Search results matching tag 'Inflation'

Where the Wild Things Are

JohnMauldin — Sat, 21 Nov 2009 05:49:00 GMT

Where the Wild Things Are
It Is Not Just Japan
The Euro-Yen Cross and the Dollar Carry Trade
New York, London, and Switzerland

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

--Old Scottish Prayer

Where the Wild Things Are is a beloved children's book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve's low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let's quickly set the background.

It Is Not Just Japan

Let's look at today's interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can't make money in this environment, you need to quit and find meaningful employment.

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

The Euro-Yen Cross and the Dollar Carry Trade

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4^th quarter 2009 estimates so as to not have to take into account the disastrous 4^th quarter of last year.)

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

"China's Liu Says U.S. Rates Cause Dollar Speculation

"Nov. 15 (Bloomberg) -- The decline of the dollar and decisions in the U.S. not to raise interest rates have caused "huge" speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission."

"The continuous depreciation in the dollar, and the U.S. government's indication, that in order to resume growth and maintain public confidence, it basically won't raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," he told reporters in Beijing today at the International Finance Forum.

"Liu said this has 'seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.'

"His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve's policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis."

"'I'm scared and leaders should look out,' Tsang said in Singapore Nov. 13. 'America is doing exactly what Japan did last time,' he said, adding that Japan's zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown."

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration's willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

Barron's just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

New York, London, and Switzerland

I am going to hit the send button on what may be the shortest e-letter I have ever done. The travel is catching up with me and I need some rest.

I am looking forward to Thanksgiving next week. It may be my favorite holiday. Family, friends, food, and football. My usual pattern is to get up very early Thursday and start the prime slow-cooking, and then turn to the side dishes. It will be no different this year. My brother will bring the smoked turkeys, which he has down to an art form. And then there are the over-the-top wines I was so graciously given this past birthday by so many friends. I will bring a few of those bottles out.

The next weekend I am in New York for Festivus with the crowd from Minyanville, and then I am home for over a month before I go to London and Switzerland in late January. Then not much is currently scheduled until April, although it always does seem to change. After the recent hectic schedule (15 cities and even more speeches in just a little over three weeks), I look forward to some home time.

I wish those of you in the US the best of Thanksgivings, and the rest of you a great week. And thanks for all the very kind words of late about Tiffani. She seems to be doing better. She is due in a month, so she is still moving slowly, but you can sense the excitement in her and Ryan. I find it all very pleasant.

Your "there's no place like home" analyst,

John Mauldin

Catching Argentinian Disease

JohnMauldin — Sat, 31 Oct 2009 02:47:00 GMT

Catching Argentinian Disease?
The Ascent of Money
The Independence of the Fed Threatened
A Few Quick Thoughts on the Dollar, GDP, and the Recession
Uruguay, Philadelphia, Orlando, and then...

I have been in South America this week, speaking nine times in five days, interspersed with lots of meetings. The conversation kept coming back to the prospects for the dollar, but I was just as interested in talking with money managers and business people who had experienced the hyperinflation of Argentina and Brazil. How could such a thing happen? As it turned out, I was reading a rather remarkable book that addressed that question. There are those who believe that the United States is headed for hyperinflation because of our large and growing government fiscal deficit and massive future liabilities (as much as $56 trillion) for Medicare and Social Security.

This week, we will look at the Argentinian experience and ask ourselves whether "it" - hyperinflation - can happen here.

The Ascent of Money

I will be quoting from Niall Ferguson's recent book, The Ascent of Money. I cannot recommend this book too highly. In fact, I rank it up with my all-time favorite book on economic history, Against the Gods, by the late (and sorely missed) Peter Bernstein. There are very few books I read twice. There are too many books and not enough time. This book I will have to read at least three times, and soon, and I have a lot of underlines and mark-ups in it already.

If there were one book I could require every member of the Congress to read, it would be this one. As I read it, I am struck again and again by how fragile and yet resilient our economic systems are. Fragile in the sense that governmental policy mistakes, no matter how well-intentioned, can destroy the wealth of a nation, and resilient in that it doesn't happen more often.

In his introduction Ferguson writes, "The first step towards understanding the complexities of the financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present day roles much easier to grasp."

As is often said, those who do not understand history are doomed to repeat it. If you want to understand what is happening in the economy, what the consequences of our choices could be, then I strongly suggest you get The Ascent of Money. It is easy to read, engaging, full of moments where you are led to pull together different ideas into an "Aha!" Ferguson is a brilliant writer and historian, and we are lucky to have this book at a time when it is sorely needed. (order it at Amazon.com)

As I have been writing, the United States in particular, and the developed world in general, are faced with a series of very unpleasant, if not downright bad choices. The time for good choices was ten years ago. Now we face the prospect of painful decisions, no matter what we do. It is not a matter of pain or no pain, of somehow avoiding the consequences of our bad decisions, it is simply deciding how much pain we will take and when, or allowing the pain to build up to a climactic event. Today we look at what I think would be the worst choice of all.

Catching Argentinian Disease

At the beginning of the 20^th century, Argentina was the seventh richest nation on earth. It's very name means "silver." "As rich as an Argentine" was a byword. Even after falling from the heights through a series of bad decisions, the country was still so wealthy that, in 1946 when new president Juan Peron first visited the central bank, he could remark that "There was so much gold you could barely walk through the corridors."

Argentina had actually defaulted on its debt in the late 19^th century, not once but twice! But still they managed to avoid destroying the currency and devastating the country. But in 1989, after years of massive budget deficits that were financed with borrowing from abroad and Argentinian citizens, the country was left with so much debt and no one was willing to lend it any more money, that the leaders felt compelled to resort to the printing press.

My Uruguayan friend and Latin American partner, Enrique Fynn, tells me of his experience of going to Buenos Aires and buying a pack of cigarettes one evening. He went into the store the next morning for another pack, and the price had doubled. He came back that evening and the price had doubled again (thankfully for his health, he has quit!). There were no prices on any items in the grocery stores. There was a man with a microphone who would announce the prices of various items, often increasing the price every few hours by 30% or more.

Workers would get their pay in cash and rush to the store to buy anything, as by the end of the week their pay would be worthless. Of course, shelves were empty. The US dollar was king, and could purchase things at amazing prices. I heard stories that were truly compelling. (It made me wish I had gone shopping in Buenos Aires at the time!)

Interestingly, the dollar is still the real medium of exchange. I was told by several people that if you want to buy a house for half a million dollars, you bring the physical cash to the closing. One person counts the money and the other checks the paperwork and title. Argentina has the second largest hoard of physical dollars in the world, only exceeded by Russia. Is it any wonder they are concerned with the value of the dollar?

Let's look at some quotes from Ferguson (emphasis mine):

"The economic history of Argentina in the twentieth century is an object lesson that all the resources in the world can be set at nought by financial mismanagement... To understand Argentina's economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon...

"To put it simply, there was no significant group with an interest in price stability...

"Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country's political economy."

Look at the chart below. Using realistic assumptions, It suggests that the annual US government fiscal deficit will approach $2 trillion in 2019. How can we come up with what looks to be about $15 trillion over the next ten years? The Argentinian answer was to print the money.

In the US, the short answer is that unless the US consumers become a massive saving machine, to the tune of 8% or more of GDP and rising each year, and willingly put their savings into US government debt, it's not going to happen. So sometime in the coming years, interest rates are likely to start to rise in order to compensate bond investors for what they perceive as risk. That will bring us to some very difficult and painful choices.

As I wrote a few weeks ago, this scenario could be averted IF the Obama administration produced a credible plan to lower the deficit over time and stuck to it. But today's thought process is about what happens if they don't.

Ferguson pointed out in the quotes above that hyperinflation is always and everywhere a political decision. Governments have to choose to print money. In theory and in practice, what would happen if the Fed decided to accommodate a politicized US government that wanted to spend money on favorite projects and support groups, maybe even deserving programs like health care or defense or pensions or Social Security? Money they could not borrow?

Then Peter Schiff and like-minded thinkers would be right. Once you start down that path, it is hard to stop short of the brink. Brazil got to 100% inflation per month and has really lowered that level over time, but it is not easy.

In such a scenario, you want to own hard assets. Gold. Foreign currencies. Stocks. Almost anything other than the currency that is being printed.

I was asked at almost every speech about that scenario. In Latin America, hyperinflation is not a theoretical issue; it has been reality. More than one person commented on that no one in US economics schools studies hyperinflation. It is required material in Latin America. For many Latin Americans, the dollar has been their safe haven. And now they are worried, with good reason.

For the record, I do not think the US will experience hyperinflation as long as the Fed maintains its independence. Read the speeches from various Fed governors and regional presidents. These are strong personalities, and they understand that going down that path ends in massive tears. Bernanke warned just a few weeks ago that the government needs to get serious about the fiscal deficit. Watch the rhetoric from the Fed heat up after his reconfirmation and the confirmation of two new governors in the first quarter.

The Fed has committed to buy a fixed amount of government debt in its quantitative easing program. That commitment will be finished by the end of the first quarter (if I remember correctly). Then comes the tricky part.

I have been writing for a long time that the main force in the economy right now is deflation. The Fed will fight deflation tooth and nail. But they don't have to buy government debt to fight deflation. They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way.

I believe the Fed will maintain its independence. Not to do so is to court economic disaster of the first order. These are bright and serious men and women. They get it.

The Independence of the Fed Threatened

The risk is that something changes to compromise their independence. And sadly, there is some risk. Let me quote my fishing buddy friend David Kotok:

"It's now official. The proposed legislation to reform America's financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America's central bank.

"The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

"The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five-member, politically configured board.

"The original seven-governor construction was designed to insulate them from political pressure, for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two-decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice.

"In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis."

This is the nose of the camel under the tent. Starting down this road is very worrisome indeed. I find it appalling that Tim Geithner and Larry Summers went along with this. This is a very clear attempt by the political class to put political pressure on the Fed. I hope the Fed responds with vigor. I can tell you that the officials of whom I am aware will not take kindly to pressure. And that might be an understatement.

(Yes, I am aware of the problems of the Fed being able to decide whom to bail out and why. It is not a perfect world. But better the Fed than Congress.)

All that being said, if the Fed starts to increase its buying of government debt above its initial commitment, then my "optimistic" scenario of a very rough economic patch, which I have been outlining the past few months, is far too rose-colored. I do not think it will happen, but I can guarantee you, I and a lot of other people will be watching.

A Few Quick Thoughts on the Dollar, GDP, and the Recession

Just a few quick notes. When world trade collapsed, so did the need for US dollars, which is what the world uses to transact business. The data looks like world trade is finding a bottom and maybe even recovering somewhat. That means there will be the need for more dollars. And since everybody and their mother are short the dollar, there could be a vicious snap-back rally. I am still bearish the US dollar (and the yen and the euro and the pound) over the long term, but there is the potential for a real rally here.

And my friend Mish Shedlock commented on the US GDP report, which said the US GDP rose 3.5%:

"Today the market is cheering over what is actually an ugly report. A misguided Cash-for-Clunkers added a one-time contribution of 1.66 percentage points to GDP. Auto sales have since collapsed so all the program did is move some demand forward. Government spending increased at 7.9 percent in the third quarter which is certainly nothing to cheer about. Personal income decreased $15.5 billion (0.5 percent), while real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent last quarter. Those are horrible numbers. The savings rate is down, which no doubt has misguided economists cheering, but people spending more than they make is one of the things that got us into trouble. The only bright spot I can find is exports. However, even there we must not get too excited as imports rose much more."

John Williams notes that one-time stimulus or inventory items represented 92% of the reported quarterly growth. The nature of the stimulus-related gains was that they tended to steal business activity from the future. The months ahead are the future. Accordingly, fourth-quarter quarterly GDP change will likely turn negative, again. (The King Report)

And David Rosenberg writes: "Only economists see the recession as being over; the man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go -- and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

"Only 29% of those polled believe the economy has hit bottom -- imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally -- not the onset of a new bull market) has not swayed their view (or ours for that matter)."

Uruguay, Philadelphia, Orlando, and then...

I am finishing this letter in Montevideo, Uruguay. I have been in Buenos Aires, Sao Paulo, and Rio de Janeiro this week. I must say that Rio is beautiful, very green and lush with marvelous beaches, which I sadly only got to drive past. I will come again. I fly back Sunday and am home for a week, then speaking trips to Philadelphia and Orlando. Then my schedule only shows a few days in New York in early December for Festivus with the gang from Minyanville, and Europe in January. I am sure other things will come up, but I am looking forward to being home for awhile.

My friends at International Living have been writing about Uruguay, and I was really looking forward to visiting the country. I have spent a few days with partner Enrique Fynn in this delightful place. Turns out it is the Switzerland of South America. Reasonable bank secrecy laws, and trades zones where you are not taxed on any business you do outside of Uruguay. Many international companies set up their headquarters here. Beautiful beaches, friendly people, and the charm of a small country, plus what will be a brand new airport in a few weeks, which can get you several times a day to any part of the region, directly to Europe, and one hop away from any major city in the world. You can learn more about the country, and other countries you may want to live in or have a second home in, by subscribing to International Living.

One of the laugh lines I use in my speeches down here is that if the Fed actually does start to monetize the debt, I will have to move to Uruguay. I could make worse choices.

Have a great week. I think this weekend I will switch it up from the heavy reading I have been doing and find some science fiction. Reality is way too scary.

Your ready to be in his own bed analyst,

John Mauldin

The Best of Times

JohnMauldin — Sat, 24 Oct 2009 02:52:00 GMT

It's The Best of Times
The Elements of Deflation
It's More Than Half Full
Argentina, Brazil, and Uruguay

What's a Fed to do? We get talk about tightening and taking away the easy credit, but we got the fourth largest monetization on record last week. This week we examine the elements of deflation, look at some banking statistics that are not optimistic, and then I write a reply to my great friend Bill Bonner about why it's the best of times to be young. I think you will get a few thought-provoking ideas here and there.

