Please Destroy Us, Mr. Bernanke!

from Testosterone Pit blog:

Dear Ben,

Please print us more money. We want you to prop up the stock market. Everybody knows it's a Ponzi scheme that will collapse without your support. You don't want us to end up like Bernie Madoff's clients. No, Ben, we love Ponzi schemes. We get in early and get out before they collapse. That's why we're rich. The bad thing is that they sometimes collapse before we can get out. But you already bailed us out twice in the last couple of years through printing trillions of dollars. Why not a third time?

That will also keep the bond-market bubble inflated. We have to admit that you've done an excellent job there, hands down. Negative real yields all the way up the yield curve! Awesome. Now if you could just print a few trillions and buy up the sovereigns from the PIIGS. Euro crisis over. End of story. And we'd get richer because we'd sell them to you at face value though we bought them at fifty cents on the dollar.

And why not forever? Just keep printing. Because as soon as you stop, stock markets will crash again, and credit markets will seize, and then we're back on this awful ride to hell.

Of course, it'll cause inflation, which is good. You yourself said that. You stated many times that you want inflation. In fact, you said that one of the goals of the Fed, after propping up the markets, is to create inflation. So stick to it, Ben. Don't slack off suddenly just because some cowboy threatened you.

Inflation, in conjunction with your near-zero yields, has all sorts of benefits. For example, it will eat up the Social Security trust fund, whose $2 trillion balance is invested in treasuries. Fixed-income investors, retirees, and everybody who has any savings will also be demolished. And homeowners. But don't worry. They won't figure it out. They don't get a statement every month that shows how much inflation cost them. It's a quiet way of stealing from them, and it'll impoverish them over time, but it'll make us, the recipients of the money you print, richer.

You see, Ben, we can charge higher prices for our goods and services. And even if we have to pay more for raw materials, we look good. Our inventories increase in value, and we can claim sales jumped 10% because we raised prices by 10%. Analysts dig that.

Recently, Ben, you've done a decent job on inflation. In July, we were running at an annual rate of 6%. Not bad. But you need to preempt any cooling off. So keep printing.

Now, we're not talking about wage inflation. Oh no. We have to keep wages down. We need cheap labor, or else we'd have to send these jobs to China—which we're doing anyway. And not just to assemble iPhones. Heck, our lawyers in India are doing the same work as our local lawyers for one-tenth the pay. So, if our local lawyers want to be competitive.... Just think how much more profit we could make if wages collapsed!

Real wages have been declining for ten years and fell another 1.7% since July 2010. But that's not enough. So get with it, Ben. Print more. And don't worry about the wusses out there who say that choking the middle class like that will put us into a permanent recession. Just get the banks to loan them lots of money so they can buy our stuff, and when the loans blow up, you buy them from the banks at face value. Full circle, Ben.  

The trillions you've printed and handed to us, well, we put them to work, and we created jobs in China and Mexico and Germany, and we bought assets, and it inflated prices, and now we're even richer. We're proud of you, Ben. Think of the influence you have. And not just here. Around the world, Ben! Look at the Middle East and North Africa. See the food riots, rebellions, and civil wars it caused? Thousands of people died and entire governments were toppled.... Oh, wait. That's a bad example.

And then there is Congress. We invested in them through campaign contributions and other mechanisms to get them to spend trillions of dollars every year on our products and services, and they even started a few wars, and it made us richer—without taxing our companies or us. It's a wonderful system.

But the deficits have become so huge that they exceed what the Treasury can borrow. So we're glad, Ben, that you stepped up to the plate and printed enough money to monetize the deficit. But Ben, you can't just stop now! You've got to keep at it. Or else, the whole system will blow up. Well, it'll blow up anyway, but we don't want it to blow up now. So, Ben, you don't have a choice. Otherwise, we'd lose a lot of money in our schemes, and nobody wants that.

Wall St Bets... On Inflation!

