Roubini says gold is done

robbie
By robbie on Sun, Jun 2, 2013 - 9:10pm

Apologies if posted elsewhere. I couldn't find it on a site search.

http://www.project-syndicate.org/commentary/the-end-of-the-gold-bubble-b...

44 Comments

Grover's picture
Grover
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Roubini is a Keynesian Economist

robbie,

I read Roubini's commentary with disbelief. This piece looks like his analysis was based on price charts only. That level of digging may be appropriate for copper or cotton, but gold has an ancient history as money. Any smart central banker would feel threatened if the price of gold took off. Why wouldn't they use all available means to suppress the price? Wouldn't manipulation appear as depressed prices?

In his first paragraph, he says that gold's price advance had all the features of a bubble. I agree that the price generally followed an exponential path, but the participation rate is measured in the low single digits. Bubbles pop when there isn't anyone left to buy. Classic bubbles have people bragging about their purchasing prowess. Did you hear anyone you personally interact with publically advocating for gold? I sure didn't.

Later in that same paragraph, he says that asset-price surges are divorced from fundamentals of supply and demand. If you believe that prices balance supply and demand, decreasing prices require lower demand or increased supply. Paper gold can be created at will (selling futures, naked shorting, etc.) Until buyers demand physical gold, the paper game will continue. Ironically, suppression tactics will reduce the amount of above ground physical because the reduced price limits mine profitability.

I'll paraphrase his 6 points in italics.

His 1st point: Leveraged purchases cause price volatility - selling to cover margins during downdrafts. He is correct for a short while. Then, prices rebound and surpass their prior highs. That has happened every time (except this last takedown, so far.)

His 2nd point: Gold performs best when there is a risk of high inflation. Now we have low inflation with little chance of inflation returning. Not quite true. We had high inflation in the '80s yet gold prices dropped. I agree that labor has no pricing power due to globalization and robotics.

His 3rd point: Gold provides no income. Since 2009, equities and real estate have outperfomed gold. I agree completely with this point.

His 4th point: Q.E. reduced real interest rates and gold responded. Now, the improving economy is reducing the need for additional Q.E. And I thought risk of high inflation was the best driver of gold prices (according to point #2.) Q.E. has always been billed as temporary and finite. I don't see how it can be discontinued without crashing the asset prices that the bankers/politicians want inflated (See point #3 for examples.)

His 5th point: Sovereign governments may have to sell their gold stockpiles in the future. The threat of Cyprus selling $520 million worth of gold triggered the 13% drop in April. What happens when a bigger player like Italy dumps their gold on the market? Did Cyprus sell any gold yet? Didn't the price drop when hundreds of tons of shorts hit the market?

His 6th point: Far-right conservatives think gold is the only insurance against governments debasing currency. These fanatics think a return to a gold standard is inevitable. Gold may be a store of value, but it isn't a store of account, nor can you buy groceries with it. As long as the current debt-based currency works, he is right. If you buy something with gold, technically you are bartering. An ounce of gold is denominated in currency terms, not the other way around.

He goes on to say:

Yes, all investors should have a very modest share of gold in their portfolios as a hedge against extreme tail risks.

I can't agree more! I've heard financial advisors advocate 5%-15% of assets should be in gold. Throughout history, there has always been about 2/3 of an ounce of mined gold per human being. If everybody had a modest amount of real gold in their portfolio, what would happen to the price? The only way for the limited supply to meet a measly 5% of assets would be for the price to soar.

Grover
 

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Excellent review Grover

What a knucklehead Rubini can be. 

Jesse makes the much more convincing Bull case here;

http://jessescrossroadscafe.blogspot.com/2013/06/the-fundamentals-of-gol...

Economists, pundits and investment managers can say whatever they like, but the proven fact remains that the world's central banks, on the whole, do not agree with them that gold is not an important store of value, and likely to become more important in the future. It is somewhat ironic that these same fellows would uphold the power of the central bank on one hand, and say things like Don't fight the Fed, or Bernanke says what the market is, but then will turn around and suggest you ignore what the central banks of the world are doing on the whole. It is hard to imagine that this is not someone woefully ignorant of current trends or with some other agenda who would take such an obtuse position.

 

 

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Roubini has a "technical" but not 360 viewpoint

Grover,

I picked this article up independently, but thank you for posting this as Roubini is widely read.

It is good to challenge our ideas, and Roubini does.  However my brief counter points to his ideas:

1)  Spikes during risk periods-  stating the obvious.  I note with some humor that he mentions the metaphorical bunker with "guns, ammunition, canned food and gold bars", while the preparedness community goes beyond "metaphors"- metaphors never filled anyone's belly.

I am reminded of a statement by Fernando Aguirre, who chronicled the Argentina collapse in the 90's, to paraphrase "everyone told me the two things they wish they had done before the bank holiday was to get their money out of the banks and buy gold, and to prepare better for crime" 

2)  High inflation- not yet.  To me it's like- "yes, you've been stabbed with a dirty knife 15 minutes ago, but you don't have a fever yet, so all is well, no risk of infection".  Also, one of the main attractions to precious metals are that they protect in inflation AND deflation.  People like Roubini always forget about deflation protection (yes, I have some cash too for deflation, and you should too).

3)  Stating the obvious again about gold not generating income.  Fair enough.  He picks a convenient window of time to make a point, something I could do for any security comparison if I picked the right size window and period of time.

4)  So the argument here is "we had really, really bad negative real interest rates, now we only have really bad negative real interest rates"?  Not strong.

5)  Cyprus was a smoke screen.  They haven't even sold any gold, this was a floated rumor.  Even if Cyprus actually sold gold, it would be a fraction of the amount of the paper gold that was (I believe fabricated) and dumped on the market.  The problem is not Central Banks selling gold, it is market participants fabricating paper gold and selling naked shorts for price manipulation and profiteering.

6)  Call me an "extreme political conservative" and "fanatic".   I guess inflating the MZM money supply massively and the Fed balance sheet from a few hundred billion to several trillion, with sky-rocketing USA debts and deficits are just facts we should ignore and go back to our "American Idol" episodes.

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Surface Treatments

Jim,

I agree that Jesse's case is much more believable. Roubini is a Keynesian. Keynesianism can only operate in a fiat monetary system. They have to attack gold as it is anti-fiat.

Roubini's credentials give him legitimacy with folks who don't understand the workings of economics. Since he's a professor, he must know what he's talking about. They can't read his arguments and come to a different conclusion. It is the sad result of the dumbing of America.

Hrunner,

First off, robbie posted the article. I read it earlier from a link provided by Jim Sinclair's Mineset. When I saw this thread was started, I felt compelled to comment. On the surface, Roubini's arguments seem plausible. Once you look deeper, the reasoning falls apart. I love your description here:

2)  High inflation- not yet.  To me it's like- "yes, you've been stabbed with a dirty knife 15 minutes ago, but you don't have a fever yet, so all is well, no risk of infection". 

I was recently at a friend's 70th birthday party. My wife and I were seated at a table with a few of his teenage granddaughters. They were talking about American Idol. I was amazed at the amount of detail they knew about each contestant. They were talking about the judges and I asked them what they knew about the Supreme Court. I got a few nervous laughs and a kick from my wife. I then asked which of the Idol judges was their favorite, and the buzz resumed.

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The absent velocity of QE

I find it interesting that no one seems to mention the low velocity of the liquidity injected by the various programs of QE. The consensus seems to be that the monetary expansion has not created inflation because it is being held by the banks and not made available for lending. I was under the impression that to jump start expansion and moderate inflation (the Feds strange idea of growth) the various iterations of QE were undertaken but thwarted by the banks just sitting back and not lending. Contemporanously with the QE and desire for expansion we hit the banks with Dodd-Frank and new lending restrictions that take time to understand and adapt to: regulations that are at cross purposes with the QE programs. Uncertainty and regulations thus conspired to prevent the first QE from working and the answer was more QE?!

There is a dam that was built of regulation and risk aversion behind which all this monetary expansion and printing has accumulated. At some juncture either the lake of money is drained to reduce pressure or it breaks through the dam and floods the areas downstream. Rather than successfully managing the volume and having controlled releases that relieve pressure the Fed and other Central Banks have only added more QE in the belief that somehow this will force more money into the system through the small vent holes, and to a point physics does cooperate with them. But the pipes are too small and cannot handle that volume, IMHO, so they just allow the further accumulation of pressure.

When the wall of money breaks through we will see the missing velocity as spending goes out of control. With no real method to "sop" up the excess the Fed and other Central Banks will struggle to control this and then inflation will become an issue as the doubling and tripling of velocity drives prices up. That inflationary environment is perfect for gold bugs to thrive, if they have the coins in hand before hand. If they are playing catch up then they will face the problem of huge delays in delivery of physical gold, which is the other issue that is troubling. If spot prices are dropping then why are so many people, worldwide mind you, placing orders for physical delivery.

There is a school of thought that collective cognition of a group is superior to that of one or two experts and that they are better predictors of future behavior. The universal signal from physical buyers of PM is that the price is going to improve, or that conditions are ripe for economic turmoil that will make tradition forms of money less useful.

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Gatortrapper, Velocity is the problem

Gatortrapper,

You correctly focus on velocity, something that only occasionally gets a mention in the MSM, but is the heart of the problem, and tells the tale, so to speak.

Even the minority of people that even mention velocity of money don't seem to go deeper into the "whys" of low velocity, they just look at it and poke it like it was some strange captive animal.

Remember, velocity of money is just a metric.  It doesn't tell you about root causes.  It is like measuring the temperature in a building.  You still to know is cold because your heater isn't working, or because someone left the front door open.  But there are several explanations that could give the same result.

The trap that the Fed is in is that their money transmission is working in a very tiny loop of Fed (QE) to bank (MBS, UST) to stock market (buy stocks) to bank (sell stocks, on margin, at a profit) to Fed (excess reserves).  I guess this makes Dow companies feel good since their share prices are going up.

As you said, lending is not happening.  Since lending is not happening, this must mean established businesses and innovative new businesses are not expanding (we know this is true- see all the stock buybacks instead of growth and capital investments) and since businesses are not expanding, new jobs are not being created.  And since new jobs are not being created, people have lower incomes and lower discretionary money, and feel generally more insecure financially.  And since people don't spend money, businesses don't see the case for expansion, setting up a negative feedback loop.

