Pushing on a String
September 24, 2010
By John Mauldin


Pushing on a String
Let’s Shift the Focus
An Invitation to an Inflation Party
Ten Years and Counting

This week the Fed altered their end-of-meeting statement by just a few words, but those words have a lot of meaning. It seems they are paving the way to a new round of quantitative easing (QE2), if in their opinion the situation warrants it. A trillion dollars of new money could soon be injected into the system. Tonight we explore some of the implications of a new round of QE. Let’s put our speculation hats on, gentle reader, as we are moving into uncharted territory. There are no maps, just theories, and they don’t all agree. (Note: this letter may print a little long, as there are a lot of charts.)

But first, as a reminder, next Wednesday, September 29 (9:00 AM PST/12:00 PM EST), I will be doing a special “webinar” with Jon Sundt, President & CEO of Altegris Investments, where we’ll discuss the forces that are shaping today’s economy and their potential influence on financial markets (the very things I write about in this week’s letter and in my new book!). This is an excellent opportunity to learn about alternative investment strategies designed to provide noncorrelated diversification for your investment portfolio in the “new normal” economy. We’ll set aside a lot of time to answer your questions.

A replay of the call will be available for two weeks starting Thursday, September 30, for . Even if you can’t make it at this specific time, I recommend you still register so you can listen to the replay at your convenience after the event.

You can register by going to www.accreditedinvestor.ws and signing up for my free accredited letter, and a representative from Altegris will call you to give you the details. Sadly, this is available only to accredited investors ($1.5 million net worth and up) and/or registered financial professionals, due to current regulations. I will be giving a preview of the conclusions from my new book, The End Game, which I think you will find interesting. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

Let’s Shift the Focus

The Fed issued the usual statement at the end of their meeting this week, and Fed watchers poured over the words, looking carefully for any sign of change in Fed policy. The consensus seems to be that the most important change was the statement concerning inflation, the first such change in over a year.

“Measures of inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.”

The next (and only other real) change was:

“The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if neededto support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” (my emphasis)

Translation: inflation may be getting too low, but don’t worry, we are on the job.

One of my laugh lines in my speeches (I don’t have that many) is: “When you are appointed to the Federal Reserve they take you into a back room and do a DNA change on you. After that, you are viscerally and genetically opposed to deflation.”

Bernanke made his famous helicopter speech about not allowing deflation to happen back in 2002. He happily assured us that the Fed has many tools to fight deflation and that it won’t happen here. Of course, he also told us the subprime problem would be contained, but I am sure that we have to give him a bit of slack – we all miss a few, including your humble analyst. (Well, I didn’t miss the subprime thingie. Nailed that one.)

Anyway, the Fed seems to be setting us up for another round of quantitative easing. That is Fed speak for buying a few trillion or so dollars of government debt and injecting said cash into the economy.

Before we get into the wisdom of such a move, let’s look at what might prompt them to do so. This is where we get into speculation.

Recessions are by definition deflationary, but if we go into recession when inflation is already as low as it is, the Fed will be behind the curve. But telling us they are going to start easing because they are worried about a recession is not a good recipe for a positive market reaction.

So? Why not just say that they are worried about the lack of inflation, “at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” That way they are not fighting a weak economy but rather something that everyone understands, i.e., deflation.

I agree with David Greenlaw from Morgan Stanley. He writes:

Growth data still take precedence. The change in the inflation language, while important, does not, in our view, signal an elevated emphasis on the incoming inflation data itself as a possible trigger for asset purchases. To be sure, the inflation data do matter, but the growth indicators matter more because, from the Fed’s perspective, the pace of growth in economic activity is a leading indicator of inflation. Here is a key excerpt from Bernanke’s Jackson Hole speech that helps explain the perceived link between growth and inflation:

” ‘…the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.’ ” (emphasis added)

The key driver for whether the Fed enters into another round of quantitative easing, likely to be in the trillions, is the growth in the US economy. If we are above 1.5-2%, I think they will hesitate, for reasons I go into below. If we drop below 1% and it looks like we are getting weaker, then they are likely to act. A slide into recession would bring about deflation. As noted, they are viscerally opposed to deflation.

