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Friday, January 8, 2010

Transcript: 341 Goldman's 10 Questions (cont.) plus 1937

Listen to this episode

We'll continue with the answers to Goldman Sachs 10 questions, its attempt to finesse a forecast in a moment
First a point on 1937 and a note from Calculated Risk on the MBS market and the Fed, which is the same thing.

Many, including Paul Krugman, have warned against the reversion to 1937 thinking, when deficit spending was reined in and interest rates raised, causing a significant recession.

At Demand Side, we still worry about 1931.  What have we done to deal with the mountain of debt that is the cause of suffering and the critical dynamic to the asset price deflation we are now experiencing.  The home owners loan corporation model to deal with mortgages and some zero rate refinancing of consumer's debt was indicated twelve months ago, and even earlier.  Now it is past due and still not on the horizon.

Let's get the banks restructured, the debt under control and some hiring going before we say we are past 1933.

Now Calculated Risk's digest of news on the MBS purchase program.  As we've noted here, the toxic Mortgage Backed Securities need to be unpacked and dealt with individually.  Instead the Fed has ratified and validated them by buying a trillion dollars worth.  They now sit on the Fed's balance sheet.

One of the great concerns of financial markets and institutions is that the Fed will stop buying these private market securities and the bottom will go out from under them.  Because nobody else will buy them.  Sure and be darned if stimulus spending in the real economy is the wrong thing to do while this ratification of some of the worst financial decisions in history is the right thing to do.

More Worries about end of Fed MBS Purchase Program

From Liz Rappaport and Jon Hilsenrath at the WSJ: Fed Plan to Stop Buying Mortgages Feeds Recovery Worries
The Federal Reserve's pledge to stop buying mortgages by the end of March is sparking fears among home builders, mortgage investors and even some Fed officials that mortgage rates could rise and knock the fragile housing recovery off course.
The authors review the concerns described in the minutes of the December FOMC meeting. From the FOMC minutes:
... some participants still viewed the improved outlook as quite tentative and again pointed to potential sources of softness, including the termination next year of the temporary tax credits for homebuyers and the downward pressure that further increases in foreclosures could put on house prices. Moreover, mortgage markets could come under pressure as the Federal Reserve's agency MBS purchases wind down.
Others are even more worried, from the WSJ:
... Ronald Temple, portfolio manager at Lazard Asset Management ... sees mortgage rates rising by a percentage point when the Fed stops buying. A withdrawal of government support, combined with high unemployment and rising mortgage foreclosures, could push home prices down 20%, he said.

... home builders and others are hoping the Fed will flinch. ... If the Fed stops buying, "it would be the beginning of a crisis again, and we haven't emerged from the last one," said Larry Sorsby, chief financial officer at home builder Hovnanian Enterprises Inc, ... Mr. Sorsby figures the Fed's withdrawal would prompt at least a one-percentage-point rise in mortgage rates, which he fears could squash recent glimmers of more demand for homes. He expects the Fed will, in fact, keep buying. "I doubt they'll just pull out," he said.
First, it is very unlikely that mortgage rates would rise by 100bps. Calculated Risk's estimate is around 35 bps.

Although the Fed has made it clear - repeatedly - that they would either continue the program or restart it if they felt it was necessary, I think it is likely that the Fed will stop buying MBS by the end of March - and then react to whatever happens ...

Now back to the Goldman Sachs questions, beginning at number

6. Will inflation fall further?

This is really a question?  Well, it has an answer.

Very likely yes, at least as far as the “core” indexes are concerned.  As we demonstrated in a comprehensive study recently, “slack” is the best predictor of inflation both at the aggregate level and in individual sectors of the economy.   Moreover, Exhibit 6 shows that slack is pervasive throughout the economy, not just in the well known data on unemployment and industrial capacity utilization.

One particular area in which slack could put significant further downward pressure on inflation is actual and imputed rents.  There is a clear inverse relationship between the rental vacancy rate and the pace of rent inflation.  With rental vacancies at a record, we expect further significant declines in year-on-year rent inflation into negative territory.

The Demand Side view is that the price level is being supported by bubble markets in commodities, or it would be down further.  Asset price deflation, except again in financial assets where the bubble is operating, continues apace.  Rental reductions are a function of the bubble in housing collapsing, rising joblessness and a weak economy.  The vacancy rate and the rent are the same phenomenon, not cause and effect.

7. Does the dollar pose an inflation risk?

Only to a very limited degree.  For one thing, the dollar just isn’t that weak—and that was even true prior to the most recent round of risk reduction.  It has certainly depreciated substantially over the past nine months, but we view this as the flip side of the normalization that has taken place in global financial markets.  Indeed, according to the Fed’s broad trade-weighted index, the dollar currently is slightly stronger than the average of the past two years.

