Welcome to an Occasional Letter, we start of this week with a reminder of the new scenario adopted in the autumn of 2008 once it became clear that our old scenario had played out exactly as we expected:

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantitative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference...... eventual emergence of new trading and commercial environments.
  

So we have a situation were the Fed and Bank of England are purchasing assets using cash or liquid Treasuries and Gilts to enable the Bank/Dealer fraternity to purchase what they believe to be underpriced assets that can be maintained in an uptrend. Once the uptrend is established and private funds from Investors, Pension Funds, Hedge Funds etc step in to purchase the trend the Bank/Dealer players who bought at the bottom can silently sell into the dumber money entering the fray. How long the reflation lasts for is our conundrum. Whilst the date of when the trend will change is not knowable, the actions that lead to such a change are.

We know that excess reserves are at levels never seen before:

Bank/Dealer (as nearly all dealers are now "banks" or acting as such) holdings with the Fed remain over $700 Billion. Most of the bailout funds (from the Fed or other sources) are still within the banking system, the trickle down effect to the real economy has not occurred in the way expected. We can see this when we compare currency in circulation to excess reserves over the same period:

We can see the relationship, currency in circulation has risen with the increase in excess reserves, however note that the amount of currency is shown on the right axis, it has increased by less than $100Billion after a stimulus programme that currently amounts to $3Trillion from the Fed and US Government and promises of a further $20Trillion, if required. Bluntly, if the effect of $3Trillion stimulus results in an increase of $100Billion of currency then the hyper-inflation argument is not based on statistics. Here is the % change of currency in circulation from the beginning of 2007:

Peanuts.

What did the tax payer get for its largesse? A mountain of toxic debt that continues to grow, the problem hasn't been "sub-prime" for over a year now, and little or no benefit to offset the ills caused by over-leveraged banks making loans that they knew had little chance of being repaid. The only reason the Paulson/Bernanke bailout plan was implemented was to buy time, to spread the pain over a number of years rather than months, enabling the bank/dealers to replace losses and rebuild capital.

Now having carried out the Eggertsson plan, invoking QE and ZIRP, there is no choice but to follow the plan, withdrawing the stimulus now would result in 2 outcomes, namely credit would contract at a higher rate and everything that the bank/dealers had purchased since March would be dumped in a fire sale. Far too many econo-bloggers and all of the mainstream media are desperate for the public to believe that the current situation is a typical recession that will result in a typical recovery. Many are following an inflation based investment strategy and need investors to believe it's the right path to follow.

It just isn't so.

The only reason money is going into various assets is thanks to the stimulus, we have mini-bubbles, a typical result of reflationary policies. How long these mini-bubbles will last is what becomes important to longer term financial planning.

Here I quote James Montier of Société Générale, who incidentally is the guest writer for John Mauldin this week, although I have seen James Montier's work before:

• "In my own work I've examined the patterns that bubbles tend to follow. By looking at some of the major bubbles in history (including the South Sea Bubble, the railroad bubble of the 1840s, the Japanese bubble of the late 1980s, and the NASDAQ bubble), I have been able to extract the following underlying pattern. Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate. This bursting is generally slightly more rapidly than the inflation, taking around two years."
  

   

  

  
  

The bust from 2000 lasted just over 3 years into the '03 bottom; the bubble lasted over 4 years into October 2007 top. So reliance on average bust and boom lengths to judge when to change an investment stance is a dangerous strategy. More important is James Montier's point that all bubbles deflate. For us that makes sense, we know bubbles are artificial and can be traced back to a combination of increased liquidity / credit and a lack of risk control, the uptrend is followed because it is an uptrend rather than any underlying fundamental.

The ingredients for the asset bubbles we have seen since March are clear, bank/dealer use of funds beyond capital replenishment to generate strong uptrends, inviting lesser players to join in. Combined with a lack of perceived risk (moral hazard) the trends will remain until monetary conditions show that an inevitable tightening is going to occur. This is not guesswork, we have seen the same behaviour occurring during a previous post crash reflation attempt in Japan:

The Nikkei peaked at just under 39,000 in late December 1989 one of the results of cheaply priced liquidity being used to finance risky loans, enabled by market de-regulation in the previous decade. Much of the loaned funds were used to speculate on domestic stocks, land and other assets. In an attempt to rein in parabolic rises in assets, especially land, the Japanese raised interest rates, starting in May 1989 and again in December 1989. The increase in rates continued through to August 1990 rising from 2.5% to 6%. The massively overleveraged Japanese banks began to suffer immediately and within months consolidation in the sector coupled with direct government intervention was all that kept the financial system functioning. The fall out lasts to this day and included the period of QE and ZIRP in the early 2000's.

We can compare the rise in rates in Japan to the Fed's attempts to also control credit expansion by using the baby step rate rises from 2004 to 2006:

The result was very similar, the increase in rates eventually made risky loans unviable. This resulted in defaults and downgrading of packaged debt (CDO's, MBS etc) leading to a withdrawal of credit in the commercial paper market as the assets offered to secure short term loans were deemed toxic. Without the ability to roll over short term lending to fund long term borrowing the mechanism that had allowed the constant expansion of debt collapsed. The resulting de-leveraging and asset depreciation led to massive losses in nearly all asset classes.

