Fed Watch Thread

[flow5]

Last week's GDP miss is now long-forgotten, as not only that but the Egyptian revolution has been priced into daily POMO and $195 billion worth of incremental liquidity from the SFP program unwind.Today, David Rosenberg ignores all the noise comprising the number which lately is almost as credible as the goal-seeked data coming out of China (not to mention seasonally and weather adjusted) and instead looks at the big picture, namely how much debt is required to purchase not only the actual incremental growth, but a trendline 7.3% quarterly annualized GDP growth in a normal recovery.

The math works out as follows: the US Economy should be adding $42 billion a month. It is at roughly half of this. But in the meantime, it is also adding $125 billion of debt per month (and soon much more). In other words, the US economy now takes $6 of debt to generate $1 of GDP growth (and would require $3 if it was growin in a normal fashion).

A COUPLE OF PROBLEMS WITH Q4 U.S. GDP

The temptation, of course, is to look at the huge growth rate in final sales and the drop-off in the inventory line as a reason to boost first-quarter GDP estimates. Here’s why it may be important to resist that temptation:

First, Q3 saw a massive boost to GDP on the inventory line, so the Q4 reversal has to be seen in that light — it is quite possibly that Chinese firms rushed to catch the export rebates that ended in June.

So, an alternative take on Q4 that has been put in front of us is that part of the ‘surge’ in retail spending was due to retailers realising they had over-ordered last winter/spring, when everyone thought the economy was on a V-shaped recovery, and thus ended up slashing prices to get rid of the excess (which also helps explain the lack of any growth in the price deflators). This would also explain why there hasn’t been much follow-through since Thanksgiving, which was clearly their best chance to rebalance their stockpiles.

Second, the question must be addressed as to how the GDP deflator slowed from 2.03% annualized in Q3 to 0.26% in Q4.

Indeed, the key point here is that nominal GDP was up only at a 3.4% annual rate. What is normal for the sixth quarter of post-recession recovery historically? Try 7.3%.

As a loyal reader pointed out to us, this comes to $42 billion per month when we are adding federal debt at a monthly rate of $125 billion. How long can this arithmetic of federal debt rising at triple the pace of nominal income growth remains stable is truly anyone’s guess.

We challenge the optimists to explain how this is sustainable.

[scaredshirtless]

I'm familiar with the $6 of debt = $1 of GDP growth in recent computations. The numbers don't lie. Never mind we aren't seeing a "multiplier" effect. Instead we see international "leakage".

So... Tell me again - why is all this debt a good thing? How's this going to "fix" things?

[maui1]

the fed hurts the american people. it is the money control proxy of the gov't and is a 'end run' around the american constitution.

the fed must go. a free market system, though not always perfect, is the best overall way to manage our economy.

[flow5]

JOHN WILLIAMS’ SHADOW GOVERNMENT STATISTICS

Reporting Focus: January Employment and Benchmark Revision
February 5, 2010

__________

1.36 Million Jobs Knocked off December Payrolls
Depression’s Job Loss Increased by 19%
January Unemployment: 16.5% (U-6), 21.2% (SGS)

Serious Jobs and Unemployment Deterioration
In Months Ahead

www.shadowstats.com/article/276-employment-2009-benchmark-revision

[usaone]

Fed isnt going any where. I dont agree with everything they do but if you look at how many depressions we had Pre-Fed and Post-Fed its an eye opener.

[usaone]

The 1800's were a mess economically in this country. One boom-bust cycle after the next.

Deregulation is the problem.

[flow5]

Economics One
A Blog by John B. Taylor

Saturday, February 5, 2011
The Monetary Reform Debate is Joined
The Atlanta Fed, through its “macroblog,” has joined the discussion about reform of the Federal Reserve. It’s a good discussion to have. David Altig, Senior Vice President of the Federal Reserve Bank of Atlanta and main blogger, wrote the latest entry on my Wall Street Journal article of last week which offered proposals to return to sound fiscal and sound monetary policy. Macroblog has no quarrel with the proposals for sound fiscal policy but, as in past posts, disagrees with the analysis of monetary policy.

The latest macroblog entry starts by appealing to a paper from New Zealand which shows that an “estimated” Taylor rule indicates that interest rates were not too low for too long in 2003-05 as I have argued. But the “estimated” policy rule in that paper doesn’t looks anything like what I proposed and given that there are already scores of existing models I fail to see the advantages of another model from New Zealand. For example, at the Federal Reserve Bank of Kansas City, George Kahn shows that deviations from a policy rule were a major reason for the housing price boom and bust. A chart from his paper which I copy below shows clearly that policy without the Taylor Rule deviation (TRDEV1) would have avoided the boom and bust.

johnbtaylorsblog.blogspot.com/2011/02/monetary-reform-debate-is-joined.html

The Atlanta Fed’s macroblog post also argues that the Fed has already laid out an exit strategy for reducing its balance sheet, and it gives a link to minutes of the FOMC with a list of tools. However, as I explained in testimony to Congress last year, a list of tools is not a strategy. A strategy is a path or contingency plan for the balance sheet over time. I gave an example in the tesimony. If it is good to lay out a path to reduce the federal debt as a share of GDP, then why not lay out a contingency path to reduce the Fed’s balance sheet?

Regarding my proposals to restore the Fed’s reporting and accountability requirements removed in 2000, I think macroblog post’s reference to Ben Bernanke’s speech at the American Economic Association last January supports my point rather than refutes it. If there had been such reporting requirements in place in 2003-05, then the Fed would have been required to report the strategy at the time in Congress, not 7 years later at the AEA. Also if you look back at the FOMC transcripts at the time you will see that the Fed was intentionally holding rates extra low for an “extended period” and only increasing them at “measured pace,” which does not seem consistent with policy as usual. In my view if the Fed had laid out its strategy at the time, then there would have been a more informed public discussion.

Then there is the question of the Fed’s multiple mandate. The record shows that explicit mention of the term “maximum employment” entered the FOMC Statement for the first time only last fall, after more than thirty years of no such mention since the mandate was put into legislation way back in 1977. So the connection between the mandate and QE2 seems most evident based on the record. In my view, the rate of inflation and the level of GDP last year justified an interest rate near zero, but not QE2. The Atlanta Fed macroblog post argues that QE2 was effective. But any connection between QE2 and its purported effects is tenuous when long-term Treasury securities, which the Fed has been purchasing, have declined in price, gone in the wrong direction.

The recent post by David Altig ends by referring to the Financial Crisis Inquiry Commission, which seems to have chosen a “perfect storm” explanation of the crisis where everyone shares some blame. In that report, the Fed shares blame, but mainly because of a failure to enforce existing regulations. The debate over interest rates seems to have ended in a draw in the Commission with short reviews of arguments made by Ben Bernanke, Alan Greenspan, and me. The conclusion of the minority that U.S. monetary policy may have contributed to the credit bubble is about as far as one could expect from such a commission and should be enough incentive to look for policy reforms to improve monetary policy in the future.

[flow5]

From Brian Rogers of Fator Securities

www.investingcontrarian.com/index.php/financial-news-network/fator-securities-market-commentary-go-all-in-on-bernankes-weak-qe3-hand/

QE3, coming to a market near you

QE2 succesful?

To have more QE or to not have more QE, that is the question.? With apologies to the Bard, that is generically the question all investors are asking regardless of the asset class(es) they trade.? Whether or not QE2 is behind the recent bout of food price inflation that is making its way around the globe is debatable.? What isn’t debatable is that since Federal Reserve Chairman Ben Bernanke announced his intention to launch QE2 at Jackson Hole, WY on August 27th, 2010, asset markets? have rallied in impressive fashion.?

All asset markets that is except US Treasury debt which has seen yields widen significantly, for example 10yr Treasury yields have widened from 2.644% on 8/27/10 to 3.637% today, almost 100 bps.? Since the current low coupon on the 10yr is pushing out the duration of these bonds to around 8.5yrs, investors in US Treasury 10yrs have taken unleveraged losses of almost 8.5% over the last 5 months.? This is a disaster in the normally staid world of Treasury investing.? The story is even worse in the 30yr bucket where bonds have widened from 3.689% in late August to 4.727% today.? With the longer duration of about 16.5yrs, 30yr Treasury bond investors have taken quite a beating since Mr. Bernanke started buying bonds to support lower yields.? And now Tim Geithner’s Treasury is contemplating issuing 40, 50 and even 100yr bonds.? The notes of the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association says that, “…significant demand exists for high-quality, long-duration bonds from entities with longer-dated liabilities.”? (link here)? Good luck with that one!

However, if we suspend reality and pretend like the sell-off in Treasury bonds isn’t something to be quite worried about, other asset markets have posted extremely strong returns.? Stocks, corporate bonds and commodities have all rallied hard since late August 2010.? Much, if not all, of this price appreciation has been attributed to the “magic” of QE2 injecting billions of liquidity into the market.? The problem the Fed and Chairman Bernanke now face is that the so-called wealth effect of the rising stock market has been dependent on the existence of QE2 and removing that punch bowl could cause the party to end and reverse the gains, both economic and market, that we have seen in the last 5 months.

In addition to the reversal of the wealth effect, there are two other reasons why I think the Fed will be loathe to remove QE.? The first is the huge benefit (from the government’s perspective) of creating an inflation problem for China which will eventually force the Chinese to strengthen the Yuan.? Congress has been pressing for harsher measures to force the Chinese to strengthen the Yuan (link here) for years and QE2 is turning out to be exactly the kind of pressure that just might work.? I’ve long argued that this is a case of be careful what you wish for because the second the Chinese allow the Yuan to strengthen materially, the prices for everything that we buy from China (which is basically every single item on Walmart’s shelves) will rise an attendant amount.? Mr. Bernanke doesn’t see any inflation now but he certainly will when the Chinese begin sending it back to us via an appreciated Yuan.

The other reason why QE is going to be with us for a long time is the ongoing need to support the massive size of monthly Treasury issuance.? With the US expected to run a $1tr – $1.5tr deficit this year and another $2.5tr in maturing bonds to roll, there is very little chance that the US could continue to issue bonds at the current low rates without huge support from Mr. Bernanke’s POMO operations.? Our total new borrowing and refunding needs will be greater than $300bn per month which is simply astronomical.? Even bond investing legend Bill Gross is calling the US Treasury a ponzi scheme (link here).? If Bill Gross isn’t buying Treasuries who is?

Playing poker with the Fed

Anyone who has ever played Texas Hold’em poker knows that the secret to winning is not just playing your own cards well but understanding how others are playing theirs.? With this thought in mind, let’s consider the tells that the Fed has recently given.? First, Mr. Bernanke has said for some time now that the recovery that we are currently experiencing in the US is going to take a long time to build strength.? The job market is being particularly stubborn and some even argue that the “natural” rate of unemployment has risen (link here).? During his speech yesterday at the National Press Club, Mr. Bernanke had the following to say about the current economic situation we face,

“The economic recovery that began in the middle of 2009 appears to have strengthened in recent months, although, to date, growth has not been fast enough to bring about a significant improvement in the job market. The early phase of the recovery, in the second half of 2009 and in early 2010, was largely attributable to the stabilization of the financial system, the effects of expansionary monetary and fiscal policies, and a strong boost to production from businesses rebuilding their depleted inventories. But economic growth slowed significantly last spring as the impetus from inventory building and fiscal stimulus diminished and as Europe’s debt problems roiled global financial markets.” (link here)

?

