Early inflation indicators?

[Tilted]

I'm not ready to sound the inflation alarm just yet. Although I am firmly convinced that we are likely to experience a problematic inflationary cycle at some point in the not too distant future, it doesn't seem to me that that particular problem is imminent yet.

However, I think the first hint of what is to come slipped by largely unnoticed and mostly unacknowledged last week. It came in the form of a $14 Billion, 30 year bond offering from the U.S. Treasury. At auction, the issues went off at a high yield of 4.288%. That's 65 basis points higher than the last issuance of the 30 year bond in March. Is that a huge deal in the grand scheme of things - no - but I do think that that steep a yield rise, in that short a time, is noteworthy. To be clear, in historic contexts, that's still a very low yield.

But, nonetheless, it's an indication that the interest in long term U.S. debt has declined some. Our borrowing costs are starting to rise. The gap between yields on England's 30 year Gilt and our 30 year bond has shrunk to 22 basis points as of this morning, and Germany's 30 year Bund is actually trading at a slightly lower yield than our 30 year bond now. The world is still in love with our debt, but the bloom has come off the rose a little since a few months ago. There are plenty of reasons for that which are actually hopeful for our economy, but those same reasons are also inflationary by their nature. It will be interesting to see how upcoming offerings of 5 and 10 year notes are received.

Again, I'm not suggesting that Jimmy Carter era inflation rates are about to crash down upon us, but we should be aware that such problems can come on fast and furious. The decision makers need to remain vigilant, forward focused, and ready to take dramatic, decisive and even unpopular action, in order to stave off that possibility. Will they react quickly enough? Can they even, at this point? I guess we'll see, but, to my mind, reacting quickly enough would probably require acting very soon.

 

[Larry Gude]

This is interesting to me and here is why;

Carter era inflation was based on, as I understand it, supply and demand fluctuations in a creaky, drifting economy; the slinky out of whack. This was long before the current era of incredibly flexible manufacturing capabilities brought about by the demands of just in time inventory control.

In my view, the ability for business to rapidly respond to opportunity imposes a discipline on pretty much every good. Out of control immigration does the same for labor.

So, if inflation isn't going to come from goods or labor getting expensive, where is it gonna come from?

Easy money.


Well, on the one had, we do have 'easy' money; they're printing it and spending it at what should be terrifying rates. However, like it or not, this is happening at the micro level; government directed, as opposed to the macro level; consumer directed.

It's one thing for we, the people, to whip out the credit cards and devalue everything because everyone has one and is buying more. That's the traditional inflation most people recognize; If all the TV's are selling out by noon at $500 a piece, day after day, time to start selling it at $600. If restaurants are jammed at $100 a plate. Time to go to $125.

it is another thing if government is spending money, paying for goods and services and putting people to work who are, in turn, not spending it like crazy, the gasoline that goes on the smoldering embers of inflation ain't being applied.

People are cutting back. People are saving. The government is keeping them, or trying to, in jobs.

There has to be a problem with all this deficit spending. However, where is it going to come from?

 

[Tilted]

So, if inflation isn't going to come from goods or labor getting expensive, where is it gonna come from?

I understand what you're saying, but let's look at it from the other direction.

For simplicities sake, I'm not going to distinguish between money velocity and money supply in this model. It is the product of those metrics, the effective money supply if you will, that matters for this model. Currently, we have increased money supply, but money velocity is very low (we are saving, not spending right now - consumers aren't as consumptive - things aren't getting bought - deals aren't getting done). So, the effective money supply hasn't increased - in fact, it has probably decreased a little (that's why some people thought we needed to increase money supply, in order to offset decreased money velocity, and maintain the effective money supply - thus preventing deflation).

In essence, inflation is a function of the effective money supply relative to the amount of goods/services we produce. When the effective money supply increases at the same rate that actual production does, then pricing levels remain constant (no inflation). When the effective money supply growth outpaces actual production, you have to have inflation. There is more money available, and the same amount of goods/services for it to pay for. Mathematically, the cost per good, or the cost per transaction, has to increase. (C=M/G - if M goes up and G doesn't, C has to go up.)

Now, the natural response is, 'If the velocity of money goes up (more activity) and increases effective money supply, doesn't that mean that actual production has to be going up too?' In the big picture, yes. But an economy of this scale is a delicate machine. The things that need to happen, to account for other things happening, don't necessarily happen at the same time and rate. Small imbalances can have cascading effects. That's what the whole notion of maintaining economic health is all about - managing subtle aspects of the mechanism, to keep the whole thing balanced, functioning smoothly, and working efficiently.

