Posts Tagged ‘inflation’

Is The Fed Giving a Pass on Sovereign Debt?

Part of the role of the Federal Reserve (the Fed) is to provide oversight to their member banks.  Approximately one-third of all U.S. commercial banks are members of the Federal Reserve.  All national banks are required to be members, and certain state chartered banks can choose to become a member.

Fed oversight involves a variety of bank operations.  Recently, the Fed conducted stress tests of the large national banks.  The purpose was to assess the strength of the bank and their ability to withstand another major economic calamity, like what happened throughout 2008.  One of their goals is preventing any bank from becoming “too big to fail.”

Bank capital is one of the measures regulators use to measure bank strength and stability.  Bank capital requirements are intended to guarantee a bank is able to withstand certain losses in its investment and loan portfolio and still meet the withdrawal demands of its depositors.

The following article describes a Citigroup analysis which discovered a recent trend in the U.S. and Europe regarding bank capital requirements and sovereign debt.  The Citigroup study revealed that bank regulators at the Fed and their European counterparts were not counting sovereign debt as part of the bank capital requirements.  The Citigroup analysts concluded the primary reason for excluding the sovereign debt was to help guarantee a market for sovereign bonds.

The United States and European countries are currently experiencing huge budget deficits.  In order to keep their respective governments operating, the nations’ treasuries and central banks are issuing new government bonds on a daily basis.  Thus, there is a constant need for someone to purchase these bonds.  If the market for a particular nation’s bond were to disappear, catastrophe would quickly follow.  Consider what would happen in the U.S. if investors stopped buying the additional $100 billion of new bonds it takes to keep the U.S. government operating each month.

Just imagine what would happen to inflation and the U.S. economy if investors are reluctant to purchase U.S. Treasuries.  You only have to look at the current problems in Europe.  Spanish 10-year bonds issued this past week carried an interest rate in excess of 6% while 10-year U.S. Treasuries were selling around 1.75%.  If the U.S. had to pay interest on our $15.8 trillion debt at a 6% rate, the annual interest cost would be near $1 trillion.  Think that might negatively impact the economy?

The Fed and European Central Bank are largely responsible for the monetary policy of their respective nations.  Interest rates and inflation are critical factors affecting monetary policy and economic results.  Consequently, you can see the vested interest the Federal Reserve and European Central Bank have in making sure there is a steady market for sovereign debt.   As a result, it appears these institutions are willing to give favorable treatment to sovereign debt when measuring bank capital.

I’m not implying there is collusion amongst the bankers.  Contrary to what some people believe, I don’t there is some grand conspiracy.  With a few exceptions, most of the people involved are honest people doing their best in a very difficult economic and political environment.  Central bankers are given tremendous responsibility for a nation’s economic health, yet they are seldom the people making important decisions on taxes, spending and debt, which greatly impact the economy.

My primary purpose in writing this article is sharing information.  I haven’t seen many articles addressing this topic, so I thought it was worth discussing.  Additionally, I think it’s another indication of the long-term problems of deficit spending and huge national debt.   Without realizing it, policy makers can make poor decisions in order to encourage people to buy sovereign debt, because it will be catastrophic if it ever stops.  It’s like a house of cards that’s growing and requires more effort to keep it from collapsing.

Time will tell, but it seems like exempting sovereign debt from bank capital requirements might be one of those decisions.

Is the Unemployment Rate Misleading?

The April employment statistics were released by the Bureau of Labor Statistics (BLS) last Friday.  The official U.S. unemployment rate for April 2012 dropped to 8.1%.  It hasn’t been this low since January 2009.

According to the BLS, 115,000 new jobs were added to the workforce in April.  Certainly that is good news for the 115,000 who are now employed, and after three years of high unemployment, it’s encouraging to see the rate dropping.

The report has been out for a week, which has given people more opportunity to dig into the numbers.  Unfortunately, the headline is much more encouraging than some of the supporting data.  Here are a few facts to consider

  • 310,000 people left the workforce in April (that’s nearly 3 times as many jobs which were created).  People who are no longer looking for a job contributed more to the reduction in the unemployment rate, than those who obtained a new job.
  • There are 968,000 people looking for work, who are classified as “discouraged.”
  • 7.8 million people are working part-time for economic reasons.
  • 5.1 million people have been unemployed for more than 39 weeks.
  • 324,000 women dropped out of the labor force in the past two months.

