The Mathematics of Why Inflaiton Will Surge

by John Hussman, Phd.:

This week's comment focuses on the current, unstable stance of monetary policy. We'll start by reviewing some important monetary relationships. While I've included a variety of graphs and equations to support the analysis, I've boldfaced several key points, and my hope is that the text has enough detail that you can skip some of the equations if you're not a math fan.

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. Though "liquidity preference" is often used to describe the broad demand for money, we will define liquidity preference more specifically here as the amount of base money demanded per dollar of nominal GDP. 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.

By comparison, Japanese liquidity preference has historically ranged from a low of about 0.08 to a high of nearly 0.12 when interest rates have been pressed toward zero.

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.

As a study by the Bank of Japan of its own huge experiment with QE concluded, "While we can enumerate several routes of the monetary base channel which suggest that expansion of the monetary base can have some expansionary effect on the economy, our analyses suggest that the quantitative magnitude of any such effect is highly uncertain and very small." [The Effect of the Increase in the Monetary Base on Japan's Economy at Zero Interest Rates - An Emprical Analysis, Bank of Japan, 2002].

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 inflation dynamics can potentially become unstable when a massive stock of base money is being kept in check by very low interest rates. This is 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, strong inflation pressures are likely to follow. Historically, it has usually taken 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 larger 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. Also, while the Fed can do little to increase the returns to holding currency, it does have the ability to raise the interest rate that it currently pays banks to hold idle reserve balances, in order to keep those balances idle. So 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.

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 - easily the highest level in history. 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.

Wars and Rumors of Wars

Is turmoil in Egypt, and the possibility of it spreading thrhough the Arab world and the Middle East, spooking the financial markets? Sure looks like it! This is apparently not merely a question of quant trading, as had been earlier thought.

Turmoil in Egypt Sends Crude Oil Skyward

from Zero Hedge:
Shockingly, the "pundits" have suddenly realized that courtesy of the upheaval in Suez, the canal with the same name may be closed, which would wreak havoc on shipping costs. Once again, Zero Hedge was just ahead of the curve: "Egyptian Stock Market Plunges Over 11% To Fresh Multi-Year Lows; Is A Suez Canal Transit Halt Imminent?" The just announced countrywide curfew will not make Suez Canal operability any easier. For those who are concerned about what a Suez closure means, we recreate what we wrote previously on the topic. And just in from Reuters, Energy Secretary Steven Chu has declined to say if he is worried Egypt protests may disrupt Mid-East oil, but believes that serious disruptions will "harm" oil prices. By harm he means make them surge higher.

Bizarre!

This is the most bizarre trading day I've seen in awhile. Crude oil is up $4 and still climbing. Gold is up $20 and still climbing. Grains are up. Stocks are down. Dollar is higher. Bizarre!

Spooked Market

NEW YORK (MarketWatch) -- U.S. stock losses deepened Friday, dragged lower by disappointment over Microsoft, Ford and Amazon earnings, and a drop in consumer sentiment...
U.S. stocks opened higher but lost gains shortly after a survey of consumer sentiment by the University of Michigan and Thomson Reuters showed individuals growing more pessimistic, largely due to rising food and fuel prices. Read more on consumer sentiment.
Gross domestic product, the broadest measure of all the goods and services produced, rose at an inflation-adjusted annual rate of 3.2% in the fourth quarter, the Commerce Department said in its first estimate of the economy’s benchmark indicator. It was below economists’s estimates for a 3.5% increase. Read more on gross domestic product.
Still, the rise takes total output to its highest level since the end of 2007, when the recession started. And for the first time in 2010, the economy also benefited from a trade surplus in October to December.
Consumer spending, accounting for about 70% of demand in the U.S. economy, rose at a 4.4% rate in the fourth quarter. That’s the fastest pace since the start of 2006 and double the average rise in spending in the previous three quarters of 2010.

