired and deflation is no longer an imminent risk. But a lack of political will and continued annual deficits in excess of $1 trillion through 2016, along with significant pressures in the economy, could likely lead to broad inflation over the next two years, with gold and strategic assets offering potential shelter from the expected storm. Porter Stansberry from Daily Wealth discusses this below.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.
– Ludwig von Mises

For most of 2009, I've had a friendly disagreement with several colleagues who believe a big deflation will be the end result of the 2008 financial crisis.

I knew they were wrong. I knew inflation would become a problem sooner, rather than later. And in the past several months, I've been proven right.

The mortgage and banking collapse of 2007-2009 saw total collateral values collapse between $5 trillion and $10 trillion. The response from our politicians and central bankers was massive: the largest creation of new money in credit since the Civil War.

The Federal Reserve created roughly $2 trillion in additional credit and loaned it against all kinds of dubious collateral, things like Bear Stearns' mortgage book. (There's a handy and simple guide to estimating the Fed's credit quality. The more acronyms in the lending programs, the worse it gets.)

The Federal government responded with a record annual deficit of at least $1.8 trillion. In the second half of 2008, the outstanding federal debt grew by roughly a 40% annualized pace (24% for the entire year). Thus, in only a few months' time, the roots – the money and credit – underlying our economy expanded at a record pace.

In the second half of last year and the first quarter of 2009, the main question in the world's financial markets was: Can the world's government print enough money, fast enough, to forestall a deflationary collapse?

I knew it was no contest. There is no way for an economy to outrun a printing press. The Fed has the power to create an unlimited amount of money or credit and the power to inject that money into the economy in any way it sees fit.

Let's look at the numbers. Let's assume the total collateral damage of the banking crisis turns out to be $5 trillion. Yes, that's a huge hit – roughly half the output of our economy each year. It's the equivalent of sending every American household a bill for $50,000 – due immediately. However, in less than a year, the Feds have already created nearly $4 trillion in new money and credit. The hole in the system has already been plugged. It only took a few months.

The fight between inflation and deflation is over. Deflation was knocked out in the first round.

The big risk is what happens next. Having turned on the presses to save the day, who will have the political clout and the desire to shut them off? Barack Obama's budget calls for annual deficits in excess of $1 trillion for the next eight years. Thus, by the end of this year, not only will all of the damage from the mortgage collapse ($5 trillion) be replaced by new money and credit, there will be significant inflationary pressures in the economy.

The good news in our economy this year, so soon after such a major collapse, means we will certainly have a massive inflation during 2010 and 2011. There's no such thing as a free ride. Bailing out the banks will carry a heavy price for anyone who doesn't have the resources or the knowledge to escape the dollar.

How can you "escape"? First off, make sure you own plenty of gold bullion. I also recommend owning assets that will run higher in an inflationary environment, like vital transportation and energy assets. Also, own some good farmland. Food and land prices will go higher.

Yes, the news is grim... but if you own gold and strategic assets, you'll survive and prosper in the coming inflation.

This article has been republished from Daily Wealth, a contrarian investment analysis and advice site.

Ben Bernanke's Plan To Prevent Inflation

Ben Bernanke outlined his plan to prevent inflation in an article in the Wall Street Journal. While this plan sounds good on paper, economist Mark Thoma from Economist's View warns that the Fed can not raise interest rates too soon and risk sending the economy back into recession. See the following post on this topic.

Ben Bernanke says that when the economy starts to recover, the Fed will take the steps needed to prevent an outbreak of inflation (the substance of the arguments can be found in the full version):

The Fed’s Exit Strategy, by Ben Bernanke, Commentary, WSJ: The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the ... federal-funds rate ... nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets...

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem... We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds ... ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. ...

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy. ...

[W]e have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination. ... [T]hese policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

As I've said many times, I'm not particularly worried about inflation, reserves can be removed or neutralized as described. The worry is not so much that they will be too slow at removing reserves, it's that they will get trigger happy and start raising interest too soon potentially stalling the recovery or perhaps even sending the economy back downward. The Fed will need to be sure that things are getting better before beginning to raise interest rates, that's why it's good to hear them use the phrase "extended period" twice when describing how long interest rates will stay low. But there are long lags associated with monetary policy, and by the time the Fed knows for sure that economy is heading solidly in the right direction, it won't have much time left to reverse course and begin removing reserves. Even so, they need to be patient and avoid the more serious mistake of raising interest rates too soon.

This post has been republished from Mark Thoma's blog, Economist's View.

Why Deflation Is More Likely Than Inflation

While many fear the possibility of inflation, Alan S. Blinder, Princeton professor and former economic adviser to President Clinton, explains why he is not worried about inflation. He argues that deflation is currently a greater danger. To learn why see the following from Economist's View.

Alan Blinder isn't worried about inflation:

Why Inflation Isn’t the Danger, by Alan S. Blinder, Economic View, NY Times: Some people with hypersensitive sniffers say the whiff of future inflation is in the air. ... Concluding that the Fed is leading us into inflation assumes a degree of incompetence that I simply don’t buy. Let me explain.

First, the clear and present danger, both now and for the next year or two, is not inflation but deflation. ... Core inflation near zero, or even negative, is a live possibility for 2010 or 2011.

Ben S. Bernanke ... and his colleagues have been working overtime to dodge the deflation bullet. To this end, they cut the Fed funds rate to virtually zero last December and have since relied on a variety of extraordinary policies known as quantitative easing to restore the flow of credit. ... But quantitative easing is universally agreed to be weak medicine compared with cutting interest rates. So the Fed is administering a large dose — which is where all those reserves come from.

The mountain of reserves on banks’ balance sheets has, in turn, filled the inflation hawks with apprehension. ... Will the Fed really withdraw all those reserves fast enough as the financial storm abates? If not, we could indeed experience inflation. Although the Fed is not infallible, I’d make three important points:

• The possibilities for error are two-sided. Yes, the Fed might err by withdrawing bank reserves too slowly, thereby leading to higher inflation. But it also might err by withdrawing reserves too quickly, thereby stunting the recovery and leading to deflation. I fail to see why advocates of price stability should worry about one sort of error but not the other.

• The Fed is well aware of the exit problem. It is planning for it... It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.

• The Fed will start the exit process when the economy is still below full employment and inflation is below target. So some modest rise in inflation will be welcome. The Fed won’t have to clamp down hard.

...But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.

In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.

My conclusion? The markets’ extraordinarily low expected inflation in January was both aberrant and worrisome — not today’s. As long as expected inflation doesn’t rise much further, you should find something else to worry about. Unfortunately, choices abound.

This post can also be read at Economist's View.

Why Hyperinflation Is Unlikely

While there have been concerns about hyperinflation of late, there hasn't been much evidence of actual inflation. Tim Iacono from The Mess That Greenspan Made argues that we will probably never see an annual double-digit inflation rate. See the following article to find out why.

Some looked at the inflation statistics released by the Labor Department earlier today and said, "See? Deflation is here!"

Others looked at the same set of price data and replied, "See? Inflation is stirring".

They can't both be right, but they can both be wrong (or at least early).

The annual rate of inflation, measured against the price level of May 2008 (back when gasoline and other commodity prices were soaring), came in at less than minus one percent causing deflationists around the world to rejoice, yet stop short of getting out the bubbly.

Why?

Because, so far, this deflation is the Japanese variety, a wimpy version of the much more serious double-digit deflation as seen in the 1930s which, unfortunately, most deflationists fail to understand is no longer within the realm of the possible, unless of course we go back to something like a gold standard instead of printing up new money by the trillions of dollars to replace the dollars that are being vaporized in the ongoing waves of credit destruction.

Then again, since the Consumer Price Index has been effectively neutered by a 25 percent weighting of owners equivalent rent that, while purportedly representing homeownership costs, instead serves to dampen reported inflation. No matter what home prices or mortgage payments do, owners equivalent rent always seems to rise at an annual rate of two percent (even when home prices are falling by ten times that amount) serving as an anchor on the government inflation data.

Due to owners' equivalent rent, the U.S. may never see another double-digit annual rate of inflation - positive or negative.

These days, as far as government reported inflation is concerned, it's all about energy prices and, there, those seeing deflation have something to look at.



Most of the year-over-year change in the overall consumer price index is either directly or indirectly related to the energy price peak last summer and comparisons to it, serving to distort whatever meaning the price index still contains.

But, the intriguing aspect of this morning's report on consumer prices is that you can see in-flation in the data too. After all, gasoline prices have soared more than 70 percent from about six months ago demonstrating the very real difference between $35 a barrel oil and the much more dear $70 type.

Inflationists (and the much more rabid "hyper-inflationists") look at this recent rise in energy prices and figure it to be a sure sign of things to come, what with all the government money printing that has occurred lately - a lot of the newly printed money seems to be going into the black goo.



Anything that doubles in price over a six month period should grab your attention and, whether or not crude oil prices remain lofty in the months ahead is anything but assured, but it's important to remember that present day oil prices are still more than 200 percent higher than the average of the last few decades.

That was the era of modest inflation that many people naively think we're about to return to.

But, that period was really just a fluke.

Never again will the world have cheap, plentiful oil at the same time that clothes, electronics, and other goods are produced at cut-rate prices in the East, only to be sold in the West, and subsequently included in the West's inflation data.

Those seeing inflation in today's data see a world where prices are very different than they were in the latter years of the 20th century, the late-2008 plunge in prices being just a temporary setback to the inevitable higher prices to come.

In the scheme of things, what happened from early-2008 to early-2009 will probably prove to be quite irrelevant - either a blip that quickly fades from memory or a blip that is eventually dwarfed by other much larger blips.

It's way too early to tell.

However, what is quite easy to discern after the last year or so of price data, is that we've entered a very different world of consumer prices and even owners' equivalent rent may not be able to dampen the effects of the price moves in the years ahead.

We probably won't know for sure until sometime in 2010 whether we'll get debilitating deflation or hyper-inflation, though both remain unlikely, at least in my view.

The current inflation numbers are largely meaningless and anyone who reads too much into them does so at their own peril.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

A Period of Economic Transition

With the prevailing wisdom pointing toward an economic recovery in the near future, the economy is likely entering a transitional period. The longer than average recession will probably mean a longer than usual transitory period. James Picerno from The Capital Spectator discusses what this transitory state could look like.

Flat to a slight upside bias. That about sums up the prevailing state of inflation at the moment, based on this morning's latest from the U.S. Bureau of Labor Statistics.

Seasonally adjusted consumer inflation rose 0.1% last month, up from zero the month before and a modest decrease in March. On its face, that's good news, as it suggests that the risk of deflation, if not quite passed, is looking more and more like a shadow of its formerly threatening self. Meanwhile, inflation as a clear and present danger also remains thin as an imminent menace.

We are in a transitory state, passing from severe danger to something less so. Anything's possible, of course, especially in the current climate. But barring some extraordinary and largely unexpected event, we're likely to press on through what we'll call a pre-recovery period, when the economic numbers improve relative to the recent past yet the numbers don't quite show the traditional bounce that typically accompanies the end of recessions.

"The economy seems to be out of intensive care," says David Shulman, senior economist at UCLA Anderson School of Management. "The freefall stage in dropping output and employment seems to be over, but the economy is still sick."

The prospect of false starts in the data looks quite high in the months ahead. The good news on one day will be reversed by bad news the next, and quite a bit of treading water at other times. The transition state that carries us from recession to growth, in short, will last longer than usual. The evidence will be particularly obvious in the lagging indicators, employment being the most conspicuous example. Indeed, the labor market is still shrinking and will probably continue to do so in the months ahead, perhaps followed by an extended bottoming-out period over several quarters. The economy's capacity to create jobs is likely to come later and be more tepid than has typically been the case following the end of recessions in the post-war era.

Extending the medical metaphor, Bruce Kasman, chief economist for JPMorgan Chase, predicts in BusinessWeek.com yesterday that "the economy will return to growth but not to health."

Last week we wrote of the "technical end" of the recession and our expectation that NBER would eventually get around to declaring the downturn's finish at, well, right about now, give or take a few months. That's good news relative to the recent standard of economic activity. But the technical demise of the recession isn't likely to bring easily recognizable good news on Main Street anytime soon.

As frustrating as that outlook is, it's even more hazardous than is generally recognized. If we're facing an unusually long transition period, there are specific risks linked to this abnormal state of affairs. That includes figuring out how and when to adjust monetary policy to balance two conflicting forces: deflation and inflation. As the former gives way, the latter isn't likely to suddenly pop out and yell "boo." Nonetheless, the future inflation risk isn't trivial, given the massive liquidity that's been created of late and the historical lessons that go with fiat currencies. As we discussed on Monday, the elevated risk this time around will be one of deciding magnitude and timing in adjusting monetary policy going forward. That's always a challenge, although it's likely to be especially problematic in the quarters ahead. Tightening monetary policy too soon may risk choking off a nascent but weak recovery; waiting too long to raise interest rates may give inflation a solid foundation to thrive, an especially troubling thought, given the massive amount of debt incurred over the last 12 months or so.

Overall, economic analysis faces unusually tough times in reading the incoming data and drawing reasonable conclusions about the implications for the future. As a basic example, our proprietary index of economic indicators, published in each issue of The Beta Investment Report, is currently flashing a robust sign of recovery, although this may be misleading because much of the rise has come from monetary policy and, so far, isn't convincingly corroborated in the real economy.

In short, interpreting the economic outlook promises to be quite difficult going forward, much more so than usual. Beware: The risk of false dawns is rising.

This post can also be viewed on capitalspectator.com.

Expectations Of Inflation Rising

Expectations of inflation are on the rise, fueled by the high level of US debt and the weakening dollar. One sign that inflation is on the horizon is that the futures market is predicting that the Federal funds rate will increase to 1.2% by this time next year. For more on this, see the following post by James Picerno from The Capital Spectator.

Arthur Laffer advises in today's Wall Street Journal that it's time to "Get Ready for Inflation and Higher Interest Rates." The market's been telling us no less, as we've been discussing now for some time. Although the deflationary risk has been front and center since the financial crisis erupted last fall, the bigger challenge has always been the next phase, once the Federal Reserve succeeds in driving away the D risk.

One need only review the market's changing forecast of inflation in recent months to recognize that the future isn't likely to look like the past. In charts we've been posting semi-regularly, such as here and here, the trend is clear: pricing power is returning. Yes, it's coming off an extraordinarily low base, which exacerbates the relative comparisons. But there's no question that the central bank has been using extraordinarily potent measures to resuscitate inflation from the grave. As we've been saying all along, we have every confidence that Ben Bernanke and company will be successful.

The market is increasingly of a mind to agree, as indicated by rising interest rates this spring in government bonds. The benchmark 10-year Treasury, for instance, now yields 3.86%, as of last night—161 basis points above 2008's close, according to data from the U.S. Treasury.

Meanwhile, the futures market is predicting that by this time next year, Fed funds will be at ~1.2%, up from the current target rate of 0-0.25%, as our chart below shows.



So far, the rise in rates and rate expectations is a good thing, as it suggests that economic equilibrium is returning and the appetite for risk is on the mend. But at some point it's time to start soaking up the massive liquidity that the Fed has created in the past year. Reasonable minds can debate on exactly when to begin and how far to go, but at some point, and perhaps fairly soon, the monetary equivalent of mopping up must commence.

Laffer's skeptical that reversing the liquidity injections will be reversed in a timely manner, if at all. "Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates," he writes.

We're not quite so pessimistic, although the history of central banking certainly offers plenty of reason to remain cautious on expecting that politically tough decisions will come easy. Indeed, one must be cognizant of the incentives that infuse a world of fiat money and mounting deficits and the political path of least resistance. As Milton Friedman once said, "Inflation is the one form of taxation that can be imposed without legislation."

This post can also be viewed on capitalspectator.com.

How Much Gold You Should Own

Ben Bernanke recently warned congress of the consequences of overspending which could include inflation. If you think inflation will accelerate in the future, it may be a good idea to consider gold to offset the affect of inflation on your investments. For more on this, read the following article by Dr. Steve Sjuggerud from Daily Wealth.

You often hear "You need to own gold!" But how much is the right amount?

You don't want to own too little gold and have the purchasing power of all your savings shrink dramatically. You can't afford that. But you don't want to be an end-of-the-world nutcase either.

Well, one of the world's shrewdest investors – Jean-Marie Eveillard – has 10% to 12% of his extremely successful investment fund allocated to gold and gold plays...

Jean-Marie Eveillard's First Eagle Global Fund beat the stock market every year this decade. What's more, he's done it conservatively... He doesn't take big risks. Over 30 years, he's proven to be one of the most successful mutual fund managers ever.

So what's Jean-Marie Eveillard recommend buying today?

"After equity markets have gone up 35%-40% or more over the past three months, ideas that are immediately appealing are few," he told Bloomberg news today. But he did have one big idea... gold.

Right now, his fund is about 10% invested "in gold and gold mining securities," he said.

His explanation is simple: "It's insurance to protect against the fact that current policies by the American government and the Fed are potentially wildly inflationary."

Jean-Marie likes gold because he expects the Fed will leave interest rates near zero for a very long time.

The Fed will "stay pat until the politicians give them the green light to raise rates, which will take quite a while. As long as unemployment is very high, politicians will be reluctant to push up short-term rates."

When I got into investing nearly 20 years ago, Jean-Marie was already a legend. After doing my homework, his First Eagle Global Fund was one of the very first investments I ever bought. (Back then, it was called the SoGen fund... it still uses its old symbol, SGENX.)

Jean-Marie started managing the fund in 1979. If you had invested $10,000 in the fund back then, it would be worth roughly $500,000 today. (Heck, I should have kept my money in there!)

