The Week's Economic Reports

Following is a summary of last week's economic reports. A rising consumer price index highlighted the week, confirming the continued concern expressed by the Federal Reserve regarding inflation. For the week, the S&P 500 Index fell 0.3 percent to 1,451 and the yield of the 10-year U.S. Treasury note fell 2 basis points to 4.67 percent.


Consumer Prices: The consumer price index rose 0.2 percent in January after an increase of 0.4 percent in December and the core rate of inflation, excluding food and energy, surprised to the upside rising 0.3 percent after a 0.2 percent increase the previous month. On a year-over-year basis, the CPI rose 2.1 in January and the core rate gained 2.7 percent, reversing the recent trend of moderating core consumer prices (see the purple line in the chart below).

Rising costs for both medical expenses (up 0.8 percent) and food (up 0.7 percent) were the major factors contributing to the monthly increase. Energy costs declined (down 1.5 percent) led by fuel oil (down 4.4 percent) and gasoline (down 3.0 percent). Rising medical costs are troublesome in that the increase was concentrated in the medical care services category that rose sharply (up 0.9 percent). With energy prices set to reverse course with next months' report, the combination of these two could result in a much worse report for February.


With this release, the Bureau of Labor Statistics (BLS) provides three additional decimal places for the monthly data. Despite the headline figure, this month's core CPI change registers only 0.25565 percent - not nearly as ominous looking as the rounded-up figure of 0.3. The added precision should not be mistaken for added accuracy. The subject of defining "inflation" continues to be a controversial topic where the most popular inflation measure, the BLS's consumer price index, appears to continue to lose favor to a number of other measures available from other government agencies.

Nonetheless, this month's increase to the core CPI and the tick upward in the year-over-year rate are not good news for policy makers. Interest rate cuts are now likely out of the question until there is downward movement in core inflation or significant economic weakness develops.

Leading Economic Indicators: The Conference Board's Leading Economic Indicators rose 0.1 percent in January, down from an upwardly revised gain of 0.6 percent in December. Six of the ten components declined, led by building permits and manufacturing hours. Consumer expectations and jobless claims led the list of components that gained, however, jobless claims have risen during the last two weeks, likely an indication of a reversal for this component next month.

MBA Purchase Applications: In a sharp break from the recent stability in the measure of new mortgage applications, a decline of 4.8 percent was seen last week putting the current level near the multi-year lows of last fall. Prior to last fall, current levels had not been seen since mid-2003, just before the housing boom kicked into high gear.

FOMC Meeting Minutes: The minutes of the Federal Reserve Open Market Committee meeting in January indicated that inflation is still the primary concern of the policy setting group and that the potential for housing weakness to spread to other parts of the economy was being watched closely.

All meeting participants expressed some concern about the outlook for inflation. To be sure, incoming data had suggested some improvement in core inflation, and a further gradual decline was seen as the most likely outcome, fostered in part by the continued stability of inflation expectations. However, participants did not yet see a downtrend in core inflation as definitively established.

All members agreed that the statement should continue to stress that some inflation risks remained and note that additional policy firming was possible.
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The ongoing contraction in the housing sector and the potential for spillovers to other sectors remained notable downside risks to economic activity, although those risks had diminished somewhat, and continuing strength in consumption suggested upside risks as well. All members agreed that the predominant concern remained the risk that inflation would fail to moderate as desired.

By far, the worst case scenario for the Fed would be the combination of higher consumer prices and a faltering housing market affecting the broader economy. The most recent data indicates that this may be where the economy is headed.

Summary: The surprise move upward in core inflation provided confirmation that inflation has not yet been whipped into submission. Asset markets reacted accordingly. Broad equity markets weakened, apparently fearful of future interest rate hikes or the lessening probability of interest rate cuts. Hard assets rose as the eroding purchasing power of the dollar became more pronounced. This marks the second consecutive week of what would fairly be termed "mostly negative" economic reports following many weeks of generally positive data. If this trend continues, the mid-February timeframe will be looked back upon as the period when economic indicators turned around.