In the good ole days of blowing housing bubbles, the Fed had a bigger money loop to work with e.g. Fed to banks to mortgage lenders to consumers to consumer market.  More money by virtue of higher home prices and home equity gave impetus to buy that new car, new boat, start a business etc.  That paradigm is missing since the only folks actually accumulating more dollars are those involved in the small loop I mentioned i.e. Fed to banks to stock market to banks to Fed.  Yes, there is a slice of the 1% that are getting wealthy (and it's a shame, because that 1% aren't really the ones creating novel products, new drugs, better fabrics- they are essentially just moving money around).  There are only so many bottles of champaign and houses in the Hamptons that can be bought.  Really a tiny fraction of the larger economy.

Harvey Dent et al. also promote the idea that we are in a worldwide demographics trap where an aging population is doing what they always do- spend less.

When the stock market turns down hard again, I think what is coming next is either /or or perhaps both/ and  1) bigger QE and direct purchases of equities by the Fed (BOJ is already doing this, and I wouldn't be surprised if the Fed is doing this quietly now) to drive Dow even higher, and 2) direct Consumer QE- purchase and forgiveness of student loans, or some kind of deal with the Obama administration to monetize vast portions of the federal budget in exchange for Obama agreement to cut tax rates- this will look good on the surface since it will look like Obama is compromising to give Repubs their tax cuts, but it in reality will be overt monetizing the debt.

This will create the bad inflation we have all been expecting.  And it will be far worse and accelerate faster than we know since all those excess reserves will come flooding out in loans, reversing the velocity of money curve and causing disastrous inflation.   So in sum, mild inflation until stocks crash, brief bad deflation, final phase of high inflation and possibly hyperinflation.  Velocity will look like slow, then real slow, then real fast.

Jim H's picture
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Speaking of Gold.... new language added to Comex disclaimer

From Dave (from Denver) today;

http://truthingold.blogspot.com/2013/06/the-comex-confirms-that-its-gold...

"The information in this report is taken from sources believed to be reliable; however, the Commodity Exchange, Inc. disclaims all liability whatsoever with regard to its accuracy or completeness.  This report is produced for information purposes only." - disclaimer now posted on the Comex gold and silver daily warehouse stock report as of Monday, June 3, 2013.......

I am willing to bet a very large amount of money that this disclaimer was put on the warehouse reports starting yesterday as a result of the large amount of gold bars that has been physically removed from Comex vaults, and specifically from JP Morgan's "eligible" account, since the beginning of the year.  This means that it is highly likely that a significant portion of the remaining gold and silver sitting in Comex precious metals vaults - especially JPM's -  has been been hypothecated in some form.

For anyone who has witnessed what happened with MF Global and the illegal hypothecation of customer assets, a situation in which JP Morgan is/was inextricably tied, if  you believe that Wall Street is willing to hypothecate the sacred customer accounts but would not hypothecate or lease out Comex gold, then you are either tragically naive or terminally ignorant.

To make matters even worse, I just looked up the Comex warehouse rules with regard to storage and guarantee requirements, and there is not any requirement that Comex vault operators establish "allocated" accounts for the individual customers who have taken delivery - theoretically - of gold or silver from the Comex and chose to "safekeep" it in a Comex vault.  Here's the link the to rules:  Comex Storage Rules

Yes, insurance is required, but there will come a time - likely sooner than most think - when there will be a rush by Comex vault customers to take delivery of the metal they have been ambivalently assured is sitting in a Comex vault.  Unfortunately for them, they will receive a notice that will say "see the disclaimer on our website, check's in the mail."

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When simple things start to sound complicated, trouble warning

Jim,

Great pickup and warning.

One of the "wisdom things" (like "if it sounds to good to be true, it probably isn't") I feel like I've learned after a few decade earth round trips is:

"If a simple thing is sounding more complicated than it should be, something bad is going on"  or similar version.

My understanding of a futures market:  Producers of commodities, such as farmers, cattlemen, miners, offer a certain number of physical units of the commodity for physical delivery in the future (May cotton, December gold).  Parties with money make offers on said commodity units.  Producers accept whatever bid they feel is reasonable and profitable.  Purchasers of said futures are allowed to resell to 2nd parties.  The COMEX is a trusted institution that merely provides a place where producers and buyers may make this exchange.  The COMEX has simple and limited duties such as "make sure the producers can actually deliver what they say" and "make sure the buyers actually have money to pay for the commodities".  That's about it, or should be.

Vaulting- you give me (or a second party that owes you something gives me) a defined number of physical items.  I store it for you, in a safe and climate-appropriate place, for an agreed upon amount per unit of time.  When you ask for the stuff I stored for you, I go get it and give it to you.

When you re-read what you just posted above, and compare it to the "simple" rules I just laid out, you realize why I believe we live in consequential times.

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metametal
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Questions on Velocity

Thank you, Hrunner, for your very interesting analysis. I have a few concerns which I hope will inspire some comments.

I'm assuming that any serious, prolonged inflation requires a broad increase in demand over supply.  In past cycles this has been largely driven by wage inflation.  Will there be a return of wage inflation or have there been structural changes that could prevent this?  Outsourcing and automation are two such structural changes.  Increasingly, any large company's labor force is considered a cost rather than as an asset.  This seems deflationary to me and I don't see how it will be reversed as long as we have a global economy where capital can readily find the cheapest labor worldwide and rapid advances in automation decimates existing  labor markets and prevents the formation of new ones that aren't highly specialized.

Absent wage inflation, what will drive a serious, prolonged inflation or hyperinflation?  Where will the serious new demand to drive it come from?  Harry Dent's [1] demographic argument seems strong that aging populations will lower demand, not raise it.  Fred Pearce [2] argues convincingly that the phenomenon of aging and falling population is happening all over the world (notable exceptions being Africa and the Middle East). The EEU's credit store is shrinking. China's growth is faltering.  From multiple perspectives it seems that stagnant or falling demand in the next few decades could be a global phenomenon.

Richard Koo [3] has argued convincingly that QE-style priming is impotent when it comes to money velocity.  His main point is that you simply can't induce companies or investors to take on new debt unless the overall economy seems relatively bullish on growth.  It's the same as trying to push on a string.  Within a few quarters, Japanese Abenomics may well confirm the futility of QE-style solutions. We'll see.

QE priming of the stock market seems ultimately unsustainable.  An equity bubble must develop and ultimately pop.  When that happens massive amounts of debt will go unserviced.  Deals to forgive student or other loans will clobber balance sheets and shrink total available credit, all of which is deflationary.  

Of course anything is possible 15-20 years out, but I don't yet see a tight argument for strong inflation or hyperinflation in a nearer term.  Deflation seems rather more likely.  Please correct me if I'm off-base.  The deflation / hyperinflation question seems to me probably the most important one an investor needs to address in making PM and other decisions.

 

[1]http://amzn.to/11rw7df

[2]http://amzn.to/16JRWJY

[3]http://amzn.to/14vOKKY

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Deflation or Inflation

metametal,

I'm going to jump in here to answer your questions. If we had honest money, deflation would rule the day for all the reasons you listed. It would rule the day because it costs lots of effort to increase the supply. What does it cost central banks to increase the supply of fiat? I think it only costs them their reputation. If they flood the market and hyperinflation takes hold, they've only lost the basis for their power.

So far, they've tried a number of things to get the economy stimulated. None of it is working. They need to continue or the fiat banking system (which requires constant growth) collapses. Central banks are firstly beholden to the private banks. With deflation, the banks lose. With mild inflation, banks win. With high inflation, banks survive to fight another day.

In 2002, when Bernanke made his infamous helicopter speech, he was indicating the extremes he was willing to go in order to keep deflation from taking hold. So far, they haven't resorted to dropping cash to the citizens. If they did, money velocity would return in a blink of an eye.

I don't have a clue as to what form the next Q.E. will take. I do believe that they will do everything in their power to keep deflation at bay. If one thing won't work, they'll try something else. When all else fails, they'll distribute money to the commoners (and threaten to continue for as long as it takes.)

Eventually, they will win their fight against deflation. Of that, I have no doubt.

Grover

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Don't Bet Against Uncle Ben
Grover wrote:

In 2002, when Bernanke made his infamous helicopter speech, he was indicating the extremes he was willing to go in order to keep deflation from taking hold. ...............

Eventually, they will win their fight against deflation. Of that, I have no doubt.

Grover

I agree 100% Grover. Bernanke will not allow deflation on his watch. He has told us over and over. My bets lean toward inflation, but I'm hedged cause I've worked too hard all my life to gamble on something out of my control. 

Hrunner's picture
Hrunner
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Inflation and Deflation

Metametal,

Great questions, they are the grist of a lot of great parlor-room debates.  Grover makes excellent points and I generally agree with his thoughts. 

That said, I have posted on inflation and deflation before, but I will confess from the outset that I don't know exactly how it's going to go down, and neither does anyone else.  There are too many variables and too many unpredictable, irrational humans involved, both acting and reacting.  One party can control the action but not the reaction- that's up to the reactor. 

Inflation sounds simple at first, but I contend, after some decent amount of study, that our historical concepts of inflation are not that useful.  Yes, if you massively increase the money supply, you will often get a general rise in prices, but as we have seen with QE, that is not a law that is strictly followed.  I gave the example of the counterfeiter in the basement who prints up billions of dollars, and reports it to the Fed, so the Fed adds it the money supply statistics, but then, for whatever reason, he chooses to let it sit in his basement (rainy day fund perhaps).  See, the money supply greatly increased but the effect on prices is zero.  A version of that is what is happening in real time with QEinfinity, with the slight modification that there is a small money loop involving a couple of parties, but nonetheless the money ends up in the basement (i.e. excess reserves).   Ditto corporate excess cash (ends up sitting in banks).

Consider also the fact that statistics that we call "inflation" or the "deflator" are composites of the relative prices of several goods and services, and even these are questionably constructed by our beloved government data sources. 

I came around to the idea that, while maybe inflation and deflation have some general value as metrics,  the most important issue is simply to track the prices of things that are important to you and affect your life.  And I subscribe to the idea of the possibility of having deflation and inflation at the same time- if we discovered a way to triple the crop yield of wheat, or alternativelly Bloomberg published a news story that American wheat was contaminated with radioactivity, then the price of bread and crackers would massively deflate, while housing prices or the price of gold could rise sharply, at the same moment in time, if the supply of new homes suddenly became constrained due to a lumber shortage, or several countries CBs printed currency like crazy all at once (kind of like now).

So which is it, "inflation" or "deflation"?  It's both, or more simply wheat price falling and gold price rising.