The Fed's answer to the repeat of the Japanese experience was to accelerate the pace of the methods the Japanese eventually employed in recognition of the Japanese policies failures in the 1990's. As we well know the addition to the package was to have an implicit inflation target and to act in a way that led to a credible expectation of future inflation.

Whilst the Fed cut aggressively and entered the zero bound rate almost with indecent haste, the Japanese did not start cutting from 6% until July 1991 and completed the cuts in September 1995, finishing at 0.5%. Not until the adoption of QE and ZIRP in 2001 did rates move lower down to 0.10%. Even with such cuts credit conditions for consumers remained tight and we saw in an earlier article the traditional savings culture no longer exists, the Japanese public have had to use excess income to purchase goods and services.

The Japanese were faced with a further problem, the appreciating Yen and low domestic rates of return on investments spurred the growth of the carry trade which took funds out of the domestic economy and assets. The response was for the Japanese Ministry of Finance and the Bank of Japan to buy assets, including stocks, as they swapped practically any asset for cash with the crippled banks.

Look back at the Nikkei, we can see some sizeable bounces as government fiscal and monetary policies enabled bouts of stock (and bonds) purchases. Yet as we can see this was no buy and hold market, indeed it was a market to be avoided by all except those willing to actively trade each move. However the carry trade began to exert an influence on non-Japanese markets, especially during the QE/ZIRP experiment.

The Dow is now subject to the same forces, it is supported by government intervention that allows speculative trading and will be subject to fluctuations in government and Fed policy. We return to our central question, how long will the reflation last for?

Simply it will last as long as the bank/dealer fraternity see no risk to their access of funds. That risk will be measured by watching the Fed and the US Treasury's ability to raise cash in the bond market. So far the Fed remains firm in its intent, that the reversal of the stimulus remains a distant prospect. The more immediate risk as I mentioned recently is a Treasury bond auction failure. Whilst we survived the last issue the details remain worrying:

	Tendered	Accepted
Primary Dealer	$57,014,000,000	$23,923,750,000
Direct Bidder	$1,068,000,000	$658,000,000
Indirect Bidder	$16,778,000,000	$14,263,000,000
Total Competitive	$74,860,000,000	$38,844,750,000

The details above are from the 5 year note auction 29 July, Primary Dealers took 2 thirds and Indirect Bidders (Foreign Central Banks) took about a third. This is an unsustainable trend.

I reiterate advice given early last year, watch the US Treasury bond markets, it will be the first place to signal strains in the system and the end of the current reflation.

For many commentators the economic travails of the past 24 months and more importantly the economic outlook for the next 10 years has resulted in periods of doubt and rejection of not only others but their own reasoning and outlook about why we are in the current situation and more importantly where we are going in the future.

It's not surprising that an element of econo "flip-flopping" occurs from time to time for those who delve into the dark bowels of the economic and capitalist system as they try to divine future movements. What can look to be fact and historically correct one week seems to be refuted the next, we see the arguments between the deflationists and inflationists rumble on, gold bugs holding outlier attitudes to maintain why gold (and other hard assets) are de rigueur whilst others firmly believe in the attributes of mattress stuffing to hoard cash.Why is there such a division in thought and comment when we are faced with a single realism that we have and are in the midst of a credit deflation and deleveraging, combated by the attempts of Central Banks to inject liquidity into the banking system and Governments attempting to reflate through fiscal stimulus?

As any doctor will tell you an effective cure can only work if the diagnosis of the illness is correct, if you diagnose the wrong disease the cure will fail, even if it is applied in a textbook manner. For economic forecasting to be correct we need to identify the ills to ensure the right cure, i.e. the correct policies are administered. If the type of recession is not correctly recognized then the economy will not recover and it will continue to deteriorate. The lack of recovery will cause more of what is thought to be the appropriate cure to be pushed into the financial arteries of the global economy in the hope that a higher dose will overwhelm the disease. Of course the increased dosage will fail and worse will cause other side effects to appear that further weaken the economy.

The results of a mistaken diagnosis and an ineffective cure can only be seen by most in hindsight. This is what Morgenthau in the late 1930s had this to say about the New Deal:

• "We have tried spending money. We are spending more money than we have ever spent before, and it does not work. ... I want to see the country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises. I say, after eight years of this administration, we have just as much unemployment as when we started .... and an enormous debt to boot."
  

Currently we see the same approach, the application of the "cures" of the '30's being applied but at an accelerated rate, as if acting quicker will change the outcome. The problem is simple, whilst the current cure might work in certain circumstances it will not in others. The difference is the type of recession we are in today.

The typical recession model is based on increasing inflation leading to an increase in interest rates that cause an economic slowdown, this causes a decline in inflation and in response interest rates are lowered, engendering economic recovery. The flow of money is restricted by banks in response to increased risk during the downturn and until the signs of recovery are apparent, however there is still demand from consumers and business to borrow.