An Invitation to an Inflation Party

The question in my mind is whether a few trillion dollars spent purchasing government debt would do the trick. What if they sent out invitations to an inflation party and nobody came? Let’s look at some data points.

The Fed purchased $1.25 trillion in mortgage assets last year. The theory was that injecting money into the economy would cause banks to take that money and lend it, jump-starting the economy and bringing us back into a normal recovery. Let’s see how the lending part went. Here are a few graphs from the St. Louis Fed FRED database.

The first is “Bank Credit of All Commercial Banks.” Please note that the straight upward line in the middle of 2010 is an accounting change. Without that the trend would still be down.

Then we have “Total Consumer Credit Outstanding.” That had been growing steadily for 65 years until this last recession.

Next we have “Commercial and Industrial Loans at All Commercial Banks.”

We could look at total residential mortgages (down); credit card debt (down); and commercial mortgages (down). The list goes on.

Sidebar from Greg Weldon:

“Also, the value of Commercial Property Loans classified as Special Servicing (restructured and-or- extended) rose to a NEW HIGH, pegged at 11.74% of all CMBS, as evidenced in the chart below.”

No wonder commercial mortgages are down.

So, what happened to the trillion-plus dollars? It doesn’t look like it went into bank lending. As it turns out, it went back onto the balance sheet of the Federal Reserve. Banks put it back into the Fed. There are several ways you can measure this with the FRED database, but one way is to look at “Reserve Balances with Federal Reserve Banks, Not Adjusted for Changes in Reserve Requirements.”

If banks are not lending now, with what seems like lots of reserves, then what is to make us think that another $2 trillion in QE will make them feel like they have too much money in their vaults?

If it is because they don’t have enough capital, then adding liquidity to the system will not help that. If it is because they don’t feel they have creditworthy customers, do we really want banks to lower their standards? Isn’t that what got us into trouble last time? If it is because businesses don’t want to borrow all that much because of the uncertain times, will easy money make that any better? As someone said, “I don’t need more credit, I just need more customers.”

How much of an impact would $2 trillion in QE give us? Not much, according to former Fed governor Larry Meyer, who, according to Morgan Stanley, “…maintains a large-scale macro-econometric model of the US economy that is widely used in the private sector and in public policy-making circles. These types of models are good for running ‘what if?’ simulations. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be ‘high-end estimates’.

“Some probability of a resumption of asset purchases is already priced in, and thus a full 50bp response in Treasuries is unlikely. Moreover, a model such as Meyer’s is based on normal historical relationships and therefore assumes that the typical transmission mechanisms are working. For example, a drop in Treasury yields would lower borrowing costs for consumers and businesses, helping to stimulate consumption, business investment and housing. But there is good reason to believe that the transmission mechanism is at least partially broken at present, and thus the pass-through benefit to the economy associated with a small decline in Treasury yields (relative to current levels) would likely be infinitesimal.” (Morgan Stanley)

That is not much bang for the buck, so to speak, but it would be pointing a gun with a very big bang at the valuation of the dollar. If QE were attempted on that scale, it would not be good for the dollar. My call for the pound and the euro to go to parity with the dollar would be out the window for some time, and maybe for good.

Now, if the strategy is to lower the dollar, then QE might make some sense; but of course no one would admit to that, not when we are accusing other countries of manipulating their currencies (as in China). No, we would just be fighting deflation. The fact that the dollar dropped would just be a coincidence, a necessary but sad thing in the important fight against deflation. (Please note tongue firmly in cheek. Not you, of course, but some other readers sometimes miss my sarcasm.)

