John Mauldin's Outside the Box : Interest Rates

Between a Rock and a Hard Place

John Mauldin — Mon, 24 Aug 2009 19:06:00 GMT

There is the strong possibility that policy makers in the US and UK will not time the transition from the current quantitative easing to a more tightened monetary policy. That is not because they are no competent. It is because the task is very tricky and there is no play book outlining the steps. This is not Tom Landry (former Dallas Cowboy coach) pacing the field with a play for every situation already planned and practiced well in advance.

The odds favor they will either be too late or too early. Getting it "just right." The Goldilocks play, would be more than fortunate. In fact, there may be no right play to call. They may be forced to choose between a slower economy and/or inflation/deflation. And as this week's Outside the Box authors note, there is also the possibility of yet another asset bubble, making the choices even more risky.

Those who are absolutely positive about which of a variety of outcomes will emerge have a level of clairvoyance with which I am not familiar. It makes risk asset (like stocks) investing particularly tricky right now. This is a time to be nimble and avoid creating opportunities for large losses if you are wrong.

We will start this week's OTB with a few paragraphs from the Bank Credit Analyst about the Great Depression and then move on to a piece from the London office of Morgan Stanley on the problems facing central bankers.

And on a less ominous but more important note, the Muscular Dystrophy Association (MDA) has issued a warrant for my arrest which goes into effect on August 26th! I will be held at the PM Lounge in the Joule Hotel from 3-6. My bail is set at $2,400, which will benefit local families living with neuromuscular disease. No one person can set me free. It will take a little help from all of my friends, family, colleagues and enemies! Please use the link below to visit my Bail Page and help me post my bond by contributing in any way that you can. Thank you for having a big heart! And come see me in jail!

CLICK HERE TO HELP RAISE MY BAIL!!

And now, the thoughts from BCA.

John Mauldin, Editor
Outside the Box

"Prematurely exiting from an accommodative policy setting, derailed the recovery in the late 1930s and led to another leg of the depression.

"By mid-1936, the Federal Reserve lifted bank reserve requirements, in an attempt to soak up liquidity and prevent speculation from returning to Wall Street. However, the banking system was still too fragile and in need of capital. Consequently, both narrow and broad money growth plunged from a healthy clip back into negative territory. To make conditions worse, by 1937 fiscal stimulus programs ended and social security taxes were collected for the first time. The federal deficit shrank rapidly from -5.4% to -1.2% of GDP, creating significant contractionary forces.

"Obviously the economic relapse in the 1930s is an extreme example. Nonetheless, it does highlight the risks of authorities exiting prematurely before the economy and banking system are ready (even after an extended period of healthy growth). Currently, U.S. and U.K. money multipliers are still impaired, although aggressive easing has allowed some liquidity to flow through to the real economy. A decline in U.S. M2 growth would be a major warning sign. U.K. broad money growth has plunged in recent months, presenting a significant threat to the economy.

"Bottom line: Policymakers will need to continue to curb investor expectations for an early exit in order to allow a sustainable recovery to materialize. It will likely be at least until the end of next year before growth conditions in the U.S. and U.K. are robust enough to withstand a reduction in stimulus." (www.bcaresearch.com)

Between a Rock and a Hard Place

By Manoj Pradhan & Spyros Andreopoulos | Morgan Stanley, London

Monetary policy usually finds traction in the real economy through different ‘channels of monetary transmission', working through falling interest rates, increasing asset prices and increased lending by banks. These translate into more consumer and business spending, which boosts economic growth. During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery. Turning away from the inflation-targeting (IT) regime that is now conventional wisdom to perhaps a price level-targeting (PT) regime or even explicitly accounting for asset prices may give central banks much-needed flexibility.

The Sequence of Events in Economic Recovery

In a garden-variety recession, policy rate cuts lead to declines in lending rates and slow traction in the form of a better outlook for consumer and business spending. Risky assets usually rally a quarter or two before the recession ends, whereas credit growth usually picks up only after recovery sets in (see "Credit Confusion", The Global Monetary Analyst, February 4, 2009). The Great Recession has not scrambled this sequence of events but it has changed the timing and response of some. Because of the freezing of credit markets, the interest rates that matter for borrowers fell much later than they would have during a more typical episode. Also, given the massive task of repairing balance sheets that confronts commercial banks and households in particular, spending and borrowing are likely to remain subdued. The risk is that credit growth could lag the end of the recession by more than usual. However, risky assets seem to have stuck to the script and rallied ahead of the bottom in economic growth by a familiar lead time.

Interest Rate Channel Less Effective So Far

When central banks cut policy rates, other interest rates respond quickest to the policy move. By providing cheaper borrowing rates to households and businesses, central banks aim to encourage spending and spur production. This is the ‘interest rate' channel for monetary transmission. This channel typically carries the bulk of the burden of resuscitating the economy. Untraditionally, during this current cycle, interest rates that matter to borrowers have fallen very slowly and much later than the cuts in policy rates. Even as they have fallen, however, they have met households who are reluctant to exploit these low rates, given the desire to save in the US and the UK and the conservative habits of German and Japanese households.

Credit Channel Likely to Be Subdued as Well

During a recession, credit flows to the private sector usually fall. Banks are less willing to lend and households and firms are less willing to borrow. Policy rate cuts normally provide commercial banks ‘carry' via a steeper yield curve, allowing them to borrow money at low rates and lend it at higher rates. In this cycle, central banks have had to resort to unconventional measures in addition to rate cuts to ensure that banks had the benefits of a steeper yield curve and an abundance of liquid funds to lend if they so desired. Surveys suggest that banks are becoming more receptive to lending but credit will likely grow with a lag (again see Credit Confusion) and quite slowly thanks to banks and households slowly rebuilding their balance sheets.

Asset Price Channel Leading the Charge...

Risky assets have outplayed the other channels by a margin over the last few months. This is an encouraging sign for central banks, who will undoubtedly welcome the economic traction that accompanies rising asset prices. A rise in equity prices should enhance the incentive to invest because the higher price of existing capital implied by higher share prices increases the relative attractiveness of investing in new capital (Tobin's q). Back in March, with the worst of the economic bad news likely already having been delivered and ultra-expansionary policy in place, risky assets rallied and rallied hard, which is a positive for investment. A possible bottoming in the housing market in the US and the UK would mean that Tobin's q could be applied to the housing sector as well. Households are more likely to buy new houses if house prices are rising, and this encourages homebuilding activity. Also, rising asset prices have supported the balance sheets of financial institutions.

...but Risky Asset Rallies Come at a Cost

One of the most important lessons from the Great Recession is the damage that asset bubbles can wreak. As the Fed and the ECB kept policy rates low for a very long time after the 2001 recession to ward off deflation concerns, they chose to allow an ultra-expansionary policy to inflate asset prices. Even though economic growth in the next couple of quarters could be very strong, the medium-term outlook for the major economies and therefore for global growth remains quite fragile. Policymakers therefore may end up having a repeat of the 2001-type dilemma on their hands.

Between a Rock and a Hard Place

If the imbalance between risky asset prices on one hand and interest rates and credit on the other persists for a significant period of time, the transition from über-expansionary policy to a neutral stance could be an extremely tricky balancing act for central banks. In the long run, asset prices cannot keep exceeding the growth potential of the economy. However, over shorter horizons, a loose policy regime with plentiful excess liquidity can lead to significant asset price inflation when markets see an improving economic outlook. If policymakers allow asset prices to surge because the other transmission channels have been weak, they risk inflating the type of bubble that got us here in the first place. If they decide to head off asset prices by tightening policy, they risk raising rates into a weak recovery! The transition to a neutral policy stance thus requires greater balance between the channels of monetary transmission - ideally from interest rates and credit growth gaining better traction in the economy as asset price inflation cools down. This balance is far from guaranteed. Worse, a revival in credit growth could further stoke asset price inflation. Not the best news for central banks.

Inflation Targeting Too Stringent

What could central banks do if they find themselves in such a situation? Using the interest rate tool to quell asset price inflation when the economy is yet to recover fully would risk sustained deviations from the inflation target on the downside. At the same time, it would expose central banks to criticism from politicians and the public since the policy might jeopardise the recovery. Central banks might try to counter the pressure by arguing that pricking asset price bubbles would foster price stability over a longer time horizon by preventing crises such as the current one. But this riposte would be problematic in the current policy framework. Deliberately using policy rates to pursue objectives other than inflation - especially in a way that is detrimental to achieving the inflation target - is incompatible with the inflation-targeting (IT) orthodoxy. More to the point, pursuing asset prices could deliver a fatal blow to the transparency of the monetary policy regime. If the public is unclear about what the objectives of monetary policy are, it could lose faith in the central banks' commitment to price stability and inflation expectations would become unanchored. One of the main advantages of IT - transparency - would then be rendered defunct.

A Way Out?

Assuming CBs want to ‘lean against the wind' of asset prices, is there a way for CBs to escape the strictures of orthodox IT without risking the loss of their holy grail, the credibility of monetary policy? Price level targeting (PT) may be the answer. Under PT, the central bank aims at a certain path for the price level, with the rate of increase in the price level given by the inflation target (see "From Inflation Targeting to Price Level Targeting", The Global Monetary Analyst, July 15). PT differs from IT in that past deviations from the inflation target have to be corrected. For example, with a price level target path consistent with 2% inflation, if inflation in one period is 1%, then it would have to be 3% in the next period. The undershoot in one period would have to be compensated for by an overshoot in the next period in order to return to the price level target path. In short, PT is essentially ‘average inflation' targeting.

How Would PT Help Central Banks?

By effectively increasing the time horizon over which the inflation target can be achieved, it would give monetary policy much-needed flexibility to, if necessary, pursue asset price inflation in the short term. At the same time, long-term inflation expectations would remain anchored since monetary policymakers would commit to achieving 2% inflation on average. Indeed, inflation expectations under PT would themselves have stabilising effects on the economy. While inflation undershoots the target temporarily in order to burst the bubble, the public would know that this would soon require a compensatory overshoot. Short-term inflation expectations would then rise, decreasing real interest rates. This would, in turn, increase spending and output.

In summary, the transition from ultra-expansionary policy to a neutral stance may be very tricky if the imbalance between different channels of monetary transmission persists. Central banks may find themselves hiking into a weak recovery to quell asset prices, or they might compensate for the weakness in the interest rate and credit channels and allow asset prices to rise but risk inflating another bubble. Central banks could gain some much-needed flexibility by thinking outside the IT box - but whether they will make a dramatic move and switch to a PT regime remains to be seen.

History lesson for economists in thrall to Keynes

John Mauldin — Tue, 09 Jun 2009 02:36:45 GMT

There is a debate in academic circles on the lessons of the current economic crisis. While most ivory tower debates are of little concern to our daily affairs, this debate should concern you, as it will inform those who hold central bank and political power. Remember, there is no playbook of rules for what to do in deflationary, deleveraging recessions. They are making it up as they go along.