And…

?

“While indicators of spending and production have, on balance, been encouraging, the job market has improved only slowly. Following the loss of about 8-1/2 million jobs in 2008 and 2009, private-sector employment showed gains in 2010. However, these gains were barely sufficient to accommodate the inflow of recent graduates and other new entrants to the labor force and, therefore, not enough to significantly reduce the overall unemployment rate.”

With this thinking in mind, that the challenges we face economically aren’t about to go away anytime soon, let’s take a look at what Fed hawk Thomas Hoenig had to say about QE2 recently, from Reuters,

The Federal Reserve could debate extending its bond-buying program beyond June if U.S. economic data proves weaker than expected, Kansas City Fed President Thomas Hoenig said.? Another round of bond buying “may get discussed” if the numbers look “disappointing,” Hoenig told Market News International in an interview published on Tuesday.? (link here)

If you blinked you may have missed it but the man at the Fed who has been famous for his hawkish stance on the Fed’s balance sheet expansion, Kansas City Fed President Thomas Hoenig, just admitted that if the data remained weak, the Fed would consider extending QE.? Then yesterday, Bernanke said that “economic growth slowed significantly last spring” and the recent gains in the job market are “barely sufficient to accommodate the inflow of recent graduates…”? In other words, we’re running to stand still.? To my mind, when you add this up, you end up with the Fed tipping their cards a bit and revealing their hand.? QE is here to stay.? Whether you call the next round QE2 lite or QE3 is irrelevant, the Bernanke put is here to say.

In other words, to put it back into poker terms, the Fed is playing as if they have a pair of aces, however, with economic and job growth slowing and long-term Treasury yields rising rapidly, the Fed is actually holding 2-7 off-suit (the worst hand in Texas Hold’em poker) and telling us as much.

How to play Ben Bernanke’s poker face
The bottom line, if I am right about QE continuing ad infinitum, is that hard assets like commodities and claims on hard assets like corporate bonds and stocks, will continue to surge confidently with the Bernanke put providing support.? This is not to say that stocks will go straight up and sovereign debt straight down, they certainly may reverse course over the short-run, but the trend is your friend and your new motto should be “Buy the dip.”? Mr. Bernanke does not bluff, he has spent his whole career studying the Great Depression and is convinced the situation was made worse by the Federal Reserve not supplying enough liquidity.? He is determined not to repeat the mistake this time around.

In Brazil, we would recommend the following names to take advantage of the 2-7 off-suit Mr. Bernanke is holding:

1.Petrobras (PETR3/4 and PBR) – Love it or hate it, oil is going up and PBR will benefit, don’t fight it.
2.Port concessionaires like Wilson, Sons (WSON11), Santos Brasil (STBP11) and Log-in (LOGN3) – Infrastructure spending, growth and pricing power make these names attractive.
3.AmBev (AMBV3/4 and ABV) – Rising salaries and low unemployment bode well for this beverage king.
4.Utilities Copel (CPLE6), Light (LIGT3) and Cemig (CMIG4 and CIG) – Defensives that will do well as emerging markets continue to underperform.
5.Telecom names like Vivo (VIVO3/4) and Telesp (TLPP4), Contax (CTAX3/4 and CTXNY).
6.Confab (CNFB3/4) as a good play on Petrobras capex which also has contracts which allow it pass along input price increases; very important during times of rising inflation.
7.Marcopolo (POMO4) – Great visibility for bus production going out for years in everything from school buses, urban buses or buses for Olympics/World Cup.
8.Valid (VLID3) – Leader in every market they participate in with strong barriers to entry
9.Localiza (RENT3) – Car rental firm with strong management and excellent growth prospects from rising economy and Olympics/World Cup.
Have a great weekend and go all-in on Bernanke’s weak hand!

[flow5]

Let Them Eat Cake
By Craig Pirrong Feb 5, 2011, 2:43 AM Author's Website

Fed Chairman Ben Bernanke’s flippancy in dealing with serious questions is becoming more and more disturbing. He responded to legitimate questions about the credibility of the Fed’s promises to cut back on its expansive policies if inflation appears to be picking up by saying that he could raise interest rates in five minutes, if need be. Procedurally, this is true, but substantively, this is a non-answer because it completely ignores the credibility issue: would the Fed have the political will to implement controversial rate hikes when the economy is still less than robust (as today’s employment report makes plain)?

But yesterday his flippancy soared to new levels (sort of like the monetary base and the Fed balance sheet). In response to questions about the effects of QE2 on inflation around the world–notably food price inflation that has helped spark unrest in Egypt and elsewhere–Bernanke was dismissive:

Answering questions after a speech at the National Press Club in Washington, Mr Bernanke said that rising food prices in the emerging world reflected the growing wealth of their populations and, in some countries, a failure to tackle inflation.

“They can, for example, use monetary policy of their own. They can adjust their exchange rates, which is something that they’ve been reluctant to do in some cases,” Mr Bernanke said.

Here’s more:

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries,” he said in answering a question from the audience. “It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Here’s an analogy. Neighbor Ben is lighting bonfires in his yard in a windstorm. He responds to your complaints that the flames and sparks from his fire have torched your bushes and threaten to set your house alight by saying: “You have all the tools you need to address the problem. You could buy a fire extinguisher. You could soak down the roof of your house. You could move.”

Food price spikes in particular have been fueled largely by supply shortages, but the boom in commodity prices is so widespread–from copper (now over $10K/tonne) to oil ($100+ for Brent), to cotton (leading to an extraordinary exchange intervention) that it is difficult to deny that expansive US monetary policy has something to do with it. I say again. Bernanke has justified QE2 by citing deflationary fears: when–ever–has a deflationary cycle been accompanied by spiking commodity prices? Usually commodity prices plunge the most. At least, this should be sparking some cognitive dissonance, a recognition that this isn’t your grandfather’s Depression–even if said Depression was the focus of your academic research. (Generals fighting the last war are very dangerous–to their own side.)

Bernanke is also rhetorically slippery. He says that “it is entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries.” That is a non sequitur. It is entirely possible–and indeed extremely plausible–that US monetary policy has a lot–a lot–to do with excess demand pressures in emerging markets. That’s the underlying shock: at least it’s one, big, undeniable shock. The channels of transmission are plainly evident. Whether countries have the policy tools to respond to that excess demand is an entirely different issue; whether they use them is another. The source of excess demand pressures and the response to it are completely distinct. Your failure to buy a fire extinguisher to defend yourself against Neighbor Ben’s pyromania does not mean that the pyromania is an illusion. It is illogical to claim that because countries have not responded to X the way Bernanke would prefer, X therefore does not exist. And QE2 is the big X factor.

Bernanke may have let the cat out of the bag and revealed an important–but not publicly emphasized–rationale for QE2 in his remark that countries “can adjust their exchange rates.” Namely, this suggests that QE2 is intended primarily to reduce the value of the dollar. To put pressure on countries–most notably China–to let their currencies rise relative to the dollar. By a lot. This is, in essence, a big game of chicken between Bernanke and policy makers around the globe–and most importantly, in Beijing.

Inflation is painful. Currency appreciation brings its own kinds of pain, in the short run, anyways. Countries are understandably–predictably–reluctant to let it happen. QE2 has put them between a rock and a hard place. And the choice is particularly discomfiting in China. The Chinese have their own rather deep concerns about the robustness of the economy and the potential for social unrest. Moreover, historical grievances and a current sense of ascendency make them particularly reluctant to knuckle under to the US. So the game of chicken is likely to continue, and end with a crash rather than a saving swerve by the Chinese.

But even if the game is between the US (and the Fed in particular) and China, the repercussions are global in scope. The collateral damage is already large, and threatens to spin out of control. We are in a Year of Living Dangerously, and despite Bernanke’s flat (but illogical) denials, a major source of that danger is US monetary policy.

[flow5]

February 5, 2011, 12:05 pm Soaring Food Prices -- KRUGMAN
What’s behind the surge in food prices? The usual suspects have made the usual claims — it’s all about the Fed, or it’s all about speculators. But I’ve been looking at the USDA World supply and demand estimates, and what stands out from the data is mainly that we’ve had a huge global harvest failure.

Here are some percentage changes in world grain production between 2008/2009 and 2010/2011, according to the USDA estimates:


USDA
Overall grain production is down — and it’s down substantially more when you take account of a growing world population. Wheat production (this time not per capita) is way down.

You might ask why a production shortfall of 5 percent leads to a doubling of prices. Part of the answer is that some kinds of demand are growing faster than population — in particular, China is becoming a growing importer of feed to meet the demand for meat. But the main point is that the demand for grain is highly price-inelastic: it takes big price rises to induce people to consume less, yet collectively that’s what they must do given the shortfall in production.

Why is production down? Most of the decline in world wheat production, and about half of the total decline in grain production, has taken place in the former Soviet Union — mainly Russia, Ukraine, and Kazakhstan. And we know what that’s about: an incredible, unprecedented heat wave.

Obligatory disclaimer: no one event can be definitively assigned to climate change, just as you can’t necessarily claim that any one of the fender-benders taking place right now in central New Jersey was caused by the sheet of black ice currently coating our roads. But it sure looks like climate change is a major culprit. And it’s not just the FSU: extreme weather elsewhere, which again is the sort of thing you should expect from climate change, has played a role in bad harvest around the world.

Back to the economics: if you want to know why we’re having a spike in food prices, the data suggest that the key cause is terrible weather leading to bad harvests, especially in the former Soviet Union.

Update: The USDA has estimates of price elasticities. For the United States, they put the price elasticity of demand for breads and cereals at 0.04 — that is, it would take a 25 percent rise in price to induce a 1 percent fall in consumption.

.

[flow5]

I follow these numbers because monetary lags never vary, & money flows currently "provide the best available single indicator" of business activity:

2010 jan ……. 0.13 ……. 0.538
….. feb ……. 0.056 ……. 0.507
….. mar ……. 0.072 ……. 0.558
….. apr ……. 0.056 ……. 0.552
….. may ……. 0.067 ……. 0.477
….. jun ……. 0.038 ……. 0.474
….. jul ……. 0.078 ……. 0.499
….. aug ……. 0.031 ……. 0.49
….. sep ……. 0.045 ……. 0.542
….. oct ……. -0.01 ……. 0.386
….. nov ……. 0.041 ……. 0.321
….. dec ……. 0.099 ……. 0.32
2011 jan ……. 0.079 ……. 0.144
….. feb ……. 0.091 ……. 0.232
….. mar ……. 0.13 ……. 0.321
….. apr ……. 0.1 ……. 0.232
….. may ……. 0.111 ……. 0.203

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

Short-term monetary flows (MVt) our means-of-payment money X's its transactions rate-of-turnover (the proxy for real output - 1st column of #'s), has turned up sharply. Money flows are going to approach, if not set, millenia records, in the 1st & 2nd qtrs of 2011.

Long-term monetary flows (the proxy for inflation - core cpi & housing prices-2nd column of #'s) has bottomed in JAN.

