The Game...

...is this:  Will the global rise in equities and corresponding wealth effect force the current broken Monetary Channel back into something resembling a healthy banking system?

This is happening quickly in the U.S., less so in the other major economies and Europe as usual being the laggards.  So I fully expect the U.S. to benefit from this global rotation and continue to lead.

We are still in the land of negative real yields.  The Fed's main concern is getting out of this predicament and returning to "normal" monetary policy and creation.

A restless night for Shalom...

...this is not the kind of result Bernanke wants to see.   More evidence that the monetary channel of "stimulus" is broken, something I have repeated here for years.  This is a major reason why deflation is should be of primary concern to the U.S. economy, and its interesting to note the policy recommendations and "debates" concerning solvency continue to get first-page treatment from the media and the political class.

But my use of "the political class" should clue you in to why that is, dear reader.

So perhaps he is sleeping very well tonight indeed.

Deposits at U.S. banks exceed loans by an unprecedented $2 trillion as the threat of a slowing economy tempers borrower demand and lenders preserve tightened standards.

Cash deposited at firms from JPMorgan Chase & Co. to Bank of America Corp. expanded 8.7 percent this year to a record $9.17 trillion through Dec. 5, Federal Reserve data show. That outpaced a 3.7 percent gain in loan assets to $7.17 trillion. The gap between what banks take in and lend out has surged since October 2008, the month after Lehman Brothers Holdings Inc. collapsed, when loans exceeded deposits by $205 billion.

The PPI today...

showing DEFLATION.  How can this be, dear readers?  With all the King's men deploying QE so liberally? 

Once again, I remind you that the monetary channel is BROKEN at this point and no amount of asset swaps will cause inflationary pressure.  Coupled with all this deficit-hawk talk out of D.C. and it will take much longer for inflationary pressures to emerge.

Paradigms Lost...

...How is it possible, in light of the massive and continuous "money printing" of QE, QE2, (QEnth), are CPI and other price indexes (unrelated to commodities, which is a separate beast altogether) deflating? As I have outlined on this blog on numerous occassions, QE is a simple asset swap between an asset with zero interest (cash) and an asset paying interest.

In this environment, where the CREDIT CHANNEL OF MONETARY CREATION REMAINS BROKEN, QE is actually DEFLATIONARY. The following CPI numbers bear this out. I have emphasized (the admittedly hard to read) relevant portion which indicates all item CPI to have DECREASED from 3.5 to 3.4 in the October/November time period. In addition, earnings statistics released today show that real income decreased as well. Where is the inflation?

======================================
Nov. Oct.
Weight 2011 2011
======================================
All items 100.0% 0.0% -0.1%
(3 decimals) 100.0%-0.019% -0.085%
6-mo annualize n/a 1.7% 2.1%
ex-food/energy 77.2% 0.2% 0.1%
(3 decimals) 77.2% 0.173% 0.136%
Y/Y
All items NSA 100.0% 3.4% 3.5% (3 decimals) 100.0% 3.394% 3.525%
ex-food/energy 77.2% 2.2% 2.1%
(3 decimals) 77.2% 2.153% 2.100%
All items SA 100.0% 3.4% 3.6%
(3 decimals) 100.0% 3.412% 3.559%

The interest rate channel

As I have maintained for some time on this blog, the interest rate channel of monetary policy is broken. Credit activity and bank lending (the primary sources of money creation) have been grinding lower. In this case, raising interest rates would create INFLATIONARY pressures due to increased interest income and also increasing non variable COSTS for firms. This effect is exacerbated by the fashion of modern finance with regard to short-term financing and the current vogue of the Corporate Treasurer as profit center. In other words, most firms are very lean, with massive dependence on external financing to achieve Positive Net Present Value project goals.

It is a strange and unprecedented set of circumstances.

The Fed chair is happy to report...

...at this wonderful gathering of reporters, that there are no material changes to anything the Fed has previously said or done. Thank you. That will be all.

What did we expect for his first official press conference? Another weapon in the inflations expectations arsenal, and a blunt, unpredictable one at that.

No wage inflation, loan activity dismal, banks still teetering, this is no time to raise interest rates. (ignoring the fact that the Rate channel of price and monetary signaling is hopelessly broken at the moment.)

The Monetary channel...a continuing series...