But before we get to the main letter, I want to recommend a book to you. I am on a 17-day, 12-city speaking tour. It is rather brutal, but I did it to myself. However, one of the upsides of traveling is that I get quiet time on airplanes to read books. I am working my way through a very large stack of books on my desk. One that caught my eye - and I'm glad it did - is a book by Tom Hayes called Jump Point: How Network Culture is Revolutionizing Business. Hayes writes about how we are getting ready to experience a cultural change every bit as profound as the Industrial Revolution. He argues that as the 3 billionth person gets online sometime in 2011, it will shift the dynamic of how we interact as businesses and consumers. We get to 5 billion by 2015. The mind boggles.

Clearly, it is already changing things, and I am not sure if I buy Hayes' thesis that 3 billion is a magical number, though it is great marketing. That being said, I found something on almost every page that I underlined or highlighted. This book made me think about the future in ways that my kids already get but Dad doesn't.

I like to read books about "important stuff" by people who have done a lot of thinking about their subjects, and who can write easily and fluidly and communicate their thoughts without weighing me down with unnecessary verbiage. Hayes has done that. (I am sure some of you, my patient readers, wish I could be better at that!)

No long review here. Go to Amazon and read the reviews. One writer wrote: "I gave the book 5 stars not because it was perfect -- I think Hayes's enthusiasm sometimes makes him jump to conclusions - but because there are so many ideas and observations here that it would take ages to put something like this together from other sources."

I agree. If you are in business, any business, you need to read this. As an aside, I will insist that all my partners worldwide get this book and read it. You can go to Amazon.com and buy the book. And Tom, if you get this (and I bet one of your friends will forward it to you), call me.

The Elements of Deflation

One of the advantages of travel is that it gives you time away from the tyranny of the computer to think. (Am I the only one who feels like I am drinking information through a fire hose?) But getting the information is important too, as it gives you something to think about. And I have been thinking a lot lately about deflation.

I get asked at almost every venue where I stop, whether I think we will see inflation, or deflation. And I answer, "Yes." And I am not trying to be funny. I think the primary forces in the developed world now are deflationary. When asked if I don't think that the Fed monetizing debt of all kinds won't eventually be inflationary, I answer, "We better hope so!"

Let's quickly summarize some of the ideas from the last few months of this letter. Just as water is made up of two parts hydrogen to one part oxygen, so deflation has its own elemental structure.

The first element is Rising Unemployment. There has never been a sustained inflationary period without wage inflation. Wages are basically flat and falling. With 9.8% unemployment, 7% underemployed (temporary), and another 3-4% off the radar screen because they are so discouraged they are not even looking for jobs, and thus are not counted as unemployed (who made up these rules?), it is hard to see how wage inflation is in our near future.

Think about this. Only a few years ago, less than 1 in 16 Americans was unemployed or underemployed. Today it is 1 in 5. That is a staggering, overwhelming statistic. Mind-numbing.

Keynes said that you should stimulate the economy in recessions in order to bring back consumer spending. That is not going to happen this time. As my friends at GaveKal point out, this time we will have to have an Austrian (economic) recovery, or a business-spending recovery. My argument will be, when I am with them in Dallas in December at their conference, "Where are we going to get business-investment spending when banks aren't lending and capacity utilization is at an all-time low?" This, of course, leads the Keynesians to jump in and say, "The government has to step up and jump-start consumption!" Which means more debt. Wash. Rinse. Repeat.

The next element of deflation is massive Wealth Destruction. Two bear markets and a housing market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas.

Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing each month. (See graph below.)

Next up in our elemental list we have Decreased Final Demand and its counterpart Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next 3-5 years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write.

And of course we must address the element of Low Capacity Utilization. While capacity utilization is rebounding, it is still lower than at any time since the data has been collected, other than the last few months. It is hard to see where businesses are going to get pricing power, when not only US but world capacity utilization is still extremely low. The chart below is not the stuff that inflation is made of.

And let's just quickly throw in Massive Deleveraging and $2 trillion in Bank Losses and a Very Weak Housing Market. Which brings us to a Slowing Velocity of Money.

As I have written on several occasions, prices are a function of the amount of money times the velocity of money. If the velocity of money is slowing, the amount of money can rise without bringing about inflation. It is a delicate balance, but nonetheless the hyperventilation in some circles about the coming hyperinflation is, well, overinflated. Simplistic. Economically naive.

The Fed is going to do what it takes to bring about inflation (in my opinion). But they will not monetize US government debt beyond what they have already agreed to. If they need to "print money" to fight deflation, they can buy mortgage or credit-card or other forms of private debt, which have the convenience of being self-liquidating. Read the speeches of the Fed presidents and governors. I can't imagine these people will recklessly monetize US debt. You don't get to their level without having a stiff backbone. (Yes, I know the gold bugs will call me terminally naive. We will have to wait to see who is right. Peter Schiff, care to make a bet on this one?)

Bernanke warned Congress again last week about rising deficits. Watch the deficit rhetoric coming from the Fed after the next two governors are appointed next year, side by side with Bernanke's reappointment. There will be a line drawn in the sand. Some in Congress will not be happy, but my bet is that the Fed will maintain its independence. If they do not, then my recent letters will prove far too optimistic (and many of you protest my rather less-than-positive suggestion of a double-dip recession). But I must admit I cannot imagine that happening. And there are not enough votes in Congress to change that independent status. There is a day of reckoning coming with the US debt. And thank God for that.

Bottom line: The Fed will do what it takes to keep us from deflation. They will deal with the problems of the ensuing inflation. I wrote six years ago that the best outcome from all the easy monetary policy and budget deficits would be stagflation. I see no need to change that assessment. I am not happy with stagflation, but as I came into my young adult life in the '70s (see below), I know that we can deal with that. The far more worrisome prospect is continued trillion-dollar deficits.

It Is the Best of Times

Now let's change the topic. My friend Bill Bonner, of Daily Reckoning and Agora Publishing fame, recently wrote about his mother. Bill also turned 60 recently. I wrote to him about the similarities between our mothers. Both were born in hard circumstances, on farms that had no indoor plumbing. They joined the WACs and met their husbands. They struggled raising families. Bill and I both grew up in rather humble circumstances (to put a mild spin on it).

That exchange caused Bill to write about the future our kids face. He has six kids and I have seven. He has graciously allowed all my kids to invade his chateau in rural France (where they mingle with his kids), and has invited us back next summer. I think Bill is the best writer, the best "turner of a phrase," in the business. I often feel like a house painter standing in front of a Rembrandt when I read his work.

But Bill is a tad pessimistic. He makes me look like Larry Kudlow. He wrote (among other books) Financial Reckoning Day, which has just been updated and is now titled Financial Reckoning Day Fallout: Surviving Today's Global Depression. It makes for some interesting reading. Get it with Jump Point.

Now to the point. As I said, Bill wrote about the future our kids face. I will repeat what he said and then respond. Bill's thoughts:

"We sat in a cab yesterday, stuck in traffic in central London. We watched people walk by and wondered. What are they thinking about? What do they want out of life? What do they think of themselves?

"There were hundreds of them...different shapes...different sizes. A businessman in a pin-striped suit, briefcase in hand, concentrating on his sales report; he almost stepped in front of a motorcycle. A salesgirl, grotesquely overweight...yellow hair streaked with brown...wishing she hadn't had so much to drink the night before. A lawyer daydreaming about his secretary. A man who would have rather been fishing...still in his waxed coat. A woman annoyed about something. A heavy construction worker, his legs splayed outward as he walked. A tense young woman who dared not look up. A woman worrying about her son. A man thinking about buying a new car. One man trying to remember a line from a song he learned 30 years ago. Another talking to herself. One looked like a doctor taking an afternoon stroll. Another was stark raving mad.

"All of them walking along...from one place to another...shuffling along...the living towards the dead.

"We were thinking of our children. What a different world they grow up in. And yet, it is still the same too. A man might have been stuck on a London street 50 years ago...and hundreds of years ago he might have watched the same shopkeepers and carpenters walk by, each caught in his own thoughts like a fly in a spider's web.

"Our old friend John Mauldin wrote to say that his mother's experience was not much different than ours. She joined the WACs during the war...met John's father...and then nature took her course.

"But both John and your editor had a big advantage in life. We both caught the upswing.

"Not so with our children. They inherit a different world. America was the world's leading nation in the '50s and '60s. And it was growing in power and wealth - rapidly. We grew up with it. Things were getting better and better...we were sure we'd live much grander, richer, and more exciting lives than our parents. The sky was always the limit!

"Now, America is in decline. China's economy grows while hers declines. The Far East has savings, while she has none. The Asia nations are net exporters, making huge profits...while American industries are judged too old, too expensive, and too highly regulated to compete. Americans have debt up the kazoo, while their competitors have little. A young person in America has to look forward to supporting 70 million retired baby boomers...and paying for their drugs, their food, their wars, and their bailouts.

"For our children - ours and John's - the situation on a personal level is different too. Coming from poor families, we could look forward to much more wealth and material success than our parents ever knew.

"We came back to Ireland this week for a reason that our parents would never have dreamed of. Your editor has set up a family office. It is a very modest affair by family office standards. The typical family office manages a fortune of $100 million, according to The New York Times. We may not even be on the same planet with these rich families; but we are in the same universe. That is, we try to think about...and manage...our wealth as rich people do...as a family legacy or an endowment, not as a retirement fund.

"What wealth we have accumulated - even if it is paltry - will be held by a family-owned corporation. Then, the corporation, run largely by the adult children, manages the assets - from our base in Ireland.

"Your editor, freed from the responsibility of managing his own money, will be free to wander and think...like a vagabond, a gypsy, a refugee, an itinerant mendicant...forced to sup on whatever is at hand and take lodging wherever he can find it - but favoring the Four Seasons and Chateau Margot when they are available.

"Whatever else this does, it puts the children in a very different situation from their parents. Instead of starting out with nothing, they're starting out with something. While this would seem to be a big advantage to them, it has huge hidden disadvantages. Like America itself, they are in danger of finding themselves slipping downhill. Instead of expecting things to get better, they may find it hard even to hold onto what they've got. Instead of the "Morning in America" that Ronald Reagan promised, they may find that it seems more like evening, both in their personal as well as their national lives.

"'From shirtsleeves to shirtsleeves in three generations,' say the French. The grandfather begins without a coat. His grandson ends that way.

"But what to do? Spend it all now...so the children begin with the same clean slate we had? Move to Brazil or India - countries with more obvious upside?

"In the deep, cosmic end, it probably doesn't matter. The advantage to starting out on an upper rung of the ladder may be about equal to the disadvantage of having to worry about falling off. Who can know?

"Every man has to play the cards he's been dealt. What else can he do? He may have a humpback or a beautiful voice. He may have had a hard upbringing or a soft head. He may have a fortune worth of poetry in his soul but not a dime in his pocket. As far as we can tell, every young man starts out even. Each one begins life in the same place - where he is. And every generation takes what it is given, and makes the best of it.

"The real advantage in life is having the gumption to get on with it; no one knows where that comes from."

It's More Than Half Full

Ok, Bill, let's review those wonderful days from whence we sprang, so fraught with the advantages of having nothing. So potent with opportunity. It was the middle of the '70s when we started our careers. Inflation was high and rising. The Soviets were seen as a major threat. Japan was beating our brains out and buying everything, even if nailed down (like Pebble Beach and New York skyscrapers). I had to borrow money at 15% (or more) to buy paper in order to meet customer demands for printing. And guess what? The banks got into trouble and called loans willy-nilly. (My bank even called my mother and threatened her to pay off my loan - against written agreements - and she did. Evil sons of bitches. The more things change... And that bank did fail, I report delightedly! Not that I hold a grudge.)

There were multiple successive and ever-deeper recessions. Gold was rising and the dollar was seen as a joke. Howard Ruff (a good friend to both of us when we were starting out!) and almost every newsletter writer were telling people to buy gold and freeze-dried food to protect themselves against a near-certain economic, if not apocalyptic, catastrophe. Unemployment was high and rising for a decade.

The correct answer to the question, "Where will the jobs come from?" back then was, "I don't know, but they will." And that is the correct answer today.

In 20 years, no one will want to come back to the halcyon days of 2005. Our kids (all 13 of them) are getting ready to live through what will be the most exciting period in human history. There will be a century's worth of change, measured by the standard of the 20^th century, just in the next ten years, and then we will double that pace in the next ten after that. Medical miracles will mean our kids and grandkids will live a lot longer than their dads, although I intend to be writing well into my 80s, like our mutual hero Richard Russell.

There will be whole new industries developed in the US. How do I know that? Follow the money. The rest of the world spends a fraction of what we do on research and development. Where do you go if you are looking for venture capital?

Do I care if the Chinese and the "developing" world are far better off, relatively speaking, than the US in 20 years? Not a whit. Good on them. I hope they make discoveries and inventions and grow new businesses that benefit us all. But we are not going into some long dark night. We, and our kids, get to choose how we respond to what is the reality of the day.

Our nation had to almost hit the wall in 1980 before a Volker could come along and force us to take the pain of recession to beat back inflation. And we will have to come perilously close to the wall this time before we take action as a nation. Way too close for comfort. Maybe you are right, and we have a soft depression. I hope not; but even so, the world will be better, far better, in 20 years, with far more opportunities than today.

It was not fun starting new businesses in the '70s and early '80s. But we did. I remember coming to Baltimore and being (literally) afraid to get out of the car to visit your offices in the slums. But that was what you could afford. A far cry from the chateau in Ouzilly.

I lived in a small mobile home. Tiffani was born there, and we converted part of the kitchen to be her bedroom. (Yes, I was white "trailer trash.") But I got up every morning just like you did and killed as many alligators as I could. The rest had to wait 'til the next day.

And that is the legacy our kids have. They know what it is to wade into the swamp every morning. Never quitting. In thinking about this, you may be the father I respect the most. You have raised your kids to be multilingual children of the world. What a work ethic. How did you get them to scrape window shutters at your chateaus? (I actually saw this, and my kids marveled. Thereafter I threatened to make them go live with you when they didn't behave!)

You have given your kids the opportunity to follow their dreams, even demanded that they do so. And such dreams they (and mine) have. Will they succeed? Who knows? But they will go at it with gusto, in a world with more opportunities than you and I ever imagined 40 years ago. And, oh boy, were we optimists back then. How else could we have done what we did? If we believed the rhetoric that the world was coming to an end, would we have dared to venture out?