BONDS are TOAST.

[flow5]

By MARK GONGLOFF
The U.S. bond market has begun sending a message that inflation risks are rising and the Federal Reserve may be too slow to act, potentially marking a significant turning point in the economic recovery.

In the past week, Treasury-bond yields have jumped to their highest levels since last spring. Yields on 10-year Treasurys surpassed 3.5% and 30-year yields broke through 4.7%, which makes some worry could mean rates will march even higher.

Long-term rates have been gradually moving higher in response to an improving economy and rising commodity prices. But in recent days the increases in yields accelerated, a move many say is due to the worry that the Federal Reserve may be underestimating inflationary pressures in the economy, and may act too slowly to tame them. Inflation is bad for bondholders, eroding the value of their fixed returns and sending the prices of their bonds lower.

While raising alarm bells about inflation, the bond market is also indicating it sees no signs that the Fed will intervene. Short-term rates, which are most sensitive to Fed moves, have held relatively steady, causing the difference between two-year and 10-year notes to reach its steepest level since February 2010.

Such a steep "yield curve" is typically a bullish sign for the economy and the stock market. It could also, however, suggest that investors see a risk of overheating.

Even if they don't consider themselves bond-market "vigilantes"—the term for investors who try to change government policies by driving interest rates higher—the effect of their actions may still be the same.

Though most market watchers express faith that the Fed can still get ahead of the inflation pressures, the doubters are exacerbating a bond-market selloff.

"It seems to a lot of people that the Fed will be behind the curve and won't be ahead of inflation," said Ira Jersey, an interest-rate strategist at Credit Suisse. "We don't buy that, but future economic reality doesn't always have a significant impact on what happens in the market."

The yield on the 10-year Treasury note closed Friday at 3.647%, the highest since May 3.

That means the effects of last year's turmoil, which sent investors running to bonds and drove yields lower, have been erased. Bond yields and prices move inversely.

The yield on the 30-year Treasury bond ended Friday at 4.732%, its highest since last April. Adding to the almost-panicky feel in the bond market on Friday, traders circulated a chart of 30-year-bond yields showing that the yields had broken out of a 30-year trendline—a sign that the decades-long bull market in Treasurys may be drawing to a close.

Most in the market have suspected that the long bull market was likely over. Friday's move seemed to help confirm these suspicions.

The recent moves in many ways look like an echo of last spring, when yields rose as the economy started picking up steam, only to come sharply down amid the "flash crash" and European debt crisis. But there as some significant differences that indicate to some that this rise in yields may be the beginning of a longer trend.

The Fed isn't even halfway through the second round of its quantitative-easing program to buy $600 billion of bonds, commodity prices are much higher, and the economic recovery has been in progress for a year.

Rates are also rising because of gnawing concerns about government finances. That will be in fresh relief this week, with the Treasury planning to sell $72 billion of new notes and bonds.
"The more bonds they issue and the more they raise capital, the less favorable it is to the bond market," said Todd Colvin, vice president of interest-rate products at MF Global.

Medium-term Treasury notes, which have been the main focus of "QE2," have suffered the most in the recent selloff, in a sign that investors are giving up any lingering hopes that the Fed will embark on a third round of bond buying when this round ends in June.

Barclays Capital strategists on Friday raised their forecast for interest rates in 2011, due in part to the market's increasing focus on soaring prices for oil, food and other commodities.

In measuring inflation, the Fed prefers to strip out such costs, which they view as transitory. Fed policy makers prefer to focus on "core" inflation measures, which are still extraordinarily low.

Some in the market think that is a mistake.

"They perceive the Fed as getting behind the curve despite core inflation remaining well below the Fed's target," Barclays rates strategist Ajay Rajadhyaksha wrote. "This perception is unlikely to reverse quickly."

Angst about Fed policy hasn't been the only factor driving rates higher. For one thing, recent economic data have been surprisingly positive.

A stronger economy, which the Fed likely is welcoming, typically argues for higher interest rates.Though the labor market has been a stubborn laggard, investors appeared to take January's head-scratching drop in unemployment to 9% at face value.

Many in the bond market also focused on a 0.4% increase in average hourly earnings in January, the biggest since 2008. Rising wages can help inflation take root.

Still, many in the bond market feel the punishment for bonds may have run its course, at least for the time being. Disappointing economic data, another flare-up of European sovereign-debt worries, or any number of issues could push investors back into bonds.

"It does feel like a repeat of last spring," said George Goncalves, Nomura Securities International's head of rates strategy for the Americas. "There are still a lot of risks out there that are unresolved."

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

If current projections of federal deficits materialize in this and the next few years, interest rates (both long and short-term) will be driven up sharply by the increased demand for loan funds. Any recovery in the economy will present a “catch 22” situation. An upturn in the economy will add increased private demand for loan funds to the insatiable demands of the federal government. The consequent rise in interest rates will effectively abort any recover.

It's called crowding out. "In economics, crowding out is any reduction in private consumption or investment that occurs because of an increase in government spending. If the increase in government spending is not accompanied by a tax increase, government borrowing to finance the increased government spending would increase interest rates, leading to a reduction in private investment" - Wikipedia

[flow5]

Federal Reserve QE2 Watch: Part 3

At the close of business on February 2, 2011, the Federal Reserve System recorded a total of $1.1 trillion of U. S, Treasury securities on its balance sheet. To be more exact, the number was $1,138,166 million.

Thirteen weeks ago, the Fed held just $842,008 million in Treasury securities. Thus, the Fed’s holdings of these securities have gone up by almost $300,000 million or $300 billion or $0.3 trillion over this time. QE2 seems to be in full swing?

Thus, in the last three months, the Federal Reserve has surpassed the holdings of U. S. Treasury securities of China, a little less than $900 billion, and of Japan, a little less than the China.
At January 31, 2011, the Total Public Debt of the United States Government was $14.13 trillion.

Thus, the Federal Reserve System currently holds a little over 8 percent of its government’s debt!

The QE2 program of the Fed stated that the Federal Reserve would buy $600 billion of United States Treasury securities over a six month period and would buy an additional $300 billion in these securities to offset the amount of Federal Agency securities and Mortgage-backed securities that resided on the Fed’s balance sheet and were maturing during this time period.

As stated above, the Federal Reserve added $296 billion of U. S. Treasury securities to its balance sheet. During this time period the Fed lost $91 billion in Federal Agency securities and Mortgage-backed securities reducing the net addition of $205 trillion to its overall portfolio of securities as a part of QE2.

Over the last four week period, the Fed acquired $107 billion in U. S. Treasury securities, but had a runoff of $30 billion in these other securities so that the “net” new purchases added up to $77 billion.

But, this was not all going on that affected the amount of reserves in the banking system. One very big “happening” was that the settlement of the AIG bailout as the Fed’s involvement in this effor. “The Board's statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," reflects the closing of the American International Group, Inc. (AIG) recapitalization plan, which occurred on January 14, 2011. The recapitalization plan was designed to restructure and facilitate repayment of the financial support provided to AIG by the U.S. Department of the Treasury (Treasury) and the Federal Reserve. Upon closing of the recapitalization plan, the cash proceeds from certain asset dispositions, specifically the initial public offering of AIA Group Limited (AIA) and the sale of American Life Insurance Company (ALICO), were used first to repay in full the credit extended to AIG by the FRBNY under the revolving credit facility (AIG loan), including accrued interest and fees, and then to redeem a portion of the FRBNY's preferred interests in ALICO Holdings LLC taken earlier by the FRBNY in satisfaction of a portion of the AIG loan. The remaining FRBNY preferred interests in ALICO Holdings LLC and AIA Aurora LLC, valued at approximately $20 billion, were purchased by AIG through a draw on the Treasury's Series F preferred stock commitment and then transferred by AIG to the Treasury as consideration for the draw on the available Series F funds.”

Basically, this adjustment, along with some other minor runoffs of other “financial emergency” management accounts, removed about $35 billion from the banking system over the past 13-week period and about $22 billion in the past 4-week period. Assuming the Fed offset this reduction in bank reserve with the open-market purchase of Treasury securities, this drops the “net” QE2 injections of reserves into the banking system to $170 billion over the last quarter and $55 billion over the last four weeks.

As always, there are the ordinary operating transactions the Federal Reserve must account for because these transactions, like movements in currency in circulation and movements of Treasury Tax and Loan monies, impact bank reserves. The Federal Reserve usually offsets these items so as to smooth bank adjustments in the regular course of business.

Over the past 13-week period, the Fed had approximately a net of $72 billion in operating transactions to offset. Over the past 4-week period, this total was approximately $7 billion.

Removing these amounts from the Fed purchases of Treasury securities, we find that the Fed bought $98 billion in securities that added to bank reserves over the past 13 weeks, and bought $48 billion over the past 4 weeks. In effect, these numbers reflect the “net” impact of securities purchased to increase bank reserves over this period of time.

Thus, one cannot say that over the last 13-week period the Fed bought almost $300 billion in U. S. Treasury securities as a part of the QE2 program because of all the other things going on during this time.

The Fed did buy over $90 billion in Treasury securities to offset the amount of securities that were running off in the rest of the portfolio, part of the $300 billion the Fed said it was going to do, but this cannot truthfully be considered a part of the $600 billion of new purchases it was supposed to undertake. And, one can make the case that the full amount of the almost $200 billion in purchases was not a part of QE2.

The real question concerns the effects this increase had on the banks and the economic system. Because of timing differences the following data don’t exactly foot. For example, reserve balances held at the Fed increased by $98 billion over this time period. The information we currently have from other sources indicate that the monetary base, which consists of bank reserves and coin and currency held outside of commercial banks, rose by almost $95 billion at the same time. So, we are roughly in the same ball park. One should also note at this time that all these data are non-seasonally adjusted!

Of the $95 billion, roughly $80 billion in the increase came in bank reserves and $15 billion came in currency held outside of banks. Of the $80 billion increase in bank reserves, about $12 billion of this was due to the increase of required reserves of commercial banks. Note that individuals and businesses are still moving their funds from money market accounts and small time and savings accounts, to demand deposits and other checkable deposits, and away from thrift institutions to commercial banks. (We will have more to say on this later this week.) The demand and checkable counts have higher reserve requirements than do the accounts that the funds have been moved from. This still remains the major reason why required reserves have increased over the past several years as well as currently.

So, $68 billion of the increase in total reserves went into excess reserves. Bank loans continued to decline in January (I will address this next Monday) so it appears as if commercial banks are still taking the excess reserves and putting them into “cash” rather than lending them. (Again there is a difference between the behavior of the big banks versus that of the smaller banks.)

The conclusion one can draw from this is that the Fed has been executing QE2, but has not been as aggressive as some people have thought when looking at just the aggregate dollar amount in the Fed’s portfolio of Treasury securities. The Fed still has other things going on that must be taken care of and this modifies any interpretation one can give to the aggregate figures. In terms of the banks: the banks still appear to be putting the “new” reserves the Fed is injecting into the banking system into excess reserves. So far, QE2 does not seem to be producing any substantial results in the banking system.
======================

Best recap on the web.

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I note Stockman's comment that the Government is currently issuing bonds at the rate of $120 billion per month, but the economy is only growing at $40 billion per month.

