November 25, 2013
Posted in Economy, Inflation, investment advisor, investment banking, investments, recession, Robert Barone at 7:59 PM by Robert Barone
The markets are torn between polar opposite schools of thought. There are those who believe we are in a period of intense deflation, which will continue for some time, and there are those who believe that inflation is inevitable and, in fact, is already with us as consumers can attest.
Deflation
The Fed must be in the deflation camp. Why else would they continue to create $85 billion/month of new and unneeded bank reserves? Several recent academic papers have indicated that the major industrial economies of the world, representing more than 70% of the world’s GDP, are so indebted (U.S. Private & Public Debt/GDP: 360%, Europe: 450%, UK: 470%, Japan: 500%) that the world has entered into a period of debt disequilibrium and deleveraging. The annals of history indicate that such periods take an average of 20 years to resolve. Because the indebtedness has actually increased since the financial crisis and Great Recession, this deleveraging cycle may be even longer.
The deflationists believe that the world’s economies will continue to falter, and that no matter how much QE the Fed provides, it won’t translate into economic growth if there is no ability to consume due to excessive debt loads. In this scenario, the price of gold and other precious metals have likely seen their peaks and may fall even further from current levels.
Inflation
The second camp belongs to those who see inflation, not only potentially in the future, but currently hurting consumers. The CPI, as produced by the BLS, just isn’t realistic for most Americans. In the Oct. 12 issue of Barron’s, commodity guru Jim Rogers opined, “The price of nearly everything is going up. We have inflation in India, China, Norway, Australia — everywhere but the U.S. Bureau of Labor Statistics. I’m telling you they’re lying.”
In some of his recent daily blog posts, economist David Rosenberg (Gluskin-Sheff) indicated that if the rapid increase in home and auto prices over the past year were used directly in the CPI instead of the massaged data that is used, today’s CPI would be north of 4% instead of the 1.5% that BLS publishes. <story_page_break>
Furthermore, private sector economists who measure inflation, like John Williams of Shadow Government Statistics or Ed Butowsky, producer of the Chapwood Index, all point to real inflation as being much higher than BLS’s CPI.
But, besides the actual everyday inflation experience, the final issue in the inflation camp, and the one that I think carries the most weight, is the rapidly approaching freight train of unfunded liabilities of the U.S. federal government. There are monstrous (unspoken) additions each year to those liabilities. Add to these the lack of recognition and inability of government to address these numbers, which are almost too long to write on a page ($85,000,000,000,000 to $120,000,000,000,000). That’s $85 trillion to $120 trillion. Just for comparison, the annual GDP of the U.S. is about $16 trillion.
To date, the U.S. government has been able to issue trillions of dollars of debt ($17.5 trillion and growing rapidly) because the dollar is the world’s reserve currency and it is used in international transactions that have nothing to do with U.S. economic activity. Unfortunately, today there are now too many dollars in the system, and other world powers are both complaining and seeking alternatives. China now settles more than 12% of its foreign trade in its own currency, versus 3% in 2010. It is likely that foreign powers will soon begin to shun U.S. debt, leaving the Fed the only buyer of the large deficits that clearly lie ahead.
Stagflation
So, which side is correct — deflation or inflation? Unfortunately, both. There is too much debt, and the pace of economic growth has significantly deteriorated in each decade since the 1980s. Because both sides are correct, the result is “Stagflation,” a world of slow or negative economic growth accompanied by rising prices. If this is the case, the price of gold won’t stay down for long.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
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November 19, 2013
Posted in Banking, Big Banks, Bonds, Economy, Federal Reserve, Finance, Robert Barone, Uncategorized at 11:12 PM by Robert Barone
The Fed’s ‘Bizarro World,’ Part II
By Robert Barone, Ph.D
The “Seinfeld” TV comedy series (1989-98) had a set of episodes, known as “Jerry’s Bizarro World,” where everything “normal” was turned upside down and inside out. I have referred to this world in a previous column, and continue to find such Bizarro patterns in our real world.
