Thursday, January 31, 2008

New Statistic Suggests Fed is Lying about Inflation

Yesterday the US Federal Reserve cut interest rates again, noting that inflationary pressures seem to be receding. Not so fast. How would we know whether or not there is monetary inflation, since the Fed ceased reporting the vital M3 statistic in March of 2006 (it's like.... they saw this coming). I've written about the importance of this move to stop reporting M3 in "Running on M3" and "A Peak Behind the Curtain." Common sense would suggest that repeated rate cuts, not to mention the arguably more significant Fed Open Market Committee subsidized bond auctions for tens of billions of dollars every few weeks, would lead to inflation. It also seems evident that, in light of our entitlement/Ponzi-scheme system and our economy's need for at least apparent growth, we will choose inflation over deflation at virtually any cost (I've written about this in "The Case for Inflation" at The Oil Drum).

While it's easy to theorize about monetary inflation, a new statistic, MZM, being tracked by the Saint Louis Fed, effectively reconstructs M3. The results are damning:

John Williams at put together this fine piece of analysis. M3 was M2 plus institutional funds and eurodollar holdings. MZM (Money of Zero Maturity) is M2 plus institutional funds--so it is a very close proxy to the old M3. Based on the graph above, the Fed is fully aware that its Open Market Committee policies are driving inflation--they are, after all, the ones who record and track MZM. I made the following graph to show the correlation between MZM and the Fed's decision to stop reporting M3:

If any one wants to check the data, the St. Louis Fed provides a handy charting tool that reveals just how much they aren't telling us in their press releases.

This raises two questions, in my mind: 1) if, as the Fed said in their statement explaining why they were dropping the M3, the "M3 does not appear to convey any additional information about economic activity that is not already embodied in M2," then why are they wasting my tax money tracking MZM, which does nothing but account part of that same additional information that the M3 included, but the Fed says doesn't exist?? 2) how do they reconcile the explosion of MZM with yesterday's fed statment that "members believed that price pressures will moderate in coming quarters"??

Rhetorical questions . . . warning, inflation ahead.

Hat tip to Tony from The Oil Drum!

Publishing Note: I've committed to publishing every Monday morning, and I'm building a backlog of non-time-critical posts to ensure this happens. However, when something pops up that can't wait until Monday, I will post mid week, in addition to a regular post the following Monday. In light of current events, this is an example of a post that shouldn't wait.

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Theo_musher said...

So, if a person had a secure job and was in debt (like most people) isn't this actually positive?
Doesn't inflationm mostly hurt people with a lot of money in investments?

I mean if you are a lender, lending people money inflation hurts worse than being a borrower. Because the money loses value over time, making it "cheaper" to pay back. So whats the long term ramifications for low interest rates and high inflation?

Or I guess what I mean is meduim term ramifications. Long term ramification is somthing that begins with a 'c' and ends with "sh"

Even my Republican Dad sees that coming.

Theo_musher said...

Check this out:

I know you know all this stuff already but I found it helpful in getting my head around this stuff:

The Trillion Dollar Secret

Jeff Vail said...

I agree that fixed rate debt is likely to be priced at a negative rate when compared to real inflation right now. Student loans and mortgages probably fall into this category, but most consumer debt does not. I think this also raises the question of the true value of investing in bonds or equities--even IF the "conventional wisdom" that they will return 10-12% over the long-term is true. Look at the top graph--MZM is currently increasing at over 12% per year. I don't see this course likely to dramatically change direction any time soon.

So why do lenders play this game if it is a loser? I think it's because 1) they need to keep the system going, and 2) thanks to fractional reserve banking "fairy dust," they are either able to get this money itself at a loan from the Fed and then loan it out again at a slightly higher rate. Even if this aggregates to a negative real rate, it may still be higher than the opportunity cost of using that money elsewhere (e.g. losing it in the stock or equity market), and, despite the recent mortgage problems, it is still possible to securitize this debt and sell it off for a pretty penny in the short term.

None of this, I don't think, undermines your basic point, though: it's disaster over the long term. I think that we have an institutionally constrained time horizon of two years or less that requires decision makers to focus only on what they can make happen within that time frame. Between election cycles, quarterly and annual reporting requirements, and the 24-hour news blitz, anyone who doesn't play by the "rules" and focus only on what they can prop up for another year or so--and damn the long term consequences--will be politically or economically selected out of the "ecosystem." This results in each new decision trying to further prop up previous gap-filling measures. I like to think of this as an exponential growth problem--the required amount of innovative/fraudulent hype and fairy dust required to keep the giant balloon inflated grows at an exponential rate (this is the "medium term"), and at some point there is no amount of hot air that can keep up.

Jeff Vail said...

I wrote about the financial derivative "elephant in the room" in September, 2006, but that article from John Riley is from January 18, 2008, and it seems that the problem has continued to explode since then--definitely worth reading.

Anonymous said...

What this means is that, if you are a borrower, you want that borrowing locked in at a fixed rate. In other words, refi your ARM now. Rates have come down and it's to your advantage. With inflation like this, rates will NOT stay down here for long. Anyone remember Paul Volcker?

It also means hard assets are going to rise in price: agricultural commodities, precious metals, oil, etc. Any fixed store of value will benefit. Their prices might seem high now, but just you wait...

Anonymous said...