His "big idea" now is very simple. Gold pays no interest. And money in the bank pays nearly no interest. You can print money. But you can't print gold. If the Fed keeps interest rates near zero for the foreseeable future, the obvious outcome is that it will take more slips of paper (dollar bills) to buy an ounce of gold.

He believes his clients' money should be about 10% or so allocated to gold and gold investments. What's right for your situation? That's up to you. But if you're substantially under or over the legendary investor's gold allocation, then you ought to consider getting more in line with him...

Dailywealth.com offers a free daily investment newsletter which focuses on contrarian investment opportunities.

Should We Worry About Inflation?

Ben Bernanke was on Capital Hill yesterday warning congress that too much deficit spending could harm the economy while downplaying concerns of inflation. It is Bernanke's job to control inflation, but will he be able to keep inflation low with $2 Trillion in deficit spending this year? James Picerno from The Capital Spectator discusses whether we should worry about inflation now.

Inflation's still not a risk but arguably neither is deflation. We're not quite ready to officially claim that the D risk has been vanquished, but we're close. As it turns out, we're not alone.

The bond market is increasingly inclined to turn the page on the fear that a deflationary spiral may threaten. But if the deflation risk is passing, as it seems to be, the change doesn't mean that inflation is back. There's no switch that turns one off and the other on as cleanly as flicking on a light.

The ebb and flow of the economy is a process, an evolution. What we're seeing now, or so it appears, is a transition from a heightened risk of deflation to the absence of that risk, which isn't to be confused with inflation. At least not yet. There's no law that says inflation must quickly follow deflation. But neither is there any force that prevents one from turning into the other. Much depends on what the central bank does; not today but next month, next year and beyond.

Inflation, when it does bite, tends to creep up on you, slowly, quietly, working its way into the economy virtually unseen. It doesn't suddenly arrive one day with fanfare and press releases. More typically, the crowd wakes up one day and realizes that inflation is back. The good news is that there are usually early warning signs. Interest rates, money supply, commodity prices, and so on. The challenge is figuring out in real time what constitutes a legitimate warning vs. noise.

For the moment, the market's telling us that deflation's a fading hazard. As the chart below shows, the implied inflation rate in the bond market (based on the yield spread between the nominal 10-year and inflation indexed Treasuries) was just under 2% as of last night's close. That's still comfortably below the 2.5% rate that prevailed before the financial system ran amuck starting last September. But it's also up sharply from the near-zero levels of December and January.

That's not necessarily surprising or even troublesome. Fearing the worst last fall, the Fed quickly dropped short rates to near zero. The medicine appears to be working, which is to say that Bernanke and company are engineering higher prices. But it's the momentum we fear. Not necessarily today, but down the road.



Some commentators say that all the talk of inflation is premature and perhaps misguided. In his column last week in The New York Times, Paul Krugman advises readers that "when it comes to inflation, the only thing we have to fear is inflation fear itself."

That's a reassuring thought, but unfortunately it runs contrary to the historical record. Maybe this time is different, but we don't know. But the past is certainly clear. Except for a few extraordinary examples to the contrary, inflation has been the norm. For the most part, it's been manageable, although sometimes it spins out of control, as it did in the 1970s and early 1980s. Recessions, of course, have a habit of pounding inflation back into the ground. Even after the current downturn ends, its after-effects are likely to put a lid on pricing pressures and so there's reason to be sanguine about future inflation threats.

The ever-trenchant Martin Wolf advises in his FT column today that there's no economic basis to fear inflation, at least not now. "The jump in bond rates is a desirable normalization after a panic," he writes. "Investors rushed into the dollar and government bonds. Now they are rushing out again."

The question, of course, is when is it safe to start worrying about inflation? The implied inflation rate for the next 10 years is roughly 2%. That's low by historical standards and if it stayed there for the next generation the central bank could claim a well-deserved victory in maintaining price stability, at least by the standards of the 20th century.

But no one knows if inflation will rise to, say, 2% and stay there or keep climbing. Again, much depends on what the central banks do from here on out. One can make an economic case that exploding government debt and massive liquidity injections aren't destined to raise inflation pressures, as Wolf and others explain. That's a reasonable view, but if you're charged with protecting assets, such claims that all's well aren't entirely persuasive.

The bond market, along with the gold and forex markets, are discounting the future and all its risks and they're telling us that the risk of higher inflation is on the march. It's quite possible that the markets are wrong and so inflation will remain a shadow of its former self. Let's hope so. But there's no way of knowing for sure. Strategic-minded investors should hedge their bets. Inflation may remain benign, but it may not. The markets are struggling to put a price on this uncertainty.

In any case, it's the trend rather than the absolute levels that worry investors. Estimating the true rate of inflation is always a contentious subject. But while we can all argue over the numbers, the trend is less obscure, and it's the trend that has some of us worried. Taking out a bit of insurance, then, seems reasonable. Should we bet that house on higher inflation? Of course not. But neither should we discount it entirely. It may be different this time, but 300 years of central banking keeps us wary on buying into yet another argument that a new era has arrived.

This post can also be viewed on capitalspectator.com.

Should Historic Deflation In Britain Be A Concern?

Could deflation be the next big road block on the road to economic recovery? News out of Britain indicates that significant deflation has hit Britain's economy which can lead to things getting worse rather than better. What does the lowest Retail Price Index since they started keeping records mean for Britain's economy? Tim Iacono from the blog The Mess That Greenspan Made, shares his view on the significance of record deflation in Britain.

The British have succumbed to the scourge of deflation and about all the rest of the world can do now is bid them a fond farewell - they've entered the abyss, as reported by the Telegraph.

Britain sinks into deepest deflation since 1948
The British economy sank deeper into deflation last month to the lowest level in more than 60 years as the effect of falling house prices and lower mortgage repayments escalated.

Inflation on the Retail Prices Index (RPI) measure, which includes housing costs, dropped sharply to -1.2pc in the year to April, from -0.4pc in March, the Office for National Statistics (ONS) said on Tuesday.

It was the lowest RPI figure since records began in 1948, and weaker than economists had expected.

The number of times that economists have been taken by surprise over the last few years has been increasing at such an astonishing rate that, sometimes, you have to stop and wonder why we even keep them around.

Maybe we'd be better off with no forecasts and no expectations for the future at all.

More importantly, you have to wonder why their counsel continues to be sought in order to remedy the ills that took them by such great surprise.

Anyway, on the subject of de-flation, the British method of measuring the changes to consumer prices appears to be even more dysfunctional than the one used in the U.S. as central bank lending rates have a direct impact on their broadest measure of inflation which happens to include interest paid via mortgage payments.

So, all other things being equal, if interest rates are slashed, inflation goes down, whereas, if the bank hikes lending rates, inflation goes up.

The main driver of the fall was lower mortgage interest payments following the Bank of England's decision to cut interest rates by half a percentage point to 0.5pc in March, the ONS said.
...
Although in the short term falling prices will appeal to consumers, RPI is used to calculate wage increases so the sharp fall in April is likely to add to downward pressure on salaries already caused by higher unemployment and falling corporate profits.
"As a result, many workers are likely to get wage freezes or even pay cuts," said Howard Archer, chief UK economist at IHS Global Insight.

Deflation poses a further threat to the economy if people expect prices to fall further and put purchasing plans on hold which can, if the trend persists, lead to lower output and even more job losses.

There's the real evil of inflation - right there in that last paragraph...

If people see negative numbers showing up in the government's measure of inflation, they'll stop obsessing about the ongoing financial market meltdown and how it must ultimately lead to the end of life as we've known it and promptly cut back on their already sharply curtailed spending plans in hopes of getting a better deal sometime in the months ahead.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

So What Is The Fed's Next Move?

With the growing number of positive economic reports coming out, many people are questioning whether the economy has turned a corner. Have we really turned a corner, though, or are we seeing a temporary upswing? The Federal Reserve is playing a difficult game right now. If they leave rates low too long we could be faced with inflation, but if they raise them too quickly it could hamper the recovery. With this in mind, the Fed has some challenging decisions ahead of them. How are they going to respond? Mark Thoma looks at a recent article from Tim Duy that addresses this in his blog post below.

Turning Which Corner, by Tim Duy: Is the economy turning a corner? And, if so, which corner is it turning? In my view, economic activity has been influenced by two separate trends since 2007. One is the structural response to an over-leveraged household sector that pushed the US economy into what was initially a mild recession. The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms. Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment. Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%. Market participants are rightly anticipating the economy is turning the corner on the cyclical trend. But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth. This is why Bernanke and Co. are more likely to fertilize the fields than plan for the next harvest.

If there is one picture that sums up the cyclical story of the past year, it is the path of real consumption:

The sharp deceleration has come to an end, of that there can be little doubt. Nor should there be much surprise. The collapse in commodity prices, lower interest rates to allow mortgage refinancing for those homeowners still above water, and tax cuts all joined to provide powerful support for household budgets allowing consumption to stabilize despite the massive job losses experienced in recent months. The stabilization in consumer demand will eventually slow the pace of job cuts. Indeed, this is already evident in the data - analysts have pointed topeak of initial claims as a key hurdle in the race to recovery. To be sure, it is difficult if not impossible to characterize the data flow as "good." But it is certainly less "bad." The path to Great Depression II has hit something of a speedbump. And seeing that, market participants have priced out some of the most cataclysmic scenarios, supporting equities and commodities while pushing bond yields higher.

There will be more opportunities for euphoria - do not underestimate the power of pent-up demand to trigger bursts of positive data. There is a portion of the population who are not credit constrained, biding their time for the perfect moment to buy a new car or schedule a vacation. Indeed, such bursts of data are more likely than not following a sharp decline in activity (the 2.2% gain in consumption spending in 1Q09 is such an example). I believe, however, that those bursts of data will not be sustainable. Far from it - at a minimum, the ability of households to carry activity forward is at its end, which by itself would leave the economy floundering .

I think it is difficult to ignore the implications of the growth of consumer dominance in defining patterns of economic activity:

The story of the last 25 years has been an increasing role for household spending, rising to perhaps a peak of conspicuous consumption, with the motto "a filet mignon in every stainless steel oven, a RV in every garage." Patterns of economic development - more to the point, capital formation - have favored taking advantage of this trend. Countless business plans are based on the expectation that this trend will continue. The baby boomers have endless wealth (not so anymore, if it ever was), there is a never ending supply of equity rich Californians to support our [insert locality] housing market, etc. Those plans will be stressed, to say the least, if the trend stalls. The implications for a reversal are even more significant. And for those that believe reversal is necessary, note that the reversal has really not even begun. What took 25 years to build may take another 25 years to destroy.

How sure are we that the trend is at an end? My thought is that the factors that supported the trend - a steady march down in the saving rate to zero and a steady march up in household debt, coupled with monetary policy that had room to go from 15% short rates to zero over nearly three decades, are at an end. Even if you believe that savings rates will not rise to 12%, the inability to sustain below zero rates puts a limit on household spending growth (as well as debt accumulation). And with underwriting conditions tightening - a permanent tightening, given the changing regulatory environment - the role of debt financing in the life of the consumer is sure to stagnate.

The challenge then is to transition the economy away from the debt-supported consumption trend that looks no longer viable to a trend more reliant on investment and external spending. This, however, is easier said then done. How quickly can 25 years of growth directed at consumer spending be reversed? And reversed to what, especially if the rest of the world continues to struggle? I see little hope of an "immaculate conception" of a fresh, sustainable pattern of economic activity. Until the transition path reveals itself, fiscal policy will be necessary to fill the economic hole likely to exist if the savings proclivities of households continue to exceed the investment intentions of firms.

Ironically, the "best" road to growth is also the riskiest from a policy perspective - a rapid expansion of emerging market activity. Such an expansion, however, would once again place the US in competition for global resources, and threaten a reversal of the commodity and interest rate trends that have been so important to supporting US consumers. Indeed, just the whiff of recovery has supported oil prices, promising an abrupt end to one of the factors supporting US consumers. In the worst case scenario, a flight of capital away from the Dollar (in response to more promising investments abroad) would generate an inflationary and structural shock that would leave the Fed juggling between renewed recession and higher inflation. In short, the optimal external shock would be one only partially supportive; anything more would push the globe to a revisiting of the commodity price surge of early 2008. Looking for a decoupling story now, however, seems like almost a naïve dream.

What is the Fed's next move? One email crossed my inbox after the April employment report suggested some thinking that the Fed could hike rates as early as November. Such a scenario (absent a stability threatening run on the Dollar) must come from a spectacularly optimistic take on incoming data. Data, I might add, that is a reflection of the massive crutch provided by the Federal Reserve and US Treasury, not necessarily a sea change in the underlying economic environment. Look too how quickly bond rates began to climb after the Fed declined to expand Treasury purchases at the last FOMC meeting. More generally, consider this tidbit on Federal Reserve Chairman Ben Bernanke's thinking back in 2003:

The 2003 FOMC transcripts showed then-Governor Ben Bernanke very tuned into financial markets as he pressed for earlier release of Fed forecasts and a willingness to lower interest rates to zero.
From the June 2003 FOMC meeting, when the Fed lowered the target fed funds rate to 1%:

“I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary…I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope.”

“It’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness."

A year and a half after the end of the 2001 recession, Bernanke was looking at the possibility of lowering rates to zero in order to maintain support for financial markets. And comparatively, financial markets were leaps and bounds healthier in 2003 than now. Is a rate hike really feasible this year - or even next - given the current state of dependence of the financial system on government largess? Moreover, consider the disinflation worries in 2003 and fast forward to last week:

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some over the next year relative to its pace in 2008. However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation.

Now consider the output gap over the last decade:

The current gap already far exceeds that of the last disinflationary scare, and Bernanke expects it to continue to expand further, and then diminish only gradually. As long as the gap continues to expand, Bernanke's bias will be in favor of additional easing. The only question is whether he remains content to allow TALF funds to slowly trickle into the economy, or speeds the pace of policy with expansions of longer dated Treasury purchases. Given Bernanke's past behavior, expecting patience on his part seems unrealistic. Moreover, the last jobs report provides less room for optimism than observers suggest. Importantly, Jim Hamilton notes the decline in hours worked appears unabated; threat of a currency collapse aside, there will be no policy tightening, only easing, until hours worked moves unquestionably and sustainably in a positive trajectory.

Bottom Line: The economy looks to be turning a corner relative to the downward cyclical force of last year. But this is only a partial victory, as the factors that that started us down this path - namely, a debt-supported consumer spending dynamic - remain in play, and will likely remain in play for years, arguing for a long period of slow growth, punctuated by short-lived bursts of positive data. In such an environment, and considering the importance of government support to sustain financial stability, the odds favor continued policy easing. Those looking for a more positive scenario are pinning their hopes on either an unlikely rapid return to past patterns of consumer behavior, an unlikely rapid evolution in patterns of economic activity that are not consumer dependent, or a decoupling of emerging market economic activity from the US (which could pose a different set of policy challenges).

This post can also be viewed on economistsview.typepad.com.

How Is The Economic Medicine Working?

The government has been injecting trillions of dollars into the economy, but how has it been working so far? James Picerno looks at recent events and attempts to answer that question in his blog post below. In addition Picerno takes a look at what lies ahead for the U.S. economy, and offers some words of wisdom for investors.

In late-March, we asked: Is the medicine working? By medicine we meant the massive injection of liquidity into the economy as a cure for fending off deflation and laying the groundwork for recovery. At the time, we were mildly encouraged, in part due to the rising inflation forecast as derived from the spread between the nominal and inflation-indexed 10-year Treasuries.

More than a month later, there's still reason for optimism, perhaps more so, thanks to the so-called green shoots that suggest better days ahead. Yet the rate spread, which is to say the market's inflation outlook, hasn't changed much since late-March. The current forecast is for inflation of 1.4% for the next 10 years, just barely up from around 1.3% from the end of the first quarter. In both cases, that's a healthy change from expecting flat pricing, as was the case at the end of 2008. Low inflation as far as the eye can see would be nice, but is that a reasonable expectation?

In the months ahead there will be a thin line between a healthy rise in inflation expectations and the potential for burdensome pricing pressures later on. Deflation is a hazard to be avoided for a number of reasons. Although we can't quite shut the book on the danger, the odds look increasingly in favor of mild inflation for the foreseeable future, as the chart above suggests. Behind this reasoning is the growing sentiment that the recession is at or near a bottom. Is it time for the Fed to begin tightening? Or are the green shoots still too tentative?

"We're seeing more indications of perhaps a bottoming in the economy," Bill O'Neill of LOGIC Advisors tells Dow Jones. "So there is an increasing—and it will continue to increase—concern surrounding inflation potential."

Gold, the perennial inflation hedge, seems to be considering the possibility, although this market hasn't quite made up its mind. The price of the metal has been hovering around $900 for much of this year, just below its all-time high of $1,033, set back in March 2008. The 10-year Treasury yield, meanwhile, has been climbing, recently bumping up against 3.2% on renewed worries that inflation may now be the bigger risk. Even so, a 10-year yield of 3.2% is still quite low.

None of the inflation anxiety is worrying the stock market, which has now reversed the selloff in the first quarter. Indeed, the S&P 500 is now marginally up on the year, as of last night's close, on expectations that by the end of this year the economy will be sitting up and prepared to get out of bed.

The big question is whether all the renewed hope that the worst is over is really just the byproduct of a bear market bounce in markets and inflation expectations? Given the extreme waves of selling last year and into March, a rebound was all but assured if the world economy didn't collapse. As we now know, it didn't. There are still lots of problems, but we'll all be here next year and so it was time to reprice assets upwards to reflect a humbled but otherwise enduring economic climate.

Investors have cheered the signs that the U.S. economy no longer seems to be contracting at an accelerating pace. Given the fears of what could have happened, that's certainly a reasonable response. Deciding that you're not going to fall into the abyss is always encouraging. But that's still a long way from arguing that growth is imminent, or that the economy won't tread water for a year or two.

