Wednesday, July 17, 2013

Three Things I Think I Think

by Cullen Roche

Some random thoughts here on a slow news day:

  • The Merrill Lynch Monthly Fund Survey says the big money is most worried about a hard landing in China.  But what’s more interesting to me is how little they’re worried about the potential for fiscal tightening in the USA.  It seems as though markets have had this one backwards for years now.  Fiscal policy has been enormous to the tune of trillions in budget deficits per year for 4 years and running.  That’s been a huge support mechanism for the state of corporate profits.  I often point out the simple and intuitive chart below which proves just how important the deficit has been in driving corporate profits.  In a normal period, corporate profits are driven primarily by dividends and private investment.  But that red bar is showing how the tables turned in recent years and corporate profits were increasingly driven by the deficit.  This means investors are getting QE precisely wrong.  They think the Fed is steering the markets and profits when in reality it has been Congress.  In other words, it’s not Fed “tapering” that we should be concerned about, but Congressional “tapering”….


  • Today’s industrial production report showed more of the same stagnant economic trends.  At 77.8 we’re still seeing capacity utilization that is operating well below capacity (the 20 year average is 80.8), but is also not rolling over.  We’re sort of just running in place. 


  • Have you seen this interview from CNBC with Joe Petrowski, the CEO of Gulf Oil?   He says we could see $50 oil this year.  And it’s not because he thinks the US economy is weakening, but because he says the supply of oil and natural gas is surging.  He says it’s “simple economics”.  Too much supply, weak demand = lower prices.  That could be an interesting tailwind for the economy if it materializes.  Of course, oil and gas prices have been going in the exact opposite direction, but if Petrowski is right we could see the equivalent of a huge wealth transfer from oil companies to households. 
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Fed Beige Book says economy growing at ‘modest to moderate’ pace

By Joshua Zumbrun

The U.S. economy maintained a “modest to moderate pace” of growth in recent weeks, bolstered by industries from housing to manufacturing, the Federal Reserve said today.

“Residential real estate and construction activity increased at a moderate to strong pace in all reporting districts,” the Fed said in its Beige Book business survey, which is based on anecdotal reports from its 12 regional banks. “Manufacturing expanded in most districts since the previous report.”

Fed Chairman Ben S. Bernanke told Congress today that central bankers will be “responding to the data” as they decide when to start reducing their $85 billion monthly pace of asset purchases. Today’s Beige Book, prepared for their next gathering in Washington on July 30-31, will be one piece of evidence they consider.

“Hiring held steady or increased at a measured pace in most districts, with some contacts noting reluctance to hire permanent or full-time workers,” the report said. Fed officials are closely monitoring the labor market to determine whether it has “improved substantially,” allowing them to wind down their bond purchases.

“Banking conditions generally improved,” according to today’s report, compiled by the Federal Reserve Bank of St. Louis and based on information received by July 8. “Credit quality improved, while credit standards remained largely unchanged.”

Previous Report

The previous Beige Book, released June 5, used the same phrase as today’s report, a “modest to moderate pace,” to describe growth across 11 of 12 districts. The 12th district, Dallas, reported “strong” economic growth in the previous report.

“Hiring increased at a measured pace in several districts, with some contacts noting difficulty finding qualified workers,” the Fed said in the June 5 report.

Employers added 195,000 jobs in May and June and 199,000 in April, according to July 5 data from the Labor Department. Even as job growth has picked up, the unemployment rate has remained at 7.6% for three of the past four months.

Fed officials predict growth will accelerate in the second half of 2013 and next year.

“My colleagues and I projected that economic growth would pick up in coming quarters, resulting in gradual progress toward the levels of unemployment and inflation consistent with the Federal Reserve’s statutory mandate to foster maximum employment and price stability,” Bernanke said today in testimony to the House Financial Services Committee.

Strong Case’

Federal Reserve Bank of New York President William C. Dudley said this month that “a strong case can be made that the pace of growth will pick up notably in 2014.”

Speaking July 2 in Stamford, Connecticut, Dudley, who serves as vice chairman of the Federal Open Market Committee, said “the private sector of the economy should continue to heal, while the amount of fiscal drag will begin to subside.”

Automatic budget cuts and a January increase in the payroll tax contributed to the U.S. government’s widest monthly budget surplus in more than five years in June. Receipts exceeded outlays by $116.5 billion last month, the biggest surplus since April 2008.

Consumer spending fell short of estimates in June, with sales at retailers climbing 0.4% last month, short of the 0.8% gain that was the median estimate of 82 economists in a Bloomberg survey.

Of the 49 companies in the Standard & Poor’s 500 Index that have reported second quarter earnings, 71% have exceeded analyst estimates. The S&P 500 hit a record high 1,682.5 on July 15.

Alcoa Earnings

Alcoa Inc., the largest U.S. aluminum producer, reported second-quarter adjusted earnings that beat analysts’ estimates after a better-than-expected performance at its unit that supplies components to aerospace and power companies.

The New York-based company expects “continued pressure on prices and demand in North American industrial products and European industrial products,” while auto demand is expected to remain strong, chief financial officer William Oplinger said in a July 8 conference call. “The economy in general is recovering slowly, with different speeds in Europe as well as in the U.S.”

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How Many European Recessions?

by Jeffrey Frankel

CAMBRIDGE – The release of revised GDP data by the United Kingdom’s Office for National Statistics in late June seemed like an occasion for cheer, because growth had not quite been negative for two consecutive quarters in the winter of 2011-12, as previously thought. The point, as it was reported, is that a second UK recession following the global financial crisis in 2008 (a “double dip”) had now been erased from the history books, and that the Conservative government would take some satisfaction from this fact. But it should not.

This illustration is by Barrie Maguire and comes from <a href=""></a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

Illustration by Barrie Maguire

The right question is not whether there have been double (or triple) dips; the question is whether there has been one big recession all along. As the British know all too well, their economy since the low point of mid-2009 has not yet climbed even halfway out of the post-crisis hole: GDP is still almost 4% below its previous peak. If European countries used similar criteria to those used in the United States for determining economic cycles, the Great Recession in Britain would quite possibly not have been declared over in the first place.

Recent reports that Ireland entered a new recession in early 2013 would also read differently if American criteria were applied. Irish GDP since 2009 has not yet recovered more than half of the ground lost between the peak of late-2007 and the bottom two years later. Following US methods, Ireland would not be judged to have escaped the initial recession. As it is, one mini-recovery after another has been heralded, only to give way to “double dips.”

Similarly, it was recently reported that Finland had entered its third recession since the global financial crisis. But the second one would be better described as a continuation of the first.

Italy, judged according to US standards, has been mired in a five-year recession: the recovery in 2010 was so tepid that by 2011, before a new downturn set in, the economy had barely recovered one-third of the output lost after the recession began. And the new downturn has been severe: Italy’s GDP is now about 8% below its 2008 level. (See graph.)

For a high-resolution version of this graph, click here.]

These measurement issues may sound like minor technical details; but they can have significant real-world implications. So, what are the differences between European and US criteria for judging recessions?

Economists generally define a recession as a period of declining economic activity. European countries, like most, use a simple rule of thumb: a recession is declared following two consecutive quarters of falling GDP.

In the US, the arbiter of when recessions begin and end is the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). Unlike European countries, the Committee uses no quantifiable rule in determining the US economy’s peaks and troughs. It looks beyond the most recently reported GDP numbers to include employment and a variety of other indicators, in part because output measures are often subject to errors and revisions.

Furthermore, the Committee sees nothing special in the two-quarter rule of thumb. For example, it generally would say that a recession had occurred if GDP had fallen very sharply in two quarters, even if they were separated by one quarter of weak growth. Similarly, if a trough were subsequently followed by several quarters of positive growth, the Committee would not necessarily announce that the recession had ended; it would wait until the economy had recovered sufficiently that a hypothetical future downturn would count as a new recession, not a continuation of the first one.

Fortunately, the US economy has recorded positive growth for 15 consecutive quarters, so recession-dating is not a salient issue currently. But things are not always so quiet. For example, according to revised data, the US economy contracted three quarters in a row in 2001. At the time, the NBER Committee declared that there had been a recession in 2001 (based on employment and various other indicators), even though the initial GDP data did not show two consecutive quarters of declining output, let alone three. The Committee has never yet found it necessary to revise the date of an economic turning point, let alone erase a recession.

The NBER is not the only institution that looks beyond a two-quarter rule and undigested GDP data. An analogous Euro Area Business Cycle Dating Committee was created ten years ago by the Center for Economic Policy Research in London. The CEPR Committee declared that the Great Recession ended in the eurozone after the second quarter of 2009, the same time as in the US. It declared that a second recession started in the latter part of 2011 – and continues to this day.

These were probably the right judgments: growth in the quarters between the two slumps was sufficiently strong in countries like Germany that economic activity on average across the eurozone had by mid-2011 recovered about two-thirds of the ground lost in 2008-09.

One cannot say that the two-quarter rule of thumb used by individual countries in Europe and elsewhere is “wrong.” There are unquestionably big advantages to having an automatic procedure that is simple and transparent, especially if the alternative is delegating the job to a committee of unelected, unaccountable ivory-tower economists.

But there are also disadvantages to the rule of thumb. One is the need to revise cyclical dating when data are revised. Claims made in good faith in last year’s speeches by UK politicians – and by economic researchers – have now been rendered false. In May, France, too, revised away an earlier recession, which would otherwise have been counted as the second since 2008.

There is a potentially more far-reaching and serious disadvantage as well. Because citizens in Ireland and Italy have been told that their economies have entered new recessions, they are likely to conclude that their political leaders must have done something wrong recently. But if these countries have been in the same recession for five years, the implication may be that the leaders have been doing the same wrong things throughout that period. That is hardly an insignificant difference.

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Paper, not taper

by James Hickling

“Bernanke stays course on Fed buying” is the FT website headline this afternoon – with the Fed chairman confirming what we’ve been saying all along: that, in his words, “a highly accommodative monetary policy will remain appropriate for the foreseeable future”.

Perhaps the Fed has been spooked by the stampede out of bonds in recent weeks following all its talk of tapering, and the damage that rising rates would do to the still fragile banking system. Or the reality that as long as Washington continues to run trillion-dollar deficits as far as the eye can see – with a relatively short maturity profile for its debt, meaning the Treasury needs to constantly role over maturing bonds – higher rates are a one-way ticket to government fiscal oblivion. Either way, they know there’s no realistic way of getting off the QE treadmill without causing a world of hurt for the US economy – and by extension, the global economy.

But so what, you might say. I bought precious metals as a means of protecting myself financially from these problems, yet gold’s down some $400 over the last six months, with an even bigger percentage drop in silver. What gives? In short, these markets are volatile (silver especially). Gold gained every year from 2001 to 2012. A large correction was not only inevitable, but also healthy when considering the longer-term value of the metal in relation to other assets, goods and services.

In more specific terms, however, there have been some extremely interesting developments in the gold market since the start of the year in relation to warehouse inventories, gold leasing rates and how this relates to the Bundesbank’s January request for the return of its gold from New York, as well as Hugo Chavez’s request – in August 2011, just before the nominal gold price peak – for the return of Venezuela’s gold from London. For the gory details, be sure to read Grant Williams’s latest “Things that make you go hmmm” newsletter. It’s well worth the time.