That being said, I'm compelled by Chris' and others thesis that the stock market is way over-valued and is due for big (30-50%) correction.  However, our USA and global economy is so fragile, this magnitude correction is going to create some very bad side effects, IMHO.  And again, I'm on the side that the Fed will fall back on 1) must do something, and 2) the only thing it knows how to do is expand the money supply.  Thus son of QEinfinity.  I believe it will be mutiples bigger, and (see below) involve a more consumer/ main street approach to get the hot money in the 'spendy' hands.  This will trigger the high inflation (10-15%).  It depends on how poorly the economy reacts to these new sets of distortions, but I think it will be quite poorly.  Hyperinflation (which is a different animal than high inflation- it is the citizens giving up on the currency and going to something else) or something equally bad.  Timing is incredibly hard to know- depends on external circumstance, confounding factors (war, drought, infectious disease), but I don't see how we keep on past 2015 without a trigger being pulled.

As for wage inflation.  It's a complex picture.  I agree with the paradigm shift- for labor that is fungible and able to be done anywhere in the world.  So computer programming, accounting, auto construction- yes.  But there are job sectors in the U.S. that will be resistant.  Remember there is some labor that is not fungible.  If you need a plumber to fix your kitchen sink, that will never be shipped overseas.  Also, I still believe the U.S. will lead in a number of "right brain" kind of jobs, namely creative work such as R&D, entertainment, marketing, anything that involves working up something that has never been done before.  So wage inflation for those jobs, wage stagnation and deflation for the former category.

Hope this long-winded post provides food for thought.

H

 

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Grover
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Supply and Demand
Hrunner wrote:

That said, I have posted on inflation and deflation before, but I will confess from the outset that I don't know exactly how it's going to go down, and neither does anyone else.  There are too many variables and too many unpredictable, irrational humans involved, both acting and reacting.  One party can control the action but not the reaction- that's up to the reactor. 

In the short term (however long that lasts) I agree. In the long run, fundamentals will win out.

Hrunner wrote:

Inflation sounds simple at first, but I contend, after some decent amount of study, that our historical concepts of inflation are not that useful.  Yes, if you massively increase the money supply, you will often get a general rise in prices, but as we have seen with QE, that is not a law that is strictly followed.  I gave the example of the counterfeiter in the basement who prints up billions of dollars, and reports it to the Fed, so the Fed adds it the money supply statistics, but then, for whatever reason, he chooses to let it sit in his basement (rainy day fund perhaps).  See, the money supply greatly increased but the effect on prices is zero.  A version of that is what is happening in real time with QEinfinity, with the slight modification that there is a small money loop involving a couple of parties, but nonetheless the money ends up in the basement (i.e. excess reserves).   Ditto corporate excess cash (ends up sitting in banks).

I understand the point you are making. Money without velocity doesn't affect prices. I've read your example before and bristled. Any monopoly hates competition. If a counterfeiter reported their success, the Fed would report the results ... to the constable. Perhaps you could change your example to what is really happening with banks parking excess reserves with the Fed for a risk-free return. I wouldn't bristle at that.

Hrunner wrote:

Consider also the fact that statistics that we call "inflation" or the "deflator" are composites of the relative prices of several goods and services, and even these are questionably constructed by our beloved government data sources. 

I came around to the idea that, while maybe inflation and deflation have some general value as metrics,  the most important issue is simply to track the prices of things that are important to you and affect your life.  And I subscribe to the idea of the possibility of having deflation and inflation at the same time- if we discovered a way to triple the crop yield of wheat, or alternativelly Bloomberg published a news story that American wheat was contaminated with radioactivity, then the price of bread and crackers would massively deflate, while housing prices or the price of gold could rise sharply, at the same moment in time, if the supply of new homes suddenly became constrained due to a lumber shortage, or several countries CBs printed currency like crazy all at once (kind of like now).

So which is it, "inflation" or "deflation"?  It's both, or more simply wheat price falling and gold price rising.

I agree that prices can and do fluctuate. Sometimes, the prices change for good reason (as in your hypothetical examples.) When the value of the dollar drops, the general trend is for prices to increase. When the value of the dollar rises, the general trend is for prices to decrease. Volume and velocity of dollars (and credit) is what drives the overall relationship that we call inflation/deflation.

When folks generally have faith that their dollars will buy more in the future, they won't be as likely to spend them. That is where we are today. That is what Bernanke is trying to modify slightly. He knows that too heavy a hand will cause faith to wither. As long as he takes baby steps, no one will sound the alarm and he can continue his game.

For an example of a bolder step, consider Japan. Abe has stated that they will weaken the yen to get 2% inflation each year. We're all watching how this unfolds. If it is successful, you can bet that Bernanke (or his successor) will incorporate the same strategy with the dollar.

Hrunner wrote:

That being said, I'm compelled by Chris' and others thesis that the stock market is way over-valued and is due for big (30-50%) correction.  However, our USA and global economy is so fragile, this magnitude correction is going to create some very bad side effects, IMHO.  And again, I'm on the side that the Fed will fall back on 1) must do something, and 2) the only thing it knows how to do is expand the money supply.  Thus son of QEinfinity.  I believe it will be mutiples bigger, and (see below) involve a more consumer/ main street approach to get the hot money in the 'spendy' hands.  This will trigger the high inflation (10-15%).  It depends on how poorly the economy reacts to these new sets of distortions, but I think it will be quite poorly.  Hyperinflation (which is a different animal than high inflation- it is the citizens giving up on the currency and going to something else) or something equally bad.  Timing is incredibly hard to know- depends on external circumstance, confounding factors (war, drought, infectious disease), but I don't see how we keep on past 2015 without a trigger being pulled.

I agree completely. They will take additional steps. If they are desperate, they will have to become bolder.

Hyperinflation is the complete loss of faith in the currency. It is the other side of the deflation coin. With deflation, there isn't enough currency moving through the system. In hyperinflation, there isn't enough good currency available.

Hrunner wrote:

As for wage inflation.  It's a complex picture.  I agree with the paradigm shift- for labor that is fungible and able to be done anywhere in the world.  So computer programming, accounting, auto construction- yes.  But there are job sectors in the U.S. that will be resistant.  Remember there is some labor that is not fungible.  If you need a plumber to fix your kitchen sink, that will never be shipped overseas.  Also, I still believe the U.S. will lead in a number of "right brain" kind of jobs, namely creative work such as R&D, entertainment, marketing, anything that involves working up something that has never been done before.  So wage inflation for those jobs, wage stagnation and deflation for the former category.

Hope this long-winded post provides food for thought.

H

Wage inflation is based on the simple premise of supply and demand. With things that can be done globally (your examples are excellent,) the available supply of labor is much larger and therefore competition drives the prices down. With things that can't be off shored, the supply is much smaller and therefore have a measure of pricing power.

I agree that plumbing cannot be off shored, but what if the number of plumbers in the area increased substantially. I've got plumbing to do and call a few to get estimates. When they give me a price, I can tell them that they want too much for their services and get them to lower the price. They are keenly aware that the number of available plumbers has increased dramatically and will be forced to lower the labor price or risk losing a customer. Meanwhile, they still have to pay for fixed costs like equipment, offices, etc. They may try to convince me that their work is superior. In the end, they lose my business if I go elsewhere. They aren't as immune to the ravages of supply/demand as you might think.

As an aside, that is why I asked Chris and Adam for advice on how to advise a young person just starting out. Right brain work isn't for everyone. If everyone did it, the supply would increase and the value would drop. If everyone got a Ph.D., we'd have garbage collectors with Ph.D.s.

Grover

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metametal
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The Fed vs. Deflation

Thanks Hrunner and Grover, I love this discussion.  More random thoughts for your comments:

What are the Fed's real options for fighting deflation?
 
1) Ben's final "helicopter" solution seems to me mere rhetoric.  A full-scale "drop" could only destroy the currency, which would bring chaos to all and benefit no one. If I'm a wealthy insider with cash or cash-equivalent reserves, I will bitterly oppose it.
 
2) A partial "helicopter" sounds more plausible, but it's unclear to me how effective it could be.  Bush II's stimulus may have helped some car makers and dealerships, but most of it apparently went to building savings and paying down debt.  Once a deflation mentality starts to set in, Main Street has probably already started to become psychologically prepared to hoard cash like everyone else.  Given a choice, families struggling with health and education costs, stressed properties and expired unemployment benefits will probably bank new "stimulus" money rather than spend it.  Velocity zero.
 
3) That "Ben will think of something" seems speculative and unproven.  "Don't fight the Fed" may be somewhat useful for certain investing decisions but gives no guarantee that the Fed can deal effectively with deflation per se.  Repeating such mantras seems to me little more than wishful thinking, not unlike that of the notorious Cargo cult.
 
4) History doesn't appear to provide examples of central bank policy effectively fighting deflation.  Time may confirm that a deflationary economy needs to wait it out until people spontaneously decide to invest and spend again, which may take a generation or longer.  It may be overly optimistic to assume we'll ever really understand the underlying dynamics better than someone like Kondratiev.  It may be like the bond market: the climate is good until it isn't, or vice versa.
 
5) Ben claims to have a big quiverfull of anti-deflation tactics, but takes care not to share any details.  Like his predecessor, he seems big on posturing and scant on credibility.
 
6) Even if the Fed had good anti-deflation tools, they would probably time the use of them badly and could end up causing more harm than good.  Hindsight (ever useful) has shown that the Fed has been mostly quite wretched in trying to time its moves.
 
And, for me, the strongest point:
 
7) Japan is in growing crisis over two decades into its deflationary struggle.  Do we really imagine that the Fed will "come up with" something that Japan hasn't thought of or tried to implement?  How is our economy qualitatively different from Japan's?  That their current solution is QE-cubed is not very encouraging.  Any flat statement that deflation is impossible in our banking system probably needs to explain why Japan has been unable to fix theirs.
 
Overall, I'd love to see a detailed argument showing how a centrally-directed stimulus plan, even in theory, might actually get good and lasting results in a deflationary predicament.
 
Side note on wage- inflation/deflation.  I found an interesting link where Mish Shedlock[1] makes a striking point that a side-effect of the Fed's keeping artificially low interest rates is that it encourages business to borrow basically-free money to invest in new technologies or methodologies precisely for the purpose of shedding more workers. That's deflationary, of course.
 