Of course, not all agree that a lower dollar would necessarily be a bad thing. Ambrose Evans-Pritchard, writing in the London Telegraph, concludes a column in where he notes that there is a lot of opposition to QE2 from some fairly significant economic luminaries, and that:

“Dr Bernanke said in November 2002 that Japan had the economic instruments to pull itself out of malaise but failed to do so. ‘Political deadlock’ and a cacophony of views over the right policy had prevented action. He insisted that a central bank had ‘most definitely’ not run out of ammo once rates were zero, and retained ‘considerable power to expand economic activity’.

“Yet eight years later, the US is in such ‘deadlock’. Worse, Fed officials now say ‘the ball is in the fiscal court’, arguing that budget policy should do more to ‘complement’ the Fed’s existing stimulus. Oh no!

“This is the worst possible prescription. What is needed is fiscal austerity (slowly) before debt spirals out of control, offset by easy money or real QE for as long as it takes. This formula rescued Britain from disaster in 1931-1933 and 1992-1994.

“Damn the rest of the world if they object. They have been free-loading off US demand for too long. A weaker dollar will force the mercantilists to face some hard truths. So keep those helicopters well-oiled and on standby.”

Hmmmm. If everyone else wants to devalue their currency, should we play along? Can you say buy some more gold?

But back to the inflation party invitation. If the economy is recovering, QE is not needed. Note that the US economy in the current quarter may be doing better than last. And if you looked at the bank lending charts I presented above, an optimist could note that it looks like we might be seeing a bottom forming and even some increase in lending. Perhaps we have turned the corner. Again, the banks have plenty of reserves, so another $2 trillion is not needed.

But what if they went ahead and threw $1-2 trillion against the wall? If it showed up back at the Federal Reserve, it would only serve to show that the Fed does not have the tools it needs, or would have to be really willing to monetize debt. It would be Keynes’ “liquidity trap” or what Fisher called debt deflation. Neither are good.

That’s called pushing on a string. If the markets sensed that, it would not be pretty.

The Fed has been buying government debt for several months, taking the money from the mortgages that are being amortized and buying the debt. Let’s maybe see how that works out before we bring out the big guns. Just a thought.

I agree with Allan Meltzer, a historian of the US central bank:

” ‘We don’t have a monetary problem, we have 1 trillion or more in excess reserves, so it’s literally stupid to say we’re going to add another trillion to that,’ Meltzer, a professor at Carnegie Mellon University in Pittsburgh, said today in an interview on Bloomberg Television’s ‘InBusiness With Margaret Brennan.’

” ‘One of the major mistakes that the Fed makes all the time is too much concentration on the short-term,’ said Meltzer, author of a history of the Fed. ‘Aiming at that is just a fool’s game.’ ” (Business Week)

That being said, we live in a world where we need to act in terms of what will be rather than what should be. And if the economy continues to weaken, I think it is likely the Fed will act preemptively and start QE2. So the next few months of economic data are very important.

And even more important is whether Congress will extend the Bush tax cuts at least until the economy is growing respectably, when they come back for the lame duck session in November. Not extending them would be a policy mistake bigger than QE2, and might force even more precipitous action. We do live in interesting times.

Ten Years and Counting

Ten years ago I started this letter online with about 2,000 email addresses. Now the letter goes to over 1.5 million of my closest friends and is still growing. It is on dozens of web sites and is quoted everywhere. I have to admit to be somewhat overwhelmed by it all. I had literally no idea when I put that first letter on the Internet that it would become what it has. Of course, I made the lucky decision back then to make it free, when there were not that many free letters, so people sent it to their friends, who subscribed.

Every letter since the beginning of 2001 is in our archives. Good, bad, or indifferent, they are all there, just as they were sent out. I sometimes wish I could edit a few sentences here or there (what was I thinking?!?!?), but we made the decision early on to just let the chips fall where they may.

It wasn’t long after that that Tiffani came to work for me (temporarily, we thought). She literally started in a closet, filing and doing data entry. Now she runs the businesses and Dad just reads and writes and does a little traveling and speaking, and from time to time finds a few new opportunities for her to add to her growing list.

