borrowing heavily to finance massive stimulus and financial bailouts have raised doubts about their ability to repay their debt

TO BE NOTED: From Alphaville:

"Time to pull back liquidity? Posted by Izabella Kaminska on Jun 10 19:16.

Wednesday has so far proved to be another inflation focused day.

Among the latest indicators of tearaway borrowing costs in the near future was a jump in mortgage rates to their highest since last November, a fact that has now begun depressing refinancing activity. The Mortgage Bankers Association’s index of mortgage applications, for example, fell 7.2 per cent w/w in the week ending June 5, marking the third consecutive weekly decline. Meanwhile, as Barcap stated:

The average rate on the 30-year conforming mortgage (as measured by the MBA) jumped 32bp to 5.57%, also the highest since November. Mortgage rates have jumped more than 100bp from the trough of 4.62% at the end of April. The index of purchase applications inched up 1.1%, leaving the four-week moving average up 0.5%.

Then there were policymaker comments: the most hawkish came from Richmond Fed President Jeffrey Lacker urging the Fed not to expand its asset purchases in response to rising bond yields. As Reuters reported:

“Right now, I don’t see a reason to increase it,” Richmond Federal Reserve President Jeffrey Lacker told reporters, referring to the U.S. central bank’s pledge to buy up to $300 billion of longer-term Treasuries by the autumn. “In fact, if anything, if yields are rising because of stronger growth that would cut against the case for increasing purchases,” he said after speaking to the North Carolina Senate Appropriations Committee.

Arthur Laffer, he of the Laffer curve, meanwhile presented the following scary graphic in a WSJ journal article:

Commenting on the above he wrote:

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base — which prior to the expansion had comprised 95% of the monetary base — has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!

That currency-in-circulation statistic by the way, was also corroborated by Fed’s own monetary base graphics released on Wednesday and reproduced below:

And if all that wasn’t scary enough on the inflation front, Reuters now reports the US government had to offer a much higher than expected yield on its long-dated bond sales on Wednesday just to attract sales:

NEW YORK, June 10 (Reuters) - The U.S. government on Wednesday paid a much higher-than-expected yield to sell longer-dated notes to attract investors who have grown wary of its burgeoning debt load. The U.S. Treasury added $19 billion to a prior 10-year note issue, originally sold in May, at a high yield of 3.99 percent, the highest since August 2008. The added yield incentive pulled reluctant participants from the sidelines, making this strongest bid 10-year auction since September 2007. This is the first auction of long-dated federal debt since questions over the U.S. government’s credit-worthiness arose in the wake of a credit rating downgrade of Britain by Standard & Poor’s. The United States and Britain are conducting similar policies to revive economic growth, but their tactic of borrowing heavily to finance massive stimulus and financial bailouts have raised doubts about their ability to repay their debt.

Laffer’s conclusion by the way ties with that of Lacker’s: Forget additional Fed asset purchases. What is needed now is the reemergence of an inflation not deflation focused committee that is ready to drain liquidity from the system. As he writes:

Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion. Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

Otherwise, behold; tick-tock the inflation clock.

Related links:
Fed releases new balance-sheet data - FT Alphaville
Federal Reserve System Monthly Report on Credit and Liquidity Programs and the Balance Sheet - Fed
Fed Would Be Shut Down If It Were Audited, Expert Says - CNBC

This entry was posted by Izabella Kaminska on Wednesday, June 10th, 2009 at 19:16 and is filed under Capital markets, People. Tagged with Arthur Laffer, federal reserve, infineon, jeffrey lacker, Treasuries."

Me:

Don the libertarian Democrat Jun 10 20:22

So, let's see, now we have higher interest on some bonds because:
1) The govt wants to sell a lot of bonds, and so they have to offer higher interest rates to attract enough buyers
2) People are seeing or predicting inflation ahead, for whatever reason, and so want a higher rate of interest
3) The money supply, as you've laid out in the graph by Laffer, means that inflation is a mechanistic foregone conclusion, and, until the money supply goes down, the govt will have to pay higher interest on bonds
Anything else? Maybe:
4) Investors are seeking higher interest because they can get

Don the libertarian Democrat Jun 10 22:22

Here's McTeer on that graph, I believe:

"People keep talking and writing about the explosion of the money supply and the coming inflationary tsunami. Let me point out once again that the M1 and M2 measures of the money supply spiked but have since come back down. There is no explosion of the money supply.

I

The monetary base (currency outstanding plus bank reserves) has exploded, and it's graph is indeed startling-startling that is until you realize that excess bank reserves on deposit at the Fed is the reason. We learned to pay attention to the monetary base because it provided the raw material (reserves) from which the banking system can create new money by lending and investing. Because of the money expansion multiplier, the monetary base has been referred to historically as "high powered money."

http://taxesandbudget-blog.ncpa.org/the-feds-balance-sheet-and-excess-bank-reserves/

I could be wrong on all this, but McTeer's post makes more sense to me. Maybe I'm misreading Laffer's graph.

