If we’re seeing increased optimism, commodity prices should go up, anticipating a stronger future.

TO BE NOTED: From the NY Times:

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June 16, 2009, 8:57 am

Parsing interest rates

Long-term interest rates have risen substantially over the past few months. But what does that mean? Is it the burden of vast government borrowing, as the deficit hawks claim? Or is it actually a good sign, an indicator of greater confidence?

I’ve argued against the fiscal explanation on the basis of both theory and the fact that rising government borrowing hasn’t offset the plunge in private borrowing.

But there’s another route. One of my favorite Jeff Frankel papers was his piece with Charles Engel on short-term interest rate movements. Back in the 80s, people still paid a lot of attention to monetary aggregates. When M1 came in above expected, interest rates tended to rise. Monetarists said, “See — the market is afraid of inflation.” Others said, “See — the market is afraid that the monetarists at the Fed will raise rates to keep to the monetary target.” Who was right?

Engel and Frankel pointed out that events in other markets — specifically, the foreign exchange market — could resolve this dispute. If it was inflation fear, a bump in the money supply should go along with a weaker dollar; if it was fear of tightening, it should go along with a stronger dollar. And the evidence clearly pointed to the fear of tightening story.

So what about now? Foreign exchange is not as useful, because we’re all sort of in the same boat. However, commodity prices could play the same role. If we’re seeing rising rates because government borrowing is crowding out private borrowing, commodity prices should go down: holding inventories becomes more expensive. If we’re seeing increased optimism, commodity prices should go up, anticipating a stronger future.

In fact, commodity prices have gone up. It’s not a slam-dunk, because commodities have bubbles, too. But it’s one more piece of evidence against crowding out."

So, there's little evidence now of inflationary pressures

TO BE NOTED: From Econbrowser:

"In Search of ... Hyperinflationary Expectations

With large budget deficits in place and projected going forward, as well as the expansion of the Fed's balance sheet, there's been some talk of inflationary pressures, and even hyper-inflation [0] McCain. I wondered if these fears were manifested in survey- and market-based expectations measures.

For certain, there is little pressure apparent in short term forecasts like the WSJ and Survey of Professional Forecasters. This makes sense (at least if one believes in the Keynesian conception of an output gap [1]) given the amount of slack displayed in Figure 1.

Figure 1: Median expected ten year inflation recorded as of second month of each quarter, from Survey of Professional Forecasters (blue, left scale), actual CBO-defined output gap (red line), and WSJ forecasted (purple triangle), in log percentage points. NBER defined recessions shaded gray; second recession assumed to end 2009Q3. Source: Cleveland Fed, BEA, GDP 2009Q1 advance release, and WSJ May survey [xls], and CBO potential GDP (9 January 2009).

I also plot the median expectation of ten-year inflation. Note that this measure has not budged much at all.

This data, of course, will not convince those skeptical of survey-based measures. What about market based measures? The standard approach is to subtract the TIPS yield from the Treasury yield. We know for a variety of reasons, this calculation can lead to misleading results. However, the Cleveland Fed has stopped publishing its adjusted series:

October 31, 2008

We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.

With that caveat in mind, Figure 2 displays the implied ten year expected inflation rate.

Figure 2: Difference between ten year constant maturity Treasury yields and ten year constant maturity TIPS, monthly data. Series GS10 and FII10. Source: St. Louis Fed FRED.

Some people are looking to commodity prices as indicators of expected inflation. I'd say that making inferences this way is fraught with difficulties, because changes in such commodity prices will incorporate both relative price and price level effects.

So, there's little evidence now of inflationary pressures. That being said, there's plenty to worry about as time goes on (as Jim recounts). And even if inflationary expectations remain well anchored, we do have to keep an eye on possible crowding out due to higher interest rates (all of us, except Dick Cheney, who didn't ever worry about deficits as the Bush Administration ran up trillions in debt [3]).

Posted by Menzie Chinn "

Equity investments are preferable to debt, a contributor to the current financial crisis, Taleb said.

TO BE NOTED: From Bloomberg:

"Global Crisis ‘Vastly Worse’ Than 1930s, Taleb Says (Update1)

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By Shiyin Chen and Liza Lin

May 7 (Bloomberg) -- The current global crisis is “vastly worse” than the 1930s because financial systems and economies worldwide have become more interdependent, “Black Swan” author Nassim Nicholas Taleb said.

“This is the most difficult period of humanity that we’re going through today because governments have no control,” Taleb, 49, told a conference in Singapore today. “Navigating the world is much harder than in the 1930s.”

The International Monetary Fund last month slashed its world economic growth forecasts and said the global recession will be deeper than previously predicted as financial markets take longer to stabilize. Nouriel Roubini, 51, the New York University professor who predicted the crisis, told Bloomberg News yesterday that analysts expecting the U.S. economy to rebound in the third and fourth quarter were “too optimistic.”