The Week Ahead

The week ahead will contain two important reports on housing - existing home sale on Tuesday and new home sales on Wednesday. Also on tap are reports on durable goods and consumer confidence on Tuesday, the second of three readings for fourth quarter GDP on Wednesday, personal income and spending along with construction spending and the ISM Manufacturing index on Thursday, ending the week with consumer sentiment on Friday.

Chart courtesy of Northern Trust.

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Yes, It Can Get Better

Last Friday afternoon, the question was asked, Can it Get Any Better than This? It is clear today, that the answer is yes. What will next week hold? We'll find out soon enough.

While the Dow was down about one percent and the Nasdaq rose by an equal amount, commodity markets posted their strongest gains in almost three months. The CRB Index was up almost three percent, copper rising almost eight percent while energy prices rose more than four percent.

Crude oil finished the week clear of the $60 mark, rising to its highest level of the year on speculation that inventories will plunge after refineries shut down for annual maintenance in the month ahead. Reports of an acceleration in Iran's uranium enrichment program didn't hurt the oil price either.


Oil stocks rose modestly. With gasoline prices rising slowly but surely, pain at the pump leading to complaints to congressmen about oil company price gouging are all becoming part of a new annual spring ritual.


The slow steady climb continues. Shhhh...


There has been some movement in gold stocks over the last week. Apparently investors are impressed with the slow and steady rise in metal prices and don't want to miss the next surge in share prices.


And the dollar has found a new range on the U.S. Dollar Index with which it is getting comfortable - 84. It spent about six weeks at 85 and now has spent the better part of the last two weeks at 84. With higher oil prices and a higher trade deficit and a weakening economy and ... well, you know what might eventually happen.


It would be much more worrisome if there were even a whiff of a mania in the air like there was last spring. That may happen soon enough.

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Regulate Thyself

The President's Working Group on Financial Markets (a.k.a., the "Plunge Protection Team" - yes, Wikipedia has everything) awoke from a seven-year slumber yesterday and decided it was time to do something about hedge funds and private equity.

Or not.

Cognizant of the danger in attempting to fix something that is not yet clearly broken (you'll surely be blamed if something goes wrong), the group instead opted to provide a set of a "principles" and vague guidelines, leaving it up to the market to figure out what it meant.

Lots of wiggle room there.

From the Treasury Department, this report of the group's most recent activity includes a new acronym (PWG, for President's Working Group) likely intended to supplant the more popular "PPT", and another opportunity to link to the hi-resolution picture of Treasury Secretary Hank Paulson from the much smaller image below (brace yourself).

The agreement among the PWG and U.S. agency principals, which will serve as a framework for evaluating market developments, specifically concentrates on investor protection and systemic risk concerns.

"The President's Working Group believes that public policy toward private pools of capital should be governed by consistent principles that set out a uniform approach to specific policy objectives," said Secretary Henry M. Paulson, chair of the group. "These principles demonstrate that U.S. regulators and policymakers have a unified perspective and are committed to providing forward-leaning guidance for the industry and its participants. These guidelines should serve as a foundation to enhance vigilance and market discipline further, which will strengthen investor protection and guard against systemic risk. We will continue to monitor developments in this ever-evolving market with these principles in mind."

The group has designed the principles to endure as financial markets continue to evolve. They provide a clear but flexible principles-based approach to address the issues presented by the growth and dynamism of these investment vehicles.

The principles are intended to reinforce the significant progress that has been made since the PWG last issued a report on hedge funds in 1999 and to encourage continued efforts along those same lines:

• Private Pools of Capital: maintain and enhance information, valuation, and risk management systems to provide market participants with accurate, sufficient, and timely information.
• Investors: consider the suitability of investments in a private pool in light of investment objectives, risk tolerances, and the principle of portfolio diversification.
• Counterparties and Creditors: commit sufficient resources to maintain and enhance risk management practices.
• Regulators and Supervisors: work together to communicate and use authority to ensure that supervisory expectations regarding counterparty risk management practices and market integrity are met.

