Fed Watch Thread

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440 Billion Drop In Shadow And Conventional Banking System Liabilities In Q4 Gives Bernanke Carte Blanche For QE3
Submitted by Tyler Durden on 03/11/2011 09:59 -0500

Asset-Backed SecuritiesBen BernankeJapanQuantitative EasingRealityRussell 2000Shadow Banking


When we last updated on the size of the shadow banking system, the financial "system" that is far more important to the economic prosperity of the US economy than the traditional liabilities held by conventional banks, we observed that after declining for 9 consecutive quarters, having hit a peak of $21 trillion in 2008, the shadow banking system had reached an inflection point and had posted a very modest increase at around $16 trillion in total liabilities in the third quarter of 2010. Well, following yesterday's Z.1 release, it seems the bulk of the data was revised, and it appears that not only was last quarter's upward pre-revision data a fluke, when in reality it was another decline of $191.7 billion, but the Q4 data further reinforced the negative trend, with shadow liabilities declining by an even greater $206.4 billion.

The components responsible for the decline were ABS Issuers whose liabilities declined by $94 billion, securities loaned by funding corporations declining by $40 billion and lastly repos, which dropped by $79 billion.

In other words, speculation that the Fed had achieved its goal of stimulating an organic reflation in the shadow banking system at which point it would be able to end QE and hand off releveraging over to the private sector were premature, and recent data confirms that the Fed has no choice now but to continue with its quantitative easing process, as it does more of the same: take capital from the public sector and proffer it to Primary Dealers in an attempt at ongoing asset reflation, which will, the theory goes, be matched by a comparable hike in liabilities.

So far this theory has been a massive disaster with 11 consecutive quarters of shadow banking liability declines. And where it gets far worse, is that after 5 consecutive increases in traditional bank liabilities which hit a record $13.1 trillion in Q3 2010, this number declined by $231 billion in Q4 to $12.8 trillion. Thus the combined move in Shadow and Traditional Banking liabilities was a whopping $438 billion in Q4!

Unfortunately, while events from Japan this morning may or may not be a catalyst for further QE, the biggest clue as to what the Fed will do is in the charts below.

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Shadow Banking System = the non-banks (the financial intermediaries - intermediary between saver & borrower).

Z.1 Release components (as defined by ZeroHedge):

(1) Money Market Mutual Funds
(2) GSEs
(3) Agency Mortgage Pools
(4) Funding Corporations
(5) Repos
(6) Open Market Paper

============================

There is no clear demarcation between these financial (institutions & instruments), & the money creating DFIs. So ZeroHedge may or may not be right.

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Still in seasonal downturn. Reversal due sometime around 3rd week in March (probably the 23rd).

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Charging interest on inter-bank balances held in the District Reserve Banks (instead of paying interest on them), would reverse the flow of loan-funds in the economy. It would shrink the size of the commercial banking system while simultaneously increasing CB profits. It would increase aggregate monetary purchasing power (by releasing the volume of savings available for real-investment).

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Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
03/01/11 0.07 0.14 0.16 0.25 0.66 1.15 2.11 2.81 3.41 4.24 4.48
03/02/11 0.12 0.13 0.17 0.26 0.69 1.18 2.16 2.86 3.46 4.30 4.54
03/03/11 0.12 0.13 0.16 0.29 0.79 1.32 2.30 3.00 3.58 4.40 4.64
03/04/11 0.11 0.12 0.16 0.26 0.68 1.20 2.17 2.88 3.49 4.34 4.60
03/07/11 0.10 0.11 0.16 0.25 0.70 1.22 2.19 2.90 3.51 4.36 4.61
03/08/11 0.07 0.11 0.16 0.26 0.73 1.27 2.22 2.93 3.56 4.41 4.66
03/09/11 0.07 0.10 0.15 0.26 0.70 1.21 2.16 2.86 3.48 4.35 4.60
03/10/11 0.04 0.08 0.14 0.25 0.65 1.13 2.05 2.74 3.37 4.25 4.53
03/11/11 0.04 0.08 0.13 0.24 0.64 1.12 2.06 2.76 3.40 4.29 4.54

=======================

Yields peaked on the 8th - sending the dollar lower (via the carry trade), while money flows are falling (sending CRB, oil, & stocks lower - until the 23rd).

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Money flowing “to” (thru), the non-banks actually never leaves the CB system, as anyone who has applied double-entry bookkeeping on a national scale should know. I.e., the source of time deposits to the CB system is demand deposits, directly, or indirectly via the currency route, or the banks undivided profits accounts. The growth of the financial intermediaries (non-banks/Shadow banks, etc), will only increase the lending opportunities of the CBs.

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Credit market borrowing amounted to $1,111 billion, seasonally adjusted annual rate, in Q4. This extended a firming trend that lasted throughout 2010; the year cumulated to $736 billion in borrowing, reversing the net paydown of $634 billion in 2009. These data are from the Federal Reserve's flow-of-funds dataset, published today for Q4 and contained in Haver's FFUNDS database. Aggregate revisions of Q3 data were modest.

The federal government was still by far the largest user of credit market funds in Q4, but at $1,320 billion, the amount was actually a bit smaller than Q3's $1.396 billion -- all of these quarterly figures are quoted at seasonally adjusted annual rates. The year 2010 came to $1,580 billion, after $1,444 billion in 2009. The household sector continued to pay down on a net basis, but with "just" $78 billion, the liquidation was less than one-third the magnitude of the Q3 reduction, and the smallest since Q3 2008, right when the credit bubble was bursting. Small noncorporate businesses also paid down debt in Q4. Nonfinancial corporate business, by contrast, raised $413 billion in Q4, the fourth consecutive quarter of net borrowing since the credit crisis, and the largest. The year came to $355 billion, following the net reduction of $42 billion in 2009.

The financial sector, in contrast, contracted its own fund-raising again in Q4. Banks, GSEs, ABS issuers and so-called funding corporations all continued or returned to paying down their own borrowings. Note that these are all the sectors who were big players in the credit bubble of 2006-07, and they continue the "deleveraging" that must be endured to bring about the healing of the economy as a whole. A notable exception is the agency and GSE mortgage pools, that is, the issuers of standard plain mortgage-backed securities (MBS). They issued $220 billion of MBS in Q4; this brought the year total to $187 billion. At once the continued net issuance here is a good sign, but it is still the smallest yearly amount since 2005, as the housing market continues to languish.

Financial institutions as lenders had had an encouraging turn in Q3, returning to their usual status as net lenders.n Q4, this quickly reverted to net withdrawals of credit, by $472 billion from Q3's +$244 billion. The major turn seems to have come from U.S. branches of foreign banks, which cut their credit by $593 billion in Q4. Other financial lenders had mixed patterns of adds and withdrawals. A very small up-blip in one banking system line-item is actually the greatest highlight; commercial banking increased its standard "bank loans, n.e.c." lending activity by $16 billion, the first net increase in these bank loans since Q3 2008. The biggest borrowing sectors for these loans were small business and foreign banks; disappointingly, loans to corporate business fell again, although by a very small amount. Other forms of bank lending, such as mortgages and consumer credit, continued to contract.

So credit market activity remains slow and hesitant. But the Q4 report generally points to smaller contractions and early hints that credit growth may be returning. Unlike much historical experience, the turn toward growth is coming gradually, rather than having credit growth burst forth, clearly signaling sustainable rebound.

www.haver.com/comment/comment.html?c=110310d.html

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the spread between LIBOR and the overnight index swap (OIS) rate.

The so-called LOIS spread serves the same general function as the TED spread between eurodollars and Treasury bills; here the subtrahend of OIS represents not the T-bill rate but rather the rate at which a bank can lock in a strip of federal funds.

A funny thing has happened since the execution of quantitative easing II (QE2) began in November 2010, marked with vertical lines in both charts. All of the money created by the Federal Reserve has driven OIS rates down toward levels last seen in February 2010 and has led to an inversion of the term structure of OIS. If you simply looked at these yield levels and term structure, you might think we were still in a financial crisis.

The exact opposite has been occurring in the LIBOR market. As these are funds held outside of the US, they are not affected immediately by money-printing. Not only have these rates not fallen, the three-month rate has increased relative to the one-month rate and thus steepened the yield curve as measured by the forward rate ratio between one and three months. This is the rate at which we can lock in borrowing for two months starting one month from now, divided by the three-month rate itself.

www.minyanville.com/businessmarkets/articles/libor-overnight-index-swap-ois-lois/3/15/2011/id/33297

If we haul out our forever-useful transitive property of equality, we can deduce the LOIS spread has been widening since QE2 began, and this indeed has been the case. Federal funds have been suppressed artificially by the Federal Reserve’s actions and are trading at an artificially wide spread below LIBOR.