Signs that the Fed is catching on. The below exerpt that Don Kohn gave today in South Carolina. Finally, some admission that the Monetary channel is broken.

Full Speech here.

A second issue involves the effect of the large volume of reserves created as we buy assets. The Federal Reserve has funded its purchases by crediting the accounts that banks hold with us. Those deposits are called "reserve balances" and are part of bank reserves. In our explanations of our actions, we have concentrated, as I have just done, on the effects on the prices of the assets we have been purchasing and the spillover to the prices of related assets. The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. Other central banks and some of my colleagues on the Federal Open Market Committee (FOMC) have emphasized this channel in their discussions of the effect of policy at the zero lower bound. According to these types of theories, extra reserves should induce banks to diversify into additional lending and purchases of securities, reducing the cost of borrowing for households and businesses, and so should spark an increase in the money supply and spending. To date, that channel does not seem to have been effective; interest rates on bank loans relative to the usual benchmarks have continued to rise, the quantity of bank loans is still falling rapidly, and money supply growth has been subdued. Banks' behavior appears more consistent with the standard Keynesian model of the liquidity trap, in which demand for reserves becomes perfectly elastic when short-term interest rates approach zero. But portfolio behavior of banks will shift as the economy and confidence recover, and we will need to watch and study this channel carefully.

The Fed.

The monetary channel was broken on the downside, and will remain broken on the upside pressure in rates. Long rates will not move to the extent the Fed thinks they will, which is precisely what happened the last time the Fed began a similar upward march.

Although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures. Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time.2

Most importantly, in October 2008 the Congress gave statutory authority to the Federal Reserve to pay interest on banks' holdings of reserve balances at Federal Reserve Banks. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.

The Federal Reserve has also been developing a number of additional tools to reduce the large quantity of reserves held by the banking system, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse repurchase agreements, a tool that the Federal Reserve has historically used to absorb reserves from the banking system, is being expanded so that such transactions can be used to absorb large quantities of reserves. The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of depository institutions' holdings of reserve balances into deposits that are less liquid and could not be used to meet reserve requirements. In addition, the FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. I provided more discussion of these options and possible sequencing in a recent testimony.

The Monetary channel...a continuing series...

Bernanke will be peppered with questions regarding mortgages, Fannie, Freddie, the FOMC, and the FHA. He will hopefully refer to the graph reproduced here.

He will also be questioned about QE, increased bank reserves, and monetary aggregates no doubt.

But the monetary channel is still broken.

Bernanke should be questioning the committee about their commitment in stoking aggregate demand and the only way to put more cash in people's pockets is tax decreases, deficit be damned. The current increase in national savings is on a smaller asset base, and tax decreases are a more efficient means of stoking real aggregate demand than monetary policy that relies on disintermediation when the disintermediators are hoarding cash due to unstable capital markets. The scale of our larger banks (the ones who benefited most from the TARP and bail-outs) is hurting lending supply and lending demand.

MMT is broken

Modern Monetary Theory (MMT) opines that decreases in interest rates portend inflation expectations, which finally leads to inflation. It also assumes that low or zero interest rates stoke inflationary pressures by making the price of credit cheaper. All things being equal, this means a greater demand for credit should follow.

Except there is a problem here, both on the supply and demand sides. Richard Koo has termed this a "balance Sheet Recession" whereby households and corporations are loathe to take on new debt in favor of cleaning up their own balance sheets. Banks are loathe to lend as assumptions for future capital needs are uncertain and access to capital markets are equally unknown.

SO BANKS DO NOT LEND AND THE CREDIT CHANNEL (via monetary policy through rate action) IS BROKEN.

Only FISCAL policy can fix this problem.

Tim Cavanaugh...

...of Reason.com gets it right.

This is one of the reasons why the monetary channel is broken and QE, ZIRP are not going to have the effects the Fed thinks they will have. The "loanable funds" theory of reserve banking makes no sense in a fiat currency world, but that is framework the Fed is operating under when making decisions and suggesting action to congress.

Krugman is the same way, and intellectual ponzi schemes have the same effect as ones based in the real world. At some point, doctrine ossifies itself within its Economist host and mental pliability becomes impossible: defending the existing framework becomes more important than the search for truth...and humans are very, very good at that as well.