You cannot have raised your kids to be such bold adventurers without instilling in them a certain high level of optimism. I am going to out you, Mr. Bonner. You present yourself to your readers as a bona fide end-of-the-world pessimist. But you are a really and truly a closet optimist. Your whole business empire (and what an empire it has become!) is based on finding people who are optimists, in the sense that they think they can actually get people to send them money for what they write. Which they do! Even if it is to read why the world will come to an end, which thankfully it never does.

You are right in this: it is personal gumption that makes or breaks us. There are those who started out with less than we did (hard to imagine but true) and made a lot more. And there are those who started out with far more and made less. But there are very few who are happier than either of us. Or luckier.

Our kids? It is not the times that dictate the man (or daughter!), but the response of the man which dictates his own time. Today promises a brighter future for someone young than any other time in history, whether they are in the US or Brazil or China. They just have to seize it.

And as our kids do just that, and as the millions of kids of those who read us do so, and the billions of kids who are just now getting ready to bust loose all work to achieve their dreams, the world is going to be a far more fantastic place. Smooth ride? Not a chance. We didn't get one; and in thinking through history, there have not been many smooth rides. Why should we think that will get any better? Our kids will just have to live with our generational (and individual) iniquities, government debt and all, and figure out how to master their own fates. But if I had a choice to take the '70s or today? In less than a heartbeat I would choose today. And I bet you would too!

(Side note: You can subscribe to the Daily Reckoning and read more of Bill's great prose. Warning: it is bearish, but lively and fun.)

Argentina, Brazil, and Uruguay

Tonight I am in Orlando, where I spoke at the Commonwealth national conference. I have been to a few conferences here and there, but I must admit to being impressed. A conference for brokers and advisors who are affiliated with them, it was exceptionally well done. And a very smart crowd. These guys have attracted some exceptional talent.

Tomorrow morning I fly back to Dallas, where I get to see my new grandson, Hayden, for the first time. Born this week a little early while I am on the road, I get a call at 3 am on Monday telling me the news and sending me a picture. Wow. The heck with deficits and deflation. How can you not be an optimist?

Then later in the afternoon I am off for Argentina, Brazil, and Uruguay, speaking in four cities and meeting with clients (and future clients) of my Latin American partner, Enrique Flynn. And then back to Philadelphia, again in Orlando, Scottsdale, and one trip to New York in early December. Then not much else is scheduled - but past performance says that will change.

There is a steak and a bottle of wine waiting for me down the hall, so it is time to hit the send button. Have a great week. I know I am. I love South America, and look forward to coming back to you with my impressions.

Your wondering who made up this schedule analyst,

John Mauldin

Dollar continues to fall...

ChuckButler — Wed, 14 Oct 2009 15:21:42 GMT

.........But First, A Word From Our Sponsor..........
Countries poised to benefit from rising commodity prices: combined into one CD

That's the Global Power Shift Index CD from EverBank®. In one CD, get the currencies of 4 countries rich in natural resources-and whose economies may benefit from rising commodity prices. The CD equally combines the following currencies:

*Australian dollar
*Brazilian real
*Norwegian krone
*Canadian dollar

CD features: 3 and 6 month terms, no monthly account fees and $20K minimum to open. Apply or learn more at http://www.everbank.com/001CurrencyCDIndexGlobalPowerShift.aspx?referid=11808

EverBank is an Equal Housing Lender and member FDIC.
......................................................
In This Issue..

* Dollar moves lower...
* China to take a role at IMF...
* US Borrow and spend policies continue...
* Gold sets a new record...

And Now... Today's Pfennig!

Dollar continues to fall...

Good day...and what a day it was in the currency markets on Tuesday! The rout on the dollar continued, and was broad based with gains in every currency we trade. The commodity based currencies led the pack, as the weaker dollar fueled a big run up in raw material prices. Reports out of both Asia and Europe signaled the global economy is recovering, and bolstered investors looking for a way out of the falling dollar.

European industrial output rose for a fourth month in August, increasing just below 1 percent from July. From a year earlier, August output fell 15.4%, a big drop but still the smallest YOY decline in 8 months. The Euro area continues to recover 'at a gradual pace' according to ECB President Trichet. The positive news coming from the manufacturing sector is a good sign the European economic recovery will be sustainable.

Another report overnight showed China's exports fell by the least amount in nine months during September. As we have written over and over again, China will lead the world out of the global recession, and the latest reports show China beginning to pull away. Reports due out next week will likely show China's economic growth accelerated to 8.9% in the third quarter; slightly above the governments target.

China has used the economic downturn to lock in a dominant position in world trade, and has replaced Germany as the world's biggest exporter. During the first seven months of this year, China has moved past Canada as the number one supplier of imported goods to the US with 19% of all imports entering the US originating in China. These exports continue to bolster China's foreign reserves which climbed $141 billion in the third quarter to a record $2.273 trillion. China has decided to keep their currency pegged to the falling dollar, which has helped them increase their exports leading to additional growth in their currency reserves.

The Chinese government is now looking to leverage their huge reserves to attain a more dominant role in the post-crisis global financial order. A story in the China Daily predicted Bank of China Vice-President Zhu Min will soon take up a crucial post at the International Monetary Fund (IMF). According to the Chinese paper, "Zhu's appointment at the IMF will be a significant step toward breaking up the US and Europe's dominant position in the international financial stage". Welcome to the new world order!

Today we will finally get some data in the US, with the release of retail sales, business inventories, and the monthly budget statement. We will also get to read the minutes of the Sept 23 FOMC meeting this afternoon. Retail sales is the number to watch, and it is expected to have dropped by over 2% with the end of the 'cash for clunkers' program. If the data come in as expected, it will confirm the US consumer will not be able to sustain their spending as the government stimulus fades. So while Europe and China look to be expanding, the US is bogged down with rising unemployment and weak growth.

I can pretty much predict what the administration will say after seeing the report: It is obvious that we need to have another stimulus package!! The administration thinks the way out of this mess is to borrow and spend, and if the US consumers won't do it on their own, the government will be more than happy to spend our money for us. But President Obama's effort to spend us out of recession is undermining the US$. In spite of his pledge to keep the dollar strong, the dollar index is down 10% during the first 8 1/2 months of Treasury Secretary Tim Geithner's term.

And the boys over at the Federal Reserve certainly don't seem like they want a strong dollar either. Fed Vice Chairman Donald Kohn put a shot across the dollars bow yesterday when he said interest rates will remain low for an 'extended period'. I expect the minutes of the FOMC meeting which will be released later today will show the members continue to focus on the short term and have turned a blind eye to the threat of future inflation. The dovish tone which the Fed has taken will continue to push the dollar lower.

I read the following quote in an article on Bloomberg which I thought was dead on: "The all night printing runs at the Treasury are chipping away at the dollar's ability to hold value compared to other currencies and commodities," Mike Sander, of Sander Capital said yesterday. "With dollar weakness, inflation fears, a huge budget deficit, energy prices creeping up, metals such as gold, silver, and copper will be pushed up in price." Sounds like Mr. Sander is a Pfennig reader!!

As I pointed out in my opening paragraph, commodity prices have surged on the positive economic news from China and Europe. Demand by China continues to support the market for raw materials, and a falling dollar has created additional demand. The prices of oil, gold, and copper all moved higher yesterday and brought the currencies of Canada, South Africa, and Norway along for the ride. The South African Rand and Norwegian Krone were both up nearly 1% vs. the US$ and the Canadian loonie moved a bit closer to parity with the US$. Norway's finance minister helped push the krone higher with the announcement that their stimulus efforts will generate an extra .5% of economic growth next year. The Norges Bank considered moving interest rates higher last month, and looks poised to deliver a rate increase at their next meeting.

I know I will get some emails accusing me of being hypocritical, bashing the US and UK stimulus plans while praising those of Norway and China. The big difference between these plans is that Norway and China are spending money they already have, while the US and the UK are borrowing in order to spend. Norway is spending some of its $450 billion oil fund in order to stimulate their economy, and China has been spending some of their record reserves. These stimulus plans will be less inflationary than the 'quantitative easing' being instituted by the US and UK.

Gold benefitted from the good economic news and a push by investors to diversify out of US$ holdings. Gold advanced to a record level for a second day as investors increased purchases in order to hedge against a falling dollar and the possibility of future inflation. A report I read this morning predicts further price gains by gold: "A weakening US dollar and easy liquidity conditions will particularly favor precious metals," Morgan Stanley analyst said in a report today. "We expect prices of gold, silver, and platinum all to register further gains over the next year." Gold at $1,100 looks like a done deal in the face of increased investor appetite for dollar alternatives.

I'll end with a funny story Chuck shared with me via email last night. He was standing with Michelle Boschert out in front of the airport in Atlanta waiting for Frank Trotter to pick him up when a car rolled up and a guy yelled out... "Hey! Are You Chuck Butler? He didn't hear him at first, so Chuck said what? And he repeated it... Hey! Are you Chuck Butler? Chuck still wasn't sure what he was saying, but Michelle heard him and answered, YES! And the guy in the car yells out, I read your newsletter! And drives away... Pretty amazing, eh? Chuck's fan base is nationwide!!

Currencies today 10/14/09: A$ .9145, kiwi .7417, C$ .9741, euro 1.4909, sterling 1.5988, Swiss .9828, rand 7.2528, krone 5.5619, SEK 6.916, forint 179.51, zloty 2.8204, koruna 17.3585, RUB 29.38, yen 89.26, sing 1.3907, HKD 7.7501, INR 46.107, China 6.8263, pesos 13.0535, BRL 1.7216, dollar index 75.58, Oil $75.10, 10-year 3.38%, Silver $17.875, and Gold... $1,064.20

That's it for today... We had a busy day on the desk yesterday, as it was the funding deadline for another BRIC MarketSafe CD. This issue was almost as large as the last one which set a record. Those that missed the opportunity will have one more chance, as we are offering a November issue. Today is 'flu shot' day here in the office with our annual health and wellness fair. Hope everyone has a Wonderful Wednesday!!

Chris Gaffney, CFA
Vice President
EverBank World Markets
1-800-926-4922
1-314-647-3837

Killing the Goose

JohnMauldin — Sat, 10 Oct 2009 03:07:00 GMT

Killing the Goose
What Were We Thinking?
Let's Play Turn It Around
Detroit, the Red Sox and the Yankees, and Traveling Too Much

Peggy Noonan, maybe the most gifted essayist of our time, wrote a few weeks ago about the vague concern that many of us have that the monster looming up ahead of us has the potential (my interpretation) for not just plucking a few feathers from the goose that lays the golden egg (the US free-market economy), or stealing a few more of the valuable eggs, but of actually killing the goose. Today we look at the possibility that the fiscal path of the enormous US government deficits we are on could indeed kill the goose, or harm it so badly it will make the lost decades that Japan has suffered seem like a stroll in the park.

And while I do not think we will get to that point (though I can't deny the possibility), for reasons I will go into, there is the very real prospect that the upheavals created by not dealing proactively with the problems (or denying they exist) will be as bad as or worse than the credit crisis we have gone through. This is not going to be something that happens overnight, and the seeming return to normalcy that so many predict has the rather alarming aspect of creating a sense of complacency that will only serve to "kick the can" down the road.

This week we look at the problem, and then muse upon what the more likely scenarios are that may play out. This is a longer version of a speech I gave this morning to the New Orleans Conference, where I also offered a path out of the problems. This letter will be a little more controversial than normal, but I hope it makes us all think about the very serious plight we have put ourselves in.

Let's review a few paragraphs I wrote last month: "I have seven kids. As our family grew, we limited the choices our kids could make; but as they grew into teenagers, they were given more leeway. Not all of their choices were good. How many times did Dad say, ‘What were you thinking?' and get a mute reply or a mumbled ‘I don't know.'

"Yet how else do you teach them that bad choices have bad consequences? You can lecture, you can be a role model; but in the end you have to let them make their own choices. And a lot of them make a lot of bad choices. After having raised six, with one more teenage son at home, I have come to the conclusion that you just breathe a sigh of relief if they grow up and have avoided fatal, life-altering choices. I am lucky. So far. Knock on a lot of wood.

"I have watched good kids from good families make bad choices, and kids with no seeming chance make good choices. But one thing I have observed. Very few teenagers make the hard choice without some outside encouragement or help in understanding the known consequences, from some source. They nearly always opt for the choice that involves the most fun and/or the least immediate pain, and then learn later that they now have to make yet another choice as a consequence of the original one. And thus they grow up. So quickly."

What Were We Thinking?

As a culture, the current mix of generations, especially in the US, has made some choices. Choices which, in hindsight, leave the adult in us asking, "What were we thinking?"

We made a series of bad choices and suffered the credit crisis because of it. Now, as a nation, we are in the middle of making an even worse choice, one that will leave us with no good choices - only choices of pretty bad to awful. Let's begin with a quote from a recent client letter by my friends at Hayman Advisors (in Dallas).

"Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero).

"There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

"According to the current Office of Management and Budget (OMB) projections, US federal expenditures are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010, with unified deficits of $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. [Emphasis mine]

"One has to ask whether the US reached the critical tipping point. Beyond the quantitative measurements associated with government deficits and money creation, there exists a qualitative aspect to such a scenario that may be far more important. The qualitative perceptions of fiscal and monetary policies are impossible to control once confidence is lost. In fact, recent price action in metals, the dollar and commodities suggests that the market is already anticipating the future."

Let me point out that the deficits for 2010 assume a rather robust recovery, and so they could turn out to be much worse, especially if unemployment continues to rise and Congress decides (rightly) to extend unemployment benefits.

The interest on the national debt in fiscal 2008 was $451 billion. Even though the debt has exploded, the interest for fiscal 2009 is down to "only" $383 billion. My back-of-the-napkin estimate says that is over 20% of total 2009 tax receipts. I guess when you take interest rates to zero and really load up on short-term debt, it helps lower interest costs. (More on that future problem later.) http://www.savingsbonds.gov/govt/reports/ir/ir_expense.htm

The fiscal deficits are projected to be about 11% of nominal GDP, which is now roughly $14.3 trillion. The Congressional Budget Office currently projects that deficits will still be $1 trillion in ten years.

