The Math Behind Inflationary Pressures

by John Hussman:

his week's comment is important. In my view, it's difficult to properly weigh the present economic climate without understanding exactly how far the Federal Reserve has pushed the limits of monetary policy. As you'll see, this is not a stable equilibrium. Since I'm a strong believer in laying out the data behind the arguments I make, there are a few graphs and equations included. Feel free to skim over these if you're not a math fan - the text should convey the essential ideas. I've bold-faced some of the more important sections.

One of the best known relationships in economics is the concept of "liquidity preference" - essentially money demand. Both theoretically and in actual data, there is a fairly tight relationship between short-term interest rates, and the amount of non-interest-bearing money that people are willing to hold, either directly as currency, or indirectly as bank reserves. Basically, the lower interest rates are, the more cash or reserves ("base money") people are willing to carry around, per dollar of nominal GDP. As interest rates move higher, people naturally respond to the opportunity to earn interest by reducing the amount of cash they carry, both directly and indirectly.

You can see this relationship in the chart below, which plots the 3-month Treasury bill yield versus liquidity preference for base money. In post-war data, the lower bound for liquidity preference has been roughly 5 cents of base money holdings for every dollar of nominal GDP. With interest rates nearly zero at present, people are directly and indirectly holding much larger amounts of base money, currently slightly more than 13 cents for every dollar of GDP. The cluster of points at the extreme right of the graph are recent data. In a panic to hold cash, liquidity preference hit 15 cents at the height of the 2009 credit crisis.

The idea of monetary "velocity" seems slightly more theoretical, but velocity is simply the inverse of liquidity preference: it measures the amount of nominal GDP per dollar of monetary base. Not surprisingly, the chart of velocity is a mirror image of liquidity preference.

The exchange equation

OK. So we've established that there is a clear relationship between money demand and interest rates. As it happens, there's also a well-known relationship between money, velocity, output and prices, which is called the "exchange equation." The exchange equation is actually just a simple identity. Notice that nominal GDP is just real GDP ("Y") times the GDP price index ("P"). Velocity is equal to nominal GDP divided by the monetary base, so

V = PY/M

which is usually written

MV = PY

Although this is a simple identity, people like to tinker with one variable or another while incorrectly assuming that the other parts of the equation are simply constant. For example, people often assume that doubling the monetary base will simply double the price level, but that requires V and Y to stay constant, which is hardly an accurate assumption. Likewise, advocates of easy money seem to believe that increasing the money supply will buy you more economic output, but this requires holding V and P relatively constant.

If you look at the historical data, neither of these arguments hold a great deal of water. Rather, what seems to be true is that the strongest effect of an increase in the money supply is to drive short-term interest rates lower, thereby increasing liquidity preference (i.e. reducing velocity). So periods of very high growth in the monetary base are typically accompanied by nearly proportionate plunges in monetary velocity , without any strong effects on output or prices. As we'll see below, that isn't quite the whole story, but to a first approximation, the main effect of changes in the monetary base is to produce opposite and proportional changes in velocity.

From this perspective, there is little reason to expect the Fed's policy of "quantitative easing" to have real effects on economic output. Thus far, quantitative easing has had the effect of increasing idle bank reserves by about $62 billion since September, with a slight downward impact on Treasury bill yields. On a seasonally-adjusted basis, the monetary base has increased by about $36 billion since September, but since the seasonal adjustment factor plunges in the first two months of the year as holiday cash demands subside, the seasonally-adjusted monetary base will spike by about $60 billion even if the Fed does nothing in the next two months.

Of course, QE2 has had additional effects on the financial markets, but these have not been driven by monetary factors. Instead, they are rhetorical, based on the view that somehow the Fed's actions create a "backstop" that will prevent potential losses in risky assets. As Ambrose Evans-Pritchard has noted, " the Fed no longer even denies that the purpose of its latest blast of bond purchases, or QE2, is to drive up Wall Street, perhaps because it has so signally failed to achieve its other purpose of driving down borrowing costs." Unfortunately, it is easy to demonstrate that the greater the volatility of a security or income stream, the smaller the "wealth effect" that can be expected from a given increase in value. Volatile dollars have less impact on consumption than smooth dollars, which is why housing values have historically had a much greater wealth effect than stock market values.

Moreover, people clearly believe that the additional reserves are flowing wildly into risk assets, pushing prices higher as if secondary markets are some sort of balloon to be filled (one second of reflection will establish that every dollar that goes "into" a secondary market in the hands of a buyer comes back "out" of the secondary market in the hands of a seller). The fact, however, is that these reserves are sitting comfortably in the banking system as idle balances.

In any event, it is clear that with regard to risky securities, the enthusiasm and rhetoric about QE2 has caused a reduction in the willingness of sellers to sell, and an increase in the eagerness of buyers to buy. That imbalance of eagerness between buyers and sellers has clearly affected prices of risky assets, but it does not generate new cash flows - it simply raises the valuation that the market places on existing streams of future cash flows, and thereby lowers the subsequent rate of return on holding those securities. I suspect this will end badly, but that's not the topic of this discussion.

Quantifying monetary policy

So let's review. Liquidity preference is simply the amount of monetary base that people are willing to hold, per dollar of nominal GDP. We've seen that this demand for base money is essentially a function of short-term interest rates. When interest rates are low, people are willing to hold higher cash balances. When interest rates are high, people tend to economize on cash balances.

Just a note - even if you hate math, it will help to skim the next few paragraphs, but feel free to skip to the next graph if you wish. After inverting velocity, taking logarithms, and doing other calculations that geeks find entertaining, it turns out that the liquidity preference function can be estimated fairly accurately. Using the 3-month Treasury bill ("i") alone, the relationship in post-war data is well described by:

M/PY = .094 - .022 * ln(i)

which gives you an implied equation for the 3-month Treasury bill yield as a function of liquidity preference:

i = exp(4.27 – 45.5*M/PY)

An even tighter relationship can be obtained by including the value of liquidity preference six months earlier:

M/PY = .0327 - .0077 * ln(i) + .65 * (M/PY)_lagged_6_mos

which again gives you an implied equation for the 3-month Treasury bill yield as a function of monetary variables:

i = exp(4.25 - 129.87*M/PY + 84.42*M/PY_lagged_6_mos)

The foregoing parameters are based on standard scaling factors used for reporting the variables, so GDP are and monetary base are in billions, and T-bill rates are in standard format. For example, given a current monetary base of $2,000 (billion) and nominal GDP of about $14,900 (billion), the expected 3-month Treasury bill yield here would be roughly exp(4.27-45.5*2000/14900) = 0.1592, which is about right (presently, the Treasury bill yield is 0.16%).

Let's take a quick look at the fit from these estimates. The chart below shows the actual velocity of the monetary base, along with estimated velocity. Notice that we've observed an enormous plunge in velocity over the past two years, which is fully consistent with the near-zero level of interest rates at present.

Of course, we can also invert this relationship. The chart below shows the actual level of the 3-month Treasury bill yield, along with the yield implied by monetary variables.

Pushing monetary policy to its unstable limits

But what about inflation? How is monetary policy related to prices?

Here is where things get really interesting. We've established that to a large extent, both liquidity preference and short-term interest rates respond fairly passively to changes in the monetary base. But of course, that's not the whole story. Not every change in interest rates or liquidity preference is passive, and when there is an exogenous "shock" to those factors - watch out.

Let's go back to the definition of liquidity preference (we'll call it "L").

L = M/PY

So

P = M/LY

It follows that we can impute the price level (GDP deflator) using base money, real GDP, and the level of liquidity preference implied by short-term interest rates.

With real GDP expected at about $13,409 billion in 2005 dollars for the fourth quarter of 2010, the implied GDP deflator is 2000/[(.094-.022*ln(.15))*13,409] = 1.10. The latest reading on the deflator was about 1.11, so the estimate is just about right.

The disturbing fact about this, however, is that the dynamics of inflation pressures can potentially become unstable at very low interest rates, because small increases in interest rates from near-zero levels imply huge changes in liquidity preference and velocity. If those changes are not offset by opposite and proportional changes in the monetary base, you can get strong inflation pressures. Fortunately, it takes an extended period of such inflation pressures (sustained over 6-12 months) before the implied inflation pressures are actually reflected in price levels. Temporary differences between the actual and implied GDP deflator are not very informative unless they are sustained.

Still, any sustained external pressure on short-term interest rates, even in the range of a quarter-percent or more, would require a rapid contraction in the Federal Reserve's balance sheet, or the upward pressure on velocity would create very strong incipient pressures on inflation.

For example, let's repeat the calculation for the implied GDP deflator, but assume a 3-month Treasury bill yield of 0.35%. In that case, holding the monetary base constant at its present level of $2 trillion, the implied deflator is 2000/[(.094-0.022*ln(0.35))*13,409] = 1.27. Compared with the 1.11 deflator implied by a 0.15% Treasury bill yield, the implied change in prices is about 14.4%.

