Category Archives: Russia

The subprime mess

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On Jan 5, 2008 9:40 PM, Steve Martyak wrote:
> http://www.autodogmatic.com/index.php/sst/2007/02/02/subprime_credit_crunch_could_trigger_col
>
>
> also….
>
> 9/4/2006
> Cover of Business Week: How Toxic Is Your Mortgage? :.
>
> The option ARM is “like the neutron bomb,” says George McCarthy, a housing
> economist at New York’s Ford Foundation. “It’s going to kill all the people
> but leave the houses standing.”
>
> Some people saw it all coming….
>

The subprime setback actually hit about 18 months ago. Investors stopped funding new loans, and would be buyers were were no longer able to buy, thereby reducing demand. Housing fell and has been down for a long time. There are signs it bottomed October/November but maybe not.

I wrote about it then as well, and have been forecasting the slowdown since I noted the fed’s financial obligations ratio was at levels in March 2006 that indicated the credit expansion had to slow as private debt would not be able to increase sufficiently to sustain former levels of GDP growth. And that the reason was the tailwind from the 2003 federal deficits was winding down. as the deficit fell below 2% of GDP, and it was no longer enough to support the credit structure.

Also, while pension funds were still adding to demand with their commodity allocations, that had stopped accelerating as well and
wouldn’t be as strong a factor.

Lastly, I noted exports should pick up some, but I didn’t think enough to sustain growth.

I underestimated export strength, and while GDP hasn’t been stellar as before, it’s been a bit higher than i expected as exports boomed.

That was my first ‘major theme’ – slowing demand.

The second major theme was rising prices – Saudis acting the swing producer and setting price. This was interrupted when Goldman changed their commodity index in aug 06 triggering a massive liquidation as pension funds rebalanced, and oil prices fell from near 80 to about 50, pushed down a second time at year end by Goldman (and AIG as well this time) doing it again. As the liquidation subsided the Saudis were again in control and prices have marched up ever since, and with Putin gaining control of Russian pricing we now have to ‘price setters’ who can act a swing producers and simply set price at any level they want as long as net demand holds up. So far demand has been more than holding up, so it doesn’t seem we are anywhere near the limits of how high they can hike prices.

Saudi production for December should be out tomorrow. It indicates how much demand there is at current prices. If it’s up that means they have lots of room to hike prices further. Only if their production falls are they in danger of losing control on the downside. And I estimate it would have to fall below 7 million bpd for that to happen. It has been running closer to 9 million.

What I have missed is the fed’s response to all this.

I thought the inflation trend would keep them from cutting, as they had previously been strict adherents to the notion that price
stability is a necessary condition for optimal employment and growth.

This is how they fulfilled their ‘dual mandate’ of full employment and price stability, as dictated by ‘law’ and as per their regular reports to congress.

The theory is that if the fed acts to keep inflation low and stable markets will function to optimize employment and growth, and keep long term interest rates low.

What happened back in September is they became preoccupied with ‘market functioning’ which they see as a necessary condition for low inflation to be translated into optimal employment and growth.

What was revealed was the FOMC’s lack of understanding of not only market functioning outside of the fed, but a lack of understanding of their own monetary operations, reserve accounting, and the operation of their member bank interbank markets and pricing mechanisms.

In short, the Fed still isn’t fully aware that ‘it’s about price (interest rates), not quantity (‘money supply, whatever that may be)’.

(Note they are still limiting the size of the TAF operation using an auction methodology rather than simply setting a yield and letting quantity float)

The first clue to this knowledge shortfall was the 2003 change to put the discount rate higher than the fed funds rate, and make the discount rate a ‘penalty rate.’ This made no sense at all, as i wrote back then.

The discount rate is not and can not be a source of ‘market discipline’ and all the change did was create an ‘unstable equilibrium’ condition in the fed funds market. (They can’t keep the system ‘net borrowed’ as before) it all works fine during ‘normal’ periods but when the tree is shaken the NY Fed has it’s hands full keeping the funds rate on target, as we’ve seen for the last 6 months
or so.

While much of this FOMC wasn’t around in 2002-2003, several members were.

Back to September 2007. The FOMC was concerned enough about ‘market functioning’ to act, They saw credit spreads widening, and in particular the fed funds/libor spread was troubling as it indicated their own member banks were pricing each other’s risk at higher levels than the FOMC wanted. If they had a clear, working knowledge of monetary ops and reserve accounting, they would have recognized that either the discount window could be ‘opened’ by cutting the rate to the fed funds rate, removing the ‘stigma’ of using it, and expanding the eligible collateral. (Alternatively, the current TAF is functionally the same thing, and could have been implemented in September as well.)

Instead, they cut the fed funds rate 50 bp, and left the discount rate above it, along with the stigma. and this did little or nothing for the FF/LIBOR spread and for market functioning in general.

This was followed by two more 25 cuts and libor was still trading at 9% over year end until they finally came up with the TAF which immediately brought ff/libor down. It didn’t come all the way down to where the fed wanted it because the limited the size of the TAFs to $20 billion, again hard evidence of a shortfall in their understanding of monetary ops.

Simple textbook analysis shows it’s about price and not quantity. Charles Goodhart has over 65 volumes to read on this, and the first half of Basil Moore’s 1988 ‘Horizontalists and Verticalsists’ is a good review as well.

The ECB’s actions indicate they understand it. Their ‘TAF’ operation set the interest rate and let the banks do all they wanted, and over 500 billion euro cleared that day. And, of course- goes without saying- none of the ‘quantity needles’ moved at all.

In fact, some in the financial press have been noting that with all the ‘pumping in of liquidity’ around the world various monetary
aggregates have generally remained as before.

Rather than go into more detail about monetary ops, and why the CB’s have no effect on quantities, suffice to say for this post that the Fed still doesn’t get it, but maybe they are getting closer.

So back to the point.

Major themes are:

  • Weakness due to low govt budget deficit
  • Inflation due to monopolists/price setters hiking price

And more recently, the Fed cutting interest rates due to ‘market functioning’ in a mistaken notion that ff cuts would address that issue, followed by the TAF which did address the issue. The latest announced tafs are to be 30 billion, up from 20, but still short of the understanding that it’s about price, not quantity.

