Select Charts in the Babson Style for Market Close 13 June 2008

Bernanke's Bluff: More on the Fed's Balancing Act of Dollar and Economy

In a purely fiat monetary system the effective limitation on the Fed is the acceptance of the dollar and the bond in objective transactions. You sell us something 'real' and we give you dollars in return. The dollar has no inherent value. It is worth what people perceive it is worth. Hence the emphasis on perceptions and tinkering with economic shibboleths and statistics.

The Fed and Treasury are playing a game of tradeoffs between repairing the financial system, stimulating the real economy, and devaluing the dollar and the bonds.

Once you understand that and keep it in mind, many things become clear.

The effective limitation on the Fed and Treasury is the acceptance value of the US dollar in non-US transactions.


Market Outlook
The Hawkish Illusion: Calling Bernanke’s Bluff
By Joseph Brusuelas


Over the past fortnight Fed Chairman Ben Bernanke has engaged in “open mouth operations” to shape market expectations regarding future monetary policy out of the US Federal Reserve. Mr. Bernanke rhetorically intervened in the global currency markets to prop up a beleaguered dollar, explicitly expressed unease over the current course of inflation and signaled that the Fed would not tolerate a breakout of inflation expectations. Not bad, for a Fed Chairman fighting multiple crisis on multiple fronts.

The concerns over inflation expectations expressed by Mr. Bernanke and the more intense hawkishness expressed by Dallas Fed President Richard Fisher and Richmond Fed President Jeffrey Lacker are well founded. Public expectations over short-term inflation have soared. According to the University of Michigan the public expects that over the next year inflation will increase 5.5% and the Conference Board's twelve-month gauge suggest a 7.7% rise in the year ahead. Even market sentiment, which has lagged public sentiment, has changed.

The market, caught off guard by the rapid change in expectations and surprised by the speed and sustained switch in rhetoric out of the Fed, changed its expectations of rate hikes in confused haste. Using federal funds futures rates as a metric for measuring changing market sentiment traders now expect that the Fed will hike rates by 50bps before the end of the year with a 37.1% probability of 75 bps in hikes by the end of the year.

Under normal circumstances, I would welcome a return of the hawkish instincts that underlie the foundation of Mr. Bernanke's hallmark academic work on inflation targeting. Such a hawkish turn would compliment my own theoretical orientation and normative preferences regarding appropriate monetary policy and the necessity of a single focus on price stability.

Such a potential move by the central bank is in line with the systematic case I have been making over the past several months regarding the future impact on inflation expectations caused by the rise in energy and commodity prices. The entire efficacy of contemporary Fed policy is hinged on a stable set of expectations and the slow and steady upward movement in those expectations over the past few months has stimulated the gravest crises faced by the Fed in many years.

While, a case can be made that there is little threat to macroeconomic stability from inflation until wage demands begin to work their way through the system, I do not concur. By the time that unit labor costs begin to rise and a newly minted Congress bestows upon labor newfound power, it will be to late. The pain that would be necessary to inflict on the public to combat a such a breakout of wage-push inflation is way beyond what our current political system and the likely leftward composition of the next Congress will be willing to stomach.

That being said, once one takes a step back and looks at the recent statements of Mr. Bernanke in the proper context, these are good reasons to be more than a bit skeptical of the recent hawkishness out of the Fed chair. Let me elaborate. Given the continued stress in financial markets, an economy moving sideways and a consumer that remains under duress we are highly suspect of the recent claims by the Fed chair that rate hikes are imminent. Moreover a simple observation of the movement in markets is quite instructive of the real problem the Fed currently faces.