Last spring I published as an Outside the Box a very important paper by Dr. Woody Brock on why you cannot grow government debt well above nominal GDP without causing severe disruptions to the overall economic system. If you have not read it, or would like to read it again, click here.

I am going to reproduce just one table from that piece. Note that this was Woody's worst-case assumption, adding 8% of GDP to the debt each year, and not the 11% we are experiencing today. The Congressional Budget Office projections are now even worse, and that assumes a very rosy 3% or more growth in the economy for the next five years. Under Woody's scenario, the national debt would rise to $18 trillion by 2015, or well over 100% of GDP, depending on your growth assumptions. Take some time to study the tables, but I am going to focus on 2015 and not the outlier years.

$1.5 trillion dollars means that someone has to invest that much in Treasury bonds. Let's look at where the $1.5 trillion might come from. Let's assume that all of our trade deficit comes back to the US and is invested in US government bonds. Today we found out that the latest monthly trade deficit was just over $30 billion, or $370 billion annualized (which is half what it was a few years ago). That still leaves $1.13 trillion that needs to be found to be invested in US government debt (forget about business and consumer loans and mortgages).

Killing the Goose

$1.13 trillion is roughly 8% of total US GDP. That is a staggering amount. And again, that assumes that foreigners continue to put 100% of their fresh reserves into dollar-denominated assets. That is not a safe assumption, given the recent news stories about how governments are thinking about whether to create an alternative to the dollar as a reserve currency. (And if I was watching the US run $1.5 trillion deficits with no realistic plans to cut back, I would be having private talks too. They would be idiots not to do so.)

There are only three sources for the needed funds: either an increase in taxes or people increasing savings and putting them into government bonds or the Fed monetizing the debt, or some combination of all three.

Now the Fed is in fact monetizing a portion of the debt as part of its quantitative easing program, and US consumers are saving more. Tax receipts are way down. I can tell you there is a great deal of angst in New Orleans tonight about the Fed monetization. This is traditionally a "gold bug" conference, and many of the participants and speakers see only inflation in our future.

Long-time readers know that I think the Fed has been able to get away with its rather large monetization program because of the massive deflationary forces let loose in the world by the credit crisis, which is forcing a monster deleveraging regime all over the world. Where has all the money gone that the Fed has printed? Right back onto the Fed's balance sheet as bank reserves. The banks are not lending, so this money does not get into the system in the usual manner associated with fractional reserve banking. Until that happens, and is accompanied by increasing wages and employment, inflation is not in our immediate future.

And this brings us to our conundrum. You cannot continue to run deficits significantly larger than nominal GDP for too long without risking the demise of the economic system. Ask Argentina or any of the other nations where hyperinflation occurred, as detailed in the study mentioned above. But we are in a deflationary environment, so the Fed can monetize the debt far more than any of us suppose without risking immediate and spiraling inflation.

But there is a limit to the Fed's ability to do so without causing real inflation. First, as long as the Fed is independent, at some point they will simply have to tell Congress we can no longer monetize the debt. While I am sure that some of you doubt they would do so, the Fed officials and economists I have been around are pretty adamant about that. There is a line they will not be pushed past. It may be further than I like, but it is there.

The Fed cannot simply buy up all the debt needed to fund the government. Again, no one on the FOMC would either advocate or allow that. That would in fact start us down a very dangerous path rather quickly. Therefore, they must have a large number of willing bond buyers outside the Fed. The good news, gentle reader, is that we will find someone to buy that debt. That is also the bad news. Let's go back 30 years.

Legend now has it that Paul Volker single-handedly took the inflation bull by the horns and ripped them off. Now, it took fortitude to do that in the face of certain recession and high unemployment. Those were not fun days. But his partner in the deed was the bond market. Bond investors simply demanded higher returns, because they were really worried about inflation.

At some point, if we do not get the government deficit under control, the bond market is once again going to react. Seemingly overnight, real (inflation-adjusted) rates are going to rise, and will do so rapidly. And I am not talking about 1 or 2%. You just cannot have 8% of a $14-trillion GDP go into US government debt every year, forever, at today's low real rates.

Let's play a thought game. If you take 8% of US consumer spending and save it, and it finds its way into government bonds, you have reduced consumer spending and therefore the actual GDP. But how about those who want to invest in stocks? Foreign bonds and currencies? New businesses? Loans of all types? How much are we going to have to save to get the necessary capital? How high will the saving rate have to be to finance all those other activities in a world where debt securitization is still anemic?

Some will point to Japan and their government debt-to-GDP ratio, which will soon be over 200%, a far cry from where we are today. Why can't we grow our debt to 200%? Because the Japanese have long had a culture of saving and investing in government bonds. It's what you do to support the country. But even they will run into a wall as their savings rate continues to drop, because so many of their citizens are retired and are now selling bonds to finance retirement. They too are running massive fiscal deficits, on the order of the size of the US deficits. And does anyone really want to have two lost decades, like Japan?

How long can we go before there is an upheaval? I don't know. The markets can remain irrational or complacent for a lot longer than most of us think. It could be years. Or not. Suddenly, it will be July 2008 and the bond vigilantes stampede.

But now, we seemingly can borrow with no consequences. The deflation that is in the air, plus the lack of bank lending holds, down the normal inflation impulses. We as a nation are leveraging ourselves up. We're partying like it's still 2005. The music is playing and we are dancing. Our Congress is trying to figure out how to run even higher deficits.

At some point, the consequences will be significant. There are two paths, and it is not clear which one we will take. First, we might see inflation kick in and actual rates rise. Since so much of our national debt is short-term debt, that means yet another rise in the deficit as rates rise. Mortgage rates rise, putting pressure on the housing market. There will be even more pressure on commercial mortgages. Consumer debt will be harder to get and cost more. It will mean funding costs for businesses will rise, and that hurts employment. It would be a return to the 1970s of high interest rates and stagnant growth in a very slow-growth environment.

Second, we could see deflation kick in and, even though rates stay more or less where they are, real (after-deflation) rates could rise as they did in the '30s and in Japan.

Some of my most knowledgeable friends argue for the inflation side, and others take the deflation side. I tend to think the Fed will fight deflation until we get inflation, but the consequences will not be pleasant. There is no benign path.

How can we avoid such an upheaval? The only way is to make some very difficult choices. There have to be some adults making the choices, as the teenagers now in control clearly cannot make them.

As I have written in the past, we can run deficits of 2% of GDP for a very long time, which in a few years would be about $300 billion. It is my belief that if the bond market and world investors saw a credible plan to put us on a path to a deficit no larger than 2% of GDP, the dire upheaval that is in our future could be avoided.

But that will mean some painful choices. It is not a matter of pain or no pain, it is just deciding when and how bad it will be. The longer we wait, the worse the consequences.

Let's Play Turn It Around

There are businessmen who are called turnaround specialists. They come into companies that are sick but have a basic competency, and that with the right management can be made into viable concerns. Generally, the choices the new management makes are painful to those involved, but they are necessary if the enterprise is to remain a going concern.

So, for the next few pages, I am going to suggest some things we can do to turn the US around. They are not easy fixes, and I know a lot of readers will not like what they read or will disagree on points. But something like this is going to have to be done, or we risk killing the goose.

First, we must acknowledge the deficit is out of control, and spending must be cut. If we raise taxes by as much as the Obama administration now wants to, we will most assuredly put the country back into a deep recession in 2011. Think what raising taxes in 1937 did to a nascent recovery. A $3-trillion-dollar budget is 20% of the US economy. That is just simply too much.

Quick fact. The most credible studies show that government expenditures exert no multiplier effect on the economy. Actually, they show them to be very slightly negative. This is not just in the US. However, the tax effect has a multiplier of 3! If we raise taxes by $300 billion in 2011, that will slam the economy in the face. Further, we will collect less taxes than projected, as economic activity will fall.

You cannot cure a too much debt problem with more debt. We cannot borrow our way into prosperity. Every crisis of the past decades has been a result of too much debt and leverage and we seem to want to repeat the past mistakes, hoping that this time it will be different. It won't.

Ok, now let's play the Turnaround Hammer Game.

+ We should start with a 5% acrossthe-board cut in spending in all programs. Federal employees, except for military personnel, should see a 5% cut in pay as part of that program. The average federal worker makes $75,419 a year, while the average in the private sector is $39,751. The rest of us are taking pay cuts in the form of higher taxes. No cost of living increases, etc. We are on an austerity program and need to do what it takes. If a program is deemed too important to be cut, then another program has to be cut more.

Then the next year another 2.5% cut across the board. And then an absolute freeze on the overall budget size until the deficit is 2% or less of GDP.

+ Social Security must be fixed now. We all know that it is going to have to be done, so why not just do it? Means testing should be a part of the mix. As an idea, for every $10,000 in income a retiree has, he gets $1,000 less in SS payments. And increase the retirement age down the road. When SS was launched, retirement age was 65. But the average life span was 65. There are other things we can do, but whatever our poison of choice is, we need to take it.

+ Medicare must be revised, with real health-care reform. The national debt is $56 trillion if we count unfunded liabilities, much of which is Medicare. It will become a nightmare around the middle of the next decade. Adding more expenses now without cutting elsewhere makes no sense. If we kill the goose, no one will get anything excect very empty promises.

Side note: there actually is a lot of waste in the system. Software should be written that analyzes every patient and procedure and produces an outcomes-based analysis of what is reasonable, rather than throwing every test at every patient. And the government should make sure, even if it has to spend the money, that the updated system is in place in every hospital and clinic in the country. And doctors should be given access to it so they can decide what type of care is appropriate to prescribe. And health-care reform means tort reform.

Today, I got a note from a friend of mine who just had yet another heart attack. It seems his stent is now blocked by 50%. He is a vet, and his primary care is the Veterans Administration. The Veterans Hospital system will not do a procedure to unblock the stent until it is 70% blocked. He does not have any money, so he is simply waiting to have another heart attack. I am really looking forward to government-run health care.

+ Each year we allow almost 1 million immigrants into the US, mostly family of people already here. I suggest that for the next two years we stop that. Instead, let anyone who can buy a home, passes basic screening, and can demonstrate the ability to pay for health insurance immigrate to the US and get a temporary green card. If they behave, then the card becomes permanent after four years.

We almost immediately put a floor on the housing market, absorb the excess homes, and within a year the housing-construction market, along with the jobs that are now gone, will be back. That is stimulus that costs the taxpayers nothing.

+ While I can't believe I am writing this, taxes are going to have to rise, if for no other reason than this Congress is hell bent on raising taxes. But rescinding the entire Bush tax cuts, plus adding a 10% surcharge as Congress wants to do in one fell swoop, is an absolute guarantee of a recession. So do it gradually over (say) 4 years, and then reinstitute the cuts when the deficit is under 2% of GDP. Remember the negative tax-multiplier effect of raising taxes. And the definitive work on that was done by Obama's chairman of the Council of Economic Advisors, Christina Romer.

We should consider a VAT tax and a major cut/reorganization of the corporate tax. We need to encourage corporations to hire more, and you do that by taxing less. Let's make our corporations more competitive, not less. Our taxes are much higher than those of any of our major competitors. And please forget that insane carbon tax. If you want to cut emissions, do it straightforwardly by raising taxes significantly on gasoline. Don't back-door it on consumers. (And I am NOT advocating such a policy.)

+ An aggressive tax benefit for new venture-capital money that is invested in new technologies will result in new industries. The only way we can grow our way out of this mess is to create whole new industries, like we did in the late '70s and '80s. (Think computers and the internet and telecom.)

+ Unemployment is likely to continue to rise and last longer than ever before. We have to take care of the basic needs of those who want work but can't find it. Unemployment insurance should be extended to those who are still looking for work past the time for benefits to expire, and some program of local volunteer service should be instituted as the price for getting continued benefits after the primary benefits time period runs out. Not only will this help the community, but it will get the person out into the world where he is more likely to meet someone who can give him a job. But the costs of this program should be revenue-neutral. Something else has to be cut.

+ We have to re-hink our military costs (I can't believe I am writing this!). We now spend almost 50% of the world's total military budget. Maybe we need to understand that we can't fight two wars and support hundreds of bases around the world. If we kill the goose, our ability to fight even one medium-sized war will be diminished. The harsh reality is that everything has to be re-evaluated. As an example, do we really need to be in Korea? If so, why can't Korea pay for much of the cost? They are now a rich nation. There are budgetary fiscal limits to being the policeman for the world.

+ Glass-Steagall, or some form of it, should be brought back. Banks, which are subject to taxpayer bailouts, should not be in the investment banking and derivatives-creating business. Derivatives, especially credit default swaps, should be on an exchange, and too big to fail must go. Banks have enough risk just making loans. Leverage should be dialed down, and hedge funds selling what amounts to naked call options in any form, derivative or otherwise, should be regulated.

Let me see, is there any group I have not offended yet? But something like I am suggesting is going to have to be done at some point. There is no way we can continue forever on the current path. At some point, we will hit the wall. The fight between the bug and the windshield always ends in favor of the windshield. The bond market is going to have to see a credible effort to get back to a reasonable deficit, or we risk a very difficult economic environment. The longer we wait, the worse it will be.

It is not going to be easy to persuade a majority of Americans that we need to do something now. More realistically, we are going to probably have to begin to experience a crisis of some type to get politicians motivated to do something.

This last Tuesday, I spoke to the Financial Leadership Association at the University of Texas at Dallas. It was mostly undergraduates, and my assigned topic was how financial research impacts our investment decisions. In touched on the topic above, in less detail, but pointing out that at some point we are going to have to bring the deficit under reasonable control. I got some push-back, as some could not understand why we just couldn't keep running deficits, as we simply owe it to ourselves. I tried to explain, but for a few of them I was not getting through (though I think most got it). And these were the finance students! I shudder to think what the sociology department would be like.

We are not going back to normal, although it is likely we will see some form of Statistical Recovery. But we cannot get complacent. Somewhere out there is the real potential for another crisis, which will dwarf the last one. You will not want to be long much of anything when it happens, except hedged or liquid investments. Though admittedly, this could go on for a long time. I just don't know how long "long" is. Other than it will be too long and then not long enough.

