Ben Bernanke: Smooth Criminal

I know this isn't a universally held opinion, but to me there is a simple reality. Between September and December we were facing a significant chance of another Great Depression. Beyond that, we were potentially looking at a financial disaster from which the United States would never recover.

Today, it looks like we are merely facing a very bad recession.

Who deserves credit? Certainly not Hank Paulson and the Bush administration. They choose philosophy over pragmatism every chance they got. They gave in to the moronic "moral hazard" bullshit argument. They stuck to their right-wing "fuck off and die" mentality toward the banking system. That worked out great didn't it? Then when they had the chance to use the TARP right, they failed miserably. Again, they gave into the moral hazard wing of the Republican party and instead of buying up bad securities, they initiated the Capital Assistance Program. No moral hazard there!

Can't credit Obama either. I'll admit that the Stress Test was a much better idea than anything Bush ever came up with, but I'd argue that by December we had already turned a corner. Obama just managed to keep the momentum going. Besides, his $800 billion stimulus program is, at best, a waste of time, and at worse, contributing to rising Treasury yields and thus retarding the recovery.

I have to give most of the credit to Ben Bernanke. He understood that while liquidity wasn't the whole problem, illiquidity could have made (and was making) the problem much much worse. He understood what really made the Great Depression a 15 year affair rather than a 2 year recession. He understood what created Japan's lost decade (and counting). He saw how dangerous debt deflation could be, and he attacked it with both guns blazing.

Some people derided the Fed's efforts as ineffective. That's because they were looking at how the stock market or housing market was reacting to Fed rate cuts. But the cuts were never meant to "solve" anything. Housing prices had to fall to more affordable levels. Nothing could (nor should have) been done to stop that. Stocks had to fall in reaction to the oncoming recession as well as the reality of a weak recovery. For that matter, unemployment was bound to rise as workers are moved from leverage-oriented jobs to someplace else. The Fed wasn't trying to solve any of these problems.

Compare this with Alan Greenspan's constant manipulation of the stock market. In today's FT, Greenspan says as much in an opinion piece. "In my experience, such episodes [rising or falling stock prices] are often not mere forecasts of future business activity, but major causes of it." (My emphasis). That sums up Greenspan's tenure at the Fed doesn't it? He's basically saying that by creating bubbles, he was able to spurn real economic activity. Look, a lot of us fell for it for a long time. He was called the Maestro for the Force's sake. But now, in hindsight, we can certainly see the folly in this philosophy.

Now the morons in congress are coming for Ben Bernanke for how he handled the Bank of America/Merrill Lynch merger. Seriously? Now, let there be no doubt. Ken Lewis was pressured by the Fed in a way that should leave a bad taste in the mouth of any free citizen. But we were in the middle of an economic war. Sometimes some bad shit happens on the battlefield and sometimes its OK if we look the other way.

If the Republicans push this, though, Obama will be left with little choice but to not reappoint him. Then we'll get Larry Summers. Great. Even if you forget all the virtues I've just bestowed on Bernanke, remember this. The key to an effective Central Bank is independence. Otherwise we have Arthur Burns. It was Burns, not oil, which caused the Great Inflation of the 1970's.

How can we seriously assume Summers will be independent of Rohm Emanuel? If Summers winds up running the Fed, mark my word, inflation will follow.

FOMC: Keep your concentration on the here and now where it belongs

So the FOMC follows Qui-Gon Jinn's advice and not Obiwan's instincts. Yesterday's FOMC release was a slightly hawkish shade of April's release, which I (and the bond market) found disappointing.

Just before the announcement, I suggested an alternate FOMC statement that emphasized both downside inflation risks (which the Fed dropped in their statement) as well as the need for an eventual exit strategy. I think my version walked the line between acknowledging the continued downside risks in the economy, the very tenuous and limited nature of the nascent recovery, as well as an admission that non-traditional monetary policy carries a risk of inflation. I've written time and time again that inflation is a low probability risk, but the severe steepness of the yield curve says otherwise.

The Fed would love to flatten the curve. That would bring down mortgage and other borrowing rates, and actually aide the recovery. The way to do that is to calm the inflation fears. No matter how much I might deride the hyperinflation story, it isn't going to magically go away. So if you are the Fed, why not assure the market that you are cognizant of this risks of quantitative easing? You don't have to give a time frame to the removal of accommodation, but you do have to convince us that it will eventually be removed.

