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[written on Sunday]

While not a problem in the US for the Fed to do this and more (in fact it should be standard operating procedure), the eurozone has self imposed treaty issues that make it very problematic.

If there are defaults its the national governments that will probably be called on to repay the ECB for any losses, but given the national governments didn’t approve the transactions the result will be chaotic at best.

Without bank defaults it will probably all muddle through indefinitely.

As before, the systemic risk is in the eurozone.

Valve repair tomorrow, going to try to smuggle in a knife under my gown to even the odds…

Bank borrowing from ECB is out of control

by Ambrose Evans-Pritchard

The European Central Bank has issued the clearest warning to date that it cannot serve as a perpetual crutch for lenders caught off-guard by the severity of the credit crunch.

Not Wellink, the Dutch central bank chief and a major figure on the ECB council, said that banks were becoming addicted to the liquidity window in Frankfurt and were putting the authorities in an invidious position.

“There is a limit how long you can do this. There is a point where you take over the market,” he told Het Finacieele Dagblad, the Dutch financial daily.

“If we see banks becoming very dependent on central banks, then we must push them to tap other sources of funding,” he said.

While he did not name the chief culprits, there are growing concerns about the scale of ECB borrowing by small Spanish lenders and ‘cajas’ with heavy exposed to the country’s property crash. Dutch banks have also been hungry clients at the ECB window.

One ECB source told The Daily Telegraph that over-reliance on the ECB funds has become an increasingly bitter issue at the bank because the policy amounts to a covert bail-out of lenders in southern Europe.

“Nobody dares pinpoint the country involved because as soon as we do it will cause a market reaction and lead to a meltdown for the banks,” said the source.

This “soft bail-out” is largely underwritten by German and North European taxpayers, though it is occurring in a surreptitious way. It has become a neuralgic issue for the increasingly tense politics of EMU.

The latest data from the Bank of Spain shows that the country’s banks have increased their ECB borrowing to a record €49.6bn (£39bn). A number have been issuing mortgage securities for the sole purpose of drawing funds from Frankfurt.

These banks are heavily reliant on short-term and medium funding from the capital markets. This spigot of credit is now almost entirely closed, making it very hard to roll over loans as they expire.

The ECB has accepted a very wide range of mortgage collateral from the start of the credit crunch. This is a key reason why the eurozone has so far avoided a major crisis along the lines of Bear Stearns or Northern Rock.

While this policy buys time, it leaves the ECB holding large amounts of questionable debt and may be storing up problems for later.

The practice is also skirts legality and risks setting off a political storm. The Maastricht treaty prohibits long-term taxpayer support of this kind for the EMU banking system.

Few officials thought this problem would arise. It was widely presumed that the capital markets would recover quickly, allowing distressed lenders to return to normal sources of funding. Instead, the credit crunch has worsened in Europe.

Not to miss out, Nationwide recently announced that it was setting up operations in Ireland, partly in order to be able to take advantage of ECB liquidity if necessary. Any bank can tap ECB funds if they have a registered branch in the eurozone, although collateral must be denominated in euros.

Jean-Pierre Roth, head of the Swiss National Bank, complained this week that lenders were getting into the habit of shopping for funds from those authorities that offer the best terms. The practice is playing havoc monetary policy.

“What we should avoid is some kind of arbitrage by banks, which say they are going to go to central bank X, instead of central bank Y, because conditions are more attractive,” he said.

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Karim writes:

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There’s nothing credit issues can do to GDP that fiscal policy can’t handle.

Congress has seemingly figured that out and probably the rest of the world as well as evidenced by the new proposed fiscal packages popping up around the world.

Yes, we can lose a bank or two, and lending standards tighten further, but GDP will continue to muddle through even if that means a series of fiscal measures.

And Congress was born to spend; so, they are all over this one.

The only thing that might slow them down is inflation, and so far they’ve seemed to support the Fed trying to step hard on the inflation pedal, rather than ‘tighten’ which presumably helps inflation.

And no one seems to notice the 8000lb bear in the room.

Our response to Russia reminds me of Monty Python’s coconut clapping Arthur trying to intimidate the French defenders of the fort with his credentials.

We threaten them with diplomatic isolation, trade sanctions, etc. as if they care.

They don’t care.

They do care about the new missiles going into Poland.

And we are committed to considering an attack on Poland or any other NATO member as an attack on US soil, as Rice reminded them and even maybe dared them to try something.

We can’t defend anyone against against Russia with our own troops without risking nuclear war.

And Russia will be a lot quicker to that trigger than we will.

And they still have maybe thousands of nuclear warheads aimed our way.

Their next step for Russia is probably to make an offer to the rest of the ex-Soviet Union members they can’t refuse.

Russia sells the Eurozone something like 30% of their oil and gas and can do it at any price they want, and demand any real terms of trade they want.

The risk is we try to draw a line in the sand in some nowhere place over there, and it escalates to where we back down or get involved in lobbing nukes.

I suppose it’s just another case of this administration not seeing the forest for the trees.