The PWG, chaired by the Treasury Secretary and composed of the chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, was formed in 1988 to further the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of financial markets and maintaining investor confidence. The PWG worked with the Federal Reserve Bank of New York and the Office of the Comptroller of the Currency in developing the guidance.

With words like "maintain and enhance" (two places), "consider the suitability", "commit sufficient resources", and "work together", it's not clear what, if any, impact the guidance will have on hedge funds and private capital.

In this report from Forbes, there were similar concerns.

Connecticut Attorney General Richard Blumenthal said during a television interview Thursday afternoon that the working group's conclusions offered very little in the way of guidance, and he expressed frustration that more wasn't being done at the federal level to force greater disclosure by hedge funds.

"A lot more teeth and a lot more specificity is required" to oversight of the hedge fund industry, said Blumenthal, whose state is home to many of the biggest funds but who nonetheless has been pushing for reform in how they are regulated. "There will be efforts on the part of states to provide guidelines if the federal government doesn't," Blumenthal said.

Most, including Blumenthal, agree that hedge funds benefit the markets by adding liquidity and forcing better pricing of securities. But there can also be blow ups, such as last fall's meltdown of the energy trading fund Amaranth Advisors.

In the last year, as pension and other institutional money has flooded the hedge fund market in search of better investment yields, there have been concerns that average investors are not adequately protected from problems that could arise from hedge fund blowups.

The SEC pursued a plan to get hedge funds to register, thus forcing greater disclosure of their risks and strategies to public scrutiny. But the agency did not appeal last summer when that rule was struck down by a Washington, D.C., Court of Appeals judge.

It's hard to have financial bubbles without hedge funds and even something as simple as requiring them to register with the SEC would surely cramp their free-wheeling style.

Since the world economy is now squarely based on a series of ever-larger bubbles, hedge funds and private capital are integral parts of a properly functioning system.

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His Timing Might Be Perfect

Get ready to see a lot more of former Federal Reserve Chairman Alan Greenspan in a few months. He'll be out promoting his memoirs, set for publication this fall, right at the peak of the summer real estate sales season - just when large numbers of anxious sellers face hesitant buyers.

His timing might be perfect.

With a new psychology overtaking the nation's housing market as subprime lenders fall, ARMs reset, and foreclosures rise, there should be an entirely new pricing dynamic at play as the former Fed Chairman goes on his book tour.

Last week, hearts were sent aflutter when it was announced that he'll be the keynote speaker at the annual publisher's convention in June.

The chairman is coming to BookExpo America.

Alan Greenspan, former Federal Reserve Board chairman and author of a widely anticipated memoir, will be the keynote speaker June 1 at the publishing industry's annual national convention, to be held in New York from June 1-3.

"We are enormously honored that Dr. Greenspan has agreed to appear at BEA," Lance Fensterman, BookExpo's event director, said Friday in a statement.

"Dr. Greenspan is one of the leading figures of the latter half of the 20th century and his insight, leadership, and impact has affected citizens in the United States and the world at large."

Greenspan, 80, reportedly received $8.5 million for his memoir, "The Age of Turbulence," scheduled to come out this fall from the Penguin Press. After his talk at BookExpo, Greenspan will answer a few questions, from an interviewer he knows quite well — his wife, NBC's Andrea Mitchell.

"We see this as a real coup," said Roger Bilheimer, BookExpo's special events director. "Sure, she's his wife, but she's a smart lady and she's been around the block. I certainly think this is an opportunity for a stimulating conversation."
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Greenspan, widely viewed as the most successful chairman in the Fed's 92-year history, served from 1987 until his retirement, in 2006. He presided over an era of low inflation rates, low unemployment and the longest economic expansion in U.S. history — a decade of uninterrupted growth from March 1991 to March 2001.

