Fwd: The "Miracle" of Compound Inflation - John Mauldin's Weekly E-Letter

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The "Miracle" of Compound Inflation By John Mauldin | April 22, 2011
In this issue: What the CBO Assumes Scylla and Charybdis – The Federal Reserve and the FDIC La Jolla, Toronto, and Cleveland
Albert Einstein is famously quoted as saying, "Compound interest is the eighth wonder of the world." And compounding is indeed the topic of this week's shorter than usual letter, but compounding not of interest but of inflation. As you might expect, I am giving a great deal of thought as to how we get out of our current financial dilemma of too much debt and deficits that are far too high. While I will use US data for our illustration, the principles are the same for any country. Let's start with a few graphs from the St. Louis Fed database (a true treasure trove of numbers). First, let's look at nominal GDP over the last 11 years, from the beginning of 2000. The data only goes through the third quarter of last year, so sometime this year it is quite likely that GDP will top $15 trillion. So, the economy has grown by roughly 50%, right? Give or take, that's close to 4% growth (back of the napkin calculation). And in dollar terms that is correct. But what if we took out all the growth that was due to inflation? The economy would only have grown to $12.5 trillion. And in fact, "real" or inflation-adjusted GDP growth was just 1.9% on an annualized basis for the last decade, the lowest growth rate since the '30s. What cost on average $1,000 in 2000 is now $1,250. Now, to see this in an interesting graph, the Fed has real GDP based on 2005 dollars. You can see that we are about back to where we were in 2008, prior to the crisis, and growing well below trend. But if we adjust for inflation, growth has not been close to what it was in nominal terms. Now let's run through a few "what-if" scenarios. What if the next 11 years look more or less like the last, with 4% nominal GDP growth? That would mean that in 2022 nominal GDP would be 50% larger than now, right at $22.5 trillion. But that is with only 2% inflation. What if inflation were 4%, with the same growth? Then nominal GDP would be $30 trillion! What a roaring economy, except that gas would $8 a gallon (assuming current levels of supply and demand). In essence, you would need $2 to buy what $1 buys today. Don't even ask about health-care costs. If your pay/income did not double, you would be in much worse shape in terms of lifestyle. That is the insidious nature of inflation. But let's think about that from a federal budget perspective. Let's assume we get 20% of GDP in federal tax revenues, which is roughly a little higher than the historical average. That means total tax revenues would be in the range of $6 trillion. With 2% inflation, revenues would be just $4.5 trillion. If the federal government froze its spending at current levels for 12 years (no inflation adjustment), we would be running large surpluses under either scenario. Higher inflation means US debt is easier to pay back, as nominal GDP is what we pay taxes on, not inflation-adjusted. Inflation is a tried and true method of dealing with too much debt. Inflation is also just another word for default, but it sounds so much better to the ear. What the CBO Assumes The Congressional Budget Office makes projections, based on various Congressional tax bills, as to what future income and expenses might be. But to do that they have to make assumptions about the growth of the economy and inflation. You can go to their website and see their economic forecasting. The data I will be discussing is on page 7, in http://www.cbo.gov/ftpdocs/120xx/doc12039/EconomicTables%5B1%5D.pdf. Let's look at one of the tables. Note that they have nominal GDP at $24 trillion in ten years (not far from my 2% inflation scenario above), but they assume rather robust economic growth for the next five years (beginning with 2012) of well over 3% and inflation down around 1.5%. Not a bad world if we could get it. That's a growth in nominal GDP of about 4.5%. Interestingly, they make those upbeat growth projections assuming that ALL the Bush tax cuts go away, but that's a story for another day. They do compare their projections for the next few years with the "Blue Chip" economists, and they are not quite as optimistic as the economists, so this is not outside of mainstream economic thinking. Look at this table. Think about what it might look like with 2-3-4% average inflation and lower growth. What if we don't get robust growth? That means higher unemployment for longer periods. And what if (God forbid!) we had a recession? Let's me see how many in the audience think we can go another ten years without another recession. Especially if we actually do start to cut spending in a manner that might get the deficits under control? I'm not seeing many hands. But it would mean that the debt-to-GDP level might not look as bad, which might just be the plan, in some circles. But not one I want to be included in. Let's think about what less-robust growth, more inflation, or a recession would do to budget projections. These are not nice thoughts for what is in Texas a beautiful spring day. I was asked several times this week if we will see QE3. My answer is, not for some time; but if we had a recession, what would the Fed do? They only have one lever now, as rates are already low. They are likely to print again. Which is inflationary. Which could give us rising inflation with low growth. What's