Deflation/Hyperinflation

[kent nickell]

I like this comment on why deflation is a bigger reality than the prospect of hyperinflation. I like his concept that insolvency is the problem and that the definition of solvency based on credit is a misperception. If you consider that people were using money from home equity loans and credit cards to keep cash flow for purchases going and then all of this stopped and all the 'markers' got called in the balance sheet would often be negative. Then add to that the decreasing value of the actual assets like home prices and then decreasing stock prices and people cannot continue to consume to support the economy. I think a lot ot the bailout money is being used by banks to try and regain solvency. A return to solvency by banks, companies and individuals that does not depend on credit (or at least will depend on reasonable credit) will be very deflationary but lead eventually to more stability and sustainability. I think the bailouts however need to be carefully crafted to try and attain this new sustainable economic pattern and to mitigate the social consequences of this readjustment..


"""Wow Roubini is back to sounding more bearish all the time. I think even he sees that nothing the Fed or the Treasury or the world central banks can do will turn back the economic tsunami we face. Simply put, they cannot create capital, they can only create credit. However, credit and liquidity are not the problem. Solvency is. Or rather the definition of solvency. We allowed the definition of solvency to become that an entity had enough access to credit to satisfy cash flow. Therefore, many (most?) entities are not solvent when you look at a more traditional method of measuring it (say the balance sheet, for instance).

Therefore, the continued application of bailouts aimed at increasing credit (like funding GMAC so they can 'lend again') will not work. Because the consumers they want to borrow are insolvent. And in fact, they have been insolvent for a very long time. They are insolvent, they are finally realizing it, and they will not be buying a car anytime soon. They realize that borrowing to buy a car is just about the last thing they would consider right now.

This is why the deleveraging is and will continue to be so painful. Because, like frogs in a pot, we have reached a fatal boiling point, and we never even realized our jeopardy until way too late. No surprise NR is bearish, in my opinion."""

Nouriel Roubini: Project Syndicate has just published my latest column titled ?Will Banks and Financial Markets Recover in 2009?? The simple answer to this question is no.

http://www.rgemonitor.com/blog/roub...l_banks_and_financial_markets_recover_in_2009

(Roubini thinks that we may see some mild recovery in 2010 and 2011. Nicolas Taleb considers Roubini an optimist and thinks there is much deleveraging to go)

 

[kent nickell]

Re: Deflation/Hyperinflation

http://reason.com/news/show/130832.html

Why 2009 Will be Worse than 2008
We are not out of the woods yet
Jeff Taylor | January 2, 2009

Whew. Now that 2008 is in the history books, $8.5 trillion in federal bailout money is in the pipeline, and bold leadership is set to take command, Americans can all breathe a little easier, right?

Uh, no. The unhappy fact is that 2009 is almost certain to feature more economic hardship than the year that preceded it. President-elect Barack Obama may think he has steeled himself and his administration for this outcome, but three major factors argue against Obama truly being prepared for what's to come.

Insane expectations. It was no mistake that Vice President-elect Joe Biden was dispatched to try to dampen surging overseas expectations that the Obama presidency will quickly reverse American actions around the globe. But a similar threat lurks domestically, where the federal government under Obama will be expected to correct every dislocation from the confused Bush years?all while providing free health care and full employment.

Most telling is the continued misunderstanding of the role that Obama's Treasury chief pick, Tim Geithner, has played in the Bush bailouts from his current perch at the New York Federal Reserve. Geithner has in every way possible functioned as a loyal member of Hank Paulson's Goldman Sachs army, seeking to reverse market judgements on bad investments with billions in federal cash. Why anyone would expect substantially different policy from an Obama administration with Geithner in place escapes me.

The one exception to this is at the Federal Reserve, where Ben Bernanke might end up as the poster-child for economic malaise, giving Obama license to show Bernanke the door. If nothing else, this could buy Obama time and reset the clock on his honeymoon. But otherwise, without some sort of dramatic gesture to placate the public, by late spring the euphoria over Obama's inauguration could give way to a crushing let down.

State and local implosions. The coming spring will also prove crucial as many states and localities write their budgets. These are the same entities that came hunting for roughly $200 billion in federal "stimulus" handouts via thousands of make-work projects.