The first phase of the post-apocalyptic visions that prevailed six months ago may be over. If so, now we're faced with the more difficult chore of deciding how to repair and rebuild the economy to foster growth while containing inflation. The hardest days are yet to come. Unless you're expecting a seamless transition, keeping some cash at the ready still makes sense, albeit less so than in past months. Volatility isn't banished, it's only hibernating, which suggests another round of value-oriented pricing opportunities in the major asset classes.

This post can also be viewed on capitalspectator.com.

Fed Holds Steady...For Now...

Earlier this week the Fed decided to hold steady with their previous policies, however, it is still likely that they will need to provide additional easing in the months ahead. Mark Thoma looks at an article from Tim Duy, in his blog post below, that talks more about the economy and what's likely in store for Fed policy.

Despite Green Shoots, Odds Favor More Easing, by Tim Duy: The Fed took an interesting risk by holding policy steady on Wednesday.With green shoots all the rage, policymakers are ready to step to the sidelines as they monitor the progress of their many programs. And clearly, they must have known that the 3% level on 10-year Treasuries was dependent on the expectation that policymakers would expand the pace of outright purchases of those assets, but are betting that economic conditions will remain sufficiently weak to prevent a crippling increase in rates. Still, given that policymakers still see the economy in decline, albeit at a slower rate, the odds favor additional easing in the months ahead, especially considering expectations of a widening output gap. Recall that labor markets, and the threat of deflation, kept the Fed easing well past the end of the recession in 2001.

Short of an outbreak of inflation, or a unexpected and unlikely surge of growth, there is little reason to think that the Fed is ready to bring policy to a sustained pause. And an imminent rise in inflation remains an outside risk for the Fed; the focus remains consistently on disinflation or, worse yet, outright deflation. A key paragraph is:

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

Policymakers are counting on a rising output gap (both here and abroad) and lags in the price setting process to keep inflation at bay. Indeed, this must be the case, as some of the current numbers are really not all that comforting. I am not inclined to place too much focus on headline inflation - oil prices appear to have found a bottom around $50 a barrel, and sustained hints of a firming of global economic activity would promise to send prices higher, thus offsetting the strong disinflationary impact of falling energy prices since the middle of 2008. In contrast to low year-over-year headline numbers, the personal income and outlays report for March revealed that core PCE prices gained by 0.2% in each of the past three months, pushing the annualized three month trend back above 2%:

And note that near-term inflation expectations have climbed back up into a normal range:

From this perspective, policymakers have done a good job anchoring inflation expectations against the possibility of deflation. Is this enough, however, to unsettle FOMC members? Despite these inflationary hints, it is simply unlikely that the Fed would ignore the disinflationary implications of the output gap. One way to ignore the gap is to argue that the US will revert to an emerging market inflation dynamic. I think such an argument requires a steady depreciation of the Dollar to hold - which could happen, but a Dollar crisis looks, for the moment, unlikely given relative global weakness. One could also argue that estimates of potential output are optimistic and don't reflect the importance of structural change in the economy. This is the issue that Nick Rowe at the Worthwhile Canadian Initiative attempts to tackle:

Even in the short run a good banking and financial system will be important in re-allocating capital between growing and declining sectors, if there are shifts in relative demand. If people want fewer cars and more restaurant meals, but banks cannot shift loans from car manufacturers to restaurants, the Short Run Aggregate Supply curve may shift left, because the restaurants won't be able to expand to meet demand, and car manufacturers' prices or wages may be sticky downwards.

If you see the financial crisis as causing the recession by shifting the SRAS curve left, then monetary and fiscal policies, which shift the AD curve right, are not the appropriate cure. Even if you see leftward shifts of the SRAS curve as only part of the story, you will see limits on what monetary and fiscal policy can achieve. When expansionary monetary and fiscal policies start to cause excessive inflation, before output and employment have returned fully to normal, you will know that purely AD policies have reached the limit of what can be expected from them.

Nick is slapped down by Brad DeLong:

But if bad banks have shifted the AS curve inward, then right now we should have stagflation: depression and inflation, as output falls and prices rise. We don't. The argument that fiscal and monetary policies won't reduce unemployment to normal levels because we have a supply side problem is completely incoherent in an AS-AD framework.

Brad is correct that in a traditional AS-AD framework, bad banks are demand shocks, not supply shocks. There is still something about Nick's argument that is important - the financial system redirected capital investment into housing and consumption related activities. Presumably, potential output includes the ability to build and sell as many houses the US economy produced at the height of the housing bubble. But what good is that output if we don’t want to build and sell that many houses in the future? How do we redirect capital away from those sectors? And how long does it take? Arguably, the narrowing of the US trade deficit is pushing that adjustment forward, as the US economy can't focus entirely on producing nontradable goods. Recall Brad DeLong from 2005:

There is an alternative scenario, one in which foreigners'--including foreign central banks'--desired holdings of dollar-denominated assets shortly hit the wall, and the asset price shifts that result from desired holdings' hitting the wall reduce, or do not increase, confidence in the dollar.

In this alternative scenario, the U.S. has to move about ten million workers out of currently-favored sectors--construction, home-equity-credit financed consumer expenditures, and so on--into export and import-competing manufactures. How much structural unemployment does such a sectoral shift require, and how long does the structural unemployment last? Other countries have to shift up to forty million workers out of export manufactures into other industries, and to generate demand for the products of those industries (without destabilizing their own monetary systems and asset prices, as Japan appears to have done at the end of the 1980s). The U.S. Federal Reserve would have to cope with whatever inflationary pressures are generated by rising import prices. Foreign central banks would have to cope with whatever stresses on their own asset prices are created by enormous losses of value in the stocks and bonds of their exporting companies.

If structural unemployment is rising - not because banks are currently bad, but engaged in bad behavior in the past - attempts to reduce unemployment back to pre-recession levels will yield higher inflation. This problem is minimized if labor resources can be quickly redirected into other sectors, a process that Nick above is implying is hampered by the existence now of bad banks. But, as Brad suggested in 2005, getting to inflation in the current environment seems to require a Dollar collapse - a story that for now is difficult to tell.

All of which is interesting, but even if you believe that structural unemployment is rising, I don't think anyone believes it is near the 8.5% rate for March (not to mention the underemployment rate of 15.6%). Nor does anyone expect that recent green shoots are sufficient to keep unemployment from rising further. Moreover, note that the Employment Costs Index released today reveals the continued slide in employee compensation costs - consistent with the FOMC's concerns about economic slack. Indeed, the ECI highlights the risks of the Fed's move to hold steady policy: Declining wage growth, coupled with higher interest rates, would play havoc with household efforts to reduce balance sheets and intensify the need to boost saving rates. Hence why the risks still favor additional policy easing - especially if programs such as TALF and PPIP are less successful than imagined.

In short, the shoots are much too green and the output gap much too wide to stimulate much discussion on Constitution Avenue that the end of easing has conclusively been reached. A pause to assess, yes. But Fed officials will be looking for clear and convincing evidence that economic activity is both self sustaining (not likely to fade after the initial burst of federal stimulus moves through the pipeline) and sufficient to substantially reduce the output gap before they sound the all clear signal. An end to the rapid pace of job loss is very different from a return to steady job growth. Again, recall the sustained pattern of easing in the wake of the 2001 recession - we need to go a long way up from -6% GDP growth before the job engine is started. To be sure, there should be some lingering concern that the Fed will act quickly (or at least the markets will act quickly), if there is a perceived need to withdraw monetary accommodation. But the data are well short of what would be necessary to justify such a shift in policy in the near future.

This post can also be viewed on economistsview.typepad.com.

Deflation Taking Hold In Europe

We have been hearing a lot about deflation here in the U.S., but so far we have been able to hold it off for the most part. It appears that Europe is not having as much luck though. Deflation can be an economic killer as we saw during the Great Depression and more recently with Japan's Lost Decade. For more on this, read the following blog post from Tim Iacono.

Spain, the U.K., Luxembourg, Portugal, Ireland - who's next to succumb to the scourge of deflation? Yesterday, the New York Times reported that Spanish merchants have been slashing prices with abandon, auguring in the possibility of a dreaded "deflation death spiral".

Prices dipped everywhere, from restaurants and fashion retailers to pharmacies and supermarkets in March.
...
With the combination of rising unemployment and falling prices, economists fear Spain may be in the early grip of deflation, a hallmark of both the Great Depression and Japan’s lost decade of the 1990s, and a major concern since the financial crisis went global last year.

Deflation can result in a downward spiral that can be difficult to reverse. As unemployment rises sharply and consumers cut spending, companies cut prices. But if sales do not pick up, then revenue can decline further, forcing more cuts in workers or wages.

Once again, falling prices are characterized as the potential source of much bigger problems ahead, as if the world had something even remotely close to "sound money" where currency maintained its value over long periods of time as it did in the U.S. prior to the creation of the Federal Reserve in 1913.

To review -- in the hundred years prior to the Fed, inflation rounded to zero, whereas, in the nearly hundred years since 1913, the U.S. dollar has lost 96 percent of its value.

Policies that have resulted in this loss of value, now accepted as conventional wisdom by central bankers around the world, make real deflation (the minus 10 to 15 percent per year variety, not the -0.1 percent Spanish version) a near impossibility today.

But, that doesn't stop dimwitted dismal scientists from looking there instead of at the bursting of the biggest asset bubble in the history of Mankind when identifying villains in the current economic and financial market maelstrom.

“It doesn’t mean it will spread here to the U.S., but we need to look closely at Spain and other places to understand the dynamic,” says Simon Johnson, a professor at the Sloan School of Management at the Massachusetts Institute of Technology and a former chief economist for the International Monetary Fund. “It’s like the front line of a new virus outbreak.”

If only economists would spend more time examining how they failed the world so miserably over the last few years instead of at a 19th century phenomenon, we'd all be better off.

In the U.K. too there is much gnashing of teeth where annual deflation is running at a whopping four times the rate now experienced to the south - minus 0.4 percent.

The funniest thing about English deflation is that it is, in large part, directly caused by central bank actions. The broadest measure of consumer prices includes mortgage costs, the vast majority of which are variable rate loans, and, as short-term rates have been slashed, these consumer costs have tumbled as detailed in this report in the Telegraph.

The Retail Prices Index (RPI) measure of inflation fell to -0.4pc in March, indicating that prices paid by consumers last month were lower than a year ago - a trend not seen since March 1960.

RPI inflation, which includes housing and mortgage costs, has been driven down by the the series of aggressive interest rate cuts from the Bank of England which have triggered lower variable rate mortgage repayments .
...
The economy is expected to remain in deflationary territory for many months, which will mean pensioners will receive the lowest possible increase of 2.5pc next year, adding just £2.40 to the full weekly pension, an amount criticized as "derisory and pathetic" by campaigners.

If health care costs in the U.K. are anything like those in the U.S., there are probably a lot of irate senior citizens.

A related story explains why we should all be fearful about deflation beginning with the moronic example of how, after television prices have been falling for the last 20 years, additional price declines will cause consumers to think twice. Really!?

1. It causes consumers and businesses to feel concerned about spending. Why buy that £400 television this week when you are confident it will be cut in price to £350 next month? The same applies to businesses – why invest in new machinery, or software when you think it will fall in price? Deflation can, if it becomes entrenched, cause the whole economy to grind to a halt.

2. Deflation causes wage cuts. Employers can argue that they do not need to give their staff a pay rise, because their staff can buy more goods with the same salary. Many companies are freezing pay and started cutting wages in some cases.

3. In theory, falling wages should not matter if the price of goods and services fall as well. But in practice it is very damaging psychologically. People paid £30,000 one year do not like being paid £29,000 the following year even if they can buy the same amount of goods. Everyone feels less wealthy, especially home owners whose main asset is falling in price. And when they feel less wealthy, they spend less, causing a vicious downward spiral in the economy.

4. Deflation causes the value of people's debts to mount. A £100,000 mortgage might cost £4,000 to service each year, but the value of the house could fall by £4,000 or more – a dispiriting experience, but you will still need to keep on servicing the debt.

Wage cuts, tumbling asset prices, and making debt service more expensive are all legitimate arguments but falling consumer prices really don't belong in this discussion unless it's something more than volatile energy prices and, in the case of the U.K.-style deflation, lower interest rates caused by the central banks that, ironically, are desperately trying to avoid seeing consumer prices move lower.

For a more complete discussion on this subject, see Seven key points on deflation or the many other items categorized under "deflation" at this blog.

This post can also be viewed in themessthatgreenspanmade.blogspot.com.

More Economists Predicting A Depression

According to a couple economists our present financial crisis looks like a recipe for a depression. The main difference they see between a normal recession and a depression, is that a depression originates in consumer debt. If these economists are correct in their theory, the recent positive market movement will only be a suckers rally. Tim Iacono looks closer at the recent article published by these economists, and adds some of his own thoughts, in his blog post below.

In this commentary in today's Wall Street Journal, economists Steven Gjerstad and Vernon Smith offer a theory about why we could again be going from a bubble into a depression.

Over the years, there have been quite a few bubbles, but not all of them cause the sort of economy-wide damage that was seen in the 1930s or over the last year or so. Why?

Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

Most people forget that it wasn't just a stock market bubble in 1929 that led to America's last lost decade. There was an enormous housing and credit bubble in the mid-1920s during which Groucho Marx and others lost a good deal of money on Florida swampland.

As has been the case thoughout history, you can't get a really good bubble going until you get broad participation from the public - preferably lots of people at the lower end of the socio-economic scale levered up courtesy of a banking system that is gushing with easy money.

That pretty much described the situation in the 1920s and in the 2000s.

The entire piece is worth a look as they go through the recent history of financial bubbles in the U.S., a sequence that really accelerated about 20 years ago when you-know-who started sitting in the big chair at the Federal Reserve boardroom.

Interestingly, they touch on one of my all-time favorite subjects since this blog began a few years ago - how owners' equivalent rent duped the Fed.

During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

Yes, "an important component of inflation remained outside the index" - that sort of thing almost always ends badly as noted here on many occasions before.

After years of writing on this subject, yours truly still comes out high in a simple Google search on the phrase owners' equivalent rent - right there in second place, behind the Bureau of Labor Statistics with "How owners' equivalent rent duped the Fed" and then again in fifth place with the memorable "The complete and utter failure of owners' equivalent rent".

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Profiting From Reflation: A Bet On Economic Recovery

I read an interesting article in the Wall Street Journal this morning that I thought I should share. There are a lot of people who have been making a great deal of money during this economic crisis by shorting the economy, or specifically betting that it would get worse. Many of these same traders are now making a different bet. They are betting that not only are these exorbitant stimulus measures going to stimulate the economy, but they are also going to lead to high inflation.

Right now the Federal Reserve is so concerned with preventing the dreaded D words (Deflation and Depression), that they are basically ignoring the threat of inflation. Once the economy gets going again, though, they are going to have to react incredibly fast in order to prevent a massive run up in inflation. Chances are the government will be slow to react, and if anything they prefer to error on the side of inflation — opposed to prolonging the recession.

What this means is that as the economy starts to recover those investments which typically do well in inflationary environments, stand to do very well. Commodities specifically have proven to be the investment of choice for many successful investors.

To read the full Wall Street Journal article click here.

We Avoided Deflation Again: Soon Inflation Could Be Problem

The latest CPI reports showed that we once again avoided the dreaded "D" word — deflation. But as James Picerno points out while we are worried about deflation now, at some point here we are going to have to unwind all the policies that have been enacted to boost the economy. Since policy makers tend to be a little behind on the unwinding side in all likelihood we will experience hefty inflationary pressure before things balance out again. So while we are worried about deflation now, soon our concern needs to move to controlling inflation off the backend. For more on this, read the blog post below from James Picerno.

Today’s report on consumer price inflation (CPI) for February confirms yesterday’s news on wholesale prices for last month: deflation is on the run. For the moment, anyway.

That’s good news, but if it’s true, then monetary policy becomes increasingly tricky in the months ahead. We say if it’s true because it’s hard to make definitive conclusions on just a few months of data. At the moment, the case for arguing that deflation has been banished rests on January and February numbers. Deciding if that’s a trend with legs remains speculative, albeit less so than in the past several months. Only once it's clear that the economy is past its worst point in the current downturn will it be obvious that deflation is no longer a threat. Where and when that point lies, alas, isn't yet obvious, at least to this observer.

Meanwhile, the Labor Department reports this morning that consumer prices rose 0.4% last month on a seasonally adjusted basis. That’s up from January’s 0.3% and both numbers stand in sharp contrast to the previous three months (Oct through Dec), when CPI dropped sharply.

Core inflation (excluding food and energy) was up 0.2%, as it was in January, suggesting that overall prices, as defined by the Federal Reserve, are more or less stable. For the year through February, core CPI advanced 1.8%, roughly in line with where the Fed would like to see it remain through time.

Does this mean the all-clear sign for deflation worries is past? Perhaps, but it’s still too soon to say. There was never any doubt that a determined central bank can engineer inflation. Indeed, that’s the natural order of economic behavior and many a central bank has unwittingly fostered higher inflation without necessarily trying. The fact that the Fed has been working over time to generate higher inflation as an antidote to elevated deflationary risks should surprise no one when the effort bears fruit.

One clue that the reflation efforts are more than noise comes by noting that CPI’s major subcategories all posted higher prices last month save for food and beverages. The same was true for January, a month when food prices climbed as well. That’s a big and productive shift from 2008’s fourth quarter, when price declines were running hard. At the time, the fear was that the negative price momentum would build a head of steam and, left unchecked, would develop into sustained deflation.