We’ve let Russia be reorganized by the ex-KGB leadership that’s a lot smarter than ours, and now we’re paying the price.

Both the inflation and cold war of the 1970s is back, except this time our opposition is far stronger.

There is no even semi-quick supply response to dislodge the Saudis and/or Russians from setting any terms of trade they want.

The Russian consolidation is on the way up supported by a bath of capitalist type riches rather than crumbling under its own weight of a failed socialist economy.

Apart from that, I’m optimistic.

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On Mon, Aug 11, 2008 at 1:25 PM, Karim writes:

http://www.federalreserve.gov/boarddocs/SnLoanSurvey/200808/charts.pdf

Yes, and note how housing showing strong signs of bottoming and GDP moving up at the same time.

Interesting to watch the blood flowing around the clot, as it necessarily does.

Though not without difficulty.

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I could fix this in twenty minutes…

Money Market `Plagued’ by Libor That Fed Can’t Reduce

by Gavin Finch

(Bloomberg) A year after central banks started to pump trillions of dollars into the financial system to end a seizure in credit markets caused by subprime mortgages, cash is about as tight as it’s ever been.

The U.S. market for commercial paper, or short-term IOUs, backed by assets such as mortgages has shrunk 40 percent from its peak in July 2007. The amount borrowed in pounds between banks in the U.K. fell by 70 percent in June from a record in February 2007. The European Central Bank received $100 billion of bids for the $25 billion it offered to financial institutions on July 29, the most since the sales began in December.

Efforts by the Federal Reserve, ECB and Swiss National Bank to shore up the world’s biggest banks and promote lending have had limited success.

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In case there was any doubt things have changed.

from his July 28 speech:

Policymakers, academic economists, and the general public broadly agree that maintaining a low and stable inflation rate significantly benefits the economy. For example, low and predictable inflation simplifies the savings and retirement planning of households, facilitates firms’ production and investment decisions, and minimizes distortions that arise because the tax system is not completely indexed to inflation. Moreover, I interpret the available economic theory and empirical evidence as indicating that a long-run average inflation rate of about 2 percent, or perhaps a bit lower, is low enough to facilitate the everyday decisions of households and businesses while also alleviating the risk of debt deflation and other pitfalls of excessively low inflation.

The rationale for promoting maximum sustainable employment is also fairly obvious: Recessions weaken household income and business production, and unemployment hurts workers and their families.

No mention of lost real output. Must have been an oversight.

As I have outlined elsewhere, these two objectives are typically complementary and mutually reinforcing: that is, done properly, stabilizing inflation contributes to stabilizing economic activity around its sustainable level, and vice versa.

Hence the dual mandate is met by sustaining low and stable inflation rates.

Nevertheless, it’s important to note a fundamental difference between the objectives of price stability and maximum sustainable employment. On the one hand, the long-run average rate of inflation is solely determined by the actions of the Federal Reserve.

And they do believe that. They believe it’s all a function of the interest rates they select.

On the other hand, the level of maximum sustainable employment is not something that can be chosen by the Federal Reserve, because no central bank can control the level of real economic activity or employment over the longer run.

And they are not responsible for the level of economic activity, only the rate of inflation.

In fact, any attempt to use stimulative monetary policy to maintain employment above its long-run sustainable level would inevitably lead to an upward spiral of inflation with severe adverse consequences for household income and employment.

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>    
>    On Tue, Jul 29, 2008 at 4:05 AM, Andrea wrote:
>    
>    In case you haven’t seen this yet: A Fed study that finds that
>    Taf has lowered Libor.
>    
>    http://www.newyorkfed.org/research/staff_reports/sr335.html
>    
>    

right, thanks, as if they needed to fund a study to figure that out!

It’s like doing a study that shows the repo rate goes down when the fed lowers its ’stop’ on repo.

(Too bad they didn’t use this study to show they should set a rate for the TAF and let quantity float, instead of setting a quantity and having an auction.)

It’s this kind of expense that gives govt. a govt. spending negative connotation.

all the best!

warren

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I hadn’t noticed this back then, but Vince got it right: The Fed purchased the $30 billion of securities from JPM/Bear Stearns, with JPM agreeing that if there were any net losses it would be responsible for the first $1 billion.

It’s very odd that the Fed would call this a non-recourse loan, as they cut a better deal than that.

Unlike a non-recourse loan, if the securities turn out to be profitable, the Fed gets those funds.

So why would the Fed use language that implies the transaction was worse for the Fed than it actually was?

Perhaps there was a legal or some other restriction that prevented the Fed from purchasing the securities?

Seem there is a lot more to the story than has been revealed?

Press Release
Summary of Terms and Conditions Regarding the JPMorgan Chase Facility

March 24, 2008

The Federal Reserve Bank of New York (”New York Fed”) has agreed to lend $29 billion in connection with the acquisition of The Bear Stearns Companies Inc. by JPMorgan Chase & Co.

The loan will be against a portfolio of $30 billion in assets of Bear Stearns, based on the value of the portfolio as marked to market by Bear Stearns on March 14, 2008.