Perhaps, other than the clear change in the federal funds futures market, the most startling shift has occurred is in fixed income space, where curve steepening trades have been rapidly unwound. The spread between 2yr and 10yr yields has closed quite quickly. This has put an unexpected bout of pressure on financial firms, who rely on the ability to borrow short and lend long and thought that they had reached a short-term point of stability. Why have financials continued to tank? In addition to the lingering uncertainty over the condition of their books, it is due to the newfound hawkishness on the part of Mr. Bernanke. Why is this so problematic? Unless, Mr. Bernanke is willing to undo much of the patchwork that his innovative and unorthodox approach to shoring up the financial system over the past several months has accomplished, we do not see him urging his colleagues to move quite quickly on rates,

Second, we are approaching what will be a very close and contentious Presidential election in the United States. After doing a bit of research, I was able to observe that with the exception of Paul Volker's rate increase ahead of the Reagan-Carter match in 1980 and Alan Greenspan's hike before the 1992 election between Clinton and Bush the elder, Fed chairman have been quite careful to steer clear of Presidential elections. It would be nice to believe that the central bank independence has been thoroughly absorbed by our monetary officials and that price stability would outweigh political considerations. But it does strike me as quite difficult to believe that Mr. Bernanke would hike rates, not once, but twice according to current market expectations, in advance of the election. This would surely facilitate the election of a candidate that would summarily reject Bernanke's reappointment early in the first term the new President.

The net effect of all of the sound and fury that the market has experienced over the past few days, will in all probability, be to set up a confrontation down the road between the market and the Fed. My own ex-ante GDP forecast strongly suggests that after two consecutive quarters of sub 2.0% growth through the middle of 2008, that output will fall back towards zero to conclude the year. I think that the Fed is counting on both output and resource utilization (unemployment) easing later this year to provide cover for their continued dovish policy.

In fact, Fed Vice-Chair Donald Kohn, who since the crisis began last August, has been something of a useful barometer for those of use who attempt to derive what the Fed will do next. Mr. Kohn in his most recent statement made the case that the proper policy path for the Fed may be to tolerate higher inflation and higher unemployment in fact of a commodity shock of the sort that we are facing today. This fact that it was made at a Boston Fed conference discussing the trade off between unemployment and inflation, better known as the “Phillips Curve,” is no accident.

What all of this tells this economist is that the Fed is going to continue to tolerate inflation, attempt to manage inflation expectations and quite simply buy time for the financial system to repair itself. If the Fed truly wanted to get serious about inflation and signal the start of a rate hiking cycle, it would begin to reduce the growth of the money base, set a date for the end of the “temporary auction facility” and raise rates at the next meeting. But it will not.

Unfortunately, the unintended consequence of this very delicate balancing act is that a potent dénouement is forming over the horizon in which the market will move to demand that the Fed move to increase rates, well before it is ready to do so. With the very credible signals out of the European Central Bank that rates hikes are just around the corner, with each passing day, the Fed finds itself slowly but surely painted into policy path that upon further review is not of its choosing. The inability or unwillingness to act on the part of the Fed will have a deleterious impact on the dollar and with it a reduction in the living standard of individual Americans.

The Myth of Self-Regulation

June 13, 2008
Op-Ed Columnist
Bad Cow Disease
By PAUL KRUGMAN

“Mary had a little lamb / And when she saw it sicken / She shipped it off to Packingtown / And now it’s labeled chicken.”

That little ditty famously summarized the message of “The Jungle,” Upton Sinclair’s 1906 exposé of conditions in America’s meat-packing industry. Sinclair’s muckraking helped Theodore Roosevelt pass the Pure Food and Drug Act and the Meat Inspection Act — and for most of the next century, Americans trusted government inspectors to keep their food safe.

Lately, however, there always seems to be at least one food-safety crisis in the headlines — tainted spinach, poisonous peanut butter and, currently, the attack of the killer tomatoes. The declining credibility of U.S. food regulation has even led to a foreign-policy crisis: there have been mass demonstrations in South Korea protesting the pro-American prime minister’s decision to allow imports of U.S. beef, banned after mad cow disease was detected in 2003.

How did America find itself back in The Jungle?

It started with ideology. Hard-core American conservatives have long idealized the Gilded Age, regarding everything that followed — not just the New Deal, but even the Progressive Era — as a great diversion from the true path of capitalism.