The Fed was established in 1913 to act as a lender of last resort to a financial system that had been plagued with “panics” and deep recessions. At inception, its main policy tool was the “discount rate” and “discount window” where banks could submit eligible collateral to obtain needed liquidity when such options had dried up in the capital and financial markets.
Open market operations
Beginning in 1922, the Fed began to use a tool known as Open Market Operations (OMO), the buying and selling of government securities to add or subtract liquidity from the capital markets, reserves from the banking system, and to impact interest rates. OMO has traditionally been considered to be the Fed’s main policy tool. But that ended in late 2010 with the implementation of Quantitative Easing II (QE2).
In 2009, as the financial system was experiencing one of those financial panics, the Fed did what it was created to do, and provided liquidity to the markets where none was otherwise available. Many argue that Fed action via QE1 was instrumental in stabilizing the U.S. and world banking systems
Look at those excess reserves!
But, then, because the U.S. rebound from the ensuing recession was too slow, in late 2010 and again in 2012, the Fed announced more QE. Today, the latest figures show excess reserves in the banking system of $2.23 trillion. The reserves required on all of today’s existing deposits are $67 billion ($0.067 trillion). Today’s excess reserves are so massive that they can support 33 times current deposit levels without the Fed creating one more reserve dollar. Yet, with QE3, it continues to create $85 billion/month.
While they sit in an account at the Fed, excess bank reserves don’t directly influence economic activity. This, of course, has been the issue for the past five years. But, when banks do lend, the newly minted money gets into the private sector, impacting economic activity with the well-known “multiplier effect” described in money and banking textbooks. When such bank lending occurs, if the labor market is tight or there is little or no excess capacity in the business community, inflation ensues. Just think of how much money the banks can create if their current excess reserves are 33 times more than they need!
Sell side of OMO is impotent
So, how is the Fed going to control bank money creation in the future? They can’t use their most powerful traditional tool, OMO, because they would have to sell trillions of dollars of securities into the open markets before reserves would become a restricting issue for the banking system. The utterance of the word “tapering” last May sent rates up 100 basis points in a two-week period. This is just a taste of what would happen to interest rates if the Fed actually began to sell (instead of just buying a lesser amount, which is what “tapering” means).
Furthermore, long-term fiscal issues have become a real concern. With somewhere between $85 and $120 trillion of unfunded liabilities rapidly approaching as the population ages (as a comparison, annual U.S. GDP is only $16 trillion), huge fiscal deficits are a certainty barring entitlement, Social Security, Medicare and Medicaid reform. To keep the cost of the debt manageable within the U.S. government budget, the Fed must continue to keep interest rates low. With foreign criticism of U.S. policies on the rise, purchases of U.S. Treasury debt by foreign entities are likely to diminish in the future. That leaves the Fed as the major lender (lender of last resort!) to the Treasury via OMO purchases.
The borrowing window in reverse
Unable to use the “sell” side of OMO to influence the banking system, the Fed is now stuck with only one tool, the discount or borrowing window. Only now, because the financial system is drowning in the sea of liquidity, the borrowing window and discount rate must now work in reverse!
In the traditional use of the borrowing window, the Fed used the discount rate (short-term borrowing rate) to encourage (by lowering rates) or discourage (by raising rates) banks from borrowing to lend to the private sector. But, in today’s Bizarro World, the Fed will have to use the rate it pays (currently 0.25 percent/year) to the banks with excess reserves to encourage or discourage bank lending. Yes! Not the rate the banks pay to the Fed to borrow, but the rate the Fed pays to the banks to encourage them to keep their reserves instead of lending them. The original concept of the Fed as the lender of last resort has been turned on its head. It’s backward — it’s Bizarro!