a Fed to do? And as it is beautiful outside and I want to find a place to dine al fresco, I will close here and finish this line of thought next week. But I leave you with this wonderful essay by my friend and fishing partner David Kotok, who ponders the very problems the Fed is faced with, while in Italy for a Global Interdependence Center event. Does the Federal Reserve face its own version of Scylla and Charybdis? We are all thinking about what happens when QE goes away, at least for a while. Scylla and Charybdis – The Federal Reserve and the FDIC By David Kotok The Strait of Messina separates the eastern coast of Sicily from the southern tip, or "boot," of Italy. This passage, three kilometers wide at its narrowest, is known for its strong tidal currents. Here is where Greek mythology recounted the tales of Scylla and Charybdis. These two monsters were believed to reside in the Strait of Messina, threatening ships and their crews as they transited through the strait from the Ionian Sea in the Mediterranean to the Tyrrhenian Sea, which lies off the western coast of Italy. The Greeks described Charybdis as a monster who manifested herself as a whirlpool, gulping and spitting out huge amounts of water several times a day, creating the treacherous currents. Scylla was a six-headed and twelve-armed monster, who would consume everything that crossed her path. It was by the presence of these two monsters Greek legend explained the shipwrecks and destruction that took place in these perilous waters. Gazing out at the Strait of Messina from the city of Taormina, I have fulfilled a lifelong dream. I remember, over half a century ago, being struck by the stories of Scylla and Charybdis in the course of studying antiquity and reading Greek mythology. A question within me: What led the Greeks to create these two mythological characters? The answer was clarified by our tour guide. He described how the tidal rise and fall of the Ionian Sea level was substantial. He then explained that the Greeks were completely unaware of how the tides were created. They did not conceive of the power of the moon to pull on water gravitationally. Because they lacked this knowledge, they created mythological explanations for the geographical phenomenon they witnessed. At peak velocity, the currents flow in the Strait of Messina at nine knots. This is a fierce current with which to contend, especially in such a narrow body of water. Such a force would easily overwhelm sailing vessels of the types used in ancient times. It is now understandable how Greek legend brought forth the myths of Scylla and Charybdis. What else could possibly explain the deadly surges ships and their crews had to fight against? Had the sailors known about the tides, would they have operated differently? Would they have timed the tides? How much of history would have changed if the epistemological questions were answered, not with mythological characters but with facts and experience? In addition to touring in Sicily, the GIC meetings in Italy afforded conversations with economists, financial advisors, investors, and colleagues. They lead me to a difficult and intricate question. Does the Federal Reserve face its own version of Scylla and Charybdis? The Fed is completing its program of asset purchases, called by many "QE2." As this program reaches its completion this summer, many participants expect the Fed to call it quits on additional purchases. The current market expectation is that the Fed will then go into a mode of preserving the then-existing size of its balance sheet. As maturities occur or paydowns take place in the mortgage-related portfolio, the Fed will replace those maturities and paydowns with purchases of treasuries. Essentially, the Fed will go into a holding pattern and await "incoming data." Meanwhile, the Federal Deposit Insurance Corporation (FDIC) has just introduced a new factor. We have written about it in the past. Since April 1, the FDIC now costs a bank an additional between and ten and forty-five basis points as a fee on its assets. That is a payment the bank must make – any American bank – to the FDIC. In making monetary policy decisions, the Fed did not have to contend with this cost prior to April 1. Now the FDIC has interfered in a way that adds a cost to the banking system at the very time the Fed is engaged in easing. The mechanics of the FDIC fee act as a form of a tightening. We estimate that the impact is the nearly the same as if the Fed were to have raised interest rates about 15 basis points. By some "guess"timates, the FDIC has taken back all the easing provided by all of QE2. In the last day or two, we have seen the Federal Funds rate trade under ten basis points. Nine basis points is the price of a transaction between two banks, in which one takes excess or additional reserves and sells it to the other. It is also the price at which the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, take their incoming cash flows and sell them to the banking system. GSEs are not permitted to deposit monies with the Federal Reserve, so they have no choice but to sell into the Federal Funds market and get whatever they can, or otherwise earn nothing. Clearly, the selling pressure from the GSEs is driving the Federal Funds rate down. At the same time, the FDIC fee means that it is costing more for banks that would buy the Fed Funds, so we have a double-edged sword at work. Is this interfering with the Fed's monetary policy intentions? Is it setting the Fed or the markets up for a shock when