View Full Version : Economics Another Gem from Doug Noland...

11-21-2009, 07:28 AM
Reflation Issues Heat Up:

The Bernanke Fed held tightly to its “extended period” language in their November 4th communication. Global markets took this as a signal that the Fed would not be shifting away from its ultra-loose stance until sometime later in 2010 - at the earliest. Then there were captivating comments this week from St. Louis Federal Reserve Bank President James Bullard: “Policy rates are near zero in the U.S. and the rest of G-7 countries, something not seen in postwar economic history. The FOMC did not begin policy rate increases until 2-1/2 - 3 years after the end of each of the past two recessions.” Markets were quick to ponder the possibility that rates might be on hold all the way into 2012. The Fed should discourage such thinking.

In fairness to Mr. Bullard, he did note that the Fed will be mindful of criticism that it has in the past maintained low interest rates for too long. Interestingly, the world seems to have suddenly woken up to some of the risks posed by prolonged near zero short-term U.S. rates. Throughout Asia, attention has shifted from crisis management to the formidable challenge of dealing with unrelenting “hot money” inflows and associated Bubble risks. Increasingly, there are fears of an extended period of Monetary Disorder.

“Asian policy makers are studying capital controls to limit ‘hot money’ inflows that may stoke asset bubbles and force their currencies to appreciate,’ according to a Bloomberg story (Shamim Adam) that ran this morning. The article noted that policymakers from South Korea, India, and Indonesia are expressing concerns regarding international flows fueling asset inflation. Central bankers in Indonesia are studying placing limits on foreign investment in short-term debt instruments. This follows last week’s move by the Taiwanese to restrict international investments in bank term deposits. The Bloomberg article also included an apt comment from the Chief Executive of the Hong Kong Monetary Authority: “These economies could of course raise interest rates to contain inflation and increases in asset prices. But the fear is that once interest rates are raised the carry trade will become even more active, attracting even more fund inflows. Asian economies are therefore facing a dilemma.”

Here at home, there is the consensus view that the weak dollar, “hot money” flows, and the reemergence of Asian and global asset Bubbles are predominantly the problem of Asia and the rest of the non-U.S. world. From Bill Gross’s latest: “Raise interest rates with 15 million jobless and 25 million part-time working Americans? All because gold is above $1,100? You must be joking or smoking – something.”

With a clear head I can argue seriously that U.S. rates were cut much too low and that leaving them at near zero for a prolonged period is another major policy blunder. It is a case of the costs of such a policy greatly outweighing potential benefits.

As my designated “analytical nemeses” for approaching a decade now, I take special interest in the commentaries coming out of Pimco. In my parlance, Messrs. Gross and McCulley are “inflationists.” I would have expected inflationism dogma to have been discredited by now. Silly me, as the inflationists remain firmly in control of the Federal Reserve and Treasury - and continue to enjoy renown and riches as our era’s “captains of industry.” And they stick unbowed with their policy ideologies – government-directed monetary and fiscal stimulus – but in increasingly massive quantities and for longer durations.

The inflationists argued passionately for extraordinary “Keynesian” stimulus after the bursting of the technology Bubble. The “market” demanded and the Fed delivered. Of course, the Fed collapsed rates after the 2000 tech wreck. Rates remained at 1.0% until June 2004 and didn’t make it above 3% until mid-2005. At the time, the inflationists argued that some real estate excesses were a small price to pay to protect the system from the scourge of deflation. Their analysis of risk was flawed.

Household mortgage debt expanded 10.6% in 2001, 13.4% in 2002, 14.3% in 2002, 13.6% in 2004 and 13.2% in 2005. Evidence of a Bubble was right there in Fed data. From my perspective, rates were inarguably set inappropriately low for much too long, and higher borrowing costs would have been constructive for a more sound and stable financial and economic system. Would we be better off today had the Fed raised rates earlier and more aggressively?

The inflationists are always keen to downplay (ignore) Bubble risks, while disparaging any analysis suggesting that government market intervention can go too far. I could only chuckle recently when CNBC’s Rick Santelli and Steve Liesman were going another round at each other. After criticizing Federal Reserve, Mr. Liesman needled Mr. Santelli’s for how he’d set policy if he were leading the Fed. Santelli responded, “I’d start by raising rates to 1.0%.” Liesman immediately snapped back, “You’re a liquidationist!”

In Mr. Gross’s latest, he refers to “mini bubbles.” The problem is that the concept of anything “mini” hasn’t applied to Bubble analysis for years - and it doesn’t apply to the current backdrop either. It is the nature of Credit Bubbles that they tend toward expansion. If accommodated, they will not remain “mini” for long. Considering the unprecedented scope of synchronized global monetary and fiscal stimulus, it should be no surprise that Bubble dynamics have emerged so quickly.