Stock Futures Sink on Renewed Global Debt Concerns

Standard & Poor’s downgrade of Japan’s credit rating to AA-minus on Thursday came a day after the U.S. Congressional Budget Office said the country’s budget deficit will hit a record $1.48 trillion in fiscal 2011, a chain of events that brought up the inevitable discussion about whether the U.S. is on thin ice when it comes to own gilt-edged rating.
“It will not be lost on investors and market observers that the S&P downgrade of Japan came on the heels of the U.S. nonpartisan Congressional Budget Office revised higher its deficit and debt ratio forecasts of the United States,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman, in a note. “The risk of a U.S. debt downgrade remains minimal, but could weigh on sentiment” for the dollar.

Social Security is Broke -- NOW!

(The Blaze/AP) — It looks like Sen. Harry Reid (D-NV) was wrong. New Congressional Budget Office projections released today show Social Security’s finances are getting worse as the economy struggles to recover and millions of baby boomers stand at the brink of retirement, in stark contrast to recent comments made by the Senate Majority Leader.
Those projections specifically show Social Security running deficits every year until its trust funds are eventually drained in about 2037.
This year alone, Social Security is projected to collect $45 billion less in payroll taxes than it pays out in retirement, disability and survivor benefits, the nonpartisan Congressional Budget Office said Wednesday. That figure swells to $130 billion when a new one-year cut in payroll taxes is included, though Congress has promised to repay any lost revenue from the tax cut. Social Security will post nearly $600 billion in deficits over the next decade
The massive retirement program has been feeling the effects of a struggling economy for several years. The program first went into deficit last year – the first deficit since it was last overhauled in the 1980s. But CBO said last year that Social Security would post surpluses for a few more years before permanently slipping into deficits in 2016.
The outlook, however, has grown bleaker as the nation struggles to recover from its worst economic crisis since Social Security was enacted during the Great Depression. In the short term, Social Security is suffering from a weak economy that has payroll taxes lagging and applications for benefits rising. In the long term, Social Security will be strained by the growing number of baby boomers retiring and applying for benefits.

The deficits add a sense of urgency to efforts to improve Social Security’s finances. For much of the past 30 years, Social Security has run big surpluses, which the government has borrowed to spend on other programs. Now that Social Security is running deficits, the federal government will have to find money elsewhere to help pay for retirement, disability and survivor benefits.
“It means that Social Security is increasingly adding to our long-term fiscal problem, and it’s happening now,” said Eugene Steuerle, a former Treasury official who is now a fellow at the Urban Institute think tank.
But that’s not what Reid said as recently as January 9, in an interview with NBC’s David Gregory:
He made a similar statement over the summer, calling any talk of Social Security going broke “fear tactics”:
It’s a bad time for the nation to be hit with more financial problems. The federal budget deficit will surge to a record $1.5 trillion flood of red ink this year, congressional budget experts estimated Wednesday, blaming the slow economic recovery and a tax cut law enacted in December.
Lawmakers from both parties have vowed to address the nation’s financial problems, including such contentious issues as Social Security and Medicare. The political climate, however, has made it difficult. Some Democrats have criticized plans to cut Social Security benefits as secret plots to destroy the program. Many Republicans have refused to consider tax increases.
“We need to get past the politics of the past and deal with this issue, making the hard decisions that have to be made,” Sen. Mike Crapo, R-Idaho, said Thursday at a Senate hearing on the budget deficit. “As we move forward in that context, I personally believe strongly that all aspects of the spending and revenue side of the equation must be on the table.”
He also called on President Barack Obama to become engaged in the issue.
A debt commission appointed by Obama has recommended a series of changes to improve Social Security’s finances, including a gradual increase in the full retirement age, lower cost-of-living increases and a gradual increase in the threshold on the amount of income subject to the Social Security payroll tax.
Obama, however, has not embraced any of the panel’s recommendations. Instead, in his State of the Union speech this week, he called for unspecified bipartisan solutions to strengthen the program while protecting current retirees, future retirees and people with disabilities.
Senate Republican leader Mitch McConnell of Kentucky said he is ready to work with Obama on Social Security and other tough issues.
“I take the president at his word when he says he’s eager to cooperate with us on doing all of it,” McConnell said.
Social Security experts say news of permanent deficits should be a wake-up call for action.
“So long as Social Security was running surpluses, policymakers could put off the need to fix the program,” said Andrew Biggs, a former deputy commissioner at the Social Security Administration who is now a resident scholar at the American Enterprise Institute. “Now that the system is running deficits, it simply becomes clear that we need to act on Social Security reform.”
More than 54 million people receive retirement, disability or survivor benefits from Social Security. Monthly payments average $1,076.
The program has been supported by a 6.2 percent payroll tax paid by both workers and employers. In December, Congress passed a one-year tax cut for workers, to 4.2 percent. The lost revenue is to be repaid to Social Security from general revenue funds, meaning it will add to the growing national debt.
Social Security has built up a $2.5 trillion surplus since the retirement program was last overhauled in the 1980s. Benefits will be safe until that money runs out. That is projected to happen in 2037 – unless Congress acts in the meantime. At that point, Social Security would collect enough in payroll taxes to pay out about 78 percent of benefits, according to the Social Security Administration.
The $2.5 trillion surplus, however, has been borrowed over the years by the federal government and spent on other programs. In return, the Treasury Department has issued bonds to Social Security, guaranteeing repayment with interest.
Social Security supporters are adamant that the program will be repaid, just as the U.S. government repays others who invest in U.S. Treasury bonds.
“It’s an IOU that is backed by Treasury bonds and the faith and credit of the United States government,” said Sen. Bernie Sanders, I-Vt.
The Associated Press contributed to this report.