The most immediate consequence of the LOIS spread will be an upward convergence of OIS to LIBOR once the money-printing stops; we might learn more about this later this afternoon when the FOMC emerges from the clouds of smoke around Mt. Sinai, clears its collective throat, and tells us to take two tablets and call them if further miracles are needed.

The rise in OIS after QE2 ends will force a deleveraging in the fixed-income markets and leveraged positions financed therewith will become more expensive to carry. Whether any of this affects credit spreads or earnings prospects is less clear, however, and no one should make an immediate connection between a narrowing of the LOIS spread and any directional move in the stock market

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Last week's Flow of Funds report issued by the Federal Reserve clearly underlines the fact that we, as a country, haven't just avoided deleveraging, but rather continue to accumulate debt. At the end of the last fiscal year, total non-financial debt (household, business, state, local, and federal) reached an all-time record high of $36.2 trillion. Not only is the nominal level of debt at a record, but also debt-to-GDP - a far more worrying statistic. In Q4:07, total non-financial debt registered 222% of GDP. In 2008 and 2009, it was 238% and 243% respectively. As of Q4:10, that figure had risen to 244% of GDP, For some perspective, look back to the turn of the millennium, when total debt-to-GDP was 'just' 182%. Even that level points to a sick economy, but today's make you wonder how the patient is still breathing.

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Understanding the Fed Funds Rate in Relation to Treasury Bills
EPJ reader Andrew Mackenzie emails;

www.economicpolicyjournal.com/2011/03/understanding-fed-funds-rate-in.html

Could you expand on the significance of the Fed Funds Rate being above the one month yield on treasury bills a little more, for those of us who aren't as knowledgeable about money and banking as we probably should be?

Is it because the Federal Government could simply borrow from the fed, as a bank would, rather than issuing treasuries?

I'm very interested in this topic, because I believe I've heard you bring it up before. I suspect some of your more amateur readers may be as well.

The key really is the interest rate the Fed pays on excess reserves, currently 0.25%. At this rate, there is no incentive for banks to buy short-term Treasury bills and put the money into the system, with one month T-bills yielding 0.07%. It makes more sense for banks to just keep it out of the economy at the Fed at 0.25%, if they are looking for absolute, short-term, safety.

I used the example of the Fed funds versus the T-Bill rate because Krugman used Fed Funds. The Fed Funds interest rate is currently at approximately 0.15%. It is lower than the rate on excess reserves becasue there are some financial institutions that can operate in the Fed Funds market but can not earn interest at the Fed on excess reserves---otherwise the two rates would be equal.

If the Fed lowered the rate on excess reserves below the current T-Bill rate of 0.07%, it would also push the Fed funds rate down to at least the same rate as excess reserves, since some banks would move funds from excess reserves to the Fed funds rate to catch the higher yield and push that rate down. This would add money to the system. So my use of the Fed Funds rate was just a short-cut to keep the post flowing without getting into too much detail.

Currently, though, with the Fed paying interest on excess reserves at 0.25%, far above the rate on T-bills, there is no reason for money on excess reserves to enter the system.

I hasten to add that the importance of the interest rate on excess reserves only came about because of the introduction by Fed Chairman Bernanke, as one of his new "tools", the payment of interest on excess reserves. Before the introduction of this tool, the Fed always acted directly on Fed funds by draining or adding funds via the purchase or sale of Treasury securities.

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The need for an IOER-fed funds spread
Posted by Izabella Kaminska on Mar 14 15:45.

Here’s an interesting view we caught sight of in Bank of America Merrill Lynch’s latest ‘US rates weekly’ note.

The Fed’s interest on excess reserve (IOER) policy — which currently pays out 25 bps in a bid to set a floor for money market rates — may have opened up a risk-free arbitrage for banks which can borrow from Government-Sponsored Enterprises (GSEs) that do not qualify for the programme.

Because GSEs are not eligible for interest on excess reserves, even though they are participants in the fed funds markets, they lend cash at rates well below the IOER rate.

So, according to BoAML’s analysts, that means banks can borrow from the GSEs at rates below 25 bps to earn a positive spread by leaving excess liquidity at the Fed. It’s why the fed funds rate has been as low as 14bp recently:

ftalphaville.ft.com/blog/2011/03/14/513576/

How nice for them.

Of course, while that might not seem so fair for the GSEs, it could serve a higher purpose for the Fed itself.

As BoAML point out, when it comes to hiking rates, the whole process might actually enable the Fed to keep some control over the short-term rate market:

In light of this softness of the fed effective relative to IOER, many observers have questioned the Fed’s ability to regain control of short-term rates once the FOMC decides to raise the fed funds target. However, in our view, the IOER rate gives the Fed adequate control over short-term rates such that it will be able to raise rates as desired. If a spread between the IOER and the fed effective persists, as we think it likely will, the FOMC could simply set the fed funds target below the IOER rate.

For example, if the FOMC raises the fed funds target to 50bp, the IOER rate could be set at 65bp or 70bp, depending on the spread that exists between the effective and IOER.

Interesting, no?

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The US dollar weighted index (major currencies), (DTWEXM), peaked @ 103.6820 this century on 5/17/2000.

It steadily fell to a low @ 69.2758B on 3/18/2008. It currently stands @ 71.1383B on 3/11/2011.

The current account defict stands @ a cummulative figure @
-7,973.625T since the U.S. became a debtor nation in 1985.

The trade deficit (Goods & Services - Balance of Payments Basis), It comprises 97% of the current account deficit since 1992. The balance of trade is the difference between exports and imports in the U.S. economy over a specific time period.

The US import of petroleum products (in thousands of barrels of oil/day) is as follows:

(2004) = 13,145 (2005) = 13,714 (2006) = 13,707 (2007) = 13,468 (2008) = 12,915 (2009) = 11,691

@ $100 per barrel (13,000,000,000 barrels/day) this comes to:

The US consumers $474,500,000,000.00 per year, or $300,000,000,000 (25*12), subtracts that amount from our trade surplus.

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Washington – The U.S. trade deficit shot up 15.1 percent in January to $46.3 billion, the Commerce Department said Thursday.

Higher prices for imported oil accounted for $2.06 billion of the $6 billion increase from December. Crude was $104.37 a barrel Wednesday on the New York Mercantile Exchange.

Private economists' median estimate for the January trade deficit was $41 billion.

Though U.S. exports rose 2.7 percent from December to January, imports were up by an even-bigger margin of 5.2 percent.

The United States spent $24.5 billion on oil imports in January, increasing its cumulative trade deficit with members of the Organization of Petroleum-Exporting Countries by $1.64 billion, to more than $9.9 billion.

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The decline of the dollar is not just related to our current account deficit. It also is presurred lower because of the surplus of dollars created abroad:

Russia, formally the epitome of state controlled economies, did not use the ruble in its foreign exchange operations. Since all trade with the Soviets was monolithic, it was to their advantage to establish a single money center bank through which all foreign financing could be channeled. Their London bank was one of the first to become a part of the Euro-dollar system, an unregulated system of money creating banks operating on the principle of prudential reserves, as contrasted to regulated legal reserves. These prudential reserves are liquid balances in the U.S., or any other major currency country.

If the bank’s balance is inadequate to meet a specific payment it borrows in the London money market at or near the LIBOR rate (the London Interbank Offering Rate), a rate substantially below the prime rates of most banks. U.S. money center banks were often criticized for loaning money “to other countries” at a lower rate than it would offer local customers.

With respect to the U.S., all transactions were financed through the Amtorg Trading Corporation which transfers all of its receipts to, and draws all of its drafts on the London bank. The only concern of the London bank with fluctuating exchange rates is to have a minimum inventory of a depreciating currency.

A common misconception is that Euro-dollars (E-Ds) are U.S. dollars that have somehow contrived to leave this country, whereas in fact all E-Ds are created abroad. The foreign commercial banks, and foreign branches of U.S. banks, which create this money, operate on the premise that they will always be able to convert E-Ds into U.S. dollars on demand on a one-to-one basis.

This exchange equivalence privilege may suggest to the E-D borrower that there is no meaningful difference between E-Ds and U.S. dollars. But in terms of our national and the international economy this is an illusion. In both an economic and legal sense the E-D is no more a part of the lawful money supply of the U.S. than is the Canadian dollar, or any other national currency.

Two principal factors were responsible for the origin of the E-D banking system; (1) the possession by foreign commercial banks of an excess volume of short-term claims against the U.S. dollar, and (2) the preeminence (at that time) of the U.S. dollar as the reserve, standard-of-value, and transactions currency of the world.

Beginning in 1950 the U.S. incurred the first of a chronic series of net liquidity deficits in its balance of payments. These deficits have grown in magnitude and continued uninterrupted ever since 1950 with the exception of 1957. By the mid sixties foreign banks had acquired more dollar balances than were required to cover their own international transaction needs – so they started lending their excess U.S. dollar balances.