[1]  http://bit.ly/15IYx3t , last paragraph
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The order of seasons

metametal,

I don't have any more specific answers to "save the system" than anyone. This is all new territory - scary for everyone involved and we're all involved. The tools that were used effectively in the past have been rendered impotent. The Fed has to do something and then wait to see the results. They'll be cautious as long as they can. Eventually, they'll become bolder when panic dictates their actions.

metametal wrote:

1) Ben's final "helicopter" solution seems to me mere rhetoric.  A full-scale "drop" could only destroy the currency, which would bring chaos to all and benefit no one. If I'm a wealthy insider with cash or cash-equivalent reserves, I will bitterly oppose it.

Wealthy insiders have one common goal - to become wealthier and more deeply ingrained in the inner circle. That drive is what got them where they are. I perceive it as a character flaw. When is enough enough? I agree that a full scale "drop" could destroy the currency. That will be reserved for later.

metametal wrote:

2) A partial "helicopter" sounds more plausible, but it's unclear to me how effective it could be.  Bush II's stimulus may have helped some car makers and dealerships, but most of it apparently went to building savings and paying down debt.  Once a deflation mentality starts to set in, Main Street has probably already started to become psychologically prepared to hoard cash like everyone else.  Given a choice, families struggling with health and education costs, stressed properties and expired unemployment benefits will probably bank new "stimulus" money rather than spend it.  Velocity zero.

A partial drop is a more likely scenario. When that fails, increasingly more complete drops will be considered and then implemented. It isn't necessarily an on-off switch. Bush II's stimulus was quite meager and was billed as a stop gap, one time event. Most people responded rationally and used the money to pay down debt. How long did it take for them to get back to the same level (or higher) debt? It takes time for these things to work.

metametal wrote:

3) That "Ben will think of something" seems speculative and unproven.  "Don't fight the Fed" may be somewhat useful for certain investing decisions but gives no guarantee that the Fed can deal effectively with deflation per se.  Repeating such mantras seems to me little more than wishful thinking, not unlike that of the notorious Cargo cult.

Look at the meager rate increases that Greenspan enacted before retiring - a quarter point per meeting. People knew that debt was becoming more expensive which meant that the price of money was currently on sale, regardless that it was going up. I remember coworkers telling me that they had to buy that house before rates rose higher. It forced more people into ARMs so they could afford the dream. Unscrupulous lenders started creating new products that they could then gouge the bag holders. Looking back, shouldn't we have known it was a house of cards? Based on his actions, wasn't Greenspan's goal to slowly deflate the bubble he created? It had the opposite effect.

The wealthy insiders didn't fight the Fed. They should have paid the price when the 2008 crisis unfolded. The world would have been quite different if they had been allowed to fail. Instead, we rewarded those who became too big to fail. Now, they're bigger and there are more of them.

metametal wrote:

4) History doesn't appear to provide examples of central bank policy effectively fighting deflation.  Time may confirm that a deflationary economy needs to wait it out until people spontaneously decide to invest and spend again, which may take a generation or longer.  It may be overly optimistic to assume we'll ever really understand the underlying dynamics better than someone like Kondratiev.  It may be like the bond market: the climate is good until it isn't, or vice versa.

Agreed. The bad debts need to be worked out so we can begin again. The wealthy insiders are likely to lose substantial amounts when the inevitable actually occurs. What lengths will they pursue to maintain their privileged life?

metametal wrote:

5) Ben claims to have a big quiverfull of anti-deflation tactics, but takes care not to share any details.  Like his predecessor, he seems big on posturing and scant on credibility.

Talk is cheap and highly effective. How many times have the FOMC minutes been released with subtle wording changes that caused stampeding in the markets? As long as Ben threatens to use his arrows and people think he will, does he really need to have them?

metametal wrote:

6) Even if the Fed had good anti-deflation tools, they would probably time the use of them badly and could end up causing more harm than good.  Hindsight (ever useful) has shown that the Fed has been mostly quite wretched in trying to time its moves.

Agreed. That is why they will err on smaller and more cautious steps.

metametal wrote:

And, for me, the strongest point:

7) Japan is in growing crisis over two decades into its deflationary struggle.  Do we really imagine that the Fed will "come up with" something that Japan hasn't thought of or tried to implement?  How is our economy qualitatively different from Japan's?  That their current solution is QE-cubed is not very encouraging.  Any flat statement that deflation is impossible in our banking system probably needs to explain why Japan has been unable to fix theirs.

Japan has felt that they must take bolder steps. You can bet that the Fed is watching intently at what happens. If they deem the results to be good, they'll follow in the same steps. If not, they'll attempt other strategies until something works.

metametal wrote:

Overall, I'd love to see a detailed argument showing how a centrally-directed stimulus plan, even in theory, might actually get good and lasting results in a deflationary predicament. Side note on wage- inflation/deflation.  I found an interesting link where Mish Shedlock[1] makes a striking point that a side-effect of the Fed's keeping artificially low interest rates is that it encourages business to borrow basically-free money to invest in new technologies or methodologies precisely for the purpose of shedding more workers. That's deflationary, of course.

I'd love to give a detailed argument of what will work. Actually, I can. Get rid of the Fed and all the nanny regulations designed to "save" the innocent. Let the market figure it out. There will be massive dislocations throughout the world. Most people will suffer. Many will die. Eventually, the economy will recover from a much smaller footprint. That is the price of hubristically thinking that central planning can actually work.

You can't go from Fall to Spring without passing through Winter.

Grover

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metametal
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Thank you, Grover

I really appreciate your responses; you've obviously thought long deeply about all this.  Just to clarify, though, my intention here was not to ask for a solution to the Whole Messy Enchilada; I take it for granted that our global Ponzi capitalism will somehow find a way to flush itself down a sewer to ooooooooblivion, before too long.

What intrigues me as an investor's thought exercise is which way we'll trend in the next ten to fifteen  years with inflation, deflation or some combination of the two. That part of it is fun. At the bigger, more harrowing  scales, I prefer to fall back on trusty old Magical Thinking rather than continually wring out hankies soaked with tears. I'm sure I'm not alone in that here.

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Inflation Graphs

Grover and Metametal,

Great, thoughtful responses, a couple of brief comments:

"Helicopter Drop" is semantics.  We are already in a "Helicopter Drop".   Repeat after me. "the Fed is printing one trillion dollars of new money each year".  The only question is will the helicopter drop get bigger or will Ben find religion and stop.  I would wager on the former.  And just to let you know, after listening to Harvey Dent talk about the demographic issue, I was impressed with the idea that not trillions but tens of trillions would need to be appropriate magnitude of QE if the Fed truly believes it needs to take the role of filling in gap of aggregate demand.

"Don't fight the Fed".  Just a phrase, but I get it, I get it.  However, not being blind and dogmatic, I will not blindly buy stocks and bonds just because the Fed is (or forcing banks to).  One may choose to ride the Fed coattails for a time, but be very careful.  The Fed is right until it is wrong.  See 2007.

Deflation.  The Fed has one arrow against deflation.  Print money.  The variation is in how it prints money (historically, lowers interest rates and helps create new money via fractional reserves, but currently QE and buy stuff).  We are in an experiment to see if printing money can solve a debt and inappropriate allocation of capital problem.  It never has.  I'm betting on the team that has a 77 /0 win/ lose record.

The fundamental struggle is not with one tool of Keynsian manipulation versus another tool of Keynesian manipulation, the struggle is Keynes versus von Mises.  I.e. highly managed economies with unlimited Central Bank power to control the money supply and "prevent" recessions and depressions by injecting money when it deems necessary, versus a sound money economy where money supply is dicated by the level of wealth produced and the needs of commerce.  And markets dictate the price of goods and services, and over-investment in companies and sectors is allowed to follow a natural and healthy course of de-investment and right-sizing investment, even if that means temporary, hopefully short-lived, pain for participants in those sectors. 

Nothing is ever completely black and white, and I acknowledge that our current system has led to a rapid expansion of growth in real industries (healthcare, IT, materials science).  Smart and dedicated people can create despite (not because of) the shackles of bad monetary policies.  The problem is the financial sector has "innovated" the fastest and largest relative to the real industries, and for the most part, has created nothing of value, though it has been exceedingly rewarded in fiat currency.

The only question for me is, when Keynesian economics fails, will the pain be so great and will society grow up and accept that we live in an imperfect world, and sound money systems and free markets have some pain and discipline as part of life.  Which is a more mature and better society.  And is a better system than the horribly unfair, and soon to be much more painful system we have currently.

Oh yeah, I thought I would post a couple of graphs from dshort.com to illustrate the point that "inflation" is not that useful of a term and it is better to drill down on products and services that are relevant to you or your business.

Energy and college tuition, high "inflation".  Apparel, "deflation".   The second graph shows why the average American family is stressed and knows something is not right.  Their income is flat, or falling in many cases, but costs are rising.  They know this is not sustainable.  Now I believe we have a long way to go before we look like Egypt with food riots, after all, we don't need to buy designer pet clothes or season tickets to the NY Yankees, but the path is not favorable.

 

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Money Velocity and Lending
Gatortrapper wrote:

I find it interesting that no one seems to mention the low velocity of the liquidity injected by the various programs of QE. The consensus seems to be that the monetary expansion has not created inflation because it is being held by the banks and not made available for lending. I was under the impression that to jump start expansion and moderate inflation (the Feds strange idea of growth) the various iterations of QE were undertaken but thwarted by the banks just sitting back and not lending. 

There is much in the data right now that is simply not amenable to historical comparisons because, well, everything is so distorted by the unprecedented Fed actions.

The money velocity is indeed down, a lot, because the banks have piled up much of the QE in the form of excess reserves.  By historical comparison we'd conclude that lending is at an all time low too.

But that's not the case.  While the rate of lending is slower than in the past, we are hitting all-time new highs in credit every month:

If the banks are not lending, then how is it that we are more than $5 trillion higher in total credit market debt from the lows in 2010?

The answer is that the Fed is lending a lot, and enabling the purchase of federal debt via its QE- programs.  That's one form of lending.  The other main one is to leveraged speculators which is also quite near all time highs.

Accordingly, we see inflation, and a LOT of it, it's just you have to measure assets as another set of 'things' that can inflate as surely as butter or gasoline.  The Fed, of course, chooses not to include assets in its measures of things that can inflate, preferring to stick to increasingly narrow measures that truly tell us very little about the risks and impacts of their policies.

Some day, and nobody knows when, all of those excess reserves will come flooding out of storage and begin to rampage across the price landscape.  At that time the Fed can either try to reel them all back in, which will crush the economy and many financial institutions, or it can let it rage and hopefully burn itself out without causing as much pain as the prior alternative.

We shall see. 