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Is Inflation Running Hotter Than we Think?

by Cullen Roche

Yesterday’s CPI report confirmed what most people think – inflation is running much cooler than most presume.  This isn’t shocking when we consider the high unemployment rate, the low capacity utilization, the substantial output gap and the generally sluggish conditions.  Producers just don’t have a huge amount of pricing power given the weakness of aggregate demand.   But inflation isn’t always an even phenomenon and asset price inflation has become an increasingly dangerous phenomenon in recent years.

Of course, this has been nowhere more apparent than it is in the real estate market where soaring prices only just recently led to a near collapse in the US economy.  And while I became fairly bullish on housing last year I have to admit that the level of the rally in real estate has been very surprising.  Prices are up 12.2% year over year according to CoreLogic.

Of course, this is a tricky way to view inflation because the BLS doesn’t count housing prices as consumption, but investment.  I don’t think the investment/consumption view of real estate is quite so black and white which is why I embed real estate prices in the Orcam Housing Adjust Price Index.  The latest reading on the OHAPI is showing 4% year over year inflation.  That’s more than double what the CPI is saying.

Now, this might not accurately reflect a price basket as well as the CPI does, but inflation is always and everywhere an uneven phenomenon and asset price inflation in the consumer’s most important balance sheet item is worth keeping an eye on.  Had we tracked something like the OHAPI in the early 2000′s we would have never fallen for the idea that inflation was low during the biggest housing boom in US history.  Had the Fed been viewing price changes through a gauge like this they might have been faster to tighten policy and get ahead of what was clearly a dangerous trend.

Are we getting into a dangerous environment like we saw in 2007?  I certainly don’t think so quite yet, but Fed policy should be proactive and not reactive.  To me, the path forward appears obvious.  I think QE is having more destabilizing than stabilizing effects here and the Fed could probably do a great deal to cool real estate trends before they potentially get out of hand again by simply ending the QE program.  The Fed could maintain ZIRP, but eliminate what is perceived as an asset inflationary policy.   I don’t think inflation is at risk of running out of control here, but the uneven price action in some markets is something we should be aware of before it’s too late.


(Orcam Housing Adjusted Price Index via Orcam Research)

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Bear Rising Wedge

By Tothetick Education

The Rising Wedge as a price pattern is fairly common and presents in all markets, time frames, & price ranges. Typically a Rising Wedge is presented as either a bearish trend continuation pattern or a reversal pattern depending on the trading environment in the background. Regardless of environment the contracting, narrowing price range outlined by the Rising Wedge is an indication that the immediate uptrend is losing strength and considered to have a definite bearish bias.

Visually Rising Wedges are characterized by a contracting range in prices with ‘converging’ or inclining toward each other trendlines that create higher lows & higher highs. By definition this means the Rising Wedge pattern outlines an immediate uptrend pattern in prices with both the immediate support & resistance trendlines slanted in the opposite direction of the larger bearish trend. The shape of the Rising Wedge is altered by the slope of the ascending resistance line which should be tighter than the steeper angle slope of the lower ascending support line.

Rising Wedges vary in their duration, but will have at least two swing highs and two swing lows in price. Traders should be prepared to adjust the trendlines as needed with additional swings. Volume usually diminishes as the pattern develops & this becomes one of the best keys to determine when the pattern may break & it represents the bearishness of the formation. If volume remains the same or increases during the wedge formation then the signal will be less reliable. Buyers & sellers create this narrowing range-bound price action and eventually prices squeeze to an Apex. The closer to the apex price gets the odds for a breakdown of the immediate price range becomes more likely.

Rising Wedges can be a little tricky to identify & to trade but traders can ‘stack the deck’ increasing the risk-to-reward ratio for profits when this pattern presents as a bearish continuation seen in a downtrend.

The bearish continuation pattern has 3 phases:

1) Background: A Strong impulsive, thrusting action with a surge in volume & price establishes a clear picture of the controlling bearish trend direction. In our rising wedge price pattern it is represented visually by a Pole. Deeper and more drama the better as the Pole is the Key to recognizing the potential for the continuation of the bearish pattern. The Pole represents trend direction as well as its strength & often this pattern is initiated as a new breakdown in price from an established area & sellers are in control.

2) The second phase is a pause for consolidation of the action both in volume & price and is represented by the rising wedge. As traders we like to see this phase short in duration with only 2 or 3 swings while our price action is range bound maintaining the higher lows & higher highs shape and the volume is ‘resting’. Again, pay close attention to the volume action with each push into the tightening slope of the resistance line which is an indication of weakening demand & offers clues to the bearishness of the pattern.

3) The pattern confirms as a bearish continuation pattern if the action creates a new bearish breakdown with a surge again from the bears in both volume & price. The immediate lower support outlined by the rising wedge is the area traders look to see confirm the breakdown. Typically the action will mimic the volatility & energy experienced with the Pole creation & volume considerations aid in recognizing further potential for the pattern. Often with a bearish breakdown pattern the reaction in volume is ‘delayed’ & price pullbacks to ‘re-test’ are common.

Options for Trading the Rising Wedge as a bearish continuation pattern:

There are two methods of trading this pattern & it depends on your trading style.

Aggressive traders will find the rising wedge to be a little tricky to trade before a breakdown actually occurs primarily because of the rising support line. However, as a bearish continuation trade the background resistance seen in the larger downtrend offers clues when combined with the tightening slope of the immediate upper resistance trendline created by the wedge. As the price action tightens in this area it is an indication of the lack of any real conviction from buyers. Aggressive entries short in this zone are available with the concept being the trend is on your side & the bears are maintaining a ‘wall of resistance’ & again, closely monitor the reactive volume with each push into this resistance zone for clues.

This can be an accurate trade that usually has a great risk:reward ratio. Stop placement can be fairly tight right above resistance & can be adjusted downward accordingly. When price approaches the lower ascending support line you should gauge the momentum: if you see that the momentum is strong stick to the position. However, if you see that support prevails, close the trade & take your profits to maximize the reward.

The aggressive trading method can highly increase the profit potential of any rising wedge. However, the trader needs to assess whether the ‘extra’ potential profits choosing the earlier entry offers a decent risk:reward over waiting for the breakdown of the rising support line. Remember that as a trend continuation pattern traders want this consolidation rising wedge formation to be relatively brief. Two or 3 swings may turn into more and the ‘spread’ or range in prices offered to the Apex should aid trade consideration. Traders want to see momentum weakening as prices squeeze to the Apex.

Conservative traders will use the more traditional method & will enter a short trade once the lower ascending support line has been broken &/or the new breakdown has confirmed.

All traders should be prepared for re-trace activity or a reaction rally to test the newly created breakdown or resistance level. An expansion of bearish volume can aid confirmation. False breakouts do happen & confirmation needed is always a traders’ choice. Several methods that apply here for either intrabar &/or close bar options offered in sequence: breakdown below support price, retrace holds new resistance line, price clears breakdown swing low price, price clears next swing low of wedge pattern, larger chart combination.

Stop placement considerations can be aggressively lowered after the breakdown of the price.

Measured Move Targets based on structure of Pole & the Bear Rising Wedge

Aggressive with Momentum & Volume: duplication of the original move or trader choice measurement of the Pole:

  • Apex or BreakDown price (minus) Pole measure = target
  • Pole measure = (Pole Base price (minus) Pole Tip price)


  • Apex or BreakDown price (minus) Rising Wedge measure = target
  • Rising Wedge measure = (swing high price of wedge (minus) swing low price of wedge)

Additional target considerations based on the Rising Wedge pattern itself are each swing low that created the pattern down to & including the re-test of the swing low of the pattern or Pole Tip price.

Examples: Rising Wedge as a bearish continuation pattern:

Bear Wedge bear Wedge May 29 1m

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Gold Chart Intraday - The Bernanke Dipsy-Doodle

by Jesse

As you know Ben Bernanke is giving what is likely to be his last testimony to Congress today as the Chairman of the Fed.
So we see gold doing the old 'wax on, wax off.'
The wiseguys need bullion going into a key delivery month of August at the COMEX. Their registered for delivery inventories are at record lows for this leg of the bull market. Overall inventories are getting thin as well.
Every time this has happened, there has been a marked change in the direction of price, higher.
Time to shake the ETF tree. Tut tut, looks like rain.

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New Stock Market Head and Shoulders Pattern

By: Anthony_Cherniawski

SPX made its first impulse down and the correction appears complete at the 38.2% retracement. What would be interesting is what happens at the open tomorrow. Given that this decline hasn’t a lot of time, I think it may pack a lot of punch right from the start. It took two days for the SPX to rally from 1671.00 to the top and only one day for it to retrace that move.

The Cup with Handle formation is intact, which means that there is a better than 50% probability that the target may be met. However, once SPX declines beneath 1570.00, the probability rises to 90%. The only issue is the time frame. If this turns into a panic decline then the likelihood of meeting this target can be very high. We will know by the time we hit 1570.00.

Meanwhile, the target for this decline offered by the Cycles Model is near 1300.00. I could settle for that by the first week of August.

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Gold Matter In “a banquet of consequences” Deficits

By: Michael_J_Kosares

DEFICITS MATTER! Democrat Franklin Delano Roosevelt was the first to publicly declare that deficits did not matter since, he reasoned, we owe the money to ourselves. Dick Cheney, who should know better, made the same claim in behalf of Republican deficits. Deficit denial has never held water simply because holders of government paper – foreign or domestic — intend to be repaid and with interest. It’s that part about creditors demanding interest that blows a hole in the “deficits-do-not-matter” argument.

Some quick background:

* * * In 2008 when the national debt stood at $10 trillion, the federal government paid $451 billion in interest at an average rate of 4.5%.

* * * In 2012, it paid $360 billion interest on a $16 trillion debt at an average interest rate of 2.3%. For a measuring stick, the ten-year treasury bill drew an average interest rate in 2012 of around 1.75%.

* * * If the ten-year treasury bill were to rise to its most recent high of 2.75% and stay there), the implied interest rate paid by the federal government would go to roughly 3.6%. The total interest paid would exceed $600 billion, the rough equivalent to what the United States spends on the national defense.

* * * If the average interest rate paid were to return to 4.5% — the blended rate in 2008 — the United States would pay $765 billion in interest, or nearly one-third of 2012 tax revenues ($2.45 trillion). At that point, markets might begin to question the solvency of the U.S. federal government.

national debt

A banquet of consequences

Wall Street trembles at the thought that the Fed may have lost control of interest rates. Now you know why.

Think too what might be behind chairman Bernanke’s impending retirement from his position at the Fed. As Neil Howe stated in an interview posted at this website a couple of weeks ago, the Fed has maneuvered itself into an inescapable policy trap he called a “cockroach hotel.” Of course, Howe believes there is a certain inevitability to the historical process and that the Fed’s current dilemma is part and parcel of the Fourth Turning he now states began in 2008. What happens when the only policy alternative is to continue monetizing the debt in order to keep the federal government reasonably solvent? Ultimately, the monetarist school would likely tell you, we might all wake up one day to the same sort of sudden and inexorable hyperinflationary explosion Germany experienced in the 1920s. As Robert Louis Stevenson put it, “Sooner or later everyone sits down to a banquet of consequences.” What the nation needs is another Paul Volcker. Under the circumstances, what it is likely to get is another Ben Bernanke.

Fitch downgrades French sovereign debt, gives U.S. debt a pass (??)