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That's a high-wire balancing act

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seekingalpha.com/article/251107-the-real-employment-picture-what-s-missing-from-the-bls-report?source=email_partial_daily_dispatch

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

JOB ANALITICS: why picture is getting worse, not better. scary stuff

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Quantitative Easing is Bodgy
Posted on February 7, 2011

Some readers have written to me asking to explain what quantitative easing is. Some of them had heard an ABC 7.30 Report segment the other night which interviewed the Bank of England Governor who outlined the BOE’s plan to “print billions of pounds” as its latest strategy to stimulate lending and hence economic activity in the very dismally performing UK economy. Once again we need to de-brief and learn what quantitative easing actually is. We need to understand that it is not a very good strategy for a sovereign government to follow in times of depressed demand and rising unemployment. We also need to get this “printing money” mantra out of our heads.

What is quantitative easing?

With very tight credit markets at present (that is, banks have upped their lending standards and made it harder for firms and households to access credit), central banks have started talking about using what is called quantitative easing to free up credit flowing especially as short-term interest rates fall towards zero. In fact, near zero interest rates are required if the central bank is to engage in quantitative easing!

Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. The aim is to create excess reserves which will then be loaned to chase a positive rate of return. So the central bank exchanges non- or low interest-bearing assets (which we might simply think of as reserve balances in the commercial banks) for higher yielding and longer term assets (securities).

So quantitative easing is really just an accounting adjustment in the various accounts to reflect the asset exchange. The commercial banks get a new deposit (central bank funds) and they reduce their holdings of the asset they sell.

Proponents of quantitative easing claim it adds liquidity to a system where lending by commercial banks is seemingly frozen because of a lack of reserves in the banking system overall. It is commonly claimed that it involves “printing money” to ease a “cash-starved” system. That is an unfortunate and misleading representation.

Invoking the “evil-sounding” printing money terminology to describe this practice is thus very misleading – and probably deliberately so. All transactions between the Government sector (Treasury and Central Bank) and the non-government sector involve the creation and destruction of net financial assets denominated in the currency of issue. Typically, when the Government buys something from the Non-government sector they just credit a bank account somewhere – that is, numbers denoting the size of the transaction appear electronically in the banking system.

It is inappropriate to call this process – “printing money”. Commentators who use this nomenclature do so because they know it sounds bad! The orthodox economics approach uses the “printing money” term as equivalent to “inflationary expansion”. If they understood how the modern monetary system actually worked they would never be so crass.

Crucially, quantitative easing requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.

The Bank of England has now cut short-term interest rates to virtually zero (the lowest since the BOE was formed in 1694) in the misguided belief that monetary policy could solve the demand failure they are facing. While still eschewing fiscal policy (spending and taxation) they now have nowhere to go with monetary policy unless they begin to engage in quantitative easing. As a consequence, over the next three months they intend to spend £150bn buying assets from the private sector called gilts (which are just government bonds) and also high quality corporate debt.

The aim is to increase liquidity in the credit markets and encourage banks to increase lending to companies as explained above.

Does quantitative easing work? The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.

It is based on the erroneous belief that the banks need reserves before they can lend and that quantititative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

The major formal constraints on bank lending (other than a stream of credit worthy customers) are expressed in the capital adequacy requirements set by the Bank of International Settlements (BIS) which is the central bank to the central bankers. They relate to asset quality and required capital that the banks must hold. These requirements manifest in the lending rates that the banks charge customers. Bank lending is never constrained by lack of reserves.

While some point to the quantitative easing experience in Japan between 2001 and 2006, the reality is that it was highly expansionary fiscal policy not the monetary policy gymnastics which kept that economy from deflating and allowed it to return to stronger growth in recent years (until the crisis hit).

We should be absolutely clear on what the BOE is doing. It is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the BOE). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear. The central banks certainly don’t know! Overall, this uncertainty points to the problems involved in using monetary policy to stimulate (or contract) the economy. It is a blunt policy instrument with ambiguous impacts.

The major problem facing the economy at present is that there is not a willingness to spend by the private sector and the resulting spending gap, has to, initially, be filled by the government using its fiscal policy capacity. I prefer direct public sector job creation to be the principle fiscal vehicle. But fiscal policy it has to be. Then when the negative sentiment is turned around, private borrowing will recommence and investment spending will grow again. Then the economy moves forward some more and the budget deficit falls.

So I don’t think quantitative easing is a sensible anti-recession strategy. The fact that governments are using it now just reflects the neo-liberal bias towards monetary policy over fiscal policy. What will motivate consumers to borrow if they are scared of losing their jobs? Why would a company borrow if they expect their sales to be depressed? The problem is a failure of demand which has to be addressed via demand measures – that is, fiscal policy. Overall, you can only take a horse to water ….!

There are also those that claim that quantitative easing will expose the economy to uncontrollable inflation. This is just harking back to the old and flawed Monetarist doctrine based on the so-called Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantititative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.

bilbo.economicoutlook.net/blog/?p=661

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

The fiat-money advocate

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Fed Spending 40% on Benchmark Treasuries as Newest Bonds Proving Cheapest
By Cordell Eddings and Daniel Kruger - Feb 6,

The Federal Reserve’s Treasury purchases already have succeeded in driving investors to junk bonds and stocks. Now, policy makers are focusing on benchmark government securities, helping contain rising yields that set rates on everything from corporate debt to mortgages.

More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009.

“They’re getting all the bang for their buck that they can” by purchasing so-called on-the-run bonds, said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $22 billion. “When you’re the largest buyer out there, when you replace China in terms of the size of your holdings of Treasury securities, that will happen.”

The Fed purchases are helping keep a lid on borrowing costs for companies and homebuyers as the economy recovers. Yields on corporate bonds have averaged about 4.84 percent since the buying began in November, below the 5.48 percent for all of 2010, according to Bank of America Merrill Lynch indexes. The average rate on a 30-year fixed mortgage has been 4.61 percent, in line with 2010’s 4.69 percent and lower than the 5.93 percent of the past decade, according to Freddie Mac in McLean, Virginia.

Maintaining Demand

Quantitative easing has boosted demand for Treasuries as President Barack Obama’s budget deficits exceed $1 trillion, adding to the nation’s $8.96 trillion in marketable debt. Investors bid $3.04 for each dollar of bonds sold in the government’s $178 billion of auctions last month, the most since September, according to data compiled by Bloomberg.

Yields on Treasuries of all maturities fell to an average of 1.88 percent in January, the first monthly drop since October, Bank of America Merrill Lynch index data show. The benchmark 10-year note may decline to 3.52 percent at the end of the second quarter from 3.64 percent Feb. 4, based on the median estimate of 76 economists, strategist and analysts surveyed by Bloomberg. Current rates compare with the average of 5.26 percent during the past two decades. The rate was little changed today as of 12:27 p.m. in Tokyo.

Weekly Slump

The 10-year note yield increased 31 basis points last week, according to BGCantor Market Data. The price of the 2.625 percent security due November 2020 fell 2 15/32, or $24.69 per $1,000 face amount, to 91 3/4.

Since Nov. 3, when Fed Chairman Ben S. Bernanke announced the plan to buy government debt to keep the economy from falling into deflation, 10-year yields have increased about one percentage point as expectations for inflation rose. The purchases and signs that the economy is recovering have reduced demand for the safety of government debt in favor of riskier assets and the Standard & Poor’s 500 Index has risen 9.4 percent.

Speculative-grade corporate bond yields fell to 4.68 percentage points, or 468 basis points, more than Treasuries last week, the least since November 2007 and down from 6.22 percentage points in November, according to Bank of America Merrill Lynch index data. Debt rated lower than Baa3 by Moody’s Investors Service or less than BBB- by Standard & Poor’s is below investment grade, or junk.

Biggest Owner

The Fed became the biggest owner of U.S. government debt in November, when holdings reached $896.7 billion, overtaking China’s $895.6 billion, according to Treasury and central bank data. It purchased $288 billion since Nov. 12, mostly from dealers, reducing Wall Street’s holdings of long-term Treasuries to a so-called net short position of negative $22.3 billion in the week ended Jan. 19.

That means prices shown to the Fed when it buys will continue to increase, according to Credit Suisse Group AG, one the 20 primary dealers that trade directly with the central bank.

Now, the Fed is turning to benchmark bonds for quantitative easing because older, or off-the-run, securities are becoming too expensive as measured by the bid-ask spread showing the difference between the lowest price for securities offered for sale and the highest bid.

The difference between the prices at which investors are willing to buy and sell older five-year notes due February 2016 has widened to 1.0833 basis points since Nov. 3, according to Bank of America. In the five months before the Fed announcement the spread was 0.97 to 0.99 basis point. Every 0.1 basis point on $600 billion of bonds would save the Fed about $6 million.

Deficits, Inflation

Creating more demand for newer bonds gives Wall Street an added incentive to buy at government sales, helping keep benchmark yields in check.

“Dealers are more likely to bid more aggressively at Treasury auctions if they can sell to the Fed in the not-so- distant future,” strategists at Bank of America Merrill Lynch said in a Jan. 31 note to investors.

While the Fed’s purchases have helped boost confidence, bigger deficits and speculation that inflation may accelerate have sent yields higher, said Larry Dyer, a U.S. interest-rate strategist in New York with HSBC Holdings Plc’s HSBC Securities unit. Treasuries lost 3.7 percent since the beginning of November, including reinvested interest, after returning 8.59 percent in the first 10 months of 2010, Bank of America Merrill Lynch data show.

“The Fed has monopoly control over front-end rates,” Dyer said. “But in bringing down long-term interest rates, the Fed is having a much tougher time.”

Yield Curve

Bernanke has kept the target interest-rate for overnight loans between banks in a range of zero to 0.25 percent since December 2008. The difference between yields on two- and 10-year yields rose to 2.89 percentage points last week, above median of 1.81 percentage points the past decade. A widening yield curve has historically been a sign that investors anticipate a strengthening economy.

The Institute for Supply Management said Feb. 1 that its factory index accelerated in January to the fastest pace in more than six years and the Labor Department said Feb. 4 the U.S. unemployment rate dropped to 9 percent in January from 9.4 percent in December as job creation slowed amid winter storms.

Optimism on the outlook for the economy allowed companies in the U.S. to sell $159 billion of bonds last month, a record for January, according to data compiled by Bloomberg.

Goldman Sachs Group Inc., the fifth-biggest U.S. bank by assets, sold $3.5 billion last week in its largest dollar- denominated issue without government backing since 2004.

Shrinking Spreads

The bank’s new securities included $2.5 billion of 3.625 percent debt maturing in 2016 that yields 158 basis points more than similar-maturity Treasuries, Bloomberg data show. In July, Goldman Sachs issued $2.25 billion of 5-year, 3.7 percent notes that paid 205 basis points more than benchmarks.

Microsoft Corp. issued $2.25 billion of bonds, according to Bloomberg data. The Redmond, Washington-based company’s $750 million of 2.5 percent, 5-year notes were priced to yield 38 basis points more than Treasuries, compared with 40 basis points on its $1.75 billion sale of 1.625 percent, 5-year debt on Sept. 22. The new spread was the narrowest since Gillette Co. sold $300 million of 2.875 percent, 5-year debentures on March 4, 2003, at 37.5 basis points.