E-D banking originated in the City of London and London based banks still dominate the E-D banking system. As the number of banks participating in the E-D transactions increased (G7), the E-D bankers discovered that the E-D deposits they created for borrowers often did not result in any diminution of their U.S. dollar balances – the System was merely shifting balances within itself. That is, drafts drawn on E-D banks increasingly were deposited in other E-D banks. Thus was laid the economic basis of an international system of “prudential” reserve banking – the discovery that the amount of actual U.S. dollar reserves required to support the E-D loans made – and E-D deposits (money) created.

The prudential reserves of the E-D banks consist of various U.S. dollar-denominated liquid assets (U.S. Treasury bills, U.S. commercial bank CDs, Repurchase Agreements, etc.) and interbank demand deposits held in U.S. banks. These are liquid balances in the U.S., or any other major currency country. If a bank’s balance is inadequate to meet a specific payment in the E-D system, it borrows in the London money market at or near the LIBOR rate (the London Inter-bank Offering Rate), a rate substantially below the prime rates of most banks.

The volume of prudential reserves held by each E-D bank presumably is dictated by “prudence” – not by any legal requirement administered by a monetary authority (nor by exchange controls). In their lending & investing operations, the ED banks, (outside of the U.S.’s Congressional jurisdiction): (1) avoid reserve requirements, (2) FDIC insurance premiums, (3) banking supervision, audits, & compliance, (4) the 35% corporate tax rate, (5) the Dodd–Frank Wall Street Reform and Consumer Protection Act’s provisions, etc. Thus competitive advantages enable the ED banks to undercut the costs of the more regulated and supervised US banks.

All prudential reserve banking systems have heretofore “come a cropper”. Money creation by private profit institutions is not self-regulatory- the “unseen hand” simply does not function in this area. Invariably the systems created too much money, speculation became rampant, inflation distorted and destroyed economic relationships, confidence that the banks could meet their convertibility obligations eroded, “runs” on the banks caused mass banking failures, and entire economies were left in ruin.

With this historical record to draw from the pertinent question is: Why did the various governments and monetary authorities allow E-D banking to grow on an unregulated, prudential reserve basis? The situation obviously required that the E-D banks be constrained in their money creating activities through the standard devices of legal reserves and reserve ratios, the volume and level of which are controllable by the monetary authorities. There is no assurance, of course, that the monetary authorities having such powers will use them to prevent and excessive creation of money.

Until the early sixties there was a chronic shortage of U.S., dollars available to finance international transactions. But the E-D system came about precisely because the U.S. balance of payments deficits had finally supplied a more than adequate volume of international liquidity. The E-D has been a superfluous and harmful addition to the world’s monetary stocks and E-D bankers have increased their earnings assets by approximately this addition. This figure is many times the U.S. means-of-payment money supply.

Euro-dollar deposits are now available in many countries worldwide, but they continue to be referred to as "Eurodollars" regardless of the location, e.g., Yaun-dollars, Yen-dollars, Petro-dollars, Foreign-dollars (U.S. trading partners), etc., are now contributing to this excess.

This vast addition to the world’s money supply has substantially contributed to the high rates of inflation that have prevailed since 1965 with U.S. trading partners. Nor can the E-D be defended as being in any way superior to the U.S. dollar as an international reserve and transactions currency since the acceptability of the E-D is totally dependent on the acceptability of the U.S. dollar.

If the E-D system is not to repeat the tragic record of all previous prudential reserve banking systems two thins are necessary: (1) the U.S. dollar must remain acceptable as the world’s transactions currency (This requires that the chronic deficits in the U.S. balance of payments cease), and (2) the E-D system must be subjected to the restraints of controllable legal reserves and reserve ratios.

But this is only the beginning. After the legal structure has been put in place we will still need monetary authorities who understand the economics of money creation, the consequences of excessive money creation – and are willing to force on the governments and business communities of their respective countries the discipline of a properly regulated money supply. The latter problem will be with us whether control is vested in the central bankers, or the International Monetary Fund is made a world central bank and control of the E-D is vested in it.

But the alternative is, at some point in time, a flight from the U.S. dollar and, therefore, the Euro-dollar. This will generate hyperinflation in terms of U.S. and Euro-dollars, and an international financial crisis of unprecedented proportions. If history is a guide it is obvious these requisite conditions will not be achieved.

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Tens of trillions of dollars are invested in the U.S. bond markets.

And - for as long as anyone can remember - the Fed, U.S. Treasury bonds and the Treasury yield curve were the bellwethers of where interest rates were headed. That's why investors watched those indicators so closely.

But they are bellwethers no more. With the $2.9 trillion market for municipal bonds now buffeted by pension, deficit, tax and potential state bankruptcy woes, it's the direction of muniyields and shape of the muni yield curve that investors should be watching to divine the future direction of interest rates.

T o divine the direction of interest rates - and stay ahead of the curve - watch the muni-bond market by watching the iShares S&P National AMT-Free Muni Bond Exchange-Traded Fund (NYSE: MUB).

Private investors - mostly individuals and insurance companies - hold about 95% of the $2. 9 trillion worth of municipal bonds currently outstanding.

Because it's essentially individual-investor demand that determines what yields states and municipalities must offer on their bonds in order to attract investors, pure supply-and-demand realities in the municipal arena make interest-rate movements much more transparent.

It's possible that budget, deficit, and pension woes will get worked out sooner rather than later.

But it's far more likely they won't.

Either way, because the muni-bond market isn't manipulated by the Fed or subject to extraordinary outside forces, demand in the face of available supply for new issues will result in true "price discovery."


A Look Ahead
The market has calmed down since it began to swoon last October. After selling off on talk about Chapter 9 reorganizations at state and local government levels - and after an onslaught of muni-mutual-fund selling - prices have stabilized along with yields.

But don't be fooled. The only reason things are quiet on the muni-bond front is because there's virtually no supply coming to market.

Only $29 billion worth of muni-bond offerings were floated in the last two months, compared to $46.5 billion in the first two months of 2010.

The rest of the year could get ugly.

The Build America Bonds program expired on Dec. 31, 2010. Under that issuer-and-buyer-friendly program, the U.S. government subsidized taxable issuance by states and municipalities to the tune of $117.3 billion. With that backstop gone, new issuance of an expected $275 billion to $300 billion this year will sorely test the public's appetite for munis.

As new bond issues do come to market, the important thing to watch will be their maturities.

Issuers want to avoid offering variable-rate demand obligations (VRDOs) because they fear that if rates rise or their creditworthiness declines, they may not be able to roll over short-term borrowings. And the only way to borrow long-term in a rising-rate environment is to offer risk-averse investors higher coupons on bonds with extended maturities.

As the muni-yield curve steepens, investors will start interpreting that steepening as a reflection of increased risk. At the exact time that issuers are offering higher yields, such an interpretation by investors will force issuers to offer even higher yields and will cause the prices of old bonds to tank.

The purity of the supply-and-demand equation in the muni market - and its resulting reflection on interest-rate levels - is where the wheat will be separated from the chaff.

And that's why - for now - i t's the muni market that investors need to embrace as their new interest- rate bellwether.

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Corporate Cash Stash Soars to $1.9 Trillion, Maybe Marx Was Right After All...
Economics / Economic Theory
Mar 16, 2011 - 05:20 AM
By: Mike_Whitney


Two and a half years have passed since Lehman Brothers collapsed and US consumers are still digging out.

Last Thursday, the Fed released its “flow of funds” report which showed that households had trimmed their debt to $13.3 trillion in the forth quarter (4Q). But the crucial debt-to-income ratio remains significantly above trend at 120.9%. That means that consumers will have to cut their spending even more.

During the boom years, (2000 to 2007) households more than doubled their debt by taking advantage of cheap, easily-available credit for purchasing mortgages, refinancing homes and maintaining their standard of living. Homeowners were able to drain (roughly) $500 billion per year from their rising home equity to spend as they pleased. The credit-binge stimulated demand, increased employment, and created a virtuous circle of profitability and growth. But now the process has slammed into reverse triggering a wave of foreclosures, bankruptcies and defaults. Consumers have been retrenching for 11 straight quarters trying to patch their balance sheets after sustaining heavy losses during the crisis.

Household deleveraging can have a devastating impact on the economy because consumer spending is 70% of GDP. Fortunately, the Obama administration initiated a $787 billion fiscal stimulus package to make up for the shortfall in private sector spending, otherwise the economy would have slipped into a long-term slump. Government spending (the deficits) pulled the economy out of recession, reduced the gaping output gap, and increased employment by an estimated 2 million jobs.