So, looking at the situation from a different direction than you did - let's say we dump a bucket of water on a flat spot of ground. We can look for the channels for it to flow through, in order to get to the low spots. And, finding none, we can say, 'How is it gonna get there?'. Or, we can trust in the general natures of water and gravity, and say, 'It doesn't matter if we can find channels, or even if they exist - we know that the water will find the low spots. That's what it does. It will create channels if it needs to.'

If we dramatically increase the money in the system, and there is not enough of an increase in total activity in the system to soak it up, then the same activities will cost more.

 

[Larry Gude]

So, looking at the situation from a different direction than you did - let's say we dump a bucket of water on a flat spot of ground. We can look for the channels for it to flow through, in order to get to the low spots. And, finding none, we can say, 'How is it gonna get there?'. Or, we can trust in the general natures of water and gravity, and say, 'It doesn't matter if we can find channels, or even if they exist - we know that the water will find the low spots. That's what it does. It will create channels if it needs to.'

If we dramatically increase the money in the system, and there is not enough of an increase in total activity in the system to soak it up, then the same activities will cost more.

Good analogy. My point is that the modern economy, modern business models, the overall number of competent people who know how to start a business and attack an opportunity means that that ground is like sand, not hard packed dirt, and will readily absorb the increase in money velocity, happily, eagerly.

People used to build a business with an eye towards the future, long term survivability, and everything else supported that; the time needed to set up manufacturing, distribution, sales, marketing, etc. You would GROW a business. That still exists.

However, it is possible to do that MUCH more quickly today be it new companies or old ones reacting quickly.

 

[Tilted]

Good analogy. My point is that the modern economy, modern business models, the overall number of competent people who know how to start a business and attack an opportunity means that that ground is like sand, not hard packed dirt, and will readily absorb the increase in money velocity, happily, eagerly.

People used to build a business with an eye towards the future, long term survivability, and everything else supported that; the time needed to set up manufacturing, distribution, sales, marketing, etc. You would GROW a business. That still exists.

However, it is possible to do that MUCH more quickly today be it new companies or old ones reacting quickly.

In effect, you are suggesting that inflationary and deflationary risks are reduced somewhat by our ever advancing, ever more efficient, production mechanisms - that our technological and conceptual advances, and our enhanced flexibility, increase the economy's ability to self-correct, to self level, if you will. That makes sense, and in general I suspect that you are right.

This most recent recession would seem to support that argument. The economy started trying to fix itself before things got too out of whack. The whole world didn't have to shut down for the adjustments to begin. It would seem that the deepest problems will be the result of the government doing too much to fix things, and not from the actual things that the government is trying to fix - they would have already gone a long way toward fixing themselves, if we hadn't used them as an excuse to expand socialistic public policy.

My suggestion that parts of our government need to react quickly to avoid inflation problems, is the result of the fact that they overreacted previously in their efforts to 'fix' the deflation problem.

 

[Larry Gude]

In effect, you are suggesting that inflationary and deflationary risks are reduced somewhat by our ever advancing, ever more efficient, production mechanisms - that our technological and conceptual advances, and our enhanced flexibility, increase the economy's ability to self-correct, to self level, if you will. That makes sense, and in general I suspect that you are right.

This most recent recession would seem to support that argument. The economy started trying to fix itself before things got too out of whack. The whole world didn't have to shut down for the adjustments to begin. It would seem that the deepest problems will be the result of the government doing too much to fix things, and not from the actual things that the government is trying to fix - they would have already gone a long way toward fixing themselves, if we hadn't used them as an excuse to expand socialistic public policy.

My suggestion that parts of our government need to react quickly to avoid inflation problems, is the result of the fact that they overreacted previously in their efforts to 'fix' the deflation problem.

And I would add that not acknowledging the new 'rapidity' was a factor in TARP I being sold as so 'critical'. In my view, 60-90 days is all that would have been required for AIG and others to be dissolved and picked clean by competitors with mid level folks with better skill sets than the brass of a 1/2 generation ago.

As for rapid government reaction to inflationary pressures, I would argue that the new 'rapidity' simply needs government consistency, not government reaction.

I think 'rapidity' in the new economy obviates the old school mantra that government must react rapidly to inflationary fears.

Further, I would argue that rapid government reaction since last fall has been the primary threat to economic recovery.

The 'new' government rules for inflation/overall economic health; Leave interest rates low. Set solid, sturdy regulation (go back to 1999 basically). Get the #### out of the way.



PS; To further elaborate, which I almost never do, Obama and company have brought the principles and ideas of the new 'rapidity' to the arena they least belong in' government.

Good government requires stability, not flash and dash.

