A brief note on the FEDs Balance Sheet composition as of the end of February. It is still growing and in fact the major growth is Government Debt. There does not appear to be a turn around here. Simple facts:
1. Commodity prices in steel and other essentials are increasing at rates in excess of 25% pa
2. Unemployment is frozen well above 9% and based upon 2008 base number well above 12%.
3. Economic growth will decrease substantially as we see oil top $150 a bbl again in the next three months.
4. Federal Debt hopefully will be abated but there needs to be leadership on both sides.
2011 does not look like a turn around year at this point.
Yet Dudley of the NY FED gave a presentation today detailing his optimistic view of the economy. We disagree with him on several points:
1. Yes the market is up mainly because the FED is holding interest rates low and this is the FEDs way of pumping money into the "backroom" so that the debt can be funded. The money as seen in M2 is not yet leaking into the front room.
2. As a result of that the equity play is the only place for the cash on hand to flow into. People still have 401K contributions and the like and this flow of funds is inflating equities. Again we may face inflation here rather than true growth.
3. He fails to note the recent 25% increase in steel, the 35% increase in fuel costs, and the pressure of food stuffs, which is reflected in corn and sugar futures.
4. The Beveridge Curve showing job vacancy rates versus unemployment rates has been a random walk for a while. Thus as we have already analyzed here before this is nonsense. Productivity is up significantly.
5. He fails to treat the issue above, namely the balance sheet of the FED and who owns the debt. The Chinese today announced an increase of almost $250B in US debt holdings. Dudley argues:
However, let me make two points. First, I am very confident that the enlarged Federal Reserve balance sheet will not compromise our ability to tighten monetary policy when needed consistent with our dual mandate goals. Second, I am equally confident that no one on the FOMC is willing to countenance a sustained rise in either inflation expectations or inflation.
Let me explain why our enlarged balance sheet does not compromise our ability to tighten monetary policy. Although our enlarged balance sheet has led to a sharp rise in excess reserves in the banking system, this has the potential to spur inflation only if banks lend out these reserves in a manner that generates a rapid expansion of credit and an associated sharp rise in economic activity. The ability of the Federal Reserve to pay interest on excess reserves (IOER) provides a means to prevent such excessive credit growth.
However we would argue that the explosion of the FEDs balance sheet should be viewed holistically across nations and indeed the Chinese will use it to their advantage as will any and all other parties.
Not withstanding the above one of the most troublesome comments was at the end of his talk:
Second, the Federal Reserve needs to continue to communicate effectively about its objectives, the efficacy of the tools it has at its disposal to achieve those objectives, and the willingness to use these tools as necessary. This is important in order to keep inflation expectations well-anchored. If inflation expectations were to become unanchored because Federal Reserve policymakers failed to communicate clearly, this would be a self-inflicted wound that would make our pursuit of the dual mandate of full employment and price stability more difficult. If we consistently and effectively communicate our objectives and our strategies, we can avoid this outcome.
The last two sentences are the concern. If things get unhinged, he is assuming that everything remains stable just with communications, and communications as the FED sees fit. That may be gross over expectations.
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