Meanwhile, things are not going well in Europe. On Friday Fitch, the rating agency, cut France’s credit rating suggesting in its report the French government needed to reform its finances. Fitch justified the downgrade by citing a projected sovereign debt to gross domestic product ratio of 96% in 2014. “The only ‘AAA’ country with a higher debt ratio is the US (AAA/Negative),” says Fitch somewhat sheepishly, “which has exceptional financing flexibility and debt tolerance afforded by the preeminent global reserve currency status of the US dollar.” (Fitch, it appears, deemed it advisable to explain why it was punishing France while giving the United States a pass.)

A good many would disagree with Fitch’s assessment of the dollar’s preeminence. The days of U.S. government’s exorbitant privilege, they say, are quickly waning. In fact, the U.S. is having trouble financing its debt. So much so that the Federal Reserve — not foreign governments, sovereign funds and central banks — has become the U.S. government’s primary lender. In 2012, the Federal Reserve purchased 45% of the government’s debt issue, and that does not include the massive back door monetization conducted via the Feds purchase of mortgage-backed securities from the commercial banks.

Gold’s market bestowed AAA rating

As you can see, DEFICITS DO MATTER! In fact, they matter a great deal and that’s why gold matters. Nation states will go about their business as they always have, and they will continue to receive their report cards, for better or worse, from the ratings agencies. The solid AAA rating for gold, on the other hand, persists without the blessing of any rating agency. It is a rating bestowed by a global financial marketplace that understands the difference between a paper promise and an asset that, as Alan Greenspan once put it, “does not require endorsement.”

I will end this postern to golden economics with a quote I have referenced here often. I return to it religiously because it states so well why nation states, insititutions and individuals alike inevitably revert, as they have over the past several years, to gold as a wealth repository in times like these. French president Charles DeGaulle presented this argument in behalf of gold in the 1960s at the height of another monetary crisis centered around the dollar. At the time, France was converting a large proportion of its dollar reserves to gold at the U.S. Treasury.

“Indeed,” he said, “there can be no other criterion, no other standard than gold. Oh, yes! Gold, which never changes its nature, which can be shaped into bars, ingots or coins, which has no nationality and which is eternally and universally accepted as the unalterable fiduciary value par excellence. Moreover, despite everything that could be imagined, written, done, as huge events happened, it is a fact there is still today no currency that can compare, either by a direct or indirect relationship, real or imagined, with gold.”

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Bubbles Forever

by Robert J. Shiller

NEW HAVEN – You might think that we have been living in a post-bubble world since the collapse in 2006 of the biggest-ever worldwide real-estate bubble and the end of a major worldwide stock-market bubble the following year. But talk of bubbles keeps reappearing – new or continuing housing bubbles in many countries, a new global stock-market bubble, a long-term bond-market bubble in the United States and other countries, an oil-price bubble, a gold bubble, and so on.

This illustration is by Paul Lachine and comes from <a href=""></a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

Illustration by Paul Lachine

Nevertheless, I was not expecting a bubble story when I visited Colombia last month. But, once again, people there told me about an ongoing real-estate bubble, and my driver showed me around the seaside resort town of Cartagena, pointing out, with a tone of amazement, several homes that had recently sold for millions of dollars.

The Banco de la República, Colombia’s central bank, maintains a home price index for three main cities – Bogotá, Medellín, and Cali. The index has risen 69% in real (inflation-adjusted) terms since 2004, with most of the increase coming after 2007. That rate of price growth recalls the US experience, with the S&P/Case-Shiller Ten-City Home Price Index for the US rising 131% in real terms from its bottom in 1997 to its peak in 2006.

This raises the question: just what is a speculative bubble? The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty, or worthless; a deceptive show. From 17th c. onwards often applied to delusive commercial or financial schemes.” The problem is that words like “show” and “scheme” suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any impresario.

Maybe the word bubble is used too carelessly.

Eugene Fama certainly thinks so. Fama, the most important proponent of the “efficient markets hypothesis,” denies that bubbles exist. As he put it in a 2010 interview with John Cassidy for The New Yorker, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble. A “speculative bubble,” I wrote then, is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.” This attracts “a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

That seems to be the core of the meaning of the word as it is most consistently used. Implicit in this definition is a suggestion about why it is so difficult for “smart money” to profit by betting against bubbles: the psychological contagion promotes a mindset that justifies the price increases, so that participation in the bubble might be called almost rational. But it is not rational.

The story in every country is different, reflecting its own news, which does not always jibe with news in other countries. For example, the current story in Colombia appears to be that the country’s government, now under the well-regarded management of President Juan Manuel Santos, has brought down inflation and interest rates to developed-country levels, while all but eliminating the threat posed by the FARC rebels, thereby injecting new vitality into the Colombian economy. That is a good enough story to drive a housing bubble.

Because bubbles are essentially social-psychological phenomena, they are, by their very nature, difficult to control. Regulatory action since the financial crisis might diminish bubbles in the future. But public fear of bubbles may also enhance psychological contagion, fueling even more self-fulfilling prophecies.

One problem with the word bubble is that it creates a mental picture of an expanding soap bubble, which is destined to pop suddenly and irrevocably. But speculative bubbles are not so easily ended; indeed, they may deflate somewhat, as the story changes, and then reflate.

It would seem more accurate to refer to these episodes as speculative epidemics. We know from influenza that a new epidemic can suddenly appear just as an older one is fading, if a new form of the virus appears, or if some environmental factor increases the contagion rate. Similarly, a new speculative bubble can appear anywhere if a new story about the economy appears, and if it has enough narrative strength to spark a new contagion of investor thinking.

This is what happened in the bull market of the 1920’s in the US, with the peak in 1929. We have distorted that history by thinking of bubbles as a period of dramatic price growth, followed by a sudden turning point and a major and definitive crash. In fact, a major boom in real stock prices in the US after “Black Tuesday” brought them halfway back to 1929 levels by 1930. This was followed by a second crash, another boom from 1932 to 1937, and a third crash.

Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over.

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Pound jumps as U.K. policy makers end push for more bond buying

By Anchalee Worrachate and Eshe Nelson

The pound (FOREX:GBPUSD) rallied against the dollar and the euro after minutes of the Bank of England’s latest meeting showed policy makers voted unanimously against expanding their stimulus program that tends to debase the currency.

Sterling strengthened versus most of its 16 major peers. In Governor Mark Carney’s first policy meeting, Paul Fisher and David Miles dropped their call for an expansion of the asset- purchase program in favor of a strategy involving guidance on future interest rates, today’s minutes showed. Gilts dropped as data revealed U.K. unemployment claims fell at their fastest pace in three years. Federal Reserve Chairman Ben S. Bernanke said asset purchases “are by no means on a preset course.”

“It does seem certain that Carney is viewing forward guidance as a favored policy tool over quantitative easing, at least for the present time,” said Jane Foley, senior currency strategist at Rabobank International in London. “In the medium term, it’s still going to be difficult for sterling to pick up the pace.”

The pound rose 0.2% to $1.5185 at 3:40 p.m. London time after falling to as low as $1.5079. It appreciated 0.6% to 86.31 pence per euro after touching 87.11 pence, the weakest level since March 13.

Sterling extended its gains versus the dollar after Bernanke said the U.S. central bank’s bond purchases could be reduced more quickly or expanded as economic conditions warrant.

Yield Difference

The benchmark 10-year gilt yield rose three basis points, or 0.03 percentage point, to 2.29%, after falling to 2.26% yesterday, the lowest since June 20. The 1.75% security maturing in September 2022 dropped 0.24, or 2.40 pounds per 1,000-pound face amount, to 95.56. Two-year yields were little changed at 0.31%.

“Given the already large size of the asset-purchase program, there was merit in pursuing a mixed strategy with regards to the different policy instruments,” the minutes said. “The committee’s August response to the requirement in its remit to assess the merits of forward guidance and intermediate thresholds would shed light on both the quantum of additional stimulus required and the form it should take.”

Carney joined the Bank of England on July 1 with a reputation for policy innovation earned in his previous role as Bank of Canada governor. The unprecedented measure of providing an indication on the interest-rate outlook followed a signal from Bernanke that the U.S. central bank may start slowing its bond-buying program later this year. The Bank of England is due to announce next month how officials will use forward guidance when setting policy.

QE Ditched

“Let’s see what form of forward guidance we have in August as clearly they put QE in the bin,” said Vincent Chaigneau, global head of rates and foreign-exchange strategy at Societe Generale SA in Paris. “We could have something a bit more specific. That could support the three- to five-year sector” of the government bond market, he said.

The yield difference, or spread, between 10-year Treasuries and similar-maturity gilts narrowed. The U.K. securities yielded 18 basis points less than their U.S. peers, compared with 27 basis points yesterday, the biggest discount since August 2006.

The Bank of England kept its main interest rate at a record-low 0.5% on July 4, left its asset-purchase target at 375 billion pounds and signaled it would keep borrowing costs low for longer than investors had expected. Policy maker Fisher said yesterday the unwinding of stimulus in the U.K. may be “years in the future.”

Unemployment Drops

Jobless claims fell 21,200 in June from the previous month to 1.48 million, the biggest drop since June 2010, the Office for National Statistics in London said today. Economists forecast a decline of 8,000 based on the median of 23 estimates in a Bloomberg survey. Unemployment as measured by International Labour Organisation standards fell 57,000 to 2.51 million in the three months through May. The rate was unchanged at 7.8%.

The pound has strengthened 2.2% in the past three months, according to Bloomberg Correlation-Weighted Indexes, as data showed the U.K. economy returned to growth in the first quarter and measures of services, manufacturing and construction all rose in June. The dollar rose 2.6% and the euro gained 3.2%, the indexes, which track 10 developed-nation currencies, also show.

The National Institute of Economic and Social Research estimates economic growth accelerated to 0.6% in the second quarter.

Gilts handed investors a loss of 2.2% this year through yesterday, according to Bloomberg World Bond Indexes. German bonds declined 0.7% and Treasuries fell 2.5%, the indexes show.

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Sugar trend remains down on Brazil crop expectations

By Jack Scoville


General Comments: Futures closed lower after failing to take out the highs of the last couple of days. There is not much new to talk about here so far this week. Futures trends remain down overall and price action has been weak. Many expect production to be higher overall in Brazil due to a record Sugarcane production and better weather now, and countries like Thailand and India also expect more production this year. The Indian monsoon is good so far this season and this should help with Sugarcane production in the country. Northern areas are in good shape, but southern areas might be too hot and dry and some stress to the Sugarcane is possible in the short term. In addition, industry sources there told wire services this week that planted area is down by about 5% and that overall production would be lower even with very good weather. Less production of Sugar beets is reported from Russia and Ukraine as farmers there elected top plant more grains. Traders will keep an eye on Ethanol demand and see if the production of Ethanol continues to siphon Sugar from the market.

Overnight News: Brazil should be mostly dry and warm this week, but could see colder and wetter weather this weekend. UNICA said that center south Brazil Sugar production is about unchanged from last year. It said that mills favor ethanol production and that the Sugar/Ethanol mix could be 42%/58% this year.

Chart Trends: Trends in New York are down with objectives of 1580 October. Support is at 1570, 1540, and 1510 October, and resistance is at 1620, 1630, and 1650 October. Trends in London are down with objectives of 448.00 October. Support is at 457.00, 454.00, and 451.00 October, and resistance is at 465.00, 466.00, and 470.00 October.