As we write, there’s reason to think the Fed’s policy of nipping deflation in the bud is working. Is it time to pull the plug on the massive liquidity injections? No, not yet. There's still a strong, negative headwind blowing in the economy, starting with the labor market. Until we learn more about how the current business cycle is unfolding, the case for keeping Fed funds just above zero is compelling. One metric to watch closely in the coming weeks is initial jobless claims, which is one of several critical components for estimating the current state of the business cycle, as we’ve discussed.

Meantime, Bernanke and company begin their two-day gab fest today at the Fed. As we write, the Fed funds futures market is expecting more of the same: leaving the Fed funds rate unchanged at just over zero. For the moment, that’s prudent, but it may not be so for much longer. When it’s clear that deflation is no longer a clear and present danger, it’ll be time to start raising interest rates to keep the inflationary medicine from bubbling over down the road. That’s not going to be easy in an economy that, even in the best of scenarios, is likely to be struggling for the foreseeable future.

In short, we may be nearing the end of the heightened risk for deflation. That suggests that a new era for monetary policy is coming, and it promises to be a difficult one, which is to say that the risk of error will be quite high. As inflationary pressures return, albeit slowly and tenuously, the central bank will have to navigate a fine line of keeping prices under control without creating excessive drag for economic growth. The previous run of monetary policy decisions look like child’s play by comparison.

This post can also be viewed on capitalspectator.com.

Energy Prices, And The Fight Against Deflation

All the talk about deflation has falling off considerably, and a lot of that has to do with energy prices. Will energy prices continue to go up? How will they continue to impact consumer prices? Do we still need to worry about deflation? James Picerno from the Capital Spectator attempts to answer these questions and more in his blog post below:

Producer prices rose last month. That's good news in the war on deflation.

The news wasn't totally unexpected, as we discussed on Tuesday. The partial rebound in energy last month—heating oil and gasoline—is a key reason for the return of inflation to wholesale prices in January. The same forces suggest that tomorrow's update on consumer prices will also post a mild gain for last month.

Producer prices rose 0.8% in January on a seasonally adjusted basis, the Labor Department reported this morning. That's the biggest gain since July—in fact, it's the only gain since July. From August to December, wholesale prices fell in each and every month. That makes today's news of higher prices welcome since it suggests that price stability may be near. It's too soon to be sure, but for today, at least, there's fresh reason for hope.

The source of the last month's rise was the 3.7% pop in the energy component of the producer price index (PPI). It's not clear that energy prices won't resume their decline. Crude oil, as we write, is trading at around $35 a barrel in New York, well below its January average of roughly $40. Heating oil, natural gas and gasoline are also losing ground so far this month.

To the extent that the January's rebound in prices depends on energy, there's probably further deflationary worries ahead. In fact, you can just about count on it. Heating oil and natural gas prices no longer have seasonal support of winter and so as the warmer weather approaches, lower prices are likely. Meanwhile, the economic weakness that's still pulsing through the American economy is likely to bring another leg down in the demand for crude oil and gasoline.

Nonetheless, the heavy losses in energy are likely behind us. That doesn't mean that prices won't go lower. But expecting another 50% in crude oil, for instance, requires an exceptionally bearish outlook that looks excessive from your editor's vantage at the moment.

Maybe, just maybe, there's a bottom lurking in energy prices in the near future. That's the view of the energy team at Bernstein Research in London. In a research note sent to clients today, Bernstein opines with contrarian flair: "The outlook for the energy space now seeming as grim as it can be in 2009 and increasingly in 2010, we believe there is limited downside to the beta energy names and therefore it is the right time to make a relative valuation call for the North American energy stocks." Bernstein recommends that investment portfolios should be "increasingly overweight energy as the year progresses…"

We're not particularly fond of dramatic changes to portfolios based on industry trends and so we remain agnostic on such recommendations. Rather, we're intrigued by the fact that some energy strategists are starting to think that the great decline in energy prices, if not over, may be close to ending.

Although Bernstein's not predicting a new bull market in oil, the shop observes that spare production capacity is still "relatively tight." Meanwhile, Bernstein estimates that oil and gas are close to their "cash cost." The firm advises that "over time [oil and gas] prices cycle around the marginal cost of supply dependent on near term supply/demand dynamics." If we're at or near cash cost, that implies that a bottom is, if not imminent, close, as suggested by the chart below, which comes via today's Bernstein report.

Even if energy prices begin treading water, that would go a long way in helping keep deflation at bay. Meanwhile, the aggressively loose monetary policy is only starting to seep into the economy. As the year goes on, the substantial reflation efforts engineered by the Fed should start to show results. The big question is whether the broad economic environment continues to deteriorate and overwhelm the reflationary trend.

Yes, 2009 is the great year of transition, with negative and positive forces battling one another in an epic struggle to claim the future. Today's price report is but a small skirmish in a larger war. Then again, victory in war comes one battle at a time. Score one for the anti-deflation army. Just don't celebrate for too long. There's still plenty of fighting ahead.

This post can also be viewed on capitalspectator.com.

EU Leaves Interest Rates Unchanged In Risky Move

All over the world central banks are dropping key interest rates in an attempt to stimulate lagging economies. Why then would the head of the European Central Bank leave interest rates unchanged despite wide spread economic turmoil among EU countries? Kathy Lien shares her thoughts on Trichet's controversial decision, along with the potential impact to currency markets, in her blog post below.

Here is a snippet of my comments about this morning’s price action on FX360.com:

There has been a lot of action in the currency market this morning, mostly centered on the British pound and Euro.

ECB President Trichet is not buckling under pressure. After leaving interest rates unchanged at 2.00 percent, he refused to make any decisive comments on where interest rates are headed in March. Trichet is still buying time to see how the economy and price pressures respond to their recent rate cuts. The Euro has held steady because Trichet said he is not pre-committing or excluding anything. The zero interest rates that Prof Roubini is calling for is out of the question especially for a central bank that remains obsessed with inflationary pressures. Trichet acknowledged that inflation will continue to fall but he expects it pick up in the second half of the year and if oil prices rebound, the acceleration of price pressures could exacerbate. Rather than being completely downbeat about growth, Trichet said that even though the risks are clearly to the downside, there are signs of stabilization. By postponing rate cuts, Trichet is putting his credibility and reputation on the line.

The ECB cannot stop cutting interest rates at this time especially as we continue to see very weak economic data. German factory orders fell 6.9 percent in the month of December, more than double the market’s forecast. Trichet who is known for his candor has already admitted that 2 percent will not be the lowest level for Eurozone interest rates and the market may be right to bet on a 50bp rate cut in March. If he doesn’t plan to cut interest rates to 1.5 percent next month, he would not comment on the market’s expectations. Although zero interest rates is off the table, we do not think that the ECB will stop at 1.50 percent. Interest rates could fall as low as 1 percent, which is why we could see more weakness in the Euro.

EUR/GBP Crushed After BoE Rate Decision

EUR/GBP collapsed following the Bank of England’s decision to cut interest rates to 1 percent. Even though the yield advantage in EUR/GBP has increased from 50bp to 100bp in the Euro’s favor, the market is less focused on interest rate differentials and more focused on recovery. The pound is trading higher because the Bank of England and the UK are being rewarded for their aggressive monetary and fiscal stimulus. The Euro on the other hand is being punished for implementing sluggish monetary policy.

This post can also be viewed on kathylien.com.

What Will The Fed Do To Stimulate The Economy Now?

Bernanke and the Fed already played their last interest rate card, so if they can't lower rates what else can they do to get the economy back on track? There is a lot of speculation going around right now about what they might do, but we shall find out for ourselves later today. James Picerno from The Capital Spectator talks about the Fed meeting and the economy in general, adding some valuable input in his blog post below.

The press release that follows the Fed's FOMC meeting today may offer clues about how the central bank will proceed now that it's out of conventional monetary policy ammunition. Then again, maybe not. We're all trapped in gray zone of trial and error about what to do next and the Federal Reserve is also now faced with grasping at straws.

Typically, an afternoon FOMC press release attracts interest for an update on where short-term interest rates are headed. Today, and probably for some time to come, everyone already knows the answer. The Fed controls short rates, starting with the all-powerful Fed funds, but with the effective Fed funds at roughly 0.16%, the mystery about what comes next is, like the price of money, virtually nil.

Yet Bernanke and company may yet surprise us by dropping fresh clues about how the Fed plans to practice unconventional monetary policy from here on out—quantitative easing, to use the phrase of the dismal science. The details are a work in progress, although the immediate goal is still clear: stabilize general price levels.

We won't belabor the issue of deflation today, in part because we've discussed it often in recent months, including here and here. Let's just say that the D risk is still very much with us, and so the Fed has a fair amount of work to do in the months ahead.

The market appears to understand this, at least by way of monitoring Fed funds futures. For the year ahead, all the contracts are expecting Fed funds to remain under 60 basis points, and quite a bit lower for the immediate future.

Long rates remain in a holding pattern as well. The yield on the benchmark 10-year Treasury Note is in the 2.5% range and it may go lower yet, depending on what the next round of inflation reports reveal, although those won't arrive for several weeks.

Meantime, there's plenty of guesswork about what the Fed's next move. "With rates going nowhere for some time, the market's focus will be on whether the Fed will be looking to buy government (or corporate) securities in the near future," Sacha Tihanyi, an analyst at Scotia Capital, opines via AFP.

John Authers in today's FT argues that the critical variable is housing prices. What can the central bank do on that front? "The Fed can give details on quantitative easing— the ugly phrase for the art of buying bonds so as to push down the yields they pay, and stimulate the economy with lower rates, especially for mortgages," he writes. "If there is a single key variable to determine when the crisis in the US banking system can be brought under control, it is house prices. The further they fall, the higher the likely default rate on the mortgage-backed securities that banks now hold on their balance sheets."

Unfortunately, the news on housing prices is still discouraging, even after several years of a falling market. One of the latest bits of housing data shows that prices fell again last month even as sales perked up. Existing home sales rose 6.5% in December, albeit driven by distressed sales at bargain prices, the National Association of Realtors reports. Nonetheless, the median national price of existing homes in the U.S. still dropped by a hefty 15.3% last month.

Even if the Fed is successful in fending off deflation, which we expect it will be, that by itself isn't a cure for what ails the economy. "Ben Bernanke is rightly concerned about deflation right now," Desmond Lachman of the American Enterprise Institute explains in The Christian Science Monitor. But that's merely step one in a multi-step recovery program. "Getting inflation back into the system … is not going to be sufficient," Lachman notes.

Convincing banks to lend and consumers and businesses to borrow is arguably the next big step beyond containing the deflation risk. Solving the latter will be easy by comparison. The real challenge will come later this year in trying to promote growth. But first things first, and so we await today's Fed commentary.

This post can also be viewed on capitalspectator.com.

Welcome President Obama: Now About The Economy...

Yesterday was basically one big party, everyone it seemed was excited to welcome in our new President. Now the party is over and it is time for Obama to get to work, and he had better act fast. The economy is struggling mightily and Americans expect, albeit a tad unfairly, that Obama's administration is going to be able to fix the problem. James Picerno from The Capital Spectator paints a dreary picture for the economy over the coming months, while holding out some hope for a recovery, in his blog post below.

Today is the first full day of President Barack Obama's administration and, as everyone knows, the new commander in chief has his work cut out for him. With a fresh start before us in Washington the question on the home front remains: What's up (or down) with the economy?

In broad terms, the answer is obvious, and the numbers only lend statistical support. Clearly, tough times lie ahead, with the next 6 months or so looking set to be the toughest. But how does that square with our proprietary measure of U.S. economic activity (CS Economic Index), which bounced sharply higher in November, the last month with the full compliment of data pieces for calculating this benchmark? What's more, based on preliminary data for December, the November bounce looks set to hold.

Alas, the rise is something of an illusion for the time being since only two factors out of the 17 in our economic index are driving the bounce skyward. Granted, the pair is on steroids trying to bring aid and comfort to the ailing economy. Statistically, the changes in those two factors are enough to push the entire index upward. Even so, those two lone bullish factors alone, unfortunately, aren't likely to spark a recovery of any substance for the foreseeable future. Looking out later in the year offers some hope, but first let's talk about the immediate future.

The two factors doing all the heavy lifting in our economic index are money supply and the interest rate spread. Both were in overdrive in November in terms of generating pro-recovery fuel to an otherwise shrinking economy. The rate spread was particularly bullish, although the growth-oriented bounce from money supply was robust too. Collectively, the pair overwhelmed the negative energy elsewhere in the economy, at least when measured on an average basis.

By rate spread we're talking of the difference between the yield on the 10-year Treasury Note less the effective Fed funds. Thanks primarily to the dramatic fall in Fed funds in November, which continued in December, the rate spread widened sharply and thereby moving definitively into positive territory, which generally is a bullish signal for the economy. Why? Because a positive sloping yield curve—rates are higher as bond maturities lengthen—historically accompanies economic growth. By contrast, a negatively sloping yield curve—rates fall as maturities lengthen—is a sign of distress/economic contraction.

Based on the rate spread, this measure went negative in July 2006 and stayed negative until February 2008, when the spread moved back into positive territory. Looking back, it turns out that the recession warning posed by the arrival of a negative yield curve in mid-2006 was an accurate forecast of an approaching recession, which officially began in December 2007.

Fast forward to November 2008 and the rate spread is telling us that it's now in high gear as an economic stimulus. That is, short rates are extremely low relative to long rates—despite the fact that long rates are also bouncing around at historically low absolute levels. Based on this measure alone, one might be bullish on the immediate future, assuming this was a normal cycle. But as we know, the times are anything but normal and so even the unusually bullish stimulants coming from the money supply and interest rate factors aren't yet dispensing their usually pro-growth influence. The reason is that the negative drag from everything else is, for the moment, still too much to overcome. Indeed, the lagging and coincident factors in our broad economic index are either flat lining or still declining.

The good news is that at some point all the monetary stimulus will take root and promote expansion. All the money has to go somewhere and eventually it'll go into corners of the economy other than banks accounts and T-bills. Banks will one day lend and businesses will borrow. In addition, now that the Obama administration is at the helm, we expect a fresh round of fiscal stimulus to compliment the monetary efforts now running at full speed.

Guessing when all this will produce some measurably positive change in the economy proper is the great question. Given the depth and magnitude of the economic headwind, we're not expecting much for the first half of this year, perhaps longer. Even when signs of growth, or at least stabilization emerge, they're likely to be tenuous, slipping temporarily back into negative territory and keeping everyone on pins and needles.

Recovery worth the name is going to take time, and perhaps a fair degree more time than we've come to expect over the past generation, when growth returned fairly quickly after a downturn.

As such, strategic-minded investors should pace themselves and use the next several quarters productively to restructure their portfolios for the day when the storm passes. As we'll discuss in more detail in the February issue of The Beta Investment Report, the ongoing economic and financial turmoil is wrenching but it also offers substantial opportunities for dynamic asset allocation strategies.

That said, the next several months are undoubtedly going to be rough, replete with surprises, false starts and lots of noise in the markets. Economically speaking, there are still a number of big unknowns lurking in the near-term future too. Investors should brace themselves for more volatility, and at the same time prepare to take advantage of it.

Risk management, in other words, has never been more important, or potentially more rewarding.

This post can also be viewed on capitalspectator.com.

Consumer Prices Fall 0.7 Percent

The latest CPI report showed that prices fell 0.7 percent in December. While this likely will have people worried about deflation, that isn't the problem yet. To fully understand what is happening with the CPI numbers one must look closer at the underlying data. Tim Iacono from The Mess That Greenspan Made attempts to weed through the information and provide some insight for us in his blog post below.

The Labor Department reported that consumer prices fell 0.7 percent last month but rose 0.1 percent during all of 2008. As is the custom, the monthly figures use seasonally adjusted data while the annual inflation rate gets the non-seasonally adjusted variety.
Interestingly, as indicated in the chart above, the seasonally adjusted data now shows a 0.1 percent annual decline in prices.

And you know what that means...

DEFLATION!!

No not really.

A 0.1 percent decline in the Consumer Price Index would be better characterized as follows:

DEFLATION!!

The big red bold type should be reserved for real deflation as was seen in the 1930s, not the Japan style "baby-deflation" where the enlarged font really only serves one purpose - to give governments and central banks license to print money at astronomical rates to once again forestall the inevitable end of another system of pure fiat money.

They always end badly ... but, the current one still has a ways to go.

Don't confuse an energy-induced downward spike with deflation as your grandparents or great-grandparents knew it - they are entirely different things. And they will still be entirely different things in the months ahead as lower energy prices push CPI-inflation lower. Remember, this summer we'll be comparing last year's $4 gasoline to something about half the price.

You can see just how much tumbling energy prices affected overall inflation last year. Shown below are the monthly and yearly changes across all CPI categories - many prices continued to rise through 2008, notably food (up 5.8 percent), education (up 3.6 percent), and medical care (up 2.6 percent).
And yes, amid all the talk of deflation and plunging home prices, owners' equivalent rent (the consumer price index substitution for the cost of home ownership) continued to rise, up 0.1 percent in December and 2.1 percent higher than where it began the year.

Maybe some day, some brave young economist somewhere will successfully challenge what others haven't had the gumption or common sense to object to - how owners' equivalent rent has made a laughing stock of the government's consumer price index (it accounts for nearly 25 percent of the headline inflation number) and, in the process, greatly contributed to the worst financial crisis since the Great Depression.

This post can also be viewed at themessthatgreenspanmade.blogspot.com.

There Is No Need To Worry About Deflation

Deflation is certainly a hot topic of late, but is it really something we should be worrying about? Deflation is a scary thing, don't get me wrong, but according to some experts the U.S. isn't about to enter into a deflationary spiral. Government officials have shown no qualms about printing money as needed, and it is likely that they will print us out of any deflationary pressure. Tim Iacono from The Mess That Greenspan Made looks a little closer at this concern in his blog post below.

An article by Rich Toscano and John Simon of Pacific Capital Associates makes a very good case for why an extended period of CPI-deflation is highly unlikely in the U.S.