Detroit, the Red Sox and the Yankees and Traveling Too Much

I leave for Detroit next Friday and speak at a private conference on Saturday, then rush to the airport to fly to New York. My friend Barry Habib has second-row behind-home-plate tickets to what we hope is a Yankees - Boston Red Sox playoff championship game. That would have to be one of the most exciting games to watch - the emotions will run as high as in any sporting event around. So I find myself in the strange position of cheering on both the Yankees and the Red Sox in the first round of playoffs, and hoping that there is not a four-game sweep in the second.

Dinner with the guys at Yahoo Tech Ticker on Monday, and then an early train to Philadelphia, where I will speak at a conference hosted by my friends and partners at CMG. Dinner that night, a very early flight to Dallas, change airports, fly to Houston to speak at Salient Partners, then a late-night flight back to Dallas, up early to fly to Orlando to be with Jon Sundt of Altegris at the Commonwealth conference, fly back early (sigh) Saturday morning to Dallas, drive home, pack, and take an overnight flight to Buenos Aires to start a speaking tour with new Latin American partner Enrique Fynn, then on to Montevideo, Uruguay, Sao Paulo. and Rio de Janeiro, and then back to Montevideo for a day of R&R. Then back home Monday. I am already tired.

Tomorrow I get to hear Karl Rove (wonder if he will remember me from our Texas days?), Howard Dean, Charles Krauthammer, and a lot of friends, then a series of parties tomorrow night. I always enjoy coming to The Big Easy for this conference. (Note to Chinese and Spanish translators: the Big Easy is a nickname for New Orleans. I can't expect them to know that one.)

It is time to hit the send button, as I have to speak at my next session. You have a great week, and remember that together we will get through all the coming problems. Just keep paying attention.

Your worried about all the unintended consequences analyst,

John Mauldin

Gold Soars To An All-Time High!

ChuckButler — Wed, 07 Oct 2009 14:46:17 GMT

...But First, A Word From Our Sponsor...
Gain exposure to currencies of emerging BRIC countries-and don't lose a dime on market risk

Don't let market risk get in the way of potentially rewarding exposure to the BRIC currencies. Our 3-year MarketSafe® BRIC CD shields you from any market risk and provides 100% principal protection on deposits held until maturity.

* 4 BRIC currencies: Brazilian real, Russian ruble, Indian rupee, Chinese renminbi
* High upside potential
* No market risk to deposited principal
* Low $1,500 minimum deposit

Some experts believe these 4 countries may become economic powerhouses in coming years. Now could be the right time to add these currencies to your portfolio. And you can do so-safely-with the U.S. denominated MarketSafe BRIC CD.

Don't miss this unique opportunity. Deadline to buy the BRIC MarketSafe CD is Oct. 13, 2009. Apply today or learn more at http://www.everbank.com/001CertificatesMSBRIC.aspx?referId=11808

In This Issue..

* It was all about Gold yesterday!
* Commodity Currencies take the lead today...
* The story behind the euro's non-move...
* Budget data prints today...

And Now... Today's Pfennig!

Gold Soars To An All-Time High!

Good day... And a Wonderful Wednesday to you! What a day for Gold yesterday! WOW! In case you were trapped in a cave and didn't hear the news... Gold, which I said yesterday morning looked like it was going to take out its all-time high, did take out its all-time high, and not just take it out! Gold pushed past the all-time high of $1,033.90, and didn't stop until it was trading $1,047 and change! WOW! No check that... Double WOW!

The Reserve Bank of Australia's (RBA) rate hike the previous night, opened the door to this run by Gold, as the Gold Bugs all came out and bought the preferred investment to counter soaring inflation... You see, if the RBA is raising rates, when most every other Central Bank is stuck in the mud with near zero rates, the RBA must see something, eh?

Well, I don't know about what they see, but I would guess it's inflation coming around the bend... I hear that inflation coming, it's rollin' around the bend, and I ain't seen the sunshine since I don't know when... Now... The RBA did say that they realized that they had reacted quickly last fall cutting rates too quickly and too low, and this rate hike would begin to reverse those panic cuts... The RBA did not say that they see inflation... But riddle me this Batman... Why would the RBA not just wait and hike rates 50 BPS in a couple of months if all they were doing was reversing their panic cuts?

So... Yesterday, was all about Gold! And why not? Gold has a few things going for it right now... 1. dollar weakness 2. inflation fears 3. rising oil prices and probably the biggest thing would be the momentum buying that takes place when mom and pops all see on the evening news that Gold has reached an all-time high, and they go out the next day and buy... Shoot Rudy, we couldn't get these people to buy when Gold was clawing its way to $900, couldn't get them to even notice Gold when it was $950, but now that its at the all-time high...

Today... I think we'll see things settle down a bit on the Gold front. I don't mean to take the move in Silver lightly... Silver pushed way past $17 once again, following Gold higher... Instead of Gold today, I think it will be more about the dollar...

Yesterday, I told you about the story in the U.K. Independent regarding the alleged secret meetings of countries to remove the dollar as the clearing mechanism for buying Oil. I did mention that the Saudis had denied these meetings had taken place. Now... Here's the big deal behind any removal of the dollar as the clearing mechanism for Oil... It's the perception, folks... The "KING DOLLAR" would no longer be needed to buy Oil...

As far as the affect on the dollar, the actual physical removal wouldn't kill the dollar per se, as most of these Oil producing countries, now take their dollars they receive for Oil and trade them right away for something else... So the net affect now on the dollar is zilch... The dollar is bought, the dollar is sold... But, the perception folks... This is the Big Kahuna here... And, think back to all the discussions we had a couple of months ago regarding the calls to remove the dollar as the reserve currency of the world... Wouldn't removing it from Oil trades, be just another step in that direction?

OK... Well today, the Commodity Currencies are the ones front and center in the assault on the dollar... Aussie, kiwi, loonies, real, rand, and krone are all lighting up "green" on my currency screen, which means they are UP VS the dollar! Doesn't it make sense that these Commodity Currencies would be the currencies to push the dollar around the schoolyard, especially after the RBA Opened Pandora's Box of interest rate hikes? I think so... Because, as I said yesterday, I think we'll begin to see more countries / Central Banks come to the rate hike table... And they are all on this list of Commodity Currencies! Which again points toward "seeing inflation pressures" in the future...

The euro? Well, even the best fall down sometime, even the stars refuse to shine sometime, eh? The official "offset currency to the dollar" participated in the currency rally yesterday moving as high as 1.4765, but overnight, it has retreated to 1.4715... Yes, even the Big Dog, has to take a back seat to the Commodity Currencies right now... But... That doesn't mean the euro is shaky... That the euro is weakening... That the euro has lost its place as the Big Dog... Not one iota! It simply means that sometimes other currencies take a flyer VS the dollar, while the euro bides its time... Taking my time, choosing my lines...

And I would bet you a dollar to a Krispy Kreme that the European Central Bank (ECB) is champing at the bit to join the RBA in a rate hike cycle! The ECB is a stickler for inflation fighting, a "hawk" if you will, and if the RBA is feeling some inflation heat, the ECB is sweating under the collar for sure! But, the Eurozone is hanging on to its nascent recovery by the skin of its teeth right now, and would not be able to continue if rates were hiked right now... So, here's the deal... The ECB "wants to"... But can't hike rates right now... But you can bet your sweet bippie that the ECB will hike as soon as they see the light at the end of the recession tunnel! I mean, they resisted cutting rates to the bone didn't they? That alone should give you an inkling of what' on their minds!

I think at this point it is important to note that even with the currencies moving strongly VS the dollar since March, they are still roughly 10% below their high levels that they had reached before the financial meltdown in August of 2008... So, some people wonder if they "missed the boat" because of the strong moves since March... I think this proves that they could potentially see the currencies move back to their previous highs...

Ty Keough, pointed something out to me yesterday when I was talking about this to the desk... Ty said, that this move probably has been more genuine, in that prior to the financial meltdown there was all that liquidity, and money flying around pushing risk assets higher and higher... Well, there certainly isn't any liquidity flying around this time! So, the moves by the currencies have been actually stronger, and with a stronger base...

Today... We'll see the Monthly Budget Statement for September. I laugh at the name of the data, given this has been nothing but a Deficit for a month of Sundays now... So, why not just change it to the Monthly Budget Deficit? I mean it couldn't even post a surplus in April or June when normally tax receipts outweigh the deficit spending! I know, I know, you're squirming in your seat thinking that I'm going to go on a tirade about deficit spending once again, when you've heard it from me over and over and over again for years now... Well, I have a treat for you... I'm not going to go there today! I mean, it certainly isn't important to our leaders... So why should I continue to make a big deal out of it?

HA! Gotcha! You know me, I can't just leave the deficit spending, and national debt alone! I can't let the leaders of our country win! I'm going to fight them to the bitter end, and you should too! Come on! Follow me! We can win this battle, if we have enough people to fight it!

And then there was this... I'm seeing more signs that the break of currencies and stocks is happening... And what a welcome thing that would be! These two have different pricing mechanisms and a low correlation to each other, which leads to both being in an investment portfolio for diversification... But, as chronicled many times in the past, since March of this year, the two have moved together... But last week, we saw a sign that fundamentals might be coming back into play... And then overnight, in Asia, we saw Asian stocks move significantly higher, and the dollar remain at current levels, not getting sold, as in the past 6 months... Hmmm... Maybe, this is just another teaser... But, I have to think that a return to fundamentals is coming... And none too soon either! For you all know what I think of future stock returns!

OK... To recap... Gold hits an all-time high and continues to move higher! Did the RBA smell the smoke of inflation burning? The Commodity Currencies are the story today as they are the leaders of the pack VS the dollar. Perception is the key to the dollar being removed as the clearing mechanism for oil... And, the Budget Deficit prints today...

Currencies today 10/7/09: A$ .8910, kiwi .7345, C$ .9455, euro 1.47, sterling 1.59, Swiss .9705, rand 7.4690, krone 5.6840, SEK 7.01, forint 182.40, zloty 2.8625, koruna 17.47, RUB 29.77, yen 88.90, sing 1.40, HKD 7.75, INR 46.67, China 6.8265, pesos 13.51, BRL 1.7590, dollar index 76.38, Oil $71.15, 10-year 3.24%, Silver $17.39, and Gold... $1,042.28

That's all for today... Well... That was SOME GAME last night in the tie breaker between Detroit Tigers and Minnesota Twins, with the Twins finally winning in the 12th inning! A BIG night for my beloved Cardinals, as they begin their playoff series with the Los Angeles Dodgers... The BIG question is will the Cardinals hit? If they do, watch out, World Series here we come! I did an interview with a writer for Business Week yesterday, I wonder what actually gets printed... If anything! Well... I've got my "blue" shirt on today, so it must be video taking day! I think we're doing two today, so I've got that going for me! OK, time to hit "send"... I hope you have a Wonderful Wednesday!

Chuck Butler
President
EverBank World Markets
1-800-926-4922
1-314-647-3837

Association of Investor Awareness - Week of 09/24/2009

AIAAdvocate — Thu, 24 Sep 2009 16:48:00 GMT

In This Issue:

Will The Right Fundamentals Please Stand Up?
The "Uncle Sam Effect"
Small Investors Are Coming Back To Stocks
Inflation Fears Are Increasing
First Some Bad News, Then Some Good News
Easy Index Gains May Be Over
These Four Favorites Should Stay On Top
And So Should China
The Bottom Line This Week

Despite all the worries about overvalued stocks, the market is continuing to advance. To be sure, the gains aren't coming by leaps and bounds anymore – but they are still adding up nicely. Since our last newsletter, the Dow and the Nasdaq rose another 1.8% and 5.1% respectively.

Will The Right Fundamentals Please Stand Up?

When it comes to stock fundamentals, value is in the eye of the beholder. Traditionalists believe the market is too expensive for the weak economic recovery they expect to see. The analysts argue that the economy may take over a year to justify the whopping 46% gain in the Dow since March. Some analysts think the recovery will never gain the necessary strength.

However, many other number crunchers believe the data suggests that stocks have further to run. Their main argument is that earnings were whacked so hard by the economic downturn that even a small uptick in growth will have a big impact on profits. The more bullish analysts believe that even a 2% expansion will double the profits of many top companies. It follows that if earnings shoot up, so should stock prices.

Other bullish investors believe it's a mistake to look solely at a company's U.S. potential. The globalists point to the much stronger recovery that is happening in the world economy. The bulls insist that investors in well-run companies with a substantial amount of business overseas can expect to prosper over the next few years.

The "Uncle Sam Effect"

We think even the most optimistic fundamental investors are missing the biggest plus for the stock market: a great deal of Uncle Sam's stimulus and bailout money is moving into equities. That's not surprising since increasing stock values was almost certainly one of the Fed's goals. That's as it should be since raising equity prices is one of the best and broadest ways to increase America's economic health.

So far, the government has pumped about $2 trillion (that's trillion with a "T") into the economy. Another $2 trillion or so has been earmarked for additional programs. Since stocks are the best-performing investments available now, it isn't surprising that they are attracting much of the money.

Small Investors Are Coming Back To Stocks

Another plus for stocks is individual investors are starting to come back to Wall Street. If that trickle becomes stronger, there should be an attractive new leg up for the bull.

Small investors hold a great deal of potential because they have some $5 trillion available to buy stocks. Money market accounts alone contain over $3 trillion, most of which is earning returns below one percent. It is no wonder that investors are chomping at the bit to find better opportunities for their cash. High quality stocks that pay good dividends are moving to the top of that list.

America's baby boomers are especially eager to boost their investment returns. Most retirement portfolios took huge hits when the market collapsed two years ago. Although the boomers are being very careful not to lose even more money, they know they must recoup their earnings if they want more than a subsistence old age.

Since April, only about $56 billion has come out of safe harbor accounts to be invested in stocks. It doesn't take a math wizard to see that a great deal of money is still available to purchase equities.

Inflation Fears Are Increasing

The huge amount of stimulus and bailout money the government is pouring into the economy is causing many people to worry about rising inflation. That's especially true since most of the money was created out of thin air for the occasion. Since the new money isn't represented by additional goods and services, many economists say it will soon begin to push prices up.

The threat of sharply rising inflation is adding to the need to find greater returns. That's because the value of cash can be expected to fall at whatever rate inflation rises.