The real trouble, however, lies in the hundreds of general funds, enterprise funds, pensions, and health care plans which are skirting the edge of bankruptcy right now. The nearly $3 trillion market for state and local debt remains in flux with the certitude that borrowing costs will creep up by about 50 basis points for all but the most well-insulated jurisdictions.

For many others, 2009 will bring a cruel ratcheting effect when reduced revenues from the slowing economy, coupled with increased investor and analyst wariness, combine to reduce debt ratings. This will further push up the cost of borrowing, which will then further strain revenues. Tax hikes might help, but only at the cost of further depressing business activity.

For that reason, the federal government will once again be called on to bail out insolvent operations?but this time it will be cities, counties, and maybe even a state or two.

Incidentally, this process may have a profound impact on winnowing the field of Republican statehouse superstars who might be in a position to challenge Obama in 2012. If Sarah Palin, Bobby Jindal, or Mark Sanford watches their state circle the drain in '09, you can pretty much write them off as a serious candidate in a time of economic strife. Conversely, should a governor truly rise to the occasion by shrinking the cost of their operations while maintaining services, they would jump to the front of the line.

Addled economics. When otherwise smart people start talking about the positive effects of inflation, we've entered desperate times. Let's walk through the root cause of America's housing bubble, which is widely held to be at the epicenter of America's 2008 economic meltdown, to see why inflation can only compound our economic woes.

Why did housing prices embark on a rocket-ride straight up in recent years? Because banks created an unlimited supply of ready buyers at every price point. How did they do that? By lending money to people without the income historically required to pay back a mortgage of a given size or, in many cases, of any size. So the ongoing housing correction, or "collapse" in some quarters, represents a return to a more sane relationship between a borrower's income and their ability to borrow.

Given this reality, income will be at a premium in 2009. Rising unemployment has already started to batter income levels. But real income can also be impacted by rising inflation, which leaves fewer dollars available to pay for things like mortgages.
In effect, those pundits pushing the inflation solution do not advocate jumping off the fake-wealth-via-permissive-lending treadmill, they just want Americans to run faster to get nowhere.

Already we see that when policymakers debase the currency with zero short-term interest rates they provoke a market response. Long-term interest rates, led by the benchmark 30-year fixed mortgage, inched up last week. This is exactly what you would expect as lenders realize that the dollars they will be getting back will have less?perhaps much less?purchasing power than the ones they are lending out.

In basic terms, this is a process that has gone on for thousands of years, since the dawn of human civilization. When kings, pharaohs, or emperors try to tamper with a society's store of value, that value shifts.

Indeed, all the talk of deregulating or reregulating markets misses the simple yet essential point that the serial bailouts of 2008 were designed to avoid market consequences for bad investments. The New Year will demostrate that this was a waste of both time and resources. In 2009, market forces will punish the human hubris that peaked in 2008, setting the stage for a brighter tomorrow.

Jeff Taylor writes from North Carolina.

 

[kent nickell]

Re: Deflation/Hyperinflation

I think that some deflation is good and that our economy needs deflationary pressures in some areas ie bringing home prices more in line with personal incomes but....

http://en.wikipedia.org/wiki/Deflation_(economics)

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. The Great Depression was regarded as a deflationary spiral.

http://krugman.blogs.nytimes.com/2009/01/10/risks-of-deflation-wonkish-but-important/

January 10, 2009

Risks of deflation (wonkish but important)

Feeling a bit deflated

There's been some talk abut risks of deflation, but there's one alarming comparison I haven't seen made. The figure above shows that the CBO is currently projecting an output shortfall from the current slump comparable to the slump of the early 1980s. Actually, it's very close: if you compare the CBO's projections of unemployment from 2008 through 2012 with its estimate of the natural rate, we're looking at cumulative excess unemployment of 13.9 point-years; that compares with 13.7 point years from 1980 through 1986. (If the natural rate ? the unemployment rate that keeps inflation unchanged ? is 5 percent, and the actual unemployment rate averages 7 percent over a year, that's 2 point-years of excess unemployment.)

Now here's the thing: the slump of the early 1980s produced the Great Disinflation, which brought the core inflation rate down from about 10 to about 4.