The motivation of policymakers is summarized nicely in this paragraph:

There is a powerful combination at work. Mainstream economic pundits, academics, and policymakers are united in their opinion that deflation must be prevented. They are providing a theoretical justification for highly inflationary policy, and right or wrong, this justification is widely accepted as truth. Meanwhile, from a politician's standpoint, inflation is a far more viable and easy path than deflation. This combination of real-world incentive and theoretical justification induces our monetary and fiscal leaders to overwhelmingly favor an inflationary outcome.

And with a pure fiat money system, where the whole idea of printing up hundreds of billions (if not trillions) of new dollars is quickly becoming the consensus "lesser of two evils" in how to best avoid another Great Depression, it all really boils down to whether or not they'll be successful.

They will.

Who knows what the world will look like when they're done, but they will be successful.

The entire piece is well worth a look, particularly the discussion of nine counterpoints, one or more of which have "deflationists" so excited at the moment:

- Pushing on a String
- Japan
- Lost Financial Asset Wealth
- Credit Deflation
- Debt Defaults
- Recessions
- Foreigners Won't Let Us Inflate
- The Fed Doesn't Want Inflation or a Dollar Crisis
- The Fed Will Reverse Course

The conclusion is as follows:

We in the United States have been dumping our dollars into the world for years and we continue to do so. We owe a staggering amount of foreign debt denominated in dollars and we are gearing up to borrow even more. Our legislators and the stewards of our currency are rabidly hostile to deflation -- they are hostile, in other words, to the idea of the dollar gaining purchasing power. They have shown via word and deed that they will do whatever it takes to prevent deflation from taking hold. When deflation is viewed as even a remote possibility, there are effectively no limits to the amount of money the government can create nor to what they can do with that newly minted money.

Under these circumstances, we just don't believe that the dollar is going to gain purchasing power in any sustainable way. The current deflationary storm could continue for a while yet, but the longer it goes on, the more violent and severe its reversal is likely to be.

Deflation is a choice within the current monetary regime. It is a choice that our government has shown it will not make. There are serious long-term risks inherent in our dysfunctional monetary system, to be sure -- but deflation isn't one of them.

The next look at the Labor Department's Consumer Price Index is due on Friday and the year-over-year reading as of November - the commonly accepted, definitive measure of "inflation" in the U.S. - printed at a lowly 1.1 percent.

It is possible that, with energy prices that have continued to plunge through the mid-December reporting period combined with a few other falling prices elsewhere, we'll get our first negative inflation number since 1955.

Just wait to you hear how acceptable the idea of "printing money" becomes then.

The word "deflation" (and, by inference, the threat of another Great Depression) may become President-elect Obama's most powerful tool in convincing Congress and hundreds of millions of Americans that "debasing the currency" has become our national duty.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

U.S. Exports Continue Their Downward Trend

Last year, while the U.S. dollar was down, manufacturers were joyfully experiencing one of the the loan bright spots in the U.S. economy, increased exports. Oh, how things can rapidly change for the worse. The latest trade report showed that U.S. exports were down again, for the fourth consecutive time. Is there any bright spots left in the economy? If so they are hiding pretty well. James Picerno from The Capital Spectator looks closer at the latest trade report in his blog post below.

The trade boom is fading. That's no great surprise, given the weakening state of the global economy. But the slippage in export-related activity comes at an especially challenging moment for the U.S.

Exports remained a bright spot for the U.S. economy last year. As other areas weakened in 2008, the American export machine bucked the trend. It was a timely boost, offering some hope that the approaching recession might be mitigated and perhaps even sidestepped altogether.

The high point came in last year's second quarter, when real (inflation-adjusted) export activity soared 12.3% on an annualized basis while GDP advanced 2.8%. That took some of the sting out of the drop in durable goods spending and a growing sense of unease otherwise in the GDP trend. In the third quarter, the export boom slowed but remained robust, rising 3.0%, in sharp contrast to the 0.5% decline in GDP.

The long-suffering dollar was no small advantage for juicing exports. As the greenback declined, the price cuts on American goods and services became increasingly attractive to foreign countries. Then in July 2008, the dollar began to rally. Although the U.S. Dollar Index has been trading in a range recently, it's still up sharply from its summer lows.

It was a tempting notion to think that exports would save us, although we warned last summer about expecting too much from the trend. "There's a limit to how much economic gain any nation can enjoy through a weakening of its currency," CS wrote in July. "Devaluation may offer short-term benefits, but the U.S. can't devalue its way to prosperity for very long."

The dollar's recent strength at the moment surely isn't helping U.S. exporting activity, nor is the credit crisis or the general economic turmoil blowing through economies around the world. Few analysts expected the fourth quarter GDP report to deliver anything other than a negative number. Today's trade update for November only strengthens that forecast. Exports dropped nearly 5.8% last month, the fourth consecutive montly decline.

No one will be shocked by the trend, although it's a humbling reminder that the economy has nowhere to hide. Employment, consumer spending, and so on have each fallen victim to the ill winds of recession. Exports are no exception. As we discussed on Friday, this is the eye of the economic hurricane and, as a result, all news from the dismal science is likely to be discouraging news for the time being. Not forever, but for a few quarters at least. Time moves slowly when you're waiting for a bottom.

This post can also be viewed on capitalspectator.com.

Fed Drops Fed Funds Rate To Zero

Well, it looks like the Fed wasn't going to take any chances, they played all their interest rate cards as they dropped the target federal funds rate down to the 0 to 0.25 percent range. They obviously were trying to send a powerful message since most investors and economists only predicted a 0.5 percent reduction. It will be interesting to see how this plays out, but the U.S. has officially won the race to zero. Economics professor Mark Thoma from The Economist's View looks closer at this new development, and brings in some additional outside thoughts and opinions, in his blog post below.

The Fed announced it will move the target federal funds rate into the zero to .25% range, an that it plans to keep it there for some time.

Here's the Fed's statement:

Press Release: The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.

Well, that's it, we're at zero now. Any further monetary policy action will have to come through other means, e.g. quantitative easing and the purchase of financial assets.

Brad DeLong adds:

Hale "Bonddad" Stewart Is Scared: The Federal Reserve reacts to the fact that the economy train has arrived in Depression City.

Stewart writes:

Hale "Bonddad" Stewart: The Fed's Kitchen Sink Interest Rate Policy: The Fed announced their policy of establishing "a target range for the federal funds rate of 0 to 1/4 percent." This brings two points to mind:

1. The Fed has no interest rate moves left. This is it.
2. The Fed is terrified about the economy. And they have good reason:

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further....

The Fed will step up their other activities...

To the point: the Fed is scared right now. I mean really scared. And they will do anything even remotely possible right now.

Paul Krugman:

ZIRP!: That’s zero interest rate policy. And it has arrived. America has turned Japanese.

This is the thing I’ve been afraid of ever since I realized that Japan really was in the dreaded, possibly mythical liquidity trap. You can read my 1998 Brookings Paper on the issue here.

Incidentally, there were a bunch of us at Princeton worrying about the Japan problem in the early years of this decade. I was one; Lars Svensson, currently at Sweden’s Riksbank, was another; a third was a guy named Ben Bernanke. I wonder whatever happened to him?

Seriously, we are in very deep trouble. Getting out of this will require a lot of Show allcreativity, and maybe some luck too.

This post can also be viewed on economistsview.typepad.com.

The Next Big Bubble To Burst: U.S. Treasuries

Everyone in the world knows that the U.S. has a huge debt, and that the U.S. economy is performing poorly. Yet, people are flocking to U.S. treasuries like never before driving yields down to record lows. The U.S. has no plans of stopping the debt train, though, so who knows how high it will go. We are on uncharted ground right now, and all it would take to push this train off the tracks is one major debt holder to start selling. Lots of other bubbles have burst recently, so why not possibly the biggest one of all? Needless to say if this happens there will be serious ramifications for the U.S. and the rest of the world, which is probably why it hasn't happened already. Toni Straka from The Prudent Investor looks closer at this looming problem in his blog post below.

Having seen most of the bubbles bursting I had listed in this post from 2005 the world may soon be in for the mother of all bubbles. With a size of $10 trillion the US government debt market has remained the world's #1, now that MBS have shed the better part of their initial values.

US treasuries have long been hailed as a safe haven for money fleeing from other overheated markets. Massive losses in more or less all other asset classes in the past 15 months have shown that investors followed Pavlov's reflexes, driving the 10-year yield to a record low of 2.55% last week.

CHART: The yield for 10-year US Treasury debt fell to a record low of 2.55% last week. This chart may see a sudden reversal based on the fundamentals.

It may be questioned whether this trust into the Federal Reserve's ability to contain long term inflation is justified, given the fact that chairman Ben Bernanke will enter history as the fastest money printer of all times.

While the Fed has reduced its federal debt holdings by $290 billion to $484 billion (buying doubtful MBS instead) in the last 12 months it was foreign investors TIC data and Treasury statistics show.

This has driven yields across the curve to record lows, leaving investors with a negative real yield when discounting inflation. US Inflation was 3.7% YOY as of October.

Institutional investors have been allocating more money into US treasuries recently, citing the safe haven status of American government bonds. But this era may be coming to an end as so many things do nowadays.

There appears to be a split of opinion. While European and American investors follow the old rule of buying US debt with a questionnable AAA rating their Asian counterparts see themselves trapped with US debt holdings they cannot sell in order to avoid a panicky stampede out of the biggest market of all.

The deficit outlook justifies a skeptical approach. Barack Obama will have to finance a budget deficit of an estimated $1 trillion in 2009, the biggest in American history. If Mr. Obama will not manage a U-turn in foreign policy which was mainly based on ignorance and arrogance under Bush, he could run into financing problems. China has urged other countries to replace Federal Reserve Notes with their own currencies in bilateral trade and voiced its concern about US fiscal policy repeatedly.

The global downturn may bring a different borrowing climate too. Losses in all asset classes across the board and record low yields will result in lower reinvestment amounts overall, it can be safely projected.
The borrowing needs will skyrocket as both the federal government and bankrupt local communities will scramble for funds to replace sudden drops in tax revenues.

Bets On A US Default Become More Expensive
While still being a mainstay for investors from all around the world, not everybody is confident about the future of a USA in the grip from the biggest financial crisis ever. Some wary souls are increasingly buying insurance against a default of the US government. According to a Reuters report from November 26, credit default swaps involving Treasuries reached a record high.

Ten-year U.S. Treasury CDS widened to 54.7 basis points from Tuesday's close of 50.0 basis points, credit data company CMA DataVision said.
Five-year Treasury CDS jumped to a record 52.0 basis points from Tuesday's close of 47.50 basis points, it said.

In plain language this means investors were willing to pay $54,700 to insure a portfolio of $10 million 10-year debt paper.

Summarizing the fundamentals such as no end to new debts, tax shortfalls, higher social and military expenditures, a central bank willing to monetize the debt and flooding the world with fresh Federal Reserve Notes, it can be safely bet that this bubble will end like all bubbles: In a gigantic burst that will unsettle everything we have learned about investing in the past.

A hat tip to Econbrowser who undug this paper by Stanford economics professor John Taylor on the failures of the Fed in the current crisis and why it all became worse this autumn.

I stand by my opinion that monetary inflation is in the early stages worldwide and will have seeped through into the real economy in 2009/10.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

The Fed Seeks Ability To Issue Own Debt

The Fed can't get enough money from the Treasury to fund all their ventures, so what do they do? Simple, they request the authority to issue their own debt. If Congress approves this measure it would give the Fed even more power, an idea that should be at least a little scary to taxpayers. Tim Iacono from The Mess That Greenspan Made looks closer at this new development in his blog post below.

One of the great mysteries of our debt-fueled financial system in general and central banking in particular is exactly when it is that "money is printed", a phrase that is thrown around quite casually by far too many people when maybe it shouldn't be.

Our fractional reserve banking system effectively "prints money" each time a new loan is made. That much should be clear. With a ten percent bank reserve ratio, each new $1,000 in deposits can generate $10,000 in loans. Where does this extra money come from? It is created "out of thin air". That's the way banks work.

Up until late-2007, Wall Street's "shadow banking system" did something similar, however, it apparently had what amounted to a zero percent reserve ratio which is one of the major reasons that we have the crisis that we have today.

As for the U.S. government, "printing money" is performed by the Federal Reserve when it buys Treasury bills (or any other assets of questionable quality) and in return provides money that it creates "out of thin air".

This is generally frowned upon for obvious reasons.

Largely as a result of the willingness of our Asian trading partners to do so, the Fed has not needed to buy much U.S. debt in recent years, its balance sheet remaining fairly constant at around $800-$900 billion up until a few months ago when Lehman Brothers was allowed to fail and the downward spiral commenced.

As most everybody knows, the Fed's balance sheet is now almost $1.5 trillion bigger, prompting the question of where exactly this $1.5 trillion came from.

Well, some of it came from the Treasury Department but, as discussed last week, a good portion of this was simply "created out of thin air" and then exchanged with companies like AIG for one toxic asset or another.

It is all adding up very quickly and, with no end in sight for the current crisis, it should come as no surprise that the central bank is looking for ways to get even more money into the system without people all around the world wondering about where all the money is coming from.

According to this report in today's Wall Street Journal, it seems the Fed is now looking at issuing its own debt in order to bypass that cumbersome Congressional approval process for issuing Treasuries.

The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

Government debt issuance is largely the province of the Treasury Department, and the Fed already can print as much money as it wants. But as the credit crisis drags on and the economy suffers from recession, Fed officials are looking broadly for new financial tools.

Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.

It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency.

Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.

As Andre Agassi used to say, "Image is everything".

Why look bad when the rest of the world remains scared to death of global financial markets, more than willing to continue gobbling up U.S. debt at ridiculously low yields, and your only real problem is that your government can't authorize enough spending fast enough?

This article has been reposted from The Mess That Greenspan Made. The full post can also be viewed on The Mess That Greenspan Made.

Here Come More Interest Rate Cuts

Central banks from around the world are cutting interest rates in dramatic fashion in an attempt to curtail the financial crisis. If these record interest rate cuts will help remains to be seen, but it seems that the world's central bankers feel it is their best hope. Tim Iacono from The Mess That Greenspan made talks more about these rate cuts in his blog post below.

Now's not the time to be timid if you're a central banker or an elected official. Day after day they watch a once vibrant world economy sink deeper into an abyss caused by a massive credit contraction following the collapse of multiple asset bubbles.

Central banks all around the world were busy today slashing interest rates with abandon:

• Bank of England -------------- cut 100 basis points to 2.0 percent
• European Central Bank -- cut 75 basis points to 2.5 percent
• Sweden's Riksbank ---------- cut 175 basis points to 2.0 percent
• Bank of New Zealand ------- cut 150 basis points to 5.0 percent
• Bank of Indonesia ------------ cut 25 basis points to 9.25 percent
  

Earlier in the week, Australia's central bank cut short-term interest rates by 100 basis points to 4.0 percent and Thailand slashed by a full percentage point.

Tumbling home prices and a rapidly weakening economy have created a near state of panic in the U.K. that makes the situation in the U.S. somehow look tame by comparison. Short term rates have fallen by 300 basis points in less than two months and they now sit at their lowest level since 1951.

On the continent, the fifteen countries that use the euro got their biggest interest rate cut in the common currency's 10-year history as the central bank attempts to mop up after collapsing housing bubbles in Spain and Ireland while also dealing with major economic slowdowns in Germany and Italy. The French just announced a $33 billion stimulus package.

Herding cats has never been more difficult.

The Swedish central bank couldn't wait for their regularly scheduled mid-December meeting and hastily made their biggest rate cut in 16 years in an attempt to combat a recession that officially began two months ago. The government also announced a $4 billion stimulus plan.

In New Zealand, rates were slashed by a record 1.5 percentage points and Reserve Bank Governor Alan Bollard indicated there are more, smaller cuts to come. The kiwis entered a recession back in the first quarter of the year and short-term rates have been slashed from 8.25 percent over the summer to just 5.0 percent.

In Indonesia, both interest rates and inflation (~12%) are still quite high and the central bank has received some criticism for making its first rate cut in over a year. They were no doubt influenced by the full-point rate cut in Thailand a few days ago.

The day is still young - there may be more rate cuts to come.

This article has been reposted from The Mess That Greenspan Made. The full post can also be viewed on The Mess That Greenspan Made.

Citigroup Bailout, Deflation And The Worldwide Financial Epidemic

The news of Citigroup's $300 billion bailout seems like déjà vu, and the scary word "deflation" that is being thrown around seems distant compared to everything else we are dealing with. The U.S. is not the only country with problems either, this is without a doubt a global financial epidemic. James Picerno from The Capital Spectator wonders, though, if the cure might be worse than the disease.

Have we seen this movie before? It certainly sounds familiar.

Once again, the government steps in to bail out a financial institution and Mr. Market takes kindly to the idea. Initially. But then reality sets in and the process starts anew. Perhaps it'll be a true sign of a bottom when the Feds engineer a bailout and the market tanks on the news.

But not yet. The latest installment of rescue revolves around the once mighty Citigroup. A giant among giants, this behemoth of financial behemoths surely fits the bill as too big to fail. If such a thing exists as a financial institution that must be saved at any cost, Citigroup looks like the poster boy for this idea.

Total assets for Citigroup were a bit more than $2 trillion in September. For those who like to keep score, that's roughly 14% of the annualized value of U.S. GDP for this year's third quarter.

