The Week in Review

Key releases this week were on net, a disappointment, one reason the 10 yr Treasury yield fell from a 3.37% Monday to a 3.30%, Friday.

Of course there are always many factors impacting Treasury prices, including both fiscal and Fed policy, and the occasional flight to quality from folks panicked about one event or another. But the major influence, ongoing, is just plain old real sector developments. Nothing fancy here whatsoever.

For example, Oct/7/2010 the 10 yr was at 2.40%. Nearly everyone looked for dismal economic performance ahead - lousy key releases that is. End of October we advised our clients to look for just the opposite. Sure enough, Dec/8 the10yr printed 3.33%, being a witness to "surprising" vigor. Then the market crowd really got behind the growth mantra, the 10 yr printing 3.53%, Mar/7. About this time we reversed course, warning our clients that there was a piano directly overhead. Yet exuberance continued into early April, the 10 yr printing 3.60% on Apr/8. The trout were still keyed in to the fly long departed. But finally, folks began to catch on. Last print - 3.30%. A interesting little journey.



The equity market went the other way this week, celebrating, but then it’s had a life of its own for some time now.

Key economic data presented nothing to cheer about. Q1 GDP came in under expectations, and key - as we had predicted they would be, those expectations had been shaved substantially from a month earlier. Next, Jobless Claims were up 25M vs market expectations for a decline. Nothing to cheer about there. Both Personal and Disposable Income grew moderately in March. OK, not bad. But Real Consumer Spending was up only 0.2%, not a stick in the eye maybe, but no spark either, suggesting that spending slowed at the end of Q1.

If there’s one primary player which has thrown the ‘ol engine a curve ball, it is oil. We got downright personal with folks several weeks ago and stated that it’s foolish to be constructive (lower prices) on crude. If you are, don’t let your friends know it. Why commit social suicide?


Robert Craven

The Federal Reserve, The Debutante Ball and The 15 Parrots

Alan Greenspan thrived through complexity. That is, he snowed his opponents.

Ben Bernanke is instead intellectually honest; he’s not trying to hide the decision making process as did his predecessor. Thus, we will have an explanation of policy intent Apr/27 following the 2-day FOMC meeting. This is a debutante ball, a coming out, something which we and two other individuals, like good parents, funded Oct/19/1993 in the halls of Congress.

So we want to prepare our clients up front for this event. Relevant background material serves as a good start.

In our Sep/5/10 sketch - Caught Flat Footed - we predicted the Fed may launch another stimulative program. That was announced Nov/3 and called QE II.

We have offered several past issues explaining the workings of the Federal Reserve for those who have a job or are otherwise occupied, but do have at least a passing interest. We have also explained the mechanics of QE II and, how it can be reversed. It’s pretty simple stuff. Want to flood the markets with money? Buy that herd of cattle at the asking price, credit the rancher’s bank’s account at the Fed. The source of the money? Thin air naturally. Want to reverse QE II? Sell a herd of cattle at the market price, debit the rancher’s bank’s account at the Fed and you’re done.

We anticipated QE II, yes, but saw it as unnecessary and still do. See our sketch of Dec/5/10- Too Big For Its Britches for the reasons why. We did not agree, understanding that QE II serves not other purpose but to 1) fuel commodity price inflation abroad and 2) bolster the equity prices of otherwise less deserving US firms. The US economy was not in need of more liquidity for goodness sake. The ground is saturated. It all runs off.

But now there is rancor in the ranks. Some policy makers are taking our side. There is always disagreement among policy makers naturally but in the old days it was hidden - all were supposed to tow the party - Greenspan’s - line. For example, Greenspan hosted a conference call before the hearing we attended, coaching all the governors and district bank presidents how to answer our inquires (as they had them in advance). They did just that, sounding like 15 parrots. (Ref., HR28, Hearing before the Committee On Banking, Finance and Urban Affairs, Serial # 103 - 78, US GPO, 1994)

No more. We have democracy at the Fed, freedom of expression.

We’ll see how Bernnake handles this bunch, Apr/27.


Robert Craven

The CPI, Fashion in Central Banking and the Fast Draw

We all recall Abe’s story - just because you call a calf’s tail a leg doesn’t make it so. And so it goes with today’s inflation report. The Federal Reserve is excused because one of them, Art Burns, snowed the BLS and Congress, Alan Greenspan style, to ex out any dangerous stuff.

Today’s CPI headline was as expected, up 0.5% yet because core was up only 0.1% the Federal Reserve by calling the tail a leg can sit tight for a bit.



In the old days folks we just plain had more fun. Politics played more of a role in worldwide central banking - no politician in his right mind wants their central bank to stomp on growth - and a lot of the central bankers went along, Burns style. That’s no longer in fashion.

It’s the fashion nowadays among central bankers to be tough hombres. We know some of them personally. It’s good for their career. Like Wyatt and Morgan Earp, they practice their fast draw at every opportunity.