The last four months have also given the markets the impression that the Fed in actual fact cares not at all about inflation, and will only talk about it, but at the end of the day will act to support growth and employment.

Markets acknowledge that market functioning has been substantially improved, with risk repriced at wider spreads.

However, GDP prospects remain subdued, with a rising number of economists raising the odds of negative real growth.

While this has been the forecast for several quarters, and so far each quarter has seen substantial upward revisions from the initial forecasts, nonetheless the lower forecasts for Q1 have to be taken seriously, as that’s all we have.

I am in the dwindling camp that the Fed does care about inflation, and particularly the risk of inflation expectations elevating which would be considered the ultimate Central Bank blunder. All you hear from FOMC members is ‘yes, we let that happen in the 70’s, and we’re not going to let that happen again’.

And once ‘markets are functioning’ low inflation can again be translated via market forces into optimal employment and growth, thereby meeting the dual mandate.

i can’t even imagine a Fed chairman addressing congress with the reverse – ‘by keeping the economy at full employment market forces will keep inflation and long term interest rates low’.

Congress does not want inflation. Inflation will cost them their jobs. Voters hate inflation. They call it the govt robbing their
savings. Govt confiscation of their wealth. They start looking to the Ron Paul’s who advocate return to the gold standard.

That’s why low inflation is in the Fed’s mandate.

And the Fed also knows they are facing a triple negative supply shock of fuel, food, and import prices/weak $.

While they can’t control fuel prices, what they see there job as is keeping it all a relative value story and not ‘monetizing it into an
inflation story’ which means to them not accommodating it with low real rates that elevate inflation expectations, followed by
accelerating inflation.

There is no other way to see if based on their models. Deep down all their models are relative value models, with no source of the ‘price level.’ ‘Money’ is a numeraire that expresses the relative values. The current price level is there as a consequence of history, and will stay at that level only if ‘inflation expectations are well anchored.’ The ‘expectations operator’ is the only source of the price level in their models.

(See ‘Mandatory Readings‘ for how it all actually works.)

They also know that food/fuel prices are a leading cause of elevated inflation expectations.

In their world, this means that if demand is high enough to drive up CPI it’s simply too high and they need to not accommodate it with low real rates, but instead lean against that wind with higher real rates, or risk letting the inflation cat out of the bag and face a long, expensive, multi year battle to get it back in.

They knew this at the Sept 18 meeting when they cut 50, and twice after that with the following 25 cuts, all as ‘insurance to forestall’ the possible shutdown of ‘market functioning’.

And they knew and saw the price of this insurance – falling dollar, rising food, fuel, and import prices, and CPI soaring past 4% year over year.

To me these cuts in the face of the negative supply shocks define the level of fear, uncertainty, and panic of the FOMC.

It’s perhaps something like the fear felt by a new pilot accidentally flying into a thunderstorm in his first flight in an unfamiliar plane without an instructor or a manual.

The FOCM feared a total collapse of the financial structure. The possibility GDP going to 0 as the economy ‘froze.’ Better to do
something to buy some time, pay whatever inflation price that may follow, than do nothing.

The attitude has been there are two issues- recession due to market failure and inflation.

The response has been to address the ‘crisis’ first, then regroup and address the inflation issue.

And hopefully inflation expectations are well enough anchored to avoid disaster on the inflation front.

So now with the TAF’s ‘working’ (duh…) and market functions restored (even commercial paper is expanding again) the question is what they will do next.

They may decide markets are still too fragile to risk not cutting, as priced in by Feb fed funds futures, and risk a relapse into market dysfunction. Recent history suggests that’s what they would do if the Jan meeting were today.

But it isn’t today, and a lot of data will come out in the next few weeks. Both market functioning data and economic data.

Yes, the economy may weaken, and may go into recession, but with inflation on the rise, that’s the ‘non inflationary speed limit’ and the Fed would see cutting rates to support demand as accomplishing nothing for the real economy, but only increasing inflation and risking elevated inflation expectations. The see real growth as supply side constrained, and their job is keeping demand balanced at a non inflationary level.

But that assumes markets continue to function, and the supply side of credit doesn’t shut down and send GDP to zero in a financial panic.

With a good working knowledge of monetary ops and reserve accounting, and banking in general that fear would vanish, as the FOMC would know what indicators to watch and what buttons to push to safely fly the plane.

Without that knowledge another FF cut is a lot more likely.

more later…

warren

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Payrolls

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On Jan 4, 2008 10:43 AM, Mike wrote:

> Warren, right now economic sectors in stock mkt are pricing in a severe
> recession-your call on no recession is extremely out of consensus now-I
> think that mkt has overdone the recession theme short term…

Agreed!

We may get to 0 or negative growth for a quarter or so, but probably not due to financial sector losses, ‘market functioning’ issues, or housing related issues.

More likely if it happens it will be a fall off in exports or something like that.

Also, the Fed can’t talk about it, but it knows it’s way behind the inflation curve due to fears of ‘market functioning.’ Their concern now turns to the ‘insurance premium’ they paid- food, fuel, $/import prices.

ISM service just came out- solid number.

Orders and employment strong, prices strong.

And in today’s employment number service sector jobs expanded faster than the rest fell, so q4 remains ok at 2% or so, and q1 still looks up.

I still see GDP muddling through (assuming exports hold up), and upward price pressures continuing indefinately as Saudis/Russians keep hiking.

Saudi production numbers due out for Dec any day. That’s the best indicator we have for whether demand is holding up at current prices.

warren
> Mike

Yes, a weak number for sure, though probably as expected by those originally looking for negative growth for the entire quarter.

And only a few months ago a negative employment number was revised to a strong up number.

And unemployment is also a lagging indicator, reflecting the weakness of several months ago.

Service sector added 93,000, other sectors lost, so employment continues its multi year shift.

And, however weak demand may have been, from the Fed’s point of view it was still strong enough to further drive up food/fuel/import prices.

3 mo libor down again and now about 75 bps lower than August in absolute terms, and spread to ff falling and way down from the wides, cp starting to expand, and most everything indicating market functioning returning and financial conditions easing..

The Fed views this as an ‘ease’ the same way it viewed the reverse as a ‘tightening’ when it cut 50.