 

[Tilted]

PIMCO's Gross: U.S. at risk of losing top AAA rating

NEW YORK (Reuters) - Bill Gross, manager of the world's biggest bond fund, warned on Thursday the United States will eventually lose its top AAA credit rating, a fear that had already spooked financial markets on Thursday and could keep the dollar, stocks and bonds under heavy selling pressure.

The United States will face a downgrade in "at least three to four years, if that, but the market will recognize the problems before the rating services -- just like it did today," Gross told Reuters.

Gross, the co-chief investment officer of Pacific Investment Management Co. and manager of the Pimco Total Return Fund, which has $154 billion in assets, earlier had told Reuters via email that market declines on Thursday were due to investor fears that the United States is "going the way of the UK -- losing AAA rating which affects all financial assets and the dollar."

I'm not ready to agree with this guy, but his comments did cause a bit of a stir in the bond markets today. Yields on U.S. Treasuries are definitely creeping up. The Treasury plans to auction a significant amount of new debt next week, including $26 B worth of 7-year, $35 B worth of 5-year, and $40 B worth of 2-year notes. It will be interesting to see how it is received.

EDIT: I should add that the notion that we might even be ready to have this discussion (about a downgrade in the U.S. credit rating) is, in and of itself, surreal.

 

[Larry Gude]

I'm not ready to agree with this guy, but his comments did cause a bit of a stir in the bond markets today. Yields on U.S. Treasuries are definitely creeping up. The Treasury plans to auction a significant amount of new debt next week, including $26 B worth of 7-year, $35 B worth of 5-year, and $40 B worth of 2-year notes. It will be interesting to see how it is received.

EDIT: I should add that the notion that we might even be ready to have this discussion (about a downgrade in the U.S. credit rating) is, in and of itself, surreal.

How old are you? Do you remember the late 70's and the 80's when older folks had their money in bonds and it was safe and secure and decent returns? Consider this; how can 'the' government satisfy the fears of older Americans who might be REAL happy with the safety of bonds? Maybe @ 5%
Or lower, no cap gains?

As for surreal, I can see the upside of a downgraded US putting the breaks on all the spending plans; government health care, cap and trade, next round of stimulus.

Maybe?

 

[Tilted]

The auctions (for the 2 and 5 year notes) that I referenced before were fairly well received. Yield rates are no doubt creeping up (the median yield was 0.910% on the 2 year and 2.249% on the 5 year), but demand was actually better than it has been in the last few months (2.94 and 2.32 bid-to-cover ratios). So, all things considered, not really inflationary indicative.

 

[Tilted]

How old are you? Do you remember the late 70's and the 80's when older folks had their money in bonds and it was safe and secure and decent returns? Consider this; how can 'the' government satisfy the fears of older Americans who might be REAL happy with the safety of bonds? Maybe @ 5%
Or lower, no cap gains?

Sorry, I didn't answer your question - I guess I didn't see it. I'm 36, so I can vaguely remember that. Right now, a lot of people (not just older people) would be happy with secure money earning 5%. Wealth preservation, not wealth creation, is the focus for a lot of people. The problem is the potential for inflation. If inflation whips around on us faster than the powers that be can, or do, mitigate it - then that money that is locked up at low interest weights will be losing value.

As for surreal, I can see the upside of a downgraded US putting the breaks on all the spending plans; government health care, cap and trade, next round of stimulus.

Maybe?

I'm sure we could create arguments supporting the notion that a downgraded sovereign credit rating for the U.S. was good. But, I think there are too many arguments stacked up on the other side of that conversation - so, I'm not looking at that potential as a good thing. Oh yeah, and 'putting the breaks' on spending?

 

[Tilted]

There was reasonably good demand for the 7-year note auction on Thursday, however, Treasury yields continue to climb - at a disturbing rate in my opinion.

The 30 year bond is now trading at a yield of 4.5% and the 10 year note is trading at 3.6%, and probably more importantly, the curve is steepening - the 2 year note is still yielding below 1%.

The yield on our 10 year note is now essentially the same as that of the UK's. It wasn't too long ago that it was trading about 1% lower. In essence, that means that people feel just as good about lending the UK long term money as they do lending the US long term money. That's a scary realization - because the UK is a mess. Their national debt, relative to GDP, is even worse than ours, and S&P recently downgraded their outlook from neutral to negative - meaning that there is a real possibility that they will lose their AAA sovereign credit rating.

Gold prices are moving sharply higher again. Crude prices are incessantly moving higher. Consumer mortgages rates have likely bottomed, despite our government pulling out all the stops to drive them lower.