Bernanke has just forced those at the ECB and Bank of China to clear leather.

Bernanke’s Federal Reserve through the policy of supplying liquidity in great excess, liquidity we in the US never needed, liquidity which like rain on saturated ground flows elsewhere, is the key culprit in triggering commodity inflation offshore (see our post of Feb/16 for background).

Now it’s understood that certain excesses are no longer appropriate. Thus, the ECB and Bank of China have already lifted their key interest rates because it’s in fashion to do so. After today’s news - higher core numbers for the EU and China, these guys will move again in the near term.

These developments cannot help our recovery, one which others have now come to understand is already being hampered by events in the Middle East.

Robert Craven

Reformation at the Fed - An Escape From the Dark Ages - A Special

Islam is the only religion not to have experienced a reformation. Many of us have suffered as a result. The Fed was the only major central bank not to have experienced a complete reformation. We all suffered as a result.

Chairman Bernanke’s recent decision to hold four press conferences following FOMC meetings signals that a central bank still clinging by a finger to the dark ages has finally relinquished that hold.

The story of reformation begins Oct/19/1993 with three of us before the House Banking Committee. We had been called as witnesses to explain the damage done to markets and taxpayers through the Greenspan Fed’s lack of transparency and lack of accountability. My presentation addressed three concerns - communication of policy change, Fed leaks, and reckless inter-meeting commentary from bank presidents and governors (something which Andrew Brimmer, former Fed gov, called an “open-mouthed practice which must be stopped.”)

Greenspan’s practice was never to announce a policy change; it had to be guessed by watching Fed numbers. This provided work for “Fed watchers” but served no other purpose aside from sparking great confusion. Sometimes Greenspan himself would leak the change to one of two WSJ reporters (an act which would have the rest of us taking our meals through a slot). We scolded one of these for cooperating. “I’ve got to feed my kids,” he responded.

Convoluted policy communication, outright leaks and careless media stunts from Fed members often resulted in violence in US markets, sometimes much higher yields on Treasury debt than would be otherwise. We taxpayers picked up the tab.

All the Fed presidents and governors were there that October day. They had our concerns up front so a few days earlier Greenspan held a practice session on a conference call as to how to best beat the rap. Indeed, each of the fifteen parroted the other, all in unison that we were wrong. Instead, they were wrong.

It did not hurt that I had Milton Friedman’s endorsement along the way. Then after the hearing we circulated a petition among street economists and academics. That received wide press coverage. This, coupled with Congressional pressure, effected the desired result. In early 1994 the Fed decided to announce policy change same day; that formalized Feb/95. The markets took this in stride, exactly as we predicted. The leaks also stopped. So did the reckless commentary.

And ground zero, the heart of darkness at the Greenspan Fed? Simply an economist’s horror at being found out, at not wanting to be cornered.

As a private economist Greenspan’s record as a forecaster was awful, “the worst” as Worth mag put it. He was a mortal; he simply did not want the rest of us to find out (a malady effecting many other policy makers). This is why at the hearing he denied there were any tapes available of past deliberations. This proved to be false.

And that is why he felt he had to be slippery when policy was changed. More than once colleagues reported Greenspan as “depressed” because markets reacted to policy change differently than he had predicted. But if the process of discovery was protracted, a cushion was provided along with an escape from accountability.

We have always praised Bernanke for his intellectual honesty. His recent change in procedure is proof we were right.


Robert Craven

Central Planners at the Fed

It never works. A planned economy that is. As most of the world has given it up - China and India the largest and most recent examples - first Obama, and now Bernanke have embraced it.

With 2012 in mind Obama pretends he’s learned his lesson. Bernanke makes no such overtures.

The Fed’s mandate was price stability; full employment is now included. An individual or individuals may see to the first, the later is far out of scope for any would-be social architect.

When the Fed sticks close to home - supplying or extracting short term funds, letting the rest of the term structure see to its own, it does pretty well. When the Fed tries to manipulate longer term interest rates - rates then no longer driven by the old fashioned myriad of mkt pressures, but by planners at the FOMC - we are in for some trouble (See our Feb/9 sketch).

Sure they’ve got all the statistics at their disposal, sure they’re all experts, these Fed types, sure they’ve got the power to pull almost any trigger. But that’s no different from any planners of the past - all of whom have failed. Heck, even modern day Communists and socialists have begun to repudiate this approach. Communist China, a phony, knows best. As they replaced planning with more reliance on markets their growth rate spiked.

Thomas Sowell reminds us that, “Elites may have more brilliance, but those who make decisions for society as a whole cannot possibly have as much experience as the millions of people whose decisions they preempt. The education and intellects of the elites may lead them to have more sweeping presumptions, but that just makes them more dangerous to the freedom, as well as to the well-being, of the people as a whole.”