JPMorgan Chase has agreed to provide $1 billion in funding in the form of a note that will be subordinated to the Federal Reserve note. The JPMorgan Chase note will be the first to absorb losses, if any, on the liquidation of the portfolio of assets.

The New York Fed loan and the JPMorgan Chase subordinated note will be made to a Delaware limited liability company (”LLC”) established for the purpose of holding the Bear Stearns assets. Using a single entity (the LLC) will ease administration of the portfolio and will remove constraints on the money manager that might arise from retaining the assets on the books of Bear Stearns.

The loan from the New York Fed and the subordinated note from JPMorgan Chase will each be for a term of 10 years, renewable by the New York Fed.

The rate due on the loan from the New York Fed is the primary credit rate, which currently is 2.5 percent and fluctuates with the discount rate. The rate on the subordinated note from JPMorgan Chase is the primary credit rate plus 450* basis points (currently, a total of 7 percent).

BlackRock Financial Management Inc. has been retained by the New York Fed to manage and liquidate the assets.

The Federal Reserve loan is being provided under the authority granted by section 13(3) of the Federal Reserve Act. The Board authorized the New York Fed to enter into this loan and made the findings required by section 13(3) at a meeting on Sunday, March 16, 2008.

Repayment of the loans will begin on the second anniversary of the loan, unless the Reserve Bank determines to begin payments earlier. Payments from the liquidation of the assets in the LLC will be made in the following order (each category must be fully paid before proceeding to the next lower category):

• to pay the necessary operating expenses of the LLC incurred in managing and liquidating the assets as of the repayment date;
• to repay the entire $29 billion principal due to the New York Fed;
• to pay all interest due to the New York Fed on its loan;
• to repay the entire $1 billion subordinated note due to JPMorgan Chase;
• to pay all interest due to JPMorgan Chase on its subordinated note;
• to pay any other non-operating expenses of the LLC, if any.

Any remaining funds resulting from the liquidation of the assets will be paid to the New York Fed.

Where No Fed Has Gone Before

Why the Federal Reserve’s ‘loan’ for the Bear Stearns deal looks like an investment—and faces serious scrutiny

March 26, 2008

by Peter Coy

The Federal Reserve has stretched its mandate up, down, and sideways to prevent a financial market deluge. Now it appears to be stretching the English language a bit as well. What the Fed is calling a $29 billion “loan” to help finance JPMorgan Chase’s (JPM) purchase of Bear Stearns (BSC) looks much more like a $29 billion investment in securities owned by Bear. Although the Fed insists that it isn’t technically buying any assets, in practical terms it’s doing exactly that. All this adds up to a big and unacknowledged step up in the central bank’s financial intervention with Wall Street investment banks.

The Fed, of course, is the only part of government with the speed, power, and flexibility to arrest a bout of market panic. By rapidly intervening in mid-March to keep Bear from filing for bankruptcy, it may well have prevented a series of cascading failures that could have severely damaged the financial system and the economy. Many economists and analysts are happy that the Fed stepped into the breach. Nevertheless, now that things have quieted down a bit, the Fed is likely to face some tough questions about the precise nature of its actions as well as the legal justification for them.

The second-guessing has already begun. On Mar. 26, Senate Banking, Housing, and Urban Affairs Chairman Christopher Dodd (D-Conn.) announced an Apr. 3 hearing to explore the “unprecedented arrangement” between the Fed, JPMorgan, and Bear. Top officials from the Fed and other regulators, as well as Bear Stearns CEO Alan Schwartz and JPMorgan CEO Jamie Dimon, will likely be grilled about the details.

“That Looks Like Equity”
Meanwhile, Treasury Secretary Henry Paulson gave the Fed a gentle prod on Mar. 26 in a speech to the Chamber of Commerce. While saying he fully supported the Fed’s recent actions, Paulson stressed that “the process for obtaining funds by nonbanks must continue to be as transparent as possible.” He also urged the Fed to continue to work with other agencies to get the information necessary for “making informed lending decisions.”

So far, few people have focused on what exactly the Fed is getting in exchange for supplying $29 billion to JPMorgan Chase. That’s a bit surprising because whatever the deal is, it’s far from a standard loan. The strangest twist is that even though the money goes to JPMorgan, that firm isn’t the borrower. So the Fed can’t demand repayment from JPMorgan if the Bear assets turn out to be worth less than promised.

What’s also odd is that if there’s money left after loans are paid off, the Fed gets to keep the residual value for itself. That’s what one would expect if the Fed were buying the assets, not just treating them as collateral for a loan. Vincent R. Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute, said in an interview on Mar. 26: “The New York Fed is the residual claimant. That doesn’t look to me like a loan. That looks like equity.”

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Hardly need a study to figure that out!

This paper from the NY Fed was just released:

The Effect of the Term Auction Facility on the London Inter-Bank Offered Rate

Summary: This paper examines the effects of the Federal Reserve’s Term Auction

Facility (TAF) on the London Inter-Bank Offered Rate (LIBOR). The particular question investigated is whether the announcements and operations of the TAF are associated with downward shifts of the LIBOR; such an association would provide one indication of the efficacy of the TAF in mitigating liquidity problems in the interbank funding market. The empirical results suggest that the TAF has helped to ease strains in this market.