The days of pulling another Lehman and letting a big bank fail are history. Better to bailout more rather than less and deal with the consequences later. The grand strategy here is that if the government bails out enough banks (and perhaps an auto company or two) while spitting out stimulus in various forms as far as the eye can see, the system will correct itself, or at least stop bleeding. At a time when deflationary risks are rising, this plan is considered prudent and timely by a growing swath of economists and voices from the peanut gallery, including yours truly. The risk of an even deeper implosion of prices and confidence must be avoided lest the vortex of deflation pull everything down the rat hole. Preventing deflation is the last battle in this horror film because once the big "D" takes hold, in sentiment and prices, the challenge becomes much, much tougher.

The problem is that no one's really quite sure if deflation with a big "D" is on our doorstep. Quite possibly it is, or so one could reason after witnessing consumer and wholesale prices fall last month on a scale unmatched since the government began keeping tabs on such things in the late-1940s. Waiting for definitive signs risks letting the monster out of the cage. Decisions, decisions. Nonetheless, there's a strong case for assuming deflation is coming. If we're wrong, we'll have more inflation on our hands than we otherwise would. But the world knows how to fight inflation, even if the political will is sometimes lacking. Attacking deflation, on the other, is another story.

Any way you slice it, there's bound to be more than a little disappointment and finger pointing in the months and years ahead. Indeed, no one should think that the necessary but risky strategy of preventing deflation is destined to end in triumph, or quick results. The stakes are high, in part because the government's moving quickly toward betting the house on a fiscal/monetary solution. On the opposing shore is the unwinding of excess, some of which has been decades in the making. When an immovable force meets government printing presses, the outcome isn't entirely clear.

All the more so if the world is looking for signs, one way or the other, by next Wednesday. It's difficult to gauge expectations as we run from one crisis to another. But this much is clear: the financial and economic problems will take time--years--to solve, and to the extent that the crowd thinks otherwise, the seeds of disenchantment have been planted.

The U.S. economy is sick, and getting sicker. Europe has the disease and Asia is at risk of contracting the same, albeit in a milder form. Looking back on the past five decades offers no clue for what may be coming. Growth has been a constant, according to GDP numbers from economist Angus Maddison, emeritus professor, University of Groningen (Netherlands). As the chart below shows, outright contraction is unknown in the postwar era.

Fifty years is a long time, virtually an eternity for mere mortals studying the past in search of clues about the future. It's all too easy to look at this track record and conclude that real declines in global GDP aren't possible, or are so unlikely as to be unworthy of considering. The IMF forecast, for one, still imagines more of the same with next year's estimate for real global GDP rising by a respectable if not impressive 2.4%.

Of course, the crowd used to think in persistent-growth terms for housing prices, and how they never fall on a year-over-year basis. Oh, sure, that happened in the Great Depression, but such episodes were dismissed as a thing from the past.

Perhaps it's time to consider the unthinkable. We've all received a crash course in just that over the last few months. But has the education so far been sufficient? Or do we still need to spend more time studying?

There are many dangers stalking the global economy, and at the top of the list is the assumption that the governments of the world can spend their way out of the slump on our collective doorstep. In the U.S. alone, the government now stands at the ready to spend $7 trillion--yes trillion with a "t"--to bring financial salvation to the system, according to Bloomberg News. That's the equivalent of three-and-a-half Citigroups, or half the U.S. economy. Scale no longer looks to be a stumbling block.

By spending enough money, governments are likely to keep inflation-adjusted global GDP floating somewhere above zero, if only slightly. That would still bring a fair amount of pain and repricing, but embedded in the expectation is the notion that a floor can be built under the crisis.

Perhaps, although at some point one might wonder if the cure will be worse than the disease. There are some awkward questions that will accompany the mother of all spending sprees now underway. First up: Is there some point at which additional government spending becomes counterproductive because a) it encourages future inflation on a scale that will be excessively burdensome; and/or b) the prospect of the government owning ever-larger chunks of the economy risks institutionalizing mediocrity or worse in the economy?

There are two great episodes of deflation in modern history, and each continues to raise questions about the associated lessons. Yes, spending is the only hope of sidestepping the beast, and if that means artificially engineered demand from the government, so be it. But it's not clear that the strategy leads to happy results all around. Meantime, there's more than one way to fight deflation.

That's not to say we shouldn't try to spend our way out of a deflationary trap. We should. We must. And we will. The risk is real this time, unlike the previous worries over deflation in 2001-2003. But the details of how we engage our anti-deflationary war may matter as much, if not more, as the decision to wage the war in the first place.

The dismal science has precious little experience with fighting deflation and so we must recognize that we may soon be caught up in an economic experiment on a scale that has little or no precedent. By all means, let's fight this war ferociously. But it also needs to be fought intelligently. What exactly do we mean by "intelligently"? We can't say for sure. No one can, and therein lies the greatest risk.

This article has been reposted from The Capital Spectator. The full post can also be viewed on The Capital Spectator.

Fed Preparing For Another Interest Rate Cut

With inflation concerns now being trumped by the fear of deflation, and the economy still struggling, the Federal Reserve is expected to cut the Fed Funds rate again during their next meeting in December. Kathy Lien examines this closer and shares her expectations in her blog post below.

US consumer prices dropped 1 percent last month, taking the annualized pace of growth to 3.7 percent, which is the lowest level since October 2007. Falling oil prices takes the credit for lower inflationary pressures with gasoline prices tracking the 50 percent decline in crude. Gas station receipts fell a whopping 14 percent and commodity prices have fallen in general, which has helped to push down transportation costs.

Although the core PPI numbers accelerated, core CPI dropped 0.1 percent and we expect it to head even lower. Less price pressure will give the Federal Reserve more room to cut interest rates. We expect the Fed to cut by another 50bp in December, but it is important to note that Fed Fund futures are pricing in a tiny chance of a 75bp rate cut next month.

The housing market continues to be one of the weakest links in the US economy. Housing starts fell to a record low while building permits dropped to the lowest level in close to 50 years. When you have an environment where foreclosures are rising at a very rapid pace, there is no desire by builders to break new ground.

This afternoon, we have the minutes from the latest FOMC meeting at which the Fed cut interest rates by 50bp to 1 percent. Given the continued concern reflected in Bernanke’s testimony to the House Financial Services Committee on Tuesday, the Fed is likely to support further easing.

All of the major currency pairs have been consolidating since the middle of last week and the FOMC minutes could be the trigger for a major breakout.

This article has been reposted from Kathy Lien. The full post can also be viewed on KathyLien.com.

Prices Are On Their Way Down--That’s Good News, Right?

Considering all the bad news in the headlines now, the fact that prices are falling is probably making most people ecstatic. The biggest excitement of course is likely surrounding gas prices, which fell nearly 25 percent last month, according to a Bureau of Labor Statistics (BLS) press release. And while prices of goods other than food and energy actually rose 0.4 percent last month, according to the same report, as the cheaper commodity prices come into play for manufacturers, we are surely going to see these prices fall soon enough. Since Americans, along with the rest of the world, are in penny-pinching mode right now, these new lower prices are a godsend. This good news, though, could quickly turn bad if it gets too out of control.

Of course we like to see prices fall; that means we can now buy more stuff than we could before, and for the most part falling prices are a good thing, especially when they had been inflated so much in recent years. What we have to watch out for is deflation. Deflation can be a horrible thing, and even though you might think it is good, it most certainly is not. Deflation leads to lower company profits, layoffs, business closures, falling wages, loan defaults (deflation increases the real interest rate on loans) and so on. People lose the incentive to spend, and borrowing becomes nearly extinct as borrowers don’t want to borrow and banks don’t want to lend. Deflation can even be the catalyst that pushes a country into a depression, and we know we don’t want to go there again.

Deflation is an extremely scary thing to think about in reality, and the only scarier thing to think about is the fact that we might not be able to prevent it from happening. Typically, preventing deflation has been as easy as lowering interest rates and adding to the monetary supply. Interest rates are already at 1.0 percent, meaning there really isn’t much more room to maneuver. Japan had to deal with their own bout of deflation during their so-called lost decade, and they weren’t able to dig out of it even with interest rates at 0 percent. Sure, there are a few other things that the government can pull out of its sleeve, but again, there is no guarantee that anything is going to work this time around.

If the government is able to help us prevent deflation, it is also possible that they could end up creating another boom and bust cycle. The following is an excerpt from an opinion piece by Gerald P. Driscoll, the former vice president of the Federal Reserve Bank of Dallas, published in the Wall Street Journal:

“The economy now confronts deflationary forces. If past is prologue the Fed will concentrate on those deflationary forces for too long and rekindle an asset boom of some kind. The fiscal "stimulus" being contemplated by Congress could be another economic accelerant. If both the fiscal and money stimulus efforts kick in just as market forces also kick in, we're likely to see another unsustainable boom that will be followed by a bust.”

Either way it seems that we are likely headed for an undesirable outcome. This reminds me of the game Operation I used to play when I was a kid. The smallest mistake in any direction is going to cause all heck to break loose. I don’t know about you, but I sure hope Obama and his new staff have amazingly steady hands.

Federal Reserve Invoking Serious Monetary Inflation

The U.S. Federal Reserve is trying everything right now to fix the financial crisis. The latest plan, as outlined below by Toni Straka at The Prudent Investor, involves sending billions of dollars to foreign countries around the world. The end result of all this is going to be severe monetary inflation, read on...

Only 75 minutes after the Federal Open Market Committee (FOMC) slashed Fed Funds half a point to the lowest recorded level of 1%, chairman Ben Bernanke started his money dropping helicopter fleet in order to shower the world with another $120 billion. This time it is the central banks of Brazil, Mexico, Singapore and South Korea that will receive up to $30 billion each in newly established swaplines.

A Fed press release states that each country will enter into $30 billion swaplines with the Fed,

in order to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.

In response to the heightened stress associated with the global financial turmoil, which has broadened to emerging market economies, the Federal Reserve has authorized the establishment of temporary liquidity swap facilities with the central banks of these four large and systemically important economies. These new facilities will support the provision of U.S. dollar liquidity in amounts of up to $30 billion each by the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore.

The Fed has now established swaplines with 14 central banks responsible for 28 countries in order to market its only product: Federal Reserve Notes (FRNs) that are backed by nothing than the belief that today's FRN will buy you the same amount of goods and services in the future.

The other central banks helping to fly the FRN helicopters are the Reserve Bank of Australia, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank, and the Swiss National Bank.

IMF Will Dish Out Still More FRNs
In its efforts to flood the whole world with FRNs the Fed

welcomes the announcement today by the International Monetary Fund of the establishment of the Short-Term Liquidity Facility, which is designed to help member countries that are facing temporary liquidity problems in the global capital markets. The Federal Reserve is supportive of the IMF's role in helping countries address and resolve their ongoing economic and financial difficulties.

Jumping to the IMF website one finds more details how the IMF will dish out more FRN loans all over the world with the newly established Short-Term Liquidity Facility (SLF). This comes one day after the IMF warned that Latin America would not escape the global turmoil.
According to the release members can borrow up to 500 percent of their quota.

Quoting IMF head Dominique Strauss-Kahn the new facility is a better design than usual standby agreements. He said the IMF would use its full financial force to stem the crisis.
Here are the details of the SLF:

• Purpose. Provide large, upfront, quick-disbursing, short-term financing to help countries with strong policies and a good track record address temporary liquidity problems in capital markets.
  
• Eligibility. Countries with a good track record of sound policies, access to capital markets and sustainable debt burdens may qualify (the IMF's standard debt sustainability analysis should indicate a high probability that both public and private debt will remain sustainable). Policies should have been assessed very positively by the IMF's most recent country assessment.
  
• Conditions. Financing is made available without the standard phasing and loan conditions of more traditional IMF arrangements. However, borrowers are expected to certify that they are committed to maintaining strong macroeconomic policies.
  
• Size of loan. Disbursement of IMF resources can be up to 500 percent of quota, with a three month maturity. Eligible countries are allowed to draw up to three times during a 12-month period.

Altogether it appears as the global banking machine requires more and more grease with every week but the engine is sputtering worse than at the beginning of the credit crisis.

We have entered the stage where even hundreds of billion of freshly created money will not be enough to deflate the biggest credit bubble in an orderly way.

Stocks reacted to the news of the rate cut in a classical "buy the rumour, sell the news" fashion. Early gains fizzled away as soon as the widely expected rate cut was announced as was the case after a second late bounce.

The near 10% advance in crude oil signals that commodities are again bought as as an inflation hedge.

Make no mistake: Only because recent inflation figures looked better than in summer does not mean that all this poisonous "liquidity" will not result in monetary inflation. What we see here is monetary inflation by the textbook and it will be felt dearly within the next 12 months. Central banks have gone wild since they found themselves behind the curve, rather following the wishes of Wall Street than insulating the inflation virus and absorbing all the liqudity that allowed the leverage excesses of this millennium.

Oh, and by the way; IMHO gold as the oldest inflation hedge has seen its low of the year with a very high probability based on the fundamentally bad outlook.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

Banks Increase Lending Standards Across The Board

The July 2008 Senior Loan Officer Opinion Survey on Bank Lending Practices released by the Federal Reserve describes a lending environment that has gotten worse across the board. I won’t bore you with all the details; feel free to click on the above link if you want those (or you can read Mish’s blog post--he does a great job of summing up this report), but I do want to make the point that these numbers are not encouraging. Sure, residential lending standards have increased--I think most people understand that-- but we need to realize that this credit tightening is not confined to just residential real estate. Banks are hesitant to lend to pretty much everyone right now. That includes businesses loans, commercial real estate loans and consumer loans.

Our economy is driven by lending and borrowing--it has to be because we don’t have any savings. It is pretty safe to say that if Americans started buying only what they could afford our economy would collapse. In order to stay afloat, we have to keep borrowing; it is the only way to keep the train chugging in the short term (which is all the government cares about, but I’m not going to get into that). That being said, when lending becomes tighter, our economy pays the price. Borrowed money is our lifeblood, and right now the flow is being restricted. The Fed is trying to do their part by making the money cheaper and more abundant, but unless banks start actually lending out this money, it isn’t going to do them much good.

While lending is the lifeblood of our economy I should also add that it most definitely is toxic. We need to understand that we cannot go on borrowing more money forever. Right now the U.S. economy is acting more or less like a ponzi scheme. Basically that means that they are taking money from investors and the only way to pay these investors back is by bringing on more investors. As long as there is a steady stream of new investors coming in with their money then there are no problems. However, if anything happens to restrict the supply of new investors so that the money they bring in doesn’t cover the payments due to the old investors, then all hell breaks loose. The U.S. government obviously has the trump card in that they can print money at their whim, but we all know where that leads.

Those who want to know more about the U.S.’s addiction to borrowing should check out the new movie I.O.U.S.A. I don’t imagine that the Fed will take these tightening lending standards lying down, though; it will be interesting, to say the least, to see what they come up with to combat them next. They say that inflation is an overriding concern right now, but that shouldn’t keep them contained for too long. The thing investors need to remember is that this party can’t and won’t go on forever. They can drag it out, but at some point people will start heading for the doors.

A Closer Look At Inflation

Inflation certainly has been on the rise of late, but a closer look at Inflation might reveal some things that are lost in the hype. If we actually look at what is driving inflation right now, the resounding culprit is commodities. From food to construction materials--and, of course, oil--commodities are seeing dramatic increases in prices. Since these are things that consumers see and buy every day naturally they are feeling the pressure, and because they are items they deal with everyday and can see how prices are increasing, it means that inflation is on their minds. In all of this, the fact that prices on many items and services are actually falling--in some cases dramatically--is being lost in the fray. In addition, there are some other underlying factors surrounding employment that could also have a serious impact on inflation.

I was reading an article from Michael Shedlock (a.k.a. "Mish") that was posted on Seeking Alpha which really brought out this next point. In the article, Mish quotes a business owner who had e-mailed him about how he is now able to get workers for $8 to 12 an hour that were previously costing him $15 to 20. Then Mish goes on to talk about how jobs have declined for six consecutive months, and that in order to break even on the job front (taking into account new people joining the workforce), we have to add at least 150,000 new jobs. He also talks specifically about how state and city layoffs are at 45,000 so far and mounting, along with the fact that strip mall vacancies are at their highest levels in more than 10 years. These are just some of the ominous signs for employment, but the basic idea is that unemployment is continuing to rise and employers have all the leverage right now.

With unemployment rising, wages seemingly falling (in some cases, at least) and people being scared out of their mind about the economic prospects, we can expect spending to fall. This was already the case before the stimulus payments went out, and as those payments dry up, so should the little boost in spending we are seeing. As demand for products and services fall, companies will have to lower their prices in order to sell their products. In some cases this may lead to businesses going under or push competitors to consolidation; regardless, we will surely see some changes.

Predicting commodity prices is a little harder because demand for commodities does not just come from Americans. Much of the commodity price increases can be traced to the ridiculous amount of growth going on in several Asian countries right now, particularly China. They are seemingly willing to pay whatever they have to in order to get their hands on materials, and it is forcing the price up for everyone. If I had to guess, though, I’d say that we should see some easing in commodity prices soon. As the U.S. and other western countries start to scale back, it will impact those Asian countries which are providing us with exports. As we cut back on our consumption, they will have to cut back on their production, resulting in less demand for the commodities used to make the products. The main thing I think that we have to worry about is food. While Americans certainly can do with a cut back in their diets, we still have to eat. Considering that we are continuing to use an increasing amount of food supplies for fuel, and the increase in global demand and consumption, food will continue to be highly sought after, although a modest price drop is not out of the question.

Rising Inflation May Lead To Deflation

Inflation is certainly on the minds of the masses today as it appears each new day brings with it a new record price for oil and food, among other things. Inflation is especially bad right now because wages aren’t keeping up with it and thus our buying power is being reduced with each passing minute. But while Inflation is certainly a bad thing, deflation may be even worse, and according to a report issued by the Bank of International Settlements (BIS), which acts as the bank for central banks, we may be heading for just that.