But I don't want to argue against Krugman with macroeconomics, a pseudoscience in which he is just one of a million witch doctors. Krugman doesn't need to be wrong in theory because he's wrong in reality. Nobody's lending because nobody's worth lending to. We are all worse credit risks than we were believed to be just a few years ago. That epiphany is going to take a long time to sort out. Runaway inflation will definitely make banks desperate to find places to put their money, but it will not suddenly make Americans into better credit risks. That can only be done through reducing borrowing, upping savings and employing policy that encourages frugality -- or actually, just policy that fails to punish frugality. The good news is that a big chunk of that work has already been done, despite the best efforts of the Keynesians in charge of U.S. economic policy. The bad news is that, just as he famously did in 2002, Krugman is arguing for the creation of another asset bubble, and too many people still take him seriously.

Round and Round...

They still don't seem to understand, and are commingling the issues of interest rates levels, and the granular credit decisions that create liquidity and inflation.

If the interest rate channel is "broken", altering the level of rates will not necessarily create credit demand as that is a function of both the cost of capital and the return on capital. If there are no opportunities, bank lending declines. This is exacerbated when bank capital is already under pressure from decreasing asset prices.

And, by the evidence we have regarding bank credit, this is precisely what is happening.

IMF floats plan to raise inflation targets

By Chris Giles in London

Published: February 12 2010 00:06 | Last updated: February 12 2010 00:06

International Monetary Fund economists are challenging economic orthodoxy on Friday by suggesting that many pre-crisis policy tools should be redesigned and some sacred cows considered for slaughter.

A staff paper co-authored by Olivier Blanchard, IMF chief economist, says the financial and economic crisis has “exposed flaws in the pre-crisis policy framework” and “forces us to think about the architecture of post-crisis macroeconomic policy”.

Suggestions include raising inflation targets from about 2 per cent to about 4 per cent so that monetary policy can better respond to shocks; automatic lump-sum payments for poorer families if unemployment rises above certain thresholds; exchange-rate intervention for smaller economies that depend heavily on trade; and giving central banks huge new regulatory tools so they can smooth the path of the economy.

The political momentum behind many of the ideas is absent, Mr Blanchard accepted. The IMF is taking a gamble by spelling out the flaws in current thinking, even if it is in a staff paper rather than formal recommendations.

Some of the tools suggested have been used in the crisis, but boosting the Federal Reserve’s powers, for instance, is highly controversial in the US.

The suggestion that inflation targets should be raised to 4 per cent will cause many central bankers to choke on their breakfasts, since they have spent their whole careers gaining and preserving the credibility of keeping inflation at levels close to 2 per cent.

‘If we had had more margin to play with on interest rates, we would probably have had to use fiscal policy less [in the crisis]‘
Olivier Blanchard, IMF chief economist

Niall Ferguson goes populistic...

From today's FT.

This is not an article to inform. It is an article to persuade. My comments (in italics) are presented below amongst relevant sections (this is not the full article.)


What we in the western world are about to learn is that there is no such thing as a Keynesian free lunch. Deficits did not “save” us half so much as monetary policy – zero interest rates plus quantitative easing – did. First, the impact of government spending (the hallowed “multiplier”) has been much less than the proponents of stimulus hoped. Second, there is a good deal of “leakage” from open economies in a globalised world. Last, crucially, explosions of public debt incur bills that fall due much sooner than we expect

Simple assertion of Zero Interest Rate Policy ("ZIRP") without evidence. I have already spoke about QE and its relative uselessness. Government Deficit spending, a flamethrower lighting a cigarette, is fraught with problems, leakages, and inefficiences. ZIRP and QE are arms of monetary policy, which is BROKEN at the moment with declining credit creation. Tax decreases should be the rule of the day in order to build demand organically.

For the world’s biggest economy, the US, the day of reckoning still seems reassuringly remote. The worse things get in the eurozone, the more the US dollar rallies as nervous investors park their cash in the “safe haven” of American government debt. This effect may persist for some months, just as the dollar and Treasuries rallied in the depths of the banking panic in late 2008.

OK, then why has the dollar has rallied against 95% of its currency competitors? There are other problems in the world unrelated to Europe. He ignores the pay to play scheme that is the U.S. and security concerns.

Yet even a casual look at the fiscal position of the federal government (not to mention the states) makes a nonsense of the phrase “safe haven”. US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.

Whatever.