the policy changes? Epistemological questions may be answered with facts, examination, research, and experience. However, the United States has never engaged in monetary policies of the type presently underway. We have no experience to guide us. Has that led us to the error of the Greeks? The alternative to relying on legend would be to see if anything can illuminate our present circumstances. Then we can build models for guidance. Our assertions may be right or wrong. That remains to be seen, but what we do now know is that we have a construction in which the Federal Reserve pays banks 25 basis points for its excess reserves, which are deposited at the Fed. At the same time, the pricing of overnight reserves traded between banks is now down to nine basis points and has been falling erratically. Simultaneously, there is a fee structure that costs banks 10 to 45 basis points, depending on the size and characteristics of the bank, and therefore that pricing is acting as a "wedge" and altering the composition of monetary policy. Think of it in the following way: a basis point on one million dollars is one hundred dollars. As stated before, the overnight interest rate on Federal Funds is nine basis points. Nine basis points are 900 dollars per year on one million dollars of reserves traded between two banks. If you divide 900 dollars by 365 days, you can see that for a smaller bank to do an overnight, million-dollar transaction in Federal Funds is to gain that bank about two and a half dollars. It is simply too much trouble for the bank to go through for such little result. Add three zeros and think in terms of one billion instead of one million. You can see that for a large bank it is still not substantial, and so the intention of Federal Reserve policy making is being altered by this present combination of pricing. We are already seeing banks reorganize themselves to qualify for the lower FDIC fee schedule. What does the pricing indicate? Does it tell us that the value of excess reserves has reached zero? There are indications that affirm this. When you look at the repo market and the pricing of the collateral used in the repo market, you have an indication of how repo is priced. It is currently near zero. One has to ask oneself why this is so. Is there such weak demand as to price the value of overnight liquidity at zero? The alternative question is: has the FDIC effect driven that overnight liquidity pricing to zero? In fact, is there so much excess liquidity that we now face the true confrontation of the "zero bound" in monetary policy? The epistemological question is as classic as Greek mythology: how do we know, and how can we arrive at an answer? The second derivative of that question is what happens when the Fed finally changes this policy. Furthermore, is this FDIC-altered policy the policy that the Fed wants? The home-mortgage interest rate is higher than when the Fed started QE2. The housing market continues to be in doubt and prices in many regions are falling. The economy got an initial burst after the financial crash of Lehman and AIG, but subsequently, economic growth rates are falling. We see revisions of growth rates ratcheting downward. The policy has clearly weakened the US dollar, as allocations of dollars are going elsewhere. What is not clear is whether that reallocation is taking place because of choices made by holders of dollars, like state sovereign oil funds, or being made by investors, or both. Epistemological questions face the Federal Reserve, investors, the US economy, and the world. The true origins of tidal forces were not apparent to the Greeks as they transited the Strait of Messina. They thought they understood; they held strongly to their belief system. The Greeks described their theories through mythological figures, and even deified them. 2500 years later, we understand how some epistemology failings misled the Greeks. As for the US and its policy at the Federal Reserve, we are operating on legend and uncertainty. As investors, we confront the likelihood that the short-term interest rate will remain near zero for the rest of this year. The gulping and spitting of excess reserves is coming from the modern Charybdis. The FDIC fee is the modern-day Scylla. Investors will face the "zero bound" in interest rates for a while longer. They can sit on their cash and earn nothing. They can fret and wring their hands about a ramp-up in inflation, but the evidence so far does not support it. They can stay in the US dollar, in which case they can watch their dollars weaken relative to the rest of the world. Travelling in Sicily or Rome validates how strong the euro is relative to the dollar. All you have to do is buy a dinner or hotel room. We are back in our office. It has been an enlightening trip. We have been able to examine some history while discussing monetary policy and financial affairs. This writer, finally, and after nearly 60 years, was able to witness Scylla, Charybdis, and the Strait of Messina. Lastly, we return during the Christian Holy Week and during the Jewish Passover festival. We celebrate faith and freedom. We do not actually burn a sacrificial animal. We invoke it as a symbol of the past. This year we do so after being reminded that those ruins of temples and amphitheaters, those paths and stone quarries, are evidence of slavery. The Trojan, Carthaginian, Greek, Roman, Arab, Norman, Spanish, and other conquerors of Sicily all used slaves. To a human being, legend and deification can be a dangerous thing. Freedom is as fragile