Along with the low inflation, low unemployment, and economic expansion came a series of financial bubbles that may or may not still be around when he starts hawking his book.

He will forever be remembered for inflating a housing bubble after the bursting of a stock market bubble - the final verdict on that gambit has yet to be rendered.

A lot can happen in a few months - he may not get the reception he's expecting.

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Stop Trying to Redefine Savings!

Everyone just stop it! If, in some twisted sort of way, redefining "wealth" or "net worth" as "savings" makes you feel better about the world and your own lot in life, then go ahead and do it - just do it in private.

Whatever gets you through the day.

But, please, stop sharing your rationalizations with the rest of us who prefer to continue believing that "savings" (as either a verb or a noun) is not something that can come and go as quickly as a subprime lender.

Call it old fashioned if you want, but, just leave the word "savings" alone. Please.

Since the personal saving rate turned negative in 2005 and then plunged even further into the red last year, there has been a steady stream of commentary and research papers intent on blurring the lines between "wealth", "net worth", and "saving(s)" - sort of like a bad doctor anxious to ease the immediate discomfort of an ailment with one pill or another while the underlying illness remains untreated.

Wealth is the value of your assets.

Net worth is assets minus liabilities.

Saving is income less expenditures or money put aside.

Stop confusing them.

Commentary such as this($), appearing in respected publications such as the Wall Street Journal, doesn't do anyone any good (particularly Chinese manufacturers of piggy banks).

This month, the Commerce Department's Bureau of Economic Analysis put the nation's personal saving at negative $116.6 billion for December 2006.

To get that number, the bureau starts with after-tax disposable income then subtracts "personal consumption" of all sorts.

Here's what doesn't get counted, though: the increased value of stocks or mutual funds in brokerage or retirement accounts, or the rising value of your home.
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If you're already trying to figure out where you stand, pay attention to the nomenclature. Commerce's study of personal saving is all about the verb -- "saving" -- what you make, minus what you spend.

But a more complete snapshot may well come from also adding in your "savings," the noun -- an accounting of your total assets and how they've grown, even if you haven't realized the gains yet.

No, there's another word for when savings are used to buy stocks - that's called investment.

And real estate?

Up until a few years ago, real estate was just a place to live in - with sometimes hefty maintenance expenses and even heftier taxes to pay. But, lately it's become plan B for retirement planning, as in, "I was too busy to save and invest while I was younger - it's a good thing my house did that for me".

Real estate is not savings.

Enter the Economists

The added perspectives of Federal Reserve economists and college professors doesn't seem to be helping the word savings retain its original meaning.

What appears below may be comforting to dismal thinkers, but translating all the squiggly lines and formulas into a conclusion that Americans may be saving too much for retirement as in this report from personal finance columnist Laura Rowley, well, that's just plain irresponsible.


[At the risk of offending any readers of this blog who may be economists, it should be noted that Economics is not a "hard science" - far from it. Some scientists and engineers view their math as kind of a "pretend" applied mathematics.]

Here's what Ms. Rowley had to say about the squiggly lines:

Conventional wisdom suggests that people are woefully unprepared for retirement. Study after study portrays most Americans as the proverbial grasshoppers, playing the fiddle with their finances while a minority of conscientious ants store up supplies for their golden years.

In 2004, for example, the Center for Retirement Studies at Boston College estimated that 43 percent of working households were in danger of having too little income to fund their retirement, even after tapping home equity.

Now a group of economists is offering a wildly contrarian view: People may be saving too much for their retirement. A few go so far as to suggest that the financial services industry is deliberately encouraging over-saving because it profits from managing such assets.

Consider a recent study (.pdf) conducted by Paul Smith and Lucy McNair of the Federal Reserve Board, and David Love, an economist at Williams College. They found that 88 percent of all households with breadwinners over age 51 had accumulated sufficient resources to finance adequate consumption in retirement.