“Buying the newer issues has a more-direct impact on yield targeting and the Fed’s goal of keeping rates low within a range,” said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc., another primary dealer. “The Fed has taken some of the liquidity out of the market, which gives their purchases more impact.”

[flow5]

We were glad to see that for the first time someone besides Zero Hedge took offense at the Fed's now ceaseless monetization of just auctioned off, more often than not 'on the run' bonds, as an indication that not all is well in Sack Frost Kansasville.

Bloomberg writes: "Fed spends 40% on newer, cheaper benchmark Treasuries" and clarifies: "More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009. “They’re getting all the bang for their buck that they can” by purchasing so-called on-the-run bonds, said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $22 billion. “When you’re the largest buyer out there, when you replace China in terms of the size of your holdings of Treasury securities, that will happen.”"

It is great that more and more are starting to pay attention to what has been a ZH peeve ever since the beginning of QE2: namely relentless taxpayer rape. We do have one problem however: when Bloomberg says "cheaper" to qualify the "newer" Treasurys, it is, unfortunately, very much wrong.

Take today's POMO for example. In 15 minutes the FRBNY will announce the completion of today's $7-9 billion monetization of bonds between 2017-2020. The most recently auctioned off CUSIP in the roster of 19 bonds is the 912828PC8 CUSIP also known as the 2.625%s of 11/15/20. This is the 10 Year bond acquired by PDs during the December auction (the January is structurally excluded as it matures in 2021).

Now if Bloomberg is correct, not one single PC8 will be monetized today, since, as Morgan Stanley once again confirms, this is among the richest (as in, the opposite of cheapest) bonds to put to the US taxpayer, and the result of such a monetization would be yet another implicit impairment of Fed fiduciary interests. We will advise readers as soon as we know what the final outcome of today's POMO is as to how much PC8 was put back to Sack Frost.

All cheapest bonds during today's POMO: note the 2.625% of 11/15/20 is not even on the list...

www.zerohedge.com/article/frontrunning-todays-pomo-1


So where is it? It is, in fact, one of the least cheap bonds available to the Fed.

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Russia, the only one of the so-called BRIC countries without capital controls, is following China and Turkey in relying on reserve requirements to drain cash from the economy and avoid luring more speculative investment.

“We stand ready to continue increasing mandatory requirements, if needed,” Bank Rossii Chairman Sergey Ignatiev said in Frankfurt on Feb. 4. Policy makers will “act decisively to meet the forecast” for 2011 annual inflation of between 6 percent and 7 percent, he said.

The central bank on Jan. 31 increased the mandatory reserve ratio while unexpectedly leaving its deposit rates unchanged after inflation in January accelerated to the fastest in 15 months. Policy makers cited the threat of rising capital inflows driven by higher oil prices.

Emerging economies are weighing the need to curb inflation against the risk of attracting speculative capital from near- zero interest rates in the U.S. and Europe. The threat of a stronger ruble and stifled exports may be a “big headache” for Russia, central banker Alexei Ulyukayev said last month.

The ruble is the third-best performer against the dollar this among more than 20 emerging-market currencies tracked by Bloomberg, having gained 3.9 percent.

Prices Surge

Consumer prices in January surged 9.6 percent from a year earlier, triggered by the worst drought in at least 50 years, while monthly inflation was 2.4 percent, the quickest in two years. Grain costs climbed an annual 70 percent last month and fruit and vegetables increased 51 percent.

Central bankers have kept the benchmark refinancing rate at a record-low 7.75 percent since June, opting to increase the deposit rate in December. They last week raised the mandatory reserve level for liabilities to 3.5 percent for non-resident companies and 3 percent for individuals and others, both from 2.5 percent.

The policy response in countries including Turkey and Russia is “highly unorthodox” and may lead to more aggressive rate increases as inflationary expectations mount, said Maria Gordon, a London-based emerging-market equity portfolio manager at Pacific Investment Management Co., which oversees about $1.2 trillion.

“I would be looking for a combination of maximum fears, when the local markets will start pricing in a large degree of tightening and I would start taking positions on interest-rate sensitive stocks,” she said in an interview in Moscow on Feb. 3, without specifying companies.

‘Hard Landing’

Traders are pricing in 0.88 percentage point of rate increases over the next three months, forward rate agreements show. Expectations on Jan. 26 were the highest in more than a year, with the forwards signalling bets for 1.15 percentage points, data compiled by Bloomberg show.

Emerging markets risk a “hard landing” as they start raising interest rates to fight inflation, Nouriel Roubini, the New York University professor who predicted the credit crisis, said at a conference in Moscow on Feb. 3.

China set record-high reserve requirements, raising the level four times in about two months. Latin American nations from Brazil to Peru are lifting the ratios and returning to capital controls to stem a rally in their currencies.

Bank Rossii raised the reserve level for liabilities to the highest since 2008 after lowering the ratio at the height of the financial crisis that year to help lenders weather the credit squeeze. It last lifted the requirement level in August 2009.

Medvedev’s Growth Target

Banks including OAO Sberbank and VTB Group, the country’s two largest, may need to set aside about 100 billion rubles to meet the new requirements, according to calculations by BNP Paribas and ZAO Raiffeisenbank.

Policy makers in Moscow are also reluctant to increase interest rates to avoid throttling economic growth, which they said is “uncertain.” Gross domestic product grew 4 percent in 2010 after shrinking 7.8 percent a year earlier.

The government predicts GDP will rise 4.2 percent this year, or less than half the 10 percent target set by President Dmitry Medvedev to pull the country in line with China, Brazil and India.

“Raising reserve requirements is the only available instrument for monetary tightening in these conditions,” Pavel Pikulev, a Moscow-based fixed-income strategist in Moscow at OAO Gazprombank, the lending arm of Russia’s gas export monopoly, said by phone on Feb. 4. “There’s a risk that the central bank will later hike rates more aggressively than it would like now.”

‘Capital Onslaught’

The U.S. Federal Reserve’s plan buy an additional $600 billion of Treasuries means that countries reliant on natural resources face an “onslaught of more capital,” Nobel Prize- winning economist Joseph Stiglitz said in Moscow on Feb. 2.

Capital inflows in 2011 may exceed the official estimate for $15 billion after three years of capital flight, Ulyukayev said on Jan. 21. Turkey the previous day reduced its benchmark rate for a second month and said it will continue to raise reserve requirements after lifting in December the ratio for deposits and savings of up to one month to 8 percent from 6 percent.

Russian-focused equity funds inflows extended to a 10th week in the seven days ending Feb. 2, posting the only gain among BRIC countries and taking in $196 million, Alfa Bank said, citing data compiled by EPFR Global, a Cambridge, Massachusetts- based research company.

“In many countries around the world there are more active policies aimed at preventing capital inflows,” Stiglitz said. There’s “more sensitivity on monetary policy, keeping the interest rate down and using other instruments like reserve requirements to restrain domestic aggregate demand. You see a lot of interesting experiments going on.”

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As of the end of December, total NYSE margin debt of $276.6 billion hit a fresh post-Lehman high, as increasingly more investors continue to purchase securities on margin (i.e., debt).

The $2.5 billion rise from November margin levels is the highest since September 2008, and $103 billion from the market lows of March 2009. That said, margin fever still has a way to go and it could easily reach the June 2007 all time high of $381 billion, a little over $100 billion from here.

Notable is that while investors had a negative net worth for the sixth month in a row, the differential declined modestly primarily due to a jump in credit balances in margin accounts which hit $148 billion: the highest since February 2009. As historically there is a decline in credit margin balances into the new year, we expect total free credit less margin debt to increase materially in January, especially as the expected January correction (in parallel with the market activity of early 2010) has not materialized, and bullish bets have to be increasingly funded on margin.

More relevantly, should short-term interest rates continue to jump (we will have more to say on the recent move in 2 Years), margin interest may soon be forced higher, making life for those who use nothing but debt to fund stock purchases a little more problematic.

zerohedge
================

Regulation T is administered by the Board of Governors of the Federal Reserve System.

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the all important shadow banking system made a positive inflection point in ending deleveraging in Q3 (and on March 10 we will know whether the Q3 strength persisted into Q4)

ZEROHEDGE

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

Not sure how SBS is defined. But it is true that for savings to match investment, the financial intermediaries (non-banks) must grow. Formally 82% of the lending market - z.1 release.

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Submitted by Brian Benton on Fri, 4 Feb 2011
You may recall from my prior missives (Fed Exit Strategy? and Fed Exit Strategy? (An Update)) that the Fed was signaling delay tactics as its approach to the management of its unprecedented balance sheet, as opposed to a real exit which would require returning the balance sheet to mostly pre-crisis levels (permanently draining the massive bank reserves it created) and once again conducting monetary policy via management of the federal funds rate (via its traditional temporary open market operations). In today's speech to the National Press Club, Bernanke made it even more clear that the primary strategy is to employ policies and tools that will "lock up" or "immobilize" excess bank reserves. A real exit where the Fed contracts its balance sheet by selling securities is mentioned as a secondary strategy.

Some quotes from Bernanke today and my comments in context ...

Bernanke:

"My colleagues and I have said that we will review the asset purchase program regularly in light of incoming information and will adjust it as needed to promote maximum employment and stable prices. In particular, it bears emphasizing that we have the necessary tools to smoothly and effectively exit from the asset purchase program at the appropriate time. In particular, our ability to pay interest on reserve balances held at the Federal Reserve Banks will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required, even if bank reserves remain high."

Yet you still have the mainstream financial press discussing the federal funds rate as if it has any significance in this monetary environment. Wake up call folks ... any tightening by the Fed is well into the future ... and when it happens, the federal funds rate will only move higher in response to a Fed increase in the interest rate it pays on reserves.

The interest rate paid on reserves serves as a floor to the federal funds rate, sans some federal funds market transactions that take place where non-depository institutions are willing to accept less than this rate in the lending of their reserves as they do not qualify for this Fed perk.

The supply of reserves massively outstripping demand results in the interest rate paid on reserves also being the ceiling. Thus, the federal funds rate is impotent in this monetary environment and is just along for the ride.

It will be the interest rate paid by the Fed on reserves that the Fed will adjust higher (at some time in the future), allowing bank reserves to not only remain at unprecedented levels ... but to increase (moving us farther away from a real exit) as the Fed funnels even more interest payments to the banks.

The only way that the Fed can return to traditional monetary policy in a timely manner is by executing a massive sale of assets on its balance sheet (allowing these purchased assets to simply mature/expire is not timely). Thus, in order for monetary policy to be conducted through its management of the federal funds rate once again, on the order of hundreds of billions $ in excess reserves must be drained from the banking system in the short to intermediate term. For such policy to be usable on a long term basis, approximately $1 trillion would need to be permanently drained. Do not hold your breath.

Bernanke:

"Moreover, we have developed additional tools that will allow us to drain or immobilize bank reserves as required to facilitate the smooth withdrawal of policy accommodation when conditions warrant."
Here, Bernanke refers to other tools such as the Term Deposit Facility, which is a program to immobilize reserves for a more predictable period of time ... in contrast to the Fed program to pay interest on reserves (banks can decide to make use of these excess reserves at any time).