Moreover, the currency is less important to inflation in the United States than elsewhere given the relatively small size of the trade sector.  Thus, while Fed officials certainly take account of its impact on financial conditions, the impact of currency changes on inflation, in particular, is quite minor.  A common rule of thumb is that a 10% depreciation in the trade-weighted dollar raises the level of the CPI by just ¼%.  So it would take a very large depreciation indeed to start ringing alarm bells about imported inflation.

Well, Demand Side would say that tradable goods have collapsed as a source of inflation risk, particularly when the Chinese peg their currency to the dollar.  The thing about the dollar is its changes are inverse to the price of oil.  Oil prices are a major inflation instigator.

8. Will Congress pass more fiscal stimulus?

Yes.  Beyond the extension of the homebuyer tax credit (and other tax relief measures) enacted in early November, the Congress has passed and the president has signed a two-month extension of unemployment benefits.  More is coming as the House has passed a much larger bill providing additional unemployment insurance (four more months) as well as more aid to states, and more infrastructure spending.  The Senate is likely to follow suit early next year, and the ultimate legislation may well include provisions such as a hiring tax credit and/or extended bonus depreciation for companies.

The president and Congress will do what Goldman tells them to do.  So expect this stimulus.

But even with these likely measures, the boost from fiscal policy to real GDP growth is likely to decline in the first half and vanish (or even reverse) in the second half of 2010.  This is because it is the change in spending and taxes that governs the impact of fiscal policy on real GDP growth.  Even with the latest round of packages—worth about $200bn altogether—the change will not be nearly as positive as it was in the wake of the $787bn package enacted almost a year ago.  ... the longer-term perspective is one of gradual fiscal restraint, though this is mostly an issue for 2011 and beyond.

Uh-oh.  Fiscal restraint will be sad for Goldman and the rest of the financial sector.  Deficits are supporting the cash flow that is the source of their profits.  In this point, Goldman implicitly acknowledges that government spending is the only game in town with regard to growth.

9. How will the Fed “sequence the exit”?

In theory, Fed officials have four choices for “exiting” from their current, highly accommodative stance: (1) terminating the current program of asset purchases, (2) draining excess bank reserves via reverse repos and/or term deposit facilities, (3) hiking short-term rates via parallel increases in the federal funds rate and the interest rate on reserves (IOR), and (4) selling assets outright.

In 2010, the main form of “exit” is likely to be an end to asset purchases.  In addition, Fed officials will probably drain some excess reserves, mainly in order to prove to market participants that they are capable of doing so.   In contrast, we expect neither a hike in the funds rate nor outright sales of assets on the Fed’s balance sheet in 2010 (or for that matter in 2011).

Very short and sweet for the trillions of dollars of Fed action in question.  Exiting apparently means not getting in any further.  Too bad it got in so far.  Hard to see how it is ever going to get out of this mudhole.  Draining bank reserves is a shadow play meaning nothing.  The reserves are no source of inflation risk, even postulating a true recovery and some impetus for investment, when it won't matter if there are zero reserves, financing will be found.  Again Goldman is telling the Fed not to mess with its zero percent financing for games.  Outright sales would mean recognizing huge losses for the Fed.  Not going to happen.

10. Will the end to the asset purchases tighten financial conditions?

Possibly, although the degree is highly uncertain.  Over the past 12 months, the Fed has bought a net $1.3 trillion in Treasury coupon debt, agency debt, and agency mortgage-backed securities, about three-quarters of the total amount of net issuance in these markets.  These purchases are already diminishing and will likely stop by the end of the first quarter, while net issuance is likely to remain at levels similar to the recent pace through 2010.  This means that non-Fed buyers will need to absorb a far greater amount of “flow supply” of securities.

This could put upward pressure on long-term interest rates.  But two points are worth noting.  First, our bond strategists’ models do not find any misvaluation of US Treasury yields at present.  If this means that the asset purchases didn’t have a dramatic impact on the level of yields, it would suggest that end of the purchases might also not have a significant effect. Second, and presumably related to this, the policy shift away from asset purchases has been very well flagged and there are plenty of market participants who have a much darker view of the outlook for federal solvency than we do.  For this reason, a sizable short base in the rates markets has been established in anticipation of the end to the Fed’s purchases.  This means that much of the impact may already be discounted in the current level of interest rates.

Phooey.  Goldman does not ask, "How can we expect the Fed to continue to throw money at us?"  They instead say, "We've consolidated our position, and we're ready to ride it out.  Thanks Ben.  Good luck suckers."

Tomorrow we're going to put up on the Relay a lecture by George Soros on the core of his reflexivity theory.  We note in listening to Soros that his analysis is broadly parallel to that of Hyman Minsky.  We see also, though, that his prescription of remedy is broadly parallel to that of the Obama administration.  Make of that what you will.

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