“Certainly the rate of economic contraction is slowing down from the freefall of the last two quarters,” Roubini said. “We are going to have negative growth to the end of the year and next year the recovery is going to be weak.”

Federal Reserve Chairman Ben S. Bernanke told lawmakers May 5 that the central bank expects U.S. economic activity “to bottom out, then to turn up later this year.” Another shock to the financial system would undercut that forecast, he added.

‘Big Deflation’

The global economy is facing “big deflation,” though the risks of inflation are also increasing as governments print more money, Taleb told the conference organized by Bank of America- Merrill Lynch. Gold and copper may “rally massively” as a result, he added.

Taleb, a professor of risk engineering at New York University and adviser to Santa Monica, California-based Universa Investments LP, said the current global slump is the worst since the Great Depression that followed Wall Street’s 1929 crash.

The Great Depression saw an increase in global trade barriers and was only overcome after President Franklin D. Roosevelt’s New Deal policies helped revive the U.S. economy.

The world’s largest economy may need additional fiscal stimulus to emerge from its current recession, Kenneth Rogoff, former chief economist at the International Monetary Fund, told Bloomberg News yesterday.

“We’re going to get to the point where recovery is just not soaring and they’re going to do the same again,” he said. “We’re going to have a very slow recovery from here.”

Fiscal Stimulus

The U.S. economy plunged at a 6.1 percent annual pace in the first quarter, making this the worst recession in at least half a century. President Barack Obama signed a $787 billion stimulus plan into law in February that included increases in spending on infrastructure projects and a reduction in taxes.

Gold, copper and other assets “that China will like” are the best investment bets as currencies including the dollar and euro face pressures, Taleb said. The IMF expects the global economy to shrink 1.3 percent this year.

Gold, which jumped to a record $1,032.70 an ounce March 17, 2008, is up 3.6 percent this year. Copper for three-month delivery on the London Metal Exchange has surged 55 percent this year on speculation demand will rebound as the global economy recovers from its worst recession since World War II.

Commodity prices are also gaining amid signs that China’s 4 trillion yuan ($585 billion) stimulus package is beginning to work in Asia’s second-largest economy. Quarter-on-quarter growth improved significantly in the first three months of 2009, the Chinese central bank said yesterday, without giving figures.

Credit Derivatives

China will avoid a recession this year, though it will not be able to pull Asia out of its economic slump as the region still depends on U.S. demand, New York University’s Roubini said.

Equity investments are preferable to debt, a contributor to the current financial crisis, Taleb said. Deflation in an equity bubble will have smaller repercussions for the global financial system, he added.

“Debt pressurizes the system and it has to be replaced with equity,” he said. “Bonds appear stable but have a lot of hidden risks. Equity is volatile, but what you see is what you get.”

Currency and credit derivatives will cause additional losses for companies that hold more than $500 trillion of the securities worldwide, Templeton Asset Management Ltd.’s Mark Mobius told the same Singapore conference today.

“There are going to be more and more losses on the part of companies that have credit derivatives, those who have currency derivatives,” Mobius, who helps oversee $20 billion in emerging-market assets at Templeton, said at the conference. “This is something we’re going to have to watch very, very carefully.”

Taleb is best known for his book “The Black Swan: The Impact of the Highly Improbable.” The book, named after rare and unforeseen events known as “black swans,” was published in 2007, just before the collapse of the subprime market roiled global financial institutions.

To contact the reporters on this story: Chen Shiyin in Singapore at schen37@bloomberg.net; Liza Lin in Singapore at Llin15@bloomberg.net."

Meltzer says political pressure will prevent Bernanke, 55, and fellow policy makers from withdrawing liquidity quickly enough as the economy recovers.

TO BE NOTED: From Bloomberg:

"Bernanke Bet on Keynes Has Meltzer Seeing 1970s-Style Inflation

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By Rich Miller

April 13 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke is siding with John Maynard Keynes against Milton Friedman by flooding the financial system with money.

If history is any guide, says Allan Meltzer, the effort will end in tears. Inflation “will get higher than it was in the 1970s,” says Meltzer, the Fed historian and professor of political economy at Carnegie Mellon University in Pittsburgh. At the end of that decade, consumer prices rose at a year-over- year rate of 13.3 percent.

Bernanke’s gamble that the highest jobless rate in 25 years and the most idle factory capacity on record will hold down inflation is straight out of the late British economist Keynes. Should late Nobel-prize-winner Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” prove right, the $1 trillion or more in liquidity Bernanke has pumped into the financial system by expanding the Fed’s balance sheet may leave him to cope with surging consumer prices.

So far, investors and economic data both back up the Bernanke-Keynes view. The market in Treasury Inflation-Protected Securities as of April 6 indicated long-term inflation expectations of 2.5 percent, below the 2.8 percent average inflation rate of the past 10 years.