Because the size of the monetary base has become so extreme relative to historical norms, the likely price pressures in response to even modestly higher short-term interest rates are equally extreme. For example, given the present level of the monetary base, an exogenous increase in short-term Treasury yields to even 1% would imply a GDP deflator of about 1.59, which is about 42.9% higher than present levels. In order to counter such pressure, the Fed would have to contract the monetary base by about $600 billion, from the present level of about $2 trillion to a still bloated but less extreme $1.4 trillion.

A more extreme increase in Treasury bill yields to 4% would imply a GDP deflator of about 2.35, which is more than double the current price level. The implication is that any normalization of interest rates would need to be accompanied by a massive contraction of the Fed's balance sheet in order to avoid inflation, otherwise the collapse in liquidity preference (resulting from the higher interest rates compared to zero interest on base money) would trigger a collapse in the purchasing power of cash.

The main factor that reduces the risk of massive inflation is that short-term interest rates usually respond fairly passively to changes in the monetary base. Absent external pressures on short-term interest rates, the Fed may be able to continue playing at the edge of the proverbial cliff for a while longer.

Still, the absence of such pressures should not be taken as a given. Any external pressures on short-term interest rates would wreak havoc on the stability of monetary policy here. In the face of upward pressures on short-term interest rates, the Fed would have to contract the monetary base in an amount equal and opposite to the implied change in the deflator. For instance, it's easy to show that given present levels of GDP, even a 0.35% Treasury bill yield would be consistent with price stability at a monetary base of $1,750 billion (that is, about $250 billion less than at present).

At the same time, barring external upward pressures on interest rates, a further non-inflationary expansion of the Fed's balance sheet of $400 billion, to $2.4 trillion (as contemplated under QE2), would imply the need for 3-month Treasury yields to fall to just 0.05%. Higher rates would be inflationary, because monetary velocity would not be sufficiently restrained. In effect, a further expansion in the monetary base requires that short-term interest rates decline enough to ensure a significant drop in velocity.

In terms of liquidity preference, a completion of QE2 requires liquidity preference to increase to 16 cents per dollar of nominal GDP. We hit 15 cents at the peak of the credit crisis. To get past that, short-term interest rates will have to decline to the point where there is no competition from interest rates at all, but where the slightest amount of interest rate pressure would either drive inflation higher or force a massive contraction in the Fed's balance sheet to avoid that outcome. Then what?

Again, I should emphasize that even if we observe inflation pressures on the basis of the monetary relationships above, it typically takes an extended period of 6-12 months before those pressures become clearly reflected in price levels (so the relationship between actual and implied inflation is tighter if the data are smoothed over several quarters). In any event, it should be clear that the Fed is operating at an unstable extreme, and further expansion of the Fed's balance sheet will only increase that instability.

Present considerations

What factors could create pressures on inflation? By itself, monetary policy often involves a simple see-saw, where higher monetary base results in lower short-term interest rates, which induce people to hold that additional base money. Historically, both in the U.S. and internationally, the primary source of inflation pressure has been growth in unproductive government spending (i.e. spending that creates demand without materially expanding productive capacity - think Germany paying striking workers in the Ruhr). Now, it's very often true that government spending is actually financed by printing money, but in that case, we've long argued that the fiscal event is what drives inflation. Simply shifting the composition of government liabilities between Treasury debt and money (without changing fiscal policy) generally causes a change in the profile of interest rates: primarily affecting short-term rates to ensure that the new outstanding quantity of base money is held (as we've seen above).

While not all U.S. government spending is unproductive, it is easily seen that the inflation pressures of the late-1960's and 1970's accompanied a period where government spending was sharply expanding as a share of GDP (the 1981-82 recession provoked a final gasp of spending even as inflation receded from its peak). While the disinflation since the early 1980's has had some fits and starts, it is also clear that this period has - until recently - been characterized by relatively stable fiscal policy. From this perspective, the recent explosion of government spending as a share of GDP is a source of longer-term inflation concern.

With regard to the U.S. economy, we continue to observe some surface progress. Barring fresh shocks, our benchmark expectation (based on gradual reversion to potential GDP) would be for job growth averaging about 200,000 per month on a sustained basis, and real GDP growth of about 3.8% annually for several years before slowing. However, that proviso "barring fresh shocks" is my real concern. Nominal GDP may be recovering, but about 10% of that still represents deficit spending. The Fed's balance sheet, as noted here, stretches the limits of monetary policy - risking instability and a lack of robustness to small shocks.

As for the U.S. financial system - particularly major banks - I am continually perplexed by the juxtaposition of tens of millions of underwater mortgages and millions of delinquent and unforeclosed homes, coupled with a set of FASB accounting rules (revised at the height of the recent crisis) that allows these debts to be carried at face value upon the discretion of the banks that report the data. I'll say one thing - it should take less than two seconds of thought to recognize that allowing dividends, bonuses, and other withdrawals of capital - without the requirement that banks mark their assets to market - is quite literally how Ponzi schemes function. We've laid a lovely turf lawn over a toxic waste dump, and are all too willing to assume that the underlying issues have been solved. The FASB and the Fed have turned the U.S. banking system into the Love Canal.

In any event, completing the Fed's planned purchases under QE2 will require a decline in 3-month Treasury bill yields to just 0.05% in order to avoid inflationary pressure. Otherwise, liquidity preference will not expand sufficiently to absorb the addition to base money, even if we assume real GDP growth at a 4% rate. Given the extreme stance of monetary policy, the avoidance of inflationary pressures increasingly relies on a very persistent willingness by the public to directly or indirectly hold the outstanding quantity of base money in the financial system. Small errors will have surprisingly large consequences. This is not a stable equilibrium.

Even With Massive Budget Cuts, U.S. Facing Fiscal Disaster

by John Mauldin:

The Unsustainable Meets the Irresistible

Kyle, Lacy, and David are typically pushed into the bearish category, but (not surprisingly to me) their forecast for the next few quarters is rather strong. None of us would be surprised by a high-3% number for GDP this quarter, and 4% is not out of the question. And we all see GDP tailing off as the year winds down. Inventory builds begin to slow, and in 2012 the 2% payroll holiday goes away. Plus, as I have written and David has noted, the pressure on state and local spending is getting larger with every passing day.
State and local spending is the second biggest component of the economy. The chart below, from David’s letter this week, gives us a visual image of just how large it is. Note that budget deficits at the state and local levels total more than 1% of GDP. Revenues, though, are still off 10% (on average) from where they were at the peak. The “fiscal stimulus” from the US government has run out and states and local communities are having to balance their budgets the old-fashioned way – through spending cuts and increased taxes.
As this budget cutting works its way through the economy, and as inventories are no longer being built (they are already at adequate levels), the growth from the current stimulus (both QE2 and payroll and federal government expenditures) the economy will have to stand on its own in terms of organic growth. And as the year wears on it will become apparent there is less true organic growth than currently meets the eye.

State and Local Spending

A few more thoughts on state and local spending. First, Congress needs to go ahead and authorize a bill allowing states to file for bankruptcy. At the very least, this send s very clear message to the states that the federal government will not come to their aid. It is not fair to ask states that have done what they need to do to keep their fiscal houses in order, to support states that have overspent, typically by trying to fund their pensions and run other well-intentioned but underfunded programs.
Second, states need the ability to force public unions to come to the table. Many states have overpromised, and they are simply in a very deep hole and need concessions. Private workers have had to take the brunt of the recent crisis, and meanwhile government workers get far more on average than private employees.
There is an interesting table in a USA Today story from last year, comparing the compensation of federal and private employees. I am going to put the whole table in this letter and let you quickly scroll down through it. The link to the article is at the end. (Notice that government economists make more than private ones!) Now let me say that I begrudge no one their income. What I am saying is that the disparity, when budgets are tight, between what the private sector must deal with and what the public sector has on its plate, should not be as great as it is.