On the other hand, the tangible asset values are likely to keep pace with inflation. That's not true for all of them, of course. Real estate, for example, doesn't look very attractive right now.

However, precious metals and some commodities should do well if inflation returns. But those hedges don't appeal to many mainstream investors. Most people are more attracted to high quality stocks that have a long history of keeping up with inflation. The icing on the cake is the best companies also pay dividends.

First Some Bad News, Then Some Good News

When we put all the stock market pros and cons together, we think the odds favor more gains. However, we should not expect additional returns to come as easily as those we received in recent months. Progress from here is likely to be bumpy.

One of the first, and perhaps the biggest, bumps may be close at hand. After the market's 46% run-up over the past six months, a correction seems overdue. If you don't wish to run the rapids, this would be a good time to take some profits. If you want to remain in the market, but with lower risk, we heartily recommend the use of stop loss orders. The more nervous you are, the tighter you should place your stops. Just be sure to pick prices that are outside each stock's normal trading range.

Easy Index Gains May Be Over

When the market started to surge in March, investors in broad index funds did very well. For the first six months, making money was a no-brainer.

From now on, however, we think investors will need to be more selective to find attractive profits. As many brokers advise, "It's time to trade your shotgun for a rifle."

Another reason to choose stocks carefully is investors have become more conservative and risk averse than they were during the boom. Whiz-bang widget makers with big dreams and short histories are getting scant attention. Instead, the market now favors known companies with proven products and solid track records. The best blue chips fit those criteria perfectly.

These Four Favorites Should Stay On Top

Four companies that we like very much this fall are:

Alcoa (AA) http://finance.yahoo.com/q/bc?s=AA,

Deere & Company (DE) http://finance.yahoo.com/q/bc?s=DE,

General Electric (GE) http://finance.yahoo.com/q/bc?s=GE, and

Caterpillar (CAT http://finance.yahoo.com/q/bc?s=CAT.

We first recommended them in our June 25 newsletter, and they have since done very well. Here are the numbers:

Name	Symbol	Price on 6-24-09	Price on 9-22-09	Percent Change	Yield
Alcoa	AA	$10.69	$14.26	33.4%	0.90%
Deere	DE	$41.83	$46.18	10.4%	2.50%
GE	GE	$11.79	$17.01	44.3%	2.40%
Caterpillar	CAT	$34.06	$54.34	59.5%	3.10%

Because all four companies are tied to the global economy, they are very efficient, and can prosper even in a slow growth environment; we continue to recommend them.

And So Should China

Another place we think you should take aim is China. While the U.S. and Europe remain mired in recession, China is booming.

In August, for example, the country's industrial production rose 12.3%. Retail sales surged over 15%. Real estate development jumped 14%. The list goes on and on. All together, China's economic growth is in the 8% range.

China is one place where stock gains are so broad that investing in an index fund makes sense. Our favorite is the PowerShares Golden Dragon ETF (PGJ) that tracks the performance of the Halter USX China Index: http://finance.yahoo.com/q/bc?s=PGJ.

The selective index contains Chinese stocks that trade on U.S. exchanges, and which have capitalizations of at least $50 million. We think the ETF is an excellent way to participate in the further growth of China.

For those investors who prefer individual stocks we have several favorites that we continue to follow and believe have significant upside potential.

Universal Travel Group (UTA) http://finance.yahoo.com/q?s=UTA

Universal Travel Group, a fast growing (20 to 25% top and bottom lines)travel services provider is engaged in providing reservation, booking, and domestic and international travel and tourism services throughout the PRC via the internet and through customer representatives. Under the theme "Wings Towards a More Colorful Life" the Company's core services include tour packaging for customers and booking services for air tickets and hotels.

Currently trading in the $13 range, multiple analysts have pegged UTA with a $20 price target.

NF Energy Saving Corp (NFEC) http://finance.yahoo.com/q?s=nfec.ob

NF Energy Saving is an integrated provider of energy conservation solutions utilizing energy-saving equipment, technical services and energy management re-engineering project operations to provide energy saving services to clients. Headquartered in Shenyang city of China, the Company currently has 220 employees and multiple proprietary energy saving technologies and patents.

In a press release issued early Wednesday morning (9/23/09) the Company stated that "based on customer orders received and anticipated project completion schedule for the remainder of 2009, the Company expects revenue for the fiscal year ending December 31, 2009 to reach $24 million, a 52% increase over revenue of $15.8 million for the fiscal year ended December 31, 2008."

Currently trading below $5, NFEC is seen by several noted small-cap analysts as a good bet to hit $8.50 to $10 a share.

Shengkai Innovations, Inc. (SKII) http://finance.yahoo.com/q?s=skii.ob

Shengkai Innovations is engaged in the design, manufacture and sale of ceramic valves, high-tech ceramic materials and the provision of technical consultation and related services. The Company's industrial valve products are used by companies in the electric power, petrochemical, metallurgy, and environmental protection industries as high-performance, more durable alternatives to traditional metal valves.

SKII has delivered 128% in gains for January investors and with an attractive P/E of 10.00 it seems to just be getting started. Check out these strong financial results.

Revenue for the year ended June 30, 2009 increased 21.5% to $39,297,235, compared to $32,355,693 for YE 2008. Net income increased $3,490,655 or 34.6% to $13,577,694 for the year ended June 30, 2009 from $10,087,039 for the comparable period in 2008.

The Bottom Line

Although the stock market is no longer shooting up at its former rate, it is still continuing to deliver attractive gains. A correction seems likely after such a big run, but we think stocks will recover and go on to greater heights.

Four stocks that are doing even better than the market are Alcoa, Deere & Company, General Electric, and Caterpillar. All of them should continue to do well as the world emerges from the recession.

One country that looks especially good is China where growth is still an impressive 8%. We think investors who seek a broad stake in China should consider the PowerShares Golden Dragon ETF that tracks the performance of the country's most successful companies. Or, for individual stock picks three small-cap profit opportunities include Universal Travel, NF Energy and Shengkai Innovations.

Until Next Time

The AIA "Advocate For Absolute Returns", a publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn't? Many sources report these issues as abstract facts. We feel that's not enough. The AIA Advocate's job is to warn you of what's important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next time...

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. The Association for Investor Awareness, Inc. (AIA) and respective staffs and associates may or may not have investments in any companies, stocks or funds cited herein, may or may not have long or short positions and/or options and warrants relating thereto and may purchase and/or sell these securities or options at any time in the open market or otherwise without further notice. AIA, its Officers, Directors, Employees and Affiliates may receive compensation for the dissemination of this information.

Communications from AIA are intended solely for informational purposes. Statements made by various contributors do not necessarily reflect the opinions of AIA and should not be construed as an endorsement either expressed or implied. AIA is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided "AS IS" without any warranty of any kind. Past results are not necessarily indicative of future performance.

In the interest of full disclosure, John M. Casson, Executive Director of AIA is president of Casson Media Group, Inc. (CMG), an affiliated company. CMG has received cash compensation and allocated $2500 for the transmission of this publication as part of a comprehensive corporate communications services agreement for Universal Travel Group. Although the Research and Editorial Staff of AIA conducts independent research and analysis, you should be aware of this potential conflict of interest.

Retail Sales Soar!

ChuckButler — Wed, 16 Sep 2009 14:20:00 GMT

.........But First, A Word From Our Sponsor..........
Countries poised to benefit from rising commodity prices: combined into one CD

*Australian dollar
*Brazilian real
*Norwegian krone
*Canadian dollar

CD features: 3 and 6 month terms, no monthly account fees and $20K minimum to open. Apply or learn more at http://www.everbank.com/001CurrencyCDIndexGlobalPowerShift.aspx?referid=11808

EverBank is an Equal Housing Lender and member FDIC.
......................................................

In This Issue..

* Currencies rally on Retail Sales!
* China likes investments in Canada...
* Big Ben the "inflation fighter"...
* Gold climbs to $1,018!

And Now... Today's Pfennig!

Retail Sales Soar!

Good day... And a Wonderful Wednesday to you! Good news for me this morning, the pain in my left knee has subsided... Now, If I could just get that swelling to go down, I'd be in tall cotton! This has been quite the ordeal on the old Pfennig writer, and one that I will be glad to put in the rear view mirror!

Well... When I turned on the currency screens this morning, the euro was trading with a 1.47 handle! WOW! It just skipped to my Lou right through the 1.46 handle, eh? It began yesterday afternoon, the dollar was getting sold on the news of a strong Retail Sales figure, more on that in a minute, and the euro was edging up the 1.46 ladder... The move to get it past 1.47 came in the overnight markets... Now, having gotten you all lathered up about 1.47, I have to say that since I turned on the currency screens, the euro has lost ground back to 1.4688, but still... That's quite an impressive move from yesterday morning, eh?

OK... The issue with the Retail Sales figure causing dollar weakness is a time honored tradition... NOT! Well, it is if you only count the last 9 months... But traditionally, a figure like the one that printed yesterday, would have attracted buyers for the dollar, not the opposite that occurred... Here's the skinny, as I see it...

Retail Sales for August were quite strong, and showed signs that the move was more than the Cash for Clunkers program, and Back to School buying... There are quite a few people/ economists/ analysts out there now jumping on the President's bandwagon that the recession is over based on this report... For those of you at home keeping score, Retail Sales for August printed at +2.7%!

Does one Retail Sales report that's being trumped up with a Government Deficit Spending program, and Back to School buying really tell us that the recession is over? Was it over when the Germans bombed Pearl Harbor? HA! (from Animal House, I know very well the Japanese bombed Pearl Harbor)... You know, it kind of ruins the funny line when you have to make disclaimers... But... I've had people send me emails before telling me, that I should know better that the Germans didn't bomb Pearl Harbor!

OK, I went off on a tangent there, eh? Any way... I wonder if all those people wearing the President endorsed end of the recession rose colored glasses ever stopped to wonder if gas purchases might have helped trump up this figure? Well, I did, you knew I would! And I found that rising gasoline prices sent service station receipts up 5.1% in the month. If we had journalists like we used to have, they would have known to go look at the rising gas price component of the report, since just last week the Trade Deficit jumped by 16% in one month due to rising oil prices!

So... With Retail Sales shooting toward the moon, the dollar selling increased... Because, if the thought here (and not my thought!) is that if Retail Sales are jumping again, it must mean the U.S. Consumer is buying again, and that will help kick the global recession in the rear, and the risk takers come out of the walls, the U.S. Treasury "safe haven" buyers sell to get out of their losses, and they all go to better investments... It may be what they think, to be better... Stocks... But for the most part, these investors seek out higher yielding or better income potential investments... And you won't find those on the Big Board... You won't find them at the local bond house... You'll only find them abroad, in foreign deposit rates, and foreign bond yields...

Now... That everyone is all lathered up about this euphoria going on in the markets... I'm still keeping a light on for a HUGE stock market sell off, which would adversely affect the values of all these risk assets that risk takers have been going into... Commodities, currencies, stocks would all be affected...

However, if that HUGE sell off never comes... Who wants to stand in front of the bus that has Gold above $1,000 and the euro posting a nearly 17% gains since March 1st... But that's nothing folks! The New Zealand dollar (kiwi) has gained 44% since March 1st... The list of currency gains since March 1st is amazing... Simply amazing... Here's a sample... Aussie dollars +38%, Norway +23%, loonies +21%, and so on... So, now you see the bus that I'm talking about!

Big Ben Bernanke had this to say yesterday... "Even though from a technical perspective the recession is very likely over at this point, it's still going to feel like a very weak economy for some time." He also said that he "may have to accept a slow recovery and high unemployment as the price for defending my inflation fighting credentials."

Ok.. Excuse me for a minute, I have to go in the other room and either laugh my rear off or, throw up! Big Ben has "inflation fighting credentials"? Since when? And just where is he hiding these credentials? Or... Maybe his description of "inflation fighting credentials" is different from mine! Hmmm... I shake my head in disgust...

Speaking of the Fed and inflation... My good friend, David Galland, who writes an absolutely fabulous daily letter regarding the goings on in the world called "Casey's Daily Dispatch", and can be found here: http://www.caseyresearch.com/casey-services/free-publications/caseys-daily-dispatch/ , had this to say yesterday regarding this subject of the Fed and inflation...

"Reason Magazine is one of the few magazines I read with any regularity. In the current edition, they had a couple of items that I thought were especially interesting. Ironic, actually.

The first was about a comic book the Fed has published discussing inflation, as well as defending its autonomy. You can view it by following the link below. What you should find interesting is that they make several clear mistakes in describing inflation - for instance, by saying that if the price of oil goes up, that causes inflation. And on the very first page, they state that "The dictionary defines inflation as a substantial and continuing rise in the general price level."

But that is not what the dictionary says - every entry I checked always includes ". related to an increase in the volume of money," or words to that effect. Kind of scary, when the organization charged with fighting inflation doesn't actually know what it is.

You can read the comic yourself here, straight off the New York Fed's website. http://ia301540.us.archive.org/2/items/gov.frb.ny.comic.inflation/gov.frb.ny.comic.inflation.pdf

OK... I'm back now... I saw a report last night that showed the results of a survey that showed the Chinese are very interested in investing in Canada... It was reported that China sees energy, natural resources, agriculture and biotechnology as the most promising areas of Canada's economy... Hmmm... Isn't that the same things I've listed over the years? (well minus the biotechnology) Any way... The report also showed China having interest in the U.S. and Australia...

Money flow is a very important thing to watch in the investment world... And if money is going to be flowing into Canada and Australia from China, that will be good for those countries and their respective currencies. As far as the U.S. is concerned... Forgetaboutit! Remember when China wanted to buy that oil company in California a couple of years ago? I doubt that China will want to get dragged through a mile of broken glass and razor blades again!

Yesterday, I told you about the dollar denominated bonds being issued by Germany, and how I viewed it as a green light from Big Ben Bernanke for other countries to take over the destruction of the dollar, that the Fed has carried the flag for since 1913... I told you I had another frightening thing that I would bring to you this morning... So with no further delay...

The Chinese government has told Chinese companies they do not have to honor derivatives and commodity futures contracts made with Western financial institutions. Ruh-Roh...