This time, however, we entered the slump with a core inflation rate of about 2.5 percent. If we experienced a disinflation comparable to that of the 1980s, that would mean ending up with deflation at a rate of -3.5 percent.

And bear in mind that neither the CBO nor the Obama team really explains where recovery comes from; it's just assumed.

So tell me why we aren't looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend. Tell me why this risk wouldn't remain high, though lower, even with the Obama plan, which as far as I can tell is expected to reduce cumulative excess unemployment by about a third.

 

[sharon sanders]

Re: Deflation/Hyperinflation

The behavior of the current US consumer is to spend. We are a nation of "de-savers". If any culture can spend themselves out of a deflationary cycle, it is us.

Pent up demand is beginning to build for automobiles and housing.

 

[Laidback Al]

Re: Deflation/Hyperinflation

The behavior of the current US consumer is to spend. We are a nation of "de-savers". If any culture can spend themselves out of a deflationary cycle, it is us.

Pent up demand is beginning to build for automobiles and housing.

Maybe in the old days, these are the new days. Just because people would like to move up to a newer car or a bigger house doesn't mean the credit market will provide the loans to them.

People are maxed out on underwater mortgages, high car payments, and ballooning credit card debt. Besides, how many more mp3 players, TVs, cell phones, computers, and kitchen appliances do people need even if they could afford them. I think consumerism is changing in the U.S. We will know for certain in the next 12 months.

 

[kent nickell]

Re: Deflation/Hyperinflation

I do like the idea of a big stimulus at this point....

http://www.ft.com/cms/s/0/8b2f754e-e012-11dd-9ee9-000077b07658.html

Obama's shot in the arm is too small

By Clive Crook

Published: January 11 2009 19:25 | Last updated: January 11 2009 19:25

Despite his clear electoral mandate and big Democratic majorities in Congress, politics is already blocking Barack Obama's efforts to deliver a fast fiscal stimulus. The country's political system was designed to force debate and delay action, and it works. Even when all of Washington agrees that speed is crucial ? which it does ? getting anything done is still difficult. Mr Obama has clout and his party is pretty much in control. But these factors are confounded by the sheer scale and complication of the stimulus plan.

Some of Mr Obama's team dared to hope that a stimulus bill would be on the president's desk awaiting his signature by the time of his inauguration on January 20. The new target is the President's Day recess on February 13, and Democrats in Congress no less than Republicans are warning that this will be hard to achieve. The American recovery and investment plan will not move forward in one piece but will be written bit by bit in committee. House and Senate versions will have to be reconciled, more changes made and further votes taken. "Congress must work its will," says Nancy Pelosi, speaker of the House.

There is fundamental disagreement about strategy, too. In large part, this is the familiar Democratic-Republican divide over spending increases or tax cuts, Democrats preferring the former and Republicans the latter. Mr Obama is proposing a sensible compromise: an $800bn (?594bn, ?527bn) two-year package, split roughly 60:40 in favour of spending increases.

Many Democrats resent the concession to Republican preferences. Many Republicans want the tax cuts to be permanent; others, having acquiesced for years in the fiscal incontinence of the Bush administration, have decided on the downslope of a severe recession to become fiscal conservatives.

That is an outrageous imposture and Democrats' exasperation is justified. In view of his party's majorities, why then does Mr Obama not simply ignore the Republicans? One reason is that the new influx of Democrats includes a draught of winners in close contests who tend more than the party average towards fiscal conservatism. Another is the lack of a filibuster-proof majority in the Senate. A third is that US public opinion is itself more centrist than the congressional Democratic leadership, and wary of vast new spending initiatives. The country has already seen hundreds of billions spent or committed to little apparent effect. There is no clamour for the next trillion.

Mr Obama's first big speech on his plan last week was mainly addressed to those concerns. He underlined the risks of doing nothing and the opportunity to boost the economy's longer-term growth by investing in new and better infrastructure. He is right to offer reassurance and to wish to keep voters onside. In this, some political cover from Republicans would be valuable and is worth a political price. Many in his party, though, still care more about punishing their opponents. Their instincts say that if the enemy likes it, the policy must be wrong. Many Republicans take the same view, of course. The consensus Mr Obama seeks will not come easily.