Robert Craven

Commodity Price Inflation - A Closer Look

World commodity price inflation continues to monopolize the headlines. We spotlighted this topic in January. Food inflation (and income inequality, and high youth unemployment) has sparked much of the recent violence in the developing world. A closer look is in order.

We hear that price hikes in food and energy stocks, past 12 months, are impoverishing folks in lesser developed countries. Mother nature had a hand in much of this. We just saw the worst drought in Russia and the Black Sea region for 130 years, lasting long enough to damage winter planting as well as the summer harvest. This was compounded by late rains in Canada, Nina disruptions in Argentina, plus increased US grain acreage for ethanol, so on and so on. For example, the world’s stocks-to-use ratio for corn is nearing a 30-year low of 12.8pc, according to Rabobank.

Next, we know the developing world is booming, or was. So this - world demand - adds pressure. But these conditions have existed before, even in tandem. What else is there? Why the spike? Many blame Bernanke. Let’s see.

Take China as an example.

Chinese consumers find themselves paying exorbitant prices for food stuffs. Here is the money portion of the equation: Everybody in the world wants to invest in China. The Fed’s printing a ton of “hot money” (money which does not come from an increase in wealth or consumer demand, but from the press) and since there’s no need for it in the US a heck of a lot of it headed for China. Coming on top of China’s massive trade surplus (in dollars) these inflows provide a migraine to the Bk of China. Why? A cheaper dollar makes their yuan more expensive; their exports shrink. So the gov’t mops up these dollars from exporters and banks and prints yuan for each dollar purchased. That’s a heck of a lot of yuan thrown on the domestic market.

This is fine for the chosen policy of mercantilism but tough on Chinese consumers. Their currency is depreciated; they pay more for cooking oil and wheat while their export industry prospers. The Chinese gov’t is sacrificing the consumer on the alter of trade by choosing to import US monetary policy. Other countries who cannot resort to currency management are doling out more subsidies for energy and food. This behavior runs the risk of stalling the recovery in the developing world.

So yes, if you inflate the world’s money supply by $1.5 trl nowadays, you can be pretty sure that you’ll spark prices on those global, auction-priced goods priced in $’s, such as food and energy. In the meantime Bernanke plods along, battling the deflationary ghost.


Robert Craven

Inflation (of another sort) at the Fed

Bernanke was taken to task yesterday by Rep Paul Ryan, a well know critic. Ryan is more than a critic; he is a would-be executioner. Some at the Fed think Ryan’s elevator doesn’t go all the way to the top. Yes it does and he’s providing a real service to all of us.

Since CSPAN came along most legislators fear a confrontation with Fed policy makers. When challenged at a hearing for example Greenspan would launch a circuitous counter attack, saying nothing really but drawing on endless words and numbers which snowed his opponents, and, right in front of their constituents. Thus, most just let it go.

Ryan won’t do that. Whether we agree of not with his view, Ryan’s providing fresh air.

Bernanke’s intellectual honesty distinguished him from his predecessor. We hope it still does. Yet he is in fact a tad “cocky” as Ryan noted. What’s behind that exactly?

Being human, policy makers are often drawn in by the aura of their surroundings, by the complexity of their wares, by the fawning of the masses, their egos soon inflating to before unknown proportions. After a while they admit they’re still mortals, but just barely. Or so they pretend.

Fed presidents remain more grounded in this regard; governors less so. Presidents work their way up, actual business people; gov’s are appointed. Some like Greenspan are simply and purely politically promiscuous. For example, Worth mag noted that Greenspan when in private practice was the “worst forecaster ever.” No problem.

All of the FOMC however, every one of them carry with them a haunting, a perceived vulnerability, their own heart of darkness. That would be the very fact that they know they don’t know a whole lot more than the rest of us; they’re not seers and they’re not prophets. Policy making is a crap shoot; they know it, they’ll just never admit it. For the rest of us to know that they know it, would, or so they believe obliterate their credibility. That is why for example they had and will always fight to the death, efforts to video tape their deliberations.

They’ve got a tough job. They make it a lot tougher by pretending they’re something they’re not.


Robert Craven

Thouhts on the Fed chair before the House.

Chairman Bernanke defended his expansionary policy today. Our view is that it’s misguided.

But whatever it is, it is a stealth operation. Bernanke points to Core CPI (not the broader #) as cover for QE2, noting that Core CPI is now as low as it's been in many years. Well naturally Ben. It’s “EX” everything that’s on its way to the moon - food & energy. This is convenient for the Fed, just as it was when Art Burns decided to take food & energy out so he could fuel Nixon’s reelection. It stuck. His rationale? The Fed has no control over wheat or oil prices; these are mostly driven by weather and other acts of God.

Now of course the spike in world commodity prices is driven, not just by natural phenomena but by the Fed’s dollar-creation machine. It hits first the 40-odd countries who peg or closely peg to the $. As we noted in an earlier sketch, they either import inflation (print their local currency to buy $’s to keep the $ expensive) or they allow their currency to strengthen and tank their exports. Either way, it comes back to hit us, or a portion of it does.