Foreclosure Crisis Deepens

LOS ANGELES (AP) - The foreclosure crisis is getting worse as high unemployment and lackluster job prospects force homeowners in an increasing number of U.S. metropolitan areas into dire financial straits.
In Seattle, Houston and Chicago, cities that were relatively insulated from foreclosures early on in the housing bust, a growing number of homeowners are falling behind on mortgage payments and finding themselves on the receiving end of foreclosure warnings. Others have already seen their homes repossessed by lenders.
All told, foreclosure activity jumped in 149 of the country's 206 largest metropolitan areas last year, foreclosure listing firm RealtyTrac Inc. said Thursday.
The firm tracks notices for defaults, scheduled home auctions and home repossessions - warnings that can lead up to a home eventually being lost to foreclosure.
Job loss, rather than time-bomb mortgages resetting to higher payments, has become the main driver behind rising foreclosures.
"We've actually had a sea change in what's causing foreclosures, from the overheated home prices and bad loans to a second wave of foreclosures actually caused by unemployment and economic displacement," says Rick Sharga, a senior vice president at RealtyTrac.
The Houston-Sugar Land-Baytown metropolitan area in Texas saw its foreclosure rate jump 26 percent from 2009, the largest increase among the top 20 biggest metro areas, the firm said.
Seattle-Tacoma-Bellevue, in Washington, ranked second with an increase of nearly 23 percent, while the Atlanta-Sandy Springs-Marietta metro area in Georgia was third with a 21 percent bump.
In the Chicago-Naperville-Joliet metropolitan area, foreclosure activity rose 16 percent, while home repossessions climbed nearly 20 percent, RealtyTrac said.
"As the economy and unemployment improve, you'll see those markets recover fairly quickly, whereas you're still going to have a bit of a hangover in places like California, Florida and Nevada," Sharga said.
Those states, and Arizona, remain the country's foreclosure hotbeds, accounting for 19 of the top 20 metropolitan areas with the highest foreclosure rates in 2010.

But Earnings Are Good!

Wall Street is already shrugging off the bad news. At least its not all bad news. Corporate earnings have been consistently good. The Fed has created an environment in which there is no perceived risk any more.

Strike 2: Durable Goods Disappoints

Fox Business:

New orders for U.S. manufactured goods fell unexpectedly by 2.5% in December, a government report showed on Thursday.

When volatile transportation orders were stripped out, durable goods orders rose 0.5%, the Commerce Department said, though this was a smaller rise than expected.