One can only hope that Democrats and Republicans wake up to the gravity of the situation and quickly compromise on the structure of the plan. Once they do that, they can attend to its real, as opposed to imagined, defects.

So far as the structure goes, a mix of temporary tax cuts and high-impact spending (albeit with a strong bias towards the latter) is wise, even though tax cuts, as Democrats say, most likely have a smaller total effect on aggregate demand. Since it is difficult to ramp up spending quickly on this scale without waste, you can make a good case for diversifying the bundle of measures to include some well-targeted tax relief. Why dig in on the wickedness of any and all tax cuts, except to annoy Republicans? It is childish. As for the Republicans' new access of fiscal responsibility, they should first have some shame, and then get the timing right: big fiscal stimulus this year and next, credible steps to reign back spending and borrowing beyond.

This is where the real problems with the Obama plan lie ? not in its basic structure (though a clearer plan for dealing with the still mounting tide of home loan foreclosures, among other things, would not go amiss), but in its scale and in its unaddressed long-term implications.

If anything, $800bn over two years now looks too small. The recession appears to be accelerating and the shortfall in demand seems likely to be bigger than the $1,000bn in 2009 that Mr Obama mentioned in his speech last week. The implications for unemployment are correspondingly dire. A stimulus of $500bn to $750bn in 2009 should be the aim. The bigger the number, the stronger the case for including temporary tax cuts in the plan. In this respect, perhaps, a bigger stimulus would improve the prospects for a deal between the two parties.

Yet even without this necessary further stimulus, the longer-term outlook for the budget deficit is alarming. The current estimate for 2009 is $1,200bn, roughly 8 per cent of gross domestic product, not counting the new plan. In later years, on unchanged policies, an enormous deficit is projected to persist. Sooner than it thinks, Washington will have to change those policies. Otherwise, in the next iteration of this crisis, the global capital market will intervene. Plans for medium-term fiscal consolidation ? higher taxes and lower spending ? need to be framed now and must be made to conform to the short-term stimulus. Next week I will suggest how this can be done.

Send your comments to clive.crook@gmail.com

Read and post comments at Clive Crook's Washington Blog

 

[kent nickell]

Re: Deflation/Hyperinflation

The readjustment continues... Bringing home prices more in line with personal incomes and trying to limit foreclosures by bringing mortgages more in line with these more realistic asset values causes pain to the secondary owners of these mortgages..... This causes a further decline in the lenders balance sheets and further tightens up credit by more correctly analyzing the risk... A lot of the bailout money currently seems to be going to plug and shore up these holes in 'Wall Street' but the holes seem so large that it's only slowly leaking out to 'Main Street'. But the criteria for the loans are also tightening up just due to more realistic standards for these loans....

It also seems clear though that these bailouts need to be balanced by bailouts more directly aimed at 'Main Street' such as beefing up various social safety nets such as unemployment benefits, food relief programs etc...


http://www.ft.com/cms/s/0/ab57e036-e111-11dd-b0e8-000077b07658.html

US bankruptcy code bill rattles the MBS market

By Aline van Duyn in New York
Published: January 13 2009

The reintroduction last week in the US Senate of a bill aimed at amending the bankruptcy code to allow the modification of mortgage contracts - and its backing by Citigroup - has sent tremors through the market for mortgage-backed securities.

The ABX index, which tracks the value of securities linked to subprime mortgages, fell sharply, with the value of triple A rated securities backed by subprime mortgages falling up to 6.5 points.

Much of this decline is attributed to the increased chances of so-called bankruptcy cramdown bills passing. Politicians such as Senator Dick Durbin have been proposing such changes for years, but now measures aimed at reducing foreclosures have more support, not least from President-elect Barack Obama.

"The bill's passage would be a clear negative for mortgage-backed securities and asset-backed securities holders," said analysts at Barclays Capital. "We fear a massive sell-off that would worsen valuations, threatening further balance sheet write-downs [for financial institutions]."

Even if a consumer files for bankruptcy, judges cannot currently change, for example, the size of the outstanding mortgage to allow a new, lower repayment plan. If such powers are given it has long been argued that the potential for changes in contracts would make investors less willing to finance the mortgage sector, or at least require a higher premium to do so.