To be sure, the Fed has been accommodating Bubbles for many years now. And with each bursting Bubble came policy reflation and only larger Bubbles. The bursting of bigger Bubbles provoked only more aggressive reflations and Bubbles of historic dimensions. The inflationists fatefully disregarded Bubble dynamics earlier this decade when their aggressive post-tech Bubble policy course fomented a much more dangerous Wall Street/mortgage finance Bubble. They are content these days to make a similar mistake.

Importantly, the unfolding global government finance Bubble is the largest and most precarious Bubble yet. Such a statement may today seem ridiculous to U.S.-centric analysts - but its becoming less so to those following developments in and around China. The unfolding backdrop is particularly dangerous because the Fed is poised to aggressively accommodate global Bubble dynamics for an extended period. Ultra-aggressive U.S. policy stimulus ensures ongoing dollar debasement, which feeds already massive financial flows to “undollar” assets and markets. Only aggressive policy tightening would contain Bubble excesses in China, Asia and the emerging markets. There appears no stomach for such an approach anywhere - and this is no mini predicament.

From Mr. Gross’s perspective, the Fed will not back away from its aggressive stimulus until “your cash has recapitalized and revitalized corporate America and homeowners…” And this seems an accurate enough assessment of the Fed’s point of view. But Gross then follows with a key sentence: “To date that transition is incomplete, mainly because mortgage refinancing and the purchase of new homes is being thwarted by significant changes in down payment requirements.” If I had to speculate, I’d say Mr. Gross struggled with that sentence – and may even wish he could have it back.

It is fundamental to Credit Bubble analysis to appreciate that the unfolding reflation is going to be altogether different than previous reflations. As I’ve repeatedly tried to explain, the epicenter of reflationary forces have shifted from the Core (U.S.) to the Periphery (China, Asia, and the “emerging” markets). The dollar and sophisticated Wall Street Credit instruments have been supplanted by non-dollar assets and markets as the inflationary asset class of choice. The underlying U.S. economic structure evolved during - and for – a Credit cycle era comprised of massive ongoing U.S. mortgage Credit expansion, resulting asset inflation, over-consumption and mal-investment. Accordingly, the U.S. economy is today especially poorly positioned for the new global reflationary backdrop.

“Down payment requirements” have essentially nothing to do with the lagging U.S. economy. A historic financial Bubble fueled a housing mania. The Bubble collapsed and the mania won’t be reappearing anytime soon. As a reminder of the nature of manias, Nasdaq traded above 5,000 in March 2000 and sits at less than half that level almost a decade later. Japan’s Nikkei traded to 38,957 on December 29, 1989 and closed today at 9,498. Reflations may create new manias, but they don’t rejuvenate the disCredited ones.

Years of steady home price inflation had convinced us that the more we borrowed to buy the biggest house - the wealthier we’d become. And the more we all accumulated debt (and Wall Street piled on leverage) the more home prices and our net worth inflated - and the more mad money we found to spend so freely. Not atypically, this mania was built upon Ponzi Credit and speculative excesses. Today, no amount of cheap mortgage Credit – and Fannie, Freddie, FHA and Treasury largess – is going to bring the housing boom back. Market psychology changed radically and the mania was crushed. The powerful inflationary bias percolating for years throughout U.S. housing and households was squelched. Spending patterns were significantly altered.

It is my thesis that there is no alternative than a major transformation of the underlying structure of the U.S. economy. In simplest terms, we must produce much more, consume much less and do it with a lot less Credit creation. The objective of current policymaking, however, is to quickly rejuvenate housing and asset prices with the intention of sustaining the legacy economic structure. Zero interest-rate policy is key to this strategy. The objective is to push savers out to the risk asset markets, as well as to transfer returns on savings from the savers to be used instead to recapitalize the banking/financial system. If this reflation is unsuccessful, the household sector will find itself with only greater exposure to risky assets.

Not only is the current course of policymaking unjust, I believe it is flawed. The nation’s housing markets will remain rather impervious to low rates, while the household sector is punished with near zero returns on its savings. At the same time, monetary policy will continue to play a major role in dollar devaluation and higher consumer prices for energy and imports. Financial sector profits have already bounced back strongly, but there is little market incentive to direct new finance in a manner that would fund any semblance of economic transformation. The focus remains on financing the old structure. Indeed, I would argue that the current course of policymaking and market interventions only work to delay the unavoidable economic adjustment process.

I believe the unfolding risks to the U.S. and global economy are enormous. Most seem rather oblivious to the risks, believing both that our asset markets are not overvalued and that economic recovery is only a matter of time. But we are taking an economy that had become dependent on massive mortgage Credit and housing inflation and making it equally addicted to zero interest rates, massive federal deficits, and tenuous global reflationary dynamics. Or let’s look at it from a different angle. From the perspective of stock market valuation - massive Credit growth, the resulting flow of finance, and the course of policymaking basically created no additional wealth over the past ten years. We now appear determined to repeat this dismal performance over the next decade. Repeating what I wrote above, I believe the costs associated with prolonged zero rates are much greater than the benefits.