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Roubini Beat Down

While gold is getting a big beat-down- I guess 11,000 more jobs (statistically) created than expected, 175,000 v 164,000 is a plausible reason to flee out of gold, I thought this was an appropriate place to post two analyses of Roubini's gold "analysis".  One by our friend Mish, the other by JS Kim.  Plus a bonus by Bill Black on the fraud of our current economic journalism.

Nouriel Roubini Seriously Misguided on Gold, on Equities, on Economic Growth, on Money
Read more at http://globaleconomicanalysis.blogspot.com/2013/06/nouriel-roubini-seriously-misguided-on.html#ciAhbQliYeVpIiyf.99

"Roubini: First, tail risks are lower. Gold tends to spike when the global economy faces severe economic, financial and geopolitical threats; but, thanks to a variety of policy actions, the tail-risks argument for holding gold is less compelling today than at any time since the start of the financial crisis in 2007.

Mish: Japan is flirting with a Yen crisis thanks to Abenomics. Nothing has been fixed in regards to structural problems in the eurozone. A US recession is at hand. A China slowdown is baked in the cake. Trade wars loom between China and Europe. A full scale housing bust is underway in Australia. The UK threatens to leave the EU. The eurozone is unlikely to survive in its current state. Tail risks are enormous (and growing). I would have thought tail risks were so obvious that any serious economist would notice them. I was mistaken."

Also, Mish's later point about gold protecting in deflation is very reminiscent about a point about gold and deflation posted here a couple of days ago.  I'm just sayin'... 

The Lies of Nouriel Roubini and Gold

http://www.zerohedge.com/contributed/2013-06-06/lies-nouriel-roubini-and-gold

"On December 15, 2009, when gold was trading at $1122 per troy ounce, Nouriel Roubini stated, "Since gold has no intrinsic value…there are significant risks of a downward correction rather than a rapid rise towards $2,000, as today’s gold bugs claim” and gold “looks suspiciously like a bubble”. A 35% drop after a bubble bursting is a reasonable fall for “bubble” talk, which would have sent gold into the low $700s per ounce. A month earlier, Roubini had declared, “gold at $1,500 is utter nonsense.” So how did gold perform after Roubini hawked his “gold is a bubble” message all over the news? Not only did it never retreat back to $700 after Roubini ranted against gold, but it never retreated back to $800 or even $900, and in fact it soared to above $1,900 an ounce less than two years higher, a 69% surge higher that not only crushed Roubini’s “gold at $1,500 is utter nonsense” declaration, but made Roubini’s prediction of gold’s future price behavior utterly wrong by more than 100%."

 Bill Black: How Elite Economic Hucksters Drive America’s Biggest Fraud Epidemics

http://www.nakedcapitalism.com/2013/06/bill-black-how-elite-economic-hucksters-drive-americas-biggest-fraud-epidemics.html#OZZ8cLQCLatsRTd8.99

"A dangerous cycle begins when prominent economists pander to plutocrats and bought politicians, who reward them with top posts, where they promote the perverse economic policies that cause fraud epidemics. Crises develop, and millions of people are ripped off. Those who fight for truth are ignored or ruined. The criminals get wealthier, bolder and more politically powerful, and go on to hatch even more devastating cons."
 

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Chris, Adam, Gold data feeds

Chris, Adam,

Just a nit-picking question, but I just noticed that kitco is posting a $1386 price for gold and PP dashboard has it at $1412 (as best I could to check concurrent page info).

When I clicked on the "Gold" line item, I was taken to oilprice.net, which didn't seem to have the gold price (I may have missed it).

What gives?  Is there a better feed source for gold?  I realize the cost may be prohibitive.  FWIW, tfmetalsreport.com captures an actual 24 hour gold and silver graph from kitco.com (don't know the history of how kitco got to be the authoritative source of the gold price, but many seem to use it).

Not whining, just trying to be constructive.

H

Edit:  My fault, I did find the gold price scrolling down the page on oilprice.net.  Note that kitco's 24 hour graph shows a 09:29 time stamp for the $1386 price (it is 10:08 as I type), so it's not real time either.

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bank lending, rampaging excess reserves myths

First, I agree - banks are lending.  Its easier to see the extent of credit growth when you recast the TCMDO chart to be a percent change year-over-year, as I did below.  Eyeballing the chart suggests overall credit growth is currently increasing at about 3.5% per year (i.e. total credit is 3.5% larger than it was this time last year).  If monetary inflation is caused by growth of money & credit, that suggests we're getting...about a 3.5% inflation rate.  Its not hyperinflation, but over a 10 year timeframe, it will chop your $100 into about $70.  Note that credit growth during 2000-2008 was 7.5-10% per year.  A big chunk of that was going into housing.  Ah, but when monetary inflation happens to your asset, its not a bad thing now is it?

 

Now then, about the threat of rampaging excess reserves.  Steve Keen has debunked this myth of reserves driving lending here:

http://www.businessspectator.com.au/article/2012/10/22/commodities/myth-money-multiplier

To me he makes a very persuasive case; simply asserting that the 1.8 trillion in excess reserves are going to become magically multiplied by 10 (18 trillion) and cause TCMDO to jump by that same amount - to convince me of this particular danger, they need to explain why Steve Keen is wrong.  In one of the first few paragraphs of the article, he references a paper from two economists at the Federal Reserve Bank itself that calls this theory into question:

The most recent proof of this is in an excellent discussion paper from Federal Reserve economists Carpenter and Demiralp, entitled "Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?”. The first clue that it doesn’t exist is given by their abstract, which notes that, "before the financial crisis, reserve balances were roughly $20 billion”. If the textbook model were correct, the total stock of money in the USA would be $200 billion, versus the multi-trillion dollar level of even a narrow definition of the money stock. As the authors note, this makes a mockery of the textbook "Money Multiplier” model.

That's not to say there is no threat from increased bank lending - rather, I'm saying it is not tied to some magic number derived from the Excess Reserves and some mechanical floodgate-type action that is triggered at some unknown time in the future.

Monetary inflation is mostly caused by willing borrowers taking on new debt.  That's why the Fed lowers rates - in order to encourage borrowers to drive this inflationary process for them.  After a debt bubble pops, that mechanism doesn't work so well anymore.  That's why rates are at historical lows, and the credit growth even today is also far below the "normal rate" of credit growth - which we can see from the chart above oscillated in the range of between 5-15% per year.  Bank lending is anemic, because people just don't feel so much like borrowing, even with mortgage rates at 3.45%.

Will they feel like borrowing in the future?  I have no idea.  Maybe they will.  But it won't be piled up excess reserves that causes this to happen, it will be regular people and companies that decide they want to (and are able to) borrow money.

This may seem like a theoretical discussion, but understanding this is critical to you being able to accurately predict what is likely to occur.  Understanding clearly just how monetary inflation actually happens is empowering, because it allows you to gather information on your own and trust yourself.  Do you think people want to borrow more - and just as importantly, can they qualify for a loan at current rates?  Ask around, get a sense.  If the answer is yes, then inflation can't be far behind.  In this way, you can spot inflation before it happens, at the "loan stage" rather than at the supermarket after it has already happened.

 

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who is borrowing now?

So in the preceeding post, I referenced TCMDO and its change to suggest credit was increasing.  I realized that it might be interesting to post a chart that gives some more details as to which segments of the economy are actually borrowing.  This chart (and more) are found at: http://mdbriefing.com/us-credit.shtml

This chart shows the change in credit year-over-year.  So if a particular segment showed "0" that means the amount of borrowing stayed the same vs last year at that same time.  For instance, we can see that the red line (Households) actually borrowed less this year than last: 32.6 billion less.  However, you can see that the rate of shrinkage has been slowly declining.  Soon, perhaps households may actually start increasing their borrowing.  But that hasn't happened yet.  Borrowing less - repaying or defaulting - is known as deflation.

Dollar-wise, most of the increase in borrowing is from the Federal Government (purple line) - 1.08 trillion vs the borrowings at this same time last year.  Next is Corporate Business (blue line), up 734 billion.

So the answer to "where is credit growth coming from" is straightfoward: business - corporate business - and the US government.

Note the black line: in 2008, total credit grew 4.77 trillion year-over-year.  How's that for money printing?  Households (red line) alone did 6 trillion (1 trillion a year) from 2003-2008.  The Fed has printed 2.6 trillion since 2008.

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Velocity Absence

I'm becoming more of the view that this is really all about emotional confidence in external, artificial factors and when that confidence departs it will go quickly. I read one economists defense of Abenomics in Japan which basically drew a parallel with FDR's anti-deflationary policies and said they worked and Abenomics will work because people felt confidence where it had been absent before. Frankly I shook my head in disbelief that Abenomics will work as the math doesn't work and only marginal adherence to notions of self interest dictate that bondholders in Japan dump their exposure and move to foreign (to Japan) equities, which would push (as I understand the dynamic) bond rates beyond a level that the Japanese government can service. When they crash the Far East crashes. When the Asian Tigers slump, China and the EU slump, which depresses commodities, which causes a repeat of the sovereign defaults by emerging countries dependent on commodity sales for balance of trade. All that adds up to a huge retrenchment in the U.S. and collapse of tax revenues and ultimately we see the U.S. go into some type of technical default and then its over because the Fed has absolutely no arrows left to fire to prevent a slide into the quicksand of depression. And it all depends on how we feel about using fiat currency. When that goes the velocity will take off as everyone seeks to hoard and convert expectations of wealth into tangible items by dumping cash. A real s%it storm.

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Inflation is hidden in the Markets

So, if I read between the lines, the missing inflation is found in the run up of the equity markets and the new housing "boom" that is being touted as a sign of recovery. While consumer level inflation has been marginal, except for those of us that actually buy food and fuel, the real inflation is to be found in the stock market. That sounds like another way of describing a bubble in the markets.

 

There are too many moving parts that just don't seem to be moving the way they should. With apologies to Chaney...it's the unknown unknowns that we should be worrying about.

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Is relationship betwn credit expansion & inflation so clear cut?

Helllo Davidfairfax,

From my admittedly amateur reference point (slap me if I'm wrong), it's not clear how a 3.5% expansion in credit necessarily translates into 3.5% in subsequent monetary inflation. To take an example, what if much of the current credit expansion is being loaned to institutions for leveraged purchases of paper assets like stocks and derivatives? How would those purchases in themselves put upward pressure on prices for ordinary goods and services?  I suppose it could do so, to some extent, via the so-called "wealth effect," if those prices go up, but that effect could be abruptly turned the other way by a market correction and is therefore fickle indeed.
 