Even write down announcements have subsided with less than 100 billion in write offs announced so far. In 1998, for example, $100 billion was lost the first day due to the Russian default, with no prospect of recoveries. That’s probably equiv to a 300b initial loss today.

Also heard this statement on CNBC: current oil prices mean $4 gasoline at the pump, and that will cut into consumer spending so the Fed has to cut rates to keep us out of recession.

That’s exactly what the Fed doesn’t want to happen- they call that monetizing a negative supply shock and turning a relative value story into an inflation story.

With the return of ‘market functioning’ the risks to growth change dramatically for the Fed.

They are now far less concerned about ‘the financial system shutting down’ and instead can now get back to their more familiar discussion of the long term relation between inflation and growth when making their decisions.

A fiscal package is being discussed to day by Bernanke, Paulson, and Bush. That would also reduce the odds of a Fed cut.

With their belief that fiscal is for the economy and monetary policy for inflation, the mainstream might prefer to see a fiscal response to support gdp rather than an inflation inducing rate cut to support growth.

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Crisis may make 1929 look a ‘walk in the park’

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Crisis may make 1929 look a ‘walk in the park’

Telegraph
by Ambrose Evans-Pritchard

As central banks continue to splash their cash over the system, so far to little effect, Ambrose Evans-Pritchard argues that things risk spiralling out of their control

Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas.
Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.

It’s about price, not quantity (net funds are not altered), and the CB actions have helped set ‘policy rates’ at desired levels.

That is all the CBs can do, apart from altering the absolute level of rates, which, by their own research, does little or nothing and with considerable lags.

Not to say changing rates isn’t disruptive as it shifts nominal income/wealth between borrowers and savers of all sorts.

As the credit paralysis stretches through its fifth month, a chorus of economists has begun to warn that the world’s central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions.

“Liquidity doesn’t do anything in this situation,” says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression.

The last major, international fixed exchange rate/gold standard implosion. Other since – ERM, Mexico, Russia, Argentina – have been ‘contained’ to the fixed fx regions.

“It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue,” she adds.

The critical issue at the macro policy level is what it is all doing to the aggregate demand that sustains output, employment, and growth. So far so good on that front, but it remains vulnerable, especially given the state of knowledge of macro economics and fiscal/monetary policy around the globe.

Lenders are hoarding the cash, shunning peers as if all were sub-prime lepers. Spreads on three-month Euribor and Libor – the interbank rates used to price contracts and Club Med mortgages – are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.

The CB can readily peg Fed Funds vs. LIBOR at any spread they wish to target.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster.

Seems they pretty much did before year end. Spreads are narrower now and presumably at CB targets.

“The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are
allowing the money markets to dictate policy. We are long past worrying about moral hazard,” he says.

They have allowed ‘markets’ to dictate as the entire FOMC and others have revealed a troubling lack of monetary operations and reserve accounting.

“They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don’t think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park,” he adds.

Hard to do with floating exchange rates, but not impossible if they try hard enough!

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. “We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other,” he says.

Seems a lack of understanding of the ‘suppy side’ of money/credit is pervasive and gives rise to all kinds of ‘uncertainties’ (AKA – fears, as in being scared to an extreme).

New York’s Federal Reserve chief Tim Geithner echoed the words, warning of an “adverse self-reinforcing dynamic”, banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Banks can only own what the government puts on their ‘legal list’, and banks can issue government insured deposits, which is government funding, in order to fund government approved assets.

Functionally, there is no difference between issuing government insured deposits to fund their legal assets and using the discount window to do the same. The only difference may be the price of the funds, and the fed controls that as a matter of policy.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.

Section 13 (3) allows the Fed to take emergency action when banks become “unwilling or very reluctant to provide credit”. A vote by five governors can – in “exigent circumstances” – authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.

The government already does this. They already determine legal bank assets, capital requirements, and via various government agencies and association advance government guaranteed loans of all types.

This is business as usual – all presumably for public purpose.

Get over it!!!

Yet still the central banks shrink from seriously grasping the rate-cut nettle. Understandably so. They are caught between the Scylla of the debt crunch and the Charybdis of inflation. It is not yet certain which is the more powerful force.

Yes, as they cling to the belief that ‘inflation’ is a ‘strong’ function of interest rates, while it is an oil monopolist or two and a government induced and supported link from crude to food via biofuels that are driving up CPI and inflation in general.

America’s headline CPI screamed to 4.3 per cent in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.

CPI might also be headed higher if crude continues its advance.

This has eerie echoes of Japan in late-1990, when inflation rose to 4 per cent on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country’s financial system tipped into the abyss.

As I recall, it was a tax hike that hurt GDP.

Yes, the world economies are vulnerable to a drop in GDP growth, but the financial press seems to have the reasoning totally confused.

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A Rescue Plan for the Dollar

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A Rescue Plan for the Dollar

By Ronald McKinnon and Steve H. Hanke
The Wall Street Journal, December 27, 2007

Central banks ended the year with a spectacular injection of liquidity to lubricate the economy. On Dec. 18, the European Central Bank alone pumped $502 billion — 130% of Switzerland’s annual GDP — into the credit markets.

Misleading. It’s about price, not quantity. For all practical purposes, no net euros are involved.

I have yet to read anything by anyone in the financial press that shows a working knowledge of monetary operations and reserve accounting.

The central bankers also signaled that they will continue pumping “as long as necessary.” This delivered plenty of seasonal cheer to bankers who will be able to sweep dud loans and related impaired assets under the rug — temporarily.

Nor does this sweep anything under any rug. Banks continue to own the same assets and have the same risks of default on their loans. And, as always, the central bank, as monopoly supplier of net reserves, sets the cost of funds for the banking system.

The causation is ‘loans create deposits’, and lending is not reserve constrained. The CB sets the interest rate – the price of funding – but quantity of loans advanced grows endogenously as a function of demand at the given interest rate by credit worthy borrowers.

But the injection of all this liquidity coincided with a spat of troubling inflation news.

At least he didn’t say ’caused’.

On a year-over-year basis, the consumer-price and producer-price indexes for November jumped to 4.3% and 7.2%, respectively. Even the Federal Reserve’s favorite backward-looking inflation gauge — the so-called core price index for personal consumption expenditures — has increased by 2.2% over the year, piercing the Fed’s 2% inflation ceiling.