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Treasuries Fall as Fed’s Plosser Calls for Interest-Rate Boost. Treasuries fell as Federal Reserve Bank of Philadelphia President Charles Plosser said the central bank should raise interest rates “sooner rather than later.”

Fisher, Stern, and now Plosser as the palace revolt gains momentum into the August 5 FOMC meeting.

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A minority view but a growing one.

They are thinking the low rates are destabilizing the housing and financial markets via the weak USD channel.

Stern Says Fed Rate Rise `Can’t Wait’ for Markets to Stabilize

by Vivien Lou Chen
(Bloomberg) Federal Reserve Bank of Minneapolis President Gary Stern said the central bank shouldn’t wait for financial and housing markets to stabilize before raising interest rates.

“We can’t wait until we clearly observe the financial markets at normal, the economy growing robustly, and so on and so forth, before we reverse course” and begin raising rates, Stern said in an interview in Minneapolis today. “Our actions will affect the economy in the future, not at the moment. Forecasts play a critical role.”

The comments by Stern, a voter on the rate-setting Federal Open Market Committee this year, may reinforce traders’ forecasts for a rate increase by year-end. Stern indicated that Treasury Secretary Henry Paulson’s rescue plan for Fannie Mae and Freddie Mac will help prevent a deeper housing and economic slump.

“We’re pretty well-positioned for the downside risks we might encounter from here,” said Stern, 63, the Fed’s longest-serving policy maker. “I worry a little bit more about the prospects for inflation.”

The bank president compared the current credit crunch to the one in the early 1990s, which restrained economic growth for almost three years. That’s a more sanguine assessment than others have. The International Monetary Fund has said it’s the worst since the Great Depression and former Fed Chairman Alan Greenspan said it’s the most intense in more than half a century.

17-Year High
Stern spoke two days after government figures showed consumer prices surged 5 percent over the past year, the biggest jump since 1991. Excluding food and fuel, so-called core prices rose 2.4 percent, higher than the 2.1 percent average over the last five years.

“Headline inflation is clearly too high,” Stern said. He added that he’s concerned that will feed through to core prices and public expectations for inflation.

As long as energy and food costs level off, core inflation ought to slow over the next year, Stern said.

Crude oil has surged 73 percent in the past 12 months, and rose to a record of $147.27 a barrel on July 11. Worldwide, prices for food commodities such as wheat and rice were 43 percent higher in April than a year earlier, according to the United Nations Food and Agriculture Organization.

Stern declined to say when policy makers may shift toward raising rates. The FOMC halted its series of seven reductions last month, after reducing the benchmark rate to 2 percent, from 5.25 percent last September.

Rate Outlook
Traders estimate 58 percent odds that the Fed will boost its main rate at least a quarter point from 2 percent in October, after keeping borrowing costs unchanged in August and September. There’s a 73 percent probability of a move by year-end, futures prices show.

Minutes of the Fed’s June 24-25 gathering, released July 15, showed that some Fed officials favored an increase in rates “very soon.” Fed Chairman Ben S. Bernanke this week said there are risks to both inflation and growth, abandoning the FOMC’s June assessment that the threat of a “substantial” downturn had receded.

“This is a very challenging policy environment,” Stern said today. “I don’t think we ought to pretend that” an end to the credit crisis “won’t take some time,” he said.

The Fed on July 13 offered Fannie Mae and Freddie Mac access to direct loans from the central bank in case the firms needed the financing before Congress acts on Paulson’s rescue plan. The Treasury chief is seeking power to make unlimited loans to and purchase equity in the companies if needed.

Stern said the proposals are “clearly designed to bolster Fannie and Freddie.”

Stern is the only FOMC member who’s served with three chairmen: Paul Volcker, Greenspan and Bernanke. He became the bank’s president in 1985.

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When in roam, pay fees of 40¢ per minute.

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The last few Michigan surveys had one-year inflation expectations over 5%.

This is not lost on an FOMC that believes inflation expectations cause inflation.

Chairman Bernanke said this yesterday after outlining the inflation expectations/inflation process:

“A critical responsibility of monetary policy makers is to prevent that process from taking hold.”

‘Prevent’ implies action, not ‘monitoring’.

Might just be a poor choice of words.