Deflation occurs when prices fall. That may seem like a great thing, but deflation is typically anything but great. The greatest depressions are accompanied not by inflation, but by deflation. Our economies today are driven by spending, and inflation spurs spending. If you know that something is going to be more expensive next month, or next year, you are probably going to buy it now, if possible. In fact, you may even borrow money to buy that good or service now. Not only do you benefit by acquiring the product at a lower price now, but assuming your loan is fixed, you win that way, too. Taking money now and paying it back with inflated dollars sounds like a pretty good plan, right? In an inflationary environment there is little incentive to save because money saved simply loses value.

On the other hand, in a deflationary environment, people are encouraged to save. They know that every day they hold out to buy something, the cheaper it is going to be. In addition, they most certainly do not want to take out a loan, because they would have to pay it back in appreciating dollars. They would be much better off to simply save their money and wait until they have enough to buy something outright. Naturally, this type of scenario doesn’t bode well for an economy that is built on spending. When people stop spending, a funny thing happens: businesses struggle and eventually close. That, of course, leads to people getting laid off, which leads to even less spending, and it becomes a vicious cycle. This is how depressions start--and become really bad really fast.

In its annual report, BIS said that the impact of rising food and energy prices on consumers' incomes, combined with heavy household debts and a pullback in bank lending, may lead to a slowdown in global growth that "could prove to be much greater and longer-lasting than would be required to keep inflation under control…Over time, this could potentially even lead to deflation," according to the Wall Street Journal. The BIS went on to essentially blame the central banks for the current financial problems, claiming that they kept interest rates too low for too long.

In a bit of good news though, the BIS said they see the chances of deflation as fairly low, and consider inflation to be a much greater threat at this time. The BIS is urging most central banks to consider raising their interest rates to combat this danger.

Argentina Defaults On Debt

Argentina became infamous earlier this decade for defaulting on their debt during a major financial crisis, and now it appears they have defaulted once again. This time around, things aren’t quite as bad in the country, and the default is a little different, but their actions still qualify as default, according to an article written by a couple economics professors for the Wall Street Journal. Carmen Reinhart from the University of Maryland and Kenneth Rogoff from Harvard claim in their article that Argentina has manipulated their inflation data in order to pay out less on their inflation indexed debt, thus putting them in default.

The professors say that the government’s scheme began with the firing of their top statisticians. Now the inflation measurements that are being “officially” reported are drastically understated. According to the article, Argentina is reporting an inflation rate of less than 10 percent when by most external measurements, the real rate should be closer to 30 percent. The Argentine government owes around $30 billion in inflation indexed debt, according to the article.

Investors should know that circumstances such as this are always a risk when investing, especially in developing countries. Argentina isn’t alone in these types of actions, either. Across the world, countries manipulate their statistics to be in their favor. Sometimes they are minor “adjustments” and sometimes that are major and pretty blatant, like in this case.

I want to also point out that, while these types of things are more pronounced in developing countries, they happen here at home, too. The U.S. has adjusted things in their favor before (such as the gold price in the '30s) and still do it today (such as the CPI and GDP). So don’t be naïve and think this will never impact you because you don’t invest abroad; government manipulations of economic data happen here, too. Inflation indexed bonds just happen to be one of the easiest debts to influence, so invest in them with your eyes wide open.

The Day The Music’s Engine Died: Gas Prices Ground Indie Artists

Disclaimer: This blog post contain explicit lyrics and should not be viewed by children.

Another heaven-ordained American right is under attack by rising fuel prices: the right to inflict your music upon others.

Long known for their frugality in touring, indie bands are finding that they can’t even break even when playing in remote locations thanks to the rising price of fuel. As quoted in an AP article on MSNBC, 23 year-old indie minstrel Steven Garcia had this to say about budgeting for his now-canceled tour:

“Once I ran the numbers it was a ‘There’s no (expletive) way’ kind of moment.”

Indeed, such an articulate sentiment will strike a chord with any driver these days. It’s surprising that we haven’t seen more artists tackling this issue in their music. Allow me to seed a few songs:

Punk	Gangster Rap	R & B
Sixty bucks to fill my tank? This must be some kind of prank F*** you Exxon, F*** you Shell! You oily pigs can go to hell!	My baby mama toll me she need money fo’ gas. Now da b**** is Super-Leaded ‘cause I popped a cap in her a**. So I’m doin’ hard time, but you all is da chumps; Droppin’ soap is still better than getting’ r**ed at the pump.	Oh baby, baby, you know you’re my world; it’s true. I’d drive three-quarter miles just to be there next to you. Call me, baby girl, and you know that I’ll come You’re my baby (You’re priceless) You’re my Super-Premium.

With CD sales already on the decrescendo, it has been suggested that artists would have to adapt and drum up most of their money through concerts and merchandise, as Prince did when he gave away copies of his latest CD in the U.K. to advertise for his concert. Under these circumstances, however, it’s questionable if young bands can avoid losing money, let alone make it. The East Coast has a greater density of towns which affords artists there a slight advantage over West Coast and Midwestern bands, who have a lot of awe-inspiring, wide-open spaces to suck their wallets dry between cities.

I have a possible solution: In the past, I’ve recommended teepees to solve the housing crisis. In a similar vein, I say we resurrect another bit of Americana to keep American rock and/or roll alive—the wagon train.

If these musical pioneers are willing to cram seven people into a single van and hit the highway to hell with half a ton of equipment designed to be as noisy as possible, then they can probably manage in a covered wagon. This “bandwagon,” if you will, might allow musicians to save money, to grow rugged and to connect with American history. As an added bonus, it’s eco-friendly...like when Sheryl Crow toured using only bio-fuel, except without the smug self-righteousness.

It seems, though, that some artists will still be getting around the old-fashioned way (as opposed to the old-old-fashioned way). Ann Yu, singer of indie band LoveLikeFire, has this to say in the AP article:

“What else can you do? It’s just the battle scars of trying to get your music out there. And for every band that doesn’t or can’t do it, there are other ones that can and will.”

Ms. Yu is probably right. The road to fame has always been arduous, and high gas prices are just one more stumbling block, and probably less damaging than band politics, drug addiction and the stress of divvying up groupies after the show. More than ever, artists must have serious dedication and financial savvy (or a trust fund) to make the cut. Which is to say, whatever their "sound" may be, they all sound more and more like one thing: investors.

Small Businesses Attempt To Tackle Inflation Creatively

This just in: Inflation is real and the Fed may not be able to stop it. That’s the reality for small businesses as they are forced to deal with the strain caused by rising food and energy costs.

The dramatic growth of the suburbs, as a result of rising home prices, combined with $4 per gallon gasoline is creating significant pressure for businesses with employees who commute. “Emerging suburbs and exurbs -- commuter towns that lie beyond cities and their traditional suburbs -- grew about 15% from 2000 to 2006, nearly three times as fast as the U.S. population,” according to the Detroit Free-Press.

This hits small businesses the hardest, since they tend to employ a greater percentage of employees at entry level salaries, and thus may have more employees who have moved further away to find affordable housing. This leaves many small employees in a bind when combined with an economy that may not support price hikes to consumers.

Some business, however, are finding creative ways to deal with the problem:

Virginia Commonwealth University Health Systems gave away $1 million to its 7,200 employees as a one-time bonus to help ease the burden of rising commuter costs, according to the Richmond Times Dispatch.

Du-West Foundation Repair recently moved 90 workers to a 10-hour, four-day workweek, according to the Dallas Morning News. Du-West is not alone. The city of Birmingham, Alabama will move to a four-day workweek for more than 4,000 employees July 1, according to Inc. magazine

Other solutions have been adopted by various businesses, including:

• Offering incentives for riding mass transit, including purchasing bus or train passes for employees.

• Offering carpool incentives, such as prime parking spaces or cash incentives for carpool riders/drivers.

• Offering additional work from home days for employees capable of telecommuting.

At NuWire, we’ve decided to explore the possibility of transitioning many of our positions so employees can telecommute. This creates a unique set of challenges but also offers the potential of a win-win for employer and employee. Having fewer employees in the office would allow us to reduce office space and some office costs. Employees would save money on gasoline, car maintenance and insurance and time lost commuting.

Although it remains to be seen whether we can create a telecommuting plan that will work for all involved, it is clear that we are not the only small business looking to retain good talent by finding creative (and proactive) ways to tackle inflation without raising prices (or in addition to raising prices).

Food Prices And Shortages Surge: Let Them Eat Dirt?

Though not nearly as compelling as lesbian rumors surrounding LiLo, or gay rumors surrounding Scott McClellan, or gay/lesbian/horrifying reality surrounding the “Sex and the City” movie (the reality being that it made over $55 million on its opening weekend), you may have heard that there are food shortages and riots around the world. You may not have yet heard that more and more Americans are going hungry, though it would be spurious to say that we are anywhere near as desperate as some of these starving nations.

Bangladesh, Egypt and India—to name a few—have all had violent and occasionally deadly food riots in recent months as failed crops, storms, gas prices and government corruption continue to cause food shortages. The ultra-rich in these countries are—as always—doing nothing. I won’t debate the ethics of this, or whether or not they are morally obligated to help. But could they at least not do things like building the world’s most expensive house, estimated at $2 billion, in the thick of it all?

Marie Antoinette is famously misquoted as saying: “Let them eat cake.” It seems today’s grande bourgeoisie has a different approach: “Let them eat dirt!” And in Haiti, that’s just what they are doing.

No longer able to afford staples like beans and rice, impoverished Haitians are increasingly reliant on mud cookies for sustenance—and I don’t mean grandma’s chocolate, walnut recipe. The confections are made of baked river mud mixed with salt and vegetable shortening and called Terre (as in ‘Terra-cotta’, ‘terra firma’, and ‘terrifying’). Eating mud does not make one ill, but it isn’t exactly a balanced meal and it effectively serves only to stave off hunger pangs.

I have followed Haiti’s situation closely over the last decade, and I’m glad to see that quite a bit of media attention has been bestowed on the troubled island in recent months. However, in terms of our ability to give aid, it couldn’t come at a worse time, as we too are seeing signs of food shortage...or at least fund shortages. An AP article recently printed in the International Herald Tribune reveals that 99 percent of 180 food banks have seen an increase in clients, some listing an estimated increase of 40 percent. According to the Labor Department, the highest increase in food prices in 18 years just occurred in April. Food banks are begging for increased funding, and so I find it doubtful that we will be able to do much for other countries at the time.

Another article shows that Americans are turning to dirt for sustenance, too, but not in the same capacity as the Haitians. The largest seed company in the U.S. has seen a double in sales over the last year as more and more people are deciding to grow their own produce, according to an AP article on MSN Money. And they aren’t the only ones:

“Seed Savers Exchange, a nonprofit dedicated to preserving heirloom vegetables, ran out of potatoes this year and mailed 10,000 tomato and pepper transplants to customers in early May, double its usual amount. The organization, based near Decorah, Iowa, sold 34,000 packets of seed in the first third of this year, more than it did all last year.”

William Blake said, “In seed time learn, in harvest teach, in winter enjoy.” But those days of leisure might be over. The new dictum appears to be, “In seed time sow, in harvest reap, in winter eat the cat.” And sorry, Santa—no cookies this year, unless you don’t mind a nice, silty aftertaste.

What does the future of the food shortage hold? Will Wolfgang Puck Express find competition against a chain of Michel Lotito Pica Buffets? Will the South Beach Diet give way to the Donner Diet? My crystal ball says things won’t be getting too dire just yet. As grease vats are emptied by grease bandits, we may have to forgo fried food, and people may be apt to take their toast with little spots of penicillin rather than chucking it at the first sign of mold (a smear of bleu cheese will cover that right up!), but we won’t be starving just yet.

Still, some investors may want to follow these food price surges and invest in farmland or consumables. Investors may also find a cash cow in dairy industry investments. With controversy surrounding biofuel production and its contribution to food shortages, investing in biofuels seems a little riskier, but keep your ears to the ground on that one. And taste some soil while you’re down there. It never hurts to try...

The Economy Is Worse Than We Know: Check Out These Numbers!

Sorry to be the one to add more doom and gloom to an already rocky financial landscape, but the economy might be even worse than we think. According to Kevin Phillips from Harper’s Magazine, the government has been artificially fudging economic statistics for years by changing the way things are calculated. The main three government statistical calculations that Phillips points out are the unemployment rate, Consumer Price Index (CPI) and GDP. If we were to calculate these numbers in the manner in which we used to, before all the changes, things wouldn’t appear nearly as rosy as they do right now.

Here are the current numbers:

Unemployment Rate: 5 percent

CPI: 4 percent

GDP Growth: 0.6 percent (Q1 2008)

Now here are the estimates given by Phillips:

Unemployment Rate: Between 9 and 12 percent

CPI: Between 7 and 10 percent

GDP Growth: Minimal growth since 2001

Phillips also makes an interesting point about why the government needs to fudge the numbers. In his article, Phillips says that according to calculations from John Williams at Shadowstats.com, if the government had failed to make the changes to the CPI index, and stayed true to the old calculations, Social Security checks would be 70 percent greater than they are today.

As most people know, Social Security payments are tied to the CPI index, and as inflation goes up, so do the checks in order to compensate. Considering that the nation is already more than $9 trillion in debt, and that the government spends every dime of incoming Social Security payments, adding billions more in Social Security liabilities would not be helpful to the economy. In addition, if inflation was reported at the higher number, we would surely see much higher interest rates across the board--again, not a big booster to the economy. Phillips gets into much more detail, but for brevity's sake, I’m not going to get into that here. If you want to read the full article you can visit Harper’s (requires subscription) or you can read a free partial version at Mindfully.

I can see why the government felt they had to make the changes they did, and some of them even seem to be warranted, such as one pointed out in a recent New York Times article. “To take just one example, years would often pass before the index included new products — like cellphones — and therefore it missed the enormous price declines that occurred shortly after those products entered the mainstream.” In addition, it is much easier to change around some numbers that most people don’t understand anyway, and in doing so lower your liabilities, than to flat out tell them their Social Security benefits are going to be cut, or taxes are going to be raised.

Other changes, though, seem questionable at best. One change that was made, as pointed out by Phillips, is that the new calculations make adjustments to people’s assumed buying habits if certain products get too expensive. For example, if flank steak gets too expensive, people are assumed to shift to hamburger. At the same time though, nobody is assumed to move up to filet mignon when things are going well. So this is a change that can only make the CPI go further down, which seems a little biased.

No matter how we slice it, or how much we think we’ve been cheated, the government can’t afford to increase our social security payments by 70 percent, or to increase any other payments to us for that matter--even if they wanted to. They probably aren’t even going to be able to pay the full Social Security benefits as they are now for many more years, so we might as well give up that argument. Below is a chart that shows intragovernmental holdings, which essentially is money that the government is "borrowing" from other government agencies, the main one being Social Security.

The best thing we can do is understand that the government-reported numbers may not be as good as they say, and make the necessary adjustments to our own calculations. Instead of using 3 percent as the inflation number in your retirement calculations, maybe it makes sense to use 5 or even 7 percent. Sure, it would be nice if the government could actually be trusted and told us the truth now and again, but hey we can’t set our hopes too high, right?

Federal Reserve Meeting Today: BYOB, Pizza Will Be Served

The Fed is meeting again today and tomorrow. To mark this diminishingly historic occasion, I have composed the following ditty. Ahem...

There once was a man named Bernanke:

For the banks, an immaculate flunky.

When their assets all failed

with our money he bailed

them all out like a good little monkey

Thank you. Thank you.

As the Fed disappears behind the curtain yet again, ‘O we of little faith’ are bracing for yet another quarter percent drop in interest rates. Soon it will be official: You will likely see more appreciation on kitsch from the Franklin Mint than anything that comes out of the U.S. Mint. My friends all laughed when I plunked down 100 smackers for my Mystical Dreamcatcher Pocketwatch, but who’s laughing now?!

For those of you who didn’t have foresight enough to invest in chilling likenesses of dead royalty and zirconium encrusted daggers, allow me to predict what the Fed is planning to do. Just let me look into my Dragon of Lore Crystal Ball (a steal at 5 payments of only $39.99!)...

Abra-cadabra!

~~Ah yes...I scry a rather stoned-looking Bernanke telling the table that he knows exactly what needs to be done. Well! That’s good news!~~

~~Oh. He wasn’t talking about the economy. He was suggesting that they order pizza.

But still...based on his track record, that’s one of his more reasonable suggestions.~~

~~Now someone else at the table is telling him that no one there can afford to have a pizza delivered

because food and gas prices have soared again.~~

~~Bernanke insists that “Referendum Deepdish” be passed as they can just print more money

in the office next door. The motion is passed.~~

~~Someone raises a new motion: Will the Reserve lower interest rates again despite the fact that it has done nothing to mitigate the housing crisis or prevent a recession? They ask the chairman directly.~~

~~Bernanke teeters in his seat for a moment, opens his mouth...and then passes out on the floor.

The attendees concur with the chairman’s motion to drop the interest rate again. Motion is passed.~~

~~The pizza arrives. The delivery fellow receives a lousy tip.~~

As we can see, it’s all business as usual at the Federal Reserve. But before I go off to polish my collection of Elvis Head Silver Dollars, I leave the Fed with three bits of advice:

1. These are tough, confusing times, and I do in fact sympathize with anyone tasked with sorting this out, but your methods have proven to be the financial equivalent of bloodletting for the ailing economy. Try something new for once, PLEEEEEEEASE!
2. We know the banks own you (literally), but at least pretend that you have the interest of the American people in mind. You know, we love a good circus act. And if you piss us off, then...
3. Don’t stiff the pizza boy: He knows where you live.

Costco And Sam’s Club Memberships: Are They An Investment?