Today we have a short essay by Niall Ferguson published last week in the Financial Times. It speaks for itself, and you should take a few minutes to read it.

John Mauldin, Editor
Outside the Box

History lesson for economists in thrall to Keynes

By Niall Ferguson

On Wednesday last week, yields on 10-year US Treasuries -- generally seen as the benchmark for long-term interest rates -- rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Most commentators were unnerved by this development, coinciding as it did with warnings about the fiscal health of the US. For me, however, it was good news. For it settled a rather public argument between me and the Princeton economist Paul Krugman.

It is a brave or foolhardy man who picks a fight with Mr Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist.

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that "the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds" was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a "painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year".

De haut en bas came the patronising response: I belonged to a "Dark Age" of economics. It was "really sad" that my knowledge of the dismal science had not even got up to 1937 (the year after Keynes's General Theory was published), much less its zenith in 2005 (the year Mr Krugman's macro-economics textbook appeared). Did I not grasp that the key to the crisis was "a vast excess of desired savings over willing investment"? "We have a global savings glut," explained Mr Krugman, "which is why there is, in fact, no upward pressure on interest rates."

Now, I do not need lessons about the General Theory. But I think perhaps Mr Krugman would benefit from a refresher course about that work's historical context. Having reissued his book The Return of Depression Economics, he clearly has an interest in representing the current crisis as a repeat of the 1930s. But it is not. US real GDP is forecast by the International Monetary Fund to fall by 2.8 per cent this year and to stagnate next year. This is a far cry from the early 1930s, when real output collapsed by 30 per cent. So far this is a big recession, comparable in scale with 1973-1975. Nor has globalisation collapsed the way it did in the 1930s.

Credit for averting a second Great Depression should principally go to Fed chairman Ben Bernanke, whose knowledge of the early 1930s banking crisis is second to none, and whose double dose of near-zero short-term rates and quantitative easing -- a doubling of the Fed's balance sheet since September -- has averted a pandemic of bank failures. No doubt, too, the $787bn stimulus package is also boosting US GDP this quarter.

But the stimulus package only accounts for a part of the massive deficit the US federal government is projected to run this year. Borrowing is forecast to be $1,840bn -- equivalent to around half of all federal outlays and 13 per cent of GDP. A deficit this size has not been seen in the US since the second world war. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House's over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 per cent of GDP by 2017. And this ignores the vast off-balance-sheet liabilities of the Medicare and Social Security systems.

It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert "no upward pressure on interest rates".

Of course, Mr Krugman knew what I meant. "The only thing that might drive up interest rates," he acknowledged during our debate, "is that people may grow dubious about the financial solvency of governments." Might? May? The fact is that people -- not least the Chinese government -- are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.

No doubt there are powerful deflationary headwinds blowing in the other direction today. There is surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank's latest quarterly report: "A policy mistake ... may bring inflation risks to the whole world."

The policy mistake has already been made -- to adopt the fiscal policy of a world war to fight a recession. In the absence of credible commitments to end the chronic US structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings. It was Keynes who noted that "even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist". Today the long-dead economist is Keynes, and it is professors of economics, not practical men, who are in thrall to his ideas.

The writer is Laurence A. Tisch professor of history at Harvard University and author of The Ascent of Money (Penguin)

The Great Experiment

John Mauldin — Tue, 20 Jan 2009 02:20:15 GMT

There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. And this week's letter from Hoisington Investment Management Company does just that.

Let me give you two quotes to pique your interest: "Monetary policy works by creating the environment for a renewed borrowing and lending cycle. This cycle would require that the debt to GDP ratio, which is already at a record level, grow even higher. Would such an outcome really be that desirable when the controlling problem of the U.S. economy is too much improperly financed debt? If the Fed were able to engender an increase in the debt to GDP ratio, this might merely serve to postpone the reckoning of the current debt levels while laying the foundation for an even more vicious unwinding down the road."

And: "The only really viable option for federal stimulus is a permanent reduction in the marginal tax rates, as highlighted in the research of Christina Romer, incoming Chair of the Council of Economic Advisors. This would have the benefit of raising after tax rates of return, but the drawback in the short run of still having to be financed by an increased budget deficit. Over time, a massive reduction in marginal tax rates would be beneficial, but the operative word is time. Refunds, or transitory tax relief, will have no better results in stemming the recessionary tide in 2009 and 2010 than it did in the spring of 2008."

Van Hoisington and Dr. Lacy Hunt give us a seminar on the current bailout programs that is not the usual analysis we see in mainstream media. This week's letter requires you to think, but it will be worth the effort.

Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies. And now let's jump right in to the essay.

John Mauldin, Editor
Outside the Box

THE GREAT EXPERIMENT

Quarterly Review and Outlook -- Fourth Quarter 2008
Hoisington Investment Management Company

The late Nobel Laureate, Milton Friedman, noted in his 1963 book, Monetary History of the United States (coauthored with Anna Swartz), that the money stock decreased by a massive 31% in the Great Depression. The turnover of that money, called velocity, fell 21%. Nominal GDP equals money multiplied by velocity. Consequently, from 1929 to 1933 the breakdown of both measures resulted in a contraction in nominal GDP of approximately 50%. However, Friedman postulated that if the Fed had not let money shrink, velocity would have been steady and the Great Depression would have been averted, i.e., nominal GDP would not have collapsed. Our current Fed Chairman, Ben Bernanke, is an expert on the Great Depression, and he has, in fact, adopted Friedman's strategy to greatly expand the money supply. Whether this prescription for economic stability will work in a period of over indebtedness, such as now exists in the U.S., is most uncertain. Indeed, this could be called the "great experiment" since this economic theory has yet to be thoroughly tested in the real world.

Presently, major sectors of the U.S. economy are experiencing a debt deflation that is causing a massive destruction of wealth, thereby curtailing jobs, income and spending. Irving Fisher who, according to Friedman, was the most brilliant of all U.S. economists has noted that when the economy enters a period of "debt and price disturbances", those forces will eventually engulf the economy. Fisher developed that concept by examining the 1929-33 depressionary period, as well as the depressions of 1837 and 1873, as examples of when excessive debt and subsequent price declines controlled "all or nearly all" other economic variables. This theory of excessive debt and its pernicious and unrelenting deflationary impulse to the economy has been best chronicled by other notable economists: Charles P. Kindleberger (1910-2003), Hyman Minsky (1919-1996), Nikolai Kondratieff (1892-1938) and Joseph A. Schumpeter (1883-1950). Fisher contends that once extreme over indebtedness occurs, fiscal and monetary policy become impotent in spurring economic growth because money velocity will decline -- something that is currently happening. Individuals and businesses struggle to repay debt with harder dollars, and saving begins to rise as caution prevails.

The debt level of the U.S. has reached unprecedented proportions (Chart 1). More important than the level, however, is the fact that for the last few years the debt was improperly loaned and financed. In the words of the late economists Minsky and Kindelberger, this type of lending activity implies there is little likelihood of repayment of principal and interest. Stock prices have plunged, and with home prices plummeting, and commercial and industrial properties losing value, a deflation of assets has clearly begun while the underlying debt remains constant. Will this deflation overwhelm the best efforts of the Federal Reserve, invalidate Friedman's theory and prove Fisher correct? Most naturally feel and hope that the superiority of unbridled monetary and fiscal stimulus will overwhelm incipient price declines and stem the expanding cyclical downturn in economic growth. Our judgment is that the power of monetary policy revolves around the ability to initiate a new borrowing and lending cycle. This can only happen if lenders are willing to lend and borrowers are wanting and able to borrow. Presently, neither are so inclined (Chart 2). If price declines in assets continue, then Shakespeare's admonition of "neither a borrower nor a lender be" will become the economic mantra, meaning that a period of very low nominal growth will likely extend for a decade. Moreover, fiscal policy actions may not be helpful either and could produce unintended negative consequences. Conventional wisdom is that the current economic contraction is nothing more than a typical post war recession. In the ensuing paragraphs we intend to frame an argument that is contrary to this conventional wisdom.

Chart 1

Chart 2

CAN FED POLICY CONTROL ECONOMIC DESTINY?

To respond to the country's severe economic problems the Fed has invented many new vehicles for injecting liquidity into the economy, but few outward signs suggest that these actions are engendering a recovery. Total reserves in the latest twelve months increased a record 1,897%. In the latest three months the M2 money stock jumped at an 18.2% annual rate, one of the largest quarterly increases on record. Many feel this is tantamount to the Fed printing money. However, nominal GDP is not equal to the stock of money but, as noted above, it is equal to the stock of money multiplied by its turnover, or velocity.

Friedman and Bernanke both believe that if the money supply is increased sufficiently velocity will stabilize and Fed actions will at least be able to keep nominal GDP stable or growing slightly. Fisher, on the other hand, argues that if a generalized debt deflation takes hold, velocity will decline, just as it did during the Great Depression.

Our analysis suggests that the Fed will not achieve the desired results of stable velocity. Velocity is a function of financial innovation, rising during periods of new innovations and falling when these innovations are reversed or unchanging. Fisher also suggested that velocity rises when leverage increases and falls when leverage abates. So far the evidence at hand suggests that velocity is thwarting the efforts of the Fed. In the fourth quarter velocity plummeted, completely offsetting the increase in M2. Thus, nominal GDP declined at a very rapid rate.

Monetary policy works by creating the environment for a renewed borrowing and lending cycle. This cycle would require that the debt to GDP ratio, which is already at a record level, grow even higher. Would such an outcome really be that desirable when the controlling problem of the U.S. economy is too much improperly financed debt? If the Fed were able to engender an increase in the debt to GDP ratio, this might merely serve to postpone the reckoning of the current debt levels while laying the foundation for an even more vicious unwinding down the road.

ARE MASSIVE FISCAL DEFICITS A CURE?

The major debate in Washington surrounds the issue of how large the fiscal stimulus should be. In this case, as in many such debates, the question being raised is probably not the right one. In 2008, the consensus opinion was that a stimulus program based on tax rebates and one time transitory payments would be sufficient to halt the recession. Discussions were based on the need to make such payments timely and targeted. Hardly any discussions were held in either official or non-official circles as to whether such a program was desirable. Had there been such discussions, the funds might not have been so badly wasted. Numerous studies had shown that consumers have a very limited tendency to spend transitory income, and that prior efforts to stimulate the economy through tax rebates had failed. Nevertheless, the political process barreled through with a program with no reasonable expectation that it would work. Now the economy is even deeper in recession and the country has an additional $177 billion in debt on which the taxpayers will pay interest in perpetuity. About 17% of the rebates were spent, a tad less than during the rebate program of 2001. The minimal spending response was exactly in line with the consumption functions under Friedman's permanent income hypothesis, as well as the equivalent Modigliani's life cycle hypothesis. These pioneering works demonstrated conclusively that consumers have a far greater tendency to spend permanent rather than transitory income.