This appears to be one of those things that passes in the night, and then one day smacks us right between the eyes, and we say, "Where did that come from?" Well... If came from the Chinese Gov't that told Chinese companies that they did not have to honor derivatives and commodity futures contracts made with Western financial institutions... That's where!

Ok, I can hear you saying, How can they do that, Chuck? Well... When you're a 200 pound gorilla, you can sit where you want, and you can do what you want! China is taking the stance that you come get us, if you think you were wronged!

What does this do to the institutions that wrote these contracts with China, Chuck? Well... That's the cheese that binds folks... It's going to hurt... And it's going to hurt bad... But, nobody really knows just how many or how much risk is out there... But, if one day you wake up and hear on the news that the financial markets here are melting down once again, you'll be able to say... Ahhh, it must be that Chinese announcement that Chuck talked about!

Big Al Greenspan was back in the news last night... First, I want to quiz you on something...
Who said, "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."

Well... You'll never guess who, so I might as well tell you, but when you hear it you'll bust a gut, given the whole low interest rate, high money supply environment he created at the Fed... It was..... Drum roll please... Alan Greenspan, from an article written in 1966 entitled "Gold and Economic Freedom"

Any way... Big Al was back in the news, and said that he's worried that lawmakers will hamper the Fed's efforts to rein in its monetary stimulus, and that inflation might "swamp" the bond market. See, how Big Al is sticking up for the Fed, and putting down the groundwork now, to blame lawmakers when inflation is soaring on the other side of the recession?

Big Al is dastardly... I wouldn't be surprised to see a Commie flag nailed to the wall of his garage! HA! Long time readers know my dislike for this guy as a Fed Head, and how he might now have paved the road to this mess we've been in, but he laid the foundation!

OK... The data cupboard will yield a boat load of data today, and it will interesting to see how the dollar reacts to it... Leading off for the data cupboard today is the stupid CPI data for August... Batting second is the Current Account Deficit, and in the all important third position in the batting order we have The Tic Flows, batting clean-up is Chuck's faves Industrial Production and Capacity Utilization... WOW! What a line-up! A Murderer's Row for data if you will!

Since no one but me and my friends over at the Daily Reckoning and 5-minute Forecast, seem to care about the Deficits, the markets will probably wax over the Current Account Deficit... And I don't care about CPI... So that brings us the TIC Flows for July, and I'm fearful that this data will be harmful to our future... And the experts are forecasting a bump up in Industrial Production and Capacity Utilization, which would indicate a stronger economy, and given what we saw yesterday with the stronger Retail Sales, one would think that a bump up in Industrial Production and Capacity Utilization would be bad for the dollar...

Finally... Someone with some brains! I was beginning to think that these guys were all kin to the scarecrow! Yesterday, I told you about how the new governing party in Japan is calling for increased currency intervention... Well, finally someone that understands! Japanese Finance Minister, Fujii, said that he is "against intervention if their moves are gradual, and that I don't think they are fluctuating rapidly now."

It looks like currency traders in the overnight markets were paying attention, and immediately began buying up Japanese yen... The yen is pushing the envelope once again to a sub 90 level... And that! Would be a very good thing for yen holders!

While I'm on "feel good stories"... I might as well mention that Gold has finally made a strong move above $1,000, moving to $1,018 as I write! Silver is kicking tail and taking names later too, with a strong move to $17.35! The Retail Sales data in the U.S. yesterday kicked off a new phase of "inflation protection buying"

OK... To recap today... Retail Sales in the U.S. were very strong, setting off a new wave of dollar selling, to currencies and precious metals. China likes Canada and Australia, and China tells their companies not to honor derivative contracts with Western institutions. And we have a boat load of data to get through today in the U.S.

Currencies today 9/16: A$ .8720, kiwi .7135, C$ .9365, euro 1.4680, sterling 1.6525, Swiss .9665, rand 7.3625, krone 5.8615, SEK 6.9070, forint 184, zloty 2.8240, koruna 17.27, RUB 30.61, yen 90.30, sing 1.4120, HKD 7.75, INR 48.24, China 6.8260, pesos 13.24, BRL 1.8030, dollar index 76.30, Oil $70.75, 10-year 3.40%, Silver $17.35, and Gold... $1,017.50

That's it for today... I just looked up and noticed I was running late with the Pfennig this morning. UGH! So, I guess it's good that I don't have a lot to talk about here... I was going to the day game today... But had to back out because of the problem with my knee... But now the pain is subsiding... I wonder if there's still a ticket... Nah... I gave it away! Go Cards! As a part of the hockey Blues web site, they have a picture of Chris Gaffney's son, Brendan! He's a star! Chris has taken Brendan to hockey games since he could barely see over the side boards. When the games were on TV, you could watch Brendan running back and forth in his space, as Chris has ticket along the glass! Ok... Enough... Time to roll, April Showers is here, and that means I'm late! I sure hope your Wednesday is Wonderful!

Chuck Butler
President
EverBank World Markets
1-800-926-4922
1-314-647-3837

Elements of Deflation, Part 2

JohnMauldin — Fri, 11 Sep 2009 16:59:00 GMT

Elements of Deflation, Part 2
The Velocity Factor
Y=MV
Sir, I Have Not Yet Begun to Print
There Are No Good Choices
Washington DC, San Diego, and New Orleans, etc.

Just as water is formed by the basic elements hydrogen and oxygen, deflation has its own fundamental components. Last week we started exploring those elements, and this week we continue. I feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we are faced with inflation or deflation in our future. (And I tell you later on when to worry about inflation.) Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.

The problem is that there is not an easy answer. In fact, the answer is that it could be both. Today I got another letter from Peter Schiff, who seems to be ubiquitous. He says the rise in gold is because of rising inflation expectations among investors. Gold is predicting inflation. Maybe, but the correlation between gold and inflation for the last 25-plus years has been zero. I rather think that gold is rising in terms of value against most major fiat (paper) currencies because it is seen as a neutral currency. The Fed and the Obama administration seem to be pursuing policies that are dollar-negative, and they give no hint of letting up. The rise in gold above $1,000 does not really tell us anything about the future of inflation.

In fact, it is my belief that if the Fed were to withdraw from the scene of economic battle, the forces of deflation would be felt in short order. The answer to the question "Will we have inflation in our future?" is "You better hope so!"

I wrote in 2003, when Greenspan was holding down rates too long in order to spur the economy, that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that is the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there is a cost.

It is not a matter of pain or no pain; it is a matter of choosing which pain we will face and for how long, and perhaps in what order. As I wrote a few weeks ago, like teenagers, we as an economic polity have made some very bad choices. We are now in a scenario where there are no good choices, just less-bad ones.

In a normal world, the amount of monetary and fiscal stimulus we are witnessing would produce inflation in very short order. That is what has the gold bugs of the world excited. It is their moment. They keep repeating that Milton Friedman taught us that inflation was always and everywhere a matter of too much money being printed. The answer to that is that the statement is mostly true, but not always and not everywhere (think Japan). The reality is somewhat more nuanced. Let's review something I wrote last year about the velocity of money, and this time we are going to go into the concept a little more deeply. This is critical to your understanding of what is facing us.

The Velocity Factor

When most of us think of the velocity of money, we think of how fast it goes through our hands. I know at the Mauldin household, with seven kids, it seems like something is always coming up. And what about my business? Travel costs are way, way up; and as aggressive as we are on the budget, expenses always seem to rise. Compliance, legal, and accounting costs are through the roof. I wonder how those costs are accounted for in the Consumer Price Index? About the only way to deal with it, as my old partner from the 1970s Don Moore used to say, is to make up the rise in costs with "excess profits," whatever those are.

Is the Money Supply Growing or Not?

But we are not talking about our personal budgetary woes, gentle reader. Today we tackle an economic concept called the velocity of money, and how it affects the growth of the economy. Let's start with a few charts showing the recent high growth in the money supply that many are alarmed about. The money supply is growing very slowly, alarmingly fast, or just about right, depending upon which monetary measure you use.

First, let's look at the adjusted monetary base, or plain old cash plus bank reserves (remember that fact) held at the Federal Reserve. That is the only part of the money supply the Fed has any real direct control of. Until very recently, there was very little year-over-year growth. The monetary base grew along a rather predictable long-term trend line, with some variance from time to time, but always coming back to the mean.

But in the last few months the monetary base has grown by a staggering amount. And when you see the "J-curve" in the monetary base (which is likely to rise even more!) it does demand an explanation. There are those who suggest this is an indication of a Federal Reserve gone wild and that 2,000-dollar gold and a plummeting dollar are just around the corner. They are looking at that graph and leaping to conclusions. But it is what you don't see that is important.

Now, let's introduce the concept of the velocity of money. Basically, this is the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 worth of flowers from you. You in turn spend the $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, in a year we would have $2400 of "GDP" from our $100 monetary base.

So, what that means is that gross domestic product is a function not just of the money supply but how fast the money supply moves through the economy. Stated as an equation, it is Y=MV, where Y is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing Y by M.

Now let's dig a little deeper. Y, or nominal GDP, can actually written as Y=PQ, that is, GDP is the Price paid times the total Quantity of goods sold. Therefore, since Y=MV, the equation can be written as MV=PQ. But the point is that Price (P) is tied to the velocity (V) of money. You can increase the supply of money, and if velocity drops you can still see a drop in the "P," or inflation.

Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few paragraphs, please. Let's assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc.; and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.

Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. But, in order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does NOT increase, that means (in our simple island world) that on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase and money supply stays the same, GDP must stay the same, and the average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production on our island is the same, but is divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. They fall into actual deflation (very simplistically speaking). So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

It is basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down, as will the price.

If the central bank increased the money supply too much, you would have too much money chasing too few goods, and inflation would rear its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let's say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn't it?

No, because only 20% more goods is produced from the two new businesses. There is a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they would spend on goods and services, which only grew by 20%. They would start to bid up the price of the goods they want, and inflation would set in. Think of the 1970s.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let's assume 10 million businesses, from the size of Exxon down to the local dry cleaners, and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month, and another hundred thousand fail. Productivity over time increases, so that we are producing more "stuff" with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, plus some more for new population, and you have to factor in productivity. If you don't then deflation will appear. But if the money supply grows too much, then you've got inflation.

And what about the velocity of money? Friedman assumed the velocity of money was constant. And it was from about 1950 until 1978 when he was doing his seminal work. But then things changed. Let's look at two charts, the first from Stifel Nicolaus Capital Markets.

Here we see the velocity of money for the last 109 years. The left side of the chart shows the velocity of money using both M2 and M3 (measures of the money supply.)

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average for the last 100 years. Lacy Hunt, in a conversation that helped me immensely in writing this letter, explained that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War II, but even then mean reversion would mean a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint. But let's look at the first chart.

Y=MV

And then let's go back to our equation, Y=MV. If velocity slows by 30% (which it well has in terms of M3 – and it is down more than 15% in terms of M2) then money supply (M) would have to rise by that percentage just to maintain a static economy. But that assumes you do not have 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, which mean M (money supply) would need to grow about 5% a year, even if V were constant. And that is not particularly stimulative, given that we are in recession. And notice in the chart below that M2 has not been growing that much lately, after shooting up in late 2008 as the Fed flooded the market with liquidity.

Bottom line? Expect money-supply growth well north of what the economy could normally tolerate for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow armchair economists (and that is most of us) to sit back and Monday morning quarterback for many years.

But this is important. The Fed is going to continue to print money as long as they are not confident deflation is no longer a problem. They can't tell us what that number is because they don't know. My guess is if they did tell us the markets would simply throw up, especially the bond market, which would of course make the situation from a deflation-fighting point of view even worse.

Sir, I Have Not Yet Begun to Print

Remember the story of John Paul Jones? An American naval officer during the American Revolution (the French gave him a medal, although the British referred to him as a pirate), he engaged a larger British ship off the coast Yorkshire. He literally tied his boat to the larger ship and they shot cannons and guns at point blank range. Legend has it that he was asked to surrender, as his ship was sinking. He is supposed to have replied, "Sir, I have not yet begun to fight!"

When faced with the possibility of deflation, I can almost hear Bernanke saying, "Sir, I have not yet begun to print!"

When will they know when enough is enough? When the velocity of money stops falling. When we see two quarters in a row where the velocity of money is rising, then it is time to start investing in inflation hedges.

Now, why is the velocity of money slowing down? Notice the significant real rise in velocity from 1990 through about 1997. Growth in M2 was falling during most of that period, yet the economy was growing. That means that velocity had to have been rising faster than normal. Why? It is financial innovation that spurs above-trend growth in velocity. Primarily because of the financial innovations introduced in the early '90s, like securitizations, CDOs, etc., we saw a significant rise in velocity.

And now we are watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset-backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in, and Wall Street began to game the system. End of game.

What drove velocity to new highs is no longer part of the equation. The absence of new innovation and the removal of old innovations (even if they were bad innovations, they did help speed things up) are slowing things down. If the money supply had not risen significantly to offset that slowdown in velocity, the economy would already be in a much deeper recession.

The Fed has more room to print money than most of us realize. How much more? My bet is that we'll find out. Will they print too much at some point? Probably.

There Are No Good Choices

What we are looking at in our near future is not inflation. We are in a period where the Fed is in the process of reflating, or at least attempting to do so. They will eventually be successful (though at what cost to the value of the dollar one can only guess). One can have a theoretical argument about whether that is the right thing to do, or whether the Fed should just leave things alone, let the banks fail, etc. I find that a boring and almost pointless argument.

The people in control don't buy Austrian economics. It makes for nice polemics but is never going to be policy. My friend Ron Paul is not going to be allowed to make monetary policy, although he might get a bill through that actually audits the Fed. I am much more interested in learning what the Fed and Congress will actually do and then shaping my portfolio accordingly.

A mentor of mine once told me that the market would do whatever it could to cause the most pain to the most people. One way to do that would be to allow deflation to develop over the next few quarters, thereby probably really hurting gold and other investments, before inflation and then stagflation become (hopefully) the end of our perilous journey. Which of course would be good for gold. If you can hold on in the meantime.

Is it possible that we can find some Goldilocks end to this crisis? That the Fed can find the right mix, and Congress wakes up and puts some fiscal adults in control? All things are possible, but that is not the way I would bet.