A separate study by John Karl Scholz, an economist at the University of Wisconsin, Madison, and two other researchers found more than 80 percent of households headed by Americans born between 1931 and 1941 have accumulated their optimal wealth targets for retirement.

The other 20 percent missed their goal by a relatively small margin, according to the study published in the Journal of Political Economy (.pdf).

Fortunately this piece was more food for thought than personal finance advice as the author ultimately recommends that individuals "err on the side of caution" and economists develop "more accurate models".

You don't get that message from just reading the first few paragraphs, which is about as far as anyone would get if they were looking to rationalize their spendthrift ways.

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The Coast is Clear

The New York market is closed and, in a few hours, Asian buyers will decide what's next for the barbarous relic with the lasting appeal - the coast is clear to put up a gold chart and pick over the events of the day.

[Note to new readers: Over the last year or so, whenever precious metals have been the subject of a post at this blog, the price seemed to go in the wrong direction (i.e., down). Commenters now sometimes plead for silence during rallies - this after-the-close commentary is something of an experiment.]

In chart form, it's pretty clear what happened with the price of gold today - a nice surge, breaking decisively through the $670 level that has been providing resistance for most of the last week.


In John Mauldin's always-excellent weekly commentary he quotes Dennis Gartman on the source of this resistance - strong sellers, it appears. Strong sellers who seem to have taken the afternoon off today.

Gold is at $668.50 and is having trouble busting through $670. There are persistent rumors that there is a major seller at this level. Dennis Gartman (no gold bug he, but he is currently bullish on the barbarous relic) writes this morning:

"Moving on to gold, we note that the resistance between $668-670 has proven formidable indeed, for gold has effectively traded within that range for the half day prior to writing yesterday's TGL and for the past full day. Once again, we've no idea who it is that is selling spot gold at $670, but it is someone of very real consequence and with very material selling to be accomplished. Once again, it may be a government, it may be a hedge fund, it may be miners hedging forward production because of bank agreements made on a project or two or three... it may be a combination of the above, or it may simply be very large 'specs' wishing to take profits on old long positions or wishing to get materially short.

"All we care about is that it is someone or something that has thus far successfully stopped gold from advancing, and with the week's end upon us, we shall not be at all surprised to see that seller remain successful in keeping gold from moving through his offers. Next week, however, the 'game' shall be played with a bit more enthusiasm, and the seller... whoever or whatever 'he' might be... shall have a far more difficult time keeping gold in check."

As I have said many times, gold is a neutral "currency." It is the one currency that cannot be printed by a reserve bank, and thus, is a long-term hedge against monetary deterioration.

Gartman gives us a very wise quote from James Burton, Chief Executive of the Gold Council, and one with which I totally agree. When queried about whether a return to a gold standard is possible in the foreseeable future, he answered:

"No - the gold standard was appropriate to the second half of the 19th century, but circumstances are now different. But this does not mean that gold no longer has a monetary role. It remains an important reserve asset for central banks since it is the only reserve asset that is no one's liability. It is thus a defense against unknown contingencies. It is a long-term inflation hedge and also a proven dollar hedge while it has good diversification properties for a central bank's reserve asset portfolio."

I would expect to see more developing central banks put some of their reserves into gold over time, as the developed world sells some of their gold. I would also not be surprised to see another bubble in gold develop at some point, as there is something about the metal that seems to alter mental reality when it starts to run. I hope not, for a bubble and the following aftermath would do a great deal of damage.

We're a long way away from a gold bubble - remember that in inflation-adjusted terms, the 1980 high of around $850 works out to over $2,000 today.

A slow steady rise at a rate far above the official measure of "inflation" would be best for everyone involved (that is, except for the central banks who continue to sell the stuff).

In this report from Bloomberg, it sounds like the combination of a higher than expected CPI and changes to open interest made sellers scarce.