Implications for investors
It is difficult for investors to deal with a system turned on its head. The bond market gets spooked whenever there is talk of the Fed “tapering” its bond purchases. The return on those bonds is simply too low for the risk involved, so the best advice here is to avoid them unless you are exceptionally skilled. That leaves equities — but that is a topic for another column in this new and Bizarro World.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
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November 6, 2013
Posted in Banking, Federal Reserve, Robert Barone tagged discount rate, securities at 5:11 PM by Robert Barone
NEW YORK (TheStreet) — The Federal Reserve has strayed so far from its original mandate that its only effective policy tool, the so-called discount window, must now be used in reverse to be effective.
A brief history of the Fed shows how we got to this point.
The Fed was established in 1913 to act as a lender of last resort to a financial system that had been plagued with panics and the inevitable recessions that resulted since at least the Civil War. At the Fed’s inception, the central bank’s main policy tool was the “discount rate” and “discount window,” where banks could submit eligible collateral to obtain needed liquidity when such options had dried up in the capital and financial markets.
Early on, the Fed contemplated the use of Open Market Operations (OMO), the buying and selling of government securities in the open market to add or subtract liquidity from the banking system, which would affect interest rates. The first use of OMO occurred in 1922, and from that time on, until recently, that is, OMO was considered to be the Fed’s main policy tool. In many of today’s money and banking textbooks, you may still find such sentiment. But the era of OMO as the Fed’s major policy tool ended in late 2010 with Quantitative Easing II (QE2).
In 2009, as the financial system was experiencing one of those financial panics, the Fed did what it was created to do and provided liquidity to the markets where none was otherwise available. Many argue that Fed action via QE1 was instrumental in stabilizing the U.S. and world banking systems. QE1 provided the U.S. banking system with excess reserves — reserves in excess of those required for the existing deposit levels — of about $1 trillion.
But, then, because the U.S. rebound from the recession was too slow for the Fed, in late 2010 and again in 2012, the Fed announced more QE. Today, the latest figures show excess reserves in the banking system of $2.23 trillion. The reserves required on all of today’s existing deposits are $67 billion.
Today’s excess reserves are so massive that they can support 33 times current deposit levels without the Fed creating one more dollar. Yet with QE3, it continues to create $85 billion per month in additional excess reserves.
Excess bank reserves are called “high powered money.” While they sit in an account at the Fed, they don’t directly influence economic activity. But when banks lend, the newly minted money gets into the private sector and affects economic activity. And if there is no excess capacity in the labor or capital markets, inflation ensues.
Just think of how much money the banks can create if their current excess reserves are 33 times more than they need. Given the magnitudes here, the use of the reserve requirement policy tool to control future bank lending doesn’t appear to be feasible.
So what about the use of its most powerful traditional tool, OMO? Unfortunately, the recent overuse via QE2 and QE3 has made this tool ineffective. Imagine the Fed trying to control bank lending by reducing excess reserves. It would have to sell trillions of dollars of securities into the open markets before excess reserves would become an issue for the banking system. Where would interest rates be at that point?
Furthermore, long-term fiscal issues have become a real concern. With somewhere between $85 trillion and $120 trillion of unfunded liabilities rapidly approaching, huge fiscal deficits are a certainty barring entitlement, Social Security, Medicare and Medicaid reform.
To keep the cost of the debt manageable within the U.S. government budget, the Fed must continue to keep interest rates low. With pressures building internationally for a different world reserve currency, foreign purchases of Treasury debt may diminish in the future. That leaves the Fed as the major lender to the Treasury via OMO purchases. Trying to reduce its holdings of securities at this time would likely result in another financial panic.
Unable to use the “sell” side of OMO to influence the banking system, and unable to effectively use reserve requirements because of the magnitude of the imbalance, the Fed is now stuck with only one tool, the discount or borrowing window. Only now, because the financial system is drowning in the sea of liquidity produced by the Fed, the borrowing window and discount rate must now work in reverse.