General Comments: Futures moved lower as reports of rain were Heard from Texas. Temperatures are much cooler in Texas and rain was reported in central and western parts of the state, including key Cotton producing areas. The rains there are called very beneficial. Conditions in Alabama, Mississippi, and Missouri are below average now, but will see warm temperatures and some showers this week, with most of the precipitation in eastern and southern areas. It is possible that futures can continue to work lower as demand has turned soft and as the weather is getting better. Weather for Cotton appears good in India, Pakistan, and China.

Overnight News: The Delta and Southeast will see mostly dry conditions. Temperatures will average near to above normal. Texas will see some showers today and drier weather later this week and this weekend. Temperatures will average near to below normal. The USDA spot price is now 80.37 ct/lb. ICE said that certified Cotton stocks are now 0.540 million bales, from 0.540 million yesterday.

Chart Trends: Trends in Cotton are down with objectives of 83.00 October . Support is at 84.00, 83.10, and 82.80 October, with resistance of 86.00, 86.50, and 87.00 October.


General Comments: Futures closed higher. Futures made a new high for the move and closed well, so some more buying is possible this week. Growing conditions in the state of Florida remain mostly good. Showers and storms are reported and conditions are said to have improved in almost the entire state. Ideas are that the better precipitation will help trees fight the greening disease. Temperatures are warm in the state, but the precipitation is the key right now. The tropics appear quiet and there are no storms in view. Brazil is seeing near to above normal temperatures and mostly dry weather, and there are reports of stress to trees and the potential for lower production.

Overnight News: Florida weather forecasts call for showers. Temperatures will average near normal.

Chart Trends: Trends in FCOJ are up with objectives of 145.00 and 155.00 September. Support is at 140.00, 136.50, and 134.00 September, with resistance at 143.00, 145.00, and 147.00 September.


General Comments: Futures were higher in New York on speculative buying tied to some forecasts for colder and wetter conditions for Brazil Coffee areas starting this weekend. No forecast is calling for damaging temperatures, but the market is short. In addition, the rain could disturb the last of the harvest. Chart trends turned up in New York with the price action yesterday. London moved higher on some buying tied to fewer offers from Vietnam on ideas that producers there are about sold out. Trends remain up in that market. Offers of Arabica from origin are still hard to find and feature strong differentials. Demand was not much stronger than the offer and the cash market remains very quiet. Brazil weather is forecast to show dry conditions, but no cold weather for the rest of the week. It could turn wetter and colder this weekend. Current crop development is still good this year. Central America crops are seeing moderate to light rains. Colombia is still reported to have good conditions.

Overnight News: Certified stocks are higher today and are about 2.748 million bags. The ICO composite price is now 121.10 ct/lb. Brazil should get dry weather except for some showers in the northeast. Temperatures will average near to above normal. Colombia should get scattered showers, and Central America and Mexico should get showers, and rains. Temperatures should average near to above normal. ICE said that 0 delivery notices were posted against July today and that total deliveries for the month are now 811 contracts. The Customs Bureau in Vietnam said exports in June were 88,367 tons, down 24.3% from May and 37.5% from last year.

Chart Trends: Trends in New York are up with objectives of 132.00 and 140.00 September. Support is at 124.00, 120.00, and 119.00 September, and resistance is at 127.00, 129.00, and 132.00 September. Trends in London are up with objectives of 1980 September. Support is at 1900, 1850, and 1820 September, and resistance is at 1975, 1995, and 2010 September. Trends in Sao Paulo are mixed. Support is at 146.00, 143.00, and 140.00 September, and resistance is at 150.00, 151.00, and 155.00 September.


General Comments: Futures closed higher on speculative buying tied to ideas that the North American grind data could be very strong. The US data should be out Thursday. Ivory Coast noted that it has forward sold a lot of the new crop production already, so that meant that selling pressure will be much less down the road. Ideas of good harvest weather in western Africa remain, although some areas might be seeing some delays from showers and storms passing through the region. Ghana and Nigeria would appear to have the most problems with the rains, and it remains a little too dry in many parts of Ivory Coast. The cash market in Africa is slow right now as buyers have already bought and are now waiting to see how the main crop turns out late this year. The weather is good in West Africa, with more moderate temperatures and some rains. A few showers are appearing again in Ivory Coast this week, but Ivory Coast will still need more rain. Other west African countries are reported to have good conditions. Malaysia and Indonesia crops appear to be in good condition and weather is called favorable. The Asian Cocoa grind was 153,792 tons in the second quarter, up 2% from last year.

Overnight News: Scattered showers are expected in West Africa. Temperatures will average near to above normal. Malaysia and Indonesia should see episodes of isolated showers. Temperatures should average near normal. Brazil will get mostly dry conditions and warm temperatures. ICE certified stocks are lower today at 4.805 million bags. ICE said that 0 delivery notices were posted today and that total deliveries for the month are 382 contracts.

Chart Trends: Trends in New York are up with no objectives. Support is at 2240, 2210, and 2165 September, with resistance at 2300, 2350, and 2380 September. Trends in London are up with objectives of 1590 and 1640 September. Support is at 1560, 1550, and 1530 September, with resistance at 1590, 1610, and 1640 September.

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US corn harvest estimates fall - but so do prices


Lanworth, citing crop damage from hot and dry weather, cut its estimate for the US corn production, and Societe Generale cautioned over a downgrade too, although the caution failed to prevent prices losing ground in Chicago.

Lanworth downgraded its forecast for the US corn harvest by 265m bushels (5.0m tonnes) to 13.668m bushels, after "temperatures during much of the last two weeks exceeded forecast levels across US production areas, while precipitation fell 50-90% below normal".

"Relatively dry conditions are expected to continue in Iowa, Kansas, much of Missouri, and Nebraska through much of the next one to two weeks," the consultancy said.

"Without above-average precipitation during the final week of the month, precipitation this July could approach the historically low levels set last year."

Indeed, the group cautioned over the potential for further downgrades in many largely westerly Midwest areas, including Iowa, the top corn-producing state.

"Initial field observations in central and northern Iowa indicate potentially significant yield losses due to poor planting conditions and establishment problems," Lanworth said.

'Significant problems'

The comments follow a caution from Societe Generale that it might lower its estimate for the US corn crop to 13.4m bushels, from a forecast made last month of 13.9m bushels.

The US Department of Agriculture, whose data set market benchmarks, pegs the crop at 13.950bn bushels.

"We continue to hear reports of significant problems in portions of Iowa," SocGen analyst Christopher Narayanan said.

Respected crop scout Michael Cordonnier reported after a Midwest tour that wet conditions had actually proved the biggest problems in Iowa, in preventing sowings.

"I saw hundreds of fields along the highway that were not planted to any crop due to the wet conditions," he said, adding that USDA assessments of crop area on the state were "not accurate".

"I can tell you from personal observations that there are hundreds of thousands of acres in north eastern Iowa and southeast Minnesota with no crops whatsoever."

Key pricing point

Nonetheless, Dr Cordonnier added that "Outside of the super-saturated areas, the corn looks healthy, is dark green in colour and actually looks pretty good.

"If there is not an early frost, most of the corn in Iowa could produce an average crop."

And Mr Narayanan cautioned over betting on price falls despite the potential for a crop far lower than the USDA has pencilled in.

Crop condition "remains above average and lacks any indication of last year's precipitous drop", he said.

While the market was "rightly concerned" over the weather threat, "especially in light of currently tight inventories, we see no serious threats yet to the US crop prospects and recommend selling any rallies.

"In our view, any production level above 13.0bn bushels will be bearish to prices."

'Average that counts'

Another US broker said that "while there are areas that are worse than others, every year we can expect to get those sore thumbs somewhere.

"It is the average that counts."

And Iowa-based US Commodities flagged that "the weather maps continued to turn cooler and wetter as the new runs were released", meaning less threatening weather for the heat-sensitive corn pollination process.

Corn for December stood 0.9% down at $5.06 ¼ a bushel at 09:45 Chicago time (15:45 UK time).

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Bernanke says Fed’s bond purchases aren’t on ‘preset course’

By Craig Torres and Joshua Zumbrun

Federal Reserve Chairman Ben Bernanke (Source: Bloomberg)Federal Reserve Chairman Ben Bernanke (Source: Bloomberg)

Federal Reserve Chairman Ben S. Bernanke said the central bank’s asset purchases “are by no means on a preset course” and could be reduced more quickly or expanded as economic conditions warrant.

“The current pace of purchases could be maintained for longer” if inflation remained too low, the outlook for employment became less favorable or “financial conditions -- which have tightened recently -- were judged to be insufficiently accommodative to allow us to attain our mandated objectives,” Bernanke said today to the House Financial Services Committee.

If the economy improved faster than expected, and inflation rose back “decisively” toward the central bank’s 2% target, “the pace of asset purchases could be reduced somewhat more quickly,” the 59-year-old Fed Chairman said in prepared testimony. The Fed would also be prepared to increase the pace of purchases “for a time, to promote a return to maximum employment in a context of price stability.”

The Fed chairman’s remarks highlight the Federal Open Market Committee’s desire to assure that the economy and labor markets have sufficient momentum before reducing its $85 billion in monthly bond purchases. Treasury yields have jumped since June 19, when Bernanke outlined a possible timetable for tapering purchases.

Baseline Tapering’

“Clearly what happened in the markets after June was well beyond what they intended, and they’re trying to pull it back,” said Julia Coronado, chief economist for North America at BNP Paribas SA in New York and a former Fed board staff economist. “He has chosen to emphasize the conditionality of the baseline tapering forecast on data -- and not just employment data but growth, inflation and importantly, financial conditions.”

Treasuries and stocks rose after the testimony was released. The yield on the 10-year Treasury note fell to 2.47% at 9:59 a.m. in New York from 2.55% before the testimony. The Standard & Poor’s 500 Index rose 0.3% to 1,680.42.

The 10-year yield rose as high as 2.74% this month from 1.93% on May 21, the day before Bernanke said the FOMC may trim its bond buying in its “next few meetings” if officials see signs of sustained improvement in the labor market.

Remain Elevated

Bernanke today said the Fed’s balance sheet would remain elevated after purchases of mortgage bonds and Treasuries end.

The Fed “will be holding its stock of Treasury and agency securities off the market and reinvesting the proceeds from maturing securities,” he said. The strategy “will continue to put downward pressure on longer-term interest rates, support mortgage markets and help to make broader financial conditions more accommodative.”

Policy makers, including Bernanke, have tried to assure investors that the Fed will hold down the benchmark interest rate after ending bond buying. Bernanke, in an appearance in Cambridge, Massachusetts on July 11, said “highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy,” a message he repeated today.

Even so, the average 30-year fixed rate mortgage has risen to 4.51% as of July 11 from 3.51% two months ago, according to Freddie Mac.

Took Pains

The FOMC said in a June 19 statement that keeping the federal funds rate between zero and 0.25% “will be appropriate at least as long” as unemployment remains above 6.5% and the forecast for inflation in one to two years doesn’t exceed 2.5%. The chairman again took pains today to explain that the Fed will look beyond the unemployment rate to assure that labor markets are improving before deciding on interest rates.

“For example, if a substantial part of the reductions in measured unemployment were judged to reflect cyclical declines in labor force participation rather than gains in employment, the committee would be unlikely to view a decline in unemployment to 6.5% as a sufficient reason to raise its target for the federal funds rate,” he said. Increases in the benchmark lending rate “are likely to be gradual” when they happen, he said.