Typically I would shy away from calling things such as Costco and Sam’s Club memberships “investments,” but in light of recent events they might just be entering into that category. I read an article from the Wall Street Journal yesterday that opened my eyes to the concept. In the article, it is explained that food prices are increasing by so much that it makes sense for people to stock pile non-perishable food rather than put that money into savings or money market accounts.

According to the article, food inflation for the average American household is running around 4.5 percent right now. Many foods are seeing price increases much higher than that. Cereal prices are rising by more than 8 percent a year, and flour and rice are up more than 13 percent. Milk, cheese, bananas and peanut butter are all up by more than 10 percent. Eggs have increased 30 percent in the past year and ground beef and chicken prices are up 4.8 percent and 5.4 percent respectively.

It is obviously not possible to stock up on perishable items such as milk and eggs, but you can buy extra cereal, rice and flour. You certainly aren’t going to make 13 percent on any bank account, so in actuality using some of your savings to purchase extra food might not be such a bad idea, or investment, for that matter.

That is where the Costco and Sam’s Club memberships come in. These warehouse stores offer much better prices than typical grocery stores; the catch is that you have to buy large quantities of the items. If you are planning to stock up on certain staple goods, you can save money by buying at these stores. So let's say you can save 5 percent off of the items you purchase at Costco or Sam’s Club over your neighborhood grocery store (though, in my experience, buying in bulk at these stores should save you much more than that)--now your “investment” looks that much better. Instead of making a 13 percent return on your money, purchasing your rice now actually could earn you 18 percent. Obviously those numbers don’t take into account the cost of your membership, or any subsequent storage or other costs which may be associated with holding the extra food, but I think you get the picture.

Also, as an added bonus, you will be in good shape in the event of a complete economic collapse, as many Ron Paul supporters are predicting.

30-Year Mortgage Rates Top 6 Percent As Investors Fear Inflation

Homebuyers who thought mortgage rates were heading down because of all the Fed interest rate cuts need to think again. According to Freddie Mac, 30-year mortgages rates increased 0.15 percent this week, despite all the rate cuts from the Fed. If you think that is strange, remember that 30-year mortgage rates are not tied to the Fed interest rates, but instead are controlled by the mortgage-backed securities market. Read our previous post: How Do Fed Interest Rate Cuts Really Affect Mortgage Rates? for more background on that. The bottom line is that when 30-year mortgage rates go up, despite the lowering of key Fed interest rates, it is typically because of inflationary fears.

It seems that mortgage rates won't be going down until the Fed can get inflation under control. The Fed is likely to only cut rates by 0.25 percent at their next meeting because they are concerned about inflation, according to the Associated Press. My thought is that if they were truly concerned about inflation they wouldn’t be dropping interest rates, even by the quarter point. Considering past actions from the Fed, I would say that inflation concerns are not at the top of their list.

I’m not sure who in their right mind is buying these mortgage backed securities anyway. I wouldn’t touch these, or even U.S. treasuries, at this point in time. Considering that the returns they offer are barely above inflation--that is, if you believe the government’s CPI numbers are accurate (I think they are much higher than that)--they just aren’t worth it…but that is a post for another day.

The moral of the story is that if you are in the market to buy a home, don’t wait in anticipation of mortgage rates going down. You can wait because of the market and you can wait for better opportunities, but don’t wait because you think mortgage rates are going down, because they just might not.

Social Security Benefits: Apparently We Have Nothing To Worry About

I read an interesting article yesterday from MarketWatch that said all the talk about the failing Social Security System, and how it is going to soon run out of money is completely overblown. According to the author, Dr. Irwin Keller, the social security system may never run out of money, let alone run out of it in the near future. He claims that people are reading only the summary page from the annual report issued by Social Security’s board of trustees, which offers a warning of the possibility of a shortage in funds, and that if people read further they would see that the projections used in predicting the fund shortage scenario are drastically conservative. Using growth projections that are more historically consistent, the fund would actually never run out of money.

This is an interesting view, but I’d like to point out one thing that he neglects to mention: there is no money in the Social Security system right now. All that’s there is a bunch of IOUs from the U.S. government that they plan to pay back to the supposed trust fund. Let’s look at some quotes from President Bush himself in an MSNBC article a few years back:

“’A lot of people in America think there is a trust—that we take your money in payroll taxes and then we hold it for you and then when you retire, we give it back to you,’ Bush said in a speech at the University of West Virginia at Parkersburg.

‘But that’s not the way it works,’ Bush said. ‘There is no trust ‘fund’—just IOUs that I saw firsthand,’ Bush said.”

The article goes on to explain that the so called “trust fund” is actually a white notebook filled with physical evidence of a couple trillion dollars worth of Treasury Bonds.

We have loaned our retirement funds to the U.S. government—the most indebted country the world has ever seen—and the government doesn’t have the money to pay us back. Of course they can print more money to pay us back, but the actual buying power of currency will likely be far less than what we put into the account in the first place. Even if we get our full Social Security benefits, as Keller argues we will, in reality the value of those benefits will have been drastically reduced.

Personally, I’m a big fan of moving at least a portion of our Social Security benefit payments into an investment account that is controlled (at least somewhat) by the taxpayer. I wouldn’t hire a financial planner with the spending habits of the government, and I certainly don’t want them in charge of my retirement money. The more control I have over my Social Security benefits, the better I will feel. I hope that Keller’s assessment is correct, but I’m certainly not counting on it. I suggest you not plan for your retirement with the assumption that you will get your full Social Security benefits either. It is far better to be pleasantly surprised and have extra than to count on your full Social Security benefits and not have enough money for retirement.

The Zimbabwe Situation: Is There Hope?

The Zimbabwe Situation, as it is being dubbed by some, is a combination of mass inflation and human rights and property rights violations. I think most people would agree that long-time leader Robert Mugabe is responsible for the present state of the country, and it's economy.

For those unfamiliar with the Zimbabwe Situation or Robert Mugabe, there is a website dedicated solely to providing information on the subjects: zimbabwesituation.com. I also wrote a blog post last month that talked about the inflation problems in Zimbabwe.

According to recent press covering the Zimbabwe Situation, there appears to be some hope for the upcoming elections. For years, the opposition party has been suppressed and elections have been rigged. Mugabe would punish any supporters of the opposition by cutting off their food supplies, among other things. Many people are not even registered to vote out of sheer hopelessness, and the last few elections in Zimbabwe have been—more or less—a waste of time.

This election seems to be different; there is a growing sense of hope among Zimbabweans. Both the opposition leader, Morgan Tsvangirai, and a rival leader from Mugabe’s own Zanu-PF party are running. Though Mugabe has employed some of his traditional election tricks, this election has been relatively peaceful, according to an article from BBC News.

Zimbabwe was one of the brightest stars in Africa prior to Mugabe’s destruction of the economy. The country is rich with natural resources, and it has much to offer both tourists and businesses, but investors will shy away until Mugabe is out of power. If Zimbabwe can elect a good leader who welcomes a free market, things could turn around for Zimbabwe. I’m not holding my breath, but hopefully someday soon we will see an end to the infamous Zimbabwe Situation.

Say Goodbye To The Once Mighty U.S. Dollar

I think that almost everyone is aware that the U.S. dollar is struggling, but many are not truly aware of the severity of the situation. The Associated Press released an article yesterday which talked about some of the issues. It mainly focuses on how many businesses in foreign countries no longer accepting the U.S. dollar, but it also talks about some of the underlying issues as well. Here are some excerpts:

“Experts say the bleak U.S. economic forecast means it will take years for the greenback to recover its value and prestige.”

“The dollar has steadily eroded in value against the euro and other currencies since 2002 as U.S. budget and trade deficits ballooned, but fears of an American recession and credit crisis have sent the dollar to stunning lows amid predictions the slump will continue for a long time.”

“The dollar fell to a 12-year low against the Japanese yen Thursday, dropping below 100 yen to the dollar for the first time since November 1995. The euro rose to all time high and is currently trading above $1.55. Meanwhile gold hit a new benchmark today at $1,000 an ounce. That's a jump of nearly 20 percent just since Jan. 1.”

“While dollar cycles have come and gone, experts caution that it's now much more difficult to predict when this one will end because the euro didn't exist as competition for the dollar before.”

“During previous U.S. economic downturns, big foreign funds typically snapped up U.S. Treasury securities, helping to shore up the dollar to a certain degree. But the euro and currencies from other nations are now seen as legitimate options, and interest rates are higher outside the United States — meaning the funds can get better returns on investments elsewhere.”

“Nations that were once seen as incredibly risky for investments — such as Brazil — are now seen as good long-term bets.”

I have long been warning that the U.S. dollar was on the way down, as many other financial experts have been, but many people still seem to be in denial of the situation. Those who are still in denial need to wake up...and fast. The problems in the U.S. are going to be around for a while, and, in the meantime, investors need to look at diversifying across currencies in order to maintain the integrity of their investments’ value. Stubborn investors who refuse to abandon (or at least strongly diversify) the dollar, are likely to be very unhappy and very poor.

The Federal Reserve And European Central Bank: A Difference Of Opinion

The Federal Reserve and European Central Bank have a very different opinion when it comes to managing economic policy. This is especially apparent when one looks at how their respective currencies, the dollar and the euro, have performed against one another. It seems that every day, the euro is setting a new high against the dollar. There is a great article in The New York Times that talks about this very issue, but I will attempt to summarize it here. Let’s take a look now at how the two central banks ideologies compare.

The Federal Reserve’s number one priority is economic growth. Their thought is that if growth stalls, then so will demand and inflation. To the Fed inflation is simply a byproduct of growth, so they aren’t too concerned with controlling it directly. They would rather control growth, and thus indirectly control inflation.

The European Central Bank focuses on growth as well, but they are also very concerned with inflation. They do not necessarily agree with the idea that inflation can be controlled (at least to their satisfaction) solely by focusing on growth.

Growth has been slowing both in the U.S. and in the European Union, but the central banks have had very different responses. The Fed has responded with a series of rate cuts, and will likely make even more of them, while the European Central Bank has left their key interest rates in place. In the U.S., the drastic rate cuts haven’t had much effect in ramping up the economy, and growth has come to a halt. In addition, inflation has been increasing dramatically, inspiring some to proclaim that the U.S. is entering into a period of stagflation. Growth in the European Union has continued to slow and inflation is above target at around 3 percent, but on both counts they are doing a little better than the U.S.

It is extremely hard to compare economic policies in this way because the two subject economies are very different. It will be interesting though to see how the two differing policies turn out in their results. I’m not a big fan of how Bernanke runs things, and I’m leaning towards the European Central Bank working out better, but we will just have to wait and see.

President Bush Says “No Recession,” So We All Can Relax Now...

During a news conference yesterday, President Bush said that the country was not recession bound. It appears that everything is going to be okay, and we all can sleep better at night without fear of the scary recession monster.

I don’t know about you, but I’m just not getting that warm and fuzzy feeling. If you believe President Bush, and you feel good about the country’s economic future, then more power to you. I just don’t think I’m ready to drink that Kool-Aid quite yet.

I look at the economy and I still see major issues. Mr. Bush says that the economic stimulus package will be more than enough to fix what ails us, but I look at it and think “what a waste of tax payer money.” Of that $168 billion how much will actually end up back in the economy? 1/2? 1/3 or less? No one can know for certain, but I have a feeling it will not be nearly as much as the Bush clan is projecting.

What I do know is that inflation is running rampant, and it appears that the Fed isn’t going to do anything to slow it down for awhile. Even if Bush and Bernanke pull out all the stops to ward off recession, with what will we ultimately be left? Recession is a natural thing, it happens every once in awhile, and whether or not we want to, we are going to have to face it eventually. If we keep delaying it and delaying it, once it eventually comes it will only come harder. It would be great if we could avoid recession forever, but that only happens in Fantasy Land, and it is high time for President Bush and Bernanke to come back to reality. I know Bush is just trying to delay the recession until after the elections, but come on, man... your legacy is already ruined, and you’re only making it worse.

Meanwhile, investment-wise it pretty much comes down to this: If you believe that Bush and Bernanke have this thing under control, then you want to buy up dollar assets. If you don’t believe Bush and Bernanke are going to pull off a miracle, and are just setting us up for a harder fall, then you want to get out of the dollar.

Consequences Of Inflation: Nonsense Says Bernanke

Federal Reserve chairman Ben Bernanke has shown once again that he could care less about the consequences of inflation. In his latest address, Bernanke made it pretty clear that at the next Fed meeting (March 18th) he is planning to lower interest rates once again. Did he not get all the reports that were released this month about ramped inflation, or does he just not care?

Every month it seems inflation is getting worse and worse, and the economy despite all the rate cuts, is continuing its downward spiral. Newsflash to Bernanke: The rate cut thing isn’t working. Well, it is certainly working to increase inflation, and devalue the dollar, but it isn’t helping the economy like he hoped. Rather than admit defeat, Bernanke is making what he must think is a valiant stand, but rather than glory all he is likely to see is stagflation and a bunch of ticked-off retired folks.

To all of the retirees out there, I offer you my sincerest apologies. It appears that your retirement money is not going to go as far as you probably planned. You can thank Alan Greenspan, and now Bernanke for that little favor. I wonder how many parents are going to have to move in with their children because they can no longer afford retirement? It would be an interesting irony considering how children are now moving out later and later in life. To all of the entrepreneurs out there, can I suggest starting a business catering to in-law additions or design? Just an idea I thought I’d share to help fill a need in this soon to be emerging market, compliments of Mr. Bernanke of course.

If you have yet to retire, hopefully you have enough time to conquer this inflation problem within your retirement portfolio. My suggestions are to diversify out of the dollar and make sure that you have exposure to gold and silver. Gold makes me nervous right now, seeing how high its price has gone, but at this point I would feel much better owning gold than dollars. Whatever you choose to invest in, make sure that you are taking inflation into account in your retirement need projections, and you had better be expecting more than 2 or 3 percent.

As The Price Of Gold Rises, What Is An Oscar Worth?

With the price of gold sky high right now, how valuable are those Oscars that got passed out yesterday?

According to The Seattle Times, each Oscar Statuette cost $500 this year, up from $400 last year. In only one year the price jumped $100, or 25 percent! That is pretty amazing, and it goes to show how bad inflation is getting, especially for materials. Each Oscar, according to The Seattle Times, is made from pewter that is plated in successive layers of copper, nickel, silver and gold, and then lacquered and buffed. The price of gold itself has jumped around 40 percent in the last year.

Those who think that $500 isn’t much to pay for an Oscar might be disappointed to know that they can’t be bought. There are strict rules forbidding their sales, and Oscar winners sign contracts guaranteeing that they won’t sell their own award. If they were to break that contract, they would probably fetch more than $500 on the black market, but instead of investing in Oscars, one might want to consider the materials that make up an Oscar.

Even though it seems that silver and gold are at ridiculous highs right now, I think there is more room to grow. Considering the rate at which the Fed is inflating the monetary supply, gold and silver are practically a must for investors right now.

Zimbabwe’s Inflation Tops 100,000 Percent

As the U.S. battles a serious inflation problem, we can at least be thankful it’s not as bad as the inflation issues Zimbabwe faces. Yesterday, Zimbabwe’s statistical office reported inflation of over 100,000 percent. That’s right, 100,000 percent; no extra zeros have been added for emphasis.

To give you an idea of what that type of inflation looks like, in Zimbabwe a simple loaf of bread costs around Z$3.5 million, according to VOA News. Can you imagine having to carry around 3.5 million dollars in cash just to buy a loaf of bread? As you have probably realized, this is not good for Zimbabwe’s economy; things have become truly disastrous there. Zimbabwe’s per capita GDP has shrunk from $200 in 1996 to around $9 now, according to CNN.

Unfortunately, a country that was on the rise has essentially been ruined by one man: Mr. Robert Mugabe. Since he won’t allow anyone to run against him in the elections, it doesn’t seem like he will be voted out anytime soon. The good news is that he is 84 years old, so he can’t last all that much longer. Castro resigned this week, so maybe Mugabe is the next dictator on his way out. Here’s hoping, anyway.

With the U.S. inflation rate at a little over 4 percent we don’t need to worry about problems of this scale, and I’m very thankful for that. But inflation in the U.S. is still a major problem. If people continue to overlook inflation, it will eventually eat their savings. Plan for inflation now, and invest accordingly. Ignore it, and your retirement could be in peril.

What Is Stagflation?

There is a lot of talk going around about stagflation, but many people have no idea what stagflation is. The term has only been around for about 40 years and is not used all that much, but suddenly it is being thrown around everywhere.

Stagflation is a blend of the words stagnation and inflation. It is used to describe an economy which is stagnating (or not growing) while also facing high inflation.

Typically, the Fed deals with economic stagnation by lowering key interest rates or adding to the money supply. These actions usually work to get the economy growing again.

On the flipside, when an economy is booming and people are making money left and right, inflation begins to rise. When this happens, the Fed typically raises interest rates thus making money harder to get. This slows the economy and inflation with it. So back to Stagflation…

In a period of stagflation, the Fed doesn’t know what to do. The economy is slow, so they want to lower interest rates and get it moving, but making money easier to get only makes inflation worse. The Fed has to decide what is more important: economic growth or inflation.

Right now, the U.S. economy is grinding to a halt, and very likely heading into a recession. Unfortunately we are also facing strong inflationary pressure as prices continue to rise (see inflation post). If we aren’t already in a period of stagflation, then it appears that we are headed straight for it. The last time the U.S. dealt with stagflation was in the 1970’s and it was not a fun experience.

Though the way we run are economy now is different than it was back then, some would argue that our current situation (housing and credit crisis) is far worse then the situation was in the 70’s leading up to that period of stagflation. I don’t know how bad it can get, but something worse than the 15 percent inflation and 9 percent unemployment seen during the past episode of stagflation doesn’t sound the least bit exciting to me. Personally, I will be heavily diversifying into foreign markets and things like gold and silver to protect myself, just in case.