Yes!

Contrary to what the inflation doves have been telling us, inflation and inflation expectations are not well contained. The dollar’s sinking exchange value signaled long ago that monetary policy was too loose, and that inflation would eventually rear its ugly head.

The fed either does not agree or does not care. Hard to say which.

This, of course, hasn’t bothered the mercantilists in Washington, who have rejoiced as the dollar has shed almost 30% of its value against the euro over the past five years. For them, a maxi-revaluation of the Chinese renminbi against the dollar, and an unpegging of other currencies linked to the dollar, would be the ultimate prize.

Mercantilism is a fixed fx policy/notion, designed to build fx reserves. Under the gold standard it was a policy designed to accumulate gold, for example. With the current floating fx policy, it is inapplicable.

As the mercantilists see it, a decimated dollar would work wonders for the U.S. trade deficit. This is bad economics and even worse politics. In open economies, ongoing trade imbalances are all about net saving propensities,

Yes!!!

not changes in exchange rates. Large trade deficits have been around since the 1980s without being discernibly affected by fluctuations in the dollar’s exchange rate.

So what should be done? It’s time for the Bush administration to put some teeth in its “strong” dollar rhetoric by encouraging a coordinated, joint intervention by leading central banks to strengthen and put a floor under the U.S. dollar — as they have in the past during occasional bouts of undue dollar weakness. A stronger, more stable dollar will ensure that it retains its pre-eminent position as the world’s reserve, intervention and invoicing currency.

Why do we care about that?

It will also provide an anchor for inflation expectations, something the Fed is anxiously searching for.

Ah yes, the all important inflation expectations.

Mainstream models are relative value stories. The ‘price’ is only a numeraire; so, there is nothing to explain why any one particular ‘price level’ comes from or goes to, apart from expectations theory.

They don’t recognize the currency itself is a public monopoly and that ultimately the price level is a function of prices paid by the government when it spends. (See ‘Soft Currency Economics‘)

The current weakness in the dollar is cyclical. The housing downturn prompted the Fed to cut interest rates on dollar assets by a full percentage point since August — perhaps too much. Normally, the dollar would recover when growth picks up again and monetary policy tightens. But foreign-exchange markets — like those for common stocks and house prices — can suffer from irrational exuberance and bandwagon effects that lead to overshooting. This is precisely why the dollar has been under siege.

Seems to me it is portfolio shifts away from the $US. While these are limited, today’s portfolios are larger than ever and can take quite a while to run their course.

If the U.S. government truly believes that a strong stable dollar is sustainable in the long run, it should intervene in the near term to strengthen the dollar.

Borrow euros and spend them on $US??? Not my first choice!

But there’s a catch. Under the normal operation of the world dollar standard which has prevailed since 1945, the U.S. government maintains open capital markets and generally remains passive in foreign-exchange markets, while other governments intervene more or less often to influence their exchange rates.

True, though I would not call that a ‘catch’.

Today, outside of a few countries in Eastern Europe linked to the euro, countries in Asia, Latin America, and much of Africa and the Middle East use the dollar as their common intervention or “key” currency. Thus they avoid targeting their exchange rates at cross purposes and minimize political acrimony. For example, if the Korean central bank dampened its currency’s appreciation by buying yen and selling won, the higher yen would greatly upset the Japanese who are already on the cusp of deflation — and they would be even more upset if China also intervened in yen.

True.

Instead, the dollar should be kept as the common intervention currency by other countries, and it would be unwise and perhaps futile for the U.S. to intervene unilaterally against one or more foreign currencies to support the dollar. This would run counter to the accepted modus operandi of the post-World War II dollar standard, a standard that has been a great boon to the U.S. and world economies.

‘Should’??? I like my reason better – borrow fx to sell more often than not sets you up for a serious blow up down the road.

The timing for joint intervention couldn’t be better. America’s most important trading partners have expressed angst over the dollar’s decline. The president of the European Central Bank (ECB), Jean Claude Trichet, has expressed concern about the “brutal” movements in the dollar-euro exchange rate.

Yes, but the ECB is categorically against buying $US, as building $US reserves would be taken as the $US ‘backing’ the euro. This is ideologically unacceptable. The euro is conceived to be a ‘stand alone’ currency to ultimately serve as the world’s currency, not the other way around.

Japan’s new Prime Minister, Yasuo Fukuda, has worried in public about the rising yen pushing Japan back into deflation.

Yes, but it is still relatively weak and in the middle of its multi-year range verses the $US.

The surge in the Canadian “petro dollar” is upsetting manufacturers in Ontario and Quebec. OPEC is studying the possibility of invoicing oil in something other than the dollar.

In a market economy, the currency you ‘invoice’ in is of no consequence. What counts are portfolio choices.

And China’s premier, Wen Jiabao, recently complained that the falling dollar was inflicting big losses on the massive credits China has extended to the U.S.

Propaganda. Its inflation that evidences real losses.

If the ECB, the Bank of Japan, the Bank of Canada, the Bank of England and so on, were to take the initiative, the U.S. would be wise to cooperate. Joint intervention on this scale would avoid intervening at cross-purposes. Also, official interventions are much more effective when all the relevant central banks are involved because markets receive a much stronger signal that national governments have made a credible commitment.

And this all assumes the fed cares about inflation. It might not. It might be a ‘beggar thy neighbor’ policy where the fed is trying to steal aggregate demand from abroad and help the financial sector inflate its way out of debt.

That is what the markets are assuming when they price in another 75 in Fed Funds cuts over the next few quarters. The January fed meeting will be telling.

While they probably do ultimately care about inflation, they have yet to take any action to show it. And markets will not believe talk, just action.

This brings us to China, and all the misplaced concern over its exchange rate. Given the need to make a strong-dollar policy credible, it is perverse to bash the one country that has done the most to prevent a dollar free fall. China’s massive interventions to buy dollars have curbed a sharp dollar depreciation against the renminbi;

Yes, as part of their plan to be the world’s slaves – they work and produce, and we consume.

they have also filled America’s savings deficiency and financed its trade deficit.

That statement has the causation backwards.

It is US domestic credit expansion that funds China’s desires to accumulate $US financial assets and thereby support their exporters.