Strike 1: Unemployment Claims Surge 51,000

Fox Business:

New U.S. claims for unemployment benefits rose more than expected last week as harsh weather conditions in some parts of the country kept workers at home and caused a backlog in the rocessing of claims, a government report showed on Thursday.

Initial claims for state unemployment benefits jumped 51,000 to a seasonally adjusted 454,000, the highest since late October, the Labor Department said. That was the largest weekly increase since September 2005.

Economists polled by Reuters had expected claims to be little changed at 405,000.
The prior week's figure was revised slightly down to 403,000 from the previously reported 404,000.

A Labor Department official said four states had reported an increase in claims that was due to snow. In addition, he said, seasonal volatility also affected the data.

Still, the four-week moving average of unemployment claims -- a better measure of underlying trends, rose 15,750 to 428,750 last week, implying a gradual labor market recovery that could compel the Federal Reserve to complete its $600 billion bond buying program aimed at bolstering the economy.

New Home Sales Decline to Lowest Level in 47 Years

WASHINGTON (AP) -- Buyers purchased the fewest number of new homes last year on records going back 47 years.
Sales for all of 2010 totaled 321,000, a drop of 14.4 percent from the 375,000 homes sold in 2009, the Commerce Department said Wednesday. It was the fifth consecutive year that sales have declined after hitting record highs for the five previous years when the housing market was booming.

Deficit to Hit New Record

Washington (AP) — A new estimate predicts the federal budget deficit will hit almost $1.5 trillion this year, a stunning new record.
The latest figures from the Congressional Budget Office are up from previous estimates because Congress and President Barack Obama teamed up in December on bipartisan legislation to extend Bush-era tax cuts that were due to expire. The new estimates will only add fuel to a raging debate over cutting spending and looming legislation that's required to allow the government to borrow more money.
The nonpartisan budget agency predicts the deficit will drop to $1.1 trillion next year.
Legislation passed in December to extend tax cuts, unemployment benefits for the long-term jobless and provide a 2 percent payroll tax cut this year adds almost $400 billion to this year's deficit.

Unemployment Rises in 20 States

And this reported by the Obamanomics Channel? How dare they!

from CNBC:
The unemployment rate rose in 20 states last month as employers in most states shed jobs.
 The Labor Department says the unemployment rate rose in 20 states and fell in 15. It was unchanged in another 15 states. That's nearly the same as in November, when the rate rose in 21 states, fell in 15 and was the same in 14.

The report is evidence that the job market is barely improving even as the economy grows. Most economists expect hiring to pick up this year, although the unemployment rate will likely remain high.

Employers in most states didn't add any net new jobs last month. The number of jobs on employer payrolls fell in 35 states in December, the department said. Only 15 states reported gains. Layoffs have slowed dramatically in the past year, but hiring has yet to pick up.

Texas and South Carolina reported the biggest net job gains in December. Texas added 20,000 positions; South Carolina gained 9,000.

Nevada, still suffering from a massive housing bust, posted the nation's highest unemployment rate at 14.5 percent. That's up from 14.3 percent the previous month and the state's highest on records dating from 1976. California reported the second-highest rate, at 12.5 percent, followed by Florida at 12 percent.

North Dakota's unemployment rate of 3.8 percent was the nation's lowest. It's followed by Nebraska and South Dakota, with 4.4 percent and 4.6 percent, respectively.

Rumors Send Gold Into Freefall

And just like that, everyone's a gold bear...
On Twitter, Doug Kass says he's hearing rumors of a big gold-long hedge fund being forced to liquidate.
Meanwhile, open interest in gold futures has been in freefall of late.
Note that the price of gold and open interest have tracked each other pretty closely up until recent months, when gold shot far ahead.
Click to enlarge.