Bernanke, seeking to help unemployed Americans find work, has orchestrated the most aggressive easing in the central bank’s 100-year history, expanding its balance sheet to $3.5 trillion from $869 billion since August 2007. He said last month the FOMC may begin tapering bond purchases “later this year” and halt the program around mid-2014 if the economy performs in line with the Fed’s forecasts.

Not Satisfactory

In today’s testimony, the Fed chairman described labor markets as “far from satisfactory, as the unemployment rate remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high.”

While risks to the economy have diminished since late last year, Bernanke said, “the risks remain that tight federal fiscal policy will restrain economic growth over the next few quarters by more than we currently expect, or that the debate concerning other fiscal policy issues, such as the status of the debt ceiling, will evolve in a way that could hamper the recovery.”

The slow pace of the recovery means that it remains “vulnerable to unanticipated shocks, including the possibility that global economic growth may be slower than currently anticipated.”

Fed officials estimate the 6.5% unemployment threshold could be reached by the end of next year. That outlook is based on estimated growth of 3% to 3.5% for the economy in 2014, according to the committee’s June central tendency estimates, which are higher than the 2.9% estimate of private forecasters in a Bloomberg survey.

Bernanke and policy makers have had to gauge how much government spending cuts and higher tax rates are sapping consumer confidence and growth. JPMorgan Chase & Co. economists estimate that an expiration of tax breaks could reduce take-home pay this year by more than $100 billion.

Retail sales climbed 0.4% last month, about half of what economists forecast, and the figures showed households are replacing outdated vehicles and furnishing new homes while cutting back on electronics and meals outside the home.

“The consumer is under pressure,” said Bob Sasser, chief executive officer of Chesapeake, Virginia-based discount retailer Dollar Tree Inc. “They’re now facing higher taxes,” a weak job market, “and the uncertainty around the economy,” Sasser told analysts and investors on a conference call in May.

‘Very Troublesome’

The U.S. faces a “very troublesome and challenging recovery,” Kendall J. Powell, chairman and chief executive officer of Minneapolis-based General Mills Inc., said in a June 26 conference call with shareholders and analysts.

Still, Fed stimulus has helped fuel a housing-market rebound and this year’s 17.5% surge in the Standard and Poor’s 500 Index of stocks.

The job market has also shown some signs of recovery. Non- farm payrolls have expanded on average by around 200,000 jobs per month from January through June. The proportion of unemployed workers who have been without a job for six months or more has fallen to less than 37% from about 40% when Bernanke launched the third round of quantitative easing in September.

‘Steady Improvement’

“We are seeing steady improvement” in the economy, Powell of General Mills said.

Slack in the labor market, including 7.6% unemployment last month, helped keep inflation for the 12 months ending May a full point below the Fed’s 2% goal, reducing the odds of any tightening based on that measure. the participants on the FOMC. In December, when the committee expanded the program of $40 billion in monthly buying of mortgage bonds with purchases of $45 billion of Treasuries, about half of FOMC participants wanted to halt the stimulus around the middle of this year, according to minutes from the meeting.

After a March staff presentation on the costs and benefits of the program, “many” participants called for slowing the pace of purchases over the next several meetings if labor markets continued to improve. By the June 18-19 meeting, “about half” of the participants “indicated that it likely would be appropriate to end asset purchases late this year,” according to meeting minutes.

Speak Out

The language suggests that concern over the risks from the program extends beyond the four Fed regional bank presidents who have publicly spoken out against it: Esther George of Kansas City, Jeffrey Lacker of Richmond, Richard Fisher of Dallas and Charles Plosser of Phildelphia.

George, the only one of the four presidents with an FOMC vote this year, has dissented against additional stimulus at all four meetings this year. In June she cited the “risks of future economic and financial imbalances” and the possibility long- term inflation expectations may rise.

Bernanke’s comments to the House today and Senate tomorrow may be his final semi-annual testimony. His second four-year term expires in January. While Bernanke has declined to describe his plans, President Barack Obama said last month the Fed chairman has stayed in his post “longer than he wanted.”

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Ben in a Box

by ilene

Courtesy of John Nyaradi of Wall Street Sector Selector

After nearly five years of quantitative easing, Ben Bernanke and his Federal Reserve now find themselves in a box. 

For several years, the only game in town has been “The Reflation Trade,” engineered by the U.S. Federal Reserve’s quantitative easing program and the Fed’s unprecedented effort to jumpstart the U.S. economic recovery. Now it seems that Dr. Bernanke wants to dial back the $85 billion/month in bond buying but finds that market forces and current conditions have him trapped in a spot from which there might be no escape.

Regarding the potential end of quantitative easing, Warren Buffett has said it would be the "shot heard round the world," and markets got a little taste of what that world might look like when Ben made comments in May that sent markets on a wild ride.

Equities dumped, gold dumped, interest rates spiked as investors contemplated just the possibility that Ben might pull the punchbowl away.

Since then, we have seen a parade of Fed Presidents and even the Chairman, himself, saying, in effect, that they were “just kidding” and that their easy monetary policies were here to stay for a long, long time. Clearly, the trial balloon regarding the end of quantitative easing went over like a lead balloon.

Today’s unfortunate situation:

1. The Fed can’t withdraw easily from quantitative easing, if at all. Markets have made this more than clear with the sharp response to even the hint of quantitative easing coming to an end, i.e., the “taper tantrum.” All recent market action reflects today’s environment which is all about the Fed. Recent assurances that the easy money would continue have been successful--major indexes are now back at levels last seen before Dr. Bernanke’s first comments.

2. The Fed has to withdraw from quantitative easing eventually. The long run of easy money has created asset bubbles and is laying the framework for higher inflation. Continuing down the current path will only make the eventual withdrawal even more painful and dramatic.

[Economatters argues that QE Policy has been a failure when it comes to the economy, anyway. The economy is not the stock market... Lee Adler predicts "Bernanke will eventually go down as the most reviled Fed chairman in history."]

3. The Fed is quickly descending into confusion and disarray. Last week saw yet another Bernanke Rally triggered after his mid-week comments, while Friday saw dueling Fed Presidents Charles Plosser and James Bullard presenting conflicting views of “to taper or not to taper.”  In between, Fed Governor Elizabeth Duke, resigned and her departure further muddies the waters.  On top of that, it’s now becoming widely accepted Dr. Bernanke will also be leaving the scene when his term expires in January and markets will be eagerly watching to see who his replacement will be.  The first hint of this came when Dr. Bernanke announced that he wouldn’t be attending the Fed conclave in Jackson Hole in August which is like Santa Claus missing Christmas, and any uncertainty regarding his successor will likely be met with significant volatility in global markets.

This confusion and disarray within the Fed could prove to be dangerous should investors lose faith in the central bank’s seemingly invincible power. The markets will continue to be whipsawed by Fedspeak and “taper talk” and we’re due for another significant round this week when Dr. Bernanke treks up to Capitol Hill on Wednesday and Thursday for testimony before the House and Senate.

So “Ben in a Box” presents the potential for danger as well as opportunity. We've already witnessed the adverse reaction from markets as they threw a temper tantrum at just the thought of the easy-money punch bowl running dry. One can only imagine what market reaction might be if and when the $85 billion per month in Federal support actually starts seeping away.

Over the past several years, “buy the dip” has been the name of the game, but there could soon be a new game if Ben can’t get out of the box and a new age of austerity and even recession is at hand.

Put options: Just because the "Bernanke Put" might be history, doesn't mean you can't go out and buy your own to protect profits or hedge against potential downside moves.

Inverse/bear ETFs and mutual funds: Bear ETFs and mutual funds are designed to help investors avoid the risks of falling markets and might also offer downside hedges to long positions should the market continue its recent decline.

Cash: Cash is the ultimate hedge in times of stress, and when markets go south in a big way, cash is always king.

U.S. dollar/Treasury bonds: While there will be few safe havens if things get really ugly, the U.S. dollar and U.S. Treasury bonds will most likely be the ultimate flight-to-quality trade. The United States might be a passenger on the Titanic, but it will be the last passenger to drown. If Titanic goes down, we can only hope that the Carpathia will arrive in time.

I think the easy money party will be coming to end soon, and that Dr. Ben is set to turn out the lights. We’ll find out more this week, but no central banker in history has ever attempted to do what he is doing, and nobody can know how this will turn out. But, as always, danger and opportunity arrive hand in hand, and this time will be no different.

Wall Street Sector Selector remains in "yellow flag" status, expecting a high risk environment ahead.


For another view on the death of QE and the Treasury market, see Lee Adler's No, Joe, No One Owes Bernanke An Apology.

John Nyaradi and Lee Adler present somewhat similar views of Chairman Bernanke’s unprecedented QE policies. However, their projections of how the game will end are different.

John speculates that cash and Treasuries will be the last refuge for investors when the SHTF (Ben In A Box).

Lee believes that Bernanke’s foolhardy actions will torpedo the bond market. "As a serial bubble blower, he already should be, but he has Joe Weisenthal and the rest of the Fed apologist crowd spinning the facts and misleading people prone to believe in the tooth fairy, Santa Claus, and helicopter money as a cure for economic ills. Their illusions will face a day of reckoning soon. As the collapse of the US Treasury market, the greatest Ponzi scheme of all time, progresses, it will reach an inflection point that will take the stock market bubble, the latest housing bubble, and the economy with it. Bernanke’s legacy will be sealed once and for all." (No, Joe, No One Owes Bernanke An Apology).

Paul Price of Market Shadows votes to avoid bonds: "Holders of long-term bonds are taking huge risks. A 1% rise at the long end of the yield curve could send 30-year bond prices down 17%. A 2% increase could drop principal values much more. Years of coupon payments could be wiped out on a total return basis." (Death by Leverage.) Paul has no idea of when the bubble will burst, but believes that it will.

What do you think?

Picture via: Jr. Deputy Accountant

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The Fed Is The Problem, Not The Solution: The Complete Walk-Through

by Tyler Durden

It may be ironic that one of the best and most comprehensive critiques of central bank policy comes from none other than Raghuram Rajan: a visiting professor for the World Bank, Federal Reserve Board, and Swedish Parliamentary Commission, he is the former chief economist of the International Monetary Fund, and currently the chief economic adviser to the government of India. Then again it should not be ironic: Rajan, as the ultimate insider in the dark corridors of the centrally planned New Normal, really gets it, unlike the vast majority of his ivory tower economist peers.

Already a recognized authority on these pages as one of the very few people who understands how shadow banking operates, we were happy to read his recent BIS speech "A step in the dark: unconventional monetary policy after the crisis", which is must read for all Congressmen (and for everyone else) ahead of tomorrow's appearance by Bernanke on the Hill for the first round of hiw Humphrey Hawkins presentation: it is a walk through for everything that central banks may (and are) wrong about although being part of the system, Rajan's diplomatic finesse lays it out in far more politically correct terms.

Consider this brilliant argument for why not only has Bernanke rendered Congress and the entire democratic apparatus meaningless, and hence why tomorrow's presentation is merely a travesty, but why it is central banks, controlled not by the people but by a syndicate of private banks, that truly run the show:

Perhaps the success that central bankers had in preventing the collapse of the financial system after the crisis secured them the public's trust to go further into the deeper waters of quantitative easing. Could success at rescuing the banks have also mislead some central bankers into thinking they had the Midas touch? So a combination of public confidence, tinged with central-banker hubris could explain the foray into quantitative easing. Yet this too seems only a partial explanation. For few amongst the lay public were happy that the bankers were rescued, and many on Main Street did not understand why the financial system had to be saved when their own employers were laying off workers or closing down.

