While some elements of the economic and financial landscape seem to be clearing up, others are getting murkier. This is always the case, of course – our knowledge about the true state of the underlying economy and markets is always imperfect, so we are continually moving through shades of murk – but it seems to be more turbulent at the moment. A couple of weeks ago, all that the markets were concerned about was the Greek drama; now, some people believe that drama to be winding down (I myself am not at all sure of that; while Italian Prime Minister Mario Monti can opine with great confidence about the level of sovereign yields, we should take into account the fact that not a single soothing pronouncement of any politician or central banker in Europe has been correct for at least a year. Besides, while Italian yields are back near 5%, Portuguese bonds are over 13% again and headed in the wrong direction).
But at the same time, the economic data are getting less uniformly upbeat. Since December, the Citi Economic Surprise Index (see Chart, source Bloomberg) has been well over 50 most of the time, indicating that the data was routinely surprising on the high side. And yesterday, there was a significant upside surprise in Confidence, continuing the theme of an improving albeit not massively improved labor market. But there was also a horrendous downside surprise in Durable Goods Orders, which clocked an abysmal -3.2% ex-Transportation. Economists tried to soothe investors by saying the downturn was the product of expiring tax incentives, but that doesn’t change the fact that (a) knowing the tax incentives were expiring, they predicted 0.0%, and (b) no matter the reason for the decline, the decline was real and has real economic consequences. Is it encouraging that we obviously moved some growth into 2011, where it can no longer do us any good?
Markets in any event didn’t respond to the weak Durables number. I’m merely pointing out that if the Durables data is a prologue, we’re about to leave the steady-strong data period we’ve just enjoyed for the last three months. We’re overdue for some negative surprises. I am not sure this is necessarily bearish for equity markets being buoyed by ample liquidity, but it doesn’t help.
On Wednesday the ECB announced that it had allotted €529.5bln in the 3y LTRO conducted on Tuesday, bringing the total liquidity it has flushed into the market to about €1trillion. One observer pointed out that the ECB provided enough liquidity through these two LTRO operations to cover 72% of all bank debt that is maturing over the next two years, reducing the roll risk that banks would otherwise have faced.
Now, the roll risk is not to be taken lightly, but we should also not cheer too loudly that this element of market discipline has been removed. For a long time, banks have made the basic error of making long-term funding commitments and receiving only short-term funding commitments from depositors and purchasers of bank commercial paper. This need not create a balance sheet mismatch if the bank hedges with interest rate swaps, but the rollover risk doesn’t go away. Enron failed because they were unable to roll short-term debt. Lehman failed in part because of its inability to fund short-term. Some leverage in banking is inevitable, but locking up the leverage for longer terms is critical to surviving rough periods like this…unless, that is, the central bank is willing to bail you out when you get in that situation, and let you live as a zombie for a while.
Weirdly, the commodities markets ignored the wall of money surging in Europe and precious metals plunged today (-5%), supposedly because Bernanke in his semi-annual Monetary Policy Report and testimony before the House Financial Services Committee did not indicate that QE3 was on tap. I’m not sure why that would be a surprise, since no one has been recently hinting that QE3 in the U.S. was imminent, and with three months of high-side surprises on the data it wouldn’t be my base hypothesis…but it’s very strange in my view that these same markets would ignore that the fact that the ECB is providing more than enough QE for both central banks at the moment. European union may not be true union, but European money is money just the same and LTRO1 and LTRO2 will support inflation globally in the same way that QE1 and QE2 did. I am not a fan of focusing exclusively on gold and silver, but commodities still have a following wind despite the setback today.
Why am I so worried about this wall of money, when so few people seem to be? The answer is that I am afraid for the same reason you’re afraid when that huge, mean-looking guy comes sauntering down the street and looking right at you. He might not actually do anything, but you’re well aware that he could do something, and it’s not really in your control. At least I am not the only person worried; for the first time (at least, that I have seen), there is someone actually in the Federal Reserve system who understands and has articulated the argument publicly. In a short “Economic Synopses” publication entitled “Quantitative Easing and Money Growth: Potential for Higher Inflation,” which is located on the research website of the St. Louis Fed, economist Daniel L. Thornton raises the issue that I’ve raised in this column before (for example see here and here). Summing up:
While discussions of the money supply are nearly nonexistent in modern monetary theory and policy, both economic theory and historical experience suggest that a significant and persistent expansion in the money supply will be associated with a significant increase in the longer-run inflation rate.
Dr. Thornton doesn’t say that the expansion of the money supply is automatically going to lead to inflation, only that it is plausible that it may because it has historically done so, and that this is a significant risk that is – as the quote above rather remarkably suggests – essentially not discussed in a serious way within the Fed.
I find it fascinating that more mainstream economists are finally asking these questions. You can also see a version of the argument I made last year via this link to an article by Dr. Steven Cunningham at the American Institute for Economic Research (I must confess that I don’t know anything about the AIER, but they have some interesting articles on the site). The difference is that Dr. Cunningham actually put hypothetical numbers that could result from the dynamic that Dr. Thornton (and I) have mused about.
Maybe I shouldn’t be surprised, but delighted, that this discussion is developing. I’ve said often enough that this crisis was going to serve as a rare opportunity to pit monetarist dogma against Keynesian dogma, at least with respect to inflation. The monetarists have scored a complete knockout, as inflation has risen despite massive output gaps (and prices were rising even in the absolute teeth of the crisis – take out energy, and the housing sector whose bursting helped cause the crisis, and inflation didn’t even decelerate very much). I think the chart in my comment here is the one that Keynesian orthodoxy just has a hard time explaining. In any event, what we are seeing is that thoughtful economists, rather than trying to force models to fit reality, are migrating to models that make more sense and asking the questions those models provoke. That’s encouraging.
Now, whether these ideas are spreading or not, it’s not going to affect central bank actions any time soon. Philadelphia Fed President Plosser can say as often as he likes, as he did today, that the first hikes may come in 2012 (despite the Fed’s promise), but it’s not going to happen unless the economy simply explodes to the upside. While we would all love that outcome, it’s not likely when overburdened debtors are simply being turned into zombie companies, zombie banks and zombie countries. As everyone ought to know by now, the real healing begins…once we kill the zombies.