Economists look to the flow of funds report to gauge the health of consumers, but sometimes the data can be misleading. For example, household net worth increased by $2.1 trillion to $56.8 trillion by the end of 4Q, but virtually all of the gains were in the stock market so it won't effect the spending habits of people who aren't invested in equities. As Barron's Randall Forsyth notes, "You have to be in the lottery to win it."

Still, Fed chairman Ben Bernanke sees rising stock prices as a sign that his bond purchasing program (QE2) is working. Like former Fed chairman Alan Greenspan, Bernanke believes that the "wealth effect" can boost spending and lead to recovery. Regrettably, the facts do not support Bernanke's claims. While the administration's fiscal stimulus increased economic activity and employment (according to 2 separate reports by the nonpartisan CBO), QE2 has merely inflated stock prices. There's nothing in the flow of funds report that suggests anything more than a normal cyclical recovery following a deep recession. In other words, QE2 is a bust.

The Fed's main policy tool is interest rates. QE2 is an attempt to push rates below zero by large-scale purchases of Treasuries. The goal is to spark investment in riskier assets. And, to some extent, it works. Thanks to Bernanke's QE drip-feed into the banking system, stocks have climbed 12% in the 4Q. But higher stock prices haven't led to greater investment or spending, just more liquidity sloshing around the financial markets. The problem is that QE2 has no transmission mechanism for getting stimulus into the real economy. It doesn't increase wages, expand credit, or remove the red ink from household balance sheets. It just adds a few more gusts of helium to the equities bubble. This is apparent in last week's Consumer Credit report as well as the flow of funds report. The Fed's Credit Report showed that --apart from student loans and subprime auto loans--consumer credit is still shrinking. In fact, lending either stayed flat or dropped off at the commercial banks, finance companies, credit unions, savings institutions, nonfinancial business and pools of securitized debts. Bottom line: There's no indication that the Fed's policy is helping households reduce their debt or to resume spending at precrisis levels. In other words, QE2 is not paving the way to another credit expansion.

And then there's this from Bloomberg Businessweek:

"Those ordinary Americans who have jobs worry about holding onto them, and they expect few if any increases in pay as the recovery inches forward. For upper-income households, it’s a different story, says Michael Feroli, a former Federal Reserve economist who is now chief U.S. economist at JPMorgan Chase in New York: “They’re the ones benefiting the most from the stock market rally, and they’re spending.”

..... Feroli estimates the top 20 percent of income earners account for about 40 percent of spending. Dean Maki, chief U.S. economist at Barclays Capital in New York, puts the figure at closer to 50 percent."

So, yes, rising stock prices have been good for the rich who have resumed their trips to Tiffanys and their dinners at high-end restaurants. But for everyone else, it's been a wash. The only thing that could change the situation is if QE2 pushed wages higher or lifted housing prices out of the doldrums. But it doesn't work that way.

Here's a clip from an article in the Wall Street Journal which sheds a little light on a part of the deleveraging story that's missed by most of the media:

"U.S. families shouldered a smaller debt burden in 2010 than at any point in the previous six years....Defaults on mortgages and credit cards played a large role in bringing down household debt, underscoring the extent of the financial distress still afflicting U.S. families. Commercial banks wrote off $118 billion in mortgage, credit-card and other consumer debt in 2010, the Fed said. That's over half the total $208.8 billion drop in household debt, which also includes new mortgages and credit cards....

Many consumers still have a long way to go to get their finances in order. Some economists believe a healthy household-debt-to-disposable-income ratio would be 100% or lower." ("Families Slice Debt to Lowest in 6 Years", Wall Street Journal)

So households are reducing their debt, but, what's interesting, is how they are doing it. They're defaulting. This is from an earlier Wall Street Journal article by Mark Whitehouse:

"The falling debt burden conjures up images of a nation seeking to repent after a decade of profligacy, conscientiously paying down mortgages and credit-card balances. That may be true in some cases, but it’s not the norm. In fact, people are making much more progress in shedding their debts by defaulting on mortgages and reneging on credit cards......on average, aren’t paying down their debts at all. Rather, the defaulters account for the whole decline, while the rest have actually been building up more debt straight through the worst financial crisis and recession in decades." ("Number of the Week: Default, Not Thrift, Pares U.S. Debt", Wall Street Journal)

Uh oh. So consumers are defaulting rather than paying-down their debts. That means more foreclosures and bankruptcies leading to larger losses at the banks and, perhaps, another bailout. It also increases the likelihood that stock and commodities prices will drop sharply when activity slows triggering another bout of deflation. So, can QE2 reverse the trend and ignite a flurry of investment and spending by tweaking the yield curve on US Treasuries? Don't bet on it. Just take a peak at this article by Mark Whitehouse and it's easy to see what's going on:

"U.S. companies’ cash hoard keeps getting bigger, a trend both good and troubling. After hitting new highs in five of the last six quarters, nonfinancial corporations’ cash and other liquid assets reached $1.9 trillion at the end of 2010, according to the Federal Reserve. That’s 7% of all their assets, the highest level since 1963....the persistent growth of companies’ cash hoard suggests a problem: Businesses appear to lack the confidence in the recovery needed to plow the money back into new projects and hiring..... companies are giving some cash back to their shareholders through stock buybacks,....hardly a sign of optimism." ("Companies’ Cash Hoard Grows", Mark Whitehouse, Wall Street Journal)

So, why aren't corporations reinvesting their $1.9 trillion stash when the Fed has lowered rates to 0% and Bernanke is supporting the markets with QE2?

It's because of the lack of demand. Financial alchemy and waves of speculation have papered over the dismal performance of the underlying economy which grows more anemic with every business cycle. Businesses are no longer able to find productive outlets for investing their surplus capital, so the whole system is slowing down. And, when corporate savings are not recycled into the economy via investment, demand dries up. That's what's happening now.

Reformers can divert attention from the central problem by pointing at deregulation, low interest rates, and a foreign "savings glut", but the fact remains that the recoveries get weaker and weaker, unemployment stays higher for longer, and the crashes get more catastrophic. All these point to a sclerotic and unstable system blighted by overproduction and underconsumption that is gradually succumbing to stagnation. The persistent slowdown is deepening inequality, inciting class antagonisms, and fomenting social unrest. Marx said that "the real barrier of capitalist production is capital itself." The $1.9 trillion sitting idle on corporate balance sheets proves that Marx was right.
By Mike Whitney

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This is just a seasonal move that has been exaggerated by some unfortunate events: no-fly zones in Libya, an earth quake & tsunami, & nuclear fallout in Japan (un-winding the Japanese carry trade), revolution in Egypt, & Bahrain protests, etc.

As I've been saying, the market usually bottoms around the 23rd of March. Equities should be oversold by then.

Commodities are being pulled down by economic deceleration (from rising oil prices & consumption substitution). But interest rates will rise (as money flows begin to rise), which will alter interest rate differentials, & eventually strengthen the US dollar (a negative for imported raw materials).

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Sorry, Ma & Pa: Smart Money Bought the Munis You Panic Sold MarketBeat By Matt Phillips

Ma and Pa: Hosed again? Interesting bit of market sleuthing by J.P. Morgan’s Nikolaos Panigirtzoglou, who cross references flows data on municipal bond fund sales with official flow of funds data on munis from the Federal Reserve. They don’t seem to be adding up. Here’s the key section, with some illustrative links we added:

Despite the strong outflows from Municipal bond funds over the past months [see here, here and here, -eds], the latest release of the US Flows of Funds data from the Federal Reserve showed that direct buying of Muni bonds by the household sector was $51 [billion] in Q4, the highest level on record.

This contrasts with the $7 [billion] of outflows from muni bond funds over the same period. Typically, muni buying through direct purchase and mutual funds have the same sign 70% of the time. This divergence in direct buying and mutual fund flows in Q4 2010 is likely driven by direct muni bond buying from non-traditional investors which do not have a separate category under the [flow of funds] and are includes in the “household” sector.

For example, hedge funds and non-profit organizations such as endowment funds are classified under the “household” sector in the Fed’s FoF. Another large buyer of Muni bonds in Q4 was commercial banks, who bought $17 [billion] of municipal bonds.

So did retail investors get too jittery about the prospects for muni defaults? The sign of hedgies, banks and endowments all diving into a market that retail investors are getting out of makes us wonder.

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"Bottom line is that here in the 20th month of the economic recovery, the sector that normally leads both recessions and expansions has yet to gain any traction," David Resler, chief economist - Nomura Securities.

=============

The first time housing didn't lead the economy out of our recessions since the Great Depression was in the early 80's.

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U.S $ INDEX (NYBOT:DX)

US Dollar index @ 75.852 -0.189 (-0.24%) this a.m.

sn117w.snt117.mail.live.com/default.aspx?n=286791085


03/17/11 Currency investors started to move back out of their ‘safe havens’ yesterday with most of the currencies moving higher versus the US dollar. The Japanese yen (JPY) was the biggest mover, setting a post-World War II high as money was repatriated back into the country.


