Friday, June 12, 2009

James Grant: Depends greatly on our own point of view

James Grant (of Grant's Interest Rate Observer) have a great interview on CNBC Wednesday, you can see it for yourself here. I'd say this interview represents the intelligent, pure monetarist argument for higher inflation. The type of thing that would have been perfect to pick apart on SMACKDOWN week!

For what its worth, I think Grant is a great writer and always an interesting read, though in recent years I think he's become more and more of a lawyer. That doesn't invalidate his argument, but it does tend to mean he seems less willing to consider possibilities away from his base view. I think its fair to say that Grant is generally against central bank intervention, particularly when it comes to stimulus. He comes from the school that thinks its necessary to keep money tight always and everywhere.

Here are a couple thoughts. First, Grant's off-handed comment that the Fed's balance sheet is as bad as Citigroup's is just dumb, and he's too smart to make that kind of comment. 54% of the Fed's balance sheet is in Treasuries and GSE debt. Another 14% is in straight currency and/or gold. 37% are short-term repo/discount window type transactions, which are all overcollateralized, mostly with extremely high quality collateral. 5% is in Bear Stearns/AIG bailout-related assets. That's the only realistic place where the Fed stands to lose money. Obviously Citigroup doesn't have such a high-quality list of assets. I said a few weeks ago that leverage alone isn't the sole determinant of risk. Is Grant trying to argue otherwise? Asset quality doesn't matter at all? Or is he just trying to throw a good sound byte out there?

He also comments that M2 is up 9% year-over-year, and that didn't happen back in the Depression. I can just imagine Ben Bernanke sitting at home throwing up his hands yelling at his TV. "EXACTLY!!" The idea is to prevent the Great Depression right?

He goes on to say that he expects higher CPI prints, but admits that its possible that the Fed's extra cash flows someplace besides consumer goods. That kind of thinking would be entirely consistent with my argument that consumer spending won't rise, and yet still suggest that the Fed's actions are problematic. In fact, I'd go so far as to agree that the cash must flow someplace. It is accurate to say that excess liquidity can and does lead to bubbles.

However, based on the data, I'd argue that the cash has all flowed into bank excess reserves. M2 is up $691 billion year-over-year. Excess reserves are up $836 billion. Is there a bubble in excess reserves?

I'd go on to say that once the cash starts to flow to consumers, they seem likely to save it. The savings rate is currently 5.7%. Household net debt has declined two quarters in a row now. If consumers see more money I'd think it would continue to flow this way. I don't think that printed money turning into balance sheet repair should worry us all that much. In fact, I think its a pretty favorable outcome, allowing consumers to improve their debt position without causing economy-wide deflation.

The risk, as similar to what I outlined last week, is that consumers become satisfied with a level of balance sheet repair, and funds start flowing elsewhere. In order to avoid this, the Fed is going to have to pull back on their extraordinary programs quickly, and frankly, soon. We'll see on June 24!

18 comments:

Andrew said...

Why would it matter if a security the Fed held ended up being worthless?

Accrued Interest said...

Depends on your point of view. If the Fed buys an asset and its, in fact, worthless, then the Fed just printed money, right?

If they buy an asset and its pays off, then there is no net impact on money.

youngwb said...

Nice post..
I had a question on the fed purchasing long bonds (10 , 30 year bonds). How does that work via the printing press mechanism?
So let us the treasury sells 10, 30 years and the fed buys it. It does not make much sense to me as it seems like a transaction where I sell you something and then my father buys it back.
Also, lets see they only buy in the secondary market. They buy long bonds from the primary dealers who because of the excess reserve mechanism just park it back in the fed.
Is this right?

youngwb said...

Sorry about the typo's
Nice post..
I had a question on the fed purchasing long bonds (10 , 30 year bonds). How does that work via the printing press mechanism?
So let us say the treasury sells 10, 30 years and the fed buys it. It does not make much sense to me as it seems like a transaction where in I sell you something and then my father buys it back.
Also, lets assume they only buy in the secondary market. They buy long bonds from the primary dealers who because of the excess reserve mechanism just park it back in the fed.
Is this right?

Advant Guard said...

Despite having the word bank in its name, the Federal Reserve Bank is not a bank. It takes deposits but usually, the deposits are not voluntary; banks hold money at the Fed because they are legally required to.

The Federal Reserve Bank makes loans, but it is not lending from deposits, it is creating new deposits while adding matching assets on the other side of its balance sheet.

In the same way, when it buys Treasuries, it creates new deposits while adding the Treasuries as assets on its balance sheet.