Gold surged to a nine-month high in New York after the U.S. said inflation accelerated more than forecast in January and commodity prices jumped.
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Gold's gain accelerated after the New York Mercantile Exchange said the number of open futures and options contracts was higher than some traders expected.

"Once the open-interest report came out, there was a big incentive to buy," said Michael Guido, director of hedge-fund marketing at Societe Generale SA in New York. "There are no new shorts coming into the market."

Some traders were concerned that gold's decline yesterday of 1.8 percent, the biggest in six weeks, would spark renewed selling and may end this year's rally. Instead, the number of open contracts fell by 3,476 contracts, or less than 0.9 percent, to 396,115, the Comex said.

Who in their right mind would be selling gold right now?

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Baby Step

At this pace, the Bank of Japan should have interest rates normalized sometime in 2014. After abandoning their zero interest rate policy (ZIRP) last July by nudging short-term rates to 0.25 percent, earlier today the central bank took a second baby step with an increase to 0.5 percent.

This AP report explains:

Encouraged by signs of robust economic growth, Japan's central bank raised its benchmark interest rate by a quarter point to 0.5 percent on Wednesday, judging that price stability and consumer spending would withstand slightly tighter credit.

The Bank of Japan's decision, which came at the end of a two-day monetary policy board meeting, highlights confidence in the continuing moderate recovery in the world's second-largest economy. The vote among the nine-member board was 8-1 in favor of the hike, the bank said in a statement.


"The bank thinks that even if prices drop, that won't cripple economic growth, and conditions were ripe for a rate hike," said Takeo Okuhara, bond strategist at Daiwa Institute of Research in Tokyo. "The bank made the right choice."
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The Bank of Japan said Wednesday that gradual growth will likely continue amid healthy production, income and company investments, and worries were diminishing about the future of the American and other overseas economies.

Apparently they missed all those disappointing U.S. economic reports last week.

Last month, the Bank of Japan surprised nearly everyone by holding rates steady after previously signaling a rate increase. A widespread perception developed that the bank had yielded to political pressure after a weak consumer spending report - a bad impression had been left by a central bank that is supposed to operate independently from the rest of the government.

Since the last policy meeting, the world's second largest economy posted an annualized growth rate of 4.8 percent for the last quarter of 2006 making today's increase more likely, though only about half of analysts polled expected the short-term rate to be increased.

What About the "Carry Trade"?

Concerns over the effect of the rate increase on the "carry trade" were blunted by clearly setting expectations for future rate increases. Aware of the distortions that low interest rates in Japan have caused in the world's financial markets, the central bank is mindful of the potential negative impact.

This report($) from the Wall Street Journal provides the details:

"As world financial markets become integrated, the time has come for us central bankers to conduct monetary policy while keeping firmly in mind its external consequences," BOJ Governor Toshihiko Fukui told a news conference.

Specifically, the governor said the BOJ wanted to quench expectations that Japanese rates would stay very low for very long, which might cause them to take "extreme positions." He said the BOJ had in mind, among other aspects of global markets, the so-called "carry trade," where investors borrow money at Japan's low rates and invest it elsewhere where returns are higher. Mr. Fukui said such borrowing could present a risk to the global economy if unwound suddenly.

Even with the latest increase, Japan's benchmark rate is still well below its equivalent in other major nations – 5.25% in the U.S. and 3.5% in the euro zone. Central banks fix the interest rates on overnight loans, which will boost borrowing costs for companies and homeowners, and increase interest income for savers.

The carry trade, plus yen-selling by Japanese investors who want better returns overseas are thought to be major causes of the current weakness of the Japanese yen, which was ¥120.28 to the dollar in late Asian trading yesterday, down from ¥114 in December and near a four-year low. Against the euro the yen was trading at ¥158.75, which is near its historic low and compares with ¥138 a year ago.

What will hedge funds do if one day there are no extreme differentials in global interest rates? Money from Japan has been cheap for more than a decade.