Even according to the White House’s new budget projections, the gross federal debt in public hands will exceed 100 per cent of GDP in just two years’ time. This year, like last year, the federal deficit will be around 10 per cent of GDP. The long-run projections of the Congressional Budget Office suggest that the US will never again run a balanced budget. That’s right, never.

That's what they thought in 1995 before 7 years of massive surplus. This is silly. 10% of GDP when GDP has contracted for 6 quarters is not so bad.

The International Monetary Fund recently published estimates of the fiscal adjustments developed economies would need to make to restore fiscal stability over the decade ahead. Worst were Japan and the UK (a fiscal tightening of 13 per cent of GDP). Then came Ireland, Spain and Greece (9 per cent). And in sixth place? Step forward America, which would need to tighten fiscal policy by 8.8 per cent of GDP to satisfy the IMF.

What would tax receipts look like if GDP grew by its historical average (NOT factoring post recession increases in same) in the next decade? The next 5 years? He cites the IMF citing Japan as the worst offender. They have "debt" twice as large as the U.S. and employed ZIRP for a DECADE and still are mired in DEFLATION. How is this possible? (my apologies for that rhetorical question...clearly the models currently used to understand and predict inflation and national debts must be re-thought.

Explosions of public debt hurt economies in the following way, as numerous empirical studies have shown. By raising fears of default and/or currency depreciation ahead of actual inflation, they push up real interest rates. Higher real rates, in turn, act as drag on growth, especially when the private sector is also heavily indebted – as is the case in most western economies, not least the US.

So why has Japan's rates stayed close to ZERO for a decade? Even with an "explosion" of debt? Why, given this debt, is there still Deflation?

Although the US household savings rate has risen since the Great Recession began, it has not risen enough to absorb a trillion dollars of net Treasury issuance a year. Only two things have thus far stood between the US and higher bond yields: purchases of Treasuries (and mortgage-backed securities, which many sellers essentially swapped for Treasuries) by the Federal Reserve and reserve accumulation by the Chinese monetary authorities.

I have no idea what the "absorbtion" theory refers to. So in reality, the FED has no power over rates? Reserve accumulation reflects the desired of China to both hold their currency at stable levels (read: better export prospects) and to save in dollars. There are many reasons for this.

But now the Fed is phasing out such purchases and is expected to wind up quantitative easing. Meanwhile, the Chinese have sharply reduced their purchases of Treasuries from around 47 per cent of new issuance in 2006 to 20 per cent in 2008 to an estimated 5 per cent last year. Small wonder Morgan Stanley assumes that 10-year yields will rise from around 3.5 per cent to 5.5 per cent this year. On a gross federal debt fast approaching $1,500bn, that implies up to $300bn of extra interest payments – and you get up there pretty quickly with the average maturity of the debt now below 50 months.

Who cares if the Fed stops QE. Japan has been "sterilizing" its debt for a decade and more with no effect. "Estimated" 5%? What "extra interest payment"? We issue debt and pay the coupon rate. 5% of 1,500 Billion is 300 Billion??? As for the "get there quickly" comment, you don't have lower rates with shorter duration?


The Obama administration’s new budget blithely assumes real GDP growth of 3.6 per cent over the next five years, with inflation averaging 1.4 per cent. But with rising real rates, growth might well be lower. Under those circumstances, interest payments could soar as a share of federal revenue – from a tenth to a fifth to a quarter.

They "could". Alot of scenarios "could" happen. Rising real rates may or may not have the assumed effect on growth. He assumes real rates will rise in an environment of low growth? This is convoluted and depends on so many assumptions as to render it meaningless.

Last week Moody’s Investors Service warned that the triple A credit rating of the US should not be taken for granted. That warning recalls Larry Summers’ killer question (posed before he returned to government): “How long can the world’s biggest borrower remain the world’s biggest power?”

Moody's is wrong in my opinion and I have written about that before on this blog. Larry Summers does not have a Midas touch. Appeals to authority will not predict anything.

On reflection, it is appropriate that the fiscal crisis of the west has begun in Greece, the birthplace of western civilization. Soon it will cross the channel to Britain. But the key question is when that crisis will reach the last bastion of western power, on the other side of the Atlantic.

It does not have to. Greece is experiencing a liquidity crisis as a non-issuer of its currency. The UK and the US enjoy different paradigms.