Case Shiller Amplifies Calls of Double Dip in Housing

NEW YORK, Jan. 25, 2011 /PRNewswire/ -- Data through November 2010, released today by Standard & Poor's for its S&P/Case-Shiller(1) Home Price Indices, the leading measure of U.S. home prices, show a deceleration in the annual growth rates in 17 of the 20 MSAs and the 10- and 20-City Composites compared to what was reported for October 2010.  The 10-City Composite was down 0.4% and the 20-City Composite fell 1.6% from their November 2009 levels. Home prices fell in 19 of 20 MSAs and both Composites in November from their October levels. In November, only four MSAs – Los Angeles, San Diego, San Francisco and Washington DC – showed year-over-year gains. The Composite indices remain above their spring 2009 lows; however, eight markets – Atlanta, Charlotte, Detroit, Las Vegas, Miami, Portland (OR), Seattle and Tampa – hit their lowest levels since home prices peaked in 2006 and 2007, meaning that average home prices in those markets have fallen even further than the lows set in the spring of 2009.
In November 2010, the 10-City and 20-City Composites recorded annual returns of -0.4% and -1.6%, respectively. November was the sixth consecutive month where the annual growth rates moderated from their prior month's pace.  Since May 2010, the housing market has experienced an unambiguous deceleration in home price returns. The 10-City Composite has reentered negative territory with a -0.4% annual growth rate in November, versus the +5.4% reported six months prior in May, and the 20-City Composite was down 1.6% in November versus its +4.6% May print.
"With these numbers more analysts will be calling for a double-dip in home prices. Let's take a moment to define a double-dip as seeing the 10- and 20-City Composites set new post-peak lows. The series are now only 4.8% and 3.3% above their April 2009 lows, suggesting that a double-dip could be confirmed before Spring. Certainly eight cities setting new lows, and with the only positive news concentrated in southern California and Washington DC, the data point to weakness in home prices," says David M. Blitzer, Chairman of the Index Committee at Standard & Poor's. "With an annual growth rate of +3.5% in November, Washington DC was the strongest market, but still well below the +7.7% annual rate of growth seen in May 2010. The only city with a gain in November was San Diego, up a scant 0.1%. While San Diego, Los Angeles and San Francisco are still ahead from November 2009, their annual rates are shrinking in recent months.
"Looking at the monthly statistics, 19 of 20 MSAs and both Composites were down in November over October. Fourteen MSAs and both composites have posted at least four consecutive months of decline with November's report. Thirteen of the MSAs and the 20-City Composite fell by 1.0% or more in November. While not always consecutive months, 13 of the MSAs and both composites have posted at least seven months of decline since the beginning of 2010. These markets saw home prices fall more than half the months reported in 2010 so far."
As of November 2010, average home prices across the United States are back to the levels where they were in latter half of 2003. Measured from June/July 2006 through November 2010, the peak-to-current decline for both the 10-City Composite and 20-City Composite is -30.3%. The improvements from their April 2009 trough are +4.8% and +3.3%, respectively.

UK GDP Miss Sends Stocks Tumbling

Don't worry! The Fed will bail them out, too!

The Coming Correction

from Barrons:
Stocks' 1% drop last Wednesday provides at least two tests. The first, naturally, is a test of the unrelenting and metronomic uptrend in the market that has prevailed since about Labor Day, with only the briefest backslide in November. The demand-versus-supply breakdown has clearly been in favor of higher stock prices; investors have been under-exposed to equities, and sellers largely remained at bay.
Then last week, with the hottest stocks—small-caps, momentum-driven tech and commodity shares—taking a stiffer hit than the big-cap indexes, there were hints the hot money might be taking a breather. How like this market to hit a new post-crisis high, and then shake out the excessive optimism among Wall Street pros right when Apple (ticker: AAPL) reports a stupendous profit performance. When the U.S. stock-market's capitalization doubles in 22 months. When retail investors invest more cash in U.S. equity mutual funds than foreign funds for the first time in recent memory, according to Lipper. When the economic data generally are upbeat. And, not least, when President Obama begins snuggling up to business.
Even a further probe of a few percentage points to the downside likely wouldn't augur anything too serious. During this nearly two-year bull run, earnings-reporting seasons have often served as times for consolidations and pullbacks. It would be helpful to the bulls' cause if this little setback were met with a sudden cooling of expert and trader sentiment and a demand spike in hedging instruments. In the words of Robert W. Baird strategist Bruce Bittles, "Before the current slide runs its course, we should see a resurfacing of caution and skepticism among investors."
The other test is being administered to the growing and increasingly vocal crowd insisting that the low-volume, low-volatility sleepwalk to new bull-market highs is evidence of a market rigged by the Federal Reserve and not allowed to decline meaningfully, with every intra-day dip rescued by what even a technical analyst quoted by The Wall Street Journal Tuesday called a "mysterious force."
Well, sure, the Fed wants to see equity markets move higher. All post-recession, ultra-easy Fed regimes in history have desired, if not engineered, rising stock prices. The main difference with the Bernanke Fed is that the chairman is honest about it, having cited higher stock prices both in an op-ed article and this month in a talk at the FDIC as one barometer of the success of its "quantitative easing" campaign. The phrase "Don't fight the Fed" is decades old, let's recall, which doesn't mean it has always been a great investing guide.
The more interesting question is whether the investment community came into this year so convinced that the Fed and assorted other actors somehow wouldn't let stocks drop meaningfully that the market's knack for confounding group expectations means just that might happen.