If nothing else, after reading Rajan's thought below at least it will allow for some more intelligent questions if not answers.

A step in the dark: unconventional monetary policy after the crisis

by Raghuram Rajan, via BIS

I am honored to be invited to give the first Andrew Crockett Memorial Lecture at the Bank for International Settlements (BIS). Sir Andrew Crockett was the General Manager of the BIS from 1 January 1994 until 31 March 2003. During this time, he led the Bank through a period of considerable change. In particular, he strongly encouraged the expansion of BIS membership beyond its traditional, mostly European, base. Earlier than most, he saw that multilateral organizations needed to change to stay relevant. But perhaps his most prescient act was the speech he gave on February 13, 2001 entitled "Monetary Policy and Financial Stability".

In it he argued

"the combination of a liberalised financial system and a fiat standard with monetary rules based exclusively in terms of inflation is not sufficient to secure financial stability. This is not to deny that inflation is often a source of financial instability. It certainly is... ...Yet the converse is not necessarily true. There are numerous examples of periods in which the restoration of price stability has provided fertile ground for excessive optimism. ..."

He went on

"If an absence of inflation is not, by itself, sufficient to ensure financial what can we look to contain their build-up? The answer is, of course, prudential regulation. However, the tools of prudential regulation are themselves based on perceptions of risk which are not independent of the credit and asset price cycle. If prudential regulation depends on assessments of collateral, capital adequacy and so on, and if the valuation of assets is distorted, the bulwark against the build-up of financial imbalances will be weakened."

In these few paragraphs, Andrew Crockett summed up what has taken many of us an entire global financial crisis and years of research to learn. The paper is only 7 pages long but contains many gems that have guided the very active research program at the BIS and formed the basis of numerous papers that have been written since the crisis. The superb research team at the BIS, including Claudio Borio, Bill White, and many others, carried on the research program laid out in Andrew Crockett's speech. It is too bad that the policy establishment paid little attention to them before the global financial crisis of 2007-2012. We must ensure we do not neglect the wisdom of Andrew Crockett and his team once again.

Central bankers today have given us many reasons to go back to Andrew Crockett's speech. In the talk today, I want to go over their new tools, which come under the rubric "Unconventional Monetary Policies". Much of the time, I will be exploring the contours of what we don't know, asking questions rather than providing answers. But let us start at the beginning, to the deeper underlying causes of the recent financial and sovereign crisis in the United States and Europe. By its very nature, this has to be speculative.

The Roots of the Crisis

Two competing narratives of the sources of the crisis, and attendant remedies, are emerging. The first, and the better known diagnosis, is that demand has collapsed because of the high debt build up prior to the crisis. The households (and countries) that were most prone to spend cannot borrow any more. To revive growth, others must be encouraged to spend - surplus countries should trim surpluses, governments that can still borrow should run larger deficits, while thrifty households should be dissuaded from saving through rock bottom interest rates. Under these circumstances, budgetary recklessness is a virtue, at least in the short term. In the medium term, once growth revives, debt can be paid down and the financial sector curbed so that it does not inflict another crisis on the world.

But there is another narrative. And that is that the fundamental growth capacity in industrial countries has been shifting down for decades now, masked for a while by debt-fuelled demand. More such demand, or asking for reckless spending from emerging markets, will not put us back on a sustainable path to growth. Instead, industrial democracies need to improve the environment for growth.

The first narrative is the standard Keynesian one, modified for a debt crisis. It is the one most government officials and central bankers, as well as Wall Street economists, subscribe to, and needs little elaboration. The second narrative, in my view, offers a deeper and more persuasive view of the blight that afflicts our times. Let me flesh it out a bit. 2

The 1950s and 1960s were a time of strong growth in the West and Japan. A number of factors, including rebuilding from wartime destruction, the resurgence of trade after the protectionist 1930s, the rolling out of new technologies in power, transport, and communications across countries, and the expansion in educational attainments, all helped industrial countries grow. But as Tyler Cowan has argued in his book, The Great Stagnation, when these "low hanging fruit" were plucked, it became much harder to propel growth from the 1970s onward.

In the meantime, though, as Wolfgang Streeck writes persuasively in the New Left Review, when it seemed like an eternity of innovation and growth stretched ahead in the 1960s, democratic governments were quick to promise away future growth to their citizens in the form of an expanded welfare state. As growth faltered though, this meant government spending expanded, even while government resources shrank. For a while, central banks accommodated that spending. The resulting high levels of inflation created widespread discontent, especially because little growth resulted. Faith in Keynesian stimulus diminished, though the high inflation did reduce public debt levels.

Central banks started focusing on low and stable inflation as their primary objective, and increasingly became more independent from their political masters. Government deficit spending, however, continued apace, and public debt as a share of GDP in industrial countries climbed steadily from the late 1970s, this time without the benefit of unexpected inflation to reduce its real value.

Recognizing the need to find new sources of growth, the United States towards the end of Jimmy Carter's term, and then under Ronald Reagan, deregulated industry and the financial sector, as did Margaret Thatcher's United Kingdom. Competition and innovation increased substantially in these countries. Greater competition, freer trade, and the adoption of new technologies, increased the demand for, and incomes of, highly skilled, talented, and educated workers doing non-routine jobs like consulting. More routine, once well-paying, jobs done by the unskilled or the moderately educated were automated or outsourced. So income inequality emerged, not primarily because of policies favoring the rich, but because the liberalized economy favored those equipped to take advantage of it.

The short-sighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory and supervisory restraint, sometimes based on the faith that private incentives worked best in this best of all worlds, the financial system overdosed on risky loans to lower middle class borrowers, aided and abetted by very low policy interest rates.

Continental Europe did not deregulate as much, and preferred to seek growth in greater economic integration. But the price for protecting workers and firms was slower growth and higher unemployment. And, while inequality did not increase as much as in the US, job prospects were terrible in the Euro periphery for the young and unemployed, who were left out of the protected system.

The advent of the euro was a seeming boon, because it reduced borrowing costs and allowed countries to create jobs through debt-financed spending. The crisis ended that spending, whether by national governments (Greece), local governments (Spain), the construction sector (Ireland and Spain), or the financial sector (Ireland). Unfortunately, spending pushed up wages, especially but not exclusively in the non-traded sectors like government and construction. Without a commensurate increase in productivity, the heavy spenders became increasingly uncompetitive and indebted and started running large trade deficits.

Of course, it did not seem at that time that countries like Spain, with its low public debt and deficits, were overspending. But as Andrew Crockett foresaw, the boom masks lending problems. Spanish government revenues were high on the back of the added activity and the additional taxes, and so spending seemed moderate. However, if spending was adjusted for the stage of the cycle, it was excessive. 3

The important exception to this pattern was Germany, which was accustomed to low borrowing costs even before it entered the Eurozone. Germany had to contend with historically high unemployment, stemming from reunification with a sick East Germany. In the euro's initial years, Germany had no option but to reduce worker protections, limit wage increases, and reduce pensions as it tried to increase employment. Germany's labor costs fell relative to the rest of the Eurozone, and its exports and GDP growth exploded. Germany's exports, at least in part, were taken up by the spending Euro-periphery.

Eventually, the financial crisis starting in 2007 brought debt-fueled growth to an end. The United States and Europe fell into recession, in part because debt-fueled demand disappeared, but also because it had a multiplier effect on other sources of demand.

The Case for Unconventional Monetary Policies

The crisis was devastating in its impact. Entire markets collapsed, depositors lost confidence in even the soundest banks, and over time, started losing faith in the debt of weak sovereigns. For the financial economist, perhaps the most vivid demonstration of the depth of the problems in the financial sector was that standard arbitrage relationships such as covered interest rate parity started breaking down. 4 There was money to be had without risk - provided one could borrow! And few could. The real economy was equally devastated. For a while, as economist Barry Eichengreen has pointed out, the downturn in economic activity tracked developments during the onset of the Great Depression.

Hindsight is 20-20. It now seems obvious that central banks should have done what they did then, but in many ways, the central banks were making it up as they went. Fortunately for the world, much of what they did was exactly right. They eased access to liquidity through innovative programs such as TALF, TAF, TARP, SMP, and LTRO. By lending long term without asking too many questions of the collateral they received, by buying assets beyond usual limits, and by focusing on repairing markets, they restored liquidity to a world financial system that would otherwise have been insolvent based on prevailing market asset prices. In this matter, central bankers are deservedly heroes in a world that has precious few of them.

If they are to be faulted at all on the rescue, perhaps it is that the repair the central bankers effected was too subtle for some. Conditional on the illiquid conditions, the financial system received an enormous fiscal subsidy - if central bank actions such as guarantees and purchases had not worked out, the tax payer would have been hit with an enormous loss if matters did not improve. But conditional on repairing the system, the subsidy seemed small. Not surprisingly, rescued bankers (and rescued countries) felt somewhat aggrieved when the rescuers expected them to change their behavior. Instead, the public saw large banker bonuses return, and banker attitudes that implied the rescue was a great investment opportunity conferred on the rescuers. No wonder bankers today, and unfortunately, have a social status somewhere between that of a pimp and a conman. I say unfortunately, because more than ever, the world needs good banking to promote growth.

Be that as it may, the second stage of the rescue was to stimulate growth with ultra-low interest rates. And thus far, the central banks have been far less successful. Let us try and understand why.

The Keynesian Explanation and an Alternative

According to the most influential Keynesian view, the root cause of continued high unemployment and a slow recovery is excessively high real interest rates. The logic is simple. 5 Before the financial crisis erupted in 2008, consumers buoyed US demand by borrowing heavily against their rising house prices. As the crisis hit, these heavily indebted households could not borrow and spend any more.

An important source of aggregate demand evaporated. As indebted consumers stopped buying, real (inflation-adjusted) interest rates should have fallen to encourage hitherto thrifty debt-free households to spend. But real interest rates did not fall enough, because nominal interest rates cannot be reduced below zero - the so-called zero lower bound became a constraint on growth. 6

The Keynesian explanation suggests that the full-employment equilibrium real interest rate in the post-crisis over-leveraged world - the so-called neutral rate -- should be strongly negative. This has been the justification for central banks to employ innovative policies to try and achieve ultra-low real interest rates. That the low rates do not seem to have enhanced growth rates quickly has only made central bankers even more innovative.

But what if low interest rates do not enhance demand in a post-crisis world beyond a point? While low rates may encourage spending if credit were easy to obtain, it is not at all clear that corporations or traditional savers today will go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside. Indeed, in simple models of the kind that the Keynesians propose, the existence of savers who have suffered a loss of savings and have end-of-working-life savings objectives can imply that lower real interest rates are contractionary - savers put more money aside as interest rates fall in order to meet the savings they think they will need when they retire. 7

The point is not that this is a strong argument that ultra-low interest rates will have a net perverse effect but that a crisis potentially creates offsetting effects even on aggregate demand (through a readjustment of savings plans) that make it difficult to argue, based on theory, that strongly negative real interest rates are the right medicine to restore demand. Years of strongly negative real interest rates might contribute only weakly to demand growth.