as a weakened monetary and political system will make it. Modern mythology resides in the temples in Washington, not in the Messina. La Jolla, Toronto, and Cleveland Dice Have No Memory This Thursday I head for La Jolla to be with my partners at Altegris Investments for our 8th annual Strategic Investment Conference. So many old and new friends will be there, as it is again sold out. It is something I really look forward to. Then Sunday I fly to Toronto, where I will be with host Adam Felesky of Horizon Exchange Traded Funds and speak at noon on Monday. I will be in Cleveland on Wednesday, speaking in Elyria in the evening. Let me commend to you a new book by my great friend Bill Bonner, of Daily Reckoning fame. It is called Dice Have No Memory. It is a collection of the best of his essays. I once said that when I read Bill I feel like a house painter standing before a Rembrandt. He is one of the really great writers I know, and can tell a tale with a point like few other writers. He is just so gifted. You can read him in short pleasurable bursts in the evening, or of an afternoon with a nice glass of wine. And finally, a fun close. I got a note from old friend James Altucher. It seems he had 105,000 unopened emails in his gmail account. For some reason he went to the oldest and it was my forecast for 2005. "Looks like you were right," he noted. Quoting from his blog: "Here's the critical piece of the email: "'When the next recession comes in 2007, the stock market will drop. Average drops during a recession are 43%. The Baby Boomer generation will realize that the stock market is not going to bail out their retirement hopes.' "Dear John, why didn't I read that email? It would've saved me some grief (assuming I would've then paid attention to it). Should I read your latest book that came out? Or will I wake up in the middle of the night screaming?" I had forgotten that little piece of lucky prognostication. I may have to go back and read to figure out why I came to that conclusion. Maybe it could help me out of my own current state of confusion. (Altucher's whole rather funny piece is at http://www.jamesaltucher.com/2011/04/105633-unread-emails/. And where did he find that picture of me with Tiffani and Peter and Barbara Bernstein? Wow. An old friend sorely missed.) Have a great week and a wonderful Easter weekend. I see family and fun in my future. Your thinking I need to buy more gold because of inflation analyst, John Mauldin John@FrontlineThoughts.com Copyright 2011 John Mauldin. 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Fwd: Charles Plosser and the 50% Contraction in the Fed's Balance Sheet - John Mauldin's Outside the Box E-Letter

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Date: Tue, Apr 19, 2011 at 5:49 PM
Subject: Charles Plosser and the 50% Contraction in the Fed's Balance Sheet - John Mauldin's Outside the Box E-Letter
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	Contact John Mauldin Print Version Download PDF Volume 7 - Issue 16 April 19, 2011 Charles Plosser and the 50% Contraction in the Fed's Balance Sheet Dr. John Hussman is no stranger to Outside the Box readers. And his recent posting has my mind reeling. In essence he is saying that if the Fed wants to stop the QE and allow rates to rise, they must either reverse the QE or bring on inflation. And he does it with numbers and his usual strong reasoning. I really did read this 3-4 times, thinking through the implications. "There are a few possible outcomes as we move forward. One is that the economy weakens, and the Fed decides to leave interest rates unchanged, or even to initiate an additional round of quantitative easing. In this event, it's quite possible that we still would not observe much inflation, provided that interest rates are held down far enough. Unfortunately, the larger the monetary base, the lower the interest rate required for a non-inflationary outcome. T-bills are already at less than 4 basis points. In the event of even another $200 billion in quantitative easing, the liquidity preference curve suggests that Treasury bill yields would have to be held at literally a single basis point in order to avoid inflationary pressures." You can read his latest work at www.hussman.net . Note on Finland. The True Finns took over 19% of the vote, with the largest party getting slightly more than 20% and the number two a little less. Basically, 15% of Finnish voters used the True Finns to register their displeasure at the bailout at the cost of Finnish taxpayers. Germany is starting to talk about "restructuring"Greek debt, another word for default. The German banks must be getting in better shape if the talk is out in the open among German leaders – much as I said a year ago. Stay tuned. Your wondering how the Fed will pull this off (without a real problem developing) analyst, John Mauldin, Editor Outside the Box Charles Plosser and the 50% Contraction in the Fed's Balance Sheet John P. Hussman, Ph.D. Last week, an unusual event happened in the money markets that should not escape the attention of investors. The yield on 3-month Treasury bills plunged to less than 5 basis points. As I noted this past January in Sixteen Cents: Pushing the Unstable Limits of Monetary Policy , a collapse in short-term yields to nearly zero is a predictable outcome of QE2, based on the very robust historical relationship between short-term interest rates and the amount of cash and bank reserves (monetary base) that people are willing to hold per dollar of nominal GDP: "Barring external