Fiscal stimulus will not work well, and may even be counterproductive, and this applies to both spending programs and to certain tax programs as well. One of the major problems on the expenditure side is that the government sector is smaller than the private sector. In the third quarter, real government spending, including the federal defense and non-defense sectors, as well as the state and local sectors, totaled $2.1 trillion, comprising 17.8% of real GDP (Chart 3).

Chart 3

If there is a desire to increase government spending, the federal government must either increase taxes on the far larger private sector, an option that would presumably be precluded under the present circumstances, or borrow funds in the financial markets that would have gone to the private sector. At this point we have to ask which sector has the better track record of growing the economic pie—private or government expenditures? The private sector has demonstrated the greater flexibility and creativity to expand the economic pie, increasing productivity and thereby improving living standards for all. The risk is that increased federal borrowing will stunt the private sector's ability to grow.

The only really viable option for federal stimulus is a permanent reduction in the marginal tax rates, as highlighted in the research of Christina Romer, incoming Chair of the Council of Economic Advisors. This would have the benefit of raising after tax rates of return, but the drawback in the short run of still having to be financed by an increased budget deficit. Over time, a massive reduction in marginal tax rates would be beneficial, but the operative word is time. Refunds, or transitory tax relief, will have no better results in stemming the recessionary tide in 2009 and 2010 than it did in the spring of 2008.

An important offset to the increased spending by the federal sector is a massive cutback in state and local expenditures. If transfer payments are excluded from federal expenditures, the spending of state and local governments totaled $1.9 trillion in the third quarter, much greater than the $1.1 trillion spent by the federal government. Further, state and local governments employed 19.8 million workers versus 2.8 million for the federal sector. J.P. Morgan estimates that state and local governments will have a $400 billion shortfall in funding this year, an economic drag since balanced budgets are required in all but one of the fifty states. Thus, spending will be curtailed or taxes will rise.

MAJOR HEADWINDS FOR CONSUMER SPENDING

Consumer spending is contracting at a near record pace despite: (a) a strenuous effort by the Fed to loosen monetary conditions; (b) a $170 billion fiscal stimulus package that occurred in the second quarter of 2008; (c) the enactment of a troubled asset recovery program totaling $750 billion, and (d) promises for a major additional fiscal stimulus in 2009. These monetary and fiscal actions were overwhelmed primarily by an unprecedented decline in household wealth (Chart 4). Moreover, the wealth loss is now being augmented by significant job losses and a shorter work week.

Chart 4

From the final quarter of 2006 through the third quarter of 2008, the real value of homes fell $3.5 trillion, while households' real holdings of stocks fell $2.1 trillion, resulting in a $5.6 trillion loss in total household wealth (Table 1). The wealth loss may exceed $10 trillion when the fourth quarter figures are tabulated. The Fed's econometric model indicates that a one dollar decline in real wealth will reduce total expenditures by 7.5 cents over three years. This means that the drag on consumer spending from declining wealth will be 3.4% per annum this year and for the next two years. By comparison, from 2000 to 2007 the annual increase in consumer spending was 2.9%. Additional losses in household income and wealth are likely in 2009.

Table 1

With consumers confronting such hostile wealth and income prospects, the saving rate is likely to rise sharply as it did after the Great Depression and, excluding the distortions created by World War II, continued to do for a half century. If the deflation now apparent in specific sectors of the economy spreads, the rise in the saving rate is likely to continue for a very long time. In the past, debt deflations have caused consumers to avoid at all cost the pattern of living beyond their means. Thus, the rising saving rate will constitute a major headwind for the U.S. economy.

GLOBAL IMPLICATIONS

As a percent of GDP, the trade deficit has fallen from 6% to 4.9% in nominal terms and 5.5% to 3% in real terms over the past two years. Real imports in constant dollars have declined by 3.5% in the latest four quarters, a dramatic reversal from the sharp increases of recent years. This drop in imports reflects the loss of consumer wealth and income, creating lower spending for imports, and this drag will persist for at least three more years. Therefore, further and even sharper declines in imports are likely. This will continue to transmit U.S. economic weakness to the rest of the world, while at the same time gradually and irregularly reducing the U.S. trade deficit.

Although the current account will narrow and fewer funds will recycle into the U.S., it is important to review the portfolios of foreign investors. Based on the latest available figures, the foreign sector held $9.1 trillion of long-term securities (Table 2). The Treasury department considers long term securities to be those with an original maturity of more than one year. As this table indicates, equities comprise 34% of foreign holdings, the highest for any category, followed by 30% in corporate bonds, 22% in Treasury securities and 14% in Federal Agency securities. The holdings of U.S. Treasury securities are primarily in the short end, with 70% held in 5 year or less maturities, 23% in 5 -10 year maturities, and just 7% in greater than 10 year securities. Thus, the shrinking U.S. capital account surplus is likely to have its greatest funding impact on the corporate bond and equity markets. The short-term Treasury market could be adversely affected, but the Fed is able to control the short-term rates.

Table 2

HISTORY OF DEBT BUBBLES AND LONG-TERM INTEREST RATES

In the world's three most recent debt deflations – the U.S. from the 1870s to the 1890s, the U.S. from the 1920s to 1940s, and Japan from the 1980s to the very present – the low in long term interest rates occurred about 15 years after the end of the debt mania (Chart 5). Even 20 years after the end of the debt boom, interest rates were not much above their yearly average lows. Using this history as a guide, it would not be surprising to experience a decade of low and declining interest rates

Chart 5

During 2008, long term Treasury bond yields fell from 4.5% to 2.7%, producing an extremely strong total return for such investments, as typified by the Wasatch-Hoisington Treasury Bond Fund (WHOSX), which returned 37.7%. Credit problems affected returns elsewhere in debt markets, limiting returns on the Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Index) to 5.2%. The decline in long Treasury yields reflected the intensification of recessionary forces as well as a collapse in inflationary expectations.

While the historical record indicates that the ultimate low in Treasury yields lies years away, the path to the ultimate low will be anything but smooth or linear as significant volatility continues. As the experience from U.S. and Japanese history indicates, many "false dawns" will occur, with investors assuming that the long-delayed cyclical recovery in economic activity is at hand. During these pleasant but relatively short interludes, stock prices will probably rise dramatically and bond yields will increase. If history is a guide, however, these episodes will further drain wealth and will be thwarted by the persistent forces of the debt deflation. With yields in the long Treasury market very low in nominal terms, the real return will be greater if deflation sets in. Moreover, in Japan from 1988 to the present, as well as in the U.S. from 1872 to 1892 and 1928 to 1948, the total return on Treasury bonds exceeded the total return on stocks. Such a condition cannot happen for the long run, but it did happen in these three instances spanning two decades. As a hedge against a recurrence of a prolonged debt deflation, some investors may want to consider even larger positions in high quality, long term Treasury securities.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Setting the Bull Trap

John Mauldin — Wed, 07 Jan 2009 23:00:48 GMT

Yesterday I sent you an Outside the Box from Paul McCulley who supports the government and Fed activity (in general) in the current economic crisis. Today we look at an opposing view from Bennet Sedacca of Atlantic Advisors. He asks some very interesting questions like:

Shouldn't the consumer, after decades of over-consumption, be allowed to digest the over-indebtedness and save, rather than be encouraged to take risk?
Shouldn't companies, no matter what of view, if run poorly, be allowed to fail or forced to restructure?
Should taxpayer money be used to make up for the mishaps at financial institutions or should we allow them to wallow in their own mistakes?

I think you will find this a very thought-provoking Outside the Box.

John Mauldin, Editor
Outside the Box

Setting the Bull Trap

by Bennet Sedacca

Bull Trap: A false signal indicating that a declining trend in a stock or index has reversed and is heading upwards when, in fact, the security will continue to decline.

You got to know when to hold 'em
know when to fold 'em
Know when to walk away
and know when to run.
You never count your money
when you're sittin' at the table.
There'll be time enough for countin'
when the dealings done

–Kenny Rogers, The Gambler.

Is the Ultimate Bull Trap Being Set?

Long time students of the market will tell you that "the crowd is usually wrong at the extremes". Judging by what I see, hear and read in the media, the current consensus is that stocks bottomed on November 20^th-21^st, an economic recovery will begin in the second half of 2009, corporate bonds are a buy, stocks are cheap and the stock market is now discounting all the bad news. This is surely a sign that the worst is likely behind us.

Even though I was looking for a low in the S&P 500 around 750 (it bottomed around 740 on November 21^st only to close at 800 the same day), I continue to believe that was a low point, but not THE low point for this bear market. We were large buyers of Mortgage Backed Securities during the Wall Street de-leveraging and have been rewarded with handsome gains, although we began to take some profits on Friday where appropriate.

Corporate bond spreads have tightened during a slow holiday season as well as spreads in CMBS (Commercial Mortgage Backed Securities). Corporate spreads may or may not tighten further as I believe there will be a wave of issuance at every level - Government, Emerging Markets, Corporations, Municipalities, etc. Treasury yields have crashed as the Fed has taken the Federal Funds Target Rate to a range of 0-0.25%.

Stocks have rallied even more to S&P 931 and could possibly make a run at 1,000- 1,100 if "performance anxiety" sets in among those portfolio managers that are afraid to miss the rally. We are not afraid of missing the rally because we are absolute return investors and have the luxury of having missed the big down move from nearly 1,600. The managers that are subject to performance anxiety are the same group that managed to a market benchmark only to get tattooed during the downturn.

The Fed is punishing savers and the Prudent Man by manipulating interest rates to zero. You can sit in cash and earn zero or you can be forced out on the risk spectrum just so you can keep up with inflation or your benchmark.

Forcing money into risky assets is perhaps the most dangerous experiment ever done, and is so large in scale and so unprecedented that we have no idea how it will end. I expect it to end poorly and with hyper-inflation. The funneling of assets into risk is masking the deteriorating fundamentals and giving the appearance of a market that has bottomed. But this is sleight of hand, an illusion

The Fed has declared a war on savers, a war on prudence and provided the ultimate Moral Hazard Card-and with our money no less. They are also setting up the ULTIMATE BULL TRAP-a trap so large that when it is sprung, perhaps as early as the end of the first quarter/beginning of second quarter that there will only be sellers left.

Why is the Federal Reserve Punishing Prudence?

Prudent—Wise in handling practical matters; exercising good judgment of common sense. Careful in regard to owns own interests; provident. Careful about one's conduct; circumspect.

-Webster's Dictionary.