And I have to mention my business partners around the world who have helped me create a dream job that gives me a comfortable lifestyle while having more fun than any one man should have. Jon Sundt and the team at Altegris, Steven Blumenthal at CMG, Niels Jensen and his team at Absolute Return Partners, Prieur du Plessis (and Paul Stewart) in South Africa, Enrique Fynn in South America, and John Nicola in Canada. Thanks so much. And of course this whole letter would not be possible without my great friend and publisher Mike Casson.

The last ten years have been a great ride, but the next ten are going to be even better. We will be launching several new web sites in the next few weeks, and reworking our old ones with total makeovers. There will be a forum where you can respond to this letter and talk with each other. I will respond to questions. We will soon be introducing audio podcasts (“The Mauldin Minute”) and, when I get the concept down, go to video. Some new subscription services, too. And a much easier and better way to find alternative investments that have the potential to work for you in this crazy economic environment. We are excited.

But the letter will stay the same. It is just you, me, and a few other of my closest friends sharing a few thoughts every weekend. At the end of the day, it is you, gentle reader, who is the reason for the growth of this letter. Your kind words and persistence in forwarding to your friends have been the reason for whatever success there has been. I am grateful and humbled.

There is not a week that goes by that I do not acknowledge my great debt to you. My most sincere thanks. I will do my best to continue to deserve your valuable time that we share each week.

And now it is time to hit the send button. Eight cities in seven countries in nine days (ten planes!) have left me a little tired. I think I will rest a great deal this weekend, although I will spend some time editing my book. We are getting close. I am ready to be finished, but it has to be right. Have a great week.

Your ready to be in his own bed for a week analyst,

John Mauldin
John@frontlinethoughts.comCopyright 2010 John Mauldin. All Rights Reserved

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

7 Responses to “Pushing on a String”

  1. It’s nice to see that John remains a typical debt-hawk, with his “What is needed is fiscal austerity (slowly) before debt spirals out of control. . . “ He never says what “out of control” means, because debt hawks never offer specifics. So let’s speculate:

    Does it mean the federal government will be unable to service its debt (the normal meaning for “out of control”)? Nope. Couldn’t be that. As a monetarily sovereign nation since 1971, the U.S. federal government has the unlimited ability to service its debt.

    So, does it mean we’ll have inflation? Nope. Since that fateful August 1971 date, there has been no relationship between federal deficits and inflation. Since that time, the cause of inflation has been energy prices.

    So, does it mean taxes will be higher or our grandchildren will owe the debt? No, there is no modern (post-1971) relationship between tax rates and inflation or deficits. Our grandchildren actually benefit from federal spending. So what does “out of control” mean. No one knows. I suspect it means something like, “It’s big and I don’t like the word ‘debt.’”

    Oh, then there is the “problem” of banks not lending, which is another way of saying, adding to private debt. Does it strike anyone as curious that the pundits want the private sector to borrow more, while these same pundits want the federal government to borrow less? Here is the private sector, where bankruptcies are rampant, and the pundits want more borrowing. And here is the government, which can service a debt of any size, and functionally is incapable of bankruptcy, and the debt hawks want to restrict debt.

    And then there is the debt hawk call for less federal spending and more taxes (the only way to get the federal debt down), while being vaguely aware that federal spending is stimulative and taxes hurt the economy.

    Oh, you don’t like stimuli because the “don’t work.” Then you will enjoy the story of the man whose house was burning. His neighbor showed up with a garden hose and actually was able to reduce the flames, but only a bit. The neighbor wanted to call the fire department, who would bring out the big hoses, but the man told him to stop, because “Obviously, water doesn’t put out fires.” And just as “obviously,” money doesn’t stimulate the economy.

    The reason debt hawks continually call for conflicting actions is they begin with a false assumption. The assumption: Federal debt has an adverse effect on the economy. The truth: Federal debt is absolutely necessary for economic growth. Without it, we would have no economy at all.