Global Inflation Fears Grow

from WSJ:
Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent's debt crisis.
In an interview with The Wall Street Journal ahead of this week's annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don't gain a foothold in the global economy.
Mr. Trichet's warning comes at a time when inflation concerns are mounting among investors around the world. Fast-growing emerging markets such as China and Brazil are seeing rising inflation at home, and their demand for globally traded commodities is pushing prices higher elsewhere.
While high unemployment and spare capacity are restraining underlying inflation pressures in the U.S. and elsewhere in the developed world, annual inflation in China is almost 5%—and a sizzling 9.8% economic growth rate in the fourth quarter triggered fears of more price pressures ahead. Inflation in Brazil is even higher.
With the global recovery still in its early stages, those moves could accelerate. Higher raw material prices, especially coal and iron ore, are pushing up steel prices across the globe. Steelmakers including AK Steel and Nucor in the U.S., and China's Baosteel and South Korea's Posco—the world's second and third largest—have been steadily increasing prices in recent weeks. The world average carbon-steel price is forecast to exceed $1,000 per metric ton by the second half of 2011, up from an average $733 last year, according to U.K.-based consultancy MEPS.
"All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to…be very careful that there are no second-round effects" on domestic prices, said Mr. Trichet in his office overlooking Frankfurt's financial district.