FOMC: Be mindful of the future

Alright I'm trying something new here... I'm going to call the actual Fed statement. In about an hour you can make fun of how wrong I was.

---

Incoming data indicates to the Federal Open Market Committee that the economy continues to contract, though the pace of contraction appears to have further slowed since April. Household spending has shown signs of stabilization, but remains constrained by ongoing job losses and lower housing wealth. Credit conditions for both consumers and businesses have moderated, yet the Committee observes that credit is generally only available to the best borrowers in both markets. There are signs that the business inventory liquidation which occurred toward the end of 2008 and first few months of 2009 has ended, and some rebuilding of inventories may be underway.

Therefore while the Committee acknowledges the progress made thus far, it also judges that economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

In light of continued economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve currently plans to purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve currently expects to buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In addition, should economic conditions warrant, the Committee may choose to curtail these security purchase programs before the full amount has been purchased.

The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee believes these programs are temporary in nature and at some point in the future will need to be wound down. While it does not judge that the need will arise in the near term, the Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

---

The key changes:

• Indicate some improvement in the economic outlook, especially the credit markets, which have improved a good deal since April.
• Suggest that QE (outside of the TALF) will not be expanded. They won't come out and say so at this point, but given the improvement in the outlook, some curtailment of QE is appropriate.
• Acknowledge the need for an exit strategy. Conditions are too fluid to outline such a strategy right now, but its enough for the moment to discuss it conceptually.
• Finally, expect the FOMC members to start giving some specific ideas about an exit strategy in their upcoming speeches.

All this should calm the bond market, creating a bull flattener, and improve the dollar.

Fed: Deflation? Over my dead body.

Many Accrued Interest readers will gafaw at the memory of John Ryding, economist at Bear Stearns from 1991 until the bitter end in 2008. Intelligent man, I'm sure, but also something of the Nouriel Roubini of the bond market. I think he was bearish on interest rates basically my entire career, which is ironic, since for most of my career, interest rates have been falling.

Anyway, the one really good piece of advice I heard from Ryding over the years was if you have a view on inflation, don't change your inflation outlook, change your Fed outlook. In other words, if you think forces are aligning toward higher inflation, bet on Fed hikes, not on inflation itself. I think this is a smart way to approach the bond market, because the Fed may actually short-circuit inflation itself (making a bet on, say, TIPs a loser).

Today St. Louis Fed President James Bullard declared that the Fed had averted a deflationary outcome, and is now considering an exit strategy. As readers know, I've been touting deflation as the Fed's primary concern for some time now. But in talking about deflation as the primary risk, I'm still thinking of Ryding's advice. I'm not necessarily betting on deflation per se, but on a Fed ready and very willing to fight it. That's why I've been willing to bet on massive rate cuts, unorthodox liquidity programs, etc.

But will we see CPI print below zero? Only if the Fed fails. In other words, sustained deflation remains a remote possibility. But sustained Fed interference in the markets in attempt to avert deflation is a strong probability.

So the bet should be not on deflation outright, but on the fallout from attempts to fight it. Weaker dollar. Higher commodities. Low short-term rates (including buying 2-year bonds as opposed to holding cash). Flat yield curve. Lower mortgage rates (at least from here).

That's is how I'm playing my deflation view.

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!

SMACKDOWN WEEK: Epiloge: At that speed are you sure we'll be able to pull out in time?

So Accrued Interest has settled it once and for all. Inflation risk is low. The Poll proves it! I posted a new poll asking if readers like the SMACKDOWN format, where I spend several posts on the same subject in greater depth. If you liked it, vote. If you hated it, vote.

As a final point on the inflation subject, I wanted to look forward, to the future, the horizon. Obviously the dire consumer situation isn't going to last forever. Even though much of the wealth destruction I mentioned last week isn't going to recover in a V-shape, we will reach some sort of equilibrium in housing eventually. Even given a L-shaped recovery in housing, consumers eventually get back on their feet. Maybe they can't spend their home equity but they'll still spend their earnings. We will also reach some sort of equilibrium in personal savings, which I think will wind up in some relatively low, but still elevated level.