Looking at the experience of Japan in the world economy over the last twenty years, China and the East Asian Tigers are deservedly wary of joining the club of purportedly free-floating currencies.

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Yes Caroline, We Are in Trouble

Caroline Baum is making more progress toward clear-headed thinking with each passing week. In today's commentary at Bloomberg she gets to the heart of the "inflation ruse" perpetrated upon the American public, striking at the Achilles' Heel of contemporary monetary policy in the U.S. (i.e., that pesky "monetary phenomenon" warning by Milton Friedman).

She goes so far as to compare Ben Bernanke to Zimbabwe Central Bank Chief Gideon Gono, famous for $1,500 rolls of toilet paper and all sorts of other monetary oddities in an African nation where prices rise at a rate of 1,600 percent - per month!

[The Central Bank of Zimbabwe has a nice looking website, replete with a Monetary Policy Statement from just a few weeks ago - looks interesting.]

Fed's Inflation Analysis Ranks With Zimbabwe's
By Caroline Baum

Maybe it was the repetition, the iteration of the same monetary policy testimony on back-to-back days last week, that did it, that left the words grating on my consciousness.

Here was Federal Reserve Chairman Ben Bernanke, one of the outstanding monetary economists of his time, talking about inflation as if it were the result of some pesky exogenous forces.

"A waning of temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation,'' Bernanke said in testimony delivered to the Senate Banking Committee on Feb. 14 and the House Financial Services Committee the following day.

What's more, the contribution "from rents and shelter costs should also fall back,'' he said.

There's a big difference between an inflation measure, which Bernanke was talking about, and the inflation process. Policy makers -- Bernanke, Alan Greenspan before him, the Fed governors and bank presidents -- talk about the effect oil prices or imputed rental costs have on inflation gauges, such as the consumer price index. That's not the same as the inflation process, which is always and everywhere a monetary phenomenon.
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Oil prices don't cause inflation. Nor do wages, even though you'd never know it from discussions on the subject. The Fed causes inflation all by itself, creating too much money relative to the supply of goods and services.

If the inflation-as-effect posture is just a shorthand way of communicating with Congress, that's one thing. If it's the Fed's analytical framework for inflation, then we're in trouble.

Caroline, it's no short hand - we are in trouble. Big trouble.

Central bankers are so far out of touch with the real world that not only do they believe "inflation" and the money supply are largely unrelated, they think that at two percent, "inflation" is overstated by up to one percent.

This is what Ben Bernanke termed "true inflation" in his previous visit to Capitol Hill.

The money and credit sloshing around the world is completely irrelevant. The central bankers of the world know better what inflation is and isn't and they'll tell the elected officials and the citizenry what to think about inflation.

Of course, this varies greatly from one country to another.

The Zimbabwe government recently outlawed inflation, arresting a number of senior executives in recent months for breaking the law: raising the price of flour and bread without the express approval of the Ministry of Industry and International Trade.

Venezuelan President Hugo Chavez adopted the same inflation- fighting tactic, threatening jail sentences and even nationaliztion if grocery store owners defy price controls.

The 1,331 word New York Times article on Zimbabwe's economy never mentions money. Rarely does the Fed refer to money -- in its public statements and apparently in its internal discussions. There are no mandated targets for the monetary aggregates, fewer aggregates (reporting on M3 was discontinued last year much to the chagrin of conspiracy theorists), no agreement on how to define money and no good way to measure it, we're told.

But excess money creation is the cause of inflation, and it would be better if the Fed could make the public understand that the rise in the price level is not a result of higher commodity prices, aggressive labor union demands for wage increases or greedy businessmen trying to milk the public.

It may not sell in Zimbabwe, where anyone trying to explain the roots of inflation might be arrested on the spot. But in the U.S., with inflation running at about 2.5 percent, the public can handle the truth.

Oh Caroline, you were doing so well there up until that last paragraph. What happened?