To predict that monetary inflation will rise pari passu with new loans from credit expansion, don't we have to analyze carefully how the newly borrowed funds from that expansion are actually used?  It seems to me that only the part of the new borrowing that creates new demand for the ordinary goods and services should be considered inflationary in a meaningful sense. Chris's recent example of new institutional borrowing driving up real estate prices is clearly inflationary in this sense; but other uses of borrowed money, such as purchasing and bidding up the price of mere paper equities, would not be inflationary in this ordinary sense.  From my own householder perspective, a spurt in stock prices does not proportionately raise my cost of living. For me, a practice of factoring equity price shifts into official inflation figures can only further muddy the term "inflation" (already muddied by government hedonics and such) to the point where it is no longer useful.
 
Also, as always, the mere fact of expanding credit would appear to say nothing about what velocity any resulting new money will end up having when it has finally been loaned into the economy.
 
Since inflation expectations drive so many investment decisions by blog members here, it seems critical that we all very clearly understand how future Fed-induced credit expansions should ultimately be expected to translate into the kinds of inflation we're really trying to protect ourselves from.
 
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inflation & credit expansion

metametal -

To predict that monetary inflation will rise pari passu with new loans from credit expansion, don't we have to analyze carefully how the newly borrowed funds from that expansion are actually used?

Yes exactly!  So for instance, when money is borrowed by the government, and gets spent by Medicare, guess what prices go up?  Likewise, when the government guarantees student loans - again, what prices rise?  And SNAP, and defense spending.

What about when a homeowner takes out a loan?  Home prices rise.  And if margin loans are taken out - inflation occurs in equities.

During the housing bubble, with a trillion a year going into housing (average about 12% per year over 6 years), it's not a shocking outcome that there was massive inflation in home prieces.  Some chunk of that leaked into the rest of the economy eventually, but with a delay, and presumably was also somewhat attenuated.  

If more money gets shoved into one sector of the economy, prices of things in that sector rise.

So we circle around to the original question: where is credit expanding?  Finance?  Home loans?  No.  Corporate business & government, so we can guess what sorts of prices are either going up - or remaining stable in an era where prices might otherwise be deflating.

Medicare, medicaid, social security, defense.  The Big Four.  And bureaucrats.  So that would say "all things medical" (drugs, supplies, healthcare salaries, etc), stuff older people buy, defense products, and property (and related economy) in Washington, DC.

Figuring out what is driving price movement in a particular sector can be challenging.

Take home prices.  Currently, home loan borrowing is contracting (by -2.7% annually) which suggests we should still have downward pressures on home prices.  But home prices are moving up.  That means money must be flowing into the sector from elsewhere - either cash from savings (hedge fund buying) or possibly money from outside the country.  Or maybe both.

But all else being equal, when credit expands, inflation follows.  So if the Fed expands credit by printing 2.6 dollars over 5 years - just how much expansion does that represent?  With total credit outstanding of 57 trillion, if the Fed expansion were to be evenly divided across the economy, the 2.6 trillion in expansion would result in a net 4.6% increase in price inflation over those 5 years.  But that's not how it works, of course.  All of that credit expansion went right into the bond market.  So bond prices rise - which means rates fall.  No doubt some of that money slopped over into other areas - but 1.77 trillion ended up being dropped into Excess Reserves.  All much of that money did was raise bond prices and then get parked.

During the same period where the Fed printed 2.6 trillion and bought bonds, 2008-2012, the US government borrowed 6.47 trillion dollars and spent it on all sorts of things.  So who do you imagine caused more "general inflation" during that period, the Fed, or the US Government?

Now back to my original statement.  Money creation even in this crazy fed-printing era is done primarily by willing borrowers taking out loans.  Mostly what the Fed really does is cheerlead from the sidelines, encouraging people to borrow more by keeping interest rates low.  Their printing operations are focused on just that - keeping rates low (although that process does drive bond-market inflation, but most of the money stops in Excess Reserves).  The Fed hopes to get private borrowing started.  They really aren't trying to cause inflation directly.  They want you and me to do the dirty work by borrowing more.

So to see whether or not massive inflation is really on the way, you simply need to have a sense as to whether or not people and businesses are willing to increase their borrowing.  Currently corporate business is to some extent, but small business and homeowners are not.

Last line of page 3, Fed Z1 (Flow of Funds) will hopefully fill this picture in a bit more clearly:

http://www.federalreserve.gov/releases/z1/current/z1.pdf

 

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Which kind of inflation are we talking about?
davefairtex wrote:

So to see whether or not massive inflation is really on the way, you simply need to have a sense as to whether or not people and businesses are willing to increase their borrowing.  

Thanks Dave!  Are you a by any chance a teacher?  If not, you'd be great at it.

To take this a bit farther (if you'll bear with me):

Is "greater willingness to increase borrowing," as you say above, really enough in itself to predict an inflationary result in goods & services?  Can you ever stop having to look very closely at how the new money is actually getting used when it hits the economy? Is it really clear that the new loans even in aggregrate will lay a foundation for increased demand for good and services (e.g., by creating good jobs)?  If the loans are mainly used by institutions for financial speculation in paper assets, how could those loans predict inflation in ordinary goods and services?  It's the latter that most of us care about.

As I read your above conclusion, it tells me that to predict mass inflation in goods & services, what we don't need to do is look at Fed anti-deflation policies, which appear to be impotent except for the attempted cheerleading.  Rather, what we do need to do is learn to think like good global macroeconomists and answer the question, "where in the world is new demand going to come from?"  The answer to that currently seems to me to be deflationary, not inflationary.  But that's a separate discussion.

CMartenson wrote:

Some day, and nobody knows when, all of those excess (Fed) reserves will come flooding out of storage and begin to rampage across the price landscape.

 

I'd ask the same question of Chris.  When these reserves come "out of storage," why should we all assume that they'll greatly effect prices of ordinary goods & services?  Couldn't they just as easily be massive bets in another asset bubble and all go poof when that bubble pops?  Are the two flavors of inflation (ordinary and asset) equally important in Chris's landscape?  Should they be in ours?

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inflation and borrowing

metametal -

Thanks for your kind words!  No, I'm not a teacher, at least not in this lifetime anyway.  :-)

Is "greater willingness to increase borrowing," as you say above, really enough in itself to predict an inflationary result in goods & services?  Can you ever stop having to look very closely at how the new money is actually getting used when it hits the economy? Is it really clear that the new loans even in aggregrate will lay a foundation for increased demand for good and services (e.g., by creating good jobs)?  If the loans are mainly used by institutions for financial speculation in paper assets, how could those loans predict inflation in ordinary goods and services?

This paragraph brings to mind Rosanne Rosanna Danna's pithy observation from 1970s SNL - "You ask a lotta questions for a guy from New Jersey!"

Clearly greater willingness to borrow isn't enough to predict price inflation.  Price inflation can be driven by a bunch of different reasons:

1) Increase in private and public borrowing [increases money supply in that sector]

2) Fed prints money and buys bonds [mostly causing bond-price inflation]

3) Commodity shortages - dropping production or rising consumption [commodity price increase]

4) Worker shortages [wage/price increase]

5) Increased money velocity [decreased confidence in the currency, prices increase]

6) Decrease in exchange rates with other currencies [import prices increase]

7) International money flows either in or out [sector prices increase or decrease]

I just focused on 1 & 2 and lumped those under the general heading of "monetary inflation."  So if we assume that everything else remains relatively constant, we can watch borrowing and assume that will be the big driver of prices, but as you say it is important to understand where the borrowing is happening so we understand where the impact is greatest and felt most immediately.  Yet even if borrowing appears only to affect assets, eventually the increase in credit will likely end up leaking into other sectors - for instance, rising home prices during the bubble eventually led to mortgage equity withdrawls, which then led to increased spending on cars & vacations.  So perhaps we can say that increasing credit from borrowing that ends up in assets first will leak out into the overall economy - but with some kind of time lag, and some amount of attenuation.

And if the Fed decides to buy stuff other than just bonds, they could really drive inflation.  This is a big wildcard.  Currently, the anti-deflation policies are mostly US government deficit spending, with the Fed injecting some monetary novacaine to neutralize the effect of all that borrowing on interest rates.  If actual deflation starts to occur again in spite of all this US Treasury borrowing, God Himself only knows what they'll try next.

But for now, Fed bond-buying won't cause mass inflation, it will only drive up bond prices.  It will have secondary effects likely prodding people to chase yield driving asset prices higher, and some of that bond-money will probably leak into the real economy, but it won't act with the same direct effect as private sector borrowing by homeowners, consumers, and businesses.  And we can also see the relative magnitude of Fed bond-buying is dwarfed by private sector borrowing.  And as I said before, the Excess Reserves danger is a myth rather than an 18 trillion dollar Monetary Sword of Damocles.  The extent of private borrowing is determined by the willingness to borrow and the strictness of the loan underwriting, not the level of reserves on deposit at the Fed.

As for "where demand will come from" - for quite some time a big chunk of increasing demand has come from people willing to take on more debt: buying stuff on credit cards, buying homes with ever-larger mortgages, companies and hedge funds borrowing money to execute leveraged buyouts, and so on.  If people get it in their heads to start this cycle up again, demand will increase, at least temporarily, until people get maxed out again.  Sustainable demand comes from higher wages, productivity, more surplus energy available to society, etc.  Getting people to borrow more and spend on consumables (including "assets" like homes) over and above their increases in income - that's unsustainable demand.  And its inflationary,  too.

At the end of the day, I believe that watching credit growth is a reasonable "first order" alarm signal for inflation.  Absent any massive Deux Ex Machina money drop from the Fed, I believe that private and government borrowing will be the source for any big burst of monetary inflation.  We could still have big price inflation moves due to a USD collapse (a double-whammy due to big money selling US assets AND a drop in the USD), and/or big price moves due to supply disruptions in oil and other commodities, but monetary inflation - its all about borrowing, absent a truly massive Fed money drop that occurs somewhere other than the bond market.

 

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Leaping into the dark

Thanks again, davefairtex!  You'll be glad to know I'm getting much closer to shutting up, at which point I expect to be well enough differentiated from the great Gilda Radner.  

You've given me much to think about.  Yes, the Fed could indeed enter even more uncharted territory out of desperation and just start buying random stuff in the real economy, helter skelter, to nudge some arbitrary, disconnected prices north.  This would mean being even more clueless than they are now, if that's possible.  

I guess I believe such tinkering would probably be too ineptly done to lay any groundwork for a real economic expansion, one that minds not yet driven into unreason might hope could spur the sustained Goldilocks inflation the Fed dreams about.  But that's just me.  I was trying to use my head but now it's time to just hand over what's left of the portfolio to my gut.  Over to you, gut.  Who the hell knows what lies ahead?  But as Gilda would say, there's always something.