All told, Japan owns an estimated $3 trillion of US securities, both stocks and bonds. With $886 billion of US Treasuries, Japan is the world’s #2-holder of US debt. In the past year it’s bought, on average, $10 billion worth of Treasuries every month.

You don’t easily replace the second-largest buyer of Treasury bills, bonds and notes. Not many countries have pockets deep enough to step up with that kind of financial firepower.


The deficit for the full year of 2010 widened to $470.2 billion, or 3.2% of GDP, up from 2.7% of GDP in 2009. This deficit is worrisome, as it combines with a budget shortfall of a record $1.5 trillion dollars to form the twin deficits. As the article from Jeff Opdyke suggests, we are absolutely reliant on foreign investors to fund this debt


U.S. dollar index @ 75.576 -0.465 (-0.60%) as of 5:10 est. March 18, 2011

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A couple of revealing charts from the Fed’s Flow of Funds data. Both show net flows into Treasuries by creditor type and the Federal Government’s borrowing during each quarter. Note, the quarterly data is annualized.

The first chart illustrates how QE2 flushed domestics out of Treasuries and effectively funded 63 percent of the budget deficit in Q4. The Treasury is prohibited from directly selling bonds to the central bank, but effectively finances the government through POMO.

Given that a large portion of the Rest of World category are central banks recycling BOP surpluses, it’s likely that 90 percent of the U.S. budget deficit in Q4 was funded by central banks. You think this may have anything to do with what’s happening in the commodity markets? That is, the central banks’ printing presses providing the fuel for speculators?

Furthermore, we ask: who is going to finance the U.S. budget deficit when QE2 ends, especially at a sub 3.50 percent 10-year Treasury rate? Bill Gross knows!

www.ritholtz.com/blog/2011/03/is-this-why-bill-gross-dumped-treasuries/

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The Fed likes to strip out the prices of things that are rising in price when it measures inflation, focusing on the “core rate” rather than the “headline rate.” The core rate excludes food and energy; in other words, the core rate excludes “necessities.” That rate rose by just 0.2% in February, so no problem, right? For Head of New York Fed William Dudley and friends, maybe, but not for those of us in the real world who have to buy things like gas and food. We’re feeling that 0.5% jump in the headline rate, and then some.

I thought I’d take a look at some of the things that real people have to buy to survive -- like food and energy. These are the necessities that the Fed likes to ignore when it is explaining to everyone how there’s no inflation. Energy prices were up by a stunning 1.6% in February. That’s on top of 2.4% in January, and 2.8% in December. In fact, since the Fed started QE2 in November, the energy component of the CPI is up by 8.3%. If you’re annualizing, that comes out to a mere 27%. But Ben Bernanke dismisses that because “it’s transitory." It’s true that energy prices have dropped just a bit here in March, but “it’s transitory.”

What about food? Food prices were up 0.4% in February according to the BLS. January saw a gain of 0.9% and December just 0.1%. Since the Fed started QE2, food prices are up 1.1%, or just over 4% annualized. As a grocery shopper that seems low to me. Not only are prices rising, but package sizes are shrinking. But I won’t quibble with the BLS figure. Let’s just assume that it’s true.

Since the Fed likes to pretend that the only prices that matter are the ones that aren’t going up, I thought that it would be nice to construct an anti-core, anti-Fed CPI, stripping out the prices of the things that are going down, and that seem to have an inordinate amount of weight in the core CPI. And what might that be? You guessed it -- housing, aka shelter.

So here’s my version of the anti-core, anti-Fed CPI -- the CPI of everything except shelter. Using the BLS data, anti-Fed anti-Core was up 0.6% in February, 0.6% in January, and 0.2% in December. It was unchanged in November. Since the Fed started QE2 the rate was up 1.4%, or just over 4% annualized.

But does that tell the whole story? The Fed actually had the audacity to reveal in its January FOMC minutes that it felt that it was difficult to understand the transmission mechanisms of inflation in real time. That’s definitely true if you have your eyes closed, your hands over your ears, and you’re holding your breath in denial until you turn blue. That’s the Fed’s usual modus operandi.

It's actually not so hard to see or understand inflation in real time. In fact, MIT is actually doing it every day. MIT publishes a daily real-time on-line inflation index called the Billion Prices Project. It measures the prices of 550,000 items (OK, so it’s not a billion) in the US daily from online prices. Its index was up 0.57% in February, pretty close to what the CPI is telling us the headline rate was. And here’s the kicker: Through March 16 the index is up over 0.3%, so it continues to run at a 0.6% monthly pace. That annualizes to over 7%. Since the Fed began QE2, this index has risen by 1.77%, which also annualizes to over 7%.

www.minyanville.com/businessmarkets/articles/inflation-fed-bernanke-william-dudle-core/3/17/2011/id/33417

MIT Billion Prices Project Inflation Chart

The Fed ignores inflation because it refuses to accept responsibility for causing it. This denial means that something’s gotta give. If the Fed continues QE2 through June, this inflation will continue, and may even accelerate. Furthermore, it will have residual momentum. It may take on a life of its own even when and if the Fed does stop printing.

In the meantime, according to tax collections and other data that I track, the economy is stalling. That conclusion is supported by today’s weak industrial production data. So the Fed is now in a catch-22. If it stops the money printing, yes inflation may subsequently slow, but the illusion of economic growth will also be laid bare. If it doesn’t stop the money printing, inflation will continue to rocket upward, and the economy will be forced to contract due to the inability of customers to bear increasing costs, not to mention supply chain disruptions. So pick your poison.

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Gold Spot (FOREX:XAUUSDO)

1418.44 +7.42 (+0.53%)



REUTERS/JEFFERIES CRB INDEX (NYBOT:CR)

351.15 +2.48 (+0.69%)

==========================

POMO's back to bolstering stocks & inflation.