upward pressures on interest rates, a further non-inflationary expansion of the Fed's balance sheet of $400 billion, to $2.4 trillion (as contemplated under QE2), would imply the need for 3-month Treasury yields to fall to just 0.05%. Higher rates would be inflationary, because monetary velocity would not be sufficiently restrained. In effect, a further expansion in the monetary base requires that short-term interest rates decline enough to ensure a significant drop in velocity. "In terms of liquidity preference, a completion of QE2 requires liquidity preference to increase to 16 cents per dollar of nominal GDP - easily the highest level in history. We hit 15 cents at the peak of the credit crisis. To get past that, short-term interest rates will have to decline to the point where there is no competition from interest rates at all, but where the slightest amount of interest rate pressure would either drive inflation higher or force a massive contraction in the Fed's balance sheet to avoid that outcome. Then what?" On further review, that "16 cents" figure actually underestimates how extreme the situation will be within a few weeks. The monetary base has already surpassed $2.4 trillion. Indeed, as of Wednesday, the U.S. monetary base stood at $2.49 trillion. QE2, as presently contemplated, will actually bring the U.S. monetary base to over $2.6 trillion. As the Fed notes in its report Domestic Open Market Operations during 2010: "With progress towards its statutory objectives of maximum employment and price stability disappointingly slow in the fall of 2010, most Committee members judged it appropriate to provide additional monetary accommodation. Accordingly, the FOMC announced at its November meeting that it intended to increase the total face value of domestic securities in the SOMA portfolio to approximately $2.6 trillion by the end of June 2011 by purchasing a further $600 billion of longer term Treasury securities in addition to any amounts associated with the reinvestment of principal payments on agency debt and MBS." With nominal GDP at about $15 trillion, the U.S. economy will then have to hold well over 17 cents of base moneof base money per dollar of GDP. In order to prevent inflationary impact from this level of monetary base (that is, to prevent base money from becoming a "hot potato" that nobody is willing to hold), we estimate that 3-month Treasury bill yields will have to be sustained no higher than a few basis points until the Fed reverses course. Tracking QE2 p>Market participants widely assume that they are relatively "safe" to take speculative risk through mid-year, on the belief that the Fed's policy of quantitative easing will be sustained through the end of June. But looking at the monetary data, it is not clear that the Fed's statement "by the end of the second quarter" means "precisely until the end of the second quarter." We can evaluate the pace of QE2 in two ways. One is by looking directly at the monetary base. QE2 transactions expand the Fed's balance sheet, increasing its assets (Treasury debt) and simultaneously increasing its liabilities (currency and bank reserves). So we can measure the progress of QE2 by calculating the change in the monetary base since QE2 was initiated. Monetary Base 11/03/10: $1985.1 billion Monetary Base 04/06/11: $2490.3 billion QE2 completed based on change in Monetary Base: $505.2 billion A second way to evaluate the pace of QE2 is to go directly to the information on "permanent open market operations" (POMO) conducted by the Federal Reserve Bank of New York. However, the POMO figures also include reinvestment of principal repayments from mortgage-backed securities. So a portion of these transactions do not change the monetary base - they simply exchange mortgage-backed assets with Treasury securities. The cumulative par amount accepted by NY FRB from 11/04/10 through 04/07/11 is $523.2 billion A $600 billion addition to the monetary base from QE2 would leave the Fed with only about $94.8 billion of QE2 transactions remaining. Alternatively, the targeted size of the Fed's SOMA (System Open Market Account) portfolio is $2600 billion at the end of QE2 (this is the primary repository of assets backing the monetary base, the remainder representing the Maiden Lane portfolios and about $11 billion in gold). As of April 6, the SOMA portfolio was already at $2421 billion. This would leave a larger $179 billion remaining to QE2, putting the program about 70% complete. The average pace of Fed purchases since February has been about $5.5 billion per business day, with about $4.7 billion adding to the monetary base, on average (the rest representing mortgage principal reinvestments). That leaves QE2 somewhere between 20 to 38 business days from completion. The next FOMC meeting is on April 26-27. While there has been some debate on whether the Fed might decide at that meeting to terminate the policy of QE2 early, that debate is actually moot. By the time the Fed meets later this month, QE2 will already be at least be at least 85% complete. Charles Plosser and the 50% contraction of the Fed's balance sheet A week ago, Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should increase short-term interest rates to 2.5% "starting in the not-too-distant-future," preferably during the coming year. Given the robust historical relationship between short-term yields and the amount base money per dollar of nominal GDP, we can make a fairly tight estimate of how much the Fed would have to contract the monetary base in order to