Prudent Man Rule—an investment standard adopted by some U.S. states to govern the action of those responsible for investing money for other people. The fiduciary is required to act as a prudent man or woman would in regards to investing monies of others.

-Bloomberg Financial Definition.

Ever since 1995, the Federal Reserve and other authorities have been assisting in the birth of the largest debt bubble in our nation's history. Money supply has grown exponentially, weak businesses have been formed and failed, the consumer is leveraged up to their eyeballs, regulation is poor, and savings have dried up. Further, the brokerage/investment banking industry has been pummeled beyond recognition; lifelines have been given to everyone from poorly run banks to poorly run auto manufacturers. Esoteric securities have been relocated from the balance sheets of reckless banks and brokers to the U.S. Treasury, FDIC and Federal Reserve. Investors worldwide watched $30 trillion of stock market equity disappear in the past year while home prices have cratered by better than 25%. What other goodies do we have?

Unemployment on every front is rising. market that has bottomed.
Tax receipts are down and State Governments are suffering.
The debt market, except that artificially supported by the Government is closed.
Earnings estimates for the S&P 500 are down 60% year-over-year.
Stocks (using the Dow as a proxy) are at the same level they were 10 years ago.
Industrial Production around the globe is imploding.

I could go on and on and on and on, but there really is no point. I could show 25 graphs or more of what is wrong with America's economy and for that matter, much of the rest of the global economy and global markets.

Here is the magical question: "why is there is so much bad news, and is it fully discounted in prices?" If so, "why are the Fed, FDIC and Treasury Department so desperate to drive down interest rates to zero, buy troubled assets, ruin what used to be an efficient debt market in Mortgage Backed Securities, Corporate Bonds and Preferred Stock?"

There seems to be two distinct markets that have developed for debt—one that the U.S. Government stands behind with all of OUR money and the one that exists in the "free market".

Before I show a few examples of why prudence is being penalized and why I believe it will be a deadly trap for those that fall in it, allow me to share with you the most recent release from the Federal Open Market Committee to give you a sense of their desperation.

FOMC Statement December 16, 2008

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.

I find it slightly ironic that I chose red, white and blue to highlight the text of the FOMC release as I do not believe what I am witnessing in the financial markets is anything close to patriotic. In fact, I find it distasteful, dangerous and Socialistic. Think for a moment about where the Fed is heading with their policies. It is the opposite of a free market, absent of "Laissez faire" and one right out of Ayn Rand's Atlas Shrugged.

Laissez faire—the theory or system of government that upholds the autonomous character of the economic order, believing that government should intervene as little as possible in the direction of economic affairs.

If you read the paragraph from the FOMC statement highlighted in red and add to that all of the new programs and bailouts paid for by "We the People", it leads me to the following questions.

Shouldn't the consumer, after decades of over-consumption, be allowed to digest the over-indebtedness and save, rather than be encouraged to take risk?
Shouldn't companies, no matter what state they reside in from a political point of view, if run poorly, be allowed to fail or forced to restructure?
Should taxpayer money be used to make up for the mishaps at financial institutions or should we allow them to wallow in their own mistakes?
Shouldn't free markets be free?
When did Socialism make its way to our shores?
How do we choose who is bailed out and who loses?
Shouldn't we place blame on the politicians, bureaucrats and other "decision makers" and put skilled people in place that know how to run the businesses?
Shouldn't investors, led blindly down the primrose path of "buy and hold, diversify and don't open your brokerage statement except once every 10 years" be allowed to follow the Prudent Man Rule?

Again, there are many questions to be asked, many with answers that no one wants to put in print. When will people stand up like in the movie Network when Howard Beale, played by Peter Finch, screams, "I'm mad as hell and I'm not going to take this anymore!!!"

I have a feeling that once the rally in equities and credit (no matter how long it plays out) ends, we will realize that the patient has only been shot up with adrenaline as opposed to good old-fashioned bed rest.

Risk taking, in a laissez faire world should be replaced with risk aversion for a period of time. Consumers that over-consumed should be allowed to strengthen their balance sheets for the next cycle and increase their savings. Companies that have been kept afloat, bailed out, nationalized, stuck in conservatorship, have become part of my national portfolio whether I like it or not, unless it actually poses systemic risk (which I am not at all in favor of), should fail. Period. After all, where is MY bailout?

A Few Examples of the "Not-So-Free-Market"

The picture above is of 30 year Fannie Mae 4 ½% mortgage pools. Note the recent 13% spike as the Fed announced that they would be buying Mortgage Backed Securities in order to stabilize the mortgage market. In a free market, these securities would be many points lower, but because there is an artificial bid (yep, with our money) investors are forced to look elsewhere toward risky assets.

The chart above may be confusing, but it is actually rather simple—it is the screen that our Head Trader and I look at all day in the land of Mortgage Backed Securities. If you focus on the middle row section, you will note that 7% Freddie Mac (FGLMC) pools trade at the same price as Freddie Mac 6% pools and lower in price than 6 ½% pools. This is yet another example of how the markets have become so disorderly and difficult to trade. But for the icing on the cake, feast your eyes on what the Prudent man would invest in during times of rebuilding one's balance sheets, Treasury Bills.

Yes folks, cash is now officially trash. If you buy 1 month Treasury Bills, you are rewarded with a yield of a gigantic 0.02% per year. That's right, 2 basis points per year. I suppose people with more than enough money can keep it invested for an entire year and make nothing or they can succumb to the pressure of, "I can't make zero forever if I want to retire."

Now, imagine that you are a professional money manager that is paid 1% a year to invest other people's money. If you feel that being prudent is to sit in cash, and attempt to charge a fee, the math is simple—0.02% per year minus any reasonable fee is a negative return. This is forcing many people out on the risk spectrum at precisely the wrong moment, when risks are the highest ever.

While we have taken some profits as mentioned earlier on, we remain rather fully invested in higher coupon mortgage backed securities that we feel have a low chance of being refinanced and will provide an adequate (4-6%) return while we wait for the dust to settle.

Summary—Why Will the Bull Trap Hurt so Many Investors???

As I have mentioned many times, markets are clearly driven by fear and greed. At Atlantic Advisors we operate without regard to market benchmarks. To guide our investing, we don't begin by looking at the construction of market benchmarks, instead we ask ourselves, "in the absence of a benchmark, what would you buy?" This leads into buying only securities that we believe have the best risk/reward profile and away from those that are not attractive, even if they are part of the benchmark.

Most money managers are driven by "beating the benchmark"; no matter how imprudent it may be to do so. Like Kenny Rogers sang in "The Gambler", "you have to know when to hold 'em and know when to fold 'em." Knowing when to fold 'em or play it close to the vest, while everyone around you is partying is perhaps the most difficult task we face as investors. I am fully aware of the Fed's goal to both "save the system" and "force everyone out on the risk spectrum", but I have seen this play before.

I believe very strongly that investors who believe that they must be invested in risky assets at the expense of prudence will rue the day that they did so. As it relates to stocks, when I consider the risk/reward ratio with equities at 22 times earnings (using 931 S&P 500 and $42 in earnings in 2009), I cringe when I hear people say that stocks are cheap.

What about municipal bonds? Pundits are declaring municipals cheap relative to Treasury bonds. Treasuries are not a good barometer as they are being manipulated lower in yield. With the insurers like MBIA and AMBAC gone, and little if any research available on the nearly 50,000 issuers out there, and downgrades coming like Noah's Flood, I cringe to think that they are attractive as well.

When I consider junk bonds, with new issuance at zero (a whopping one new issue was completed in the 4^th quarter of 2008), they may seem cheap relative to Treasuries, but with the window for new money issuance closed, and money scarce, who will the buyers be? Expect a record high default rate in junk bonds in 2009-2010.

As for preferred stocks, I am cautious there as well as I wouldn't be surprised to see Uncle Sam exercise his muscle and step in to tell banks that they CANNOT pay common OR preferred dividends. Such is the life of Socialism.

In sum, I think many investors are being forced into taking risk so as to avoid a zero return when they actually would rather play it safe.

Again, we remain conservatively invested with a trading attitude towards the best of breed companies and sectors, those that do not need Federal assistance to stay in existence.

Once last thing - please check out the chart below to see what the government has purchased for our national portfolio. Lovely. Just Lovely.

The End of the Inflation Scare?

John Mauldin — Mon, 30 Jun 2008 17:34:00 GMT

I mentioned in last Saturday's letter a report by Louis Gave of GaveKal fame on whether inflation may be waning and its importance. Louis gave me permission to use it as this week's Outside the Box. It is typical of the thoughtful analytical work they do.

Louis and his partners and associates at GaveKal write some of the more thought-provoking material I read. They really challenge my position on numerous matters, causing me to look at many items from a different view. That of course, makes this particular piece good for Outside the Box. Whether you agree or disagree, you need to know why you hold a position. If you can't articulate the "against," how can you be sure you truly understand the "for"?

I think given the current debate on inflation, this week's Outside the Box is a must read. While it may look longer, there are a lot of very important graphs here. And thanks to Doug Harrison for helping with the tricky technical aspects of getting this letter out today. It was a lot more than a simple cut and paste, and way beyond my pay grade.

And congratulations to Louis and his wife Kelly who by this time may have a new child. She was due any minute on Friday. I trust you are enjoying your summer. I will be on Larry Kudlow's show tomorrow evening and then having dinner with he and Louis' father Charles (and Tiffani of course). And expect an announcement about a new survey in the next few days.

John Mauldin, Editor
Outside the Box

The End of the Inflation Scare?

by Louis-Vincent Gave

While most economists and strategists spend time worrying about growth, changes in inflation are usually a much greater driver of financial markets than changes in economic activity. This is because:

1- A surge in inflation usually increases volatility of economic growth--which in turn reduces P/Es and the willingness of the private sector to take risks.

2- As highlighted in The Myth of Reverting Margins, inflation typically takes a much meaner bite out of margins than a recession does. As we wrote back then concerning the US growth/margin relationship: "Margins bear little relationship to the level of GDP or consumption growth. In fact, as the economy accelerated from the mid-1960s to the early 1980s, margins plunged. Similarly, as the economy slowed from the early 1980s to the present, margins accelerated... It is inflation, not growth, which wreaks havoc on profit margins (ironically, if everyone has pricing power, no one makes money).

3- Finally, a surge in inflation typically means interest rates will be rising in the near future. Which means that investors get to lose money on both bonds and equities. For example, from 1966 to 1980 (i.e.: the last "inflationary surge" period), US bonds shed -2% per annum and US equities fell -4.9% per year.

Unsurprisingly, given the above, fears are now running high that we may have reentered such an "inflationary bust" period (see The Inflationary Bust Threat). And to be sure, growth almost everywhere around the world is slowing while inflation in almost every country is still accelerating.

