"I explained that the deflation hype was rather exaggerated"

Emre Deliveli also sees Inflation ahead:

"At my inaugural column last week, I explained that the deflation hype was rather exaggerated, as the two commonly-quoted signs of deflation, U.S. October inflation and yields on American inflation-protected securities, were not accurate indicators at all. However, other market prices such as weakening oil and dividend yields on stocks surpassing yields on 10-year Treasuries have been pointing to deflation as well.

It seems that the market is definitely pricing for Deflationary Inferno even if deflation itself is not very likely. However, the alternative, Inflationary Purgatorio, is still far off the the markets’ radar. While many have learned to trust markets painfully, my overconfidence stems from the ongoing and prospective firefighting. After all, as a reader rightly noted, “numbers are important, but it is government policy that will shape the future”. And both fiscal and monetary policy are pointing towards eventual inflation.

The direction of monetary and fiscal policy

Even though he has been quick to announce his Economics team, you should not expect anything on the fiscal front until Obama settles in. This means that we are not likely to see the effects of fiscal policy on the economy until the second half of 2009 at the earliest. But once the stimulus comes, it is likely to be on the larger side because as this year’s Nobel Prize winner Paul Krugman notes, unlike monetary policy, fiscal policy is inherently asymmetric: It is easier to fix too much of it with contractionary monetary policy than too little of it with another stimulus package. Therefore, when it comes, the fiscal boost is likely to have an inflationary bias.

While fiscal policy is still far away, the Fed has had its hands full for some time now. While traditional monetary easing has not been effective, it has been complemented with more unorthodox tools such as intervening directly in credit markets. As the so-called quantitative easing is now semi-official, we can expect more of such creative policy from the Fed, whose balance sheet is starting to look increasingly like a hedge fund’s. In a similar vein, last week’s announcement that it would purchase USD 100bn in debt obligations from GSEs –government sponsored enterprises- is a first step in the monetization of public debt. With the low money multipliers, Fed’s actions are having a very limited impact on money supply for now. But the mere fact that the Fed is willing to shift to the extreme of policy means that it is not worried about inflation at this point."

This is what I believe is happening as well. Purgatorio is the Mezzanine Tranche of the Afterlife.

"Market implications, risks, and short-run outlook

Crises are always marked by the breakdown of time-tested relationships, but two interesting anomalies have emerged lately: Stocks have rallied while yields on the long end of the curve have fallen and the well-known positive correlation between dollar and long-dated Treasuries has broken. The scenarios I have explained above might shed some light on what is going on.

The recent flattening of the yield curve hints that quantitative easing is well-understood by markets, but its implications are not: All that liquidity and fiscal stimulus could find its way to inflation, which would in turn raise interest rates. With a huge US and global bond supply, we could even end up with a considerable bond market crash and another recession before the recovery from the current one is completed. While this dreaded W-shaped outlook is unlikely to pose a threat before the second half of 2009, it is in line with the anomalies above and paints a rather confusing outlook for the dollar (to be continued)."

I have already posted that we might have a bond market crash, and you know my theory of why these rates are so low. I believe it has to do with an overreaction based on the fear and aversion to risk, and an accompanying flight to safety.

"I still see inflation as the bigger risk. "

Excellent post on News N Economics:

"The Fed’s liquidity measures have become an obsession of mine; I am simply befuddled about the the massive liquidity injections that the Fed has undertaken to try and unclog a stopped-up banking system. Banks are sitting on the new funds and holding them as excess reserves; however, interbank lending has not come to a grinding halt because the Fed has injected $1 trillion into the banking system over the last year. But that's not the only reason: the re-distribution of funds across the regional Federal reserve banks indicates that there will always be a positive demand for interbank (overnight) funds."

Please read the whole post. Here's where I really agree:

"The Fed is smashed between a rock and a hard place; its massive liquidity injections still have not penetrated the brick wall of term lending. Overnight lending is flowing, but in order for the real economy to function, term lending must flow as well. Its various funding facilities for money market and commercial paper are a good start, but until these funds flow to the real economy, the credit crisis will continue. And each week that the credit crisis continues, the risks to the real economy grow.