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(an email exchange)

>    On Tue, Jul 15, 2008 at 11:03 AM, Mike wrote:
>
>    Should we be looking at selling protection on USTs for 20bps?
>

makes sense

And makes even more sense for the Fed to be selling it:

1. free money (really sort of a tax for those who want to pay it, but whatever)
2. assists market functioning

 
 
>
>
>    Sov CDS: ny open 15Jul08
>
>    Credit 5yr 10yrket Credit 5yr 10yr
>    Austria 12.5/15.5 17.0/18.5 Ireland 27.5/30.5 37.0/39.0
>    Belgium 19.0/22.0 26.5/29.0 Italy 41.0/43.0 51.5/53.5
>    Denmark 10.0/12.5 15.0/17.5 Nether 10.5/12.5 15.0/17.0
>    Finland 10.0/12.5 15.0/17.5 Portug 38.0/40.0 48.0/50.0
>    France 11.0/13.0 15.0/17.5 Spain 38.0/40.0 47.5/49.5
>    Germany 6.0/8.0 9.75/10.75 Sweden 10.5/12.5 15.0/17.0
>    Greece 51.0/53.0 61.5/63.5 UK 14.5/17.5 21.0/24.0
>    Iceland 250/290 240/300 US 14.5/18.5 19.0/25.0
>
>

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Doesn’t look like a funding operation.

Looks like JPM sold the Bear Stearns securities to the Fed and retained a first loss piece:

Text in JP Morgan’s 10Q:

“Concurrent with the closing of the merger, the Federal Reserve Bank of New York (the “FRBNY”) will take control, through a limited liability company (”LLC”) formed for this purpose, of a portfolio of $30 billion in assets of Bear Stearns, based on the value of the portfolio as of March 14, 2008. The assets of the LLC will be funded by a $29 billion, 10-year term loan from the FRBNY, and a $1 billion, 10-year note from JPMorgan Chase. The JPMorgan Chase note will be subordinated to the FRBNY loan and will bear the first $1 billion of any losses of the portfolio. Any remaining assets in the portfolio after repayment of the FRBNY loan, the JPMorgan Chase note and the expense of the LLC, will be for the account of the FRBNY.”

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From Chairman Bernanke’s July 07 speech:

As you know, the control of inflation is central to good monetary policy. Price stability, which is one leg of the Federal Reserve’s dual mandate from the Congress, is a good thing in itself, for reasons that economists understand much better today than they did a few decades ago. Inflation injects noise into the price system, makes long-term financial planning more complex, and interacts in perverse ways with imperfectly indexed tax and accounting rules. In the short-to-medium term, the maintenance of price stability helps avoid the pattern of stop-go monetary policies that were the source of much instability in output and employment in the past. More fundamentally, experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally, with potentially adverse effects on risk-taking, investment, and other productive activities that are sensitive to the public’s assessments of the prospects for future economic stability. In the long term, low inflation promotes growth, efficiency, and stability–which, all else being equal, support maximum sustainable employment, the other leg of the mandate given to the Federal Reserve by the Congress.

Note that the current anti-’inflation’ argument within the FOMC is that the high prices for imports take discretionary income from consumers that reduces domestic demand and reduces the ability to service domestic debt. There was no thought or mention of that reason for ‘inflation’ being a ‘bad thing’ a year ago.

I suppose one could argue that this problem is due to there not being inflation, as with wages ‘well-anchored’ there is only a relative value story. If we did have ‘real inflation’ with rising wages, we wouldn’t have the problem of insufficient consumer income to support domestic demand, but we would have the traditional negatives from inflation.

But Bernanke’s response to Congress was that exports are replacing domestic consumption and that is a ‘good thing’ as it brings the US trade back to ‘balance’ and restores ‘national savings’ - the old mercantilist, gold standard imperatives. But it does leave weak domestic demand and rising prices. That brings us back to the tail end of Bernanke’s statement:

Admittedly, measuring the long-term relationship between growth or productivity and inflation is difficult. For example, it may be that low inflation has accompanied good economic performance in part because countries that maintain low inflation tend to pursue other sound economic policies as well. Still, I think we can agree that, at a minimum, the opposite proposition–that inflationary policies promote employment growth in the long run–has been entirely discredited and, indeed, that policies based on this proposition have led to very bad outcomes whenever they have been applied.

Seems that either way you look at it, rising prices (whether you call it inflation or not) lead to ‘bad’ outcomes.

And it sure looks to the dissenters in the FOMC that this is exactly what is happening. Only time will tell, but all Fed speakers now agree the risk of inflation is elevated substantially, and we will soon see if they still agree the cost of letting the inflation cat out of the bag is far higher than letting a near-term recession run its course and (hopefully) contain prices and keep a relative value story from turning into an inflation story.

Also, not how the Fed continues to use ‘other tools’ for market functioning as Bernanke just now indicates they will keep lending directly to their primary dealers.

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(an email exchange)

On Thu, Jun 26, 2008 at 2:25 PM, Tom wrote:
>   
>   
>   

Where’s Bernanke’s Inner Volcker?

by Larry Kudlow

(NRO) On the day after an unusually important Fed policy meeting both gold and stocks severely rebuked the central bank’s decision to take no action in support of the weak dollar or to curb rapidly growing inflation. Gold spiked $30, a clear message that Bernanke & Co. won’t stop inflation. Stocks plunged over 200 points, an equally clear message that the Fed’s cheap-dollar inflation is damaging economic growth.