achieve a 2.5% yield without provoking inflationary pressures. While the monetary base will be over $2.5 trillion by the end of this month, a 2.5% interest rate would require a contraction of about $1.4 trillion in the Fed's balance sheet, to a smaller monetary base of just over $1.1 trillion. [Geeks Note: The interest rate estimates here are based on the inverse of the liquidity preference function, which explains 96% of the historical variation in money holdings as a fraction of nominal GDP. The dynamic equation is i = exp(4.25 - 129.87*M/PY + 84.42*M/PY_lagged_6_mos). This has the steady-state of i = exp(4.27 – 45.5*M/PY). See the original " Sixteen Cents" piece for further details]. In his comments, Plosser discussed a plan to sell about $125 billion in Fed holdings for every 0.25% increase in the Fed Funds rate. That overall estimate (implying $1.25 trillion in total balance sheet reductions) is slightly low, but close to our own calculations. Plosser's estimates correctly imply that a 2.5% non-inflationary interest rate target would require the Fed's balance sheet to contract by more than 50%. The problem, however, is that the required shift in the monetary base is not linear. It's heavily front-loaded in the sense that massive reductions the Fed's balance sheet would be required in the first few hikes (see the scatter plot near the top of this comment). Based on the historical liquidity preference relationship (which explains about 96% of the variation in historical data), and assuming nominal GDP of $15 trillion, the following are levels of the monetary base consistent with a non-inflationary increase in short-term interest rates up to 2.5%. The non-inflationary provision is important. You can't just allow interest rates to rise without contracting the monetary base. Otherwise, as noted earlier, non-interest bearing money would quickly become a hot potato and inflation would predictably follow: Treasury bill yields and monetary base consistent with price stability 0.03%: $2.60 trillion 0.25%: $1.92 trillion 0.50%: $1.68 trillion 0.75%: $1.54 trillion 1.00%: $1.44 trillion 1.25%: $1.36 trillion 1.50%: $1.30 trillion 1.75%: $1.24 trillion 2.00%: $1.20 trillion 2.25%: $1.16 trillion 2.50%: $1.12 trillion The upshot is that Plosser's estimate of about $125 billion in asset sales for every 0.25% increase in yields is a reasonably accurate overall average, but the profile of required asset sales is enormously front-loaded. The first hike will be, by far, the most difficult. In order to achieve a non-inflationary increase in yields even to 0.25%, the Fed will have to reverse the entire amount of asset purchases it has engaged in under QE2. Indeed, the last time we observed Treasury bill yields at 0.25%, the monetary base was well under $2 trillion. In my view, this is a major problem for the Fed, but is the inevitable result of pushing monetary policy to what I've called its "unstable limits." High levels of monetary base, per dollar of nominal GDP, require extremely low interest rates in order to avoid inflation. Conversely, raising interest rates anywhere above zero requires a massive contraction in the monetary base in order to avoid inflation. Ben Bernanke has left the Fed with no graceful way to exit the situation. As a side note, it's probably worth noting that the Federal Reserve has already pushed its balance sheet to a point where it is leveraged 50-to-1 against its capital ($2.65 trillion / $52.6 billion in capital as reported the Fed's consolidated balance sheet ). This is a greater leverage ratio than Bear Stearns or Fannie Mae, with similar interest rate risk but less default risk. The Fed holds roughly $1.3 trillion in Treasury debt, $937 billion in mortgage securities by Fannie and Freddie, $132 billion of direct obligations of Fannie, Freddie and the FHLB, and nearly $80 billion in TIPS and T-bills. The maturity distribution of these assets works out to an average duration of about 6 years, which implies that the Fed would lose roughly 6% in value for every 100 basis points higher in long-term interest rates. Given that the Fed only holds 2% in capital against these assets, a 35-basis point increase in long-term yields would effectively wipe out the Fed's capital. Still, the Fed also earns an interest spread between its assets and its liabilities, providing about 3% annually (as a percentage of assets) in excess interest to eat through, which would allow a further 50 basis point rise in interest rates over a 12-month period without wiping out that additional cushion. In that case, the interest paid on the Federal debt held by the Fed would be used to cover the Fed's losses, rather than being remitted back to the Treasury. In any event, it is clear that if the Federal Reserve was an ordinary bank, regulators would quickly shut it down. To avoid the potentially untidy embarrassment of being insolvent on paper, the Fed quietly made an accounting change several weeks ago that will allow any losses to be reported as a new line item - a "negative liability" to the Treasury - rather than being deducted from its capital. Now, technically, a negative liability to the Treasury would mean that the Treasury owes the Fed money, which would be, well, a fraudulent claim, and certainly not a budget item approved by Congress, but we've established in recent quarters that nobody cares about misleading balance sheets, Constitutional prerogative, or the rule of law as long as speculators can get a rally going, so I'll leave it at that. Looking Ahead Assets compete. If you