It's excess money that causes "inflation", but you actually believe it to be only 2.5 percent?

Oh Dear. You're as out of touch as the Fed Chairman.

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The Mysterious Magic of Financial Engineering

Less than two years ago, during his extended farewell tour, former Fed Chairman Alan Greenspan spoke glowingly about evolving credit markets in general and subprime lending in particular. This speech was delivered in April of 2005, just as risky mortgage lending was shifting into high gear.

With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.

Last fall, the Federal Reserve Bank of Chicago deemed the recent housing boom a product of "wealth creation technology" in the mortgage lending business. After the continuing fallout in subprime lending that now threatens the rest of the economy, housing continues to be a topic of discussion at the Chicago Fed, but references to this new technology were not to be found in recent literature.

How quickly times change.

How quickly everyone comes to their senses when the bottom line is materially impacted.

How quickly the euphoria of a speculative bubble changes to finger pointing.

In the current issue of The Economist, they weigh in on subprime lending calling it the "mysterious magic" of "financial engineers" - clearly a more accurate characterization aided by the passage of time. In the process, they provide one of the better images depicting the current state of technological innovations in mortgage lending lauded by the Federal Reserve not so long ago (the loan originator is in the middle).

Bleak houses
America's riskiest mortgages are set to pop. Where will the shrapnel land?


LAST March, ResMAE, a mortgage lender catering to risky borrowers, cut the ribbon on its new headquarters in Brea, California. The sprawling, 135,000-square-foot building dwarfed the company's 458 local employees. But it fitted the firm's outsized ambitions. Less than a year later the company, rather than its ribbon, was facing the chop. This week it said it had filed for bankruptcy and was selling its assets for a diminutive $19m.

ResMAE is one of over 20 casualties among America's “subprime” mortgage lenders, which serve borrowers with spotty credit histories at higher interest rates. This end of the market took on $605 billion of new mortgages last year, more than a fifth of the total. But as interest rates have climbed, these loans have soured and the shares of bigger subprime lenders, such as Countrywide Financial and IndyMac, have sagged.

Does the rot run deeper?
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Some banks do get caught holding the live grenade. FDIC reckons that depository institutions hold $3 trillion of mortgages. Much of this is higher-quality stuff, but not all. And even banks eager to securitise their loans sometimes retain the “residual”—the most risky slice where losses hit first. CreditSights, a research firm, notes that Bear Stearns holds about $6.8 billion in residuals, although only a fraction is below investment grade. Banks that write mortgages are also contractually obliged to buy back securitised loans if their underwriting is shown to be shoddy or if the loans sour too quickly. That is what felled ResMAE and is hurting Accredited Home Lenders Holding, a San Diego lender.
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Should loan losses climb, investors in mortgage-backed securities will also get burnt, especially those holding the riskier, higher-yielding bonds. Financial engineers worked their mysterious magic with these securities, turning the junkiest mortgages into high-grade, sometimes AAA-rated, securities. They could do this only with the blessing of credit-ratings agencies, which made a profitable business out of rating these securities. But critics say the agencies got complacent, and doubt the pooled loans were sufficiently diverse, or sliced up with sufficient art truly to have dispersed risk. One possible blind spot is that the dodgiest mortgages all behave similarly in times of stress. Another is that it is hard to avoid heavy exposure to mortgages from California, the biggest market in America, where alternative products were popular.

No one quite knows in whose hands these little bombs will ultimately explode. The hope is that the risks are widely and thinly spread. The fear is that they all sit in the lap of a few big hedge funds. But the real casualties may be homeowners, who often took out risky loans they could barely afford or did not understand. The FDIC has already tightened rules on underwriting negative-amortisation loans, and the Senate has begun to hold hearings on predatory mortgage lending. With Democrats now in charge of Congress, there is a fair chance the politicians will act. The Eliot Spitzer of the housing downturn may be about to start his charge.

The mysterious magic of financial engineering will always define this era.

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