Too bad for offshore folk but not to worry here in the US says Bernanke because he can exit gracefully when things become overheated. Maybe so but we don’t see how. Recall that under QE1 & 2 the Fed buys longer-term treasuries and mortgage paper through so-called recognized dealers. It pays for these bonds by crediting the banks’ account at the Fed. (If the bank wants paper $, the Mint takes care of that, and delivers the things in trucks.)

So how will Bernanke reverse? He will sell securities to this group, reversing the process by taking the money out of circulation. If he sells short-term T-bills, short term rates will move higher. If he sells longer-dated stock, longer term rates will come under pressure. They don’t own as many t-bills so we guess they’ll hammer the longer end - 2 - 10 yrs perhaps that impact all of us.

He figures he can fine tune the act but over the years we have never known the Fed to have much of a handle on anything but their traditional targets - O/N money and reserves. They are far out of their league when they try to figure the direction of longer rates.

Every prospective home buyer, corporate planner, trading operation and saver has a stake in just how they pull this off, if at all.

Robert Craven

Thalidomide and the Fed

Until their plan to buy everything-under-the-sun the Fed provided (or extracted) liquidity mainly through an O/N market by the way of so-called “repos” or “reverse repos,” these with so-called registered dealers. The Fed fine-tuned with “Fed Funds” as the speedometer. FF’s is the rate prime banks charge each other for O/N money on which to make their required reserves good with their regulator. Some are flush, some aren’t. The hungrier banks are to make loans the more pressure on FF’s. If the Fed wants to slow things then they won’t meet the demand in that mkt; short term rates will spike, and in theory, economic activity will slow. If the Fed wants to be accommodative they supply more money to that market; banks take it as reserves and (Econ 101) the multiplier effect takes over.

Key here folks is that nothing was forced on the market, on the general interest rate environment; takers could come to or stay away from the trough, given demand or lack of in the economy. Longer-term rates ( 2 - 30 yrs) which impact all of us, were left to find their own level.

This worked fine until Q4 ‘08. Policy makers were desperate. Nothing in the medical cabinet would impact this new pathogen. Thus massive Fed intervention - no longer just short term operations, but buying long treasuries and mortgage paper, QE 1 (12/08 - 3/10) - was meant to 1) prevent a world meltdown and then 2) fire a recovery with lower rates. The meltdown was prevented. No one knew the side effects of this kind of medicine however.

Now there is no crisis but they’re at it again. We all know that Bernanke decided on the second major dose - QE 2, Nov ‘10 and plans to continue that medication to Q3 ‘11. Bernanke is now out of his league; if there is a Oath of Hippocrates for central bankers he hasn’t taken it.

Instead of a central banker he has become a government planner. QE2 is fraught with danger. His intervention is a useless as Obama’s attempt at gov’t planning, that which delayed the recovery. Bernanke is providing money which is not needed or wanted, except by the gov’t, banana republic style (The fed owns more Treasuries now than the Bank of China.) The US economy in not in need of liquidity.

The Fed’s program is meant to 1) feed the gov’t and to 2) feed the home market, a repeat mistake. It only penalizes the prudent - savers who would otherwise put their savings to more productive uses. This provides a distortion as these lower rates are purely artificial, driven by money created out of thin air. The Fed’s buying spree could create the very bubbles which brought us here in the first place. At the very least it is creating malformations on the US economic body.


Robert Craven

Update

First, to spending. Last week we saw that consumer spending for Q4 ‘10 gained 4.4% (the most since Q1 ‘06 ) following a 2.4% increase Q3. We did not know at the beginning of Q4 that spending would print 4.4%, only that it would flatten St estimates. This was the result.

Look for any surprises over the near term to be to the side of more, not less vigor than forecast. This is the course-of-least-resistance for the US economy and it is especially true for discretionary spending. Thus planners in those businesses linked to such activity are to embrace the reality of more demand for their product, H2, not less.

Background: Most analysts missed recent vigor because they 1) did not fold results of Nov/2 and traction obtained into their models, 2) gave imbalances in housing and the mess in states’ finances too much weight and 3) took consumer confidence reports to heart.



Of course, there are always wild cards - those cataclysmic events which carry the hrsp to retard US growth. A closure of the Suez Canal is one. This brings to mind the current crisis.

We followed the Mid Eastern situation (including the Brotherhood from ‘06) in a separate blog. http://bobcraven.blogspot.com/

Better, see the recent article by Vic Hansen for a primer http://pajamasmedia.com/victordavishanson/whats-the-matter-with-egypt/.

After that exercise readers will understand the failure of Mid Eastern society, and, the West as the appointed scapegoat. Along comes the internet and anyone under 40 got jealous. Dictators stand in the way. Here is the cause of recent violence. The trigger however was food prices.