create a huge volume of non-interest bearing money, somebody somewhere has to hold it. So long as close substitutes such as Treasury bills offer any competition at all, investors try to shift out of the non-interest bearing stuff into the interest-bearing stuff. Of course, in equilibrium, that sort of shift is impossible in aggregate since somebody still has to hold the money. So the result of the Fed's quantitative easing is that short-term interest rates have dropped to about zero. As long as that happens, people are OK holding the money, and you don't need to have inflationary consequences, but the sensitivity to small errors becomes magnified. Meanwhile, QE has also caused investors to seek out riskier assets, and the result has been an increase in stock prices, commodity prices and a variety of speculative securities. As prices rise, prospective future returns fall. The process stops at the point where all assets, on a maturity- and risk-adjusted basis, are priced to achieve probable returns near zero. And so here we are. There are a few possible outcomes as we move forward. One is that the economy weakens, and the Fed decides to leave interest rates unchanged, or even to initiate an additional round of quantitative easing. In this event, it's quite possible that we still would not observe much inflation, provided that interest rates are held down far enough. Unfortunately, the larger the monetary base, the lower the interest rate required for a non-inflationary outcome. T-bills are already at less than 4 basis points. In the event of even another $200 billion in quantitative easing, the liquidity preference curve suggests that Treasury bill yields would have to be held at literally a single basis point in order to avoid inflationary pressures. A second possibility is that we observe any sort of external pressure on short-term interest rates, independent of Fed policy. In that event, the Fed would have to rapidly contract its balance sheet in order to avoid an inflationary outcome. As noted above, even a quarter-percent increase in short-term interest rates would require a full-scale reversal of QE2. Alternatively, the Fed could leave the monetary base alone, and allow prices to restore the balance between base money and nominal GDP. In order to accommodate short-term interest rates of just 0.25% in steady-state, leaving the monetary base unchanged at present levels, a 40% increase in the CPI would be required. I doubt that we'll observe this outcome, but it provides some sense of what I mean when I talk about the Fed pushing monetary policy to its "unstable limits." In case the foregoing comment seems preposterous, it's helpful to remember that the U.S. economy has never held even 10 cents of monetary base per dollar of nominal GDP except when short-term interest rates have been below 2%. We are presently approaching 17 cents. So you can think of the situation this way. Short-term interest rates of 2% are consistent with money demand of about 10 cents of base money per dollar of GDP. To get there, with the monetary base unchanged, you would have to increase nominal GDP (mostly through price increases) by 70%. Again, because the relationship is non-linear, this impact would be front-loaded. Significant inflation pressure would emerge in response to an increase of even 0.25% - 0.50% in short-term interest rates. Historically, it has taken about 6-8 months for such pressures to translate into observed inflation. A third possibility is that the Fed intentionally reduces the monetary base, gradually moving interest rates higher as Plosser suggests. This is undoubtedly the best course, in my view, but it's important to recognize that there are already substantial risks baked in the cake as a result of the Fed's recklessness up to this point. The first 25 basis points will require an enormous contraction of the Fed's balance sheet. Risky assets have already been pushed to price levels that now provide very weak prospective returns. Our 10-year annual total return projection for the S&P 500 remains in the 3.4% area. Expected returns for shorter horizons are near zero or negative, but are associated with greater potential variability. Commodity prices have been predictably driven higher by the hoarding that results from negative short-term interest rates (if you expect inflation, but interest rates don't compensate, you have an incentive to buy storable goods now, and this process stops when commodity prices are so high that they are actually expected to depreciate relative to a broad basket of goods and services, to the same extent that money is expected to depreciate). In short, the outcome of the present situation need not be rapid inflation, and need not be steep market losses. Rather, the predictable outcome is instability. If you put a brick on a flagpole, and keep raising the flagpole and adding more bricks, you don't have the luxury of predicting when the bricks will fall, or in what direction. What you do know, however, is that the situation is not stable. People may briefly be rewarded for standing directly below, cheering, while branding anyone who keeps their distance as fools or worse. But if you look closely, those cheerleaders are typically hiding enormous welts, scars and gashes from being repeatedly smacked over the head - if you look even closer, you'll find that they have typically thrived no better for it over the long-term. While it's possible to continue without unpleasant events, the Fed has already placed the course of the economy, inflation, and the