Now everyone knows where the slowdown in growth comes from: de-leveraging in the financial sector, overextended consumers needing to tighten their belts, transfers of wealth from the private sector to the public sector through high oil prices, etc... And there are of course myriad opinions as to how long the slowdown will last. But meanwhile, on inflation, our clients seem to be much longer on questions than answers. Where does the current inflation spike come from? How long is it going to last? And can inflation abate without a "Paul Volcker" like monetary policy from the Fed?

In this ad hoc comment, we aim to review some of these questions and, as we always tend to do--answer these questions with yet more questions of our own!

1- Where Does the Inflation Come From?

Just like George Orwell's farm animals, all currencies are equal... though, of course, one is more equal than others. Indeed, the US$ remains the world's reserve currency and, thanks to this status, foreigners cannot impose a particular kind of monetary policy unto the US. As Treasury Secretary Connolly once said: "the US$ is our currency and your problem". And lately, there is little doubt that the US$ has indeed become the world's problem, with its fall in value associated with the spike in commodity prices, which in turn has triggered a sharp upturn in inflation rates all around the world, but especially in the emerging markets (where food and energy represent a much bigger piece of the average family's spending than in most OECD countries).

But of course, the surge in commodity prices cannot be the sole explanation for the recent surge in inflation numbers around the world. After all, an event like the spike in oil prices could also prove to be highly deflationary, since it takes money from the private sector and gives it to the public sector which will typically waste it (i.e.: Chavez financing Castro, Ahmadinejad subsidizing Hamas and Hezbollah, etc...). For a commodity price spike to be inflationary, it needs to be accompanied by excess money creation. If it is not, all that we witness is a change in relative prices across the economy (i.e.: oil prices up, auto and house prices down). This is why Milton Friedman once said that "inflation is always and everywhere a monetary phenomenon" while, around the same time, Jacques Rueff made the observation that "inflation is subsidizing expenditures that give no returns with money that does not exist".

So given that we are now living through a surge in inflationary prices, the questions we should ask ourselves is a) where the excess liquidity creation of recent years has come from? and b) whether excess liquidity continues to be pushed into the system, hereby guaranteeing further increases in inflation in the coming quarters and years?

2- What Explains the Surge in the Amount of Money?

As highlighted above, the US$ is "more equal" than other currencies and, consequently, the Fed holds a "special place" in our current financial system. Undeniably, the Fed is the world's most important central bank and it is thus not that surprising that, as inflationary pressures accelerate around the world, most people are quick to blame the Fed for "falling asleep at the wheel" and allowing money supply in the US to grow unchecked. But is this a valid criticism?

After all, as the charts below highlight, narrow money supply growth in the US (i.e.: the aggregate mostly under the control of the Fed) has not seen much of a rise in recent years (incidentally, the same can be said about Japan and money growth is now decelerating fast in Europe):

While the Fed did print money aggressively between 2002 and 2005 (M1 annual growth was above +5% and sometimes close to +10%), in recent years, the pace of monetary creation has by and large been tame. So the ‘excess money' had to come from somewhere else.

Now as we never tire of pointing out, two sets of players can create money ex- nihilo in our system: central banks and commercial banks. So if the excess liquidity creation has not been the central banks, then the explanation must lie with the commercial banks.

And sure enough, in recent years, banks have ridden the 'financial revolution' as hard as they possibly could and we have witnessed an unprecedented expansion in credit (witness the growth in C&I loans at US banks, red line below):

And, as we now know, money creation off the banks' balance sheets was also, until recently, going strong. Witness, for example, the rapid expansion in corporate paper outstanding in the period between 2003 and 2007 (red line below):

To return to our old favorite, Irving Fisher's equation of MV=PQ, it seems obvious to us that the current increase in P (prices) has more to do with the past few years' extremely buoyant V (velocity) than excessive M (money) growth. A possibility which immediately raises the question of whether velocity will remain as buoyant over the next two years as it did in the 2003-2007 period.

3- Will Velocity Remain As Strong?

As the chart below suggests, the answer to the above question is a simple "No". With bank balance sheets under severe strain, and with bank shares almost everywhere around the world plumbing new depths, an increase in the willingness to take risk from private lenders would be very surprising. And sure enough, after its longest period ever in negative territory, our velocity indicator is once again negative after a brief respite:

This message of slowing private sector liquidity growth is also confirmed when adding the loans at commercial banks with the issuance of commercial paper (for a total private credit growth aggregate--blue line on following page). We have slumped from an annual growth rate of +13% in private credit one year ago to +2.8% today; a level not seen since 2003 (see chart).

So we are now in a situation where a) The Fed is not printing money and b) US financials are de-leveraging rapidly. Thus, if inflation is "always and everywhere a monetary phenomenon", one may conclude that what we are now seeing in the inflation numbers is the echo of the 2003-2007 credit boom, but that looking ahead, the inflation picture should start improving rather dramatically. But such a conclusion would miss out on the other big contributor to global liquidity growth, namely the US current account deficit.

4- The Importance of the US Current Account Deficit

Because the US$ is "more equal" than other currencies in our global system, the US current account deficit plays a specific, and very important, role in our global monetary systems. In essence, the US current account deficit provides the world with its working capital. After all, at any given point, the world needs US$. For example, Nokia needs US$ to pay for the chips it may buy in Taiwan. China needs US$ to pay for the iron ore it buys from Australia and Sweden needs US$ to pay for the oil it buys from neighboring Norway...

This is why, whenever we see an improvement in the US current account deficit, somebody somewhere goes bust. Indeed, when the US exports a lot of dollars, then the rest of the worlds gets used to a "plentiful" liquidity situation... and when the US exports less money, then somebody gets cut off.

So in essence, the current account deficit has always been the mechanism through which the United States could reflate, or deflate, the global economy. When the US current account deficit improved, the US deflated other countries and vice versa.

Now today, the US current account deficit still stands at a rather large 6% of GDP. However, the composition of this deficit has changed dramatically: two years ago, around two-thirds of the US deficit went to non-oil producers and one third was for petroleum products. Today, that situation is inversed to the point where one could argue that, while the US is still reflating oil producing countries (which hardly need it), it is now deflating non-oil producing countries by around 2% of GDP. Moreover, should oil prices start pulling back, we would move extremely rapidly into a situation where the US current account deficit was deflating the whole world (below is a chart we borrowed from The Economist)!

The fact that the US is no longer reflating non-oil producing countries is a very important change in our economies. Indeed, over the past few years, the prevalent belief amongst investors of all stripes has been: a) the US runs a large current account deficit, b) that US interest rates are low, and that, consequently c) the value of the US$ could only fall. And if the value of the US$ could only fall, then borrowing in US$ to finance whatever real estate project, factory, or financial market speculation made perfect sense. This is why, in a number of countries, we started to witness a growth in central bank reserves which far outpaced trade surpluses and foreign direct investment inflows; all of a sudden, a number of large countries started to save more than they earned!

But how can one save more than one earns? The answer, we have argued in the past (see The Surprisingly Strong Growth in Chinese Reserves) is simple: one borrows the difference. As mentioned above, if the perception is that the US$ can only fall against the RMB, INR, VND, MYR, etc... then why borrow in local currency to finance one's capital expenditures or investments? Much better to finance any spending in the ever falling, and cheap to borrow, US$!

So what happens when a Chinese property developer, or a Vietnamese industrialist, borrows US$ to finance his latest project? The first thing he does is that he changes the dollars he does not need for RMB, Rupee, Dong, etc... And, at this point, the foreign central bank has three choices:

1- It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years.

2- It can print money to prevent its currency from rising and then sterilize its FX intervention.

3- It can print money to prevent its currency from rising and just accept the consequences of fast money supply growth (usually higher inflation and asset prices).

And by and large, this is what most nations on the other side of the US current account deficit (i.e.: Asia and OPEC) have done. And unsurprisingly, these are the countries that are today dealing with the largest inflation threats.

We would thus argue that the US current account deficit has been a double inflationary force for the world at large. First, the US current account deficit has pushed a number of countries towards reflation, and secondly, the large US current account deficit has helped propagate the belief that the US$ could only fall, and thus encouraged large borrowings of US$ outside of the US.

And the US current account deficit, combined with the willingness to borrow US$, has been an inflationary force for more than just Asia and the Middle East. It may also explain the surge in money growth in Europe! Indeed, with central bank reserves growing very rapidly around the world (despite a high oil price which, at the very least, should have drained the reserves of Asian and European countries), central banks such as the PBoC or the RBI have likely spent the past few years diversifying their reserves, which for all intents and purposes means buying the Euro... And, as we argued in our book The End is Not Nigh, this "diversification" of reserves means buying European government bonds or, in other words, subsidizing the expenditures of foreign governments with domestically borrowed money.

Et voila! We are now back to Jacques Rueff's definition of inflation being "a policy which subsidizes expenditures that give no returns (i.e.: government spending in Europe or the US) being financed with money that does not exist (i.e.: central bank reserves that have been borrowed, not earned)!"

5- Will the US Deficit Continue to be an Inflationary Force?

Having established that one of the main factors of excess liquidity growth in the world (the willingness of the financial sector to lend very aggressively) had now disappeared, can we rely on the US current account deficit to continue providing excess liquidity to the world. Will an ever growing US trade deficit continue to force other countries to reflate and lead to an ever lower US$? We tend to believe that the answer to that question is a very firm "no". And, this for several reasons:

Reason #1: As reviewed on page 6, the US current account deficit is already improving. Moreover, since oil is now a bigger percentage of the US deficit, should oil prices roll over, we could witness the most rapid improvement in the US current account deficit ever seen. But even without oil rolling over, the recent weakness of the US$ argues for a continued improvement in the deficit:

As does the weakness in US housing:

Meanwhile, the prevalent belief of recent years that borrowing US$ to invest in local currencies was a "no-brainer" is now undergoing a significant test. For example, in recent months, the "long dong" strategy has undeniably failed (the black market now expects a devaluation of over 20% in the Vietnamese currency). The strategy is also failing in India where the Rupee, to many investors' surprise, has been amazingly weak in recent months....

In fact, an interesting development is occurring on the US$: fewer and fewer currencies have lately been rising against the US$ and this despite some pretty poor news from the US (MBIA downgrade, fears on Lehman, weak housing, weak growth, high oil, fears of war with Iran...). Now the typical pattern for an equity bull market is that, as it nears its peak, fewer and fewer shares make new highs even as indices keep on powering ahead. Major corrections are typically preceded by a narrowing breadth... And today, we are undeniably witnessing a deteriorating breath in the "anti-US$" bull market:

To cut a long story short, and with hindsight, the large US current account deficit and the weak US$ were another very potent inflationary force in our system. But, at least at the margin, these inflationary forces should abate, rather than acceler- ate, over the coming months.