Job	Federal	Private	Difference
Airline pilot, copilot, flight engineer	$93,690	$120,012	-$26,322
Broadcast technician	$90,310	$49,265	$41,045
Budget analyst	$73,140	$65,532	$7,608
Chemist	$98,060	$72,120	$25,940
Civil engineer	$85,970	$76,184	$9,786
Clergy	$70,460	$39,247	$31,213
Computer, information systems manager	$122,020	$115,705	$6,315
Computer support specialist	$45,830	$54,875	-$9,045
Cook	$38,400	$23,279	$15,121
Crane, tower operator	$54,900	$44,044	$10,856
Dental assistant	$36,170	$32,069	$4,101
Economist	$101,020	$91,065	$9,955
Editors	$42,210	$54,803	-$12,593
Electrical engineer	$86,400	$84,653	$1,747
Financial analysts	$87,400	$81,232	$6,168
Graphic designer	$70,820	$46,565	$24,255
Highway maintenance worker	$42,720	$31,376	$11,344
Janitor	$30,110	$24,188	$5,922
Landscape architects	$80,830	$58,380	$22,450
Laundry, dry-cleaning worker	$33,100	$19,945	$13,155
Lawyer	$123,660	$126,763	-$3,103
Librarian	$76,110	$63,284	$12,826
Locomotive engineer	$48,440	$63,125	-$14,685
Machinist	$51,530	$44,315	$7,215
Mechanical engineer	$88,690	$77,554	$11,136
Office clerk	$34,260	$29,863	$4,397
Optometrist	$61,530	$106,665	-$45,135
Paralegals	$60,340	$48,890	$11,450
Pest control worker	$48,670	$33,675	$14,995
Physicians, surgeons	$176,050	$177,102	-$1,052
Physician assistant	$77,770	$87,783	-$10,013
Procurement clerk	$40,640	$34,082	$6,558
Public relations manager	$132,410	$88,241	$44,169
Recreation worker	$43,630	$21,671	$21,959
Registered nurse	$74,460	$63,780	$10,680
Respiratory therapist	$46,740	$50,443	-$3,703
Secretary	$44,500	$33,829	$10,671
Sheet metal worker	$49,700	$43,725	$5,975
Statistician	$88,520	$78,065	$10,455
Surveyor	$78,710	$67,336	$11,374

Source: Bureau of Labor Statistics, USA Today analysis http://www.usatoday.com/news/nation/2010-03-04-federal-pay_N.htm
You can see in the next graph that this differential has built up over time. It used to be that a federal government job paid less but was more secure. Now it is still more secure but pays about 44% more on average (35% higher wages and 69% higher benefits). (source: Reason magazine)

Further, while there has been a clear drop in private employment, we have seen 10% growth in federal employment (state and local employment was flat through the middle of last year, but is likely to fall this year, with budget cuts).

That clearly implies there is room at the federal level for some “austerity.” The calls for a rollback to the budget and employment levels of 2007 will become more vocal as the set of facts we will address in a moment become evident.
Before we get to that, however, I want to take a side trip. Illinois recently passed a very real tax increase as a way to start the process of dealing with its massive deficits. It did so in a lame duck session of its state legislature, even though the voters had clearly elected a far more fiscally conservative legislature that would not have passed the tax increases.
The response of the governors of Indiana and Wisconsin, their closest neighbors? They immediately suggested to Illinois businesses that they are welcome to come to their states and set up shop and pay less taxes.
Higher taxes are hardly a cure. Look at the migration of businesses from high-tax states to low-tax states. Over the last ten years it has been pronounced. For those who argue that higher marginal taxes don’t make a difference, the facts clearly overrule you. Oregon decided to tax the wealthiest 2% of its citizens. They collected 40% less than they projected, and over 25% of the people they expected to tax somehow “disappeared.” And that is just in the first year. At some point, the “rich” get tired of being in the crosshairs of politicians and repair to more favorable climes.
This is all part of the national conversation we need to have on taxes and spending. That we need a complete tax overhaul, a thorough rethinking of how we raise the monies we need, should be obvious. To hear the “this is dead on arrival” conclusions of the various federal deficit commission reports, from the left and even from Republicans, is disheartening, at least to me. There are a lot of things I do not like in those reports, but they are a starting point for a much-needed national conversation. We are soon going to find ourselves in very deep kimchee, if the report Kyle showed me today is close to right.

QE Policy Meets the Tea Party

Kyle shared with me a presentation by the Lindsey Group called “QE Policy Meets the Tea Party.” It was wide-ranging in scope, but what caught my eye was the table I print below. Larry Lindsey is one of the better economists in the country, a former Fed governor with stints at the White House. I have not met him, but his associate Marc Sumerlin is whip-brilliant. (http://www.thelindseygroup.com/)
America, they assert, is in a fiscal trap due to the low interest rates we currently enjoy. What if I told you we could cut defense and discretionary spending by 20%, put in a two-year pay freeze on federal employees, and go ahead and let the Bush tax cuts on the “rich” expire. Wouldn’t that go a long way to fixing the deficit? The answer is, sadly, likely to be no.
As the table shows, if interest rates go back to their long-term historical average, spending could rise by $800 billion in just 8 years. Even under the more optimistic assumptions of the Congressional Budget Office, it is still $500+ billion. The government debt held by the public would be around 120% of GDP (back of my napkin), or close to what I said last week was completely unsustainable by the Irish. It will be no less so for the US. Spend a few moments with the table, and see how even deep cuts and freezes have so little impact. That is not to say they are not necessary, but this just shows that a much different approach is needed.

What approach might that be? Dealing with entitlements, of course. The very item that most politicians give lip service to but have no real solutions for. But that is a topic for another month’s worth of letters.
The takeaway is that we are on an unsustainable path. Absent something more serious even than what the Lindsey Group has outlined, long before we get to 2019 the bond markets will have taken away our ability to finance our debt at low rates.
Peter Orszag wrote a column in the Financial Times today. (Orszag was the Director of the Office of Management and Budget under President Obama.) His closing paragraph:
“The bottom line is that there may well be U.S. public debt tremors this year, both during federal debate over raising the debt ceiling and with at least a limited number of crises in local and city governments. The bigger problem, though, lies beyond 2011, as the unsustainability of the federal government’s fiscal trajectory becomes increasingly clear. I hope it does not ultimately require a crisis to restore fiscal sustainability at the federal level, but I fear it will.”

A Bug in Search of a Windshield

One of my speech lines that usually gets a laugh (although I am not sure how it will go over in Japan next month) is that Japan is a bug in search of a windshield. In today’s FT there is an article quoting an interview with the new Japanese finance minister, a rather surprise appointment from the opposition party and a budget hawk. Quote:
“ ‘We face a dreadful dream that one day the long-term interest rate might rise,’ Kaoru Yosano, the new minister for economic and fiscal policy, told the Financial Times. Japan has hit a ‘critical point’ where it risks losing investor confidence if politicians fail to reach agreement on how to rein in the ballooning national debt, a cabinet minister has warned.”
Greece. Ireland. Japan. They are coming to the end of their ability to raise debt at an affordable level. There will be defaults in one form or another. Whether you call it restructuring or adjustments or printing money, it will happen.
If the US does not get its act together, we will soon be trying to avoid the windshield of the bond market, which will be coming at us faster than we can swerve to avoid it.
On a more optimistic note, I have just returned from giving a speech in Winnipeg. In the mid-’90s, Canada was in much worse shape than the US is in today. They made the tough choices and have since done very well. So has Sweden. We do not have to become Argentina or what will soon be Japan. Let us hope that we make the tough choices and avoid that windshield. The world does not want to suffer through a crippled US economy and government. That is almost unthinkable. So we must start to think the unthinkable and hedge our bets. Just in case.

Obama's Budget Guru Orszag Warns of U.S. Debt Crisis

I thought it interesting that he said fiscal sanity can't be restored without tax increases on those who earn LESS than $250,000 per year!

by Peter Orszag in FT:

America is experiencing the hard slog of recovering from the financial crisis. Prospects have turned more positive over the past two months. But a year ago growth was picking up too – and then it stalled, at about the same time Greece’s fiscal problems infected the global economy. The question now is whether a home-grown fiscal crisis could derail this year’s rebound.
Some analysts have reached dramatic conclusions, suggesting the near-certainty of hundreds of billions of dollars in government defaults within the US over the next 12 months. Such predictions will undoubtedly turn out to be substantially overblown. Yet the rejection of one extreme is not the affirmation of the other. International investors would be wise to pay close attention to fiscal trends within the US.
The severity of fiscal risk varies considerably depending on which level of government is under discussion. At the federal level the combination of ongoing weakness in the labour market and large structural budget deficits means that the right policy mix should be more stimulus now and much more deficit reduction, enacted now, to take effect in two to three years. Policymakers have acted on the first part, most prominently through the payroll tax holiday announced in December – one of the factors making the short-term outlook more promising.
They have not, however, undertaken the harder work needed to reduce projected deficits over the next decade. Most fundamentally it is difficult to see how the medium-term federal deficit can be reduced to sustainable levels without additional tax revenues from those earning less than $250,000 a year. And yet it is equally difficult to see the political system embracing that reality without being forced to do so by the bond market.
If policymakers will not act before we have a fiscal crisis at the federal level, a fiscal crisis we will ultimately have. Until then we will see a microcosm of this broader problem arise dur­ing debate about increasing the federal debt limit, later this spring. This will be contentious. We may have to experience some temporary market turbulence before it is resolved.
At the level of state governments, revenue remains more than 10 per cent below pre-recession levels. Public pensions are also significantly underfunded, leading to well-publicised concerns about debt defaults. As a recent paper from the Centre on Budget and Policy Priorities correctly argues, states will have to take immediate and painful action to reduce their operating deficits, while also gradually closing their pension gaps. Outright defaults are not likely, but these fiscal problems require concerted effort and political will, especially in larger states such as California and Illinois. This will impose some macroeconomic drag on the US economy as taxes are raised and spending is cut.
Facile analogies to indebted European countries, or the US mortgage crisis, however, are both misplaced. Although comparisons of debt across different levels of government are fraught with difficulties, US state debt levels are nowhere close to those of Greece. Debt service obligations are similarly much lower.
Unlike in the mortgage crisis, state debt has not generally been repackaged into opaque, complex securities. Furthermore, and contrary to what many pundits suggest, state governments cannot simply declare bankruptcy. Bondholders are also privileged creditors in almost all states. It is thus difficult for states to default: they would generally have to stop paying employees before they stopped making debt payments.
At the local level, however, the situation is different. Many US cities can declare bankruptcy – and given their numbers a severe crisis in at least one major city is both feasible and quite possible. As a thought experiment, take the top 30 or so cities. Assume any one has only a 2 per cent probability of a severe problem. Then the probability that at least one experiences a crisis is almost 50 per cent.
In such a city-level crisis, the state government could help – as has already occurred in Harrisburg, Pennsylvania. States would be wise to consider in advance their options in this kind of crisis scenario. But even if the relevant state government decides not to step in, and a city is forced to default, the direct macroeconomic consequences are unlikely to be substantial – unless that default triggers others to follow. In this scenario the possible contagion effect among investors in the debts of different cities is a crucial consideration.
The bottom line is that there may well be US public debt tremors this year, both during federal debate over raising the debt ceiling and with at least a limited number of crises in local and city governments. The bigger problem, though, lies beyond 2011, as the unsustainability of the federal government’s fiscal trajectory becomes increasingly clear. I hope it does not ultimately require a crisis to restore fiscal sustainability at the federal level, but I fear it will.
The writer is a vice-chairman of global banking at Citigroup and former director of the US Office of Management and Budget under Barack Obama