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Econ 202 Midterm 2
Multiple Choice. 2.5 points each.
1. Four bonds are issued today, offering the payments noted below. The market interest rates for bonds of
similar riskiness are as noted. Which should fetch the highest price in the bond market?
a. $100 per year for two years beginning two years from today. r = 10%
b. $100 per year for two years beginning two years from today, r = 20%.
c. $100 per year for two years beginning three years from today, r = 10%..
d. $50 in one year, $50 in two years, and $100 in three years. r = 10%.
2. If you deposit $100 of currency into a demand deposit at a bank, this action by itself
a. has an indeterminate effect on the money supply.
b. decreases the money supply.
c. does not change the money supply.
d. increases the money supply.
3. Which of the following could reduce the money multiplier?
a. the Fed increases the rate of interest it pays banks on their reserves.
b. the Fed decreases the required reserve ratio.
c. people decide hold less currency, and deposit more in their checking accounts.
d. banks decide to lend out more of their excess reserves.
4. When driving a car equipped with airbags, you might drive less carefully than you would if it did not have
airbags. This is an example of
a. moral hazard.
b. market risk.
c. risk aversion.
d. adverse selection.
5. The Fed can increase the money supply by conducting open market
a. sales and raising the discount rate.
b. purchases and raising the discount rate.
c. sales and lowering the discount rate.
d. purchases and lowering the discount rate.
6. In the language of macroeconomics, the word “investment” refers to
a. the purchase of stocks, bonds, or mutual funds.
b. saving.
c. the purchase of new capital equipment and buildings.
d. All of the above are correct.
7. UPS Corporation develops a way to speed up its deliveries and reduce its costs. This would probably
a. raise the demand for existing shares of UPS stock, causing the price to rise.
b. raise the supply of the existing shares of UPS stock, causing the price to fall.
c. raise the supply of the existing shares of UPS stock, causing the price to rise.
d. decrease the demand for existing shares of UPS stock, causing the price to fall.
Econ202 Exam 2, Spring 2011 Douglas
2
8. An assistant manager at a restaurant gets a $100 a month raise. He figures that even with his new monthly
salary he cannot buy as many goods and services as he could buy last year.
a. His real and nominal salary have risen.
b. His real salary has risen and his nominal salary has fallen.
c. His real and nominal salary have fallen.
d. His real salary has fallen and his nominal salary has risen.
9. Suppose that in a closed economy GDP is equal to 15,000, Taxes are equal to 5000, Consumption equals
7500, and Government purchases equal 5000. What is national saving?
a. 2500
b. -2500
c. 7500
d. 0
10. Other things the same, an increase in velocity means that
a. the rate at which money changes hands falls, so the price level falls.
b. the rate at which money changes hands rises, so the price level rises.
c. the rate at which money changes hands falls, so the price level rises.
d. the rate at which money changes hands rises, so the price level falls.
11. What kind(s) of risk can diversification reduce?
a. Both market and firm-specific risk.
b. Only market (“aggregate” or “systematic”) risk.
c. Only firm-specific (“idiosyncratic”) risk.
d. Neither market or firm-specific risk.
Table 29-5
Bank of Springfield
Assets Liabilities
Reserves $12,000 Deposits $200,000
Loans $188,000
12. Refer to Table 29-5. If the required reserve ratio is 5%, what is the largest amount that the Bank of
Springfield can lend from its current reserves?
a. $10,000
b. $200,000
c. $12,000
d. $2000
13. Interest rates and investment rise. Based on the model we studied of the Loanable Funds market, which of the
following could explain these changes?
a. the government replaces the income tax with a consumption tax
b. the government runs a larger deficit
c. the government institutes an investment tax credit
d. None of the above is correct.
14. The supply of loanable funds slopes
a. upward because an increase in the interest rate induces people to save more.
b. upward because an increase in the interest rate induces people to invest more.
c. downward because an increase in the interest rate induces people to invest less.
d. downward because an increase in the interest rate induces people to save less.
Econ202 Exam 2, Spring 2011 Douglas
3
15. Which of the following events would cause the price of lawnmowers to rise?
a. Increased gasoline and land prices cause people to leave suburbia and move into
apartments.
b. The price of fertilizer rises.
c. The cost of steel used in lawn mower blades increases.
d. Scientists develop a new strain of grass that stops growing when it is 3 inches tall.
16. If people had been expecting prices to rise but in fact prices fell, then who would benefit?
a. neither lenders nor people holding a lot of currency
b. lenders but not people holding a lot of currency
c. lenders and people holding a lot of currency
d. people holding a lot of currency but not lenders
17. When a bank loans out $1,000, the money supply
a. increases.
b. decreases.
c. does not change.
d. may do any of the above.
18. After Anna finishes high school she starts looking for her first job. As a result, the unemployment rate
a. decreases, and the labor-force participation rate decreases.
b. is unaffected, and the labor-force participation rate increases.
c. increases, and the labor-force participation rate is unaffected.
d. increases, and the labor-force participation rate increases.
19. Suppose the Fed requires banks to hold 10% of their deposits as reserves. The Fed buys a Treasury bond from
a bank for $9,000. How much could this action by the Fed eventually change the money supply?
a. $90,000
b. $9000
c. $900
d. -$90,000
20. What will happen to the equilibrium price and quantity of cellphones if the price of land-line phones (a
substitute) rises, and a new technology is developed for producing cellphones?
a. Quantity will rise and the effect on price is ambiguous.
b. Price will rise and the effect on quantity is ambiguous.
c. Price will fall and the effect on quantity is ambiguous.
d. Quantity will fall and the effect on price is ambiguous.
21. Which of the following is correct?
a. Risk-averse people will take a risk if they are compensated for it.
b. Risk-averse people will not hold stock.
c. Stock prices are determined by fundamental analysis rather than supply and demand.
d. Diversification cannot reduce firm-specific risk.
22. Which of the following is not a prediction of the efficient market hypothesis?
a. Stock prices will follow a random walk.
b. There is no point in studying the business pages looking for undervalued stocks.
c. Index funds will typically outperform highly managed funds because their fees are lower.
d. Technical analysis can be used to identify stocks whose price is likely to rise.
23. The primary advantage of mutual funds is that they
a. provide customers with a medium of exchange.
b. always make a return that "beats the market."
c. allow people with small amounts of money to diversify.
d. All of the above are correct.
Econ202 Exam 2, Spring 2011 Douglas
4
24. You get money for babysitting the neighbors' children. This best illustrates which function of money?
a. medium of exchange
b. unit of account
c. store of value
d. liquidity
25. Which of the following is included in both M1 and M2?
a. demand deposits (checking account balances)
b. money market mutual funds
c. savings deposits
d. small time deposits
26. Megasoft wants to purchase new equipment for developing a new software program, but they don’t have
sufficient internal funds. Megasoft will likely
a. supply loanable funds by selling bonds.
b. demand loanable funds by selling bonds.
c. supply loanable funds by buying bonds.
d. demand loanable funds by buying bonds.
Figure 30-2. 1/P
M
27. Refer to Figure 30-2. Suppose the relevant money-demand curve is the one labeled MD1; also suppose the
economy’s real GDP is 30,000 for the year. If the money market is in equilibrium, what is velocity?
a. 4
b. 8
c. 6
d. 12
28. The inflation rate is calculated
a. by determining the percentage increase in the price index from the preceding period.
b. by computing a simple average of the price increases for all goods and services.
c. using the national income accounts.
d. by adding up the price increases of all goods and services.
Econ202 Exam 2, Spring 2011 Douglas
5
Short Answer Question. 30% total. Answer in the space provided.
29. Since the financial crisis of September 2008, the Federal Reserve has purchased about $1 trillion worth of bonds from
banks, paying for them by crediting the banks’ reserve accounts at the Fed. This action more than doubled (circle all
that are correct: a. M2, b. MONETARY BASE, c. EXCESS RESERVES). Explain briefly, in the space provided below,
why this action would normally be expected to more than double the money supply.
In fact, since 2008 the money supply has grown by only 20%, or about 5.5% per year. Explain how banks’ reserves can
grow by so much while the money supply has grown relatively little (perhaps using information discussed in class and in
the assigned reading by James Hamilton).
Since late 2008, which of its four tools (discussed in class) has the Federal Reserve used to help prevent the money
supply from growing faster despite the increase in reserves?
The money supply has grown by 5.5% per year since 2008. Real GDP growth has been about zero over the same period.
By the quantity equation MV = PY and the classical theory of inflation, one would expect the inflation rate to be about
____% over the period. Explain your answer in terms of money neutrality. ALSO illustrate it with a curve shift on
the money supply and demand diagram (be sure to label the vertical axis and all equilibrium prices and
quantities; just get the direction of the shift right, don’t worry about making the curve shift and price change to scale).
OVER
Econ202 Exam 2, Spring 2011 Douglas
6
The inflation rate over the last three years has been about 1% per year. In terms of the quantity equation, the variable
____ must have (INCREASED, DECREASED) in order for the inflation rate to have been about 1% when the money
supply increased 5.5% with constant real GDP. The change in this fourth variable would correspond to a
RIGHTWARD, LEFTWARD shift of the MS, MD curve. Show the curve shift, labelling the vertical axis and all
equilibrium prices and quantities. .
ID: A
1
Econ 202 Midterm 2
Answer Section
MULTIPLE CHOICE
1. ANS: D MSC: Definitional
2. ANS: C MSC: Applicative
3. ANS: A MSC: Definitional
4. ANS: A MSC: Interpretive
5. ANS: D MSC: Definitional
6. ANS: C MSC: Definitional
7. ANS: A MSC: Analytical
8. ANS: D MSC: Interpretive
9. ANS: A MSC: Applicative
10. ANS: B MSC: Analytical
11. ANS: C MSC: Definitional
12. ANS: D MSC: Analytical
13. ANS: C MSC: Analytical
14. ANS: A MSC: Definitional
15. ANS: C MSC: Applicative
16. ANS: C MSC: Definitional
17. ANS: A MSC: Definitional
18. ANS: D MSC: Applicative
19. ANS: A MSC: Applicative
20. ANS: A MSC: Analytical
21. ANS: A MSC: Definitional
22. ANS: D MSC: Interpretive
23. ANS: C MSC: Definitional
24. ANS: A MSC: Definitional
25. ANS: A MSC: Definitional
26. ANS: B MSC: Interpretive
27. ANS: D MSC: Applicative
28. ANS: A MSC: Definitional
ID: A
2
SHORT ANSWER
29. ANS:
Reserves are part of the monetary base. They are not part of the money supply (M2). Monetary base and excess
reserves more than doubled; M2 did not.
We would expect the money supply to more than double because reserves support the money supply (i.e., banks create
money by lending out excess reserves) and excess reserves have more than doubled.
Bank reserves have grown much faster than the money supply because banks have been unwilling or unable to lend out
their excess reserves.
The Fed has paid interest on reserves to discourage banks from lending out excess reserves.
We would expect a 5.5% inflation rate (5.5% change in P), as MV = PY, M is increasing, Y is constant, and the real
variable V should not be affected by a change in M due to money neutrality.
The graph should show a rightward shift in the MS curve, causing 1/P to fall (i.e., P to rise).
The variable V must have DECREASED. This would show up as a RIGHTWARD shift of the MD curve, which would
cause equilibrium 1/P to rise (i.e., P will fall).