6- Conclusion

There is little doubt that, right now, inflation is proving to be a massive headwind for financial markets. And part of that "inflation headwind" is the fear that the Fed, the ECB and other central banks will have little choice but to tighten monetary policy in the coming months. This is most likely true of some central banks, but maybe not all? After all, looking around the world, the inflationary threat is a sure thing in certain regions, and less of a threat in others:

In the US: In a recent paper (see The Dollar's Successful Devaluation), Charles argued that the Fed had just managed to engineer a "good devaluation" for the US$, whereby the currency is brought down without an explosion in monetary aggregates and a rapid acceleration in inflation. This makes the economy competitive and local assets attractive for foreigners. Since then, not much has happened to warrant a change in this view. In fact, since then, the main development has been the roll-over in velocity and renewed fears as to the health of the US financial sector. With velocity plummeting, we think that the bond market is broadly right to not anticipate an acceleration in US inflation.

In Euroland: Just like in the US, the bond market does not seem to really anticipate a massive surge in inflation. And given the very overvalued currency and the inverted yield curve, this makes sense to us.
In the Middle East: The one region of the world which is still experiencing reflation from the US current account deficit is the Middle-East (and to a lesser extent Russia). The unwillingness of policymakers to revalue their currencies (see The Arab Pegs) and the inability of local central banks to sterilize their FX intervention means that the local economies are condemned to continue experiencing inflation as long as they refuse to revalue their currency. More worryingly, a pursuit of the current fixed exchange rate, inflationary policies could lead local economies into the same kind of boom-bust cycle that Vietnam (and maybe India?) are now having to endure.
In India and Southeast Asia: If the US went through a ‘good devaluation' (i.e.: a lower currency without a spike in inflation, triggering an increase in foreign and domestic investments and productivity gains), then it increasingly looks as if India and Southeast Asia have just gone through a ‘bad devaluation' (i.e.: a lower currency which brings about fast money growth, higher inflation, deteriorating trade balances and foreign investor flight). As such, certain countries (India, Vietnam...) are now stuck in the unfortunate position of having to defend their currencies, which is rarely conducive to either economic, or asset price growth.
In China: Inflation is undeniably a problem but, thus far, it seems to be mostly contained to food and energy prices (see A Dummy's Guide to Chinese Inflation). Meanwhile, the only pressures on the RMB are still of a positive nature. Thus, if either the US$ rebounds or commodities roll over (two events that are likely to happen simultaneously), China's inflation problem could dissipate relatively quickly. Chinese and HK shares would then soar.
In Japan, Korea, and Taiwan: Japan, Korea and Taiwan have seen little "hot money" inflows in recent years and have also been better at letting their currencies rise against the US$ (this year, the NT$ is one of the world's best performing currencies with a +6.5% rise while the KRW was one of the best performing Asian currencies between 2004 and 2006). In general rule, these countries today have far less of an inflationary problem than the rest of Asia:

While the markets had started to rally in April and early May, the spike in oil prices fuelled fears of faster inflation and triggered a threat of coming rate hikes from the Fed and the ECB. In turn, all these events weighed down equity markets around the world. However, as we have tried to show in this paper:

The inflation threat is very different between countries. At most risk today are the Middle East, India and Southeast Asia. Meanwhile, inflation is far less of a threat in the US, Japan and North Asia.
Given the fact that the forces behind the recent pick-up in inflation are now turning around (strong willingness to take risk amongst financial firms, growing US current account deficits, overall weakness in the US$), inflation could well start abating in the coming quarters. Moreover, with the turnaround in velocity and the implosion in the banking systems, it seems increasingly likely that neither the Fed, nor the ECB will be willing/have to match their recent hawkishness with rate hikes.
As inflation rolls over in the OECD, the leadership of equity markets should go through a serious adjustment.

Your meditating on inflation analyst,

John Mauldin

A Kind Word for Inflation

John Mauldin — Mon, 23 Jun 2008 17:01:00 GMT

This week's Outside the Box will challenge a few of your base assumptions. Paul McCulley, the managing director at PIMCO, offers us a kind word for inflation and the reasons that the Fed will be on hold for a lot longer than the markets currently think. And part of that is to avoid a real recession or even a depression. Getting this debate right is important.

These are indeed interesting times we live in. I look forward to being with Paul at the end of July on our Maine fishing expedition, where he can defend his proposition to the group of economists and analysts gathered there. Have a great week.

John Mauldin, Editor
Outside the Box

A Kind Word for Inflation

by Paul McCulley

No, I have not lost my mind. I'm fully aware that inflation is not kind to bonds, so offering a kind word for inflation is de facto offering an unkind word about my own business. Investment managers don't tend to do that. But facts are facts. And the essential fact right now is that the American economy needs an inflation rate above the Fed's comfort zone. Needs, you ask?

Yes. Soaring commodity prices, particularly for petroleum and food, and especially in recent months, are an unambiguous negative real terms of trade shock to America. For those not familiar with the term, a nation's terms of trade is the ratio of what it must give up to get what it imports. The easiest way to understand the concept, at least for me, is to think of the number of hours of work necessary, at the average national hourly pay rate, to buy a barrel of oil – a real variable compared to another real variable. The chart below tells that simple story.

Misery Is as Misery Does
Americans are working more hours for the same barrel of oil. That is a negative real terms of trade shock. Put differently, we are less rich or more poor than we were before oil prices took off. There is no getting ‘round this. In turn, there is no escaping collateral adjustments of temporarily higher inflation and temporarily lower growth and employment. The question of the hour is how this pain should be apportioned. Last week, Fed Vice Chairman Don Kohn provided the right answer, presuming there is a right answer (my emphasis):

"... an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains."¹

Mr. Kohn was preaching the raw, honest truth: a surge in oil prices raises the Misery Index, temporarily lifting both inflation and the unemployment rate. In turn, those outcomes beget lower real wages and, presumably, lower real profits, too. We are less rich or more poor – period. Thus, those who holler and scream at the Fed for letting the inflation genie out of the bottle need to calm down. A negative terms of trade shock is a real shock, so it must be translated into lower real wages and profits. That simple and that painful. Logically, it also must be translated for a time into lower, even negative, real short-term interest rates, the rate of return on money.

Spiral Risk?
But, you retort, if the Fed surrenders to negative real interest rates, it will set off an inflationary spiral, as second and third round effects on prices and wages take hold: capital and labor will extrapolate what should be viewed as a transitorily higher inflation into permanently higher inflation. In a world of perfectly indexed prices and wages, this could well be the case. The 1970s resembled such a world, and nasty oil price shocks that should have been one-off adjustments in the price level via temporarily higher inflation morphed into a price-wage-price inflationary spiral.

In monetary policy terminology, inflation expectations in the 1970s were not firmly anchored at the pre-oil price shock level. This is true, I think, but more elementally, the highly unionized, closed-economy structure of the American economy price and wage setting process was inherently geared to transforming a one-off inflationary shock into an enduring inflationary shock.

We no longer live in such a world. Most importantly, wage inflation is now only loosely connected to price inflation, in the wake of a more globally competitive, less unionized labor force. As Vice Chairman Kohn hinted, the combination of somewhat higher inflation and higher unemployment is a prescription for diminished pricing power by labor, leading to lower real wages (than would be dictated by labor's productivity growth). Thus, unlike the 1970s, there is little wage fuel to generate over-heating aggregate demand and, thus, a sustained price-wage-price inflationary spiral.

This is good news indeed. Fed officials would make this argument through the lens of well-anchored inflationary expectations, and I have no quarrel with that interpretation, though I think it is but a veil over a more global, more competitive, less oligopolistic price and wage setting structure in the United States. Indeed, I believe the more nasty is the negative terms of trade shock, the fatter is the fat tail of asset price deflation rather than the fat tail of accelerating goods and services inflation.

Avoiding a Modern Day Depression
Deflating asset prices in a highly levered economy are a much more nefarious outcome than temporary increases in inflation in goods and services. This is particularly the case from a starting point of low inflation in goods and services (excluding those involved in the negative terms of trade shock). How so? Simple: a negative terms of trade shock and asset price deflation are a prescription for not just a recession, but a nasty one. More to the point, from a starting point of low goods and services inflation, the Fed is never far from the zero lower limit on nominal short-term interest rates, commonly known as a liquidity trap.

Therefore, the more flexible are wages in the face of a negative terms of trade shock, particularly if it coincides with asset price deflation, the greater is the risk of policy makers losing control of the economy on the downside. In turn, this reality argues for the Fed to tolerate higher headline inflation in the wake of a negative terms of trade shock.

To be sure, the Fed must be aware of the dreaded second and third round effects, constantly checking to make sure that real wages and real profits are being eroded by the aberrantly high headline inflation. But, assuming the evidence supports that thesis, as the following graph displays, it would be an absolute folly for the Fed – or any central bank in similar circumstances – to hike interest rates in an attempt to make the negative terms of trade shock go away. By definition, it can't. And if it tries, it will create an even bigger mess. In this case, the motto of a central bank should be the same as that of a physician: first, do no harm.

I think the Fed thoroughly understands these exigencies in the wake of a negative terms of trade shock. It doesn't mean that the Fed won't or shouldn't rhetorically sound tough at times, in the name of preventing inflationary expectations from becoming unmoored. But the bottom line is that as long as there is a huge gulf between the negative terms of trade cup and the wage inflation lip, the Fed should talk about the cup and focus on the lip.

Bottom Line
Which means, my friends, that low, even negative real short-term interest rates are here to stay for a considerable period. Yes, I know that many believe that it is somehow sinful or immoral for the Fed to hold nominal short rates so low as to render the real return on cash to be negative. I don't buy this proposition. Why should it be that those who only have labor to offer to the market should not be made whole for a negative terms of trade shock, while those with cash should be made whole?

In the wake of a negative terms of trade shock, all factors of production should absorb a negative hit to their real returns. If indexing to headline inflation is inappropriate for labor wages and capital's profits, why should cash yields be indexed by the Fed?

And what if holders of cash don't like it? Then they can step out on the risk spectrum. After all, a basic of capitalism is no risk, no reward. And temporarily higher inflation in the wake of a negative terms of trade shock is an efficient lubricant for the economy to make the necessary real adjustments.

Paul McCulley
Managing Director
June 16, 2008
mcculley@pimco.com

¹ http://www.federalreserve.gov/newsevents/speech/Kohn20080611a.htm

Your betting the Fed will be on hold a long time analyst,

John Mauldin

Two Essays on the Continuing Financial Crisis

John Mauldin — Mon, 28 Apr 2008 22:00:00 GMT

This week in Outside the Box we look at two brief essays which give us different perspective on the Continuing Crisis. The first is by Mohamed El-Erian, the co-chief executive and co-chief investment officer of Pimco. His book, 'When Markets Collide: Investment Strategies for the Age of Global Economic Change', will be published by McGraw Hill in June, and it will be on my summer reading list. El-Erian argues in the thought-provoking piece from the Financial Times that the crisis is still far from finished, and that those who think we are returning to more placid times may be surprised when volatility suddenly becomes even more pervasive.