These are stall tactics being implemented in an attempt to nurse the banking system back to health, while attempting to prevent the majority of these reserves (base money) from leaking into the money supply (via bank lending and securities investment) and creating substantial inflation (both monetary and price).

Note that Bernanke does not say "permanently drain". A real exit requires excess reserves to be permanently drained. He uses the term "drain" because the tools to which he refers are reverse repurchase agreements, the Treasury Supplemental Financing Program, and other similar tools which will only temporarily drain reserves. These reserves re-enter the banking system once the agreements mature.

For the sake of completeness, as I have written on several occasions, even a real exit by the Fed contracting its balance sheet may not (will likely not) prove to be a full exit. At this point in time, the Fed does not have the ability to drain all of the excess reserves it created when it purchased the assets, as in aggregate the assets on its balance sheet have fallen in value.

This situation is more likely to get worse than better as there will likely be more pressure on interest rates going forward, not to mention the prices of these assets if the Fed were to execute such a liquidation. The result would be some amount of excess reserves remaining in the banking system after liquidation, with the Fed functionally no longer able to sell assets to absorb those reserves. Another reason why the Fed payment of interest on reserves may be here to stay.

Bernanke:

"If needed, we could also tighten policy by redeeming or selling securities."
What is the only real exit strategy is practically mentioned in passing and in the last sentence of the portion of the speech addressing monetary policy. "If needed" This tells you all you need to know about the future of monetary policy.

There is a new normal. That new normal is massive levels of excess reserves due to a super-sized Fed balance sheet coupled with a myriad of programs attempting to keep most of these reserves on deposit with the Fed, aiding in the slow but steady recapitalization of the banking system.

We are already experiencing the predictable side effects of such policy, as evidenced by asset bubbles and commodity inflation. The macro result will be continued volatility in the financial markets, asset bubbles, inflation, and many misreadings of the economy by entrepreneurs and businesses deciding whether or not to make capital investments.

[itstippy]

The original strategy was to "unfreeze credit markets and get the economy moving again". The "providing liquidity" rationale for printing so much money and giving it to the banks in return for illiquid crap securities.

Now we plan "immobilize" the banks' excess reserves by paying enough interest on them that the banks won't be tempted to flood the economy with the ill-gotten loot.

The whole thing stimulates me all to He**.

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Food and failed Arab states
By Spengler

Even Islamists have to eat. It is unclear whether President Hosni Mubarak of Egypt will survive, or whether his nationalist regime will be replaced by an Islamist, democratic, or authoritarian state. What is certain is that it will be a failed state. Amid the speculation about the shape of Arab politics to come, a handful of observers, for example economist Nourel Roubini, have pointed to the obvious: Wheat prices have almost doubled in the past year.

Egypt is the world's largest wheat importer, beholden to foreign providers for nearly half its total food consumption. Half of


Egyptians live on less than $2 a day. Food comprises almost half the country's consumer price index, and much more than half of spending for the poorer half of the country. This will get worse, not better.

Not the destitute, to be sure, but the aspiring and frustrated young, confronted the riot police and army on the streets of Egyptian cities last week. The uprising in Egypt and Tunisia were not food riots; only in Jordan have demonstrators made food the main issue. Rather, the jump in food prices was the wheat-stalk that broke the camel's back. The regime's weakness, in turn, reflects the dysfunctional character of the country. 35% of all Egyptians, and 45% of Egyptian women can't read.

Nine out of ten Egyptian women suffer genital mutilation. US President Barack Obama said Jan. 29, "The right to peaceful assembly and association, the right to free speech, and the ability to determine their own destiny … are human rights. And the United States will stand up for them everywhere." Does Obama think that genital mutilation is a human rights violation? To expect Egypt to leap from the intimate violence of traditional society to the full rights of a modern democracy seems whimsical.

In fact, the vast majority of Egyptians has practiced civil disobedience against the Mubarak regime for years. The Mubarak government announced a "complete" ban on genital mutilation in 2007, the second time it has done so - without success, for the Egyptian population ignored the enlightened pronouncements of its government. Do Western liberals cheer at this quiet revolt against Mubarak's authority?

Suzanne Mubarak, Egypt's First Lady, continues to campaign against the practice, which she has denounced as "physical and psychological violence against children." Last May 1, she appeared at Aswan City alongside the provincial governor and other local officials to declare the province free of it. And on October 28, Mrs Mubarak inaugurated an African conference on stopping genital mutilation.

The most authoritative Egyptian Muslim scholars continue to recommend genital mutilation. Writing on the web site IslamOnline, Sheikh Yusuf al-Qaradawi - the president of the International Association of Muslim Scholars - explains:
The most moderate opinion and the most likely one to be correct is in favor of practicing circumcision in the moderate Islamic way indicated in some of the Prophet's hadiths - even though such hadiths are not confirmed to be authentic. It is reported that the Prophet (peace and blessings be upon him) said to a midwife: "Reduce the size of the clitoris but do not exceed the limit, for that is better for her health and is preferred by husbands."
That is not a Muslim view (the practice is rare in Turkey, Iraq, Iran and Pakistan), but an Egyptian Muslim view. In the most fundamental matters, President and Mrs Mubarak are incomparably more enlightened than the Egyptian public. Three-quarters of acts of genital mutilation in Egypt are executed by physicians.

What does that say about the character of the country's middle class? Only one news dispatch among the tens of thousands occasioned by the uprising mentions the subject; the New York Times, with its inimitable capacity to obscure content, wrote on January 27, "To the extent that Mr. Mubarak has been willing to tolerate reforms, the cable said, it has been in areas not related to public security or stability.

For example, he has given his wife latitude to campaign for women's rights and against practices like female genital mutilation and child labor, which are sanctioned by some conservative Islamic groups." The authors, Mark Landler and Andrew Lehren, do not mention that 90% or more of Egyptian women have been so mutilated. What does a country have to do to shock the New York Times? Eat babies boiled?

Young Tunisians and Egyptians want jobs. But (via Brian Murphy at the Associated Press on January 29) "many people have degrees but they do not have the skill set," Masood Ahmed, director of the Middle East and Asia department of the International Monetary Fund, said earlier this week. "The scarce resource is talent," agreed Omar Alghanim, a prominent Gulf businessman. The employment pool available in the region "is not at all what's needed in the global economy." For more on this see my January 19 essay, Tunisia's lost generation. There are millions of highly-qualified, skilled and enterprising Arabs, but most of them are working in the US or Europe.

Egypt is wallowing in backwardness, not because the Mubarak regime has suppressed the creative energies of the people, but because the people themselves cling to the most oppressive practices of traditional society. And countries can only languish in backwardness so long before some event makes their position untenable.

Wheat prices 101 and Egyptian instability
In this case, Asian demand has priced food staples out of the Arab budget. As prosperous Asians consume more protein, global demand for grain increases sharply (seven pounds of grain produce one pound of beef). Asians are rich enough, moreover, to pay a much higher price for food whenever prices spike due to temporary supply disruptions, as at the moment.

Egyptians, Jordanians, Tunisians and Yemenis are not. Episodes of privation and even hunger will become more common. The miserable economic performance of all the Arab states, chronicled in the United Nations' Arab Development Reports, has left a large number of Arabs so far behind that they cannot buffer their budget against food price fluctuations.

Earlier this year, after drought prompted Russia to ban wheat exports, Egypt's agriculture minister pledged to raise food production over the next ten years to 75% of consumption, against only 56% in 2009. Local yields are only 18 bushels per acre, compared to 30 to 60 for non-irrigated wheat in the United States, and up 100 bushels for irrigated land.

The trouble isn't long-term food price inflation: wheat has long been one of the world's bargains. The International Monetary Fund's global consumer price index quadrupled in between 1980 and 2010, while the price of wheat, even after the price spike of 2010, only doubled in price. What hurts the poorest countries, though, isn't the long-term price trend, though, but the volatility.

People have drowned in rivers with an average depth of two feet. It turns out that China, not the United States or Israel, presents an existential threat to the Arab world, and through no fault of its own: rising incomes have gentrified the Asian diet, and - more importantly - insulated Asian budgets from food price fluctuations. Economists call this "price elasticity." Americans, for example, will buy the same amount of milk even if the price doubles, although they will stop buying fast food if hamburger prices double. Asians now are wealthy enough to buy all the grain they want.

If wheat output falls, for example, due to drought in Russia and Argentina, prices rise until demand falls. The difference today is that Asian demand for grain will not fall, because Asians are richer than they used to be. Someone has to consume less, and it will be the people at the bottom of the economic ladder, in this case the poorer Arabs.

That is why the volatility of the wheat price (the rolling standard deviation of percentage changes in the price over twelve months) has trended up from about 5% during the 1980s and 1990s to about 15% today. This means that there is a roughly two-thirds likelihood that the monthly change in the wheat price will be less than 15%.

It also means that every so often the wheat price is likely to go through the ceiling, as it did during the past 12 months. To make life intolerable for the Arab poor, the price of wheat does not have to remain high indefinitely; it only has to trade out of their reach once every few years.

And that is precisely what has happened during the past few years:

After 30 years of stability, the price of wheat has had two spikes into the $9 per bushel range at which very poor people begin to go hungry. The problem isn't production. Wheat production has risen steadily - very steadily in fact - and the volatility of global supply has been muted:

The line in Chart 3 above marked "production volatility" is the five-year standard deviation of annual percentage changes in world wheat supply (data from US Department of Agriculture). During the 1960s and 1970s, it hovered around the 3% to 5% range, but fell to the 1% to 3% range.

It shows an approximately two-thirds likelihood that world wheat supply will change by less than 3% each year. Wheat supply dropped by only 2.4% between 2009 and 2010 - and the wheat price doubled. That's because affluent Asians don't care what they pay for grain. Prices depend on what the last (or "marginal") purchaser is willing to pay for an item (what was the price of the last ticket on the last train out of Paris when the Germans marched on June 14, 1940?). Don't blame global warming, unstable weather patterns: wheat supply has been fairly reliable. The problem lies in demand.

Officially, Egypt's unemployment rate is slightly above 9%, the same as America's, but independent studies say that a quarter of men and three-fifths of women are jobless. According to a BBC report, 700,000 university graduates chase 200,000 available jobs.

A number of economists anticipated the crisis. Reinhard Cluse of Union bank of Switzerland told the Financial Times last August:
"Significant hikes in the global price of wheat would present the government with a difficult dilemma.

Do they want to pass on price rises to end consumers, which would reduce Egyptians' purchasing power and might lead to social discontent?

Or do they keep their regulation of prices tight and end up paying higher subsidies for food? In which case the problem would not go away but end up in the government budget.

Egypt's public debt is already high, at roughly 74% of gross domestic produce (GDP), according to UBS. Earlier this year the IMF projected that Egypt's food subsidies would cost the equivalent of 1.1% of GDP in 2009-10, while subsidies for energy were expected to add up to 5.1%.

Tensions over food have led to violence in bread queues before and it wouldn't take much of a price rise for the squeeze on many consumers to become unbearably tight."