These market warnings are two sides of the same coin. Inflation, which is caused by excess dollar creation, is the cruelest tax of all. It is a tax on consumer and family purchasing power. It is a tax on corporate profits. It is a tax on the value of stocks, homes, and other assets. Crucially, the capital-gains tax — the most important levy on all wealth-creating assets — is un-indexed for inflation. Hence, long before Barack Obama or Congress can legislatively raise the capital-gains tax rate, rising inflation is increasing the effective tax rate on real capital gains. That’s an economy-wide problem.

By doing nothing at the June 25 meeting the Fed turned its back on the very inflation-tax problem it helped create. The spanking it received from the markets was well deserved.

Former Fed chairman Paul Volcker, who is advising Sen. Obama’s presidential campaign, issued a stern warning at the New York Economics Club a few months back. He said inflation is real and the dollar is in crisis. Soon after, Fed head Ben Bernanke changed his tune in public speeches, pledging greater vigilance on inflation and hinting at a defense of the dollar. Treasury man Henry Paulson and President Bush also stepped up their rhetoric regarding a stronger greenback.

But words were no substitute for actions this week.

It is an interesting historical footnote that Paul Volcker is still highly regarded as the greatest inflation fighter of our time. Working with Ronald Reagan, it was Volcker who slew the inflation dragon in the 1980s. Indeed, the combination of tighter monetary control from the Fed and abundant new tax incentives from Reagan launched an unprecedented twenty-five-year prosperity boom characterized by strong growth and rock-bottom inflation. At the center of the boom was a remarkable 12-fold rise in stock market values, a symbol of the renaissance of American capitalism. But that was then and this is now.

Talk of major new tax hikes is in the air today, while the inflationary decline of the American dollar is plain fact. It’s as though our economic memory is being erased, both in tax and monetary terms. Staunchly optimistic supply-siders Arthur Laffer and Steve Moore are even finishing a book on the subject. Called The Gathering Economic Storm, its concluding chapter is titled: “The Death of Economic Sanity.”

The Volcker anti-inflation model presumably handed down to Alan Greenspan and Ben Bernanke always argued that price stability is the cornerstone of economic growth. Yet it appears that today’s Fed has reverted to a 1970s-style Phillips-curve mentality that argues for a trade-off between unemployment and inflation, rather than the primacy of price stability.

History teaches us otherwise. It states that since rising inflation corrodes economic growth, inflation and unemployment move together — not inversely. Even in the last 18 months this is proving true. Inflation bottomed around 1 percent in late 2006. Unemployment bottomed at 4.4 percent about 6 months later. Today, the CPI inflation rate has climbed to over 4 percent, wholesale prices have jumped to 7 percent, and import prices have spiked to 18 percent. Unemployment, meanwhile, has moved up to 5.5 percent.

Over the past five years the greenback has lost 40 percent of its value. Oil is close to $140 a barrel. And gold, now trading above $900 an ounce, is warning that if the Fed fails to stop creating excess dollars, inflation could rise to 6 or 7 percent.

I had hoped Ben Bernanke would reveal his inner Volcker at Wednesday’s meeting. He didn’t. While the Fed acknowledged that “the upside risks to inflation and inflation expectations have increased,” it took no action taken to raise the fed funds target rate, which now stands at 2 percent and is actually minus-2 percent adjusted for inflation. Even a quarter-point rate hike — merely taking back the last easing move in April — would have been a shot heard ’round the world in defense of the beleaguered dollar. It didn’t happen.

Only Richard Fisher, president of the regional Dallas Fed, dissented in favor of a higher target rate. That leaves the hard-money Fisher as the lone remaining protégé of Paul Volcker.

Of course, if Fed policymakers reconvene immediately to right their wrongheaded mistake, the value of our money could be quickly restored. The next scheduled Open Market meeting is August 5, but they needn’t wait that long.

Let’s hope they come to their senses.

>   
>   
>   

Good, thanks, as expected, this is where the mainstream (no pun intended) is going, though Kudlow is of course not ‘center’ mainstream.

Good luck to us!

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(an interoffice email)

On Thu, Jun 26, 2008 at 7:48 AM, Karim wrote:
>   
>   
>   

Global Economic Integration and Decoupling

Vice Chairman Donald L. Kohn
At the International Research Forum on Monetary Policy, Frankfurt, Germany
June 26, 2008

For the moment, higher headline rates of inflation have shown only a few tentative signs of embedding themselves in core inflation or in longer-term inflation expectations.

>   -talking about u.s. here
>   
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However, policymakers around the world must monitor the situation carefully for signs that the increases in relative prices globally do not generate persistently higher inflation. Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

>   -not describing/talking about u.s. here;
>   focusing on EM primarily.
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right, gets back to bernankes testimony a while back that the falling dollar has been a good thing as it works to lower the trade gap via increasing US exports that sustain US demand. the old ‘beggar they neighbor’ policy from the 30’s.

unfortunately for us it’s actually a ‘beggar thyself’ policy on closer examination as most mainstream economists will attest. they all say you don’t ‘inflate your way to prosperity’ by weakening your currency. otherwise latin america and africa for example would be the most prosperous places in the world

seems they are still in the mercantalist mode where exports are good and imports bad, and this policy is making us look like a bananna republic at an increasing rate.

recall from previous emails the dollar decline has been triggered by paulson succeeding in keeping cb’s from buying $US, Bush keeping oil producing monetary authorities from accumulating $US, and Bernanke discouraging foreign portfolio managers from accumulating same.