Stocks Still Sinking -- Kind of Like California

I'm surprised the bulls have reversed it yet. 

Jerry Brown, California’s governor, declared a state of fiscal emergency on Thursday for the government of the most populous US state to press lawmakers to tackle its $25.4 billion budget gap.
Democrat Brown’s declaration follows a similar one made last month by his predecessor Arnold Schwarzenegger, the former Republican governor.

Democrats who control the legislature declined to act on Schwarzenegger’s declaration, saying they would instead wait to work on budget matters with Brown, who served two terms as California’s governor in the 1970s and 1980s.

Existing Home Sales Hit Lowest of Recession

WASHINGTON (AP) - The number of people who bought previously owned homes last year fell to the lowest level in 13 years, and economists say it will be years before the housing market fully recovers.
High unemployment and a record number of foreclosures are deterring potential buyers who fear home prices haven't reached the bottom. Job growth is expected to pick up this year, but not enough to raise home sales to healthier levels.
"We built too many houses during the boom, and now after the crash, it will take us a long time to get back to normal," said David Wyss, chief economist at Standard & Poor's in New York.
The National Association of Realtors reported Thursday that sales dropped 4.8 percent to 4.91 million units in 2010. That was slightly fewer than in 2008, which had been the weakest year since 1997.
The poor year for sales did end on a stronger note. Buyers snapped up homes at a seasonally adjusted annual rate of 5.28 million units in December, the best sales pace since May and the 12.8 percent rise from November was the biggest one-month surge in 11 years.
Gains in mortgage rates may have spurred some fence-sitters to buy homes in December before rates moved higher, analysts noted.
The increase was an encouraging sign after a dismal year for home sales, said Mark Zandi, chief economist at Moody's Analytics. But he cautioned against raising expectations for a rapid recovery in housing.
"The job market is still very weak, and unemployment is very high. Until we get more jobs, people will be reticent about buying homes," he said.
Zandi said home prices would fall another 5 percent this year. Sales of previously occupied homes would likely exceed 5 million. That's a slight improvement from last year, he said, but it will probably take until 2013 or 2014 for sales to reach a healthy level of 6 million units a year.
Home sales will benefit from an improved hiring market. Many economists predict employers will double the number of jobs added this year compared with 2010. A reason for more optimism is a decline in the number of people applying for unemployment benefits over the past four months.
Last week, applications fell to a seasonally adjusted 404,000, the Labor Department said. That followed a spike in applications in the previous week, which is typical after the holidays end and employers let temporary workers go. Even with the holiday bump and this past week's decline, the latest figures were only slightly higher than the 391,000 level reached last month - the lowest in more than two years.
Fewer than 425,000 people applying for benefits is considered a signal of modest job growth. Economists say applications must fall consistently to 375,000 or fewer to substantially reduce the unemployment rate.
Still, the unemployment rate is not expected to fall much below 9 percent this year. And the housing market cannot fully recover until the glut of foreclosed homes is cleared.
Last year, a record 1 million homes were lost to foreclosures, and foreclosure tracker RealtyTrac Inc. predicts 1.2 million more will be lost this year.
Foreclosures or distressed sales such as short sales - when lenders let homeowners sell for less than they owe on their mortgages - are forcing home prices down in many markets. That has made it difficult for some potential buyers looking to upgrade, because they would have to accept less money to sell their current home.
Even historically low mortgage rates have done little to boost the sales.
The average rate on a 30-year fixed mortgage rose to 4.74 percent this week, Freddie Mac said Thursday. That's up from a 40-year low of 4.17 percent in November. The average rate on the 15-year loan, a popular refinance option, slipped to 4.05 percent last week. That's nearly half a point higher than the 3.57 percent rate in November - a 20-year low.
For December, sales rose in all parts of the country, with the strongest gain a 16.7 percent increase in the West. Sales rose 13 percent in the Northeast, 10.1 percent in the South and 11 percent in the Midwest.
The median price for a home sold in December was $168,800, down 1 percent from a year ago.

Dollar Slash and Burn

Confirmed -- New Dollar Downtrend! No wonder commodity prices are still well supported and moving higher!

Roaring Rally!

It's interesting to me that the futures rose overnight, and initially at the open, but have started to fall now. It will be amusing to see what happens the rest of the day from here.

World Going Crazy for Cocoa!

...And Hurts Some More!

Amazing that the Dow is down only a few points, while the S&P 500 has fallen off a cliff!

Housing Hurts!

We're back down again!

from Bloomberg:

Builders began work on fewer homes than projected in December, a sign the industry that triggered the recession continued to struggle more than a year into the U.S. economic recovery.
Housing starts fell 4.3 percent to a 529,000 annual rate, the lowest level since October 2009, Commerce Department figures showed today in Washington. The median forecast in a Bloomberg News survey called for a 550,000 rate. A jump in building permits, a proxy for future construction, may reflect attempts to get approval before changes in building codes took effect at the beginning of this year.
Companies like KB Homes and Lennar Corp. project demand will be slow to rebound as elevated unemployment and mounting foreclosures discourage buyers. While low borrowing costs and falling prices are helping revive sales from last year’s post tax-credit slump, Federal Reserve policy makers are concerned housing may undermine the economic expansion.
“With sales still near record lows and a lot of unsold properties in the market, there’s very little reason for builders to add more homes to the supply,” said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto, who had forecast starts would drop to a 527,000 rate. “Housing remains a key downside risk to the economy.”

The Daily Shrug Begins

Despite the almost universally-bad news today, the daily shrug-it-off begins!

Corn Plunges Despite Fundamentals

No doubt sympathy with stocks is playing a role!

from Bloomberg:

Corn rose for a fifth day to a 30- month high in Chicago and wheat climbed amid shrinking global stockpiles. Soybeans advanced on speculation that a strengthening yuan may spur imports into China.
World corn supplies will fall 14 percent this year and wheat inventories will drop 9.8 percent, the U.S. Department of Agriculture said last week. Prices also gained as the dollar weakened, making U.S. crops cheaper in terms of other monies. The yuan advanced to a 17-year high against the U.S. currency yesterday.
“The fundamentals are all in place for a very strong rally all of this year,” said Gary Mead, an analyst with VM Group in London. “The USDA figures sent a bolt of lightning through the market because the stocks-to-use ratio is going to be tight indeed through the end of August. And we have a lot of weather uncertainties to get through.”
Corn for March delivery gained 0.9 percent to $6.655 a bushel at 11:27 a.m. London time on the Chicago Board of Trade. The grain touched $6.6625, the highest price since July 17, 2008. March-delivery soybeans added 1.2 percent to $14.3025 a bushel.
Chinese President Hu Jintao met yesterday with U.S. President Barack Obama, boosting hopes that trade relations recently under strain will improve, Chung Yang Ker, an analyst at Phillip Futures Pte, said by phone from Singapore.