These powers would likely affect mainly risky mortgages such as subprime. These are different to the mortgages backed by government mortgage agencies Fannie Mae and Freddie Mac. Securities backed by these have rallied after the Federal Reserve last week began a $500bn buying plan.

Chris Flanagan, analyst at JPMorgan, said the bankruptcy cramdown may reduce foreclosures and stabilise house prices but that higher costs would be passed onto consumers.

Increased bankruptcy filings could also increase losses on securities backed by credit cards and other consumer loans, he said.

"We are not surprised to see the market react negatively," Mr Flanagan went on. "While lenders have long maintained that [the lack of cramdown] was needed to keep mortgage rates low, that notion ultimately proved to be a farce. To say that now is not a good time to change the bankruptcy code merely echoes the sentiment of the last 30 years, and ignores the facts that [this part] of the mortgage market is shut down anyway."

Last week, financial industry groups denounced Citigroup's support of the changes. The bank was bailed out by the US government last year after the value of its mortgage-backed assets collapsed, further increasing the hole in its capital base.

The Securities Industry and Financial Markets Association and the American Securitisation Forum said the bankruptcy proposals "would have serious and negative consequences, increasing risk and uncertainty in an already challenging mortgage market and raising mortgage rates for future homeowners at a time when the availability of consumer credit is already severely constrained".

 

[kent nickell]

Re: Deflation/Hyperinflation

It seems like I'm always thinking that the housing market has at least 2 to 3 years to go to level out but this recent Merrill Lynch analysis ratches it up to new levels...

https://www.fs.ml.com/publish/weekly_pdfs/MarketEconomist.pdf

""Even with a moratorium on homebuilding, it would take 17 years to work through the excess inventories at the current sales pace, attesting to the persistent problem at hand.""

And this could be optimistic as there are also large areas of 'hidden' inventories where people are holding onto properties rather than putting them up for sale in this type of market. Also even with heroic measures being made to try and keep interest rates low the intermediate to long term pressures are almost certainly for continued tight credit and eventually higher interest rates. Not to mention the stress that continuing unemployment and underemployment are putting on this market.

Also: """Inflation checkpoints: In addition to the industrial production and capacity utilization data we will get updates to both the producer and consumer price reports. We anticipate producer price deflation will continue while consumer price inflation remains close to zero. These updates on the inflation outlook should show that deflation, rather than inflation, is now the greater threat to the economy. The long-term deleveraging trend that is evident from the most recent flow of funds report suggests that deflation will continue to be the greater threat in the future."""

And... ""Going forward, with the manufacturers' inventory-to-sales ratio at an already elevated level, further cutbacks in output and employment in this sector are expected. The decline in manufacturing output is also expected to trim utility production. In year-over-year terms, industrial production is expected to drop a stunning 11.2%. We expect capacity utilization to fall by 1.0ppt to 71.0%, a rate last seen in late-1982. Manufacturing capacity utilization, already at an all-time low, is expected to drop 2.0 points to 66.6%. Note that with automobile manufacturers closing plants, further reductions in capacity are expected."""

 

[kent nickell]

Re: Deflation/Hyperinflation

It seems like the large number of foreclosures with the large number of vacant residencies (inventory) on the one hand and a financially strapped public with tent cities, food lines, employment problems, strapped city and state resources on the other hand combined with billion dollar bailouts to the financial industry is a powder keg crying out for aggressive creative problem solving. Much of this deleveraging is necessary but any forms of taking debt out of the system would probably be useful....

 

[kent nickell]

Re: Deflation/Hyperinflation

This Merrill Lynch analysis emphasizes the severity of the employment piece of the puzzle leading to prolonged wage deflation pressures. The permanent nature of the job losses probably relates to the housing industry with the huge inventory of homes and the large slowdown of home equity and credit card lines of credit to fuel consumer spending....

http://cfcr.ml.com/GetDoc.aspx?e=xl...s=10823592&v=1&m=0wpbvXQNz5voFrpmsKVNpOWRUDU=


Double digit unemployment by summer
None of these factors suggest the consumer recession will end any time soon. In fact, the new GDP profile suggests we will see another 2.5 million jobs lost in 2009, 300k more than our previous expectation, and that the unemployment rate will hit the ignoble double digit level by early summer. Our weaker capex and export outlook means more shuttered production, steeper job cuts, and moves the re-hiring process off further in the distance. Against these headwinds the 30 cent jump in gasoline prices is doing little more than adding insult to injury ? though it nonetheless serves as a $38bn drainage from discretionary spending.