So inflation isn't dead. Not yet. And thus the Fed will eventually have to pull way back on its current policy accommodation. How and when will this happen, and what are the risks.

The biggest risk is Fed independence. You want to know what really worries me for the long-term? Fed independence.

I believe firmly that the men and women who are responsible for normal Fed policy actually learned the lessons of the 1970's. That inflation is an insidious problem, and once it takes hold, its is painful to wrench out of the system. I realize many readers will disagree, given the aggressive policy of the last 12 months, but spend a day going back and reading Ben Bernanke's old speeches, and I think you'll agree. Policy of the last 12-18 months has been all about eliminating a Great Depression style debt deflation. Once that battle is won, I believe the Fed's policy makers will want to wind down their non-traditional policy maneuvers.

There are those who say they can't remove these policies in a timely manner. I don't get this argument, as it seems to be merely based on the sheer size of the programs. Remember that inflation is a rate of change, therefore stock measures aren't terribly relevant. Its all about marginal changes.

To see what I mean, consider the Fed's MBS purchase program. As of June 3, the Fed had $428 billion in MBS on their books. To simplify, let's call that $428 billion in incremental demand in period 1. If they Fed just held their position, no new buys or sells, what's the inflationary impact in period 2? None right? No marginal demand for MBS from the Fed, no money printed. So execution of the exit is relatively easy.

To me its all about timing and will. The timing is a bit of a guessing game. I think we have seen some legitimate green shoots since January of this year. Consumer spending is way down, but no longer seems to be collapsing. Thus there should be some commensurate slowdown in the pace of the Fed's policy actions. Its also clear that the Treasury buying program has been a major failure, in that it spooked foreign investors. I expect the Fed to let the Treasury program die a quiet death, and let that be their first removal of some accommodation.

But do they have the will? There are those that say the Treasury has made the Fed its padawon. The Fed is creating inflation to help solve the Treasury's debt problem. I don't think this is the case, but its a scary thought. It would represent a return to Nixon-era central banking, where the Fed was highly political and thus unwilling to tackle inflation with the steady hand necessary.

Consider this. Will a Fed with an expanded mandate, as the primary regulator of banking and possibly other elements of the financial system, becomes more political? Probably. Will Congress get more oversight of the Fed-as-regulator? Certainly. Will that translate into less independence on the monetary policy side? Its a very big risk.

SMACKDOWN WEEK: Now consumers are all but extinct

Today on SMACKDOWN we'll look at just how inflationary the Fed's programs have been to date.

My premise remains that consumer inflation occurs because consumer spend more nominal dollars. I won't go over the rationale for this viewpoint right now, you can read it here or here. Given this, any program will only be seen as inflationary if it puts cash into consumer pockets, or at the very least, results in goods being purchased.

The headline grabbers are stories like this one at the New York Times. They throw out numbers like $12 trillion and we all cry out inflation! But a large percentage of these figures are asset guarantees, such as the money market insurance program. These programs are clearly not inflationary as they never even involved any exchange of cash.

In order to see how much money may actually go into the economy, let's take a real look at the Fed's balance sheet. We know it has exploded in size:



We also know that most of the Fed's outlays have been funded by crediting bank reserves. That is, the Bernanke's old "electronic printing press." If printing money makes you shudder, you aren't alone.

But remember, even printing money doesn't cause inflation unless that money reaches consumers. I've said before: if the Fed mints a quadrillion new Sacagaweas and just sticks them in a vault at Ft. Knox, there is no inflationary impact.

Alright so what's in the Fed's balance sheet? What have they buying with all that printed money? (All figures represent an increase).



I've color coded this based on inflationary impact. The various shades of blue are non-inflationary. Starting at the top and moving to the left, the first is the Maiden Lane transactions. These are all related to Bear Stearns and AIG bailouts (note I added some AIG-related loans that technically aren't part of Maiden Lane LLC into this figure). Can't see how these impact inflation in any meaningful way. The next is related to dollar swaps with foreign central banks. Again, while I think this helps provide meaningful liquidity to the worldwide financial system, the impact on consumer inflation is minimal, even if the Fed is "crediting reserves" to help provide the cash. Finally we have "other" Fed activity, which involves stuff like the Fed's gold stock. Not an issue.