More Limit Up Cotton

Back to "Blame the Speculators"!

my post on Zero Hedge this morning:

I guarantee that will cause HIGHER prices, not lower ones. Speculation is not the root cause; it is a symptom of problem, not the root cause. If you hack at the branches (speculators), the root cause (Fed's easy money) remains intact. History shows that by shrinking the size and liquidity of the market, it also shrinks the supply. This eventually results in HIGHER prices. Hugo Chavez has tampered endlessly with attempts to lower food prices in Venezuela, but supplies keep shrinking and prices keep going higher. The antidote to speculative influence is to increase the size and liqudity of the market, not shrink it.
The Hunt Bros' attempt to corner the silver market was a good example. When the market was small, their wealth could easily manipulate the market. But as prices rose, more and more people entered the market. Even housewives were selling their silver at pawn shops. But as the market size and liquidity rose, the Hunts lost control and the market crashed.
History shows that speculators are among the first to perceive an overbougght market and short it. CFTC and other studies have also repeatedly shown that speculators FOLLOW the market, not lead it. CFTC studies have also repeatedly shown that speculators constitute only about 12-18% of total trading volume, even during the commodity boom of 2008. In fact, CFTC studies showed that speculative trading during 2008 was LESS than during 2006, when commodity prices were supressed, as a percentage of total open interest. Studies have also repeatedly shown that non-exchange traded commodity prices rise HIGHER than non-futures traded commodities. If the presence of speculative funds were the real cause, this would not be the case. Those who blame speculators for high prices also forget that by necessity, speculators MUST offset their positions with an opposing position in order to exit the market and take profits. Hedgers don't because they take physical possession. Thus, by definition, speculators negate their effect on the market when they exit their positions. They have no choice! They have to!
The true net cause of high commodity prices is still the Fed's easy money policies that buoy up all risk assets. As long as the Fed is ramping up the stock market, commodity prices will too! Fed policy doesn't just increase the supply of funds. It is also suppressing interest rates that would otherwise give investors a viable alternative and reasonable returns. By denying investors these reasonable returns, it forces them to buy more speculative assets like commodities in order to try to preserve the value of their capital in an inflationary, dollar devaluative environment. Fed policies literally feed the inflationary monster by incentivizing risk assets more than would otherwise be warranted.
By shrinking the size and liquidity of commodities markets, we shoot ourselves in the foot because large investors -- the blue whales of the investment world -- will have GREATER influence on markets, and they will simply move their funds to other commodities exchanges in other countries, where their money is welcome. This thus causes capital flight, thus devaluing the Dollar even more, and thus amplifying the very effect that caused prices to rise in the first place. A blue whale has a lot more influence in a fish pond than the Pacific Ocean. It's the same in the financial markets. The larger and more liquid the market, the less influence the blue whale has. Limiting the market size and participation will drive prices HIGHER, not lower.
These are only a few of the reasons why all attempts to control prices by controlling markets lead to HIGHER prices, not lower ones!

Fed's Money Creation to Have Terrible Consequences

This printing money is going to lead to huge trouble. It’s going to lead to higher interest rates. It’s going to lead to more inflation and at some point there is going to be a train wreck in the currency and the bond market." Market commentator and money manager Bill Fleckenstein

Hoisington: Low Growth Ahead

Growth Recession Continues
Factoring in a 4% Q4 growth rate, the U.S. economy expanded by 3% in real terms from the 4th quarter of 2009 through the 4th quarter of 2010. Despite this rise in GDP, the unemployment rate remained stubbornly high at 9.6% in the last quarter of 2010, only slightly lower than the 10% rate it averaged in the same quarter one year ago. Positive real GDP growth with high unemployment is the definition of a growth recession. An even slower growth rate of real GDP should be recorded over the next four quarters, suggesting the unemployment rate will be essentially unchanged a year from now. As we have noted previously, this modest expansion is due to the significant over-indebtedness of the U.S. economy. We see seven main impediments to economic progress in 2011 that will slow real GDP expansion to the 1.5%-2.5% range.
First, fiscal policy actions are neutral for 2011. Second, state and local sectors will continue to be a drag on the economy and labor markets in 2011. Third, Quantitative Easing round 2 (QE2) will likely produce only a slight economic benefit as the Fed continues to encourage additional leverage in an already over-indebted economy. Fourth, while consumers boosted economic growth in the second half of 2010 by sharply reducing their personal saving rate, such actions are not sustainable. Fifth, expanding inventory investment, the main driver of economic growth since the end of the recession in mid-2009, will be absent in 2011. Sixth, housing will continue to be a persistent drag on growth. Seventh, external economic conditions are likely to retard U.S. exports.
Fiscal Policy in Neutral
The recent tax compromise between the President and Congress merely extended existing tax rates for another two years and provided a transitory 2% reduction in social security tax withholding. Personal taxes, including federal and non-federal, rose to 9.44% of personal income in November, up from a low of 9.1% in the second quarter of 2009 (Chart 1). Even with the tax compromise this effective tax rate will continue moving higher as a result of higher state and local taxes. Economic research has documented that temporary changes in tax rates are far less beneficial than permanent ones since consumers spend on the basis of permanent income. Higher outlays for unemployment insurance were also legislated, but these were negated by cuts in other types of spending. Federal spending through early March will mirror its pace in fiscal 2010, and the rest of the 2011 budget will decline slightly in real terms. Therefore, total real federal expenditures are likely to contract in real terms this year.
Chart 1

If fiscal policy becomes focused on long-run considerations (e.g. deficit reduction) economic conditions will improve over time. But, if fiscal policy remains focused on short-term stimulus, the economy's prolonged under-performance will persist since the government expenditure multiplier is less than one, and possibly close to zero.
The recent scientific work on the expenditure multiplier is aligned with the Ricardian equivalence theorem as well as the views of the Austrian economists who continued to follow Ricardo even when the Keynesian revolution was ascendant. Economist Gary Shilling made this point very well in his outstanding new book, The Age of Deleveraging – Investment Strategies for a Decade of Slow Growth and Deflation.
Dr. Shilling's analysis of the simplified and unsubstantiated Keynesian multiplier (p.216) still taught in many colleges and universities is extremely insightful. ÒBut the Austrian School of economists like Friedrich Hayek and Ludwig von Mises believed that the economy is much more complicatedÉ The Austrian view suggests that the government spending multiplier may be only 1.0 and that there are not any follow-on effects. More recent academic studies indicate that the multiplier is less than 1.0, and perhaps much less.Ó
After recognizing the difficulty of calculating the multiplier, Dr. Shilling writes, ÒAlso, the inherent inefficiencies of government reduce the effects of deficit spending and lower the multiplier.Ó Thus, if steps are taken to reduce deficit spending, the economy's growth rate will recover after the initial transitory negative impact as additional resources are provided to the private sector.
State and Local Governments Drag
Municipal governments face substantial cyclical deficits and significant underfunding of their employee pension plans. In addition, municipal bond yields rose sharply in the second half of 2010, increasing borrowing costs, probably an unintended consequence of QE2. The municipal bond market proceeds are used primarily for funding capital projects, which suggests that such projects will be delayed. State and local governments typically do not undertake capital projects freely when they have large cyclical deficits.
To reign in these financial imbalances, state and local governments have five choices: (1) cut personnel; (2) reduce expenditures including retirement benefits; (3) raise taxes; (4) borrow to fund operating deficits; or (5) declare bankruptcy. All retard economic growth. Any trend toward increased bankruptcy would raise caution in the broader municipal market and add to higher borrowing costs. Raising taxes may give bondholders more confidence, but such actions can fail to raise new revenue as slower economic conditions retard spending. The demographic trends in the decennial census also show that people are increasingly moving to low tax regions, contributing to worsening fiscal imbalances from the exited areas.
QE2's Problems
Clearly, Fed actions have affected stock and commodity prices. The benefits from higher stock prices accrue very slowly, are small, and are slanted to a limited number of households. Conversely, higher commodity prices serve to raise the cost of many basic necessities that play a major role in the budget of virtually all low and moderate income households.
For example, in late 2010 consumer fuel expenditures amounted to 9.1% of wage and salary income (Chart 2). In the past year, the S&P GSCI Energy Index advanced by 14.6%. Since energy demand is highly price inelastic, it seems there is little alternative to purchasing these energy items. Thus, with median family income at approximately $50,000, annual fuel expenditures rose by about $660 for the typical family. In late 2010, consumer food expenditures were 12.6% of wage and salary income. In the past year, the S&P GSCI Agricultural and Livestock Commodity Price Index rose by 40%. If we conservatively assume that just one quarter of these raw material costs are ultimately passed through to consumers, higher priced foods will have added another roughly $626 per year of essential costs to the median household budget. These increased costs could be considered inflationary, however, with wage income stagnant, higher food and fuel prices will act like a tax increase. Indeed, the approximately $1300 increase in food and fuel prices is equal to 2.6% of median family income, an amount that more than offsets the 2% reduction in the social security tax for 2011.
Chart 2