Some Western observers have blamed the Fed for the recent chaos and even deaths; they argue the US is an exporter of inflation expressed in the very commodity prices which triggered this deal. Let’s see what this is all about.

Sure enough, inflation in milk and flour prices triggered protests in Algeria that left 3 people dead. Then a food vendor in Tunisia set himself alight. Now Egypt is ablaze. Egyptians suffer for example because cereal grains are up 39% in the last year, oils and fat, up 55%. Going after the nearest bad-guy target - Mubarak - is understandable.

But is Bernanke also one of the bad guys? In the sense that he conducts US monetary policy without the interests of the developing world folded in, he is. But it takes two to tango and the complainer, the developing country must make the decision to import inflation to get things going!

Higher commodity prices are not just a monetary phenomena of course - witness the worst drought in Russia and the Black Sea region for 130 years, late rains in Canada, Nina disruptions in Argentina, and a series of acreage downgrades in the US. But what about money?

We know the Fed is flooding the world with $’s; the more of them the less they’re worth. And we know that an Egypt, or a China, or an Algeria or any other developing country must buy their food in $’s. But these guys are mostly exporters. What happens if the $ cheapens relative to their currency? Right, this dampens their exports (one $ buys less), their life blood. So what do their central banks do? They print their currency out of thin air and buy dollars. Why? To keep dollars expensive to the local currency. Thus, just like China is doing these countries make a choice or decision to import inflation. That is the core to their problem. At the expense of their own savers they flood their own mkt with their own currency. That’s about all there is to it.

An Egypt or China which may want to insulate itself from this food inflation has to appreciate its currency significantly. But then its exports would tank. No way they’ll do that. Or, they have to subsidize food prices - price controls. These measures always fail. Absent these two drastic measures, countries have to live with the implication of US monetary policy.

Robert Craven

Vigor Ahead

Our anchor set in mid Oct will continue to hold. US spending and employment activity will exceed Wall St estimates. Forecasters will continue to revise their estimates higher. For business planners or investors it is better to anticipate this event than react.

N. Behravesh, chief economist of IHS Inc recently noted, “There’s no question the consumer is playing an increasingly larger role. We’re seeing an improvement in the overall economic outlook.”

Morgan Stanley’s David Greenlaw, “Consumers will be a significant contributor to the growth outlook. More jobs mean we will see incomes grow by about 2.5 percent. You’ll get gains very similar to that on the spending side.”

As the new consensus continues to build it will carry with it the characteristic of self fulfillment. This is simply the way these things work.

PIMCO, which manages the world’s largest bond fund today raised its forecast for 2011GDP from 2 - 2.5% to 3 - 3.5%. Bill Gross, the founder, was a UCLA classmate. We addressed this bunch on strategy, years back. They should have called this time. The firm attributes sound fiscal and monetary policy for their change of heart. Fiscal yes but monetary, no way.

We don’t have a liquidity problem for goodness sake. We have a balance sheet problem. There is nothing more the Fed can do but make noise.

From Gerald O’Driscoll, “The declines in home values, investor portfolios and 401(k) plans, and the uncertainties surrounding retirement plans, have all had a big impact. The solution lies in restoring balance sheets. For financial firms, that means raising capital. For consumers and businesses alike, that means saving more of their reduced incomes.”

And then we’re really off to the races.

Robert Craven.

Too Big For Its Britches?

The Federal Reserve system was created under Wilson in 1913. Originally tasked with protecting the value of the currency its mandate was expanded in the 70's when the Federal Reserve Act was amended to promote the goals of, “maximum employment, stable prices, and moderate long-term interest rates,” (Section 2A).

“Stable prices,” means protecting the value of the $. The Fed is armed to do this by expanding or contracting the supply of $’s available - too many and they are worth less, too few and they are worth too much.

“Moderate long-term interest rates,” are not something the Fed controls very well, if at all. “Maximum employment,” are the two words however that can get the Fed in a lot of trouble.

At the moment critics claim that through the pursuit of this “maximum employment” mandate the Fed has been reduced to an extension of the administration, that is, Bernanke more the politician than the central banker.

We’ve all heard of QE2. This means that the Fed is buying practically everything under the sun in an attempt to quick start a recovery. The idea is to get medium-to-longer term rates lower, the dollar just a tad weaker in order to spur exports, all of this with employment in mind. This is not equivalent to addressing a crisis, to preventing a melt down. (Without the Fed’s emergency action Q4 ‘08, we’d all be paupers.) No, it is a completely discretionary, non rule-based activity and a mistake, one which first will have little to no impact on the pace of recovery and two, is corrosive to Fed independence, a necessary item, the heart of monetary control.

It is this trend at the Fed toward discretionary actions that is alarming to so many and who see this, correctly we believe, as just an attempt to bail out BO’s failed fiscal policy.

A group of 23 economists, money managers and former government officials issued an open letter to Bernanke on Nov. 15 saying the central bank’s planned bond purchases “risk currency debasement and inflation” and won’t boost employment.