In the traditional use of the borrowing window, the Fed used the discount rate (short-term borrowing rate to encourage (by lowering rates) or discourage (by raising rates) banks from borrowing to lend to the private sector. But now because of the volume of excess reserves created by QE2 and QE3, the Fed will have to use the rate it pays, currently 0.25%/year, to the banks with excess reserves to encourage or discourage bank lending.
Yes! Not the rate the banks pay to the Fed to borrow, but the rate the Fed pays to the banks to encourage them to keep their reserves instead of lending them.
The original concept of the Fed as the lender of last resort has been turned on its head. Instead of the private-sector banks paying to get needed liquidity, the public sector, i.e., taxpayers, will be paying the banks not to use the excess the Fed has created. It’s backward — it’s Bizarro.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
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November 5, 2013
Posted in Federal Reserve, Finance, Uncategorized tagged Robert Barone (Ph.D. at 9:38 PM by Robert Barone
The Fed has proven to be a terrible caretaker of the responsibilities that come with reserve currency status, even while the U.S. economy benefits greatly from it. The bungling is so great that the dollar is now at risk of the loss of that status, and with it, those huge benefits.
Some history
After both world wars, the U.S. had the strongest economy. And despite FDR’s removal of the U.S. from the gold standard in 1933, the Bretton Woods agreements of 1944 established a “gold exchange” standard wherein balance of payment deficit nations were to settle up with surplus nations in gold (at $35 per ounce).
Under this system, when gold payment settlements were made, the gold never was physically shipped but simply “moved” in the holding vault to an area designated for the recipient country.
In 1971, Republican President Richard Nixon removed the world from the gold exchange standard when France demanded physical delivery. Since then, the dollar has served as the world’s reserve currency, with “trust” as the only underlying asset.
The perks of reserve status
Most international transactions today occur in dollars, even if none of the transacting parties is American. For example, if Hyundai (South Korea) sells autos to a business in Argentina, the buyer must first convert the Argentina peso to dollars to pay for the autos. Hyundai can either hold the dollars, or convert them to their home currency (Won).
Note that this transaction has little to do with U.S. economic activity. Yet, it means that there has to be a lot of dollars floating around to support worldwide trade.
The reserve currency status and trust in the U.S. dollar has resulted in the U.S. government’s ability to overspend and issue debt because of the demand for dollars in international trade.
On the other hand, when an emerging economy’s government runs a large and systemic deficit, there are serious fiscal consequences. The value of the currency immediately falls, inflation occurs and the markets force up interest rates, thus impacting that economy’s economic growth.
The reserve currency status and the accompanying trust in the currency also have resulted in the investment of excess dollars in the international system back into U.S. Treasury securities, allowing the Treasury to run large deficits without significant consequences for the currency’s value.
Emerging pressures
Of course, we’ve all heard stories that countries like China and Russia have been advocating that the world adopt a different reserve currency. Many dismiss China’s and Russia’s positions as political rants. But these gripes are legitimate, and unless they are changed, the existing monetary and fiscal policies in the U.S. eventually will move the world toward an alternative reserve currency system.
Policy impacts
While Congress has played a major role, the Fed in particular has been irresponsible as the caretaker of the world’s reserve currency. Because the U.S. never openly asked that the dollar be the reserve currency, the Fed maintains that its only interest is in America’s economic performance. But Fed policies, such as quantitative easing, have huge consequences worldwide.
For example, when the Fed tells the capital markets that interest rates will be 0 percent for an “extended period,” as it did in 2012, hedge funds borrow dollars at minuscule yields and send unwanted dollars to higher-yielding emerging market economies.
Those capital movements have been monstrous, often overwhelming the emerging economy’s underdeveloped financial system, causing inflation in the local economy along with rising interest rates and slowing economic growth.
Then, last May, when Fed Chairman Ben Bernanke used the word “taper,” those huge flows, which had built up over a period of months, almost instantaneously reversed as the hedge funds raced to repay their borrowings before interest rates rose further.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
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