Reflecting the inflationary psychology of the higher stock and commodity prices, mortgage rates and municipal bond yields have risen significantly since QE2 was first proposed by the Fed chairman, increasing the cost and decreasing the availability of credit for two sectors with serious underlying problems. Also, Fed policy has pushed most consumer time, money market, and saving deposit rates to 1% or less, thereby reducing the principal source of investment income for most households. Clearly the early read on QE2 is negative for the economy.
Substitution Effects
In a November speech in Frankfurt, Germany, Dr. Bernanke said that the use of the term Òquantitative easingÓ to refer to the Federal Reserve's policies is inappropriate. He stated that quantitative easing typically refers to policies that seek to have effects by changing the quantity of bank reserves. These are channels that the Chairman considers relatively weak, at least in the U.S. context. Dr. Bernanke goes on to argue that securities purchases work by affecting yields on the acquired securities in investors' portfolios, via substitution effects in investors' portfolios on a wider range of assets. This may well be true, but the substitution effects are just as likely to be detrimental (i.e. the adverse implications of increasing commodity prices and rising borrowing costs for some and reducing interest income for others). Importantly, the Fed has no control over these substitution effects.
In his reputation-establishing 2000 book, Essays on the Great Depression, Dr. Bernanke argues that Òsome borrowers (especially households, farmers and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe, but not unprecedented downturn of 1929-30 into a protracted depression.Ó Interestingly, when QE2 drives up borrowing costs for homeowners and municipalities, thereby restricting credit, the Fed is creating (according to Dr. Bernanke's book) the exact same circumstance, albeit on a reduced scale, that helped cause the great depression---rather bizarre!
Liquidity Mistakes
For the past twelve years the Fed's policy response to economic problems has been to pump more liquidity. These problems included: (1) the failure of Long Term Capital Management in 1998; (2) the high tech bust in 2000; (3) the mild recession that began with a decline in real GDP in the fall of 2000; (4) 9/11; (5) the mild deflation of 2002-3; (6) the market crisis and massive recession and housing implosion of 2007-9; and now, (7) the lack of a private-sector, self-sustaining recovery.
The Fed diagnosed each of these events as being caused by insufficient liquidity. Actually, the lack of liquidity was symptomatic of much deeper problems caused by their own previous actions. The liquidity injected during these events led to a series of asset bubbles as the economy utilized the Fed's largesse to increase aggregate indebtedness to record levels. The liquidity problems arose as the asset bubbles burst when debt extensions could not be repaid and generally became unmanageable. Each succeeding calamity or bust reflected reverberations from prior Fed actions.
While governmental directives to Fannie and Freddie to increase home ownership clearly also played a role, the Fed supported this process by providing excessive liquidity to fund the housing bubble as well as other unprecedented forms of leveraging of the U.S. economy. The heavy leveraging and the associated asset bubbles, however, produced only transitory and below trend economic growth. Similarly, like its predecessors, QE2 is designed to cure an over-indebtedness problem by creating more debt.
In addition to failing to revive the economy permanently, major unintended consequences have arisen. The LTCM bankruptcy created a $3 billion loss, a very modest amount in view of the sums required by subsequent bailouts. The Fed's reaction to LTCM served to give market participants a signal that the Fed would back-stop those regardless of whether they engaged in or enabled bad behavior. Also, Fed actions have conditioned Wall Street to seek Fed support whenever stock prices come under downward pressure. In fact, the process of leaking out QE2 began in the midst of a stock market sell off.
Well-intentioned actions to promote growth and fine tune the economy by micromanagement have instead produced failure. Although the Fed had little choice in massively supporting financial markets in 2007/8, no Fed intervention would have been a more long-term productive stance in the previous economic events. QE2 is another example of flawed Fed policy operations.
The Saving Rate Decline
In the second half of 2010, real GDP grew at an estimated 3.3% annual rate (assuming the fourth quarter growth rate was 4%), up from 2.7% in the first half of the year. Transitory developments in two of the most erratic and unpredictable components of the economy---the personal saving rate and inventory investment---accounted for all of this acceleration.
From 6.3% in June 2010, the personal saving fell by a significant 1%, to 5.3% in November (Table 1). Consumer spending is slightly in excess of 70% of real GDP. Without the one percentage point reduction in the personal saving rate, the second half growth rate would have been 2.6%, a shade slower than the first half growth pace, and materially less than the presumed second half growth rate.
Table 1

When job insecurity is high, and defaults, delinquencies and bankruptcies are at or near record levels, a drawdown in the saving rate would seem to be an unlikely event. This development is certainly viewed favorably by retailers but the issue is whether the economy's future is better served by using the funds to make mortgages current, pay other debts and prepare consumers for potential emergency needs. Thus, the lowering of the saving rate is similar to running monetary and fiscal policy to meet short-run needs while ignoring long-term consequences.
Inventory Reversal
Inventory investment was the main driver of economic growth since the recession ended in mid-2009. Based on published data, real GDP grew at a 2.9% annual rate over this span. However, real final sales, which excludes inventory investment from GDP, increased at a paltry 1.1% pace. In the third quarter, inventory investment surged to 3.7% of GDP while preliminary fourth quarter figures on retail, wholesale and manufacturing inventories indicate this figure might have reached 4% (Chart 3). In the final quarter of the recession, inventory investment was -5.1% of GDP. Since 1990, the period of modern inventory control mechanisms, inventory investment averaged only 1.1%. At a minimum, the dominant source of aggregate economic strength will not repeat in 2011.
Chart 3

Housing Drag Persists
Housing will remain a drag on economic activity in 2011. Prices have re-accelerated to the downside over the past four months, as mortgage yields have risen and the housing overhang has increased. The housing overhang, as explained by Laurie Goodman writing in the Amherst Mortgage Insight, "is not caused solely by the number of non-performing loans that exist in the market. The problem also includes the high rates at which re-performing loans are re-defaulting, along with the relatively high rates at which deeply underwater loans that have never been delinquent are running two payments behind for the first time."
Another major problem is that home prices are still too high. An excellent and well-researched study by Danielle DiMartino Booth and David Luttrell in the December 2010 Economic Letter from the Dallas Fed documents this issue very authoritatively. Booth and Luttrell write, "As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85% to their highest level in August 2006. They have since declined 33 percentÉ In fact, home prices still must fall 23% if they are to revert to their long-term mean."
From the standpoint of most households, the home is the main component of wealth, not stock market investments. The continuing drop in housing prices serves to underscore the ill advised and likely temporary drop in the personal saving rate that was so critical to economic performance late last year.
Adverse Global Considerations
The global economy since 2009 may be referred to as a two-speed recovery, with China, India, Brazil, and other emerging economies at the high speed and the U.S. and Europe at the slow speed. That pattern is likely to continue, but with an important difference. China, India, and Brazil are likely to slow adversely affecting the U.S. and Europe. Thus, the two-speed recovery will continue, but with the entire world growing at a much more modest pace. Two major considerations point to this outcome. First, the higher food and fuel prices discussed earlier will serve to significantly depress growth in countries like China, India and Brazil where food and fuel are known to be a much higher percentage of household budgets. Already reports have surfaced from international agencies on the growing adverse consequences of higher food prices, and social unrest has also been witnessed on a limited basis.
Second, Chinese economic policy is designed to slow growth and reduce inflationary pressures. Although the People's Bank of China (PBoC) has already taken several actions to contain surging inflation, more steps may be needed. In China, as elsewhere, inflation is a lagging indicator. It is worth considering that the PBoC has never been able to engineer a soft landing, which suggests that ultimately a downturn in China may be greater than the prevailing consensus.
Thus, changing global conditions should serve to moderate U.S. exports. Ironically, the U.S. current account deficit still may continue to improve. A stabilization of the saving rate will reduce U.S. imports, while a higher saving rate will cut imports significantly. Already this two-speed global economy has resulted in a reduction in the U.S. current account deficit of approximately 3% of GDP (Chart 4). A continuation of this trend will serve to underpin the value of the dollar, which rose in 2010. The firm dollar, in turn, will serve to keep U.S. disinflationary trends intact.
Chart 4

Bond Market Conditions
In spite of the adverse psychological reaction to the QE2, long Treasury bond yields dropped to 4.3% at the end of 2010, down 30 basis points from the close of 2009, producing a total return of slightly more than 10% for a portfolio of long Treasury and zero coupon bonds. The problematic economic environment and its depressive effect on inflation suggests long Treasury bond yields could easily decrease another 30 basis points in 2011, which would produce another double-digit rate of return for a similar portfolio. The probabilities of even lower yields are significant.

More Meltup

The Fed is fulfilling its new, self-appointed mandate of creating a permabull in the stock market.

Europe Worries About China as Creditor

from Ambrose Evans-Pritchard

Herman Van Rompuy, Europe's president, said during a visit to Downing Street that the Chinese may have "political" thoughts in the back of their minds for coming to Europe's help, and gave a strong hint that they are also engaging in currency manipulation.

"When they buy euros, the euro becomes stronger and their currency a little bit weaker. That is not neutral in regard to their competitive position. But I go no further in this topic. It could be too delicate," he said.

Mr Van Rompuy nevertheless welcomed the latest purchases of bonds from the eurozone periphery as a valuable gesture of support. "They invested even in some weak countries, so they are very confident in the solvency of some countries," he said.