The second is by good friend and Maine fishing buddy David Kotok, the chief investment officer of Cumberland Asset Managers (www.cumber.com). He was recently in Africa where he met with the head of the central bank of a small country with headline inflation of 10%. The problem is that "core inflation" is 5% and food inflation is 15%, yet accounts for 50% of the GDP. He asked a group of financial thinkers (including your humble analyst) to ponder what that central banker should do. Do you set high rates and target overall inflation or set lower rates and not worry about food inflation.

Why should we worry about inflation in a small African country? Because the principles are the same, and it makes a real difference where the Fed comes down at the end of the day on this very question.

This week's reading should be very helpful and thought-provoking. I hope you enjoy this read as much as I did.

John Mauldin, Editor
Outside the Box

Why This Crisis is Still Far From Finished

By Mohamed El-Erian

During the past few weeks we have seen a growing number of market participants predict an end to the dislocations that erupted last summer and claimed victims throughout the financial system and beyond. While their predictions are understandable, they are premature. The dynamics driving the disruptions are morphing and may again move ahead of both the market and policy responses.

The optimistic view is based on two distinct elements. First, that the deleveraging process is reaching its natural end as valuations stabilize and institutions come clean about their losses and raise capital; second, that a series of previously unthinkable policy responses have been effective in restoring liquidity to the financial system.

Both views have merit. Financial institutions, particularly in the US, have recognized the scale of the problem and are taking remedial steps. Just witness the recent round of capital raising by Citigroup, Merrill Lynch, JPMorgan and Wachovia. At the same time central banks in Europe and the US have opened up their financing windows, expanding the size of the financing, the range of institutions that can access it and the list of eligible collateral.

Yet, consistent with what we have seen since last summer, the dislocations are entering a new phase. As such, bold reactions on the part of policymakers may, once again, prove to be too little and too late.

Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.

Economic data in the US have taken a notable turn for the worse. Most importantly, the already weakening employment outlook is being further undermined by a widely diffused build-up in inventory and falling profitability. History suggests that the latter two factors lead to significant employment losses.

Pity the US consumers. Their ability to sustain spending is already challenged by the declining availability of credit, a negative wealth effect triggered by declining house values, and a lower standard of living as the result of higher energy and food prices and a depreciating dollar. Job losses will accentuate the pressures on consumers, leading to income declines and a further loss of confidence.

While the financial system has taken steps to enhance balance sheets, they speak essentially to addressing the consequences of excessive leveraging and imprudent financial alchemy. As such, the nasty turn in the real economy may fuel another wave of disruptions that, this time around, would also have an impact on mid-size and smaller banks.

It is thus too early to declare the end of the turmoil that started last summer. Instead, during the next few months we may witness a new phase of dislocations, led this time by the real economy. The blame game will intensify; political pressure will continue to mount; momentum will build for greater and broader regulation of financial activities within the banking system and beyond.

The focus will also be on the reaction of policymakers. Here the outlook is mixed. The good news is that the crisis is now moving to an area where traditional policy tools are more effective. This is in sharp contrast to the situation of the past few months, where central banks were forced to use instruments that were too blunt for the purpose at hand.

But there is also bad news. The sharp slowdown in the US real economy will occur in the context of continued global inflationary pressures. As such, the Federal Reserve's dual objectives - maintaining price stability and solid economic growth - will become increasingly inconsistent and difficult to reconcile. Indeed, if the Fed is again forced to carry the bulk of the burden of the US policy response, it will find itself in the unpleasant and undesirable situation of potentially undermining its inflation-fighting credibility in order to prevent an already bad situation from becoming even worse.

It is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility.

And our next essay:

Food Price Inflation, Monetary Policy & Financial Markets

By David Kotok

Suddenly food price inflation has become the premier hot topic. The media is now attuned to food issues including emerging market country riots.

In the US, the politicians are gearing up to castigate the speculators and blame everyone but themselves. They conveniently forget that they are the ones who passed the ethanol subsidy and they are the ones who appropriate taxpayer money to pay farmers not to grow crops. And so the political circus begins.

Notice how the three presidential candidates are silent on how the US ethanol subsidy has caused a food price explosion in grains. They avoid the issue of US policy starving many in the world. 1 billion very poor people sustain themselves on $1 or less a day. We have doubled the cost of their food.

Ethanol directly impacted corn which, in turn, also drove up maize. In addition, the substitution of wheat and rice are not easily occurring because of crop issues and concomitant price inflation in those items.

Well Cumberland is in the financial market and money management business. We eat food. We don't grow it and we don't process it. So let's try to inject some serious monetary policy issues into this media hysteria and political cacophony.

In the mature countries, food is a minor portion of the price index. And some of the food costs originate from eating out and some come from food processing. Processed food cost is heavily dependent on the inputs which are non-food items. Labor, machinery, transportation and distribution all come in to play. So in the mature countries we see that the food price inflation may be topical and attention getting but it is not a crisis.

Also, the major mature countries are mostly in food surplus. In the US we are very efficient in running our agriculture enterprise. We actually pay farmers not to till their soil. This is dumb. It occurs only because of our sorrowful Congress who has learned how to bribe the farm belt for votes at the expense of the rest of us.

In the US food has a 14% weight in the consumer price index. Compare that with Canada at 17%, the Euro zone at 16%, England at 11% and Japan at 25%. Only Japan lacks the fullness of food self sufficiency. Sure, food price inflation is important. But it is not the most important issue in these major economies.

The reverse is true for the emerging markets. In some of them the food price component is as much as half the price index. In a few it is above half. Since many of these economies are open to some degree, the importation of food price inflation is hitting them particularly hard. Some are responding with tariff adjustments. Others have actually embargoed food exports. Of course they ultimately make matters worse when they restrict world trade and in the end all suffer because of this protectionism.

What about monetary policy?

Here is where it gets difficult. We will admittedly simplify now and we acknowledge to our critics that we know there are second order effects and are ignoring them to make our point. In our view, monetary policy cannot easily and directly address food price inflation when the source of the inflation is in the raw food commodity. This is also true for energy costs when the source is in the oil or natural gas. The whole concept of "core" inflation vs. total inflation originates in this notion that monetary policy should be directed at the price level changes it can affect.

Let's get to the inflation problem in an emerging economy. Our example is imaginary for simplicity's sake. But it reflects characteristics that are very similar to many countries and regions in the emerging markets of the world.

We developed this simple and theoretical case study and then sent it to a number of economist friends. We suggested that following facts: the economy in question is a small and open emerging market. The food price component is 50% of the price index and is inflating at 15%. The non-food component is inflating at 5%. Thus the overall index is inflating at 10%. In this small and open economy, the main items in the food component are based on maize; therefore, the US ethanol policy which has raised the corn priced has also pressured an increase in the maize price.

Suppose you are the governor of the central bank. You have to set your policy interest rate. Do you base that decision on overall inflation rate of 10% or on the core inflation rate of 5%? Or are you going to confront the food inflation rate of 15%. Let's further assume that your economy is growing at a trend rate of 5% and all other aspects are in trend or neutral position. You have no negative output gap and no above trend pressures. Your only direct problem is what to do about inflation.

My economist friends who answered offered a suggested policy rate as low as 6% and as high as 13.5%. The answers were about equally divided and the respondents sample size is over 20. The distribution of answers was distinctly bi-modal. About half the answers were bunched in the lower range of 6%-8%; the other half were in the double digit area between 11% and 13.5%.

The divided views centered on whether or not to target food, ignore food, or blend policy. No one wanted to set the interest rate above the 15% food price inflation. Nearly all acknowledged that this central bank would have difficulty in communicating whatever it decided. Most respondents worried about changes in inflation expectations because of the complexity of this issue. Most believed the citizens in the country would not understand the monetary policy dynamics that led to the decision.

Some worried that setting the policy interest rate in double digits would impose a very high financing cost on the non-food portion of the economy and cause it to go into recession. They argued that the real (inflation-adjusted) rate of interest for that non-food half of the economy would be 7% or so. That would set the threshold of finance too high.

Others argued that the monetary policy expectation effect would cause the rate of inflation to accelerate if the policy rate was not set in double digits. They were willing to take the recession in the non-food area in order to keep inflation expectations under control. No one mentioned substitution effects. Perhaps that was overlooked. Or it may be because rice and wheat are not easy cultural substitutes and those grains are each experiencing their own price pressures.

In sum, almost two dozen folks with some monetary economics expertise were equally divided on this technical question. It is a question that impacts billions of citizens in this world and many countries, their governments, their currencies and, possibly, their political stability.

We do not know the correct answer. Our view would support the lower interest rate and we would focus on the non-food portion of the economy but we can argue the other side with equal vigor. For us a lot would depend on how the food price inflation spreads into wages and if it could trigger a broader wage/price spiral.

In many respects this question is now being asked of the major and mature economy central banks as well. It appears that the European Central Bank (ECB) favors the higher mode while the US Federal Reserve is positioned in the lower one. For the emerging markets it appears that there is quite a mix of policy and that it is made more complicated by the management of each currency's foreign exchange rate. In sum, our simple case study is actually quite complex when applied in the real world.

David R. Kotok, Chairman and Chief Investment Officer

I trust you enjoyed this week's Outside the Box. And for the record, I thought rates in our hypothetical African country should be at the lower end. Targeting food inflation with high interest rates would hammer the productive, job creating portion of the economy. I have been to 15 countries in Africa and they are in desperate need of jobs. Better to target inflation through control of the money supply and encourage capital formation and foreign direct investment. But it is a tough question.

Your glad I don't have to be a African central banker analyst,

John Mauldin

Quarterly Review and Outlook - First Quarter 2008

John Mauldin — Tue, 22 Apr 2008 02:08:00 GMT

This week's Outside the Box is from my friends at Hoisington Management. While somewhat technical, they make the case that a slowdown in consumer spending is inevitable. This is worth taking some time and thinking about. Quoting: "This means that consumer spending increases should be approximately zero for the next three years. Further exacerbating the problem is the personal saving rate which declined from 5.2% in the decade of the 1990s to average 1.3% in the last seven years, and now stands at 0.3%. Should declining wealth, rising unemployment and poor economic conditions cause consumers to begin to save and lift the rate back to the 1.3% average of the past seven years, real consumer spending would experience a multi-year contraction."