Term Auction Debt and the CP/money market programs are a little more nebulous. These plus the actual discount window is in green. The Term debt is mostly the TAF and the TSLF, both of which were meant as quasi-discount window loans to banks and primary dealers. Neither is as heavily used as it was in late 2008. I'd argue that the these term loans are merely replacing other types of borrowing that would otherwise have occurred in the capital markets. So while it is interfering in markets, it isn't inflationary. The commercial paper program is similar. If it just replaces private sector borrowing, it isn't inflationary.

Now wait a minute, you say, the market is over-leveraged. This kind of short-term debt is what helped get us into this mess! The private sector should be winding down! The Fed shouldn't be encouraging short-term borrowing of this nature. That's besides the point when you are thinking about inflationary impact. Inflation (or deflation) is caused by the change in effective money supply from one period to the next. If all the debt was suddenly drained from the system, it would surely be severely deflationary. So to the extent the Fed is substituting its own balance sheet for private lending, that's a neutral event in terms of inflation. Indeed, according to the Fed, financial debt grew at a 6% pace last year, down from 12% in 2007 and the slowest pace since 1991.

The other programs (in yellow) do have some inflationary impact. Securities held directly are, most notably, the Fed's mortgage, agency, and Treasury buying programs. (I've subtracted the decline in repo from this figure, since these new programs really replace the Fed's old repo-based programs.) When the Fed buys bonds, they are buying them from someone, and that cash eventually makes it into the system. I've argued that in fact, securities purchases are just a convenient means of pumping dollars into the economy. So it seems that an inflationary result is the goal.

Same with the TALF. The idea behind the TALF is to restart the ABS markets, which would provide cash directly for credit-based consumption. This is practically printing money and giving it to consumers. However, for better or worse, the TALF has been little used. It was supposed to be up to $1 trillion. It would be just as well to let him go, he's too far out of range.

Now let's add up the "inflationary" increase in the Fed's balance sheet. $528 billion.

Now let's compare that with some other key indicators of consumer behavior. The chart below compares the increase in the Fed's programs with the decrease in the other indicators. The decreasing elements have been inversed to illustrate the relative size.



The amount of inflationary Fed programs is slightly larger (in the scheme of the overall economy) than the decline in nominal GDP, consumer debt, and consumer spending. Now none of these figures are directly comparable, i.e., you can't say the inflationary impact is simply x - y. But comparing the relative size of each of these gives some sense of context.

Now if we add the decline in household assets...



Suddenly the Fed's activity seems like a drop in the bucket. And that figure is only through 12/31/08. We don't yet have the Fed's Flow of Funds report through 1Q. We know that household assets are continuing to decline, as evidenced by the continued drop in home prices.

Now we know that eventually consumers will regain their footing and start to spend (and borrow) again. So even if you agree that the Fed's actions aren't inflationary for now, they may become inflationary once the economy starts recovering. So its all about the exit strategy. That will be next time, on SMACKDOWN!

Fed to Treasury Market: It is you who are mistaken

Its flying a little under the radar this morning, but the Fed just disavowed the market of the notion that they would defend the 10-year at 3%. Today's Permanent Open Market action was to buy a paltry $3 billion in 10-year and longer notes.

Here are the last several POMOs of Treasury bonds (excluding TIPs)

I color coded it by the portion of the yield curve which the Fed was buying at each action. Notice that its very clear that the Fed isn't doesn't have a soft target of 3% on the 10-year. Moreover, the Fed isn't focused on the 10-year portion of the curve at all. Most of the buyer has occurred in the 4-7 year area, which I'm assuming the Fed thinks will be most influential on consumer borrowing rates.

This leaves me tactically short the 10 and longer part of the curve, looking to re-enter (I'm still a deflation believer) at a higher yield level. Technically, I don't see any stop points between 3.07% and 3.80%, so I'll probably we waiting a bit before re-entering the long-term Treasury market.

2009 Forecast: That bad huh?

For most of my career, with an exception here and there, there have been two persistent trends. One is that in the debt markets, the fundamental outlook has generally been good. You had persistently low inflation, mostly low volatility, and a growing economy. Sure, some bonds went bad, but for the most part, the fundamental picture was good. The problem was always valuation. You'd look at a corporate bond and see a whopping 100bps spread or something and it would seem like all downside, no upside risk. But of course, you had to buy something, so you'd hold your nose and buy it.