As the renminbi’s exchange rate is the linchpin for a raft of other Asian currencies, a sharp appreciation of the renminbi would put tremendous upward pressure on all the others — including Korea, Japan, Thailand and even India. Forcing China into a major renminbi appreciation would usher in another bout of dollar weakness and further unhinge inflation expectations in the U.S. It would also send a deflationary impulse abroad and destabilize the international financial system.

Yes, that’s a possibility.

Most of the world’s government reaction functions are everything but sustaining domestic demand.

China, with its huge foreign-exchange reserves (over $1.4 trillion), has another important role to play. Once the major industrial countries with convertible currencies — led by the ECB — agree to put a floor under the dollar, emerging markets with the largest dollar holdings — China and Saudi Arabia — must agree not to “diversify” into other convertible currencies such as the euro. Absent this agreement, the required interventions by, say, the ECB would be massive, throwing the strategy into question.

Politically, this is a non starter. The ECB has ideological issues, and the largest oil producers are ideologically at war with the US.

Cooperation is a win-win situation: The gross overvaluations of European currencies would be mitigated, large holders of dollar assets would be spared capital losses, and the U.S. would escape an inflationary conflagration associated with general dollar devaluation.

Not if the Saudis/Russians continue to hike prices, with biofuels causing food to follow as well. Inflation will continue to climb until crude prices subside for a considerable period of time.

For China to agree to all of this, however, the U.S. (and EU) must support a true strong-dollar policy — by ending counterproductive China bashing.

Mr. McKinnon is professor emeritus of economics at Stanford University and a senior fellow at the Stanford Institute for Economic Policy Research. Mr. Hanke is a professor of applied economics at Johns Hopkins University and a senior fellow at the Cato Institute.

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gas demand +.9%

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Give Saudi/Russians comfort that they can keep hiking.

And markets say Fed will keep ‘accommodating’.

So much for higher prices curbing demand!

DJ US Gasoline Demand +0.9% On Week – MasterCard SpendingPulse(DJ)

NEW YORK (Dow Jones)–U.S. gasoline demand for the week ended Dec. 21, measured by purchases at the pump, rose 0.9% from a week earlier, according to a report by MasterCard Advisors LLC, a division of MasterCard Inc. (MA). Gasoline demand increased by 597,000 barrels, or 85,286 barrels a day, to 67.919 million barrels, or 9.703 million barrels a day, last week, according to the report, which is compiled by SpendingPulse, a retail data service of MasterCard Advisors. The four-week average demand level was 65.518 million barrels, or 9.36 million barrels a day, MasterCard said, up from 96,429 barrels a day from a week ago. Retail gasoline prices fell 1 cent to an average $2.98 a gallon over the week, the report said. That is 28.4% higher than a year ago.

SpendingPulse is a macroeconomic indicator that reports on national retail sales and is based on aggregate sales activity in the MasterCard payments network, coupled with estimates for all other payment forms, including cash and check. MasterCard SpendingPulse doesn’t represent MasterCard financial performance. The Department of Energy is due to issue its weekly petroleum data, including gasoline demand, on Thursday at 10:30 a.m. EST.

The data, put out by the DOE’s Energy Information Administration statistics and analysis unit, doesn’t count how many gallons are sold. Instead, it offers a “Product Supplied,” or implied demand figure, in its weekly report. “Product Supplied” represents the total volume of gasoline that has moved on from refineries, pipelines, blending plants and terminals on its way to supplying retail stations.

-By Matt Chambers, Dow Jones Newswires; 201-938-2062;
matt.chambers@dowjones.com
Dow Jones Newswires
December 26, 2007 14:00 ET (19:00 GMT)
Copyright (c) 2007 Dow Jones & Company, Inc. – – 02 00 PM EST

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Saudi/Fed teamwork

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Looks like markets are still trading with the assumption that as the Saudis/Russians hike prices the Fed will accommodate with rate cut.

That’s a pretty good incentive for more Saudi/Russian oil price hikes, as if they needed any!

Likewise, the US is a large exporter of grains and foods.

Those prices are now linked to crude via biofuels.

And the new US energy bill just passed with about $36 billion in subsidies for biofuels to help us keep burning up our food for fuel and keeping their prices linked.

This means cpi will continue to trend higher, and drag core up with it as costs get passed through via a variety of channels. In the early 70’s core didn’t go through 3% until cpi went through 6%, for example.

Ultimately everything is made of food and energy, and margins don’t contract forever with softer demand. In fact, much of the private sector is straight cost plus pricing, and govt is insensitive to ‘demand’ and insensitive to the prices of what it buys. And the US govt. indexes compensation and most transfer payments to (headline) cpi.

And while the US may be able to pay it’s rising oil bill with help from its rising export prices for food, much of the rest of the world is on the wrong end of both and will see its real terms of trade continue to deteriorate. Not to mention the likelihood of increased outright starvation as ultra low income people lose their ability to buy enough calories to stay alive as they compete with the more affluent filling up their tanks.

At the Jan 30 meeting I expect the Fed to be looking at accelerating inflation due to rising food/crude, and an economy muddling through with a q4 gdp forecast of 2-3%. Markets will be functioning, banks getting recapitalized, and while there has been a touch of spillover from Wall st. to Main st. the risk of a sudden, catastrophic collapse has to appear greatly diminished.

They have probably learned that the fed funds cuts did little or nothing for ‘market functioning’ and that the TAF brought ff/libor under control by accepting an expanded collateral list from its member banks.

(In fact, the TAF is functionally equiv of expanding the collateral accepted at the discount window, cutting the rate, and removing the stigma as recommended back in August and several times since.)

And they have to know their all important inflation expectations are at the verge of elevating.

They will know demand is strong enough to be driving up cpi, and the discussion will be the appropriate level of demand and the fed funds rate most likely to sustain non inflationary growth.

Their ‘forward looking’ models probably will still use futures prices, and with the contangos in the grains and energy markets, the forecasts will be for moderating prices. But by Jan 30 they will have seen a full 6 months of such forecasts turn out to be incorrect, and 6 months of futures prices not being reliable indicators of future inflation.

Feb ff futures are currently pricing in another 25 cut, indicating market consensus is the Fed still doesn’t care about inflation. Might be the case!