"inflation may “firm” during any rebound if the Fed holds interest rates low for too long."

Here's another inflation worrier. From the WSJ:

"Federal Reserve Bank of Richmond President Jeffrey Lacker warned Friday that economists shouldn’t count on a weak economy to automatically reduce price pressures.

Lacker also outlined a relatively optimistic scenario for the U.S. economy despite the current “trying times,” saying consumer spending could rise sharply once labor market uncertainties recede and the housing drag should lessen next year.

Against that backdrop, Lacker cautioned that inflation may “firm” during any rebound if the Fed holds interest rates low for too long.

While many economists expect a weak economy to result in a decline in core inflation, which excludes food and energy, “I would be cautious about relying on it as a causal relationship,” Lacker said in prepared remarks to the Tech Council of Maryland."

I agree that;

1) The economy is in better shape than many think

2) The decline in prices is temporary, and different than deflation

"Lacker noted that while it may seem “premature” to talk about inflation in the midst of recession, “we need to be sure our policy remains consistent with a strategy that does not allow inflation to ratchet up over the business cycle.”

Once the recovery begins, the temptation is to keep interest rates low until a clear rebound is ensured, Lacker noted. “The risk associated with that path is that inflation may not moderate obediently during the downturn, and may firm with the ensuing recovery,” Lacker said.

Meanwhile Lacker offered a number of reasons to predict a recovery next year, which he called a “reasonable expectation.”

For one, monetary policy is “quite stimulative,” Lacker said, while energy prices have reversed most of their past gains, which “will free up a portion of consumer budgets for spending on other goods and services.”

Meanwhile, the drag from housing should lessen next year, though Lacker joked he’s been making that forecast for three years now, “so my outlook is tempered by more than the usual amount of humility.”

In addition, Lacker said that once uncertainties surrounding labor, housing and equity markets fade, consumer spending “is likely to pickup substantially.”

I agree that:

1) We need to really worry about inflation down the road

2) The economy will improve next year

"The government’s mixed signals about rescuing financial institutions may have added to market turmoil in recent months"

Interesting post on the WSJ :

"The government’s mixed signals about rescuing financial institutions may have added to market turmoil in recent months, a Federal Reserve policy maker said Monday.

In remarks to a conference in Israel, Federal Reserve Bank of Richmond President Jeffrey Lacker said the “disparate” government responses to potential failures at major firms created uncertainty and “may have made it difficult for market participants to forecast whether and in what form official support would be forthcoming for a given counterparty.”

“Shifts in expectations regarding official intervention may have added volatility to financial asset markets that were already roiled by an increasingly uncertain growth outlook,” Mr. Lacker said at a conference at Hebrew University of Jerusalem, according to his prepared text released by the Richmond Fed...

Many investors and Wall Street executives have sharply criticized the U.S. response — spearheaded by Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke — for sending mixed signals during the crisis about which firms might get taxpayer support to prevent their failure. The Fed stepped forward with $30 billion in March to prevent the bankruptcy of Bear Stearns Cos. and facilitate its sale to J.P. Morgan Chase & Co. Six months later in September, however, it declined to offer support to prevent the failure of Lehman Brothers Holdings Inc. Fed officials believe Lehman’s circumstances wouldn’t have allowed for a similar rescue.

The rescue of insurer American International Group Inc. just after Lehman’s failure added to criticism. Now, after Congress passed a $700 billion financial-sector bailout last month, banks are lining up to receive capital infusions from the Treasury."

Here's my comment:

” for sending mixed signals during the crisis about which firms might get taxpayer support to prevent their failure.”

This is the truth. Investors were counting on government intervention in this crisis. Any signal that this might not be forthcoming was seen as a looming disaster.

The government should have acted immediately and decisively, since it had given implicit and explicit guarantees that it would intervene in a crisis. The failure was also one of not having clear policies and guidelines of what would trigger intervention. Consequently, all moral hazard arguments have been fruitless.

In future, we need clear guidelines of government intervention, and moral hazard needs to be clear

Comment by Don the libertarian Democrat - November 3, 2008 at 10:06 am

Lacker does give a positive view of sorts:

“We have to give serious consideration to the idea that this episode of credit and financial market turmoil is part of the economy’s natural response to the sharp decline in the underlying fundamentals in housing finance,” Mr. Lacker said. “My sense is that the deterioration of economic conditions is playing a more prominent role in the tightening of credit terms right now than the direct effects of financial market turbulence.”

But Mr. Lacker said an economic recovery sometime in 2009 is a “reasonable expectation” because the Fed’s interest-rate target has come down to 1%; the major shocks that dampened economic activity — such as high energy prices — are subsiding; and the drag from the housing sector “seems likely to lessen in the next year.”

Call me a cock-eyed optimist, but I agree that we're moving past the crisis stage into the recession stage, and that is actually progress. Also, maybe it's the influence of Casey Mulligan, but I believe that things will begin to improve faster than many think possible.

The long term problems will still be there, but we will have an opportunity to right this ship.