 

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Velocity better than GDP

PPers,

I came across this short article from last August, after the comments in this thread about inflation, and the velocity of money:

"Velocity of money is the  frequency with which a unit of money is spent on new goods and services.   It is a far better indicator of economic activity than GDP, consumer prices, the stock market, or sales of men’s underwear (which Greenspan was fond of ogling).  In a healthy economy, the same dollar is collected as payment and subsequently spent many times over.  In a depression, the velocity of money goes catatonic.  Velocity of money is calculated by simply dividing GDP by a given money supply.  This VoM chart using monetary base  should end any discussion of what ”this” is and whether or not anybody should be using the word “recovery” with a straight face:

In just four short years, our “enlightened” policy-makers have slowed money velocity to depths never seen in the Great Depression.  Hard to believe, but the guy who made a career out of Monday-morning quarterbacking the Great Depression has already proven himself a bigger idiot than all of his predecessors (and in less than half the time!!).  During the Great Depression, monetary base was expanded in response to slowing economic activity, in other words it was reactive  (here’s a graph) .  They waited until the forest was ablaze before breaking out the hoses, and for that they’ve been rightly criticized.  Our “proactive”  Fed elected to hose down a forest that wasn’t actually on fire, with gasoline, and the results speak for themselves.  With the IMF recently  lowering its 2012 US GDP growth forecast to 2%, while  the monetary base is expanding at about a 5% clip, know that velocity of money is grinding lower every time you breathe.

The Fed’s refusal to recognize the importance of velocity of money quickly goes from idiotic to insidious.  Here’s a question:  If I give you 50¢ and as a result of that transaction, you owe me $1.00, what interest rate have I charged you?  Obviously, I’ve charged you 100% interest and I don’t give a rat’s ass about you or your kids.  I’m pure evil and you’re pure stupid.  But believe it or not, this kind of master-slave  arrangement isn’t enough to satisfy a true narcissist.   The narcissist needs to be exalted for his actions, no matter how unjust.  "

I had not heard a position that money velocity was better than GDP to measure economic activity, but given my concerns and critiques of how GDP is calculated, added to the general feeling that we are experiencing more like a recession than a recovery, I think it is a concept worth considering.  For money supply and money velocity students.

Entire article, by Mark McHugh, at:

https://acrossthestreetnet.wordpress.com/2012/08/19/shhhh-its-even-worse...

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Inflation, then Deflation, then High Inflation

I thought this was an excellent piece on zerohedge, perhaps because it underscored exactly what I think will happen.  But I find usefulness in scenario planning to visualize what things may look like when the economies of the world start to decompensate:

Charles Gave Warns: "Should The Fed Lose Control, The Downside Move In Markets May Be Terrifying"

Charles Gave:

"What kind of failure?

By propping up asset markets, the Fed has created an illusion that wealth is being created. The next step, according to Bernanke’s plan,  should be for growth to follow. In fact, there is no reason why the rise in prices of financial assets should lead to actual investments or a rise in the median income. So far, it has not. There has been no real increase in the private sector propensity to borrow, and the danger may be that any further public sector borrowing will hasten the decline because of our “permanent asset hypothesis”.

This means that, should the Fed lose control of asset prices (is this what is now happening in Japan?), then the game will be up and the downside move in markets may well be terrifying. Most at risk would be low and medium quality credits, banks, commodity producers, and any companies with negative cash-flow.

It is obvious, then, that if Bernanke’s experiment fails, it will be a profoundly deflationary failure. The best hedges in a deflation and in financial panic are US long bonds and the US dollar. Renminbi bonds seem also to be developing safe-harbor status. In fact, we found it interesting how, in May, every bond market around the world sold-off, except for the RMB bond market."

Zerohedge:

"in an environment of permanent low interest rates there is no impetus on behalf of the private sector to spend for growth, either in the form of capital spending or the hiring of incremental workers. The only net money exchange is the issuance of debt to fund dividends and stock buybacks: or simple EPS-boosting balance sheet arbitrage"

and

"

However, we disagree that the final outcome will be a "profoundly deflationary failure." This will be an interim step. Recall that the Fed and its private bank conspirators simply can not accept deflation as a resolution. Which means that faced with the specter of full on deflationary collapse, Ben Bernanke will simply resolve to doing what he has hinted, if jokingly, in the past: he will literally paradrop money out of helicopters. Maybe not in that fashion, but he will find a way to bypass the banking sector as a monetary transmission mechanism, and bring crisp, fresh, just off the press banknotes into the hands of consumers in order to finally get the much needed inflationary spark as too much cash chases after too few products and services.

And remember: hyperinflation is and always has been a phenomenon concurrent with the full loss of faith in a given currency, be it reserve or not. It may emerge for economic, monetary or purely political reasons. It is also why the most valuable commodity a central bank has is credibility, and faith in fiat, or fiath as we like to call it. Furthermore for those who say that the Fed has a reserve currency premium, we like to show one of our favorite charts: reserve currencies through time..."

http://www.zerohedge.com/news/2013-06-10/charles-gave-warns-should-fed-l...

Sounds a bit like the "QE for Consumers" idea, I posited below, no?

Anyway, important food for thought as we watch events unfold.

Check your buckles, for the roller coaster is leaving the station.

 

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Can we assume the Fed will "just find a way?"
Charles Gave wrote:

Recall that the Fed and its private bank conspirators simply cannot accept deflation as a resolution.

Sure, bankers will find deflation "unacceptable" because many of their banks would fail.  However, what if the  Fed is able to forestall deflation-driven bank failures with more QE moves or maybe some new accounting gimmicks while at the same time remaining utterly impotent to end deflation in the economy at large?  What's to prevent our muddling on indefinitely in this fashion, like Japan?

Charles Gave also wrote:

[Bernanke] will find a way to bypass the banking sector as a monetary transmission mechanism, and bring crisp, fresh, just off the press banknotes into the hands of consumers.

Find a way for the Fed to take over fiscal policy?  How would that work?  Doesn't our gridlocked Congress own those purse strings?

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velocity of money: know your denominator

So BASE = currency + reserve deposits of depository institutions.  This would seem to include those magical Excess Reserves that everyone seems to like to use in their charts to make everything look horrid.  In other words, picking BASE as your denominator seems wrong to me - unless of course you simply want to come up with a chart that has a line going down in an unpleasant-sort-of-way and that in essence chooses to focus entirely on the growth in excess reserves.

If your intent is to divide GDP by actual "money in circulation" - it is probably better to pick something like CURRENCY, M1, or perhaps M2.  In fact, FRED has a couple of series already - M1V and M2V which are GDP/M1 and GDP/M2 respectively.

If we want to use a denominator representing money readily available (M1: currency + demand deposits + other checkable deposits), it might make sense to use M1V.  That would look like this:

Gun to my head, this chart makes more sense than the one using AMBASE as its denominator.  Definitely velocity has slowed down, but only back to 1995 levels.  Odd, but not a five-alarm fire.

 

If your goal is to see whether we're having a recovery in the economy overall, I'd recommend using some of the energy consumption timeseries provided by the EIA; I have one here.  I believe it comes to a similar conclusion, but I think it has more of a factual basis behind it.

Theory behind this chart is, "energy slaves = standard of living."  So fewer slaves = lower standard of living, per capita, in the US.  Notice we dropped off a bit of a cliff in 2008, and there has been no recovery at all.  Energy use is rated in millions of BTUs per person, per year.  Certainly some decline could be attributed to increased efficiency over time, but that steep dropoff in 2008 was likely not efficiency-related.   And now we're lower than levels last reached in 1982.

eia-pc-total.png

This chart comes from a monthly EIA timeseries TETCBUS, annualized, then filtered through a 12-point moving average.  The MA applies a time lag to the data, but the original series is so noisy it is very difficult to see trends clearly.  With the moving average applied, the trend is quite easy to see.

 
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Endgame, metametal

Meta,

I believe the Fed will "forestall deflation-driven bank failures", but this will be in name only.  We have unprecedented fast speed of information flow via the internet, plus the general hair-trigger fear and nervousness of at least a goodly part of the American public, will lead to major bank-runs as the Fed performs their deflation-defying stunts. 

I've been on record as predicting a stepwise process that looks like a doubling or quadrupling current "bank QE", followed by outright purchases of stocks (to levitate the stock market, and I don't dismiss the possibility this is going on right now, via commercial bank transmission mechanisms- hell, all the CBs in the world may be conspiring in one big cabal to levitate all global stock markets), followed by QE to consumer.

To me, the world is too generally unstable and weak to survive a Japan ten to twenty year stretch with the world's largest economy muddling through.  Once you have a weak system, there are any number of triggers that can give it a devastating blow.  And though any single trigger is low probability, taken as a group, the total probability is high that some trigger will be pulled.

The Fed is already bypassing Congress.  The Fed is, and has always, enabled reckless spending and too big deficits by just expanding the money supply (low interest rates, QE) and recently by simply monetizing the debt.  But even without Congress the Fed is printing a trillion dollars a year.  It does need, nor has it asked Congress' permission to do that.   BB makes perfunctory trips to Congress, but it's all a show.

Despite what Mario "and believe me, it will be enough" Draghi says, it will not be enough.  It sort of analogizes to some of our congressional elections in recent years.  Some candidates outspent their opponents 3 to 1, 5 to 1, 10 to 1, and I'm sure felt smug about their certain victory.  Yet on election night, they lost, often big time.  At some point, you lose the people (and markets).  And no amount of money will get them back.

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Dry Powder

Davefairtex,

I appreciate your good point, but I think you may be missing the big picture.

The velocity story is meant to capture the speed "spendable" dollars (my term).  Your point about M1 is well taken.  I would argue it demonstrates the same picture, but, as you say, just not as dire.

However, those excess reserves dollars are dry powder which can be spent just as effectively as 'money in circulation', so I think it is proper to include them in the velocity calculation.  Velocity is like asking "of all the dry powder in the economy, how fast is it turning over from party to party, versus sitting somewhere'.  While one may make distinction about that "somewhere" where the money is sitting, it's somewhat academic to me.  In other words, I believe the money in these two worlds can move freely between them, and thus should be considered one big pool of dry powder.