There are two further problems in the view that a restoration of undifferentiated aggregate demand is the right solution. First, after a debt-fueled boom, the paucity of demand is localized in certain social classes, certain regions, and certain productive sectors. Second, in the years leading up to a debt crisis, it is not only demand that is distorted through borrowing, it is also supply.

To see all this, let us focus for the moment on household borrowing. Before the crisis in the United States, when borrowing became easier, it was not the well-to-do, whose spending is not constrained by their incomes, who increased their consumption; rather, the increase came from poorer and younger families whose needs and dreams far outpaced their incomes. 8 Their needs can be different from those of the rich.

Moreover, the goods that were easiest to buy were those that were easiest to post as collateral - houses and cars, rather than perishables. And rising house prices in some regions made it easier to borrow more to spend on other daily needs such as diapers and baby food.

The point is that debt-fueled demand emanated from particular households in particular regions for particular goods. While it catalyzed a more generalized demand - the elderly plumber who worked longer hours in the boom spent more on his stamp collection - it was not unreasonable to believe that much of debt-fueled demand was more focused. So, as lending dried up, borrowing households could no longer spend, and demand for certain goods changed disproportionately, especially in areas that boomed earlier.

Of course, the effects spread through the economy - as demand for cars fell, the demand for steel also fell, and steel workers were laid off. But unemployment, household over-indebtedness, as well as the consequent fall in demand, as my colleague Amir Sufi and his co-author, Atif Mian, have shown, was localized in specific regions where house prices rose particularly rapidly (and also, I would argue, more pronounced in specific sectors such as construction and automobiles that lend themselves to debt). Hairdressers in Las Vegas lost their jobs because households there skipped on expensive hairdos when they were left with too much debt stemming from the housing bust. Even if ultra-low real interest rates coerce older debt-free savers to spend more, it is unlikely that there are enough of them in Las Vegas or that they want the hairdos that younger house buyers desired. And if these debt-free savers are in New York City, which did not experience as much of a boom and a bust, cutting real interest rates will encourage spending on haircuts in New York City, which already has plenty of demand, but not in Las Vegas, which has too little. 9

Similarly, one could argue that even healthy firms do not invest in the bust, not because they face a high cost of capital, but because there is uncertainty about where, when, and how, demand will reappear. In sum, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations because the old debt-fueled demand varied both across sectors and geographically, and cannot be revived quickly. 10

There is thus a subtle but important difference between the debt-driven demand view and the Keynesian explanation that deleveraging (saving by chastened borrowers) or debt overhang (the inability of debt-laden borrowers to spend) is responsible for slow post-crisis growth. Both views accept that the central source of weak aggregate demand is the disappearance of demand from former borrowers. But they differ on solutions.

The Keynesian wants to boost demand generally. He believes that all demand is equal. But if we believe that debt-driven demand is different, the demand stimulated by ultra-low interest rates will at best be a palliative. There is both a humanitarian as well as economic case for writing down the debt of borrowers when they have little hope of paying it back. 11 Writing down former borrowers' debt may even be effective in producing the old pattern of demand. But relying on the formerly indebted to borrow and spend so that the economy re-emerges is irresponsible. And new borrowers may want to spend on different things, so fueling a new credit boom may be an ineffective (and unsustainable) way to get full employment back. 12

If the differentiated demand that emerged in the boom is hard or irresponsible to recreate, the sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand. Some of that adjustment is a matter of time as individuals adjust to changed circumstances. And some requires relative price adjustments and structural reforms that will generate sustainable growth - for example, allowing wages to adjust and creating ways for bankers, construction workers, and autoworkers to retrain for faster-growing industries. But relative price adjustments and structural reforms take time to produce results.

The five years since the crisis have indeed resulted in significant adjustment, which is why a number of countries appear to be recovering. How much of this recovery owes to the varieties of stimulus, we will debate for a long time to come. Much as quacks claim the self-healing powers of the body to common cold for their miracle cures, I have no doubt that some economists will claim the recovery for their favorite brand of stimulus.

What is true is that we have had plenty of stimulus. The political compulsions that abetted the boom also mandated urgency in the bust. Industrial countries that relied on borrowing to speed up growth typically wanted faster results. With the room for fiscal stimulus limited, monetary policy became the tool of choice to restore growth. And the Keynesian argument - that the equilibrium or neutral real interest rate is ultra-low - has become the justification for more and more innovation.

Unconventional Monetary Policies focused on Ultra Low Rates

I have argued that unconventional central bank policies to repair markets and fix institutions worked. Even the European Central Bank's promise to do what it takes through the OMT program to bolster sovereign debt has bought sovereigns time to undertake reforms, though a fair debate could be had on whether this implicit guarantee has a quasi-fiscal element. As we have seen earlier, it is the central bank's willingness to accept significant losses contingent on its intervention being ineffective that allows it to move the market to a new trading equilibrium where it does not make losses. Many interventions to infuse liquidity have an implicit fiscal element to them and OMT is no exception.

Let us turn now to unconventional monetary policy intended to force the real interest rate very low. 13 As I have argued above, the view that the full employment equilibrium real interest rate is strongly negative can be questioned. Once that is in doubt, the whole program of pushing rates lower as a way of moving the economy back to full employment is also questionable. But I want to move on to focus here on the zero lower bound problem. I will then turn to whether low rates are being transmitted into activity.

Which interest rate is the operative one for influencing economic activity? Clearly, the long term rate matters for discounting asset prices such as stocks and bonds, as well as long term fixed asset investment, while the short term rate affects the cost of capital for entities engaged in maturity transformation. The interest rate channel (where the central bank affects consumption, savings, and investment decisions through the interest rate), the asset price channel (where the central bank aims to alter asset prices and thus household wealth and risk tolerance through interest rates), the credit channel (where the central bank affects the valuation of firm and bank balance sheets and thereby alters the volume of credit) and the exchange rate channel (whereby the central bank affects the exchange rate) all probably work through a combination of short and long rates with varying degrees of emphasis on each part of the term structure. 14

The central bank directly controls the policy rate, and thus the short term nominal rate. The zero lower bound problem stems from its inability to push the short term nominal policy interest rate below zero. Further reductions in the short term real rate will come only if it can push up inflationary expectations.

Because long term nominal interest rates are typically above zero even when the policy rate is zero, the central bank can try to push down long term nominal rates without tampering with inflationary expectations. Of course, an immediate question is why the long term nominal rate stays above zero when the equilibrium long rate is lower. One possible answer is that arbitrage from rolling-over investment strategies using the higher-than-equilibrium expected short rate holds the long rate higher than it should be.

So two strategies of bringing down the nominal long rate present themselves; First, commit to holding the short rate at zero over time even beyond the point when normalizing it would be in order. This is what the Fed calls forward guidance. Second, buy long term bonds thus creating more appetite for the remaining ones in public hands, thus pushing down the long rate. The Fed aims to use its Large Scale Asset Purchase (LSAP) program to take long bonds out of private portfolios with the hope that as they rebalance their portfolios, the price of long bonds (and other assets) will rise and yields will fall. 15 The Bank of Japan wants to add to these strategies by raising inflationary expectations, which is not an explicit objective of the Fed. 16 Neither central bank talks about depreciating the exchange rate as a central objective, though they do not rule it out as a side effect.

One could ask whether these policies should work even theoretically. Forward guidance relies on the central bank being willing to hold down policy rates way into the future below what would otherwise be appropriate - below, for example, that suggested by the Taylor Rule. 1 7 Thus it implicitly implies a willingness to tolerate higher inflation levels in the future. But what ensures such commitment? Will the fear of breaking a prior transparent explicit promise (say to hold policy rates at zero so long as unemployment is above 6.5 percent, inflation is below 2.5 percent, and long term inflationary expectations well anchored) weigh heavily on the governors? Or will they fudge their way out when the time comes by saying that long term expectations have become less well anchored?

Some argue that the source of commitment will be the LSAP itself. The central bank may fear losing value on its bond holdings if it raises rates too early. However, one could equally well argue that it could fear a rise in inflationary expectations if it stays on hold too long, which in turn could decimate the value of its bond holdings. The bottom line is that it is not clear what makes forward guidance credible theoretically, and the matter becomes an empirical one.

And then we have the asset purchase program. If markets are not segmented, a version of the Modigliani Miller Theorem or Ricardian Equivalence suggests that the Fed cannot alter interest rates by buying bonds. Essentially, the representative agent will see through the Fed's purchases. Since the aggregate portfolio that has to be held by the economy does not change, pricing will not change. Alternatively, households will undo what the Fed does. 18 For LSAPs to work, the market must be segmented with some agents being non-participants in some markets. Alternatively, the market must not internalize the Fed's portfolio holdings. As with forward guidance, the effectiveness of LSAPs is an empirical question.

Much of the evidence on the effectiveness of asset purchase programs comes from the first Fed LSAP, which involved buying agency and mortgage backed securities in the midst of the crisis. Fed purchases restored some confidence to those markets (including by signaling that the government stood behind agency debt), and this had large effects on the yields. Event studies document the effects on yields in the following rounds of LSAPs were much smaller. 19

Regardless of the effect Fed purchases may have had on the way in, speculation in May 2013 that it would start tapering its asset purchases led to significant increases in Treasury yields and large effects on the prices of risky assets and cross-border capital flows. This is surprising given the theory, because what matters to the portfolio balance argument is the stock of long term assets in the Fed's portfolio, not the flow. So long as the Fed can be trusted to hold on to the stock, the price of risky assets should hold up. Yet the market seems to have reacted to news about the possible tapering of Fed flows into the market, which one would have thought would have small effect on the expected stock. Either the market believes that Fed implicit promises about holding on to the stock of assets it has bought are not credible, or it believed that flows would continue for much longer than seems reasonable before it was disabused, or we do not understand as much about how LSAPs work as we should!

Given that long term nominal bond yields in Japan are already low, the Bank of Japan's focus has been more directly on enhancing inflationary expectations than on pushing down nominal yields. One of the benefits of the enormous firepower that a central bank can bring to bear is the ability to unsettle entrenched expectations. The shock and awe generated by the Bank of Japan's quantitative and qualitative easing program may have been what was needed to dislodge entrenched deflationary expectations.

The BOJ hopes to reshape expectations more favorably. Direct monetary financing of the large fiscal deficit will raise inflationary expectations. A collateral effect as the currency depreciates is inflation imported through exchange rate depreciation. Nevertheless, the BOJ's task is not easy. If it is too successful in raising inflationary expectations, nominal bond yields will rise rapidly and bond prices will tank. So to avoid roiling bond investors, it has to raise inflationary expectations just enough to bring the long term real rate down to what is consistent with equilibrium without altering nominal bond yields too much. And given that we really do not know what the neutral or equilibrium real rate is, how much inflationary expectation to generate is a matter of guesswork.

The bottom line is that unconventional monetary policies that move away from repairing markets or institutions to changing prices and inflationary expectations seem to be a step into the dark. Of course, central bankers could argue that their bread and butter business is to change asset prices and alter inflationary expectations. However, unconventional policies are assumed to work through different channels. We cannot be sure of their value, even leaving aside the theoretical questions I raised earlier about pushing down the real rate to ultra-low levels as a way to full employment. Let us now turn to their unintended side effects.