China has emerged as the transforming force in the eurozone debt crisis over recent days, pledging to use part of its €2.87 trillion (£1.82 trillion) reserves to safeguard global stability. The question is whether the Communist regime is hoping to extract strategic concessions in exchange.

The footsteps of a giant creditor were clearly felt in Portugal's bond markets on Wednesday, and again on Thursday in Spain and Italy. Madrid sold €3bn of five-year debt at 4.54pc, a full percentage point jump from November but still below the danger level. Italy also enjoyed a benign auction.
The exact role of China is unclear. Chinese vice-premier Li Keqiang promised to buy Spanish debt during a visit to Madrid last week, reportedly up to €6bn (£5bn).
China was the secret buyer in a private placement of €1.1bn of Portuguese debt last week, according to the Wall Street Journal. Finance minister Fernando Teixeira dos Santos said China "may well have been" a key buyer in this week's debt auction.
China was not the only force at work. Traders say the European Central Bank (ECB) acted aggressively behind the scenes, calling some 20 dealers to buy Portuguese debt in the secondary market.
This created what amounted to a "short-squeeze" in Portuguese bonds just before auction, causing spreads to tighten dramatically and inflicting damage on market makers acting in good faith. City sources say this has caused some bitterness.
Charles Grant, head of the Centre for European Reform and author of a book on EU-China relations, said China's top goal is to secure an end to the EU arms embargo, imposed after the Tiananmen Square massacre in 1989. It rankles as humiliating treatment for a global superpower that has since changed profoundly.
The EU has refused to move on the sanctions until China ratifies the International Covenant of Civil and Political Rights, and China's arrest of Nobel peace dissident Liu Xiaobo has further complicated matters.
Yet Brussels has suddenly begun to shift gear. Baroness Ashton, the EU's foreign policy chief, said the embargo is damaging EU-China ties and called for new thinking to "design a way forward".
Mr Grant said Britain, France and Germany are all wary of giving ground, cleaving closely to US policy. Washington views China's growing military might as a strategic threat to the Pacific region. There have already been hot words over the South China Sea, and the Pentagon claims that China has an "operational" ballistic missile able to sink aircraft carriers at long range.
A WikiLeaks cable from the US embassy in Beijing last January cites the EU's mission chief, Alexander McLachlan, saying Spain had tried to curry favour with Chinese leaders, "seeking advantage at other EU states' expense". He said China was fully aware of Madrid's game but was exploiting intra-EU divisions to gain leverage.
China's second goal is to secure market economy status from the EU. This would make it much harder for the EU to impose anti-dumping measures against Chinese imports. As it happens, the EU has just lifted its punitive tariff on Chinese shoes.
Mr Grant said Beijing will not risk much cash to woo Europe. "They are very hard-nosed. They may splash some money around for goodwill but they are not going to waste the hundreds of billions that may be needed. Nothing short of meaningful action by Europe's leaders can genuinely stabilise the eurozone," he said.
China's sovereign wealth funds, including the central bank's exchange fund SAFE, have been severely criticised at home for losing money on US investment banks during the credit crisis, or on dollar losses from US Treasury debt. They will be careful about fresh risks in euroland.
"It is debatable whether China would actually be willing to become buyer of last resort of the debt of a country close to default," said Julian Jessop from Capital Economics. "Chinese officials are acutely aware of past losses and will not want to be seen to risk their peoples' capital on a lost cause. Their actions frequently fall short of expectations raised by their words."
Simon Derrick, from the Bank of New York Mellon, said that China must find somewhere to recycle its fresh reserves or lose control of its own currency. It is already sated with US assets. Holdings are 65pc in dollars, 26pc in euros, 5pc in sterling and 3pc in the yen.
"They may start buying some emerging market bonds but basically the only place they can go is into euros, and buying €6bn of Spanish debt is a good investment if it helps protect their other euro assets," he said.
Mr Derrick said Beijing appears to take the view that the ECB's monetary policy is fundamentally more rigorous than the money-printing ventures of the US Federal Reserve. "The Chinese have made it clear that they don't see any meaningful shift in US policy."
In the global beauty contest, Europe's debt still looks less ugly than the main alternative.

Could the Fed Go Bust?

from Reuters:

With the U.S. unemployment rate at 9.4 percent and only tentative signs that businesses are beefing up hiring, Fed officials, including Chairman Bernanke, see a duty to prevent a further deterioration of economic conditions -- and have signaled a readiness to use all the tools at their disposal.
Last November, as the economic recovery appeared to falter, the Fed said it would buy a new round of $600 billion in Treasury securities through June of this year. That's on top of the $1.7 trillion in Treasuries and mortgage-backed securities it had purchased in response to the financial crisis.
Still, the pitfalls of the Fed's approach are almost as numerous as the lending facilities it undertook to stem the crisis. Perhaps most daunting, the Fed's purchases of Treasury debt and mortgage-backed securities have effectively turned it into a mammoth investor -- a thoroughly undiversified one.
"The biggest risk is losses on its portfolio on long-term debt if inflation rises," said Alan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh.
QUANTITATIVE TEASING
That threat is already apparent in the Fed's latest round of bond buying, or so-called quantitative easing. According to calculations by Reuters Insider credit analyst Ed Rombach two weeks ago, the average duration of the Fed's new portfolio of bonds is just under 5 years, and every 1-basis-point rise in 5-year to 6-year Treasury yields results in a loss of about $65 million.
The Fed is sitting on paper losses of about $2.3 billion on the purchases of U.S. Treasuries it made from November 12 until late last week, according to an analysis by Reuters Insider.
The Fed is also vulnerable to losses through its so-called Maiden Lane portfolios, a collection of investments it acquired when it brokered J.P. Morgan Chase's takeover of a floundering Bear Stearns and bailed out failed insurer AIG.
The portfolio will likely generate losses, according to many analysts. Still, the total Maiden Lane portfolio amounts to just $66 billion, a small slice of the Fed's growing pie of securities.
For most Fed officials, a concern over credit losses would be a luxury compared with the risk they see as predominant: that the economy will not grow quickly enough to return more than 14 million unemployed Americans to work, and inflation so low that it leaves the country exposed to possible deflationary shocks.
"The risks are worthwhile given that the economy would be in the toilet if the Fed never did anything to expand its balance sheet," said Michael Feroli, chief economist at JP Morgan and a former New York Fed staffer.
Feroli does not believe asset sales will be a primary avenue for the Fed's exit. Indeed, Bernanke appears to think the ability to raise interest rates on bank reserves might prove the most effective way to withdraw stimulus. But even that tool is not without its mechanical difficulties.
The problem lies in the basic workings of fixed income. By definition, bond prices decline when their yields or interest rates go up. That means that as the economy recovers and pushes inflation higher, the Fed will move to increase interest rates, pushing down the value of its giant bond portfolio.
"What would the international reaction be if the Fed suddenly had to go and be recapitalized?" said Bob Eisenbeis, chief monetary economist at Cumberland Advisors and a former head of research at the Atlanta Fed. "I don't think that would bode well for Treasuries, or for the dollar, or anything else. It would be embarrassing."

Debt Ratings Warns U.S. of Potential Disaster

With attention focused on sovereign-debt worries in Europe, two major credit-rating firms reminded investors again that the U.S. has debt problems of its own.

Investors bought Treasury debt nonetheless, ignoring the comments, which echoed prior statements by the companies and may still be months or years away from having any practical meaning.
"The warning on the U.S. rating is well-founded," said Brian Yelvington, chief fixed-income strategist at Knight Capital. "However, it will probably fall on deaf ears until the peripheral Europe story plays out."
Moody's Investors Service said in a report on Thursday that the U.S. will need to reverse the expansion of its debt if it hopes to keep its "Aaa" rating.
"We have become increasingly clear about the fact that if there are not offsetting measures to reverse the deterioration in negative fundamentals in the U.S., the likelihood of a negative outlook over the next two years will increase," Sarah Carlson, senior analyst at Moody's, said.
Separately, Carol Sirou, head of Standard & Poor's France, told a Paris conference on Thursday that the firm couldn't rule out lowering the outlook for the U.S. rating in the future.
"The view of markets is that the U.S. will continue to benefit from the exorbitant privilege linked to the U.S. dollar" to fund its deficits, Ms. Sirou said. "But that may change."
However, Ms. Sirou, who has an administrative role and has no say in sovereign ratings, was mainly reiterating statements the agency has made in the past. She specifically referred to a comment more than two years ago by John Chambers, chairman of S&P's sovereign-rating committee, suggesting that AAA ratings can always be changed.
The U.S. currently has the highest possible credit rating and a stable outlook at both raters, but both have warned repeatedly in recent years that the government's long-term budget headaches must eventually be addressed.
The firms' latest comments had no apparent impact on an auction of $13 billion in 30-year Treasury debt Thursday afternoon. The auction was slightly weaker than analysts expected, leading the government to pay 4.515% on the bonds, up from 4.492% before the auction.
But demand was higher than in other recent 30-year auctions, and this came at the end of a full week of new debt offerings that went off without a hitch.
Benchmark 10-year Treasury notes rallied on the day, lowering their yield, which moves in the opposite direction of price, to 3.307%. The cost of insuring U.S. debt against the risk of default in the credit default swap market was little changed, remaining well below that of Germany, the euro-zone benchmark.
Germany's elevated default-insurance price is based partly on its exposure to the nagging debt problems of countries on Europe's periphery. Those worries have also helped drive investors to U.S. Treasurys as a relatively safer alternative.
In its report, Moody's said the U.S., Germany, France and the U.K. still have debt metrics compatible with their Aaa ratings.
But all four countries must bring future costs of pension and health-care subsidies under control if they "are to maintain long-term stability in their debt-burden credit metrics," Moody's said in its regular Aaa Sovereign Monitor report.
These measures of the U.S. debt burden include federal debt to revenue, estimated to average 397% of gross domestic product until 2020. The ratio of interest to revenue, meanwhile, is expected to rise to 17.6% by 2020, nearly double last year's level. These are "quite high for an Aaa-rated country," Moody's said in its report.
The report also said that there is "a small but increasing likelihood that markets will demand a higher risk premium on government debt, in sharp contrast to the safe-haven status that the U.S. Treasury bond has long enjoyed."
Higher borrowing costs could make cutting deficits more difficult in the future, the Moody's report said.
Write to Mark Brown at mark.brown@dowjones.com and Nathalie Boschat at nathalie.boschat@dowjones.com