McHugh's point was also that both GDP is low and money supply is high, an ugly combination.  Remember we have a GDP problem that I think Chris would say is partly caused by financial constraints and distortion (E for economy) and partly by physical limitations of our world (Energy and Environment).  We can do something about the former, with great leadership and some pain, but the later two are hard limits.  Thus GDP is low as far as the eye can see.  To get back to health, we need, among many remedies, to have an appropriate money supply and appropriate interest rate return on money.  Right now we seem to be on the path of manipulating the only E we can, e.g. the money supply.

Thank you for the EIA btu chart, it's very helpful, and something we should watch along with the Baltic Dry Index, and other numbers that are hard to "fake".

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the magic fed

"What's to prevent our muddling on indefinitely in this fashion, like Japan?"

um, this slow motion collapse is because we are living in a way which is beyond the earth's capacity to support. you see, we live on a finite planet with finite resources... and 7.1+ billion people are now vying for a depleting resource base. this is simply not sustainable.

as much as we would like, there is no way to cheat reality... even printing 85 billion a month will not be able to sustain the unsustainable.

wise people see what is unfolding and are doing what they can to mitigate what is happening.

 

todd

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more excess reserves - what is dry powder?

Hrunner says,

those excess reserves dollars are dry powder which can be spent just as effectively as 'money in circulation', so I think it is proper to include them in the velocity calculation.

That does make some sense.  Are Excess Reserves dry powder?  M1 is clearly dry powder, M2 could be as well.  Do Excess Reserves qualify?  I went to dig a bit further to explore more about Excess Reserves.

Back in October 2008, the Fed started paying interest on Excess Reserves.  At that moment, along with the Fed's other operations, excess reserves started to take off.  At the same time, the Fed Funds rate plummeted.  By Dec 2008, the Fed Funds rate was under 0.2% and the interest paid on excess reserves was 0.25%.

So what are excess reserves, really?  Its money that used to be lent to other banks in the overnight market, but instead sits at the Fed because they pay better rates.  And this is an artifact of policy constructed during the 2008 crash.  And they are (effectively) Your Tax Dollars At Work.

If the Fed stopped paying interest on Excess Reserves, all that money would flee the Fed, and run off to somewhere else and depress rates there - say short term Treasurys or overnight loans to other banks.  Does that mean all that "dry powder" would evaporate?

In a New York nanosecond.

So all those charts purporting to show how dangerously inflationary all these Excess Reserves would seem to be dog bollocks.  It is merely an artifact of the Fed paying 0.25% in a market where alternative investments at a similar level of risk pay a lot less.  One could consider it a decent "financial repression indicator."

Christ, if I could deposit my savings at the Fed and earn 0.25% in a place that really does have zero default risk, I'd do it for sure.  My alternatives are 6-month treasury bills, which net me 0.08%...

 

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The U.S. Is Not Zimbabwe

An argument that hyperinflation unlikely to happen here:

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Where would the evaporating funds go?
davefairtex wrote:

If the Fed stopped paying interest on Excess Reserves, all that money would flee the Fed, and run off to somewhere else and depress rates there - say short term Treasurys or overnight loans to other banks.  Does that mean all that "dry powder" would evaporate?

In a New York nanosecond.

So all those charts purporting to show how dangerously inflationary all these Excess Reserves would seem to be dog bollocks.  It is merely an artifact of the Fed paying 0.25% in a market where alternative investments at a similar level of risk pay a lot less.  One could consider it a decent "financial repression indicator."

Dave,

I'm intrigued by this portion of the post. As I understand the whole situation, the excess reserves are parked at the Fed because the Fed is offering risk free return of 0.25% to the banks. I reduce this down to a give-away program intended to recapitalize the ailing banks. If other investments could generate more than the 0.25% risk free return (or if the Fed reduced the interest rate to less than outside rates,) wouldn't the banks pull their funds from the Fed and chase those higher returns?

By evaporating, do you mean that these funds would be employed elsewhere and therefore wouldn't be sitting on the sidelines? Or do you mean that they would disappear completely? Or do you mean something entirely different?

As it stands now, these funds have absolutely zero velocity. If they move into the economy, velocity will increase and it will have impacts elsewhere. The tone in your post tells me that you dismiss this potential almost entirely. I'm thinking that these funds can be sterilized quickly and without market disruption at any time. Could these excess reserves be used as a front for the Fed to mop up QE without really impacting the market? Wouldn't the MSM jump on this story to say, "see, the Fed has it under control"?

I'm just trying to wrap my mind around the situation.

Grover

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velocity, excess reserves

Grover -

Yes, if the Fed stopped paying interest on reserves, I think those funds would definitely be employed elsewhere, in a place where they would no longer show up as "excess reserves."  We'd see no more exciting 60-year charts with BASE in the denominator!  However, I claim that money would be put to work in a similar sort of instrument with a similar risk profile - such as short term treasurys.  But since Excess Reserves pay more than treasurys (a policy just started Oct 2008), they stay at the Fed.  In some sense and at this moment in history, Excess Reserves should be counted in the exact same way as bank holdings of < 1 year treasury bills.  Presumably bank holdings of treasurys also have zero velocity, but nobody is totalling them up and talking about how they're about to rush out into the economy and wreak havoc.

Just because FRED has a timeseries, various people start using it in random ways to startle the horses and prove their own points.  It all looks very official and ominous.  Until you dig into what it really means.  Just my opinion, of course.

Now then, could the Fed "mop up" all those excess reserves without any fuss and bother just because they are excess reserves?  No.  Just because they are excess reserves doesn't mean the Fed can snatch them away from the depositor at terms of the Fed's liking.  To "mop up liquidity" the Fed needs to sell something on its balance sheet at the current market price for that something.  [see link below, table 2]

http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab2

In a hypothetical mopping-up operation, the Fed would sell off chunks of its portfolio, sucking money out of the system.  But what would it cost them?  Presumably, they'd only do this when inflation started to really become apparent, and if that happened, rates likely would already have moved up.  Back of the envelope: average maturity is perhaps 8 years, and the average rate they bought it was 1.4%, and we imagine the 8-year rate bounces back to (say) 5%, this means the whole portfolio loses about 24% of its face value ($800 billion) if they were to decide they want to do the mop-up operation all at once.  No doubt rates would scream higher as a result, too, increasing the losses as they sold.

To me, that's the real question.  How much of a loss is the Fed willing to take selling those bonds?  It makes 100 billion or so in interest from its portfolio each year.  Presumably they could take losses up to that amount, but above that?  Hard to know.  These geniuses are buying bonds by the truckload at the (likely) top of the 30 year bond bull market.  Unwinding that position is not likely to be a profit opportunity.

Bottom line: excess reserves don't give the Fed any quick-and-easy route to mopping up.  It would be better for the Fed to let the bonds simply roll off - although it won't happen very quickly.  If the Fed stopped buying today, in 5 years the portfolio would shrink by 25%.  It would take 10 years to drop it down by 75% - back to where it was in 2008.  And we're completely ignoring the MBS, just for simplicity.  The more rates rise, the longer the effective duration on those MBS (nobody wants to pay off their 3.5% 30 year mortgage early when rates climb to 6%), so if anything, the situation is moderately worse than I make it out to be.

And yes, I think paying for excess reserves is a great deal for banks.  They get fed above-market rates for their money, something not available to you and me, who just have standard savings and/or money market accounts.  Once again, I wish I got the same deal they have.

 

Hrunner's picture
Hrunner
Status: Gold Member (Offline)
Joined: Dec 28 2010
Posts: 256
Fed worried about losses?

Dave,

Interesting post as always.  One question.  Why would an entity with monopoly power to print money at will, and whose main mission is to prop up commercial banks (and allegedly to keep prices "stable" and employment full), care about losses?

Just wondering.

davefairtex's picture
davefairtex
Status: Diamond Member (Offline)
Joined: Sep 3 2008
Posts: 5067
losses and the Fed; do they matter?

Hrunner -

Why might the Fed worry about losses?  Does it even matter?  Another interesting question.  Here's a bloomberg article on the subject:

http://www.bloomberg.com/news/2013-02-26/fed-faces-explaining-billion-dollar-losses-in-stress-of-qe3-exit.html

Some key points.  In the Fed's "adverse scenario" stress test they imposed on banks recently, the Fed themselves would stand to have mark-to-market losses of 500 billion dollars.  The article above talks about going through a period of time where the remittences to the Treasury were zero for some number of years.  

However, the Fed isn't required to mark its portfolio to market, and it cannot go bankrupt and may continue to operate with losses on the books.  So in that sense, they don't care.

Effectively, any losses at the Fed directly impact receipts by the Treasury.  Are we explicitly on the hook for any losses?  I'm not sure, but I bet we are.

Is this article simply regurgitating Fed talking points?  That I don't know.  It certainly seems to suggest the point of view that "losses don't matter" - at least not very much anyway.  Likely, that's what the Fed would like us all to believe so my instinct here is to say that yes, this is the Fed speaking through Bloomberg.

My guess is, losses do matter, at some point, and at some level and they act as a constraint on the Fed's freedom to maneuver, but I have no idea what those values are.

I think we may see what happens when a central bank loses money pretty soon - in Japan.  If rates get away from the BOJ, we'll get to see how that whole scenario plays out from the standpoint of confidence, etc.

 

metametal's picture
metametal
Status: Bronze Member (Offline)
Joined: Jul 12 2011
Posts: 25
Trying to get a handle on SDRs

I was watching a 2012 debate between James Rickards and Harry Dent.  

Rickards says that in the next global crisis the IMF could use force majeur to justify printing tens of trillions $$ worth of Special Drawing Rights (SDRs) and that this could be used effectively to fight or prevent deflation. (It's not clear to me how printing globally on this scale addresses to address deflation's underlying cause of insufficient demand).  Rickards makes the interesting claim that governments "will not tolerate deflation" because they don't have a way of taxing the appreciation of nominal dollar incomes and profits that deflation produces.

Harry Dent counters that IMF / SDR printing as above would only create huge unsustainable bubbles that would inevitably burst , cancelling whatever benefit Rickards is assuming.  Dent also says the SDR "solution" assumes you can "fix" economies with a central "thermostat," whereas economy needs to go through a Kondratieff winter and you can't get around that.  To him IMF / SDR is just another misguided thermostat approach.

It seems to me that Dent's argument about IMF / SDR is fairly isomorphic to the FED / $$$.  Per  Dent, the Fed's partial-helicopter moves in the next crisis would have at best a temporary thermostat effect and deflation would win out if that's what the Kondratieff fundamentals demand.  This argument seems persuasive to me.

Here's a good link to links on SDRs: http://bit.ly/12N9AuN

 

 

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