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Re: liquidity or insolvency–does it matter?

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(email with Randall Wray)

On Dec 15, 2007 9:05 PM, Wray, Randall wrote:
> By ________
>
> This time the magic isn’t working.
>
> Why not? Because the problem with the markets isn’t just a lack of liquidity – there’s also a fundamental problem of solvency.
>
> Let me explain the difference with a hypothetical example.
>
> Suppose that there’s a nasty rumor about the First Bank of Pottersville: people say that the bank made a huge loan to the president’s brother-in-law, who squandered the money on a failed business venture.
>
> Even if the rumor is false, it can break the bank. If everyone, believing that the bank is about to go bust, demands their money out at the same time, the bank would have to raise cash by selling off assets at fire-sale prices – and it may indeed go bust even though it didn’t really make that bum loan.
>
> And because loss of confidence can be a self-fulfilling prophecy, even depositors who don’t believe the rumor would join in the bank run, trying to get their money out while they can.

If there wasn’t credible deposit insurance.

>
> But the Fed can come to the rescue. If the rumor is false, the bank has enough assets to cover its debts; all it lacks is liquidity – the ability to raise cash on short notice. And the Fed can solve that problem by giving the bank a temporary loan, tiding it over until things calm down.

Yes.

> Matters are very different, however, if the rumor is true: the bank really did make a big bad loan. Then the problem isn’t how to restore confidence; it’s how to deal with the fact that the bank is really, truly insolvent, that is, busted.

Fed closes the bank, declares it insolvent, ‘sells’ the assets, and transfers the liabilities to another bank, sometimes along with a check if shareholder’s equity wasn’t enough to cover the losses, and life goes on. Just like the S and L crisis.

>
> My story about a basically sound bank beset by a crisis of confidence, which can be rescued with a temporary loan from the Fed, is more or less what happened to the financial system as a whole in 1998. Russia’s default led to the collapse of the giant hedge fund Long Term Capital Management, and for a few weeks there was panic in the markets.
>
> But when all was said and done, not that much money had been lost; a temporary expansion of credit by the Fed gave everyone time to regain their nerve, and the crisis soon passed.

More was lost then than now, at least so far. 100 billion was lost immediately due to the Russian default and more subsequently. So far announced losses have been less than that, and ‘inflation adjusted’ losses would have to be at least 200 billion to begin to match the first day of the 1998 crisis (August 17).

>
> In August, the Fed tried again to do what it did in 1998, and at first it seemed to work. But then the crisis of confidence came back, worse than ever. And the reason is that this time the financial system – both banks and, probably even more important, nonbank financial institutions – made a lot of loans that are likely to go very, very bad.

Same in 1998. It ended only when it was announced Deutsche Bank was buying Banker’s Trust and seemed the next day it all started ‘flowing’ again.

>
> It’s easy to get lost in the details of subprime mortgages, resets, collateralized debt obligations, and so on. But there are two important facts that may give you a sense of just how big the problem is.
>
> First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.

Incomes are sufficient to support the current prices. That’s why they haven’t gone down that much yet and are still up year over year. Earnings from export industries are helping a lot so far.

>
> Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.

Yes, there was a large drop in aggregate demand when borrowers could no longer buy homes, and that was over a year ago. That was a real effect, and if exports had not stepped in to carry the ball, GDP would not have been sustained at current levels.

>
> As home prices come back down to earth, many of these borrowers will find themselves with negative equity – owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

‘Often’? There will be some losses, but so far they have not been sufficient to somehow reduce aggregate demand more than exports are adding to demand. Yes, that may change, but it hasn’t yet. Q4 GDP forecasts were just revised up 2% for example.

>
> And the numbers are huge. The financial blog Calculated Risk, using data from First American CoreLogic, estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.

Not likely if income holds up. That’s why the fed said it was watching labor markets closely.

And government tax receipts seem OK through November, which is a pretty good coincident indicator incomes are holding up.

>
> That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

Enough money funds in particular have decided to not get involved in anyting but treasury securities, driving those rates down. That will sort itself out as investors in those funds put their money directly in banks ans other investments paing more than the funds are now earning, but that will take a while.

>
> How will it all end?

This goes on forever – I’ve been watching it for 35 years – no end in sight!

> Markets won’t start functioning normally until investors are
> reasonably sure that they know where the bodies – I mean, the bad
> debts – are buried. And that probably won’t happen until house prices
> have finished falling and financial institutions have come clean about
> all their losses.

And by then it’s too late to invest and all assets prices returned to ‘normal’ – that’s how markets seem to work.

> All of this will probably take years.
>
> Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed.

Right, only a fiscal response can restore aggregate demand, and no one is in favor of that at the moment. A baby step will be repealing the AMT and not ‘paying for it’ which may happen.

Meanwhile, given the inflationary bias due to food, crude, and import and export prices in genera, a fiscal boost will be higly controversial as well.

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A tale of mixed metaphors

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Ben Bernanke will save the world, but first we bleed

Posted by Ambrose Evans-Pritchard on 14 Dec 2007 at 12:48

The Bernanke ‘Put’ has expired.

Are Bernanke’s academic doctrines blurring his vision?

The Fed cuts a quarter point, and what happens? Wall Street’s ungrateful wretches knock 294 off the Dow 294 in an hour and half; the home builders index dives 10pc; Japanese bond surge; Euribor spreads rise to an all-time high of 99 basis points.

Have the markets begun to digest the awful possibility that central banks cannot cut rates fast enough to prevent a profits crunch because they are caught between the Scylla of the credit crunch and the Charybdis of inflation, a new deviant form of stagflation?

Nor is there any evidence or credible theory that interest rate cuts would help. For example, fed economists say that 1% rates didn’t do much – it was the fiscal impulse of 03 that added aggregate demand and turned the economy.

US headline CPI is stuck at around 3.5pc to 4pc, German CPI is 3pc (and wholesale inflation 5.7pc), China is 6.9pc, and Russia is skidding out of control at 10pc.

Note ‘out of control’. Mainstream theory says inflation will accelerate once it gets going.