I still see inflation as the bigger risk. Eventually the banking system will unclog, and the funds will flow. I believe that a signal that lending is clearing up again will be when markets price in the risk of inflation."

I see inflation as the looming problem as well.

"Why didn’t policymakers think to look at these, instead of relearning everything again? "

Interesting post by Felix Salmon. He interviews Citibank chairman Bill Rhodes:

"A Citibanker since 1957, few bankers have racked up more air miles than Bill Rhodes over the course of their careers, and probably none have done so in the cause of resolving so many crises, from Jamaica to Nicaragua to Korea to Uruguay, with many in between. His name is especially associated with the resolution of massive Third World debt problems in the early Eighties.

But Rhodes freely admits that he’s never seen a crisis as big or as dangerous as the one we’re in now.

FS How did we get to this place?
WR Confidence disappeared and was replaced by fear, all of which was exacerbated by the policymakers’ incremental approach to problem resolution – we’re letting one company go, but not letting the next one. The decrease in market confidence was seen in the interbank lending market. When liquidity started to become scarce, the lack of confidence grew worse. Liquidity, capital, and then deposits have become king, all in that order. First you need to have liquidity. Then you need capital. Investment banks suddenly realised that they needed to have a deposit base and that they couldn’t go to the markets easily and cost-efficiently to raise funds.

FS You say that policymakers exacerbated the problems. Were they too complacent?
WR We’ve had two false dawns here. The first one was the period around November, because the initial hit to the system in August was assuaged by the tremendous amount of liquidity that the Fed, the European Central Bank and others put in the system. But in spite of those actions, we never got the confidence back in the interbank market and among counterparties. We got into December and January, and the problems started to become more apparent. The cost of LIBOR and the monoline insurance company problems were indicators that the problems in the markets hadn’t been resolved.

Then we suddenly had Bear Stearns in March. People thought once that bail-out was complete, the worst was over. I remember attending meetings where some of the seniors of major investment banks were saying, ‘The worst is over in the credit markets because the investment banks and brokerage houses were given access to the Fed window.’ And that’s what you also heard in Washington. I was hearing all sorts of comments of reaching the ninth inning of a nine-inning baseball game. And all this was being said in spite of the credit markets still being unsettled and the housing markets continuing their decline into what amounts to the worst housing crisis since the Great Depression."

Read the whole interview. Here's my comment:

Posted: Nov 04 2008 01:51am ET

First of all, thanks for the Rhodes interview. That's just what I was looking for when asking for asking people involved.
Second, here:
"Confidence disappeared and was replaced by fear, all of which was exacerbated by the policymakers’ incremental approach to problem resolution – we’re letting one company go, but not letting the next one.'
This is what I believe was the main cause of the crisis. The uncertainty over the implicit and explicit assumptions about government involvement, and the belief that it would intervene.
Third,here:
"Financial institutions need to do a much better job of risk management and corporate governance. The regulators have to do a better job on the regulatory oversight. You’ve got to look at both the buy-side and the sell-side of the market. In many cases the sell-side was pushing paper that they probably shouldn’t have, but at the same time, the buy-side wasn’t properly analysing the investments being taken on to their balance sheet. So it cuts both ways.

On the regulatory side, what we don’t need is a lot of over-regulation which is what we may be headed for – what we need is smart regulation that is properly enforced.

Where the ratings agencies are going to come out of all of this is not clear. I think there was an over-reliance by individual institutions on rating agencies. I also think in some cases there was an over-reliance by the regulators on ratings agencies."
I believe that some investments were fraud or negligence,and this was the second big cause,but there was some lack of knowledge by investors.
Third, I agree about regulation.
Fourth, I've already said that I thought that ratings agencies were another real problem,but you reminded me that these banks, etc., had done some of their own rating.
Great article from my point of view.

By DonthelibertarianDemocrat