Now its just the opposite. The fundamental outlook is piss poor, but the valuations look extremely cheap across all risk sectors.

Risk assets are pricing in Armageddon. As long as no one spies any horsemen running around, those risk assets ought to pay off well for investors in the very long term. But that's the real trick isn't it? When to jump in?

I think the key to bond investing in 2009 is two fold.

1) Protect your liquidity. Professional investors, whether leveraged or not, never know when their clients will need cash. And the cost of turning bonds into cash has never been higher than now. Non-pros tend to underestimate the probability of needing cash, and frankly, non-pros don't have as many resources for producing liquidity in bonds. No offense, but its true.

I believe that liquidity has probably bottomed, or put another way, that liquidity won't get any worse than it is now. But when I say probably I mean like 65%. There is still a decent chance of another blow-up causing another spate of deep illiquidity.

That being said, bid/ask levels are going to remain very wide, probably for the next several years. We've seen improved liquidity in high-quality sectors, like agencies and munis, but even there, I expect liquidity to wax and wane with buyer demand. Remember that dealers used to be the guardians of liquidity. That's gone and it ain't coming back.

2) Buy what you can hold. This isn't to say you can't put money into a bond as a trade, but given how wide bid/ask is, and given that you don't know when bids are going to suddenly disappear, you can't assume you can flip a position. So when buying a bond, ask yourself: would I hold this bond for the next year? Two years? To maturity? Is this credit strong enough that, if I had to, I'd hold this bond indefinitely?

I argue that you shouldn't buy anything in 2009 where you can't answer that question with a confident yes.

So with all that being said, here is my basic economic forecast for 2009. I'll follow this post up with thoughts on some of the major bond sectors. As always, I'll discuss a most likely scenario along with a less likely but possible scenario.

Growth
Most Likely: Sharply negative real growth in 4Q 2008, continuing (at a less severe pace) at least through 1H 2009. 2H 2009 likely near zero. Meaningful recovery doesn't start until 2Q 2010.

Less Likely: Government fumbles stimulus, and growth is negative through 2010 and possibly into 2011, with a deeper trough.

I think the immediate period after the Lehman/AIG/GSE/WaMu/Wachovia failures resulted in a massive pull back in economic activity. We saw it in Existing Home Sales in October/November, in auto sales activity, bank lending, everything.

That took what was already going to be a recession and turned it into something much worse. I had thought that mortgage foreclosures could bottom in mid-2009, because that seemed like long enough for the bad loans to burn out. But the sharp contraction in 4Q 2008 will result in much higher unemployment, I suspect around 10% by the end of 2009, and thus the foreclosure party will continue on.

And it will take a slowdown in foreclosures for housing prices to bottom. I suspect it will be government intervention that is the catalyst for this. We've already seen the government move to lower mortgage rates, which really should give us pretty good affordability. And while part of the initial problem with housing was over-building, but that ship has sailed. Housing starts have plummeted, and now all starts are pretty much multi-family or made to order.

Anyway, you need demand to outstrip supply in order for prices to start rising. As long as foreclosures are rising, that means supply is rising. Demand is going to be tepid until the employment picture improves. Rising supply and unchanged demand equals falling prices.

So I see home prices falling throughout 2009, absent direct government intervention either buying foreclosed properties or subsidizing banks to prevent foreclosures. Obama & Co. may actually take these steps, but I'd say it'll take several months for such a thing to pass Congress, then several more months to actually be implemented. So we're still looking at late 2009 at best.

GDP growth will probably be worst in 4Q 2008, then more modestly negative in 1Q and 2Q 2009. Beyond that is difficult to say. My base case is for 2H 2009 to be about zero real GDP growth, with a meaningful but tepid recovery in beginning in 2Q 2010.

The risk to this forecast is that the government bungles the bailout attempts, most likely by letting another financial institution fail. It currently doesn't look like that's their strategy, but then again, after Bear Stearns it didn't seem like they wanted to let another institution fail. But then came Lehman.

Another risk to this forecast is...