It is becoming clearer and clearer that we have put ourselves into a fiscal situation which will be almost impossible to recover from. Our national debt is going to reach much higher levels, much faster, than our leaders have acknowledged. There will be little way to combat the problems created by that, except to tax everything that isn't nailed down AND devalue the dollar. Both of those things will further perpetuate the problem.

I'm ready now to sound the inflation alarm. I'm not saying that run-away inflation will be here tomorrow, but I am saying that we have to act on it today. If we don't make preventing inflation our priority today, it will get too far ahead of us, and we won't be able to catch up to it when we finally decide we need to. Fed and Treasury, are you listening? Forget about deflation, it is time to start worrying about inflation - it is time to act decisively.

I won't pretend to know whether or not the economy is close to 'recovery'. But, I do firmly believe that inflation potential is now ahead of economic recovery potential. So, if we do see significant economic recovery, we are likely to see problematic inflation. And, if we don't see problematic inflation, that will probably mean our economy remains stagnant.

 

[Larry Gude]

I won't pretend to know whether or not the economy is close to 'recovery'. But, I do firmly believe that inflation potential is now ahead of economic recovery potential. So, if we do see significant economic recovery, we are likely to see problematic inflation. And, if we don't see problematic inflation, that will probably mean our economy remains stagnant.

It's already being allowed to happen in oil. Everyone seems to readily discount the devastating affect on mood of the general public when it costs us more to fill the car up than it does to go out to dinner.

 

[Tilted]

Bernanke Urges Deficit Reduction, Sees Growth This Year - WSJ.com

Treasury yields are headed back up today, and the 2/10 spread is back to 2.75%.

Consequently, average mortgage rates jumped significantly this week, with the 30 year fixed now at 5.29%.

 

[Tilted]

The yield spread has come in some because the yield on the 2 year note has risen dramatically in the last few days, up to 1.34%. It would seem that some people are expecting some liquidity to come out of the market (such as because the Fed starts raising the fed funds target rate).

There is an $11 Billion auction of 10 year notes on Wednesday, and a $19 Billion auction of 30 year bonds on Thursday. I wonder how they will be received.

 

[Beaver-Cleaver]

Bernanke Urges Deficit Reduction, Sees Growth This Year - WSJ.com

Treasury yields are headed back up today, and the 2/10 spread is back to 2.75%.

Consequently, average mortgage rates jumped significantly this week, with the 30 year fixed now at 5.29%.

But the government's been saying deflation is the problem.

 

[toppick08]

Oh, it's coming....

 

[Tilted]

Treasury yields are climbing significantly today, ahead of the results of the 10 year note auction (due after 1 PM). The 10 year note is now yielding 3.95%, and the 30 year bond is yielding 4.76%.

The actual yields aside, the scary thing is that they are both higher than the comparable British and German debt instruments. Investors would rather loan money to the German government than the U.S. government right now, and are willing to take .4% less interest on a 30 year instrument, to do so.

 

[Larry Gude]

Treasury yields are climbing significantly today, ahead of the results of the 10 year note auction (due after 1 PM). The 10 year note is now yielding 3.95%, and the 30 year bond is yielding 4.76%.

The actual yields aside, the scary thing is that they are both higher than the comparable British and German debt instruments. Investors would rather loan money to the German government than the U.S. government right now, and are willing to take .4% less interest on a 30 year instrument, to do so.

That's not scary to me; it's just symptomatic of uncertainty about the US economy; what is the value of a contract in the US? When Obama is tearing up contract law, it is only reasonable to be concerned with the future of US promises. Frankly, .4 is probably good news; there is reason for more concern than that at this time. Who is going to loan Chrysler or GM money right now, at any rate?

 

[Tilted]

That's not scary to me; it's just symptomatic of uncertainty about the US economy; what is the value of a contract in the US? When Obama is tearing up contract law, it is only reasonable to be concerned with the future of US promises. Frankly, .4 is probably good news; there is reason for more concern than that at this time. Who is going to loan Chrysler or GM money right now, at any rate?

That's my point - that's what's scary. There was a time not too long ago, even in the midst of the recent economic turmoils, when 'the full faith and credit of the United States of America' was one one of the most inherently valuable concepts in the world. It is losing that value because confidence in our system, generally, and confidence in our fiscal condition, specifically, are waning.

About 4 months ago, people were willing to take almost a full percentage point less interest to entrust us with their money rather than Britain. In a very short period of time, that dynamic has switched - and they feel more comfortable giving it to Britain.

 

[Tilted]

But the government's been saying deflation is the problem.

Generally speaking, they still are. But, they are wrong.