One parameter to watch closely is the Egyptian pound. Insurance against Egyptian default was the London Interbank Offered Rate (Libor) +3.3% a week ago; on Friday, it stood at Libor + 4.54%. That's not a crisis level, but if banks start reducing exposure, things could get bad fast. In 2009 Egyptian imports were $55 billion against only $29 billion of exports; tourism (about $15 billion in net income) and remittances from Egyptian workers (about $8 billion) and other services brought the current account into balance. Scratch the tourism, and you have a big deficit.

Egypt has $35 billion of central bank reserves, adequate under normal conditions, but thin insulation against capital flight. Foreigners hold $25 billion of Egypt's short-term Treasury bills, for example. It would not take long for a run on the currency to materialize - and if the currency devalues, food and fuel become all the more expensive. A vicious cycle may ensue.

Under the title The Failed Muslim States to Come (Asia Times Online December 16, 2008), I argued that the global financial crisis then at its peak would destabilize the most populous Muslim countries:
Financial crises, like epidemics, kill the unhealthy first. The present crisis is painful for most of the world but deadly for many Muslim countries, and especially so for the most populous ones. Policy makers have not begun to assess the damage. The diplomatic strategy of the industrial nations now resembles a James Clavell potboiler, in which an earthquake interrupts a hopelessly immured plot. Moderate Islam was the El Dorado of the diplomatic consensus.

It might have been the case that Pakistan could be tethered to Western interests, or that Iran could be engaged peacefully, or that Turkey would incubate a moderate form of Islam. I considered all of this delusional, but the truth is that we shall never know. The financial crisis will sort them out first.

I was wrong. It wasn't the financial crisis that undermined dysfunctional Arab states, but Asian prosperity. The Arab poor have been priced out of world markets. There is no solution to Egypt's problems within the horizon of popular expectations. Whether the regime survives or a new one replaces it, the outcome will be a disaster of, well, biblical proportions.

The best thing the United States could do at the moment would be to offer massive emergency food aid to Egypt out of its own stocks, with the understanding that President Mubarak would offer effusive public thanks for American generosity. This is a stopgap, to be sure, but it would pre-empt the likely alternative. Otherwise, the Muslim Brotherhood will preach Islamist socialism to a hungry audience. That also explains why Mubarak just might survive. Even Islamists have to eat. The Iranian Islamists who took power in 1979 had oil wells; Egypt just has hungry mouths. Enlightened despotism based on the army, the one stable institution Egypt possesses, might not be the worst solution.

Spengler is channeled by David P Goldman. Comment on this article in Spengler's Expat Bar forum.

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ZEROHEDGE: Today's 3 Year bond auction priced without much fanfare, and luckily so: while it came at 1.349%, slightly weaker than expected (1.345%), compared to last auction's 1.027%, ot a 30% jump in interest in one month, it is the internals that were most disturbing.

The Bid To Cover was strong enough at 3.01, compared to 3.06 previously, and 3.14 LTM average, yet what was remarkable was the takedown.

And as we have been warning for a while now, it was the Indirect Bids (the Chinas of the world) that basically decided to take a raincheck on the auction. The Indirect takedown was just 27.6% of total, with $8.8 billion of the $32 billion going to Indirects (nonetheless the hit rate was 57%).

This is the lowest Indirect takedown since May of 2007! And while the direct bid was a subpar 10.1%, it was the Primary Dealers that saved the day: at 62.3%, or $20 billion of the entire auction, the Fed essentially monetized two thirds of the entire auction de novo. And remember this Cusip: QH6: we can guarantee that within a month, the Fed will buy back at least 50%, or $10 billion, of the Primary Dealer take down portion

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www.westernasset.com/EU/qe/pdfs/commentary/WhatTheFedIsDoing201101.pdf

The fear of rising interest rates seems ubiquitous these days. One driver of this fear is the belief that US inflation is set to take off, thanks to the US Federal Reserve’s (Fed) quantitative easing (QE) programs. Popular wisdom is that the creation of $2 trillion of new Federal Reserve assets is inflationary.

However, there is quite a gulf between perception and reality concerning the Fed’s QE policy. When we look at the Fed’s actual actions and results, we conclude that nothing that the Fed has done so far has been inflationary, and Fed actions are unlikely to prove inflationary in the future. Nearly all of the new liquidity injected into the financial system has found its way back to the Fed.

Virtually none of the new liquidity is circulating through the economy, and it is unlikely to do so as long as the banking system remains in its current state of impairment. We’ll detail these facts below alongside a parsing of Fed Chairman Ben Bernanke’s pertinent statements on these issues.

“We’re not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way.”
—Ben Bernanke, on 60 Minutes
05 Dec 10

Strictly interpreted, Mr. Bernanke’s first remark here is dissembling. “Printing money” can be said to occur whenever the Fed expands its balance sheet. The Fed creates liabilities that did not previously exist, and it uses that “credit” to acquire assets. It doesn’t matter whether the new liabilities are Federal Reserve notes (currency) or banks’ deposits at the Fed.

So, the Fed has been printing money, but what matters for the economy and for inflation is how the private banking system is utilizing that “Fed credit.”

From this perspective, Mr. Bernanke’s statements ring true. While the Fed injected over $1 trillion of new liquidity into the banking system during the first round of quantitative easing (QE1) between September 2008 and January 2009, virtually none of that liquidity has circulated through the economy.

As he says, neither currency in circulation nor the broad money stock has picked up (Exhibit 1). Instead, virtually all of the new liquidity is sitting idle as excess reserves held by banks (Exhibit 2).1 The same can be said of the liquidity injected in the past three months as part of quantitative easing (QE2).

What the Fed Is Actually Doing:
Some Perspective on Current Rate/Inflation Fears
Exhibit 1
M2 Money versus Prior Trend versus Fed Liquidity
5.56.06.57.07.58.08.59.00.51.01.52.02.520032004200520062007200820092010USD (
trillions)USD (trillions)QE1 Begins QE2 Begins 2003–07 M2 Trend,5.0% per year Fed Liabilities(right scale) Actual M2(left scale)

For any measure of liquidity or money, what matters is both how much is in existence and how rapidly that stock is turning over. The effects of the money stock on the economy depend partly on the size of that stock and partly on how many times each dollar in the money stock is spent—the velocity of money.

For the stock of liquidity—the Fed’s liabilities—what matters is its size, as well as the number of dollars of liquidity that are needed for the financial system to support each dollar of money stock: the money multiplier.

Over the last three years, the trend growth in money has essentially remained unchanged (Exhibit 1), but the velocity of M2 money has declined substantially (Exhibit 3) so that nominal GDP growth has slowed substantially.

While the stock of liquidity has more than doubled relative to previous trends, again, the money stock has not changed at all. Twice as much liquidity now supports each dollar of money stock, as was the case prior to the credit crisis. The money multiplier has fallen by half. As Exhibit 3 shows, there has been no substantive reversal of the late-2008 plunges in the velocity of money and the money multiplier.

These measures of turnover have declined partly because of increased caution and fear among businesses and consumers and partly because the Fed began paying interest on reserves in late 2008, giving banks an incentive to hold more reserves against any given stock of deposits.

However, the main driver of the dramatically smaller money multiplier is most likely the more conservative operations undertaken by banks in the face of heightened financial uncertainty and increased bank regulation.

Banks are holding 16 times as much cash reserves for every dollar of deposit liabilities as they did previously. In effect, increased Fed leverage has merely offset dramatic deleveraging by banks, consumers and businesses, with no net impact on the economy and so no reason to expect any inflationary pressure.

What would in normal conditions be inflationary is not inflationary under current, abnormal conditions in the US financial system, and there is no indication that those abnormalities are about to
Exhibit 2

Fed Balance Sheet versus Banks’ Excess Reserves
-0.20.00.20.40.60.81.01.21.4Jan 07Jul 07Jan 08Jul 08Jan 09Jul 09Jan 10Jul 10Jan 11Fed Balance Sheet vs. Banks' Excess ReservesUSD (trillions, semen. chg. since 08 Sep 08 Banks’ Excess ReservesCumulative Change in Monetary Base
As of 26 Jan 11
Source: Federal Reserve Board
Exhibit 3
Velocity of Money and Money Multiplier
1.61.71.81.92.02.12.2456789101995199619971998199920002001200220032004200520062007200820092010Velocity of Money & Money MultiplierVelocity of Money(GDP over M2 lagged 2 Quarters)(left scale)Money Multipler(M2 over Monetary Base)(right scale)
Source: Bureau of Economic Analysis

change. This was the lesson learned from the Great Depression. Then, both the velocity of money and the money multiplier plunged much as they have recently, and those declines were sustained until 1940, 11 years after the initial banking panic.

2 Parallel developments are now taking place, and history provides no reason to think that current abnormalities will be quickly reversed.

As the banking system and the US economy recover, there may come a point when some of this liquidity needs to be withdrawn to sustain a non-inflationary environment. However, for now, there is no good reason to believe that Fed policy has entered inflationary territory.

“What we’re doing is [lowering] interest rates by buying Treasury securities.”
—Ben Bernanke, ibid.

Judging by Mr. Bernanke’s statement here, it would appear that QE2 has been quite unsuccessful so far. During QE1, Treasury and corporate bond rates declined dramatically from October/November 2008 through January 2009. Nearly three months into QE2, Treasury and corporate yields at all maturities beyond three years were at their highest points since June 2010, well before the markets began to anticipate QE2.

Why did yields behave differently in QE2 compared with QE1? Much of the difference reflects changing expectations about the economy. Also, when QE1 began, liquidity was in extremely short supply, while at present, liquidity is plentiful. The failure to drive interest rates lower certainly casts even more doubt on the belief that QE2 will prove to be stimulative to economic growth or inflation.
“We’ve been very, very clear that we will not allow inflation to rise above two percent or less.”
—Ben Bernanke, ibid.

Well, not quite. In the weeks leading up to the beginning of QE2, various Fed officials made comments suggesting they desired higher inflation. William Dudley, president of the US Federal Reserve Bank of New York, was reported as favoring “temporary” inflation of as much as 4% in order to offset recent inflation rates that were below the Fed’s desired level. President Charles Evans of the US Federal Reserve Bank of Chicago made similar comments.

Real-world experience from the 1960s and 1970s is clear: once inflation takes hold, it is exceedingly difficult to contain. Those difficulties are largely political. As Mr. Bernanke went on to say, “We could raise interest rates in 15 minutes if we had to.” Certainly, the Fed could. The question is whether Fed members would indeed find the political will to do so. This was much of the reason that we were initially troubled by the onset of QE2 late last year.

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Ben Bernanke says that the Fed is not monetizing the federal debt. He's trying to confuse his critics. The process shouldn't be confusing. It's pretty simple.

1. The Fed buys $25-30 billion a week in Treasury notes and bonds from the primary dealers. That's $50-60 billion every two weeks.

2. When the Fed buys the paper, it pays for it by depositing the cash in the dealers' accounts at the Fed - $50-60 billion over two weeks.

3. Every other week, the Treasury sells more notes and bonds, normally $50-60 billion in new paper every two weeks.

4. The primary dealers buy that paper with the $50-60 billion in proceeds from their prior two weeks of sales of inventory to the Fed. However, they only need to use part of it, because they have leverage. The rest stays in their trading accounts which they leverage up to buy stocks, commodities and even more bonds if they so choose.