Inflation
Most Likely: Inflation? What inflation? The Fed will spend most of 2009 fighting deflation, although by 3Q or 4Q it will be apparent that the Fed will indeed win the battle. Headline CPI will print negative multiple times in 1H 2009, predominantly on falling food and energy prices.

Less Likely: We fall deeper into deflation, most likely because the less likely growth scenario comes to pass.

I've written a few times on deflation, which is truly the primary concern of the Fed right now. The Fed has plenty of tools to fight it, and Ben Bernanke is the right man for the job, having spent his academic life studying how the Fed blew it in the 1930's.

I don't see Japanese-style deflation taking hold, at least not for the same reasons as it took hold in Japan. The Bank of Japan maintained a ZIRP policy for many years to no avail. They still suffered from deflation. Why? Because you can't get consumer inflation without consumer spending. I argued this multiple times when energy prices were rapidly rising. Energy doesn't "create" inflation, rising money supply does.

But even in the face of rapidly rising money can't create inflation unless consumers are spending. Right now, money is contracting and consumers are pulling back. In fact, those two things are usually correlated. But in the case of Japan in the 1990's, consumers refused to spend despite massive fiscal and monetary stimulus.

But here is where I think the U.S. differs from Japan. The Japanese are fundamentally savers. Americans are fundamentally spenders.

Unemployment is going to be bad in 2009, heading toward 10%. But the other 90% of Americans will keep spending their income. Now they won't be able to spend their home equity, as in the past, but basically we're a nation of spenders. Once the American stimuli take hold, consumer spending will advance anew. That's not to mention the fact that the U.S. Fed has been far more aggressive far earlier than the BoJ ever was.

Eventually this leads to some inflation problems, probably not till 2H 2010. To suggest that the Fed will provide just enough stimulus to avoid deflation but not create a significant inflation problem down the road is ridiculous.

Key to the Fed's success is the progress on quantitative easing. The TALF is the quintessential example of QE, where the Fed targets interest rates away from overnight bank lending rates. There will be no limit as to how far the Fed goes to fight deflation. They could buy corporate bonds, municipal bonds, commercial mortgages, anything. Beware what you short!

However, if we get another big leg downward in economic growth, resulting in even tighter consumer lending conditions, then the deflation fight becomes more difficult. I'd still see the Fed eventually winning, but such an outcome would result in a much longer period of ZIRP and eventually much bigger inflation spike.

In the next couple days, I'll be discussing my investment strategy around this forecast.

Deflation: A new threat

Does the rate cut matter? We know that 1% fed funds isn't making mortgage rates lower, or spurring banks to lend. So what's the point? Is the Fed pushing on a string? Are they out of bullets?

I think too much of the commentary has been focused on the impact of fed funds on the stock market and/or the lending markets near term. There has also been way too much debate on whether the Fed's actions will "work" or "not work" in terms of averting a recession. The Fed isn't trying to revive the stock market nor is it trying to avert a recession. Those that continue to think in these terms will continue to misunderstand the market for the next two years.

The Fed is currently focused on deflation. They may not have made direct mention of this in their recent post-meeting press release, but deflation is the Fed's ultimate concern. Right now we have a weak economy which is headed for a recession. Nothing can stop that now. The tail risk here is another Great Depression. And what would bring about another Depression?

Here's what Milton Friedman has to say. "I think there is universal agreement within the economics profession that the decline - the sharp decline in the quantity of money played a very major role in producing the Great Depression."

Friedman believed very strongly that a proper reaction by the Fed in 1930 would have prevented the Depression. The deleveraging of our economy will result in a contraction in the money supply, all else being equal. In the recent past, the rapid expansion of credit has created huge amounts of spending power. This spending power is now being removed much faster than it was created. On top of that, the massive loss of consumer wealth, both from housing and from equity markets, will force individuals to increase their savings rate to fund large ticket purchases and long-term financial needs. A contraction in the money supply will result in deflation.

So what does Ben Bernanke think of the Fed's culpability in causing the Depression? At Milton Friedman's 90th birthday, Bernanke said, "Regarding the Great Depression. You're right, we [the Fed] did it. We're very sorry. But thanks to you, we won't do it again." That's all you need to know when thinking about the Fed's playbook for the next year or two. Bernanke will fight deflation with everything he's got. The only lower bound on fed funds will be zero. Here is a quote from Bernanke in 2002. "As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken."