(more later on how it’s actually not happening due to fed rate policy, but they think it is)

as suspected, the $US is most likely to take another major leg down as it adjusts to a level where the trade gap is in line with foreign desire to accumulate $US financial assets which is probably a lot lower than the current 55-60 billion per month.

the ‘cost push inflation’ is pouring in through the trade channel, and the fed is increasingly taking the heat from the mainstream (not me- i’m the only one who thinks inflation isn’t a function of rates the way they do) for its apparent weak $US/inflate your way out of debt approach.

furthermore, the mainstream (and the stock market) sees the low interest rate/weak dollar policy as taking away US domestic demand as higher price for food/fuel leave less domestic income for everything else, including debt service.

that is, they see the falling dollar hurting us domestic demand more than the low interest rates are helping it.

the reality is there’s foreign monopolist- the saudis (and maybe russians)- that’s milking us for all they can with price hikes, and keeping us alive buying our goods and service and thereby keeping US gdp muddling through.

the real standard of living for most working americans has dropped by perhaps 10% as they work, get paid enough to eat and drive to work, and the rest of their real output is exported.

and our policy makers, including bernanke and paulson who’ve ‘engineered it’ think this is all a good thing- they think imports are bad and exports good and we are paying the price in declining real terms of trade.

while in my book interest rates are not a factor, the mainstream thinks they are, and the response when the inflation gets bad enough will be higher interest rates. The ‘correct’ anti-inflation rate last August was 5.25 when the fed didn’t cut.

by Jan 08 it was probably at least 7% with headline moving through 3% to get a sufficient ‘real rate.’

today it’s probably moved up to 8%+ as cpi is forecast to go through 5% over the next few months and gdp muddles through around 1%.

the mainstream (not me) will say that by having a real rate that’s too low now the fed will need a rate that much higher down the road as inflation accelerates due to over accommodative fed policy.

by the time the cost push inflation works its way to core- probably over the two quarters- the fed will ’suddenly’ feel itself way behind the inflation curve and recognize they made a horrible mistake and now the cost of bringing down inflation is far higher than it would have been early on- just like they’ve always said.

the mainstream knows this, and now sees a fed with its head in the sand regarding inflation. they also see this weak dollar policy as subversive as it undermines the currency and inflation accelerates.

i expect there will be a groundswell of mainstream economists calling for the replacement of bernanke, kohn and the entire fomc very soon.

ironically, in my book low rates have helped moderate inflation via cost channels and have helped moderate domestic demand via interest income channels.

rate hike will add to domestic demand as net interest income of the private sectors from higher government interest payments add to personal income and demand.

and rate hikes will add to the cost push inflation via higher interest costs for firms.

it’ all going down hill fast, with policy makers both going the wrong way on key issues as they have the fundamentals backwards.

the only near term ’solutions’ are near term crude oil supply responses like 30 mph speed limits which isn’t even under consideration in any form, nor are any other crude supply responses. most other alternative energy sources don’t replace crude.

medium term supply responses include pluggable hybrids that only start being produced in late 2010.

longer term supply responses include nuclear which might come on line 15 years down the road.

a collapse in world demand is possible if china/india let up on their deficit spending and growth, but so far that doesn’t seem in the cards. all their ‘tightebning’ seems to be on the ‘monetary’ side which does nothing of consequence apart from further increase inflation.

so with no supply responses on the horizon expect the saudis to keep hiking prices, and keep spending the new revenues to keep world gdp muddling through, cb’s hiking interest rates that will bring results that will cause them to hike further, and continuously declining real terms of trade for oil importers.

what to do?

cds on germany- it’s one go all go over there, and germany is the least expensive insurance.

forward muni bmas over 80 with no interest rate hedge as markets should discount the obama lead and long move up with inflation.

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Real GDP

Can you find the recession? Year over year will be reasonable until last year’s large Q3 number drops out without similar sized q3 this year.

Capacity Utilization, ISM Manufacturing

Down but not out as GDP muddles through.

Philly Fed Index, Chicago PMI, ISM Non-Manufacturing, Empire Manufacturing Index

Limping along, but off the lows
The survey numbers seem to be depressed by inflation.

Retail Sales, Retail Sales Ex Autos, Total Vehicle Sales, Redbook Retail Sales Growth

Personal Spending, Personal Income

Apart from cars and trucks, retail muddling through, and getting some support from the fiscal package.

Non-farm Payrolls, Average Hourly Earnings, Average Weekly Hours, Unemployment Rate

Certainly on the soft side, but still positive year over year, earnings still increasing, and unemployment still relatively low (the last print was distorted a couple of tenths or so by technicals).