While there are some who are very sure of our near future, I for one am not. There are just too damn many variables. Let me give you one scenario that worries me. Congress shows no discipline and lets the budget run through a few more trillion in the next two years. The Fed has been successful in reflating the economy. The bond markets get very nervous, and longer-term rates start to rise. What little recovery we are seeing (this is after the double-dip recession I think we face) is threatened by higher rates in a period of high unemployment.

Does the Fed monetize the debt and bring on real inflation and further destruction of the dollar? Or allow interest rates to rise and once again push us into recession? (A triple dip?) There will be no good choice. The Fed is faced with a dual mandate, unlike other central banks. They are supposed to maintain price equilibrium and also set policy that will encourage full employment. At that point, they will have to choose one over the other. There are no good choices. I can construct a number of scenarios. All end with the same line: there are no good choices.

Washington DC, San Diego, and New Orleans, etc.

It is time to hit the send button. I have struggled through this letter with a very upset stomach. I rarely eat pizza, but my son and his friends ordered and I ate half of a very good pizza with everything, which I very rarely do. It really kicked my gut. Maybe that is why I am a little more bearish than normal tonight.

I fly to Washington, DC on Sunday and will have dinner with good friend Neil Howe (of Fourth Turning fame). I am really looking forward to that. Neil is a very interesting dinner partner. I do some consulting on Monday and then catch a long night flight to San Diego. I will be at the Schwab conference on Tuesday, September 15. If you are going to be there, look me up. I will be at the Altegris booth at the first break and then the Gemini booth with my partners from CMG, where we will be talking about the new mutual fund. (You can learn more about it by reading a report I have prepared, entitled "How to Deal with Volatility in Extraordinary Markets - Introducing the CMG Absolute Return Strategies Fund." Simply click here.) And there will be books there!

That is my only trip in September. But then it gets interesting. I celebrate my 60th birthday the first weekend of October, then fly to New Orleans to be at the annual New Orleans Conference, October 8-11. The speaker line-up is better than ever. I find this to be one of the best conferences I go to very year. I have been attending on and off for over 25 years. You should think about this one. http://www.neworleansconference.com/speaker-eblast-JohnMauldin/

Then I will spend the next weekend in Detroit, then probably go to New York, then Philadelphia for a CMG conference October 20, then down to Houston, over to Orlando, stop to change clothes and pack at home, and then fly off on a whirlwind trip to Argentina, Brazil, and Uruguay, speaking at a series of CFA conferences. Denver and Orlando in mid-November, and nothing else so far. Switzerland and London in January.

Trey came home tonight a little discouraged, with four of his friends. He had been at his first school dance (8th grade). "Dad, I got a Bohac." This is bad. Mr. Bohac is a very reasonable, pleasant enough fellow. However, he is also the vice-principal, and as such is the nemesis of 8th-grade boys. When you get called down for whatever reason, you get what they call a Bohac, which means you have to go to his office. I grimaced. What had he done? A fight? Girls? My mind went through a dozen bad scenarios in about 3 seconds. My stomach, already roiled, immediately got worse.

As it turns out, he simply wore the wrong kind of shorts to the dance. Seems he didn't know the dress code for the dance here in Highland Park. He evidently was not the only one. When he changed and all the kids left the house, I must confess I did not see any difference. Oh well. With any luck, this will be his only Bohac this year. And Dad can live with that.

I'll leave you with this thought I gleaned from a newsletter from Australia called The Privateer (www.the-privateer.com).

"In 1909, the US federal government had an annual budget of $US 0.8 Billion. With this it governed a population of just over 90 million people. The cost of government was about $9 per capita. In 2009, the US federal government has an annual budget of $US 3,550 Billion. With this it governs a population of just over 300 million people. That's a cost of about $11,675 per capita."

Are we 1200 times better off?

Have a great week. With all my flying, I might make it through a few books on my desk this week. I will let you know if anything should be on your radar screen.

Your trying to Muddle Through analyst,

John Mauldin

Between a Rock and a Hard Place

JohnMauldin — Mon, 24 Aug 2009 19:06:00 GMT

There is the strong possibility that policy makers in the US and UK will not time the transition from the current quantitative easing to a more tightened monetary policy. That is not because they are no competent. It is because the task is very tricky and there is no play book outlining the steps. This is not Tom Landry (former Dallas Cowboy coach) pacing the field with a play for every situation already planned and practiced well in advance.

The odds favor they will either be too late or too early. Getting it "just right." The Goldilocks play, would be more than fortunate. In fact, there may be no right play to call. They may be forced to choose between a slower economy and/or inflation/deflation. And as this week's Outside the Box authors note, there is also the possibility of yet another asset bubble, making the choices even more risky.

Those who are absolutely positive about which of a variety of outcomes will emerge have a level of clairvoyance with which I am not familiar. It makes risk asset (like stocks) investing particularly tricky right now. This is a time to be nimble and avoid creating opportunities for large losses if you are wrong.

We will start this week's OTB with a few paragraphs from the Bank Credit Analyst about the Great Depression and then move on to a piece from the London office of Morgan Stanley on the problems facing central bankers.

And on a less ominous but more important note, the Muscular Dystrophy Association (MDA) has issued a warrant for my arrest which goes into effect on August 26th! I will be held at the PM Lounge in the Joule Hotel from 3-6. My bail is set at $2,400, which will benefit local families living with neuromuscular disease. No one person can set me free. It will take a little help from all of my friends, family, colleagues and enemies! Please use the link below to visit my Bail Page and help me post my bond by contributing in any way that you can. Thank you for having a big heart! And come see me in jail!

CLICK HERE TO HELP RAISE MY BAIL!!

And now, the thoughts from BCA.

John Mauldin, Editor
Outside the Box

"Prematurely exiting from an accommodative policy setting, derailed the recovery in the late 1930s and led to another leg of the depression.

"By mid-1936, the Federal Reserve lifted bank reserve requirements, in an attempt to soak up liquidity and prevent speculation from returning to Wall Street. However, the banking system was still too fragile and in need of capital. Consequently, both narrow and broad money growth plunged from a healthy clip back into negative territory. To make conditions worse, by 1937 fiscal stimulus programs ended and social security taxes were collected for the first time. The federal deficit shrank rapidly from -5.4% to -1.2% of GDP, creating significant contractionary forces.

"Obviously the economic relapse in the 1930s is an extreme example. Nonetheless, it does highlight the risks of authorities exiting prematurely before the economy and banking system are ready (even after an extended period of healthy growth). Currently, U.S. and U.K. money multipliers are still impaired, although aggressive easing has allowed some liquidity to flow through to the real economy. A decline in U.S. M2 growth would be a major warning sign. U.K. broad money growth has plunged in recent months, presenting a significant threat to the economy.

"Bottom line: Policymakers will need to continue to curb investor expectations for an early exit in order to allow a sustainable recovery to materialize. It will likely be at least until the end of next year before growth conditions in the U.S. and U.K. are robust enough to withstand a reduction in stimulus." (www.bcaresearch.com)

Between a Rock and a Hard Place

By Manoj Pradhan & Spyros Andreopoulos | Morgan Stanley, London

Monetary policy usually finds traction in the real economy through different ‘channels of monetary transmission', working through falling interest rates, increasing asset prices and increased lending by banks. These translate into more consumer and business spending, which boosts economic growth. During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery. Turning away from the inflation-targeting (IT) regime that is now conventional wisdom to perhaps a price level-targeting (PT) regime or even explicitly accounting for asset prices may give central banks much-needed flexibility.

The Sequence of Events in Economic Recovery

In a garden-variety recession, policy rate cuts lead to declines in lending rates and slow traction in the form of a better outlook for consumer and business spending. Risky assets usually rally a quarter or two before the recession ends, whereas credit growth usually picks up only after recovery sets in (see "Credit Confusion", The Global Monetary Analyst, February 4, 2009). The Great Recession has not scrambled this sequence of events but it has changed the timing and response of some. Because of the freezing of credit markets, the interest rates that matter for borrowers fell much later than they would have during a more typical episode. Also, given the massive task of repairing balance sheets that confronts commercial banks and households in particular, spending and borrowing are likely to remain subdued. The risk is that credit growth could lag the end of the recession by more than usual. However, risky assets seem to have stuck to the script and rallied ahead of the bottom in economic growth by a familiar lead time.

Interest Rate Channel Less Effective So Far

When central banks cut policy rates, other interest rates respond quickest to the policy move. By providing cheaper borrowing rates to households and businesses, central banks aim to encourage spending and spur production. This is the ‘interest rate' channel for monetary transmission. This channel typically carries the bulk of the burden of resuscitating the economy. Untraditionally, during this current cycle, interest rates that matter to borrowers have fallen very slowly and much later than the cuts in policy rates. Even as they have fallen, however, they have met households who are reluctant to exploit these low rates, given the desire to save in the US and the UK and the conservative habits of German and Japanese households.

Credit Channel Likely to Be Subdued as Well

During a recession, credit flows to the private sector usually fall. Banks are less willing to lend and households and firms are less willing to borrow. Policy rate cuts normally provide commercial banks ‘carry' via a steeper yield curve, allowing them to borrow money at low rates and lend it at higher rates. In this cycle, central banks have had to resort to unconventional measures in addition to rate cuts to ensure that banks had the benefits of a steeper yield curve and an abundance of liquid funds to lend if they so desired. Surveys suggest that banks are becoming more receptive to lending but credit will likely grow with a lag (again see Credit Confusion) and quite slowly thanks to banks and households slowly rebuilding their balance sheets.

Asset Price Channel Leading the Charge...

Risky assets have outplayed the other channels by a margin over the last few months. This is an encouraging sign for central banks, who will undoubtedly welcome the economic traction that accompanies rising asset prices. A rise in equity prices should enhance the incentive to invest because the higher price of existing capital implied by higher share prices increases the relative attractiveness of investing in new capital (Tobin's q). Back in March, with the worst of the economic bad news likely already having been delivered and ultra-expansionary policy in place, risky assets rallied and rallied hard, which is a positive for investment. A possible bottoming in the housing market in the US and the UK would mean that Tobin's q could be applied to the housing sector as well. Households are more likely to buy new houses if house prices are rising, and this encourages homebuilding activity. Also, rising asset prices have supported the balance sheets of financial institutions.

...but Risky Asset Rallies Come at a Cost

One of the most important lessons from the Great Recession is the damage that asset bubbles can wreak. As the Fed and the ECB kept policy rates low for a very long time after the 2001 recession to ward off deflation concerns, they chose to allow an ultra-expansionary policy to inflate asset prices. Even though economic growth in the next couple of quarters could be very strong, the medium-term outlook for the major economies and therefore for global growth remains quite fragile. Policymakers therefore may end up having a repeat of the 2001-type dilemma on their hands.

Between a Rock and a Hard Place

If the imbalance between risky asset prices on one hand and interest rates and credit on the other persists for a significant period of time, the transition from über-expansionary policy to a neutral stance could be an extremely tricky balancing act for central banks. In the long run, asset prices cannot keep exceeding the growth potential of the economy. However, over shorter horizons, a loose policy regime with plentiful excess liquidity can lead to significant asset price inflation when markets see an improving economic outlook. If policymakers allow asset prices to surge because the other transmission channels have been weak, they risk inflating the type of bubble that got us here in the first place. If they decide to head off asset prices by tightening policy, they risk raising rates into a weak recovery! The transition to a neutral policy stance thus requires greater balance between the channels of monetary transmission - ideally from interest rates and credit growth gaining better traction in the economy as asset price inflation cools down. This balance is far from guaranteed. Worse, a revival in credit growth could further stoke asset price inflation. Not the best news for central banks.

Inflation Targeting Too Stringent

What could central banks do if they find themselves in such a situation? Using the interest rate tool to quell asset price inflation when the economy is yet to recover fully would risk sustained deviations from the inflation target on the downside. At the same time, it would expose central banks to criticism from politicians and the public since the policy might jeopardise the recovery. Central banks might try to counter the pressure by arguing that pricking asset price bubbles would foster price stability over a longer time horizon by preventing crises such as the current one. But this riposte would be problematic in the current policy framework. Deliberately using policy rates to pursue objectives other than inflation - especially in a way that is detrimental to achieving the inflation target - is incompatible with the inflation-targeting (IT) orthodoxy. More to the point, pursuing asset prices could deliver a fatal blow to the transparency of the monetary policy regime. If the public is unclear about what the objectives of monetary policy are, it could lose faith in the central banks' commitment to price stability and inflation expectations would become unanchored. One of the main advantages of IT - transparency - would then be rendered defunct.

A Way Out?

Assuming CBs want to ‘lean against the wind' of asset prices, is there a way for CBs to escape the strictures of orthodox IT without risking the loss of their holy grail, the credibility of monetary policy? Price level targeting (PT) may be the answer. Under PT, the central bank aims at a certain path for the price level, with the rate of increase in the price level given by the inflation target (see "From Inflation Targeting to Price Level Targeting", The Global Monetary Analyst, July 15). PT differs from IT in that past deviations from the inflation target have to be corrected. For example, with a price level target path consistent with 2% inflation, if inflation in one period is 1%, then it would have to be 3% in the next period. The undershoot in one period would have to be compensated for by an overshoot in the next period in order to return to the price level target path. In short, PT is essentially ‘average inflation' targeting.

How Would PT Help Central Banks?

By effectively increasing the time horizon over which the inflation target can be achieved, it would give monetary policy much-needed flexibility to, if necessary, pursue asset price inflation in the short term. At the same time, long-term inflation expectations would remain anchored since monetary policymakers would commit to achieving 2% inflation on average. Indeed, inflation expectations under PT would themselves have stabilising effects on the economy. While inflation undershoots the target temporarily in order to burst the bubble, the public would know that this would soon require a compensatory overshoot. Short-term inflation expectations would then rise, decreasing real interest rates. This would, in turn, increase spending and output.

In summary, the transition from ultra-expansionary policy to a neutral stance may be very tricky if the imbalance between different channels of monetary transmission persists. Central banks may find themselves hiking into a weak recovery to quell asset prices, or they might compensate for the weakness in the interest rate and credit channels and allow asset prices to rise but risk inflating another bubble. Central banks could gain some much-needed flexibility by thinking outside the IT box - but whether they will make a dramatic move and switch to a PT regime remains to be seen.