So is the unemployment rate misleading?  Personally, I don’t think it’s misleading, but you also shouldn’t take it at face value.  A deeper understanding of the supporting data will provide a better picture of what’s really happening.

Realize the unemployment rate is only an estimate.  No one knows for sure how many people are truly unemployed and looking for work.  For example, many people think it’s misleading to exclude those who have given up looking for work.  While that may be the case for discouraged and frustrated people who can’t find a job, what about those who retire, start their own business or decide to stay home to take care of a family member?  Those people may have no intentions of re-entering the workforce, at least in the near term, so it would also be misleading to count them as unemployed.  Thus, the quandary of who should be classified as unemployed.

I don’t think the unemployment rate is misleading, unless the BLS changes its data collection and classification measures, which happened at the beginning of 2011 (read more here).  Since the BLS hasn’t changed their methodology recently, the drop in the unemployment rate can be considered legitimate.  However, you should investigate some of the supporting data, and draw your own conclusions about the U.S. employment situation.

Since it’s an election year, expect politicians and political pundits to quote the rate as a measure of their job performance or some other elected official and make their political argument for supporting a particular candidate.  Don’t be misled by a headline or political statement, since they rarely tell the whole story.  The unemployment rate may not be misleading, but other people can be.

Quantitative Easing and Funding the Deficit

The U.S. Federal Reserve (the Fed) decided last week to engage in an additional round of quantitative easing.  Financial industry experts and commentators have dubbed it QE II.  Over the next six months, the Fed will print money to purchase an additional $600 billion of government securities.  The goal is to keep interest rates low and encourage economic growth.

There has been a mixed reaction to QE II. While not offering a personal endorsement, President Obama has been supportive of QE II, but some members of Congress have been vocally critical.  Rep. Mike Pence from Indiana said the Fed was taking an “incalculable risk.”

Criticism has also come from abroad.  Finance ministers from China, France and Germany have expressed their concerns with QE II.  Granted, they are looking out for the financial interests of their respective countries.  As large exporting countries, China and Germany are concerned that increasing the money supply will further devalue the dollar and make U.S. exports more competitive globally.  China has another point of contention.  For years, the U.S. has accused China of keeping the yuan artificially low to make their global exports cheaper.  QE II seems to do the same thing we have criticized China of doing for years.

Beyond the risks of inflation and devaluing the dollar, I believe there is another correlation that needs to be made.  Congress has yet to pass a fiscal 2011 budget, and the government is operating under a continuing resolution, which keeps spending at the same level as fiscal 2010.  Although the final numbers have not yet been calculated, the 2010 budget deficit is approximately $1.4 trillion.  The 2011 budget presented by President Obama projects a $1.3 trillion deficit.

This means that the U.S. government is overspending by approximately $100 billion per month. Coincidentally, the Fed will be purchasing $600 billion of government securities over the next 6 months.

Although I don’t believe these matters are directly related or that there is some great Washington conspiracy, we are in essence self-funding our own deficit spending by printing an additional $600 billion of cash.  The U.S. government and economy may be sufficiently large enough to handle QE II.  However, I believe there is grave danger for any nation that funds its own spending and deficits by printing money, even for a short time.  It’s like lighting the fuse to a box of dynamite.  You can let it burn for a while, but if it burns for too long… be ready for an explosion.

I admit that I am not an economist or as smart as the Fed Board of Governors, but I do believe there are tremendous risks associated with QE II.  The more I analyze QE II, the more I see that Rep. Pence’s calling QE II an “incalculable risk” might be more than a partisan political statement.

The way I see it, the Fed, Congress and President have a short time to deal with the economic and fiscal challenges of this nation.  Quantitative easing may be intended to keep interest rates low and spur economic growth, but printing money – to buy government  debt – to fund deficit spending is a vicious cycle, that can have disastrous effects for the long-term stability of this nation. 

Let’s hope that QE III is the name of a new British cruise ship; not another round of quantitative easing.

Quantitative Easing: Out of Nothing

Quantitative Easing is a monetary policy used by a nation’s central bank to stimulate the economy.  The central bank buys its own government’s bonds on the open market, thereby increasing the money supply. This additional money is supposed to stabilize or lower interest rates, and make it easier to borrow money.