As for the Fed, it now has to fret about the dollar – Banquo’s ghost at every FOMC meeting these days. A little beggar-thy-neighbour devaluation is welcome in Washington: a disorderly rout is another matter. No Fed chairman can sit idly by if half Asia and the Mid-East break their dollar pegs, threatening to end a century of US dollar primacy.

They are more worried about ‘imported inflation’ than ‘primacy’.

Yes, inflation is a snapshot of the past, not the future. It lags the cycle. After the dotcom bust, US prices kept rising for ten months. Alan Greenspan blithely ignored it as background noise, though regional Fed hawks put up a fight.

He had a deflationary global context, as he said publicly and in his book. That has changed, and now import prices are instead rising substantially.

Ben Bernanke has not yet acquired the Maestro’s licence to dispense with the Fed staff model when it suits him.

As above, different global context.

In any case, his academic doctrines may now be blurring his vision.

Not sure why they are, but all evidence is they are based on fixed exchange rate/gold standard theory.

So, in case you thought that every little sell-off on Wall Street was a God-given chance to load up further on equities, let me pass on a few words of caution from the High Priests of finance.

A deluge of pre-Christmas predictions have been flooding into my E-mail box, some accompanied by lavish City lunches. The broad chorus-by now well known – is that the US will hit a brick wall in 2008.

Yes, originally scheduled for 07. Not saying we won’t, but I am saying those forecasting it hae a poor record and suspect models.

Less understood is that Europe, Asia, and emerging markets will also flounder to varying degrees, knocking away yet another prop for US equities – held aloft until now by non-US global earnings.

Yes, that is a risk.

Morgan Stanley has just added a “mild recession” alert for Japan (Buckle Up) on top of its “manufacturing recession risk” for the eurozone. It’s US call (`Recession Coming’), it is no longer hedged about with many ifs or buts. Americans face a “perfect storm” and CAPEX is buckling. Demand will shrink by 1pc a quarter for nine months.

The bank has cut its target MSCI emerging market equities by 6pc next year. I suspect that this will be cut a lot further as the plot thickens, but you have to start somewhere.

They have been bearish all year.

Merrill Lynch has much the same overall view. “The US consumer is on the precipice of its first recessionary phase since 1991. The earnings recession has already arrived.”

Maybe, but no evidence yet. Employment remains sufficient for the consumer to muddle through, and exports are picking up the slack.

“Real estate deflations are unique and have never ended well for the consumer, the credit market, or the economy. Maybe it will be different this time, but we fail to see why.”

The subtraction to aggregate demand due to real estate is maybe a year behind us and rising exports have filled the gap.

And this from a Goldman Sachs note entitled “Quantifying the Stock Market Impact of a Possible Recession.”

“Our team believes that there is about a 40pc to 45pc chance that the US will enter recession over the next six months. If a recession does occur, it has the potential to feed on itself,” said bank’s global markets strategist Peter Berezin.

Goldman just upped their Q4 GDP foregast by 1.5%, and it’s now at 1.8%.

“We expect home prices to decline 7% in 2007 and a further 7% in 2008. But if the US does fall into a recession, home prices could decline by as much 30% nationwide, which would make it the worst housing bust since at least the Great Depression.

“If global growth slows next year as we expect, cyclical stocks that so far have held up quite well may feel more pressure. It seems unlikely that the elevated earnings estimates for next year can be sustained,” he said.

Lots of ‘if’ and ‘we expect’ language, but no actual ‘channels’ to that end. No one seems to have any. Best I can determine if exports hold up, we muddle through.

Now, stocks can do well in a soft-landing (which Goldman Sachs still expects, on balance), since falling interest rates offset lost earnings. But if this does tip over into outright contraction, History is not kind.

Stocks are likely to adjust PE’s to higher interest rates now that expectations are moving toward lower odds of rate cutting due to inflation.

The average fall in S&P 500 over the last 9 recessions is 13pc from peak to trough. These include 1969 (18pc), 1981 (23pc) and 2001 (52pc).

Still up 5% for the year. And it has been an OK leading indicator as well for quite a while.

As for the canard that stocks are currently cheap at a projected P/E ratio of 15.3, this is based on an illusion. US profit margins are currently inflated by 250 basis points above their ten-year average.

Inflated? Seems a byproduct of productivity and related efficiencies. No telling how long that continues. And products changes so fast there is no time for ‘competitive forces’ to drive down prices to marginal revenue with many products; so, margins remain high.

While Goldman Sachs does not use the term, this is obviously a profits bubble. Super-cheap credit in early 2007 – the lowest spreads ever seen – flattered earnings.

Not sure it’s related to ‘cheap credit’ as much as productivity.

I would add too that free global capital flows have allowed corporations to engage in labour arbitrage, playing off cheap Asian wages against the US and European wages. This game is surely played out. Chinese wages are shooting up.

Yes, as above, and this is the global context Bernanke faces – import prices rising rather than falling.

Voters in industrial democracies will not allow capitalists to continue take an ever larger share of the pie. Hence Sarkozy, Hillary Clinton, and the Labour victory in Australia.

Not sure both sides are pro profits. That’s where the campaign funding is coming from and most voters are shareholders or otherwise profit directly and indirectly from corporate profits. Wage earners are a shrinking constituency with diminishing political influence.

Once you strip out this profits anomaly, Goldman Sachs says the P/E ratio is currently 26. This compares with a post-war average of 18, and a pre-recession average of 17.

As above. PE’s are more likely to adjust down near term due to valuation issues – rising interest rates and perception of risk.

“It is clear that if the US enters a recession, there is significant scope for both earnings and stock prices to decline beyond what the market has already priced. The average lag between peak and nadir in stock prices is only 4 months. This implies a swift correction in equity prices.”

Sure, but that’s a big ‘if’.

The spill-over would be a 20pc fall in the DAX (Frankfurt) and the CAC (Paris), 19pc fall on London’s FTSE 250, 13pc on the IBEX (Madrid), and 10pc on the MIB (Milan).

Doesn’t sound catastrophic.

Be advised, this is not a Goldman Sachs prediction: it is merely a warning, should the economy tip over.

Yes, but without a direct reason for a recession, nor a definition of a recession, for that matter.

Now, whatever happens to US, British, French, Spanish, Italian, and Greek house prices, and whatever happens to the Shanghai stock bubble or to Latin American bonds, the Fed and fellow central banks can – and ultimately will – come to the rescue with full-throttle reflation.