Another critic is Fed governor Kevin Warsh, who noted recently that, "The Federal Reserve is not a repair shop for broken fiscal, trade, or regulatory policies.”

Apparently, Bernanke is not listening. We need only recall Hayek’s “Fatal Conceit” to know that a few individuals, no matter how gifted cannot replace in their judgement the complexities of a free functioning market. This applies to the FOMC as well as to Obama’s wanna-be planners.

We have followed the Fed closely for 20 years; never has it come so close to shedding its independence. Let us hope the new Congress re-writes the Fed’s mandate to confine its activities only to those of price stability.

Robert Craven

We Are Left With The Fed

The new administration’s rescue plan(s) will impact over the longer term, if at all. There will be no near term impact, zero, notwithstanding the mix. We are left with the Fed.

Few of us specialize in central banking. Yet central banks - Fed if American, Bk of Eng if Brit, ECB if European - hold the key to the West’s economic well being. Fed policy now impacts all of us Americans directly, sometimes immediately. Thus, hadn’t we better get a grip? Who are these guys and what are they up to?

We are told that the Fed’s target is near zero. What in the world does this mean? From soph year, Eco & Bkg 101 recall that banks are required to hold a certain % of reserves against loans. Day to day some are flush, some are short. Those that are flush lend o/n to those that are short. The rate they charge is called the Fed Funds rate. This is also the Fed’s target. Here is why. Reserves and currency are base money - the heart of the system. The Fed figures that by manipulating, fine tuning the amount of reserves available it can fan or retard the economic flames. Very true, usually. The FF’s rate simply indicates tension. The Fed can increase or decrease the supply of "non-borrowed" reserves through so-called "open-market operations". No big deal here. It means that the NY desk injects reserves by buying U S securities, usually on a temporary basis, or repo, agreeing to reverse the transaction in a few days. It does the reverse to shrink reserves. In the orchestration it is far more complex; fine, we don’t care as long as we have the thrust of it.

So now, with the FF’s target at near zero banks can fetch all the reserves they want (with which to make loans) at practically nothing. But they’re not. Why? It’s not just that they’re risk adverse - wimps really, but that is for another sketch. It’s that many of their assets are near garbage and even they don’t know what they’re worth, yet. They’d rather see to that first, as soon as they can get a grip, poor things.

Back to the Fed. So orthodox policy is not working. What is next is what Bernanke calls "quantitative easing" or the Bk of Eng "the nuclear option". It’s not nuclear or new, just rarely used. No one at the Fed has much experience with it; yet the Fed as it turns out can buy anything they want, outright (not temporary, not a repo) - a herd of long horn steers / the NY Giants. All the Fed needs is emergency powers and those exist under Article 13 (3) of the code. Where does the Fed get the $? Out of thin air. For a non-special forces approach, assume the U S gov’t cuts taxes, financed by bond issuance. The Fed can buy this US debt outright. The Fed’s balance sheet expands, the $ goes to US citizens.

But the Fed is now working out of its comfort zone, more of a Delta Force approach. Bernanke says he can "expand the menu of assets he buys". Sure enough, the Fed is already fast at it. Have a credit card? Haven’t received a notice that your limit has been reduced? Likely because the Fed is already buying securities collateralized by credit card receivables. Have a mortgage? Terms are easier? Same answer. You’re a corporation with a good credit but can’t sell your commercial paper (short-term IOU’s) anymore? Call the Fed. For three months they have been buying this stuff.

Back to Eco 101. Isn’t this inflationary? Guess not. All observers see are signs of deflation. There is no fear on the part of central bank officials at the moment. They’ll reverse policy at the appropriate time. Maybe.

Robert Craven

Banks - Useless At Best

Policy initiatives in place have eased the credit crisis. As Fed Governor Kevin Warsh pointed out last week: "We have had a forceful response from monetary, fiscal and financial policymakers. There are some notable signs of improvement. Short-term funding spreads are retreating from extremely elevated levels. Funding maturities are being extended beyond the very near term. Money market funds and commercial paper markets are showing signs of stabilization. And credit default swap spread of banking institutions are narrowing significantly."

Translation - the liquidity crisis, inter-bank, is over. Fine. Great. What’s it mean for us? Next to nothing. Banks won’t lend. Banks are essential but they refuse to act. As Willem Buiter puts it, "After years of excess and anything goes, the bean counters and risk controllers now rule supreme in the banking world. There is little upside to lending and taking a risk, but a lot of downside. Rolling over an old loan or extending a new one won’t help your bonus and it may cost you your job."

This is critical folks. Unless the banks start lending in normal volumes very soon, this recession could indeed become another great depression. We did not label our sketch of Oct/9 - "1929?", on a whim.