You have looked at it from the borrowers side of the equation now try the lenders. If you had large savings would you put it on deposit in a bank for say 3-4% interest if you knew inflation was eating away at it at say 10-12% or more? Of course not. All the smart money and big money will either move it abroad to somewhere where inflation is not so high or invest in hard assets. Also what makes you think banks, who know all this, would continue to lend for a negative return? The result of this will be a squeeze on money available for lending. No matter how good your credit rating.

The problem with high inflation and low interest rates is that money flees the country. Before the early 1980s most countries had capital restrictions which stopped money leaving a country and going abroad because that is exactly what this kind of situation encourages.

Jeff Vail said...

"The result of this will be a squeeze on money available for lending."

Well, this is exactly what is happening to some degree. The problem is that the big banks have backed themselves into something of a Catch-22 situation: they own huge amounts of securitized debt, the "market value" of this debt is dependent on the stability in home values, and if they stop making credit available--even at a loss--they take it in the teeth on the value of their existing holdings because the inability to get financing to buy homes causes their values to drop.

To some extent, the ability to bundle and securitize debt has allowed banks to profit in excess of the face-interest rate on their loans. The rise of Credit-Default Swaps has allowed them to push the envelope even more. The question is, when will the value of these products face a reconciling with reality (e.g. the market value of the underlying asset), and will it be the result of a crash or a "soft-landing"? That's the $200 TRILLION question right now: how do you engineer a soft landing? The present answer seems to be to inflate-away the immediate problem, but I think this only exacerbates the issue over the long term. Thoughts?

Theo_musher said...

I think the US is screwed no matter what. I think people in the best position to engineer a soft landing are the EU and China and second world countries aligning themselves with those two.

In their case the question is "How can we protect ourselves from the US economy collapsing?"

It seems like whatever they do will hurt us. Who needs the US anyway? We don't make anything any more. We don't educate the best brains in the world anymore.

We are a big market for walmart, I guess.

Jeff Vail said...

I think we still do one (*good*) thing better than anywhere else in the world: we produce people that combine a solid foundation in science and business WITH creative capability and a certain spirit of rebelliousness.

I think we do this less and less, but at least from what I've seen elsewhere, we still do this best, and it's important. This is what drives innovation. We can't justify our relatively higher standard of living based on how many years of school we've been to or how well we know our multiplication tables, but our ability to produce stand-out innovators is what keeps us afloat. In my opinion, this is where our education system should focus. Unfortunately, I think we're trending in exactly the opposite direction... I'm not sure we can turn it around based solely on this attribute, but, on a positive note, I think this feature creates a much greater base of resiliency than is often seen in a snapshot of the American economy. I don't mean to get all Larry Kudlow here--I think the government will manage to screw things up royally (because they're structurally predisposed to do so), but I think we will also see a renaissance in individual innovation in America over the next few decades, necessity being the mother of invention and all that...

Theo_musher said...

Yeah, that's a good point.

There are a lot of smart capabale innovative type people that are "green" too in the US.

Jeff Vail said...

I think that collapse--in whatever form it may take from prolonged recession to complete dissolution of existing power structures--will really spur innovation in small-scale, decentralized "green tech." Right now, there is no real motivation to figure out how to do things in a small-scale, vernacular, sustainable way, since the existing financial and economic infrastructure both heavily subsidizes centralized/corporate ventures and makes them artificially out-compete the "rhizome" alternative. If you take that away--say the breakdown of the interstate highway system, unavailability of general freight transport, or the soaring cost of imported raw materials (the latter of which is already happening), then I think you take the lid off an already simmering innovation revolution. That's a bit of a cliche phrase, but historically collapse and hardship has often opened the door for radical new thinking, often with highly influential results. I think we'll see the same thing over the next few decades--radical and revolutionary innovation in business. It just won't come from the places most mainstream pundits expect (like thin-film solar or energy efficient cars, both of which I see as attempts to hold on to the past).

Theo_musher said...

Well, it should be fun!

The only thing I wonder about is regionalism. I mean, the idea of people splitting off into insular little groups, that aren't really friendly towards each other.

My thoughts are on Alaska, because I am moving there. The Eskimos and the Athabascan Indians were two groups that were the best examples of a rhizome social structure I can think of. But the thing is they were at continual war with each other. It never escalated, because it was a stalemate and each group kept to its own area.

When each group respectively began to be exploited by Whites, it kind of ended the feud. Basically both groups transitioned from a subsistence economy to a fur trapping economy and then later lots of bad things as their cultures were each destroyed, for the most part, through alcaholism, welfare etc.

But anyway as warped as it may sound economic exploitation creates peace in a way and unites people, creates communication networks.

Not that there is anything on the horizon that will set the clock back 10,000 years, but still to me rhizome looks like tribal life that is cut off from everyone outside the region, wheras Emperialism connects people, through creating pluralistic societies.

So I have to wonder if regionalism, local economies, might become "too local".

Sventastic said...

Interesting stuff.
I think things will get quite decentalized and much more local in the coming decades.
There will be peaks and valleys, in many diverse forms.
But since the English and Spanish languages are so prevalent on this continent, I think communications will continue to flow.
Whereas, historically, different cultures had different languages (even if from a common root) inhibiting free communication.
Here in North America, many of us from diverse backgrounds, and regions, share some common ground in terms of cultural conditioning and especially language.
This will evolve into regionalized vernaculars, but will be common enough for many generations to come.

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