He goes on to say that currency only has value because it has a limited supply. If the problem is that the currency is overvalued (i.e., the currency buys too many goods), the solution is simple: increase the supply. From the same speech: "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

We may have a long way to go before we are literally printing money. But the fact that Bernanke would even mention such a thing shos the kind of resolve the Fed has in fighting deflation.

So what's the trade? First, you need to revise your thinking about the impact of ballooning government debt on the economy. Normally deficit spending results is both inflationary and negative for the dollar. In this case, the government debt is mostly going to offset a rapid decline in private leverage. Thus the increase in debt will not necessarily cause inflation or a devaluation of the dollar, but rather alleviate the deflationary impact of deleveraging.

Second, forget the idea that there is some natural lower bound on interest rates. It is easy to look at 2-year Treasury notes at 1.5% and scoff that rates simply can't go lower. But depending on how effective the Fed is in fighting deflation, rates could keep falling from here.

Finally, the odds are good that the Fed will succeed in preventing sustained deflation, simply because they have such powerful tools at their disposal. But the more unconventional means they employ to fight deflation, the more difficult it will be to control the outcome. In other words, an aggressive fight against deflation may eventually result in more volatile prices in the future.

Stagflation: I can't shake it! I can't shake it!

Thursday's employment report paints a pretty bleak picture of the economy. Consumers are already facing a massive wealth drag from housing, and now more and more are facing lay-offs as well. Yet somehow the consensus is for rising inflation. The 1-year inflation expectation, based on TIPS trading levels, is currently 4.31%, up from 2.24% at the beginning of the year. The weak economy and the relatively high inflation outlook has some uttering the S-word: stagflation.

The pervasive inflation talk in the media may be hard to ignore, but ignore it you should. The conditions for a real inflation spike just aren't in place, and making investment decisions with an inflationary view will wind up costing you money.

First, let's talk briefly about what inflation really means to economists. It isn't rising cost of living, which is probably how the average person thinks of inflation. Clearly with energy and food prices rising, the cost of living is going up. But inflation is defined as too many dollars chasing too few goods. In other words, inflation is always and everywhere a monetary phenomenon, the result of the intersection of money supply and money demand. Surging oil prices due to increased demand from China is not inflation. Higher cost of living? Sure. Inflation, no.

Unfortunately, measuring the effective money supply and demand is nearly impossible. But what we can do is estimate how much money people have to spend vs. how many goods are being produced. This should get at how many dollars are in the hands of consumers versus how many goods those dollars are being chased. A combination of unit labor costs and productivity should do the trick. The following chart compares Unit Labor Costs, Non-Farm Productivity, and Total CPI (all from the Bureau of Labor Statistics). We'll specifically look at 1974, 1979, and 1980 (the three double-digit inflation years) as well as 2007 and 2008 (annualized Year-To-Date).



We see that labor costs surged (blue bar) in the 1970's inflation spike, while productivity (yellow bar) waned. So it was costing more per unit of labor, and each unit of labor was producing less. Sure sounds like too many dollars chasing too few goods. Looking at 2007 and 2008, we don't see the same pattern. Unit labor costs advanced at a modest pace, while productivity has been robust.

Another definition of inflation is a pervasive rise in prices over time. In the 1970's, we certainly saw large price increases across a wide variety of goods. Today, not so much. The chart below is a histogram of CPI components for the same years as above. Again, the data is from the BLS, and again, the 2008 data is annualized.



To build this chart, each CPI component was categorized based on its percentage change, with the groupings done in 5% increments. The bars show the percentage of all components which registered a change within the indicated range. For example, in 1974, 74% of all CPI components clocked at least a 10% price increase, whereas only 2% showed a price decline. 1979 and 1980 showed a similar pattern, with at least 90% of all items showing a 5% increase or more.

Today's pattern is completely different. So far in 2008, the distribution of price increases is more evenly distributed. If inflation were on the rise because of loose monetary policy, or a weaker dollar, the price of everything would be rising at once. That just isn't the case right now.