It’s not just US banks. In the UK, legal curbs may be imposed on banks if they fail to abide by a new code of practice on lending. They will also be compelled to open their books to the government so that their lending can be monitored. Whoa! But good businesses and consumers are starved of credit so why not. "I am in no doubt that the single most pressing challenge to domestic economic policy is to get the banking system to begin lending in any normal sense. That is more important than anything else at present," Bk of Eng gov Mervyn King said this week. King (the very best of all central bank gov’s, our view) also held the threat of wholesale nationalization over these banking clowns!

From Buiter, "We have no longer just a crisis in the financial system. We have gone even beyond the stage where there is a crisis of the financial system."

Getting banks to lend again is even more essential than establishing primary and secondary markets for garbage assets. In the US as elsewhere, small and medium enterprises rely overwhelmingly on banks for external finance. We all know that. Without access to bank loans, credit lines and overdraft facilities, countless small and intermediate sized businesses that would be perfectly viable with a functional financial and banking system, that are great credits, are threatened with bankruptcy. They’re innocent for goodness sake!!

What is to be done? 1) The US may have to set aggregate lending targets to the domestic non-financial business sector for each bank (last year’s total plus 7 percent, say). The banks themselves can decide who to lend to and on what terms. Any shortfall of actual lending from the target is translated dollar for dollar into some kind of tax. Since not meeting the target amounts to throwing money away, the banks will probably lend. Or, 2) nationalize those that don’t (paying as little as possible to the existing shareholders), fire the existing management and board of directors, and have the government appoint a new executive and a new board that are serious about meeting lending targets.

This is nonsense.

Robert Craven

Greenspan and the Home Mortgage Crisis

American homeowners are not a happy bunch. First, the party began to end two years ago; next some Wall St types got caught with their pants down early this year, then home prices really took a dive. Credit vanished. Finally, as taxpayers homeowners just might be asked to bail out the very clowns that helped get them into this mess. What in the world is going on? Where did this all start?

Professor Anna Schwartz (92 and still working at the National Bureau of Economic Research) is a revered figure in central banking circles. She with Milton Friedman wrote the joint opus - A Monetary History of the United States, which revolutionized thinking about the great depression. The book was a bombshell, turning conventional wisdom upside down. What Friedman/Schwartz demonstrated was that incompetent Fed officials caused the depression, not the free market. I met Schwartz in Oct/93 as the two of us testified before the House Banking Committee. And what does she have to say now? According to Schwartz the original sin of the Greenspan Fed was to hold rates at 1% from 2003 to 2004, long after the dotcom bubble was over. "Rates of 1% were bound to encourage all kinds of risky behavior," says Schwartz.

By "risky behavior" Schwartz means that of both lenders and borrowers in the housing market, and the lenders’ Wall St counterparts. Looking for higher yields in the artificially low rate environment of ‘03 and ‘04, encouraged by politicians to direct more lending to poorer neighborhoods, encouraged by the lack of supervision (50% of subprime loans were made by state chartered but not federally supervised companies), encouraged too by Wall St, lenders increased risky subprime lending through nontraditional loans. Brokers originated the loans with little concern for quality and lenders went along as they could simply peddle the loans to Wall St underwriters who in turn packaged the loans as securities to sell to unwary investors. We all know what happened next.

Greenspan has looked to clear his name by blaming the period of artificially low rates and the bubble this created on the Asian saving glut which supposedly created stimulus beyond the control of the Fed. Schwartz says this is nonsense. "This attempt to exculpate himself is not convincing. The Fed failed to confront something that was evident. It can’t be blamed on global events," she says. And in fact Greenspan did not understand the situation. His skill has always been a remarkable ability to charm politicians coupled with a gift to say absolutely nothing at great length with no real position of any kind. He got where he did because of his political promiscuity; his "strength" is that he could be trusted not to rock the establishment boat, which includes maintaining a near incestuous relationship with Wall St. His skill at predicting events tied to policy change is about nil. CNBC one described Greenspan’s forecasting record as "the worst". Worth mag in 1995 said that, "...most of his predictions have turned out to be wrong." Indeed, as a private economist and a hired gun for Charley Keating’s Lincoln S&L (his fee was $40,000) Greenspan told California banking regulators that Lincoln management, "...was seasoned and expert...with a long tack record of outstanding success." He told the regulators that Keating’s S&L would pose no risk of loss to federal insurers (i.e. taxpayers). In fact, Lincoln cost the taxpayer $3 billion bucks. Keating was convicted of securities fraud, conspiracy and racketeering.

Chairman Bernanke’s intellectual honesty detaches him from the Greenspan mold yet he has for the most part carried on the tradition. His Fed remains too close to Wall St and financial institutions - responding to their needs to the detriment of the wider economy. The Fed overreacted to the crisis, misjudging the importance of financial stability to the overall economy and created a deeper inflation problem as a result. Another acquaintance of ours - Bill Poole, until recently head of the St Louis Fed, called the Bernanke-Paulson decision to take some of the banks’ diciest loans onto it own balance sheet "appalling," the worst mistake of a generation.