Figures to be published April 15 will probably show that the March consumer price index was unchanged from a year earlier, thanks to a steep decline in energy costs, according to economists surveyed by Bloomberg News. In February, the index rose at a year-over-year rate of just 0.2 percent.

Increasing Expectations

Still, the 2.5 percent expectation represents an increase from 2.1 percent at the end of last year. And Meltzer, 81, who has written an 800-page history of the Fed’s first 38 years and is now working on volume two, isn’t alone in seeing a return of sky-high inflation as a result of Bernanke’s policies.

John Brynjolfsson, chief investment officer at hedge fund Armored Wolf in Aliso Viejo, California, says the Fed is still in the early stages of its effort to pump up the economy.

“We’ve got at least nine innings of reflation ahead of us, ultimately ending with probably double-digit inflation,” he said in a Bloomberg Television interview on April 6.

Investors are starting to protect themselves from the risk of faster price increases by buying TIPS, pushing up the return on the securities to 6.1 percent in March, the best performance since the U.S. government introduced them in 1997, according to Merrill Lynch & Co. index data.

A Ballooning Balance Sheet

Behind investors’ caution: a ballooning Fed balance sheet that has climbed $1.2 trillion in the past year to $2.09 trillion and expanded the nation’s money supply. It is poised to increase even further after last month’s Fed decision to buy an additional $1.15 trillion worth of assets, including $300 billion in Treasury securities.

M2, a broad measure of the money supply that includes checking accounts and money-market mutual funds, rose in the last six months at an annual rate of 14 percent. That compares with an average 6.3 percent during the last decade.

Meltzer says political pressure will prevent Bernanke, 55, and fellow policy makers from withdrawing liquidity quickly enough as the economy recovers. That’s similar to the pattern that occurred back in the 1970s, he says. Then-Chairman Arthur Burns allowed excessive money-supply growth because he was unable or unwilling to resist pressure from President Richard Nixon’s White House to hold down unemployment, leading to the “great inflation” of that era, he says.

‘Squandered’ Independence

Now, Bernanke and fellow policy makers have “squandered their independence” by becoming involved in bailouts of financial firms and by taking long-term and illiquid assets onto their balance sheet, Meltzer says. “They don’t have the political ability to control inflation.”

John Ryding, founder of RDQ Economics LLC in New York and a former Fed economist, agrees that the central bank will be slow to soak up all the cash it has injected into the financial system, in part because policy makers will be fixated on still- high unemployment. The rate rose to 8.5 percent in March, compared with 7.2 percent in December.

“They pay lip service to inflation being a monetary phenomenon,” he says. “But they’re too much concerned with the Keynesian explanation of inflation.”

There are signs that the Fed’s stimulus -- combined with the efforts of central banks and governments elsewhere in the world, including China -- is starting to lift some commodity prices. Copper rose to a five-month high and platinum reached a six-month peak on April 9.

Oil Prices

“All that money is going to find a home,” says Ken Mayland, president of ClearView Economics LLC in Pepper Pike, Ohio. He sees oil prices increasing to “$80, $90, $100 before the end of next year” from $52 a barrel now.

Commodity prices may be more prone to rise as the world economy recovers because tight credit and volatile pricing will discourage investment in new supplies, says Mark Zandi, chief economist at Moody’s Economy.com, in West Chester, Pennsylvania.

Chesapeake Energy Corp. of Oklahoma City, and Houston-based Carrizo Oil & Gas Inc. are among energy producers that are limiting spending and curbing drilling after a collapse in credit markets drove up debt costs.

Some Fed policy makers seem more worried about deflation than they do about inflation. A sustained fall in prices can debilitate the economy by causing consumers and businesses to postpone purchases.

“For some time to come, disinflation, and even deflation, will represent greater risks than inflation,” San Francisco Fed President Janet Yellen said in a speech on March 25.

Below Potential

At the root of that concern is substantial and growing slack in the economy, which, according to White House chief economist Christina Romer, is operating 5 percent to 10 percent below potential. That means the economy will have to grow a percentage point above trend -- reckoned by the administration to be about 2.5 percent annually -- for five or more years before the slack is used up.

The Phillips curve -- developed by economist A.W. Phillips using Keynesian concepts -- posits that such excess will reduce inflation as firms stuck with idle capacity cut prices and workers facing layoffs accept smaller wage hikes.

Not everyone at the Fed buys into that argument. Noting that some economists forecast substantial slack will keep inflation low for several years, Richmond Fed President Jeffrey Lacker said in a March 26 speech that he would be “cautious about relying on this correlation.”

The Fed is “running a laboratory experiment” on what drives inflation: the money supply or the output gap, says Laurence Meyer, a former Fed governor and now vice chairman of St. Louis-based Macroeconomic Advisers

“How it turns out will do a lot to influence the economic debate,” he says, adding that his money is on Bernanke.

To contact the reporter on this story: Rich Miller in Washington o rmiller28@bloomberg.net"