Note: Buying Treasuries is routine business for the Fed, the Fed bids at each Treasury auction for securities to hold on its balance sheet; I am not sure why every makes such a fuss about it, especially the tiny amounts that are currently authorized.

Accrued Interest said...

If the Fed buys bonds from a primary dealer, they credit the dealer's account, and take delivery of the bonds. This is, in effect, printing money since the "credit" comes out of thin air.

youngwb said...

right..but if that primary dealer does not lend that money out and it puts it back in reserves..does it matter?

Accrued Interest said...

In terms of inflation? I'd say no. It wouldn't matter at all.

But it does reduce the marginal supply of Treasuries, so would have a downward impact on yields, all else being equal.

youngwb said...

Okay that is what I thought. Thanks for answering my question.

Is that not the crux of the inflation argument?

Also, really liked your smack down week posts

Duff said...

Brilliant...

"I can just imagine Ben Bernanke sitting at home throwing up his hands yelling at his TV. "EXACTLY!!" The idea is to prevent the Great Depression right?"

It's like saying after you win a game of basketball, "You didn't miss the basket at the buzzer like we did when we lost last week!"

Well durr.. You play to WIN THE GAME!

Flow5 said...

Grant's a tattle-tale.

the transactions velocity is dropping during a normal seasonal increase

july should be another trading month (rates fall, prices rise) if the FED doesn't monetize alot more debt

In Debt We Trust said...

AI,

Can you provide a translation please?

http://market-ticker.denninger.net/
archives/1115-30y-Bond-Results-
Beware.html

Accrued Interest said...

That guy isn't making any sense. Here is what he seems to be saying.

1) Foreign investors buy the long bond because they expect deflation/dollar appreciation.

2) Foreign investors can pull their dollar funding and cause US inflation/dollar depreciation.

3) You don't want to bet against someone who can cause their bet to win.

#1 says foreigners don't want #2 to happen. Thus #3 isn't relevant.

Accrued Interest said...

OK. Reading it again, he's might be saying that foreign central banks can cause U.S. deflation. I don't know how they could do that, honestly. For what its worth, central banks aren't known for being return-oriented traders. They aren't trying to make money playing markets. There is no cabal.

chad rich said...

This rationale makes for a great trade. But, beyond that, you're out to lunch.

The paragraph about balance sheet repair is the whole crux. How is Bernanke gonna TAKE that back?! There's no monetary consequence of that? So, we avoid deflation. That is good. But, what's the trade-off? Tepid economic growth? Is that it? Hell, if that's the worst that can happen.........I don't see the problem in creating bubbles! Maybe Greenspan actually got it right along!?


Personally, I think the gold-bugs are very early to the party. But, I also believe that the ramp will happen so quick.......you'll be paid for being patient and early.

Deflation? Are you serious? I'm totally on your side if there were no politicians or federal reserve bankers. There is no effing way deflation will be allowed to stand. Forget it. I don't think you realize just how political deflation now is. It will not be allowed to stand. The fed wants inflation, its begging for inflation. That is the only clue they've won. And they won't stop until they kill everybody or win.

In Debt We Trust said...

I think what KD is saying is he believes the super cabal of international central bankers are engineering an equity mkt crash to push money back into the treasuries market.

But based on the unfolding japan-italy bond scandal it seems like the opposite is happening

Urizen said...

Bernanke gave some interesting comment on inflationary pressure and excess reserves in this speech (see first par. under Exit strategy).
http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm

What I wonder about is a possible mismatch in financing the Fed activities.

Assume for a moment that circulation of money normalizes, that banks repay the Fed and that excess reserves are withdrawn because banks can now find more interesting investments than depositing them at the Fed.

Could the deflating of the Fed's balance sheet from over 2T to let's say 1T pose a problem for the Fed?

The Fed would need to dump most the securities it held on the market (they went from about 450 T to 1,133 T and only 200 T is financed by the US Treasury) or it would have to print money. Now the latter would undoubtly be inflationary while the first would imo be devastating for the bond market. A deviation from the private sector to risk because of a normalization of the financial markets would already be accompanied by a more risk assertive investment philosophy, thus away from the government notes and bonds and this would coincide with a Fed dropping treasuries and mortgage backed securities in the market.

Matt Johnson said...

I didn't think that reserves held at federal reserve banks are included in the Fed's M1 (and hence M2). it's unusual not to include high powered money in the M1, but it doesn't matter much. if the member banks create credit with their excess reserves, it'll THEN show up as M1, as it'll appear as a deposit - and hence show up in M1.

for mine, this is the reason we don't need to worry much about so called money printing. the excess reserves are ammo that the banks can use to create a credit boom - but just now they are not lending, so it's not the point.