Global inflation isn't just coming from volatile commodities that track the ups and downs of the world economy. Fast-growing emerging nations are taking increasingly aggressive actions to beat back rising food prices as they grow more worried about threats to stability.
Mr. Trichet's remarks come as the ECB must balance a widening debt crisis in Southern Europe and Ireland with a robust recovery in its largest member, Germany, and rising inflation throughout the euro bloc.
Last month, inflation unexpectedly jumped to 2.2% in the euro zone from 1.9%, the first time in more than two years it has exceeded the ECB's target of just below 2%. Some economists say it will rise above 2.5% in the next two months.
In Greece, Ireland and other countries on the euro zone's periphery, austerity drives are pushing up unemployment and bringing additional pain to economies already struggling with the effects of burst credit bubbles. Many economists worry that higher interest rates would do further damage in such countries, where the interest burdens on high private-sector debts are closely linked to the ECB's policy rates. Mr. Trichet rejected calls to take special heed of stragglers on the euro zone's fringe.
"All countries in the euro area have an immense stake in the solid anchoring of inflation expectations," he said.
Mr. Trichet first ratcheted up his anti-inflation rhetoric at his monthly news conference earlier in January, spurring many economists to move forward their forecasts for rate increases.
In the interview, he dismissed some economists' argument that the ECB should hold off on raising rates because euro-zone "core" inflation, which excludes food and energy prices, was still weak at 1.1% in December.
"In the U.S., the Fed considers that core inflation is a good predictor for future headline inflation," he said. But in the euro zone, "core inflation is not necessarily a good predictor."
That implies the ECB could raise rates this year if it senses that companies and workers expect headline inflation to stay above 2% for some time—even if the main source of inflation is world commodity markets.
Changes in food and energy prices are largely determined on world markets, and thus aren't directly influenced by interest rates in any one economy. For that reason, central banks in many major economies, including the U.S., put greater weight on core inflation than on headline measures. For now, Fed officials don't see much evidence that commodity prices are feeding broader inflation in the U.S.
The Fed isn't expected to raise its key interest rate for some time, in order to help the U.S. economy recover despite signs of rising headline inflation. The Bank of England has yet to raise rates, though U.K. inflation is approaching 4%. The potentially divergent U.S. stance is reminiscent of what happened in the summer of 2008, when the ECB raised short-term interest rates in the face of rising oil prices while the Fed held rates steady amid concerns about economic growth.
Mr. Trichet argues that budget discipline would help growth in Europe more than renewed stimulus, and called on the euro zone's 17 member countries to strengthen "surveillance" of each other's fiscal policies. In Europe, budget discipline benefits growth and job creation by "improving confidence of households, enterprises, investors and savers," said the 68-year-old Frenchman.
In contrast, the U.S. is extending fiscal stimulus this year as Federal Reserve Chairman Ben Bernanke tries to boost growth through a government bond-buying program.
Mr. Trichet's inflation warnings signal a symbolic shift from the crisis mentality that has dominated ECB policy for much of the past three years back to its traditional role—keeping prices stable. It also helps shore up his anti-inflation credibility in Germany, where officials and the public have been skeptical of the ECB's decision last May to buy government bonds of Greece, Ireland and Portugal.
Still, Mr. Trichet's remarks suggest that, for now, his tough talk is aimed at keeping inflation expectations in check rather than signaling an imminent rise in rates. If consumers see energy- or food-driven price increases as temporary, they are less likely to alter their behavior or push for higher wages. But if workers expect permanently higher inflation, they are likely to press for faster pay rises. "At this stage, we do not see" those longer-term forces, Mr. Trichet said, "and everybody knows we would not let [such] second-round effects materialize."
To boost investor and consumer confidence, Mr. Trichet said, euro-zone nations should sign up to stricter rules on budget discipline, including credible sanctions for miscreants. Euro-zone governments are currently negotiating a slate of overhauls to their bloc's economic governance, including more-generous aid for countries in a debt crisis, that they hope will restore investor confidence in the finances of the zone's weaker economies.
Although governments have so far declined to agree to tougher penalties for budgetary indiscipline, Mr. Trichet hasn't given up. The European Parliament might yet force national governments to stiffen the rules on sanctions, he said, praising its ability to do "what is essential for Europe."
He repeated his call to national leaders to make the euro zone's bailout fund for crisis-hit members bigger and more flexible, while declining to comment on specific measures currently under debate.
Struggling countries on the euro zone's fringe, including Greece, Ireland and Portugal, face an extended period of economic pain: They must raise taxes and cut spending to reduce government debt, while holding wages down to make their products more price-competitive. At the other extreme, Germany's mix of rapid, export-driven growth and tumbling unemployment usually puts central bankers on edge because it often leads to rising wages and prices. Other euro-zone countries, such as France, are somewhere in the middle. Their economies are recovering, but growth remains uneven with unemployment high.
Mr. Trichet dismisses these divergences as normal, and similar to those among states and regions in the U.S. But the U.S. and other large economies have big federal budgets that can channel funds from prosperous areas to those that have fallen on harder times. Europe doesn't have a central fiscal authority, putting pressure on the ECB to stabilize a diverse set of economies with one interest-rate tool.
He brushed off skeptics of Europe's focus on budget austerity, including the International Monetary Fund and, recently, the United Nations, which warned "the impact of fiscal austerity planned or under way risks a renewed economic downturn" in Europe.
"I do not buy the very simple reasoning that would suggest that pursuing sounder fiscal policy would hamper growth," Mr. Trichet said.
—Jon Hilsenrath and Robert Guy Matthews contributed to this article.

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.