America, This is Your Wakeup Call!

It was the most startling of warnings. If the US does not get its finances in order “we will have a European situation on our hands, and possibly worse”, claimed Paul Ryan, the new Republican chairman of the House of Representatives budget committee.

ECB Acknowledges Inflation, Euro Surges, Dollar Plunges

Dollar

Euro

Fed Creates Stock Market History

from Zero Hedge:

As part of the most recent observations on the boil up (melt up is so QE1) in the S&P, we find something quite interesting. A quick glance at the chart below shows the general market 45% climb since Bernanke's leak of QE2 in August, as well as the market's 10 day (purple line) and 50 day (green line) moving averages. As a point of reference the S&P has been above the 10 day average for 30 days straight, and above the 50 day average for 92 days straight. What is remarkable are some statistical findings as pertain to the average's movement with respect to the SMAs. Sentiment Trader points out that while as part of the recent surge in the S&P, the market has gone for "92 days without closing below its 50-day average, which has been matched only 17 other times since 1928." Where it gets scary, is that as pointed out, the market has not closed below the 10 DMA once during the past 30 days. And as Sentiment Trader notes, "this has never happened before, in 82 years of history." Congratulations to the Centrally Planned Socialist States of America: its Chairman has just made the Guinness Book of Manipulation Records.

S&P, Moody's Both Warn of Degradation of U.S. Debt Rating

from WSJ:

LONDON—Two leading credit rating agencies on Thursday cautioned the U.S. on its credit rating, expressing concern over a deteriorating fiscal situation that they say needs correction.
Moody's Investors Service said in a report Thursday that the U.S. will need to reverse an upward trajectory in the debt ratios to support its triple-A rating.
"We have become increasingly clear about the fact that if there are not offsetting measures to reverse the deterioration in negative fundamentals in the U.S., the likelihood of a negative outlook over the next two years will increase," said Sarah Carlson, senior analyst at Moody's.
Standard & Poor's Corp. on Thursday also didn't rule out changing the outlook for its U.S. sovereign-debt rating because of the recent deterioration of the country's fiscal situation. The U.S. currently has a triple-A rating with a stable outlook at both agencies.
"The view of markets is that the U.S. will continue to benefit from the exorbitant privilege linked to the U.S. dollar" to fund its deficits, Carol Sirou, head of S&P France, said at a Paris conference Thursday. "But that may change. We can't rule out changing the outlook" on the U.S. sovereign debt rating in the future, she warned. She added the jobless nature of the U.S. recovery was one of the biggest threats to the U.S. economy. "No triple-A rating is forever," she said.

PPI Rose 1.1% In December

U.S. producer prices climbed 1.1% in December after a 0.8% rise in November

Commodity Indexes Post New Record Highs

POMO Schedule Jan 13-Feb 9

The Fed's new Insanity Schedule for the next 30 days:

Grain Stocks Paper Thin

from various tweets regarding the USDA's grain report this morning:

US soybean stocks at 140 mln bu equates to a 15.2-day supply - the tightest of the past 40 years!

China buys 40k tons US soyoil 

USDA's tight soybean stocks est was only achieved by "assuming" that prices would ration beans available for domestic crush 

Global corn stocks fall to just a 55.4-day supply; 2nd tightest of past 35 years; 2nd only to 54.9-day supply 4 yrs ago

Today's USDA #s are bullish long-term, altho we could see profit taking if buying int wanes today

Today's USDA data means that corn needs 93 mln and soybeans need 79 mln acres w little margin for bad weather

USDA tightens stocks leaving no room for error in next season's plantings and will require rationing of ethanol demand

from Futures Knowledge:


Cotton prices ended the day limit bid and are trading near limit gains this morning.  The USDA January supply/demand report was supportive for cotton but was quite bullish for grains and soybeans which is causing cotton to rally.  For the US, USDA raised US production of cotton by 50,000 bales to 18.32 million bales. Raised Use by 100,000 bales to 3.6 million and left exports at 15.75 million bales. And left ending stocks at 1.90 million bales.  For the world, USDA lowered production by 70,000 bales to 115.46 million bales, raised World Use by 280,000 bales to 116.58 and reduced World ending stocks by 550,000  bales which puts them at 42.84 million bales.  Whenever world ending stocks are reduced it is bullish on its face. The USDA left production unchanged in Australia, India, and China though they are likely to lower those estimates later. They raised Brazil’s production by 100,000 bales to 8.2 million. USDA raised India’s cotton consumption by 500,000 bales to 21.5 million. USDA lowered soybean ending stocks by 25 million bushels to 140 million. USDA lowered wheat ending stocks by 40 million bushels to 818 million.  USDA lowered corn ending stocks 87 million bushels to 745 million.  Today, the US Dollar Index is down 38 points at 80.75. Crude oil is up 55 cents at $91.65. March soybeans were up 14 cents overnight at $13.71. March corn was up 5 1/2 cents overnight at $6.12 ½. July wheat was up 11 ½ cents overnight at $8.19 ¾. China’s cotton futures and forwards were higher overnight.

...And Still Another Rally

Another Flash Crash? This Is Soooooo Cliche!

More EPA Overreach

The American Farm Bureau Federation has filed a lawsuit in federal court to halt the Environmental Protection Agency's pollution regulatory plan for the Chesapeake Bay. AFBF says the agency is overreaching by establishing a Total Maximum Daily Load or so-called "pollution diet" for the 64,000 square mile area, regardless of cost.  The TMDL dictates how much nitrogen, phosphorous and sediment can be allowed into the Bay and its tributaries from different areas and sources.
According to Farm Bureau, the rule unlawfully "micromanages" state actions and the activities of farmers, homeowners and businesses.  EPA's plan imposes specific pollutant allocations on activities such as farming and homebuilding, sometimes down to the level of individual farms. Farm Bureau contends the Clean Water Act requires a process that allows states to decide how to improve water quality.
Also, Farm Bureau says EPA's TMDL is based on inaccurate assumptions. Farm Bureau President Bob Stallman says there is a basic level of scientific validity that the public expects and that the law requires. That scientific validity is missing here, and the impact could starve farming and jobs out of the region.
And finally, Farm Bureau believes EPA violated a requirement to allow meaningful public participation on new rules. The suit alleges that EPA failed to provide the public with critical information about the basis for the TMDL and allowed insufficient time for the public to comment.

Without Entitlement Cuts, Fiscally Sound Government Is Impossible

from No Money, No Worries blog:

The following chart should dispel the commonly held notion that we will be able to balance the federal budget by eliminating programs widely perceived as wasteful – the expenditures devoted to studying the mating habits of jellyfish and the like.

The above chart is a back-of-the-envelope calculation based on numbers published by the Congressional Budget Office.  The sad truth is that according to current projections, we could eliminate ALL federal non-defense discretionary spending and still run a deficit.
The elephant in the room is entitlements – especially the fast growing Medicare and Medicaid programs.

Unfortunately, there is no sign that the public is ready to accept mathematical reality, despite all of the heated rhetoric, both at the federal and state levels.

- In a poll last year, Texans’ told Texas’ five largest newspapers that they would like to see budget cuts instead of tax increases. The newspapers put another poll in the field to see which programs Texans would support cutting to balance the budget. They overwhelmingly said that public education and health services should be spared. The problem? Those two programs consume a vast majority of the budget.

RG Ratcliffe and Peggy Fikac report on the conundrum offered up by public opinion to lawmakers. (Chronicle, Express-News)