Despite a steady drumbeat of bad economic news, Wall St is buying up stocks steadily since Bernanke's speech last Friday. They are convinced that more inflationary quantitative easing by the Fed is on the way. Worse yet, they are convinced that it is necessary!
They are therefore ignoring the strong likelihood of another recession that is already under way, and are instead placing their bets... on more inflation. They are therefore bidding higher the stock market, even in the face of a growing chorus of evidence in support of the view of a new recession.
This is going to have terrible results, because the higher cost of the inflation that the Fed denies is going to contribute toward, and even accelerate the onset of that recession. The Fed, in its refusal to acknowledge its destructive role in driving us toward that cliff, is advancing the very scenario it claims it wants to prevent. By pursuing a policy that now has an evidentiary history of raising inflation and putting greater pressure on household budgets, they are increasing the likelihood of that recession. It's a classic case of shooting oneself in the foot.
And like the Fed, they either still don't get it, or, as I believe, don't care about the destructive consequences! They don't care because higher inflation and monetary policy that causes it serve their interest. They therefore pressure the Fed to create still more of it despite that it harms their countrymen and advances the very economic scenario that we are now dreading.

The Fed -- Painting Itself Into a Corner of Monetary Mayhem

This is one of the reasons that I am convinced that much higher inflation is coming. If the Fed doesn't reverse its purchases of Treasuries, it will create a cash "hot potato" that will ignite rampant inflation. And if it does, who will want to buy all those treasuries, and what will be the impact on the broader economy of much higher interest rates? And if they can't accomplish this quickly enough, while maintaining a balance between these variable, then what could the the (unintended) consequences? I think that the result will be more monetary mayhem, and the likelihood is toward much higher inflationary pressures. That "hot potato" could bring hyperinflation!

John Hussman at Hussman Funds:


One of the most important factors likely to influence the financial markets over the coming year is the extreme stance of U.S. monetary policy and the instability that could result from either normalizing that stance, or failing to normalize it. It is not evident that quantitative easing, even at its present extremes, has altered real GDP by more than a fraction of 1% (keep in mind that commonly reported GDP growth rates are quarterly changes multiplied by 4 to annualize them). Moreover, it's well established - on the basis of both U.S. and international data - that the "wealth effect" from stock market changes is on the order of 0.03-0.05% in GDP for every 1% change in stock market value, and the impact tends to be transitory at that.

Still, by replacing an enormous quantity of interest-bearing assets with non-interest bearing money, quantitative easing has created profound distortions in asset prices, where Treasury bills now yield less than 5 basis points annually, while "risk assets" such as stocks and commodities have been driven to prices high enough that their likely future returns now compete perfectly (on a time-horizon and risk-adjusted basis) with the zero expected returns on cash.

Taken together, despite the limited and transitory real effects of QE on output and employment, the Federal Reserve has created an unprecedented monetary position that creates an extremely unstable equilibrium for the financial markets. There are several ways that this might be resolved. Based on the very robust relationship between short-term interest rates and the monetary base, it is clear that a normalization of short-term interest rates, even to 0.25-0.50%, would require the Federal Reserve to fully reverse the $600 billion of asset purchases it conducted under QE2. Alternatively, with the monetary base now exceeding 16 cents for every dollar of nominal GDP, any external upward pressure on interest rates (that is, not produced by a Fed-initiated reduction in the monetary base) would quickly provoke inflationary pressures.

Last week, my friend John Mauldin reprinted our April 11 market comment Charles Plosser and the 50% Contraction in the Fed's Balance Sheet . John told me that he had received several nearly identical questions, along the lines of "Wait, now I'm confused - I thought that the Fed reduces inflation pressures by raising interest rates. Why would higher interest rates trigger inflation?"

So, this is where that phrase "external upward pressure" comes in. We have to distinguish between what economists would call an "endogenous" increase in interest rates - one that the Fed itself provokes by reducing the monetary base - and an "exogenous" increase in interest rates - one that is produced by changes in the behavior of investors and the economy, independent of actions by the Fed.