So where does the central bank get the money?  It prints it.

Last week, the U.S. Federal Reserve (the Fed) decided to engage in another round of quantitative easing.  Over the next eight months, the Fed will purchase $600 billion of US government bonds. This will be in addition to the $1.7 trillion of U.S. bonds the Fed purchased between January 2009 and March 2010.  Thus, by the end of June, the Fed will own $2.3 trillion of U.S. debt. The Fed is expected to print up to $900 billion of new money to fund these purchases. 

In a Wall Street Journal article defending the decision, Fed Chairman Ben Bernanke has justified the action as part of normal monetary policy.  He stated that “We see an economy which has a very high level of under utilization of resources and a relatively slow growth rate.”

However, quantitative easing is not without risks.  A spike in inflation is one of the primary concerns.  Printing money creates assets ex nihilo (out of nothing).  Since no additional value is created, pumping more money into the system devalues the existing dollars, which often leads to inflation.  The ability to print money ex nihilo is why the U.S. government will never go bankrupt.  All it needs to do is print more money to cover its debts.  However, this technique usually results in hyperinflation.  History is full of nations that have inflicted financial ruin on themselves by using this type of monetary policy.

Apparently the Fed believes that a lack of liquidity is the cause of anemic economic growth.  I’m not an economist nor as smart as the Chairman, but something doesn’t seem to add up.  We’ve been hearing for months that banks and corporations are currently sitting on approximately $2 trillion of cash. Their reluctance to invest this money is hindering the economic recovery.  If there is already $2 trillion of excess cash, what is the benefit of creating $600 billion of additional liquidity?  Lack of demand and uncertainty of the future seems to be a greater hindrance to economic growth than a lack of money.

The first round of quantitative easing didn’t seem to have much of an effect on the economy. Time will tell if Chairman Bernanke is correct in his assessment of round two.  Hopefully it does as he expects and the economy grows.  More importantly, let’s hope it doesn’t backfire and spark a significant rise of inflation.  If so… we could easily return to the days of stagflation in the late 70’s and early 80’s.

Repeating History: The Predictability of Economic Indicators

Baseball is a sport that relies heavily upon history.  Managers make decisions about pitchers, hitters, runners, etc. based upon historical statistics.  If a certain batter has a lower batting average against a left or right-handed pitcher, the manager may make a pitching change.  The batter may still hit a homerun, but statistically it’s less likely.

Much like baseball, leading economic indicators are based upon the premise that economic history will repeat itself. Leading economic indicators are various statistics or observations that are intended to give an indication of the future direction of the economy.  As written in a previous article, they can be a nationally publicized economic statistic or someone’s instinct of what’s coming next.

Ben Bernanke, the current Federal Reserve Chairman, is considered to be a leading authority of the Great Depression.  He has dedicated a lot of his career studying the causes and remedial measures of the Great Depression.  His intent… to learn from history and avoid making similar mistakes.

The assumption is that economic output will react the same way to similar measures.  As a simple example, raising the discount rate will slow the economy and curtail inflation, and lowering the rate will encourage lending and growth.   The same principle was the basis for passing the $787 billion Stimulus Bill in February 2009.  The premise goes all the way back to President Roosevelt’s plan for ending the Great Depression with the passage of the New Deal.  The ultimate effect of the New Deal and the Stimulus Bill will be debated for years, but the assumption is that if it worked in the past, it will work again.

This theory influences the way economists, investors, politicians and policy-makers approach the economy.  The historical economic results of certain changes in economic indicators form the basis for how they make current decisions.

The difficulty arises when the economy reacts differently.  Economic conditions are as unique and unpredictable as people.  Although statistics may point a certain reaction, the economy doesn’t always function as expected.

Oil prices are a great example of this.  When oil prices spiked in the early 1970’s and 1980’s the economic effects were staggering.  The economy fell into a great recession and inflation took off.  From the beginning of 2007 to the middle of 2008, oil went from $61 per barrel to over $140, a 130% increase.  Although people grumbled and businesses scrambled, the economy didn’t fall into a great recession.  A major recession started in the third quarter of 2008, but it was more a result of imploding real estate and financial markets, than the price of oil.