Deflation still a significant risk
In spite of the efforts to re-inflate the economy, the wheels of deflation have already been set in motion and the risks that it could become entrenched in consumers? expectations remain a significant risk. Spare capacity is already close to 6% of GDP and the gap will probably press to a very deflationary 7.5% before the Public Private Investment plan buys their first mortgage backed security. Moreover, given that over half of all workers have lost their job forever ? this is no ordinary production slump we are dealing with after all ? the path to a lower unemployment rate remains far from clear, in our view. And, with 15 million workers hunting for a meager pool of jobs, we expect wage deflation to persist for the next several years.

 

[kent nickell]

Re: Deflation/Hyperinflation

More from Merrill Lynch... Even with the large amount of liquidily trying to be added to the system though various types of quantiatiative easing these are still offset 5:1 by deleveraging/deflation pressures... ""the government is cushioning the blow, but cannot prevent nature from taking its course""

""The reality is the patient is still in sickbay and the Fed knows it""

""it?s pretty clear that the Fed does not see any flicker of light at the end of the tunnel just yet. Mr. Market may be in for yet another surprise.""

""we have a situation where not only are 1 in 11 homeowners with a mortgage now either delinquent or in the foreclosure process, but we also have 1 in 7 individuals who are either unemployed or underemployed. We?re not sure how to classify such a macroeconomic backdrop, but it certainly is not a garden-variety recession.""

""for the first time ever, household liabilities have contracted ona year-to-year basis. This is what happens in a deleveraging phase, and it is highly deflationary.""

http://cfcr.ml.com/GetDoc.aspx?e=xl...s=10823614&v=1&m=rHeBnqkkID/GhdBwYpBLDy9IUaI=

1) Stimulus being offset by nearly a 5 to 1 ratio
The Fed and the Treasury are pulling out all the stops to bring mortgage rates down, and it is not too hard at this point to see them falling to historic lows of 4.5% or perhaps even lower. Through the balance of the year, that rate relief should total $115bn at an annual rate. And starting April 1, low- and middle-income households will start to see withholding taxes coming off their paychecks, which we estimate will total around $35bn at an annual rate. So, the tailwind from monetary and fiscal policy, as far as the consumer is concerned, is a hefty $150 billion at an annual rate.

Balance sheet repair the biggest headwind
The savings rate is on a visible uptrend and by year-end when it is closer to 7%, will have drained $175bn out of spending. Every one percentage point rise in the savings rate, as a static stand-alone development, is equivalent to 2.2 million jobs being lost in terms of GDP impact. On top of that, we have job losses totaling 2.5 million from now to the end of the year, and that comes at a cost of $125bn to personal income (again, at an annual rate). Based on our assumptions on asset values, we think the negative wealth effect will end up posting a drag on spending to the tune of $400bn at an annual rate through year-end. These headwinds amount to $700bn, offsetting the stimulus by nearly a 5-to-1 ratio. On net, the $550bn drag on consumer spending is equivalent to a 5% contraction, though we are sure that there will be more offsets in the form of further fiscal stimulus and expansion of the central bank?s balance sheet.

2) Government cannot prevent nature from taking course
While the additional $1.15tn expansion of the Fed?s balance sheet announced this week is large as a stand-alone event, it really is just a drop in the bucket when one considers that there is still almost $8tn of combined household and business sector credit that must be unwound in order to mean-revert the private sector debt-to-GDP ratio (which is still close to a record-high of 176%). Once again, the government is cushioning the blow, but cannot prevent nature from taking its course, in our view.