Total Hours Worked, Labor Participation Rate, Duration of Unemployment, Household Job Growth

Help Wanted Index, Chicago Unemployment, ISM Manufacturing Employment, ISM Non-Manufacturing Employment

Philly Fed Employment, Challenger Layoffs

Most of the labor indicators are on the weak side, but not in a state of collapse. And GDP is picking up some from the fiscal package which should stabilize employment.

NAHB Housing Index, NAHB Future Sales Index

Housing Starts, Building Permits, Housing Affordability, Pending Home Sales

Leveling off to improving a touch.
Housing is still way down and could bounce 35% at any time.
And still be at relatively low levels.

MBA Mortgage Applications

Mortgage apps are down but they are still at levels previously associated with 1.5 million starts vs today’s approx 1 million starts (annual rate).

Fiscal Balance, Govt Public Debt, Govt Spending, Govt Revenue

It’s an election year, and here comes the Govt. spending which is already elevating GDP.

CPI, Core CPI, PCE Price Index, Core PCE

PPI, Core PPI, Import Prices, Import Prices Ex Petro

Export Prices, U of Michigan Inflation Expectations, CRB Index, Saudi Oil Production

The ‘inflation’ is only going to work its way higher as it pours through the import and export channels.
And with Saudi production completely demand driven, there’s no sign of a fall off of world demand for crude at current prices.
Yes, the world’s growing numbers of newly rich are outbidding America’s lower income consumers for gasoline, as US demand falls off and rest of world demand increases.

Empire Prices Paid, Empire Prices Received, Philly Fed Prices Paid, Philly Prices Received

All the price surveys are pretty much the same as ‘inflation’ pours in.

ABC Consumer Confidence, ABC Econ Component, ABC Finance Component, ABC Buying Component

And all the surveys look pretty much the same as ‘inflation’ eats into confidence

10Y Tsy Yield

And with all the weakness rates have generally moved higher as it seems inflation is doing more harm than ultra low interest rates are helping, perhaps causing the Fed to reverse course.

10Y Tips

The TIPS market has been discounting higher ‘real’ rates from the Fed.

Dow Index

Even as stocks look to test the lows

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This still reads hawkish to me:

The results of such exercises imply that, over recent history, a sharp jump in oil prices appears to have had only modest effects on the future rate of inflation. This result likely reflects two factors. First, commodities like oil represent only a small share of the overall costs of production, implying that the magnitude of the direct pass-through from changes in such prices to other prices should be modest, all else equal. Second, inflation expectations have been well anchored in recent years, contributing to a muted response of inflation to oil price shocks. But the anchoring of expectations cannot be taken as given; indeed, the type of empirical exercises I have outlined reveal a larger effect of the price of oil on inflation prior to the last two decades, a period in which inflation expectations were not as well anchored as they are today.

Nonetheless, repeated increases in energy prices and their effect on overall inflation have contributed to a rise in the year-ahead inflation expectations of households, especially this year. Of greater concern is that some measures of longer-term inflation expectations appear to have edged up since last year. Any tendency for these longer-term inflation expectations to drift higher or even to fail to reverse over time would have troublesome implications for the outlook for inflation.

The central role of inflation expectations implies that policymakers must look beyond this type of reduced-form exercise for guidance. After all, the lags of inflation in reduced-form regressions are a very imperfect proxy for inflation expectations. As emphasized in Robert Lucas’s critique of reduced-form Phillips curves more than 30 years ago, structural models are needed to have confidence in the effect of any shock on the outlook for inflation and economic activity.

This was considered the dovish part:

In particular, 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.

So the question is whether that point was realized by a 2% Fed funds rate currently?

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.

But it was then qualified by this return to hawkishness regarding the inflation expectations that he previously said showed signs of elevating:

I should emphasize that the course of policy I have just described has taken inflation expectations as given. In practice, it is very important to ensure that policy actions anchor inflation expectations. This anchoring is critical: As demonstrated by historical experiences around the world and in the United States during the 1970s and 1980s, efforts to bring inflation and inflation expectations back to desirable levels after they have risen appreciably involve costly and undesirable changes in resource utilization.11 As a result, the degree to which any deviations of inflation from long-run objectives are tolerated to allow the efficient relative price adjustments that I have described needs to be tempered so as to ensure that longer-term inflation expectations are not affected to a significant extent.

And the FOMC all agree that long term inflation expectations have been affected to some extent already.

Summary
To reiterate, the Phillips curve framework is one important input to my outlook for inflation and provides a framework in which I can analyze the nature of efficient policy choices. In the case of a shock to the relative price of oil or other commodities, this framework suggests that policymakers should ensure that their actions balance the deleterious economic effects of such a shock in the short run on both unemployment and inflation.

Of course, the framework helps to define the short-run goals for policy, but it doesn’t tell you what path for interest rates will accomplish these objectives. That’s what we wrestle with at the FOMC and is perhaps a subject for a future Federal Reserve Bank of Boston conference.

This all could mean a Fed funds rate that causes unemployment to grow and dampen inflation expectations down, but not grow so much as to bring inflation down quickly is in order.

The question then is whether the appropriate Fed funds rate for this ‘balance’ between growth, employment, and inflation expectations is 2% or something higher than that.

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