In this case, history didn’t repeat itself.  Yes… oil prices may have been a contributing factor, but I don’t believe it was the primary cause, like it was in the 70’s and 80’s. 

I’m not suggesting that there is no value to leading economic indicators, but their utility in predicting future economic results is limited.  To the extent you study economic indicators and listen to pundits espouse their opinions of the implications of economic measures, keep this one principle in mind – leading economic indicators assume history will repeat itself, but the economy is like people… it is unpredictable.

Controlling Economic Growth with the Federal Reserve Discount Rate

The Federal Reserve (the Fed) is charged with managing the U.S. money supply and keeping inflation in check.  Increasing the money supply (i.e., printing money) is intended to spur economic growth.  Additional money is supposed to make it less expensive to borrow, thereby encouraging investment and growth. It also devalues the dollar against other currencies, which should increase exports by making American goods less expensive to buy internationally.

The Conference Board includes the Federal Reserve money supply as part of its composite index of leading economic indicators.  Bankers, economists, currency traders and exporters are particularly tuned into the supply of money in the financial system.    

The discount rate is another primary tool the Fed utilizes to achieve its objectives.  The discount rate is the interest rate the Fed charges other banks to borrow from it. 

If banks are in the business of lending money, why are they borrowing from the Fed?  It’s called leverage.  Being able to borrow money from the Fed allows banks to leverage their deposits and loans.  Banks only keep a fraction of the money deposited to them on hand.  The rest is loaned out.  However, if you want your money, they have to be able to pay you when you to withdraw it.  The ability to borrow from the Fed allows banks the ability to keep fewer reserves and lend more money. Consequently, the discount rate affects the interest rate banks charge you to borrow money.

In general, the Fed increases the discount rate when the economy is doing well.  Raising the interest rate slows growth, which is intended to keep inflation in check.  Furthermore, in good economic times, people don’t need as much of an incentive to take risks or borrow money and are willing to pay a higher interest rate to access capital.  Conversely, in recessionary times, the Fed will reduce the discount rate to lower lending rates and spur economic growth. 

If you study the history of the Fed discount rate, you’ll see increases during periods of economic prosperity and rate cuts during recessions.  The size and timing of the rate cuts or increases are indications of the economic conditions. 

This is evidenced in the Fed discount rate over the past two years. The Fed dropped the rate seven times in 2008, reducing the rate by 0.75% three times.  The rate was 0.5% at the end of 2008, and hasn’t been that low in over 30 years.  This is an indication of the severity of the current recession, as if you needed another sign.

The Fed raised the rate 0.25% in February 2010, on signs the economy was strengthening.  However, the Fed has indicated that it doesn’t expect any rate increases for an extended period of time.  With rumblings that the recovery is slowing, the Fed may be pushed to lower the rate once again, but it doesn’t have much further it can go.

You don’t have to wear yourself out trying to understand monetary policy, money supply and inflation factors.  If you want to get a quick synopsis of the Fed’s current view on the economy, just watch their action on the discount rate.  No change means you can expect things to stay the same for a while.  A reduction is a sign of trouble, and an increase is an indication that things are getting better.

With the Fed saying that they expect to hold the discount rate static for an extended period of time, you can expect the economy to continue to slog along.  It may not be great, but hopefully it doesn’t get worse.

Paper Money and the Gold Standard (The Value of Money – Part III)

If you’re unfamiliar with the principles of a gold standard currency vs. fiat money, has a great article you can read.  As Mike Moffatt, stated in this article, it’s unlikely that the U.S. will return to a gold standard for currency any time in the near future. 

One of the primary benefits of a gold standard is that it tends to keep inflation in check, but it can also restrict government monetary policy because the government can’t print money that is not backed by value of the gold it controls.  This may be one of the reasons that President Franklin D. Roosevelt  pushed to remove the gold standard in 1933, which was part of his economic plan to move the country out of the Great Depression.

For most of us, it doesn’t matter too much whether our money is backed by gold, so long as we can buy what we want.  Since inflation has been relatively low for the past 30 years, we have yet to experience the loss of purchasing power resulting from government monetary policy gone awry.