Thus, when Grover Norquist, the anti-tax advocate, was asked about his ultimate goal, he replied that he wanted a restoration of the way America was “up until Teddy Roosevelt, when the socialists took over. The income tax, the death tax, regulation, all that.”

The late Milton Friedman agreed, calling for the abolition of the Food and Drug Administration. It was unnecessary, he argued: private companies would avoid taking risks with public health to safeguard their reputations and to avoid damaging class-action lawsuits. (Friedman, unlike almost every other conservative I can think of, viewed lawyers as the guardians of free-market capitalism.)

Such hard-core opponents of regulation were once part of the political fringe, but with the rise of modern movement conservatism they moved into the corridors of power. They never had enough votes to abolish the F.D.A. or eliminate meat inspections, but they could and did set about making the agencies charged with ensuring food safety ineffective.

They did this in part by simply denying these agencies enough resources to do the job. For example, the work of the F.D.A. has become vastly more complex over time thanks to the combination of scientific advances and globalization. Yet the agency has a substantially smaller work force now than it did in 1994, the year Republicans took over Congress.

Perhaps even more important, however, was the systematic appointment of foxes to guard henhouses.

Thus, when mad cow disease was detected in the U.S. in 2003, the Department of Agriculture was headed by Ann M. Veneman, a former food-industry lobbyist. And the department’s response to the crisis — which amounted to consistently downplaying the threat and rejecting calls for more extensive testing — seemed driven by the industry’s agenda.

One amazing decision came in 2004, when a Kansas producer asked for permission to test its own cows, so that it could resume exports to Japan. You might have expected the Bush administration to applaud this example of self-regulation. But permission was denied, because other beef producers feared consumer demands that they follow suit.

When push comes to shove, it seems, the imperatives of crony capitalism trump professed faith in free markets.

Eventually, the department did expand its testing, and at this point most countries that initially banned U.S. beef have allowed it back into their markets. But the South Koreans still don’t trust us. And while some of that distrust may be irrational — the beef issue has become entangled with questions of Korean national pride, which has been insulted by clumsy American diplomacy — it’s hard to blame them.

The ironic thing is that the Agriculture Department’s deference to the beef industry actually ended up backfiring: because potential foreign buyers didn’t trust our safety measures, beef producers spent years excluded from their most important overseas markets.

But then, the same thing can be said of other cases in which the administration stood in the way of effective regulation. Most notably, the administration’s refusal to countenance any restraints on predatory lending helped prepare the ground for the subprime crisis, which has cost the financial industry far more than it ever made on overpriced loans.

The moral of this story is that failure to regulate effectively isn’t just bad for consumers, it’s bad for business.

And in the case of food, what we need to do now — for the sake of both our health and our export markets — is to go back to the way it was after Teddy Roosevelt, when the Socialists took over. It’s time to get back to the business of ensuring that American food is safe.

Foreclosure Nation

"If the American people ever allow private banks to control the issue of their currency, first by inflation then by deflation, the banks and the corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs." Thomas Jefferson

Foreclosures Rise 48% in May as U.S. Bank Repossessions Double
By Bob Ivry

June 13 (Bloomberg) -- Bank repossessions more than doubled in May and foreclosure filings rose 48 percent from a year earlier as previously foreclosed properties dragged down housing prices, RealtyTrac Inc. said in a report today.

One in every 483 U.S. homeowners lost their houses to foreclosure or received either a default warning or notice that their home would go up for sale at auction, RealtyTrac said. That was the highest rate since the Irvine, California-based company began reporting in January 2005 and the 29th consecutive month of year-over-year increases. Nevada, California and Arizona posted the highest rates in the U.S. and New Jersey entered the Top 10, according to RealtyTrac.

``It's definitely a different kind of market than what we got used to a couple years ago,'' said Devin Reiss, owner of Realty 500 Reiss Corp. in Las Vegas. ``We used to sell homes in a day. Now 50 percent of our sales are foreclosures.''