Finally one needs to consider the impact of contracting consumer credit. Part of the effective money supply is how much banks are willing to lend to consumers. When the Fed cuts interest rates, it is in part trying to encourage borrowing to expand the money supply. But it is clear that consumers access to credit will be tight for the foreseeable future, mitigating any direct impact from the Fed's actions.

There is scant evidence that we're currently experiencing monetary inflation. And therefore it is unlikely we'll see any Fed hikes in the near future. Yet Fed Funds futures still price about an 80% chance of a hike by October. Investors holding on to cash hoping to see better investment rates in the future will be in for a long wait. There are much better opportunities in 2-5 year bonds, both in municipals and high-quality taxables.

Economy to the Fed: I thought I told you to remain on the command ship

The Federal Reserve is set to announce its rate decision today, and is broadly expected to hold their Fed Funds target rate steady at 2%. However, despite the weak economic growth picture and continued pressure on the banking system, most traders now expect the Fed's next move will be a rate hike. Energy and food prices are creating substantial inflation, and the Fed must snuff it out, so the argument goes. Futures on Fed Funds suggest about a 40% chance of a hike at the August meeting, with at least one hike fully priced in by the December meeting. Indeed the 2-year Treasury yield, trading around 2.90%, suggests an aggressive path of Fed rate hikes in the near future.

Would the Fed hike rates with the economy growth and employment picture so weak? Their recent rhetoric would suggest they would. Nearly every speech by Federal Reserve board members and regional presidents during June has mentioned the problem of inflation expectations. Inflation expectations can be a self-fulfilling prophesy, and the Fed must act to prevent such expectations from becoming ingrained in consumers minds. In the late 1970's, as inflation ballooned, expectations for inflation became unhinged, forcing the Fed to tighten monetary policy in an unprecedented way, creating two recessions in the process.

The comparison between the late 1970's and today are particularly chilling. Both periods saw rising energy prices and a stagnant economy. Are we reliving those times?

A look at the correlation between the change in the overall price level (measured by the consumer price index (CPI)) vs. the same measure excluding food and energy (Core CPI) is revealing. If food and energy prices are rising because of loose monetary policy or the weak dollar, then the Core and total CPI figures should rise and fall at the same time. In other words, the correlation will be high.

1970 to 1982, was a period marked by predominantly rising energy costs. The "energy" portion of CPI rose at an annualized rate of 12.1% during this period. The correlation between total CPI and Core CPI was 72.7% when measured monthly and 89.5% when measured annually. Note that a perfect correlation of 100% would suggest that core and total CPI always moved in tandem, whereas a correlation of zero would indicate no relationship between the two figures.

1983 to 1999, was a period of mostly falling energy prices. During this period, energy CPI was a mere 0.1% on an annualized basis. Yet the correlation between total and Core CPI remained relatively high: 58.5% monthly and 85.8% annually.

So over a period of three decades, it was rare that a move in Core CPI would not be mirrored in headline CPI. If one was elevated, the other was elevated. If one was tame, the other was tame.

However, the 21st century hasn't followed the same pattern. From 2000-2008, the correlation between total CPI and Core CPI has broken down: only 7.6% measured monthly and 21.4% measured annually. This despite the energy portion of CPI rising at a 1970's style 9.5% annualized. During the current decade, there has been no particular relationship between total inflation and core inflation.

What does this mean? The data is telling you that rising energy and food prices have been due to supply and demand conditions in those markets. Not classic inflation, which is a monetary phenomenon. In other words, rising oil is indeed due to strong demand from emerging markets and a lack of new supply. Not the weak dollar or loose monetary policy.

The Fed can't do anything to create more oil or temper demand from China. The Fed can only influence the money supply. For the Fed react to a non-monetary phenomenon with a monetary response would be a colossal mistake. Especially when the economy and banking system are as weak as they are.

So the Fed will talk a good game to try to keep inflation expectations low. They might even hike by 25bps to keep inflation expectations under control. But a long series of hikes? No way. Not until the economic growth picture is improving.

This makes 2 to 5 year bonds very attractive, especially for investors holding large money market positions. 2-year Agency bonds are yielding over 3.5%, and 2-year municipals are in the 2.6% area. Both promise to out-yield money markets easily over the next two years should the Fed remain mostly out of the picture.