Wrong, the fed doesn’t have that button. Lower interest rates maybe, if they dare to do that with the current inflation risks of the triple supply shock of crude, food, and the lower $US.

But as shown with Japan, low rates do not add aggregate demand as assumed.

Merrill says the Fed may cut rates to 2pc. (rates were 1pc in 2003 and 2004). Let me go a step further. It would not surprise me if debt deflation in the Anglo-Saxon countries proves so serious that we reach Japanese extremes – perhaps zero rates, with a dollop of ‘quantitative easing’ for good measure.

Right, and with the same consequences – those moves have nothing to do with aggregate demand.

The Club Med states may need the same, but they will not get it because they no longer control their monetary policy. So Heaven help them and their democracies.

True, the systemic risk is in the Eurozone. Not sure he knows why.

The central banks are not magicians, of course. We forget now that Keynes and his allies in the early 1930s knew that monetary policy ‘a l’outrance’ could be used to flood the system by buying bonds. They concluded that such a policy might backfire – possibly causing panic – since investors were not ready for revolutionary methods.

Keynes was right but was talking in the context of the gold standard of the time. Not directly applicable today without ‘adjustments’ to current floating fx regimes.

This at least has changed. The markets expect a bail-out, demand it, and believe religiously in its benign effects.

Ben Bernanke said in his 2002 ‘helicopter’ speech that there was practically no limit to what sorts of assets the Fed could buy in order to inject money.

No limits, but big differences to aggregate demand. Buying securities has no effect on demand, while buying real goods and services has an immediate effect, also as Keynes and others have pointed out many times.

The bank’s current mandate does not allow it to buy equities, but that could be changed easily enough.

Yes. Won’t support demand, but will support equity prices.

So yes, in the end, the Fed can always stop a deflationary spiral.

Yes, but more precisely, the tsy, as they can buy goods and services without nominal limit and support demand at any level they desire. The ‘risks’ are ‘inflation’ not solvency. (See ‘Soft Currency Economics‘.)

As Bernanke said to Milton Freidman on his 90th birthday, the Fed will not repeat the monetary crunch it allowed to happen 1930-32.

That was in the context of the gold standard of the day. Not applicable currently.

“Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Thanks to floating the $, it hasn’t happened since.

Bernanke is undoubtedly right. The Fed won’t do it again. But before the United States can embark on an economic course that radically transforms the nature of capitalism, speculative markets may have to take a beating – for appearances sake, at least.

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Crude oil demand revised up

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This means Saudis/Russians will continue to be price setters for at least the next few quarters.

IEA Lifts 2008 World Oil Demand Growth Forecast

By Reuters | 14 Dec 2007 | 05:32 AM ET

World oil demand will grow more quickly than expected next year fueled by the Middle East and proving resilient to record-high prices, the International Energy Agency said on Friday.

The IEA, adviser to 27 industrialized countries, said in its monthly Oil Market Report that demand will rise by 2.1 million barrels per day (bpd) next year, up 200,000 bpd from its previous forecast.

“A lot of this demand is in the non-OECD countries, where we don’t have any downgrades in economic growth forecasts,” said Lawrence Eagles, head of the IEA’s Oil Industry and Markets division.

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UST ASW update

Posted on by

(an interoffice email)

>
>
> 16bp day for 2yr spreads today:
>
>
>
> The market went into the fed announcement expecting perfection
>
> 25-50bp cut and 50bps on the discount window.
>
>
>
> Spreads were 6 lower on the day in the 2yr sprds and 3 lower in tens before
> the Fed.
>
> Needless to say the market was disappointed…
>
> Spreads moved back to the wides in the front end
>
> and now are repricing an expectation of extended financial market /
> financing turmoil

Hi,

Looked to me like the post fed moves were unwinds of all sorts, and didn’t fit any other theme, so I’ll be watching for reversals after things settle down tomorrow am.

Interesting that the markets were shocked that the Fed cared about inflation. I read the speeches as saying they do care a lot, but the media glossed over those parts and didn’t even report those references.

And also interesting that interest rates went lower in response to the Fed caring about inflation.

Also, the strong yen vs the pound and euro, for example, was the reaction to ‘stress’ type of move we saw beginning in August.

While the FOMC didn’t do much to alleviate stress per se, they didn’t actually *do* anything to make it worse, either, and there were signs it was running its course, with the year end issue the remaining
hurdle. I’ll be looking for signs the NY Fed is working on that tomorrow and watching to see if 3 mo libor comes back down over the next few days.

The CPI and PPI are expected to be off the charts Thursday and Friday, and the media could start harping on inflation, blame the Fed for high oil prices, questioning whether a half point in the funds rate over the last few months was worth a $20 increase in the price of crude, and continue pushing that theme if crude goes up as I expect it will, as Saudis continue to (irregularly to hide what they are doing) hike posted prices and let the quantity they pump vary. (and Russia
probably doing same as well.) At 120 crude, retail gasoline should be pushing $4 and food up as well via the biofuel connection, and the media attack on the Fed for letting the inflation cat get out of the bag can elevate expectations rapidly, with tips breakevens and Michigan expectations numbers elevating rapidly.

So far, higher crude means lower yields, as it is anticipated the economy will weaken and the Fed doesn’t care about inflation. If/when that changes- as evidenced by higher crude causing higher interest rates even with risk to gdp- tensions and stresses move up several notches, as anyone working through the 70’s and 80’s should recall.

Given the coming inflation numbers, a segment of the mainstream will start to point out that the ‘correct’ fed funds rate is about 7% with inflation at about 4. To them a neutral real rate would put the ff rate at 6, so it will take 7 to be restrictive. They will argue headline cpi is the rate to use, as food and energy are trending and sustaining the higher levels, along with import and export prices rising at more than 5% rates, and therefore this group will give greater weight to core moving up to headline as happened in the 70’s when crude trended upwards for an extended period of time. And should crude continue to move up, this initially small group of mainstream economists will grow, and CNBC will help promote this ‘scare story’ as it attracts more and more viewers.

Hoping things don’t go that way but concerned they will. Looking forward to reactions to the data later this week and what commodity prices do from here.

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