    But try telling facts to a debt hawk.

    Rodger Malcolm Mitchell

  2. [...] Mauldin responded to my comment on his post, “Pushing on a String” “I don’t know why you think I would not respond. Just happened to see this on Google [...]

  3. John Mauldin responded to my comment on his post, “Pushing on a String”

    “I don’t know why you think I would not respond. Just happened to see this on Google alerts.

    I have been quite clear on what is too much debt. I have done whole e-letters on it. It is debt growth above nominal GDP on a consistent basis, which ends up in a Greece like state. In fact, I will have a book out in January called The Endgame which goes into hundreds of pages of detail about the problems with debt and debt crises.

    Now, I do not want private businesses or people borrowing beyond their own means or banks lending if they do not think there is reason to believe they will be repaid. And there is a limit to how much countires can borrow. To assert that the US can borrow without limit is rather absurd. You write:
    ‘And here is the government, which can service a debt of any size, and functionally is incapable of bankruptcy, and the debt hawks want to restrict debt.’

    Go read Rogoff and Reinhart. 266 crises in 60 countries over the last few hundred years, from countries that can print their own money to gold standard currencies. Everything was fine until the last moment. There are more than one ways to default on debt, and one way is to print the money and debase the money supply. Inflation ruins pensioners and savers. If that is your ideal future, then by all means, run up that debt!


    First John, you have my apology. You responded, and did so without name-calling, which not only is commendable, but a rarity in the debt hawk world. Unfortunately, you didn’t offer any facts, so I will supply one.

    Again, you said,“I have been quite clear on what is too much debt . . . It is debt growth above nominal GDP on a consistent basis, which ends up in a Greece like state.”

    Here is a graph you might find interesting:

    It shows that in the past 40 years GDP has risen less than 1,400% while federal debt has risen 3,500% — well more than double the rate. I would call that “debt growth above nominal GDP on a consistent basis,” wouldn’t you? Yet, where is the inflation?

    The last big inflation was in 1979, at a time when debt growth did not exceed GDP growth.

    Also, ” . . . ends up in a Greece like state . . .” makes no sense, whatsoever. The U.S. is monetarily sovereign. Greece is not. It functionally is impossible for a monetarily sovereign nation magically to transform itself into a “Greece like state.”

    The debt hawk inflation bogeyman emerges every time deficit spending is mentioned. I’m surprised you didn’t offer pre-war Germany or Zimbabwe as examples. But that bogeyman has hurt the lives of real people. It has prevented universal health care. It has restricted Social Security and Medicare benefits. It has given us a monster, wasteful, unnecessary federal tax system. And all because the debt hawks tell us that eventually — eventually — we will have inflation.

    Yet, money debasement is not related only to money supply, but more importantly to money demand (interest rates), which is why in the past 40 years, there has been no relationship between federal deficits and inflation.

    Again, I do appreciate your comments and your courage, but because you do not understand monetary sovereignty, you simply are wrong.

    Rodger Malcolm Mitchell

  4. When John wrote,“I have been quite clear on what is too much debt . . . It is debt growth above nominal GDP on a consistent basis, which ends up in a Greece like state,” I called attention to data showing that debt growth consistently has been above nominal GDP without inflation, and that it is impossible for the U.S. (a monetarily sovereign nation) to end up in a Greece-like (i.e., non-monetarily sovereign) state.

    I also complained that debt hawks never respond, because they have no facts with which to respond.

    How surprised I was when John did respond, but alas, he responded not with facts about the issue, but rather with a plug for his upcoming book. So with this response, I’ll give it one more try, knowing that facts probably will not be forthcoming, but hoping, hoping . . .

    Rodger Malcolm Mitchell

  5. [...] time I start wondering about a “correct” valuation for gold, I get a nice little reminder of why we might not be done with the rally: That is not much bang for the buck, so to speak, but it [...]