Well, most of us recall the Chrysler debacle of 1979. It like Bear Stearns was "too big to fail". Free market thinkers worried not that the bailout would fail but that it would work. It did, thus lowering any resistance to future flights of Wall St socialism. Of course Fed seers argued that Bear was so connected to the financial system in opaque ways that the radiating consequences would be a catastrophe. We doubt that is true. We do know that the Fed now has a mandate to be the deal makers for Wall St’s brand of socialism - socializing losses while privatizing gains.

And so the irony is that the mortgage crisis is in large part the fault of the Fed’s own reckless monetary policy. Low real interest rates for too long created a subsidy for debt that spurred the housing and credit bubbles that have now burst. Prices got higher than they should have been. The only healthy recovery is to let those prices settle on their own, to let those firms which reaped great benefits now accept the consequences of their overreaching. Fed-Treasury interference in the process of price discovery will only prolong the process and increase the odds that losses are in fact dumped onto taxpayers - a very real possibility.

Robert Craven

Fed Policy - An Update

In the last sketch (July/7) we highlighted the Fed’s apparent lack of concern for a weak US currency and the consequences, using the price of oil as an example.

Since then there has been a change in Fed rhetoric designed to indicate a growing willingness to support the $. First, Bernanke assured lawmakers that inflation is a concern for the central bank. Then Gary Stern, the long-time president of the Minneapolis Fed and a voting member of the FOMC said that, "We’re pretty well positioned for the downside risks we might encounter from here. I worry a bit more about the prospects for inflation. Headline inflation is clearly too high."

These two statements were enough to birth a change in view among Fed watchers and currency, bond and commodity traders. We had advised in the last post that either a rate lift or jawboning to that effect was necessary to firm the $. That was the result, the $ improving against most other currencies, especially the Euro. That is also one key reason that crude prices have dropped considerably, past few days.

Robert Craven

Bernanke - Out Of His League

Say the words "Federal Reserve" and you’ve lost your audience. As one friend noted, "These are the guys who have meetings every couple of months, do something or other with the money supply or interest rates or whatever. Fine. Now, as I was saying, the White Sox slugger Manny Ramirez..."

With this new site we intend to provide a layman’s guide to the Fed. And from that, something on the economy. A similar comment may appear under our Presidential Election blog given the preeminence of this topic in the electoral debate.

A dear friend responded to our recent post on oil; she wondered how if Fed-directed lower interest rates drive oil prices, may not this be self-defeating? That is, won’t higher oil prices restrain an expansion and isn’t, just the opposite of what the Fed is after? This provides a good start.

The Fed controls only the Fed Funds rate - the rate on short-term loans between prime banks. The idea is that by making liquidity available lenders will lend, borrowers will borrow and off to the horse race. The fed funds market can be considered the heart of the system under today’s operating procedure; or better yet, the horse trough; the Fed can fill ‘er up but no way to force ‘ol Jimmy (my Dad’s last horse) or Speedy-the-mule to drink.

The Fed has slashed fed funds from 5.25% to 2.00% in an attempt to spur the economy. Traditionally that works but this time not much happened. Why? Because 1) housing, responsible for perhaps 40% of all eco activity, has not responded as it traditionally does due to the bloated inventory of homes, and 2) the credit mkt is completely dysfunctional. Yet lower interest rates DO mean world investors are less likely to hold the $, especially as they have seen higher and higher signs of US inflation and a less-than-vigilant Fed, making the $ even less valuable in the future, THEIR VIEW. So they have been selling $'s, fleeing that market for other currencies with higher yields, and, for commodities (cheap to inventory with low short-term rates). Hence the weaker dollar. Hence the food/commodity price spike. Sure enough, the Producer Price Index is soaring.

But back to oil: Most oil contracts are in $'s. The weaker the $, the more expensive for US buyers as it takes more and more dollars to a given contract. The $ price of oil is up roughly 70% from late Q4, 07. I don't have the resources here but maybe 40% of that price spike at the pump is currency related - weakness vs the Euro, other currencies; much of the rest, as we indicated in the last sketch under the Robert Craven Report can be tagged to the perceived conflict and the accompanying dislocations in the Middle East given Iranian intransigency and the US/ Israel response.

So yes, our friend is on to something, but just half of something. Lower short-term rates don’t mean higher oil prices by definition. This is only true now because of $ weakness, the world’s perception that the Fed is behind the curve. The Fed’s duty as set out in the charter is to preserve the integrity of the US dollar. The Fed’s duty is NOT to avoid a recession at all costs. Although he doesn’t know it yet, Bernanke is now taking a moderate slow down and is close to creating a bruiser. So until Bernanke’s Fed begins to lift short-term rates, or at least jawbone to that effect we will experience a still weaker $ and higher commodity prices. The FOMC has to commit to long-term price stability or they will turn a slowdown into the worst of both worlds: a prolonged recession and excessive inflation.

Robert Craven