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Is the Treasury undermining QE?
Mar 18th 2011, 15:56 by G.I. | WASHINGTON

.QUANTITATIVE easing suffers its fair share of controversy, but not over this aspect: whether you like it or not, it’s the central bank’s job and no one else’s. I’ve just read a paper that suggests otherwise: done right, the Treasury could achieve the same thing through debt-management policy. Better yet, the Treasury and Fed working together should be able to multiply the impact of QE.

The new paper by Eric Swanson of the San Francisco Fed re-evaluates an early attempt at QE. In the early 1960s, the Treasury and Federal Reserve embarked on Operation Twist, under which the Fed would buy up long-term bonds in an effort to nudge down their yields. To finance those purchases, it, and Treasury, would sell short-term Treasury bills.

Operation Twist has long been considered a failure. Research in particular by Franco Modigliani and Richard Sutch found very little impact on long-term yields. This helped reinforce the orthodox academic view that efforts to influence security prices by altering their supply were doomed to failure. By this argument, bond yields were determined by investors’ expectations of inflation, growth, fiscal and monetary policy. You could withdraw every dollar of Treasury debt from circulation if necessary and the yield on the last remaining dollar wouldn’t change. This was one reason why so much scepticism greeted the Federal Reserve’s latest round of QE.

Mr Swanson has re-examined the historical record and concluded that the early analysis was wrong: it examined yields at overly wide intervals, thus failing to isolate the impact of Operation Twist from other influences. Mr Swanson looked at bond-market responses within days of news on Operation Twist, and concluded that it lowered long-term bond yields by 15 basis points—the macroeconomic equivalent, he said, of lowering the federal funds rate by 100 basis points.

With Operation Twist only the maturity, not the amount, of outstanding Treasury debt changed. By contrast, with QE the amount of publicly held debt actually shrank. This, Mr Swanson argues, is a technical distinction: it does not matter whether the bond purchases are financed by Treasury issuing short-term bills or by the Fed creating bank reserves. I’m not sure I agree; newly created bank reserves would not crowd other investments out of investor portfolios, and are not seen as liabilities of the federal government even if they technically are.

But let’s say Mr Swanson is right and that it doesn’t matter whether bond purchases are financed by issuing Treasury bills or by printing money. If so, then everything the Fed is now doing could be accomplished by Treasury simply altering the structure of the debt by halting bond issuance and financing the entire federal deficit by issuing Treasury bills. When the deficit skyrocketed at the onset of crisis and recession, Treasury financed it by issuing bills since it does not like to alter its bond auction schedule. As a result, the average maturity of its debt plummeted. It has, in the last year, been trying to rectify this by upping issuance of long-term bonds, and the average maturity of the debt has been rising.

Lou Crandall of Wrightson, my go-to man on these matters, tells me that since QE2 began on November 12, the Fed has bought $440 billion of Treasury notes and bonds. Since November 1, however, Treasury’s total issuance of such paper has been $533 billion, so the public’s holdings of long-term debt have on net risen. Mr Swanson’s findings suggest that Treasury’s debt managers are working at cross purposes to QE.

When I put this to Mr Crandall, his response was: “[T]hank God they are. The worst thing they could do would be to further undermine confidence by allowing their rollover risk to rise. Showing a commitment to prudent finance is part of what you need to do if you are going to run a deficit of 10% of GDP.” Rollover risk refers to the threat that a spike in interest rates would sharply elevate debt-service costs as short-term debt matured, or worse, that the government could be locked out of the markets (Greek style) if no buyers showed up.

But I suspect this is a narrow view. The rollover risk the Treasury sheds by issuing more long-term bonds is absorbed by the Fed as it buys those bonds. Should short-term rates rise suddenly, the Fed will absorb market losses on its bond holdings, and future interest income (which it repays to Treasury as seigniorage) will be lower since it will have fewer maturing short-term holdings to reinvest at higher rates. Moreover, the presence of the Fed as the buyer of last resort of Treasury debt makes a Greek-style lock-out of financial markets pretty unlikely. The best argument in favour of keeping Treasury out of the QE business is that it avoids commingling the responsibilities of the fiscal and monetary authorities. On the other hand, that didn’t seem to bother anyone during Operation Twist.

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www.mikeastrachan.com/2011/03/16/notes-on-quantitative-easing-2/

« QUANTITATIVE EASING 2 A Boost to the Economy or to Inflation
Notes on Quantitative Easing 2

1. Now that Treasury deposits at the Fed have fallen closer to normal levels it is easier to see the effect of Quantitative Easing 2. As can be seen from charts 1&2, practically all the funds injected by the Fed through its purchases of treasury securities ended up in the banks’ excess reserves, i.e. reserves not needed to make loans. There is no surprise there. Excess bank reserves before the operation started were about a $ trillion so the availability of reserves did not pose an effective limit on growth of bank loans.


Chart 1: Quantitative Easing 2


Chart 2: Quantitative Easing 2

2. One unstated objective of Quantitative Easing 2 was achieved in February. The real trade weighted value of the $US declined to a new low (chart 3). No surprise there either. There were strenuous objections to this operation from around the globe and particularly from countries exporting to the US and those holding large amounts of dollars as foreign reserves. China in particular apparently stopped accumulating dollars some time ago. There may be harsh implications for this debasement of the dollar – - including loss of confidence in it as a reserve currency – - but for now, it helps in improving the US balance of trade and reducing the real value of US debt.


Chart 3: Quantitative Easing 2
3. Recently the Fed announced a policy target of raising core inflation from about 1% closer to its presumed target of 2%. I proposed a similar policy a couple of years ago in order to ease the down pressure in the housing market. Now, however, maybe a bad time for such a policy. With headline inflation already running high and assuming that by time this policy starts showing results China will be accelerating again – - it has already started easing monetary policy – - and Japan will be pouring money for reconstruction, there is a substantial risk of a further sharp rise in inflation expectations.
In testimony in Congress, Bernanke said he is 100% confident that he could stop the rise of inflation when this is deemed desirable. This would be a reasonable assessment under normal circumstances. All that would be needed is to raise short-term rates high enough. That would be accomplished by the Fed absorbing enough reserves – - via the sale of treasury securities – - to set the market price of reserves (the Federal Funds rate) at the desired level.
In the present situation, however, this would be impossible. The Fed would probably have to sell over a trillion dollars worth of intermediate and long-term treasuries (or MBSs it bought in the Quantitative Easing 1) to mop up excess reserves, before the federal funds rate started to move up. Doing so at a time when the treasury is selling large quantities of securities to finance the budget deficit would crack the bond market. Alternatively, the Fed could raise reserve requirements but here too size would be a problem. Finally the Fed may pay interest on reserves held at the Fed at the rate it wants to set as a floor to the Federal funds rate. This, of course, would be a cost to the taxpayer. Also, it would not reduce the amount of excess reserves and would not set an effective limit on the growth of bank loans and of the money supply. Thus, the effectiveness of such a rate increase in curbing inflation is doubtful.
All in all, there is no easy exit strategy from quantitative easing and the problem is still growing.

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Will the Japanese sell off their foreign assets to finance their own post-earthquake reconstruction? If they do so, will they sell off foreign currencies and buy back yen, which will make the yen stronger?

On Oct 15, 2010, Pimco, the world's largest bond fund manager, with probably US$1 trillion under management, announced that their Total Return Bond fund was cutting their holdings in US Treasuries as a result of quantitative easing. Most retail investors probably did not notice that announcement.

But on March 9 this year, the head of Pimco, Bill Gross, announced that at the end of February 2011, the fund had sold off all its US Treasuries and agency debt. To me, that is as significant as a tsunami in financial markets.

I did not fully digest the significance of that event because I was travelling from Washington DC to Bali. But after I downloaded Gross' comments, available at www.pimco.com, I began to understand his thinking. He showed a fascinating chart on who was and will be holding US Treasuries. In the past, the Federal Reserve only held 10%, foreigners 50% and US institutions and individuals held 40%. Since the beginning of QE2, the Fed has been buying 70% and foreigners are buying 30%, while US institutions are staying on the sidelines.

So why are US funds like Pimco not buying? Part of the reason is that “Treasury yields are perhaps 150 basis points or 1.5% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%.”

In other words, the US dollar is violating the second of the three pillars which give it the most-favoured-currency status, according to Barry Eichengreen, professor at University of California at Berkeley, who has a great understanding of the special role of the US dollar from the span of economic history.

On March 2, 2011, Prof Eichengreen wrote an article in the Wall Street Journal arguingL: “Why the Dollar's Reign is Near an End”. The three pillars are firstly, the depth of US dollar-denominated debt securities, secondly, the dollar is the world's safe haven, and thirdly, the dollar benefits from a dearth of alternatives.

Currently, 42.5% of global foreign exchange transactions are conducted in US dollars, compared with 19.5% for the euro, 8.5% for the yen and 6.4% for sterling. This is because commodities like oil and gold are priced in dollars. Moreover, a large chunk of foreign exchange reserves are held in US dollars, the largest being Asian and Opec central banks and sovereign wealth funds.