If they are right, and the evidence of their research is compelling, then we are in for a much tougher time than the recent stock market rallies suggest. The stock market is not always a leading indicator. This week's letter suggests that businesses that depend on the US consumer for growth may be in trouble.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook - First Quarter 2008

Semantics

Nominal GDP in the first quarter totaled an estimated $14.2 trillion, a 3% annual rate of increase from the final quarter of 2007, which also registered a 3% gain. This two quarter growth rate in nominal GDP is typically associated with recessionary periods (Chart 1). The various price deflators applied to this nominal gain will now determine whether real GDP will be negative or positive, possibly clarifying the debate of whether an actual recession is in place. For financial participants, however, this argument is moot since the U.S. economy, at best, has been in a growth recession since mid-2007.

Solomon Fabricant, the NYU professor and NBER committee member who first identified this particular characteristic of the business cycle, stated that a growth recession occurs when economic conditions are sufficiently poor that unemployment rises and industrial capacity falls. From the cyclical low in March 2007 to March 2008, the unemployment rate jumped from 4.4% to 5.1%. In February, the manufacturing capacity use rate was 78.7, down 1.4% from its peak in July. Both signify a deteriorating economy. Growth recessions, like full scale recessions, produce falling inflation, a margin squeeze on corporate profits, eroding stock prices, and declining interest rates. Thus, the difference is really one of semantics. The point for investors is not what type of recession we are experiencing, but rather how long the downturn will last. Our conclusion is that our present economic difficulties will persist for at least two years.

An Extended Slump

Going forward, the main problem for the U.S. economy is likely to be a protracted period of restrained consumer spending. In the expansion from 2002 to 2007, real Personal Consumer Expenditures (PCE), which comprised 71.5% of GDP at the end of last year, posted a 3.1% per annum increase, down from 3.5% and 4.2%, respectively, in the expansions of the 1990s and 1980s (Chart 2). The subdued gain in spending would have been even less had consumers lived within their means, as real personal income (2.5%) expanded less than the spending rate. With spending outpacing income, the personal saving rate dropped from 2.4% in 2002 to 0.4% in 2007.

A disparity of 0.7% per annum between the growth of income and spending might seem insignificant until you consider that income must also support all the other demands on consumers -- investment in housing and other real assets, financial investment, and gifts to charitable and other causes.

The main cause of the weaker trend in personal income in this decade was lackluster real wage and salary income that rose just 1.8%, or one-half the rate of gain in the expansion of the 1990s. This meager gain was caused by the sluggish .8% payroll employment growth rate that was the smallest of any expansion since World War II. With this key determinant of consumer spending restrained, consumers lived well beyond their means, only because their paper worth was boosted by surging home prices.

Consumption And The Wealth Effect

One of the most studied issues is the consumption function - the factors that determine the way in which consumers are motivated to spend. For example, in Macroeconomics by Andrew Abel of Wharton and Ben Bernanke (now of the Federal Reserve and formerly of Princeton University) have a lengthy section entitled "the effects of changes in income and wealth on consumption and saving". This analysis like many others of a similar nature conclude that both income, expected future income, wealth as well as other considerations are causally related to spending. Using econometric models, economists are able to assign different numeric weights to those elements in the consumption function. These studies indicate, as a general rule, that expected or permanent income is more important that current income and that income considerations are more important than wealth. However, something known as initial conditions (the current starting point in the business cycle) may serve to over-ride the general rule. We, for example, believe that there are notable difficulties facing the U.S. economy that were typically not present in the past.

Wages, salaries, interest, dividends and rent generate funds that are available for spending. When wealth rises, however, funds are not typically generated that, in turn, can be translated into spending. Thus, understanding the mechanism of how wealth translates into spending may involve additional steps.

Consumers could turn wealth into spending funds by selling appreciating assets. However, if all consumers decided to do this at roughly the same time, the prices of those assets would fall, reversing the rise in wealth that had seemingly occurred. Thus, the main mechanism that increased wealth leads to rising consumption is for consumers to borrow against those assets. This, therefore, avoids the necessity of selling the appreciating asset and avoiding or at least postponing the decline of the appreciating assets.

Our research suggests that the mechanism of choice from 2002 to 2007 to convert rising wealth into spendable funds was borrowing against what consumers and their lenders apparently believed to be was a permanent rise in housing wealth - i.e. something that we have come to know as equity cash take outs.

The Home Equity Connection

From 2002 to 2007, home equity extraction, as determined by Freddie Mac, averaged $51.5 billion per quarter, up from $5.8 billion in the 1990s expansion (Chart 3). If we convert these cash outs into real dollars (using the PCE deflator), we see that they represented 2.4% of real PCE from 2002 to 2007, compared with a miniscule .4% of PCE in the 1990s. Thus, for spending, the shortfall in jobs and income was substituted by the famous home ATM machine. However, the connection between equity withdrawal and wealth is a complex matter. A great deal of econometric research has demonstrated that for every dollar change in real wealth, real spending shifts by 7.5 cents over the ensuing three years. If the massive real wealth gains derived from both homes and the equity markets in the 2002 to 2007 period are adjusted by the $1 to 7.5 cent relationship, the real wealth gains amounted to 2.5% per annum, expressed as a percent of real PCE. For all practical purposes, this is equal to the 2.4% per annum rise in mortgage cash outs. Consumers borrowed against the value of their homes in virtual direct proportion to their wealth gains.

The problem going forward is that real wealth is now declining, with the bottom yet to be found. Assuming home prices fall only 30% from their peak (some estimate a 50% decline), while stock prices rise 10% from the first quarter level and inflation is 2% per annum, the real wealth loss is about $7 trillion (Chart 4). Using the $1 to 7.5 cent ratio, this will constitute a drag on real PCE of 1.8% per annum from 2008 to 2010. Considering that the 3.1% rate of increase was the last expansion's average, a 1.8% drag will be a 60% reduction in consumer spending growth over the next three years just from the cash out/wealth effect alone.

However, there are other constraints. During the postwar recessions, real personal income's average growth was only 1.9%, but it has risen only 1.1% over the past 12 months. If real personal income moves back up to 1.9%, in itself a highly optimistic assumption, it would, nevertheless, be completely offset by the negative wealth impact of 1.8% mentioned above. This means that consumer spending increases should be approximately zero for the next three years. Further exacerbating the problem is the personal saving rate which declined from 5.2% in the decade of the 1990s to average 1.3% in the last seven years, and now stands at 0.3%. Should declining wealth, rising unemployment and poor economic conditions cause consumers to begin to save and lift the rate back to the 1.3% average of the past seven years, real consumer spending would experience a multi-year contraction. It is not a stretch to predict an extended quasi-recessionary period.

Is Inflation Accelerating?

In the last twelve months, the CPI increased by 4.1%, well above the 2.8% average annual increase this decade. Do these readings mean that the inflationary spiral has started? Other factors that contribute to inflation fears are the acceleration in M2 growth to a 13% rate of increase in the past three months, $100 plus per barrel oil, elevated prices for food, a wide variety of other commodity prices, and a weak dollar. A related question is whether the higher CPI readings, combined with poor economic growth, will result in stagflation, a condition last witnessed nearly three decades ago. Four considerations suggest that these fears are not likely to be realized.

First, inflation is a lagging indicator. This is true of all major broad based inflation barometers -- the CPI, the core CPI, the more reliable core PCE deflator and the Employment Cost Index (ECI). Over the past five cyclical downturns, the year over year increases in these four series did not peak until the economy was in recession (Chart 5). In all these situations, major reductions in inflation occurred in the early stages of the ensuing recovery. This historical pattern is due to the fact that productivity surges rapidly in early stage expansion, causing unit labor costs to rise much more slowly than wage costs.

Second, in this particular episode all these inflation gauges have peaked well before the start of the growth recession in mid-2007. The year over year increases peaked as follows: 4.7% for the headline CPI in September 2005; 2.9% for the core CPI in September 2006; 2.5% for the core PCE in February 2007, and 4% for the ECI all the way back in the fourth quarter of 2003. The year over year change in the fourth quarter was a substantially lower 3%.

Third, the unprecedented deceleration in the increase in the ECI of one full percent during the past three years of economic expansion strongly documents the impact of globalization on the United States inflation rate. Even with the recent increases, the unemployment rate is still 1.2% lower than in June 2003. Despite this tighter job market, wage cost increases decelerated, a clear reflection that employers have global options, and wages are increasingly set in the global marketplace. This is strong confirmation that the upturn in headline inflation is transitory. Higher food and fuel costs have not fed into wages, a critical element since wage, salary and benefit costs comprise almost 70% of the cost of production in the United States. Persistent inflation episodes have all exhibited a price/wage spiral.

Fourth, in spite of the 13% rate of growth in M2 in the past three months, and the striking new creations in Federal Reserve lending and financial support activities, we actually judge the thrust of monetary polity to be somewhat restrictive, not expansionary. This is based on the consideration of both the stock of money (M) and its velocity (V). For example, the first quarter surge in M2 growth has been more than entirely neutralized by a dramatic decline in M2 velocity (Chart 6).

Moreover, velocity is likely to continue to decline. Velocity falls when financial innovations are not forthcoming and declines sharply when previous financial innovations are reversed. In the midst of the current massive credit crunch, this cycle's innovations in mortgage finance, collateralized debt obligations, and structured investment vehicles are all being reversed. In the first quarter, nominal GDP grew around a 3% annual rate, meaning that velocity dropped to 1.85 from 1.9 in the fourth quarter, remaining well above the post 1900 average of 1.67.

More striking, perhaps, has been the impact of velocity over the past seven quarters. M2 growth has accelerated to 6.8% versus 4.4% in the seven quarters ended in the second quarter of 2006 when velocity peaked. Based on M2 alone, the economy should have been accelerating, not falling into the current slump. However, in the past seven quarters V2 (the velocity of M2) declined 2.3% per annum, causing GDP growth to decelerate from 6.5% to 4.4% (Table 1). This declining velocity will mean the Federal Reserve's best efforts are likely to be thwarted, and nominal GDP will slow coincident with inflation and output.

Interest Rate Possibilities

Treasury yields have dropped to near record lows, but the historical record suggests the ultimate bottom in cyclical rates is considerably in the future. On average, thirty year Treasury bond yields are a lagging economic indicator. This is not surprising since inflation is a lagging indicator and inflation is the main long run determinant of bond yields. Since the end of World War II, the thirty year Treasury yields reached their cyclical lows, on average, 14.9 months after the end of the business cycle troughs (Table 2).

Thus, if this growth, or outright recession, ends in 2008, the low in bond yields will be some time in 2010. However, if we are in an extended growth recession that lasts into 2009 or 2010, as we suspect, and if rates are at record low levels, similar to the 1940s and 1950s, then the low in rates is likely to coincide with the end of the recessionary period.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Your doing my bit to keep up consumer spending analyst,

John Mauldin

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