financial markets beyond a comfortable scope of control should surprises emerge. Market Climate As of last week, the Market Climate for stocks was characterized by a syndrome of overvaluation, overbought conditions, overbullish sentiment, and rising yield pressures that has historically been hostile to stocks on average. Every component of this syndrome worsened last week. Our estimate of 10-year projected total returns for the S&P 500 is presently just 3.4% annually, the major indices remain overbought on an intermediate-term basis, and Investors Intelligence reports that bullish sentiment has surged to 57.3% bulls and only 15.7% bears, which is close to the spread we observed at the 2007 market peak. Investors Intelligence observes "extreme readings, as we are experiencing right now, historically have major significance." Meanwhile, upward interest rate pressures reasserted themselves last week. Both Strategic Growth Fund and Strategic International Equity remain well hedged here. Importantly, our defensive stance is not driven by the expected completion of QE2, nor our considerable doubts about the potential for a successful economic "handoff" to the private sector in the face of tightening federal and state budgets and a fiscal cliff as stimulus funding to the states rolls off about mid-year. All of those considerations make us aware of potential risks, but in practice, we are defensive based on testable and observable market conditions that have historically been associated with a negative return/risk profile, on average. Though the market has not recovered to its February highs here, the measures that define the "overvalued, overbought, overbullish, rising yields" syndrome are actually worse now, on balance. While there remains a possibility that we can clear some component of this syndrome without also observing a strong deterioration in broader market internals (including breadth across individual stocks, industries, and sectors, leadership measures, price-volume action across a wide range of industries and security types, and other factors), conditions are so extended here that there is now only a narrow "window" between a market decline that would be sufficient to clear the overbought or overbullish components of the present hostile syndrome, and a market decline that would signal a larger and more robust shift toward investor risk aversion. Put simply, a market decline that clears this syndrome could be a whopper. That said, we'll respond to the evidence as it emerges, and will continue to look for opportunities to accept exposure to market fluctuations as the overall return/risk profile improves. In bonds, the Market Climate deteriorated last week. On Tuesday, in response to evidence of accelerating yield pressures, as well the recognition that QE2 was much further along than investors widely seem to believe, we substantially cut our bond duration to about 1.5 years in Strategic Total Return. In gold, the further advance in prices on shallow corrections brings us back to the concern I expressed a few weeks ago about bubble-type action. Silver prices are displaying even more exaggerated "log-periodic" behavior, as are some agricultural commodities. We don't know exactly when this will end, but we would prefer to scale back early rather than late. A Sornette-type analysis (see Anatomy of a Bubble ) suggests a "finite-time singularity" within days or weeks. Any additional upward leaps in price, with very shallow corrections and increasing volatility at 10-minute intervals would strengthen that impression further. I've been generally bullish on gold since September of 2000, when it was below $300 an ounce and we observed a clearly favorable shift in the set of conditions I noted in Going for the Gold . Our actual gold models are more elaborate in practice, but as I noted back then, precious metals shares tend to perform far better in the face of falling Treasury yields, particularly when the ISM indices are weak. Those conditions are absent at present, and the recent extreme price behavior is of some concern. The rally in gold stock prices late in the week gave us an opportunity to clip our exposure back to about 6% of assets in Strategic Total Return. The risks in precious metals are clearly increasing. * As a technical note, I've seen a comment from a number of analysts lately, along the lines of "there's been an 80% correlation between the size of the monetary base and the level of the S&P 500 since early 2009." This is just poor statistics. There's little doubt that the two have been related, but the seemingly impressive strength of the correlation is completely an artifact of the shared upward slope. If you take any two series with generally diagonal trends and little cyclical fluctuation, you'll always get a "strong" correlation. That's not to say that the stock market has not been substantially driven by Fed policy, but rather to warn against careless statistical reasoning more generally. I guarantee that there's also a correlation of more than 80% between the height of a baby kangaroo in Melbourne and the cumulative number of eggs laid by a hen in Oklahoma since early 2009. John F. Mauldin johnmauldin@investorsinsight.com You are currently subscribed as jmiller2000@gmail.com. To unsubscribe, go here. Reproductions. If you would like to reproduce any of John Mauldin's E-Letters or commentary, you must include the source of your quote and the following email address: JohnMauldin@InvestorsInsight.com. 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