The preliminary report on foreign holdings of US securities as at the end of June 2010 was published at the end of February 2011 by the US Treasury. Foreign holdings increased US$1 trillion from a year ago to US$10.7 trillion, of which US$2.8 trillion was in equities and the balance in debt securities. Out of the US$10.7 trillion, China held US$1.6 trillion (15%), Japan US$1.393 trillion (13%) and Middle East oil producers US$350bil. So, the real fear of Bill Gross is the question: “Who will buy Treasuries when the Fed doesn't?”

More important, what happens if the foreigners decide like Pimco not to buy any more Treasuries, especially when they decide to bring their money home for their own domestic purposes?

Consequently, we are even closer to the edge of higher currency volatility than what the market is telling us. One of the big lessons of the recent past is that the price of money and risk spreads (and credit rating agencies) have not warned investors of the inherent risks in financial securities.

With QE2 and near-zero interest rates in the major reserve currencies, the spreads simply do not reflect the inherent risks that I have outlined above. This means that sooner or later there will be a spike in the price, or a sharp fall in value, if history is any lesson to go by.

Indeed, I have argued that even though the Dow Jones Industrial Average has doubled since the beginning of QE2 in 2008, if you deflate the index by the price of gold, the equity market has crashed already.

I would be the first one to hope that the current economic recovery in the United States and Europe will be sustainable. I strongly hope that Japan will recover quickly from this sudden shock and tragedy. But I would not be responsible if I did not think that the financial markets are once again not reflecting the risks out there. Just like Bill Gross, it is legitimate to ask “whether Quantitative Easing policies actually heal, as opposed to cover up, symptoms of an unhealthy economy.”


Andrew Sheng is the author of the book “From Asian to Global Financial Crisis”.

biz.thestar.com.my/news/story.asp?file=/2011/3/19/business/8291469&sec=business

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quotes.ino.com/chart/?s=NYBOT_DX

U.S. dollar index closed @ 75.572 -0.469 (-0.60%)

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Dollar to reverse this week?

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With Fed Consent, Banks Raise Dividends and Buy Back Stock
By ERIC DASH
10:35 a.m., March 19 | Updated

For long-suffering bank investors, the wait is over.

After securing the Federal Reserve’s blessing, a series of financial giants rushed to raise their dividends and buy back stock on Friday, underscoring how Wall Street profits and an improving economy have helped the biggest banks stage a broad recovery since they were laid low by the financial crisis.

Within hours of being told by regulators they had passed a second round of stress tests, JPMorgan Chase, Wells Fargo and several other major lenders laid out specific plans. Meanwhile, American Express and Goldman Sachs announced they were resuming large-scale stock repurchases, with Goldman buying back the $5 billion stake it sold to Warren E. Buffett in the fall of 2008.

Other institutions, like Capital One, PNC Financial and Bank of New York Mellon, took a more cautious stance, putting off for now plans to restore dividends to anywhere near the levels that prevailed just three years ago. Regions Financial did not even bother to submit a dividend request to the Fed — it has not fully paid back its bailout funds.

Still, the news caused bank shares to rally, helping lift the overall market. The KBW Index, a popular measure of financial stocks, rose about 1 percent on Friday. Shares of JPMorgan climbed 2.65 percent, to $45.74. Wells Fargo shares rose to $31.83, a 1.5 percent increase.

“It signals the banking industry is back on its feet,” said Jason Goldberg, an analyst at Barclays Capital. “Once out of the penalty box, we look for the dividend payout ratios and earnings to grow over time.”

Since the beginning of January, the Fed has put the nation’s 19 biggest lenders through an extensive review of their financial soundness, in an effort to determine whether they were strong enough to start returning capital to shareholders. Regulators tested the ability of the banks to cope with a range of economic shocks, including the possibility of a 1 percent decline in gross domestic product and unemployment of 11 percent this year. They also built in an assumption that housing prices would fall an additional 10 percent.

Still, some bank analysts doubted whether the stress tests were all that stressful. “Although they still have the economy in a recession in 2011, they have home prices down an additional 10 percent,” noted Frederick E. Cannon, the chief equity strategist at Keefe, Bruyette & Woods. “A lot of people are already expecting that in the current environment.”

In any case, Friday’s results did not mark the end of stress tests; in fact, they are only the beginning. The Fed plans to make the kind of review that was just completed an annual event. In addition, as part of the financial regulatory reform bill passed by Congress last summer, the Fed is also preparing yet another battery of stress tests that would evaluate the ability of the biggest lenders to handle losses if the economy turned south....


dealbook.nytimes.com/2011/03/18/fed-to-release-results-of-bank-stress-tests/

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Transactions Velocity of money (money actually exchanging hands)

The Fed calculates these velocity figures by dividing the aggregate volume of debits of these banks against their demand deposits:

1974-Oct. ,,,,,,, 77
1974-Nov. ,,,,,,, 70
1974-Dec. ,,,,,,, 75
1975-Jan. ,,,,,,, 75
1975-Feb. ,,,,,,, 67
1975-Mar. ,,,,,,, 72
1975-Apr. ,,,,,,, 75
1975-May ,,,,,,, 73
1975-June ,,,,,,, 73
1975-July ,,,,,,, 75
1975-Aug. ,,,,,,, 72
1975-Sep. ,,,,,,, 73

Income Velocity (the contrived figure)

1974-07-01 5.604
1974-10-01 5.680
1975-01-01 5.705
1975-04-01 5.747
1975-07-01 5.843
1975-10-01 5.984

"Velocity is a ratio of nominal GDP to a measure of the money supply. It can be thought of as the rate of turnover in the money supply--that is, the number of times one dollar is used to purchase final goods and services included in GDP."

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One example of Milton Friedman's income velocity moving in the opposite direction of the transactions velocity of money (an actual figure).

There is no monetary metric with a higher correlation coefficient to nominal gDp than money flows (our means-of-payment money X's its TRANSACTIONS rate-of-turnover).

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Rents Could Rise 10% in Some Cities
By Les Christie, CNNMoney.com
Mar 16, 2011 Provided by: Renters beware: Double-digit rent hikes may be coming soon.

Already, rental vacancy rates have dipped below the 10% mark, where they had been lodged for most of the past three years.

"The demand for rental housing has already started to increase," said Peggy Alford, president of Rent.com. "Young people are starting to get rid of their roommates and move out of their parent's basements."

By 2012, she predicts the vacancy rate will hover at a mere 5%. And with fewer units on the market, prices will explode.

Rent hikes have averaged less than 1% a year over the past decade, according to Commerce Department statistics, adjusted for inflation. Now, Alford expects rents to spike 7% or so in each of the next two years -- to a national average that will top $800 per month.

In the hottest rental markets, the increases will likely top the 10% mark annually for the next couple of years. In San Diego, Alford anticipates rents will rise more than 31% by 2015. In Seattle rents will climb 29% over that period; and in Boston, they may jump between 25% and 30%.

With fewer home buyers on the market, rents are rising sharply
Chart: Census Dept. and Rent.com

realestate.yahoo.com/promo/rents-could-rise-10-in-some-cities.html

This is a sharp change from the recession, when many Americans couldn't afford to live on their own. More than 1.2 million young adults moved back in with their parents from 2005 to 2010, said Lesley Deutch of John Burns Real Estate Consulting. Many others doubled up together.

As a result, landlords had to reduce prices and offer big incentives to snag renters.

Now that the recession is easing, many of these young people are ready to find new digs, mostly as renters, not owners. Plus, the foreclosure crisis continues unabated, and the millions losing their homes are looking for new places to live.

Apartment developers many not be able to keep up with this heightened demand, which will force prices upwards, according to Chris Macke, a real estate analyst with CoStar, which tracks multi-family housing trends.

"There will be an envelope of two or three years," said Macke, "when the rise in demand for rentals will exceed the industry's ability to meet it."

Plus, Alford added, "there's been a shift in the American Dream. We're learning from our surveys that a huge proportion of people are choosing to rent."

They've experienced the downsides of homeownership -- or seen friends and family suffer -- and don't want to take the risks or pay the higher costs of homeownership.

Where homeownership costs are particularly high, there are many more renters than owners. In Manhattan, for example, only about 20% own their homes; in San Francisco, about of third of the population does; in Los Angeles, less than 40%; and in Chicago, about 44%.

There's one factor that could rein in rent increases: the huge number of foreclosed homes that could hit the market over the next few years.

In many markets, like Phoenix and Las Vegas, there are neighborhoods filled with recently built, single-family homes going for fire-sale prices. When the cost of owning homes falls well below the costs of renting them, more people will buy.

"That's always been the biggest competition for rentals," said Deutch.