5. The $50-60 billion in cash which the primary dealers paid to the U.S. Treasury for the new Treasury debt it just issued goes into the Treasury's account at the Fed.

6. In the ensuing weeks, the Treasury spends that $50-60 billion, whereupon it enters the banking system.

It's that simple. This is how Dr. Bernanke's "printing press in the basement" works. You can call it whatever fancy names you want - monetization, quantitative easing, QE. I call it "printing money."

As long as the Fed is printing money in this way, it is up to the primary dealers to decide what to do with it. The signs from the first three months QE2 are clear. The dealers will continue to purchase Treasuries from the government, as is required by their role as primary dealers. The government will continue to spend this newly printed money. This will continue to stimulate the economy as it has done already.

That's the apparent upside. But there's an insidious downside. The primary dealers have also elected to use this cash at the margin to push stock prices and commodity prices higher. This bull run can only continue for as long as the Fed continues to pump this cash into their trading accounts. Once the Fed ends the program, the market could face a demand vacuum.

So enjoy the money printing while it lasts. But be ready to jump ship before June, or at the first sign that the Fed will curtail the program. If the commodity price pressures that are squeezing corporate profits and curtailing the consumer's ability to spend on discretionary items continue to build, the Fed could insert words in recognition of that in the next FOMC statement on March 15. That would be advance warning that they could slow or stop the presses ahead of schedule. The markets would probably react badly.

LEE ADLER - SA

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This is not "indirectly funding the primary dealers." The Fed's purchases are direct with the PDs. This is fundamental. Open market operations are always and only between the Fed and the Primary Dealers. The Fed's trading desk has a conference call with them every morning to map out their needs and expectations about how the market will play out. Until the Fed started its now discontinued emergency alphabet soup programs in 2007, open market operations were the only means via which the Fed carried out policy, with the exception of the immaterial activities at the discount window.

The Fed has again made it the sole means of carrying out monetary policy. The biggest difference is that the operations under QE2 are orders of magnitude greater than the usual temporary OMO and occasional permanent OMO that were the order of the day for the 10 years or so leading up to the crisis in 2007.

The indirect bid hasn't increased this week. There was a shift from shorter maturities to the 10 year, but the total indirect bid so far this week is less than the last rounds of the same auctions. Don't forget, $25 billion in SFP CMB paper is being paid off. That cash has to go somewhere. The indirect bid should be much higher than it is under the circumstances.

The Fed purchases $55-60 billion in additional new paper every 2 weeks over and above the amounts the Treasury rolls over (pays off principal with new paper) as it moves toward its stated goal of adding $600 billion to its balance sheet. Again, go look at the last 4 or 5 or 10 H41 statements line by line, just the assets and liabilities. You can skip the notes.

The Fed does not sell bonds.

The Fed's purchase of long term securities is nothing new. The Fed has always purchased long term Treasuries. There have been years when the majority of its assets were intermediate and longer term maturities. They were a significant portion of the Fed's balance sheet prior to QE. The difference is that they are now purchasing them from the Primary Dealers, rather than direct from the Treasury at the auctions in the past as was usually the case.

This is an important distinction. It accomplishes two things. It allows the Fed to claim that it is not monetizing the debt, which is patently false. The monetization may not be as direct as a straight purchase from the Treasury but it is monetization nevertheless, as described above. The other thing it accomplishes is to increase the amount of cash in Primary Dealer trading accounts, which would not happen if the Fed bought the paper directly from the Treasury. It could have chosen to do so, but that would not have achieved the goal of propping up the financial markets. It would have lit a roaring fire under the economy, but they chose this route because they are trying to ignite a stock market bubble.

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Monetization is the process of converting or establishing something into legal tender. It usually refers to the printing of banknotes by central banks, but things such as gold, diamonds and emeralds, and art can also be monetized...Monetization may also refer to exchanging securities for currency, selling a possession, charging for something that used to be free or making money on goods or services that were previously unprofitable.

In many countries the government has assigned exclusive power to issue or print its national currency to independently operated central banks. For example, in the USA the independently owned and operated Federal Reserve banks do this.[1] Such governments thereby disavow the overly convenient 'slippery slope' option of paying their bills by printing new currency. They must instead pay with currency already in circulation, or else finance deficits by issuing new bonds, and selling them to the public or to their central bank so as to acquire the necessary money.

For the bonds to end up in the central bank it must conduct an open market purchase. This action increases the monetary base through the money creation process. This process of financing government spending is called monetizing the debt.[2] Monetizing debt is thus a two step process where the government issues debt to finance its spending and the central bank purchases the debt from the public. The public is left with an increased supply of base money.

WIKIPEDIA

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research.stlouisfed.org/publications/es/10/ES1014.pdf

Governments can finance deficit spending by issuing debt or printing money. In most countries, a government- created central bank controls the money supply¡ªin the United States, this task belongs to the Federal Reserve System. This means that the U.S. Treasury has only one option for financing deficit spending¡ªissuing debt.1 Of course, the government could still finance deficit spending if the central bank created money by purchasing government debt. For example, assume the Fed purchased government securities. The Treasury would pay interest on the government securities to the Fed and the Fed could then return the interest income (net of its operational expenses) to the Treasury. The Fed would effectively be financing deficit spending by ¡°printing¡± money. It would simply be a two-step process: The government would sell debt to the public and the Fed would exchange the public¡¯s holdings of government debt for money.

Many analysts call this two-step process ¡°monetizing the debt.¡±2 I argue that this definition of monetizing the debt is narrow and uninteresting. I also contend that from a more interesting and economically relevant perspective (discussed below), the Fed need not purchase Treasury securities to ¡°monetize government debt.¡± Finally, I suggest that monetizing the debt depends crucially on the purpose of the Fed¡¯s (or any central bank¡¯s) actions. The idea that the Fed monetizes government debt by the simple act of exchanging money for government debt is too narrow and uninteresting because the Fed conducts monetary policy primarily through open market operations¡ª buying and selling securities¡ªmost often government securities.

When the Fed purchases securities the stock of high-powered money (also known as the monetary base) increases.3 When it sells securities the monetary base decreases. If ¡°monetizing the debt¡± is defined as the act of converting government debt to money, there would be no reason to ask, ¡°Has the Fed monetized the debt?¡± The answer would be simple: ¡°Yes, every time it purchases government securities.¡±

Moreover, the goal of the Fed, and most other central banks, is to promote maximum sustainable economic growth and price stability. In the process of achieving this goal, the money supply expands over time with the needs of a growing economy. While the Fed¡¯s actions to increase the supply of money over time would, in effect, be financing deficit spending by ¡°printing¡± money, this would not be the purpose of the Fed¡¯s actions and, hence, critics would be wrong to claim that the Fed has monetized the debt.

I suggest that an economically meaningful definition of ¡°monetizing the debt¡± must be based on the Fed¡¯s motive for increasing the money supply. For example, during World War II the Fed had an explicit agreement with the Treasury to stabilize the Treasury¡¯s cost of war finance. Consequently, the Fed purchased large quantities of government debt to keep interest rates from rising. This created a large increase in the monetary base and the money supply.

After the war concerns arose that the Fed was continuing its policy of helping the Treasury finance the large war debt by attempting to keep interest rates low. This led to an accord between the Federal Reserve and U.S. Treasury on March 4, 1951, that established the Fed¡¯s independence.4 In effect, the accord gave the Fed the freedom to control the money supply to achieve its monetary policy goals rather than aid the Treasury with its debt-financing effort.

An example may help differentiate the motivation aspect versus actions taken by the Fed. If the Fed purchases government debt solely to achieve its objectives of price stability and maximum sustainable economic growth, it is not monetizing the debt. In this case, the Fed¡¯s actions are designed not to reduce the amount of interest-bearing government debt held by the public, but rather to provide an appropriate growth in the money stock consistent with price stability and maximum economic growth.

While more economically meaningful, this definition is difficult to make operational for two reasons: uncertainty regarding the Fed¡¯s primary motivation and timing of the intervention. First, it is difficult to determine whether debt purchases are solely driven by the Fed¡¯s policy. Second, the Fed increases the monetary base whenever it purchases any asset¡ªnot only when it purchases government debt. For example, the Fed has completed its purchase of $1.25 trillion in mortgage-backed securities (MBS) in an effort to support the sagging mortgage market. These purchases have increased the monetary base just as if the Fed had purchased an equivalent amount of government securities. Whenever the Fed purchases any debt, it increases the total supply of credit in the credit market by the amount of the purchase. For example, if the Fed is holding $1.25 trillion in MBS formerly held by the private sector, the credit previously supplied to the MBS market by the private sector is available to purchase government debt. Hence, as long as the amount of credit supplied by the private sector is not affected by the Fed¡¯s actions, the implications of the Fed¡¯s actions for federal finance will be much the same as if the Fed had purchased government securities¡ªa central bank does not have to purchase government securities to monetize debt.

Since March 2009 the Fed has increased its holding of MBS, federal agency debt, and long-term government securities by more than $1.5 trillion for the express purpose of helping the mortgage market and flattening the yield curve to mitigate the effects of the financial crisis. At the same time, the government has been running an unprecedented fiscal deficit.

So far, banks have been content to hold the reserves created by these actions. If banks were to lend these reserves, there would be a massive increase in monetary aggregates like M1 and M2. The Fed has expressed a desire to neutralize the potential effect of its massive acquisition of securities on the monetary aggregates by paying interest on bank excess reserves and/or by offering banks term deposits that bear a market rate of interest. Such a scenario would mean that much of the interest income generated by the Fed holding these assets would be paid to banks rather than rebated to the Treasury.

From the point of view of Treasury finance, the effect would be much the same as if the private sector (specifically, banks) were holding the debt. Indeed, if the interest paid by the Fed exactly equaled its interest income, the effect would be the same as if banks were holding the debt. The Fed would be merely allocating credit by purchasing securities from the private sector and paying the interest income from these securities to banks.

The only effective way to determine whether the Fed (or any central bank) has monetized debt is to compare its performance relative to its stated objectives. Many central banks have adopted a numerical inflation target. If inflation is running above the target when the government is faced with a debt-financing issue, one might suspect that the central bank is monetizing the debt. The Fed has not adopted a specific numerical inflation target, which makes it more difficult to determine whether its actions are purely motivated by its policy objective. In general, the more explicated a central bank is about its policy objectives, the easier it is to determine whether it is monetizing the debt. ¡ö
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1 The Fed is forbidden by law to purchase government securities directly from the government. The government first sells securities to the private sector and the Fed then purchases securities from the private sector, specifically, government securities dealers.
2 For a number of such definitions, perform a Google search for ¡°monetizing the debt.¡±
3 The monetary base (currency plus reserves) is called ¡°high-powered money¡± because each dollar of reserves can support multiple dollars of bank deposits that are included in various monetary aggregates like M1and M2.
4 The statement read ¡°The Treasury and the Federal Reserve System have reached a full accord with respect to debt-management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government¡¯s requirements and, at the same time, to minimize the monetization of the public debt¡± (Federal Open Market Committee Minutes, March 3, 1951; cited at www.richmondfed.org/publications/research/economic_quarterly/2001/ winter/pdf/hetzel.pdf).