“THE ECONOMY HAS BEEN HIT BY TWO shocks,” said Andrew Sentance, a Bank of England policymaker, in a speech last Tuesday night.

He was talking specifically about the British economy, but these two shocks have smacked policy wonks square in the face across the developed world.

The two ugly fists — both with “hate” tattooed on the knuckles — are “financial market turbulence and a sharp rise in oil and some other commodity prices.”

“[They] are operating in opposing directions in terms of their impact on inflation,” says the Bank of England’s man. “So judging the appropriate monetary policy response will not be easy.”

But who needs to judge the right response when you’ve got a printing press and an unlimited line of credit from taxpayers?

Growth in the European money supply hit a 28-year record in October, the central bank reported last week.

The broad M3 money supply — “which the ECB uses as a gauge of future inflation,” as Bloomberg notes — rose 12.3% from October last year, the fastest rate of growth since July 1979. But this monetary inflation can only rise faster when November’s numbers come out late in December.

Last week alone, the European Central Bank promised to supply the money markets with an extra €30 billion ($44.27 billion) in short-term funds, “another indication that the credit crisis is far from over,” as Sean O’Grady reports for The Independent in London.

So far, however, no cigar. On Wednesday this week, the ECB made its biggest loan of three-month money since April 2001, as the global credit crunch pushed the interbank lending rate up to 4.74%.

The ECB’s current target rate for eurozone interest rates is 4%, and these short-term loans are designed to help ease upward pressure on the free-market rate by making easy with central bank cash.

But even after last week’s record auction of €50 billion ($73.7 billion) “We didn’t see any effect on markets,” one money-market trader told Reuters.

“The amount [that private banks are] needing is a lot more than the ECB is allotting.”

Resolving tensions in the financial markets is only one half of a central banker’s task, however. His other key responsibility — and central bankers are almost without fail always male, if not men — is defending “price stability.” In other words, inflation must not be allowed to rise above some target or other, decided over tea and biscuits in the hushed conference suites where politicians and central bank wonks chew the cud.

The inflation target is currently set at 2% in both Europe and the United Kingdom. On Tuesday last week, however, the Federal Statistics Office of Germany announced that consumer price inflation in the world’s third-largest economy will rise by 3% in November — the highest rate of price increases since February 1994.

“A sense of impending inflation is currently influencing German consumers,” warns the highly regarded GfK consultancy. “The positive factors currently evident, such as the sustained improvement on the job market and rising incomes, seem unable to prevent the evaporation of optimism.”

“Solid anchoring of inflation expectations is all the more important in a period of turbulences associated with this market correction,” as Jean-Claude Trichet, president of the European Central Bank, said in a speech on Monday this week.

That neatly sums up the head-scratcher now costing central bankers their hair the world over. You either bail out the money markets with a flood of liquidity…or you keep a lid on inflation.

You can’t do both, not according to history. And every so often — not least when you’re bruised and beaten by a fearful credit crunch on one side and a hateful oil-price shock on the other — it seems you can’t achieve either.

Just ask Andrew Sentance at the Bank of England. In Tuesday night’s speech, he ‘fessed up to an inflationary mess that looks a little like this…

The U.S. Federal Reserve, meanwhile, is also presumed to be targeting 2% annual growth in its consumer prices.

But just like the ECB too, it’s also pumping money into the New York credit market at a record clip.

Can central bankers really have it both ways?

The U.S. Fed is forever making short-term loans to the money markets. Adding liquidity is nothing unusual.

The Fed offers money to the big New York banks in exchange for good-quality securities — securities such as, say, U.S. Treasury bonds or government agency debt. And it will lend money for anything between one day and two weeks or more.

On any one day, you might find the New York Fed making two, three or more of these loans via auction. And between the start of 2001 and the end of last month, the average sum lent in each of these auctions was $6.01 billion.

Since the start of this month, in contrast, each of the Fed’s short-term liquidity auctions has averaged $10.17 billion.

But let’s put quantity to one side for a moment, even if it does seem to be driving a sharp rise in German consumer price inflation. The quality of the collateral that the Fed is accepting when it makes these loans has changed dramatically, too:

The Fed has always been happy to accept mortgage-backed bonds as security for the short-term cash injections it makes.

If the New York interbank lending rate needs a little shot in the arm to cool it down, AAA-rated mortgage-backed securities are just fine. But as you can see, the big banks stepping up to the Fed’s auctions have always been keen to use more mortgage-backed securities (MBS) as collateral than the Fed would accept.

Indeed, the ratio of MBS submitted to MBS accepted averaged only 0.55 between November 2000 and the end of July 2007. More times than not, the Fed said “no” to home loan-backed bonds and demanded U.S. Treasury notes or agency debt as collateral instead.

Since the credit crunch first bit at the start of August, however, the New York Fed has relented somewhat. The ratio of MBS submitted to MBS accepted when bidding for the Fed’s cash has risen to 0.85.

And while the size of the Fed’s injections — as well as the volume of mortgage-backed bonds held against them — have both grown substantially, the frequency of those injections has also soared. There were 29 temporary Fed injections in the first 28 days of November alone.

Over the preceding seven years, the New York Fed averaged fewer than 25 injections per calendar month.

But it’s not only the Fed that’s supporting the local housing market by accepting mortgage-backed bonds as collateral for new loans. Last week, Australia’s central bank lent Aus. $500 million — some U.S. $435 million — in a series of repurchase agreements based on mortgage-backed bonds. On Thursday alone it bought Aus. $100 million of home loan debt, set to mature in just over three months.