I recall being in Romania in 2001 and 2002. The exchange rate was about 32,000 Romanian Lei to $1 U.S. in 2001.  A year later, the exchange rate was nearly $36,000 Romanian Lei to $1 U.S.  The inflation rate was about 10% per year.  Not the worst in the world, but definitely not great either.   In 2001, the Romanian government had just begun printing the 500,000 Romanian Lei bill (the equivalent of about $13.89), because of the large amounts of cash people were required to carry.  Those 500,000 bills came in handy when paying the dinner tab for our group, which could easily exceed 10,000,000 Romanian Lei, and trust me, we weren’t eating in posh places.  On July 1, 2005, the Romanian government revalued their currency for the fourth time.  It was revalued at 10,000:1.

If you don’t live in Romania, you may wonder what this has to do with you.  The point… any government (including the U.S.) can print as much fiat money as it wants. The question is… what’s it worth?

The Federal Reserve System of the United States (the Fed) controls the monetary policy of the U.S.  In order to help stimulate the economy and prevent the financial markets from collapsing in 2008, the Fed increased money supply by approximately $1 trillion.  How did they do that?  Since it is fiat money, all they needed to do was crank up the printing presses.  The money then entered the financial system through the discount window and by the Fed’s purchase of bonds.  With a federal deficit of $1.42 trillion for the year ended September 30, 2009, who do you think bought some of those U.S. Treasury Bonds?

Still seem like it doesn’t matter to you.  Maybe it won’t, but maybe it will.  The challenge now facing the Fed is the how to reduce the money supply.  That could result an increase in the interest rate at the discount window, which will likely cause a tightening of credit and higher interest rates for borrowers.  It could also slow down the economic recovery.  Alternatively, leaving the money in the system for too long could cause a significant rise in inflation.  The Fed may find that it’s a lot easier to print $1 trillion, than it is to get back $1 trillion.

The Fed controls the U.S. monetary policy, and there is little you can do about it.  However, by paying attention to the Fed, you can keep tabs on the value of your money.  Under a fiat money system, your dollar literally may not be worth what it used to be.

Your Money vs. Other People’s money will be the topic of The Value of Money – Part IV.

Currency & Commerce (The Value of Money – Part II)

One of the primary values of money is the facilitation of commerce.  A common currency is the medium of exchange which facilitates your ability to buy or sell something.   The buyer and seller know what they are giving up in value and what they are receiving in return.

What would you do if you didn’t have money or your money had no value?  You might try bartering for what you need.  Try that the next time you go to the store to buy groceries or stop at the gas station to fill up.  Imagine the look on the cashier’s face when you ask if you could pay with your watch or a sack of potatoes, rather than cash or your debit/credit card.

The current economic climate and concerns for the future have caused some people to suggest that you should stock up on gold and silver to preserve your ability to continue buying things in the event of a complete economic collapse.  Dave Ramsey is one prominent opponent to this idea.  His contention is that gold would be as useless as paper money because people would resort to bartering instead.

Without addressing the point of whether or not gold is a good investment.  I see his point. Even when gold was the principle form of money, it was still transformed into a common currency.  No one carried around bags of gold rocks or bullion. They used gold coins… minted into identical sizes and shapes representing specified values (just like our silver coins today).

At the same time, I don’t think that even in a complete economic collapse bartering would last long. It may occur for a short time following a major catastrophe or natural disaster, but our society is far too complex and advanced to function solely through bartering.  Most of us would be in deep trouble if we had to barter for our existence.  Urban society doesn’t lend itself to providing food yourself and most of our skills have a limited marketplace.  My family would be in trouble if I had to barter tax and accounting services with everyone necessary for us to live.

Gold, silver and other precious metals are commodities and may have a place in your portfolio as a hedge against inflation.   However, I don’t think it should be seen as a replacement currency to purchase goods and services.  Gold and silver coins might be easier to barter, but I doubt that they would become a replacement currency.  How would a merchant know what your gold coin is worth?  How would they know if it’s pure gold or just gold-plated?

In the event of a major economic catastrophe or collapse of the financial system, I would prefer to have a stash of cash in a safe deposit box than try to barter with gold and silver.  Hyperinflation may cause the cash to be worth less, but at least it’s a standard that everyone know how to value.

As long as we’re talking gold, the Value of Money – Part III will address the paper money and the gold standard.