Page 1 of 4 CREDIT BUBBLE BULLETIN Reflation issues heat up
Commentary and weekly watch by Doug Noland
The US Federal Reserve and chairman Ben Bernanke held tightly to their
"extended period" language in their November 4 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 last week from St Louis Federal Reserve
Bank president James Bullard: "Policy rates are near zero in the US and the
rest of Group of Seven countries, something not seen in postwar economic
history. The FOMC [the interest-rate setting Federal Open Market Committee] did
not begin policy rate increases until two-and-a-half to three 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 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 US 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 on Friday 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 the move a week earlier 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 in the United States, 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-US world. From the
latest views of Bill Gross, co-founder and co-chief investment officer at
PIMCO: "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 US 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 Pimco managing director Paul 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 US
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-stock wreck.
Rates remained at 1% 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, Liesman needled Santelli 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 Gross's latest statement, 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. 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. 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
US-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 US 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 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 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 differently than previous reflations. As
I've repeatedly tried to explain, the epicenter of reflationary forces have
shifted from the core (US) 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 US economic structure evolved during - and for - a
credit cycle era comprised of massive ongoing US mortgage credit expansion,
resulting asset inflation, over-consumption and mal-investment. Accordingly,
the US economy is today especially poorly positioned for the new global
reflationary backdrop.
"Down-payment requirements" have essentially nothing to do with the lagging US
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 on Friday at 9,498. Reflations may create new
manias, but they don't rejuvenate the dis-credited 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 Mae, Freddie
Mac, Federal Housing Administration, 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 US
housing and households was squelched. Spending patterns were significantly
altered.
It is my thesis that there is no alternative other than a major transformation
of the underlying structure of the US 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.
No 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.
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