The Unintended Effects of Unconventional Policies

Risk Taking and Investment Distortions

If effective, the combination of the "low for long" policy for short term policy rates coupled with quantitative easing tends to depress yields across the yield curve for fixed income securities. Fixed income investors with minimum nominal return needs then migrate to riskier instruments such as junk bonds, emerging market bonds, or commodity ETFs, with some of the capital outflow coming back into government securities via foreign central banks accumulating reserves. Other investors migrate to stocks. To some extent, this reach for yield is precisely one of the intended consequences of unconventional monetary policy. The hope is that as the price of risk is reduced, corporations faced with a lower cost of capital will have greater incentive to make real investments, thereby creating jobs and enhancing growth.

There are two ways these calculations can go wrong. First, financial risk taking may stay just that, without translating into real investment. For instance, the price of junk debt or homes may be bid up unduly, increasing the risk of a crash, without new capital goods being bought or homes being built. This is especially likely if key supports to investment such as a functioning and well capitalized banking system, or policy certainty, are missing. A number of authors point out the financial risk taking incentives engendered by very accommodative or unconventional monetary policy, with Stein (2013) providing a comprehensive view of the associated economic downsides. 20 As just one example, the IMF's Global Financial Stability Report (Spring 2013) points to the re-emergence of covenant lite loans as evidence that greater risk tolerance may be morphing into risk insouciance.

Second, and probably a lesser worry, accommodative policies may reduce the cost of capital for firms so much that they prefer labor-saving capital investment to hiring labor. The falling share of labor in recent years is consistent with a low cost of capital, though there are other explanations. Excessive labor-saving capital investment may defeat the very purpose of unconventional policies, that is, greater employment. Relatedly, by changing asset prices and distorting price signals, unconventional monetary policy may cause overinvestment in areas where asset prices or credit are particularly sensitive to low interest rates and unanchored by factors such as international competition. For instance, the economy may get too many buildings and too few machines, a consequence that is all too recent to forget.

Spillovers - Capital Flows and Exchange Rate Appreciation and Credit Booms

The spillovers from easy global liquidity conditions to cross-border gross banking flows, exchange rate appreciation, stock market appreciation, and asset price and credit booms in capital receiving countries - and eventual overextension, current account deficits, and asset price busts has been documented elsewhere, both for pre-crisis Europe and post-crisis emerging markets. 21 The transmission mechanism appears to be that easy availability of borrowing increases asset prices, increases bank capitalization and reduces perceived leverage, reduces risk perceptions and measures (as indicated by the VIX index or value at risk), all of which feed back into more credit and actual leverage. When this occurs cross-border, exchange rate appreciation in the receiving country is an additional factor that makes lending appear safer. The mechanism Andrew Crockett laid out has played repeatedly. 22

For the receiving country, it is unclear whether monetary policy should tighten and attract more inflows, or be accommodative and fuel the credit boom. Tighter fiscal policy is a textbook solution to contain aggregate demand, but it is politically difficult to tighten when revenues are booming, for the boom masks weakness, and the lack of obvious problems makes countermeasures politically difficult. Put differently, as I will argue later, industrial country central bankers justify unconventional policies because politicians are not taking the necessary decisions in their own countries - unconventional policies are the only game in town. At the same time, however, they expect receiving countries to follow textbook reactions to capital inflows, without acknowledging that these too may be politically difficult. Prudential measures, including capital controls, to contain credit expansion is the new received wisdom, but their effectiveness against the "wall of capital inflows" has yet to be established. Spain's countercyclical provisioning norms may have prevented worse outcomes, but could not prevent the damage that the credit and construction boom did to Spain.

Even if the unconventional monetary policies that focus on lowering interest rates across the term structure have limited effects on interest rates in the large, liquid, sending country Treasury markets, the volume of flows they generate could swamp the more illiquid receiving country markets, thus creating large price and volume effects. The reality may be that the wall of capital dispatched by sending countries may far outweigh the puny defenses that most receiving countries have to offset its effects. What may work theoretically may not be of the right magnitude in practice to offset pro-cyclical effects, and even if it is of the right magnitude, may not be politically feasible. As leverage in the receiving country builds up, vulnerabilities mount, and these are quickly exposed when markets sense an end to the unconventional policies and reverse the flows.

The important concern during the Great Depression was competitive devaluation. While receiving countries have complained about "currency wars" in the recent past, and both China and South Korea seem affected by the sizeable Japanese depreciation after the Bank of Japan embarked on quantitative and qualitative easing (though they benefited earlier when the yen was appreciating) the more worrisome effect of unconventional monetary policies may well be competitive asset price inflation.

We have seen credit and asset price inflation circle around the globe. While industrial countries suffered from excessive credit expansion as their central banks accommodated the global savings glut after the Dot-Com bust, emerging markets have been the recipients of search-for-yield flows following the global financial crisis. This time around, because of the collapse of export markets, they have been far more willing to follow accommodative policies themselves, as a result of which they have experienced credit and asset price booms. Countries like Brazil and India that were close to external balance have started running large current account deficits. Unsustainable demand has traveled full circle, back to emerging markets, and emerging markets are being forced to adjust. Will they be able to put their house in order in time?

What should be done? How do we prevent the monetary reaction to asset price busts from becoming the genesis of asset price booms elsewhere? In a world integrated by massive capital flows, monetary policy in large countries serves as a common accelerator pedal for the globe. One's car might languish in a deep ditch even when the accelerator pedal is pressed fully down, but the rest of the world might be pushed way beyond the speed limit. If there is little way for countries across the globe to avoid the spillover effects of unconventional policies emanating from the large central banks, should the large central banks internalize these spillovers? 23 How? And will it be politically feasible?

Postponing Reform and Moral Hazard

Central bankers do get aggrieved when questioned about their uncharacteristic role as innovators. "What would you have us do when we are the only game in town", they say. But that may well be the problem. When the central banker offers himself as the only game in town, in an environment where politicians only have choices between the bad and the worse, he becomes the only game in town. Everyone cedes the stage to the central banker, who cannot admit that his tools are untried and of unknown efficacy. The central banker has to be confidant, and will constantly refer to the many bullets he still has even if he has very few. But that very public confidence traps him because the public wants to know why he is not doing more.

The dilemma for central bankers is particularly acute when the immediate prospect of a terrible economic crisis is necessary for politicians to obtain the room to do the unpleasant but right thing. For instance, repeated crises forced politicians in the Euro area to the bargaining table as they accepted what was domestically unpopular, for they could sell it to their constituents as necessary to avert the worse outcome of an immediate Euro break-up. The jury is still out on whether the OMT announced by the ECB, essentially as a fulfillment of the pledge to do what it takes to protect and preserve the Euro, bought the time necessary for politicians to undertake difficult institutional reform or whether it allowed narrow domestic concerns to take center stage again.

And finally, there is the issue of moral hazard. Clearly, when the system is about to collapse, it is hard to argue that it should be allowed to collapse to teach posterity a lesson. Not only can the loss of institutional capital be very hard for the economy to rebuild, the cost of the collapse may ensure that no future central banker ever contemplates "disciplining" the system. And clearly, few central bankers would like to be known for allowing the collapse on their watch. But equally clearly, the knowledge that the central bank will intervene in tail outcomes gives private bankers an incentive to ignore such outcomes and hold too little liquidity or move with the herd. 24 All this is well known now. Less clear is what to do about it, especially because it is still not obvious whether bankers flirt with tail risks because they expect to be bailed out or because they are ignorant of the risks. 25 Concerns about moral hazard are, of course, irrelevant if bankers are merely ignorant! Once again, we do not know.


Having experienced the side-effects of unconventional monetary policies on "entry", many now worry about exit from those policies. The problem is that while "entry" may take a long time as the central bank needs to build credibility about its future policies to have effect, "exit" may not require central bank credibility, may be anticipated, and its consequences brought forward by the market. Asset prices are unlikely to remain stable if the key intent of entry was to move asset prices from equilibrium. What is held down must bounce up.

One might think that countries that have complained about unconventional monetary policies in industrial countries should be happy with exit. The key complication is leverage. If asset prices simply went up and down, the withdrawal of unconventional policies should restore status quo ante. However, leverage built up in sectors with hitherto rising asset prices can bring down firms, financiers, and even whole economies when they fall. 26 There is no use saying that everyone should have anticipated the consequences of the end of unconventional policies. As Andrew Crockett put it in his speech, "financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle."

Countries around the world have to prepare themselves, especially with adequate supplies of liquidity. Exiting central bankers have to be prepared to "enter" again if the consequences of exit are too abrupt. Will exit occur smoothly, or in fits and starts, or abruptly? This is yet another aspect of unconventional monetary policies that we know little about.


Churchill could well have said on the subject of unconventional monetary policy, "Never in the field of economic policy has so much been spent, with so little evidence, by so few". Unconventional monetary policy has truly been a step in the dark. But this does raise the question of why central bankers have departed from their usual conservatism - after all, "innovative" is usually an epithet for a central banker.

A view from emerging markets is that, in the past, crises have typically occurred in countries that did not have the depth of economic thinking that the United States or Europe have. When emerging market policymakers were faced with orthodox economic advice that suggested many years of austerity and unemployment as well as widespread bank closures were needed to cleanse the economy after a crisis, they did not protest. After all, few had the training and confidence to question the orthodoxy, and the ones that nevertheless did were considered misguided cranks. Multilateral institutions, empowered by their control over funding, dictated policy from the economic scriptures.

When the crisis did hit at home, Western-based economists were much less willing to accept that pain was necessary. The Fed, led by perhaps the foremost monetary economist in the world, proposed creative solutions that few in policy circles, including the usually conservative multilateral institutions, questioned. After all, they no longer had the influence of the purse or the advantage in economic training.

This is, however, not a satisfactory explanation. After all, Nobel Laureates like Joe Stiglitz, whatever one may think about his remedies, did protest very publicly about the adjustment programs the multilateral institutions were imposing on the Asian economies.

Consider another explanation; Perhaps the success that central bankers had in preventing the collapse of the financial system after the crisis secured them the public's trust to go further into the deeper waters of quantitative easing. Could success at rescuing the banks have also mislead some central bankers into thinking they had the Midas touch? So a combination of public confidence, tinged with central-banker hubris could explain the foray into quantitative easing. Yet this too seems only a partial explanation. For few amongst the lay public were happy that the bankers were rescued, and many on Main Street did not understand why the financial system had to be saved when their own employers were laying off workers or closing down.

Let me try again. Perhaps it was the political difficulty of doing nothing after spending billions rescuing the private bankers that encouraged central bankers to act creatively. After all, how could one let a technical hitch like the ZLB (zero lower bound) come in the way of rescuing Main Street when innovative facilities such as TARP and TALF had been used to save Wall Street? Was it that once central bankers undertook the necessary rescues of banks, they were irremediably entangled in politics, and quantitative easing was an inevitable outcome?

Or perhaps it was simply common decency: being in a position of responsibility, and in a world where much had broken down, central bankers decided to do whatever they could, which included instruments like quantitative easing.

As with much about recent unconventional monetary policies, there is a lot we can only guess at. The bottom line is that if there is one myth that recent developments have exploded it is probably the one that sees central bankers as technocrats, hovering cleanly over the politics and ideologies of their time. Their feet too have touched the ground.

On a more practical note, let me end with a caution from Andrew Crockett's speech:

"The costs of uncontrolled financial cycles are sufficiently large that avenues for resisting them should at least be explored. At a minimum, it seems reasonable to suggest that, in formulating monetary policy aimed at an inflation objective, central banks should take explicit account of the impact of financial developments on the balance of risks."

Then as now, this is very good advice. Thank you very much.

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