Foreclosures add to inventory and crowd out regular sales, Michelle Meyer and Ethan Harris, economists at Lehman Brothers Holdings Inc. in New York, wrote in a report yesterday. Foreclosures will account for 30 percent of national home sales this year as 1.2 million foreclosed single-family homes will eventually enter the market, they said. They estimate that foreclosed properties, which typically sell for about 20 percent less than other homes, will depress home prices by 6 percent.

Feedback Loop

``The risk is that an adverse feedback loop will develop, in which problems in the housing market undercut the economy, causing even more stress in the housing and mortgage markets,'' Meyer and Harris wrote.

A homeowner usually receives a notice of default after falling more than 90 days behind on mortgage payments. If the borrower still doesn't pay what's owed, the property is sold to the highest bidder at an auction, typically held at a county courthouse. If bids don't reach a set amount, the lender takes ownership. Such houses are referred to as REO, or ``real estate- owned.''

Lenders took possession of 73,794 houses in May, more than doubling the 28,548 REOs in May 2007, RealtyTrac said. That pushed total REOs to more than 700,000, RealtyTrac said.

``Right now, lenders are afraid to lend and buyers are afraid they'll be under water in a year, so unless something dramatic happens we're going to continue to see the trend go in the wrong direction,'' said Rick Sharga, RealtyTrac's vice president of marketing.

Federal Legislation

Legislation that would allow the federal government to guarantee up to $300 billion in refinanced mortgages passed the House of Representatives and awaits debate in the Senate, which is scheduled to recess before the July 4 holiday.

Government help would make it easier for homebuyers to get loans and would ease the number of foreclosures, said John Gall, president of the Arizona Association of Realtors and owner of Arizona Land Quest LLC in Kingman, Arizona. (As we noted in an earlier blog, approximately 90% of new mortgages are being done by government sponsored agencies already - Jesse)

``Resolving credit issues is going to require cooperation between Wall Street and Washington to provide a secure platform for lenders to loosen up their criteria,'' Gall said. ``It would absolutely help here in Arizona.''

Arizona's foreclosure rate -- one in every 201 households received a filing in May -- was a 119 percent increase compared with May 2007 and ranked third in the U.S., RealtyTrac said.

Only Nevada, with one in every 118 households, and California, with one in every 183, had higher filing rates in May, the company said.

New Jersey

One in every 467 New Jersey households received a foreclosure filing in May, making it No. 10 on RealtyTrac's list of states. That represented an 89 percent increase from a year ago and a 44 percent increase from April, RealtyTrac said.

The number of national foreclosure filings grew 7 percent from April, according to RealtyTrac.

The nationwide rate of default warnings in May increased 1 percent from April and the number of auction notices fell 3 percent, the company said.

Metropolitan areas in California and Florida accounted for nine out of the top 10 metro foreclosure rates for the second month in a row, RealtyTrac said. Seven California metro areas were in the top 10: Stockton, Merced, Modesto, Riverside-San Bernardino, Vallejo-Fairfield, Bakersfield and Sacramento.

Stockton's rate, one in every 75 households, was more than six times the national average, the company said.

Deluged

``One of the big problems is the banks have been deluged and are way behind in actually doing the foreclosures,'' said Alan Nevin, chief economist with the California Building Industry Association in San Diego. Nevin said he's forecasting lower foreclosure rates in California starting in the last three months of the year.

The Cape Coral-Fort Myers area, on Florida's Gulf Coast, had the second-highest metro foreclosure rate in May, with one in every 79 households. The other Florida area in the top 10 was Port St. Lucie-Fort Pierce, on the Atlantic coast, at No. 10.

The only city outside Florida and California in the top 10 was Las Vegas.

RealtyTrac said it has a database of more than 1.5 million properties and monitors foreclosure filings, including default notices, auction sale notices and bank seizures.

To contact the reporter on this story: Bob Ivry in New York at bivry@bloomberg.net.