See, when the Fed decides to raise interest rates, it does so by reducing (or slowing the growth) of the monetary base, which can reasonably be viewed as an "anti-inflationary" policy. However, if interest rates rise independent of any change in the monetary base, then cash - which doesn't bear interest - becomes a "hot potato" that is suddenly less desirable. Somehow, the excess cash has to be "absorbed" in the sense that someone becomes willing to hold it despite the higher interest rates. Unless real output expands sufficiently to absorb that cash, you get one of two alternative outcomes: people holding cash may bid up Treasury bills, lowering short-term interest rates to the point where people are again indifferent between cash and non-cash alternatives, or failing that, the attempt to get rid of cash holdings in other ways provokes inflation and a depreciation in the foreign exchange value of the dollar (which was the outcome in the 1970's).

As I've argued elsewhere, one of the primary sources of exogenous inflationary pressure is growth in unproductive forms of government spending (spending that creates demand but does not expand capacity or incentive to produce), but I'll leave that feature of the argument for another time.

Monetary Policy in 3-D

The extreme stance of monetary policy is such a critical factor in the financial markets here that it is worth spending a bit more time on the relationship between interest rates, inflation, and the monetary base.

Let's return to the concept of "liquidity preference" - basically the "demand curve" for base money (currency and bank reserves). To make this operational, we define liquidity preference as the amount of base money that individuals choose to hold per dollar of nominal GDP, given any particular level of short-term interest rates. The chart below shows this "demand curve" for money in monthly data since the 1940's. Notice that when interest rates are high, there is a significant "opportunity cost" to holding base money, so people cut back on the balances they hold. When interest rates are low, people are willing to hold a greater amount of non-interest bearing money per dollar of GDP.

What's critical about liquidity preference is this - while there are numerous combinations of T-bill yields, monetary base, and nominal GDP that will produce equilibrium (demand for money = supply of money), the three variables are "jointly constrained." For example, suppose that there is upward pressure on interest rates which reduces the attractiveness of non-interest bearing cash. If the Federal Reserve does not reduce the monetary base sufficiently to move left to the appropriate point on the "demand curve," the burden of adjustment is instead thrown onto nominal GDP. Since variations in real GDP have a fairly limited range, the majority of that adjustment is forced to take the form of price increases (i.e. inflation) sufficient to bring the ratio of the monetary base to GDP down to the appropriate level.

Similarly, if the Fed creates a great deal of base money, and the components of nominal GDP (real GDP and prices) are fairly "sticky", short-term interest rates will decline to a level sufficient to ensure that the additional money is held (this has been essentially the story of QE2).

If you like equations (if not, skip this paragraph), by our estimates, about 96% of the historical variation in U.S. money demand is described by a fairly simple equation relating the Treasury bill yield ("i") and the amount of monetary base per dollar of nominal GDP (M/PY): i = exp(4.25 - 129.87*M/PY + 84.42*M/PY_lagged_6_mos). In some of the recent pieces I've written, I've used the "steady state" of this equation, which is i = exp(4.27 – 45.5*M/PY). See the original "Sixteen Cents" piece for further details.

Below, I've plotted this liquidity preference relationship as a 3-dimensional surface. This is essentially the "policy surface" faced by the Federal Reserve. Nearly all of the historical data is captured by periods where the amount of monetary base per dollar of GDP changed by less than 1 cent either way over any 6-month period. The blue marbles on the graph represent actual data points since the 1940's. The marbles on the floor along the right side of the graph aren't technically off the policy surface, but are clearly outliers because of the abrupt shift in monetary base per unit of GDP that occurred between 6-month periods during the recent financial crisis, which were associated with a plunge in interest rates toward zero.