The Fed does not operate in a vacuum
What many pundits seem to be missing is that Fed policy does not operate in a vacuum. The Fed is responding to what we can only refer to as severe trauma on the US household balance sheet. The aggregate loss in household wealth is now an eye-popping $12.9tn (and now roughly up to $20tn in 1Q). This constitutes a 20% decline in household wealth since the peak was put in back in mid-2007. Wealth destruction of this magnitude is unprecedented since the Great Depression.

Risings savings rate is hugely deflationary
At the rate it is going, the personal savings rate will be north of 10% within a year. That is a hugely deflationary event unless personal incomes are somehow shored up at the same time (though this is much more effectively addressed via fiscal policy). Yes, the Fed?s balance sheet and the balance sheet of the federal government are both expanding at record rates. That is what makes the headlines, and that is what analysts, strategists and economists will be consumed with today ? the latest operation technique by the surgeons.

The reality is the patient is still in sickbay and the Fed knows it
This was highlighted in the second paragraph of this week?s FOMC statement, to wit: ?? the economy continues to contract ? Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. US exports have slumped as a number of major trading partners have also fallen into recession?.

Yikes. This is with the Fed funds rate effectively at zero. But it?s pretty clear that the Fed does not see any flicker of light at the end of the tunnel just yet. Mr. Market may be in for yet another surprise.

3) Most sources of borrowing are drying up rapidly
The Federal government is expanding its balance sheet at its second fastest rate in recorded history. Debt has exploded by 24% year-on-year as of 4Q08. But the Federal government does not operate in a vacuum ? other sources of borrowing are drying up rapidly. From nearly 7% growth a year ago, the annual trend in household credit has vanished. Corporate borrowing growth has gone from 13.5% a year ago to a YoY trend of 4.7% currently. State/local governments have sliced debt growth to 2.2% in 4Q from 9.3% a year ago. All in, domestic credit growth even with the Federal government surge, slowed to an eight-year low of 5.8% YoY in 4Q, down from 6.3% in 3Q and 8.6% a year ago. All the surge inWashington has done is slow the overall descent; it has certainly not prevented overall credit growth from subsiding. Antidote, yes. Panacea, no.

6) Home prices will continue deflating
Nothing we see from a policy standpoint is preventing home prices from deflating. There is simply no sustainable recovery in the economy, the stock market or the financial backdrop until we get some clarity on the outlook for residential real estate prices. And on this score, the news has been unremittingly negative. One in seven individuals are unemployed or underemployed We get asked all the time if we are going to see the unemployment rate breach the post-WWII high of 10.8% set in 1982 recession. Suffice to say, theunemployment rate that is most inclusive in terms of accounting for all forms of ?underemployment? such as this shift toward part-time and away from full-time work is the U-6 measure, which soared from 13.9% in January to 14.8% in February, a record high for this particular series. So, we have a situation where not only are 1 in 11 homeowners with a mortgage now either delinquent or in the foreclosure process, but we also have 1 in 7 individuals who are either unemployed or underemployed. We?re not sure how to classify such a macroeconomic backdrop, but it certainly is not a garden-variety recession.

10) Not obvious that demand for borrowing will be there
While the Fed can do all it can to put the financial system into a situation where it is able to extend credit again, it is not at all obvious to us that the demand for borrowing is going to be there as households, in particular, continue to focus their attention on climbing out of their record debt burdens. By the time 4Q08 had rolled around, the Fed and the Treasury already expended plenty of resources to rekindle the credit cycle, including the central bank move to cut rates to 0% effectively. Even with that effort, households cut their liabilities by over $300bn, or at over an 8% annual rate. This marked the second time in the past three quarters that the household sector moved, on net, to reduce their overall indebtedness. And for the first time ever, household liabilities have contracted ona year-to-year basis. This is what happens in a deleveraging phase, and it is highly deflationary. And as we saw in Japan, this requires time and massive doses of fiscal and monetary stimulus to even partially offset.

 

[sharon sanders]

Re: Deflation/Hyperinflation

I agree that fiscal and monetary policy can only do so much.

The economy will "do its own thing".

Money flows to what is perceived as the most profitable (or safest) asset.

So if we are talking the general economy, much is uncertain and needs to be worked out. The contraction of credit is a very serious phenomena. It stifles any growth in the economy.

If we are talking the stock market - well it depends on what asset class is seen as a "hedge" against the general economy.