“This is the first high-volume activity ever in this market and may encourage further investor participation,” reckons Warren Mellor, an analyst at National Australia Bank in Sydney, talking to Bloomberg. It might just encourage Australia’s financial firms to park as much of their home loan inventory at the reserve bank, too.

Sales of Australian mortgage-backed bonds sank by 94% between July-September, the newswire adds, down to a meager Aus. $1.8 billion — a five-year low.

Can the Reserve Bank of Australia reverse this slump? It claims to love mortgage-backed bonds so much right now, it’s willing to lend hard cash against them at a bargain rate of interest.

Sydney’s interbank lending rate for three-month loans ended last week at 7.165%, just shy of an 11-year high. The RBA, however, was happy to lend for 0.24% below that market rate.

Or put another way, the flood of money trying to wash away the current slump in world credit markets is truly global.

Think this will help ease inflation in your cost of living?

Regards,
Adrian Ash

December 3, 2007

Two Shocks, One Solution was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Just five things:

1. Lack of authority.
2. People would use it to pay off debt.
3. Banks do not want to be paid back with money that is worthless.
4. The Fed will act to bail out banks, not consumers.
5. Hyperinflation ends the game. The Fed is simply not in the business of destroying itself.

Rest assured the Fed is going to do almost everything under the sun to encourage more borrowing. That includes slashing the discount rate and the fed funds rate, loosening rules on collateral, etc. Some of those we have already seen. This is likely the first inning.

But the one thing the Fed is not going to do is send everyone $100,000 or $10,000 or even $5,000. If for some reason I am mistaken and the Fed starts sending out checks or depositing money into people’s checking accounts to a significant degree, then I am willing to eat my deflation hat. Just so we are clear on this, another piddly $300 from Congress is not enough.

The Cart and the Horse

Many people in government and the media misunderstand the causes of inflation. In an attempt to answer some of the questions people have, Peter Schiff wrote this in an editorial article on Gold-Eagle.com:

“Inflation has only one cause, and that is the Federal Reserve itself. In the United States, the supply of money and credit is regulated by the Fed. Since inflation is by definition an increase in the supply of money and credit, only the Fed can create it.

“If the money supply were held constant, increases in some prices would be offset by decreases in others. The result would be no overall inflation. In fact, without government-created expansions of the money supply, the natural tendency of prices would be to decline as technology allowed for more efficient production of goods and services. So while most regard the Fed as the primary inflation fighter, in reality, it is the sole inflation creator.”

That is a near-perfect explanation. Certainly, Schiff’s definition of inflation is perfect: “Inflation is by definition an increase in the supply of money and credit.”

Schiff did make an error, however. That error is in the phrase “only the Fed can create it.” When it comes to credit, the statement is simply wrong. Money, in the form of credit, is borrowed into existence every day. This is a systemic problem, and the Fed is clearly not in control of it.

Money as Debt

There is an educational five-part YouTube series on money and debt. It covers in nice cartoon animation what has happened to money over time, fractional reserve lending, how money is created today, why interest rates are so low, why we get unsolicited credit offers, and why debt is exploding.

The video concludes that it is taking exponential increases in debt (money) to stave off a collapse of the entire banking system, and that this cannot go on forever.

Click here to see this five-part series on debt.

I agree with the video that there are practical limits on how high debt can get. Unfortunately, the video’s conclusion is a bunch of socialist nonsense: Eliminate interest, let governments — and only governments — create money, and supposedly, government will then use that money wisely to build roads and bridges that will add value to society.

However, the video does a reasonable job of pointing out many of the problems with the current system of debt creation in a very entertaining and (for the most part) educational way. On that basis, I recommend watching all five parts.

Ability to Take on Debt Is Not Infinite

At the top of this article, I outline five reasons the Fed is not going to give money away. If one believes that rationale, then one must logically accept there is a practical limit to debt, at least at the consumer level.

Proof of concept is easy enough to find. Massively rising delinquencies, foreclosures, and bankruptcies should be proof enough. At the state level, it’s easy to see what is going to happen. Unlike the federal government, states are required to have balanced budgets. That means one of three things:

• Raising taxes
• Cutting spending
• Floating bonds to postpone the problem.

Raising taxes headed into a consumer-led recession will not work. Cutting spending is absolutely needed, but will throw people out of work at the worst time. Postponing the problem is not solving the problem. Postponement only makes things worse.

This is yet another version of “Economic Zugzwang,” wherein there are no winning answers (at least as far as politicians are concerned).

The proper solution is to let free market forces work. If that means banks fail, then banks fail. If that means the stock market collapses, the stock market collapses.

Letting (encouraging) the dollar fall to zero is not a solution, for the simple reason it does not create any jobs where they are needed, which is right here, right now.

Given the amount of credit in the system versus actual cash and global wage arbitrage and slower consumer spending, it would take a mammoth effort from Congress and the Fed to forestall the inevitable once again.

A Sure Thing?

Right now, the surest bet in the world is that when the dollar drops, the U.S. stock markets rise. How long that remains so is anyone’s guess.

There is going to come a time when borrowing dollars to invest in equities is going to blow up. Of course, the carry trade may blow up first (sinking everything in its wake). Perhaps a massive derivatives unwind sinks everything first. Then again, perhaps the trigger is something from way left field that no one is watching.

What I am certain of is this: The fuse is now lit. The structural imbalances worldwide have never been greater, and the fuel at the end of the fuse is enormous. In addition, the amount at risk increases every day.

The interesting thing is that no one knows how long the fuse is. For some inexplicable reason, everyone acts as if they can get out before the stick ignites. It’s simply not possible.

Regards,
Mish

October 30, 2007

Which Comes First: The Cart or the Horse? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.