As should be evident, the historical liquidity preference relationships we've been discussing are very tight. This is why I am so adamant that quantitative easing is an irresponsible policy - we know how these variables are related. Specifically, it will be nearly impossible to normalize interest rates, even slightly, without a massive contraction in the Fed's balance sheet. Likewise, as we approach 17 cents of monetary base per dollar of nominal GDP, even the slightest exogenous interest rate pressure will imply the need for massive reversals in the monetary base in order to avoid steep inflationary pressures. My hope is that my previous comment Will the Real Phillips Curve Stand Up? makes it clear that there is very little "tradeoff" between unemployment and general price inflation.

Since a picture is often worth a thousand words, I've included a few additional perspectives of the "policy surface" that the Federal Reserve faces here. The chart below is a head-on view. The point at the far right shows the present stance of monetary policy. Charles Plosser of the Philadelphia Fed is quite correct that normalizing interest rates to about 2.5% would imply a reduction of nearly 50% in the Fed's balance sheet, but as I noted two weeks ago, the required cutback in the balance sheet is extremely front-loaded, as a non-inflationary move to a Fed Funds rate of just 0.25% would require a reduction in the monetary base from about 17 cents to less than 13 cents per dollar of GDP, taking the monetary base from $2.6 trillion to less than $2 trillion - effectively reversing QE2 in its entirety.

The following chart shows the policy surface, along with actual data points, from the origin. We are now way out on the flat part of the curve. Again, in order to achieve even a slight endogenous increase in interest rates, the Fed will have to reduce the monetary base sharply. Alternatively, in order to offset the inflationary pressure from a slight exogenous increase in interest rates, the Fed would be forced to respond with a sharp tightening in its balance sheet. Both normalizing policy, and failing to normalize it, now present the economy and the financial markets with hazards that, in my view, were needless in the first place.

As a final note, the Fed does have an additional policy tool - the ability to pay interest on bank reserves, in hopes of preventing base money from becoming an inflationary "hot potato." The difficulty here is that the Fed's balance sheet is now leveraged 51-to-1. Even 0.25% of annual interest on reserves works out to about 12% of the Fed's total capital. The Fed is already in a position where a 35 basis point increase in long-term interest rates would effectively wipe out that capital. Though the Fed does earn interest on the Treasury debt it holds (which is remitted back to the Treasury for public uses), it would still take an increase in long-term interest rates of less than 1% to wipe out the Fed's capital as well as its entire net interest margin. So while the Fed might have the latitude to pay another 0.25% of interest on reserves, every extension of its present policy course, be it more quantitative easing, or paying interest on existing bank reserves, substantially increases its already untenable level of balance sheet leverage, and the likelihood that the public will quietly need to subsidize that balance sheet.

Fed to Expand Programs Further to Prevent Worsening

From Bloomberg:

The Federal Open Market Committee, gathering today and tomorrow in Washington, needs to redouble its efforts after the central bank’s balance sheet shrank 17 percent from a $2.3 trillion December peak, Fed watchers said. The retreat came even as Bernanke acknowledged the chance that the unemployment rate will exceed 10 percent for the first time in a quarter century.

“It takes massive balance-sheet expansion to generate significant easing in financial conditions,” said Andrew Tilton, an economist at Goldman Sachs Group Inc. in New York who used to work at the Treasury. “More needs to be done.”

This week’s FOMC meeting could mark a shift toward more aggressive monetary expansion to fight deflation after demand waned for many of the Fed’s existing programs.

Read the full story here.

This is troubling, because it suggests that, contrary to what Mr. Bernanke said in his 60 Minutes interview over the weekend, the Fed believes the economy may contract even more. Why else would they express the need to expand their programs and balance sheet even more?

Building the Treasury Bubble

Treasuries continue to move even higher. This is one monster bubble!

Has anyone stopped long enough to ask what is going to happen to interest rates when this bubble pops and/or the Fed starts to sell all those treasuries it is buying? One should consider also that when the Fed starts to sell, so will many other traders and investors. Just as many other investors are buying treasuries today (don't fight the Fed, right?), pushing them into bubble territory, when the Fed starts to sell, other investors will sell treasuries also. When that happens, I shudder to think what the consequences will be, both for the American People, and for interest rates!