This is the general pattern of recessions since the '40's with the recovery following reasonably quickly after the onset of a recession. This allows market participants to attempt to front run the recovery in the hope they have bought or borrowed at or near the bottom by using the historical pattern of previous recessions. In other words it's never different this time.

The untypical recession model is not caused by the efforts to control inflation. Instead a credit bubble allows the growth of an asset (or assets) bubble. When the asset bubble collapses there is a debt deflation and a loss of available credit that leads to an economic downturn and a deflationary environment. Even if credit is made available from banks the willingness of consumers and business to increase borrowing may disappear, replaced instead by a wish to pay down debt and rebalance their books.

The second type of recession is called untypical because we don't see them that often but they do occur. Usually the amount of debt throughout the economy is historically large, as one would expect in a credit bubble and the availability of this over-issuance results in too much money chasing physical assets, causing booms to occur in housing, stocks, business valuations and commodities. The collapse of the asset price bubble(s) causes losses that force a change in spending leading to the economy turning down. When faced with these circumstances consumers and businesses look to reduce debt and or de-leverage. With a reduction or cessation of borrowing the amount of cash and credit in the economy reduces, creating deflation.

We are without doubt in an untypical recession that cannot be pushed into recovery by simply reducing interest rates, waiting for an increase in credit demand and therefore increasing monetary growth.

Japan has seen and is still suffering from the effects of an untypical recession that became embedded in the early '90's with of course the '30's Depression as another recent example. Both relied on government intervention to attempt to replace the amount of available credit, either through fiscal spending or monetary injections, to try and reflate the economy.

The current cure is the same medicine that was applied to both Japan and the US in the '30's with one notable exception, the Fed has made it clear that the mistake that prolonged the '30's depression will not be made again - the Fed will not tighten by raising interest rates until recovery is firmly in place.

So we see the adoption of a Zero Interest Rate Policy, reducing nominal interest rates to banks to a negative level. Combined with ZIRP is Quantitative Easing where Fed cash and treasury holdings are exchanged for bank held assets in an attempt to increase liquidity.

The question is, increased liquidity for who and why?

For that we have to realise that in 2008 a decision was made to keep the current banking system, not withstanding the odd bankruptcy and bailout, and the efforts of the Fed and others were directed to recapitalising those thought worth keeping.

So with ZIRP in place to allow cheap money and QE enabling the swapping of illiquid assets for cash or nominal cash (low or no interest paying US Treasuries) banks have been given the tools and importantly the time to recapitalise. As we have discussed before this does not mean an increase in the money growth outside of the banking system. Banks are hoarding capital and using it to set aside reserves for further losses and allowing them to re-enter into financial trading, with the exception being the refusal to lend to businesses or consumers that are not considered "bullet-proof".

Until the banks (and other financials) have repaired their balance sheets credit will remain severely restricted, especially to consumers. However even when the banks have corrected the imbalances there is no guarantee that consumers will wish to add to their debt burden, preferring instead to continue to lower debt levels.

How far are consumers along in the process of de-leveraging? The following chart shows various consumer revolving credit levels with the blue dashed line representing individual consumer loans at all banks (rhs):

The process has barely begun beyond Finance Companies. The reduction of all consumer loans is just over $20Billion, the level of debt for consumers still remains high. Whilst some might say that such a small reduction means the fear of credit deflation is overblown, I prefer to look at the more realistic outlook, that the consumer has stopped new lending but has yet to meaningfully either pay off or default on current debt. Further consumers are continuing to save:

This should not be ignored, if consumers continue to save now and have gained a healthy aversion to new debt then a Japanese style scenario of deflation becoming embedded is almost certain. One outcome of an embedded deflationary environment will be a future reducing long term saving rate (savings will be eroded by the need to supplement income) and a reluctance to take on debt as the population moves to a higher retired and unemployed ratio to the working population. Current debt will take many years to pay down as day to day living costs and the inability to sell assets at a profit or a reluctance to use any profit to pay off debt is forced upon an aging population and those caught in the chronic unemployment trap. Remember debt in a deflationary environment, even at a low rate of interest, is an onerous burden.

This then is the reasoning behind the need to increase fiscal spending by the government, to replace the withdrawn amount of money (lack of new debt and increased savings) from the economy by injecting funds to cause demand to increase both now and in the future.

So far the medicine used to cure the economic illness appears to be a slightly upgraded version of the Japanese / '30's dosage, with the promise to engender an implied level of inflation and the willingness to hold rates at very low levels until recovery is well under way being the added ingredients.

However, there is one problem with a direct comparison of the current US position and the Japanese / '30's scenarios. Back in the '30's the US, like Japan in the '90's, was a creditor nation with surpluses due to exports from a strong industrial base. That is not the situation now; the US is a debtor, owing Trillions to the rest of the world and is therefore reliant on the goodwill of others to accept further increases of US debt. Add in one other problem, it's not just the US that is looking to increase its debt to enable an increase in fiscal spending.

During the Japanese QE / ZIRP period, from early 2001 to early 2006 the reduction in bank lending to consumers and business was replaced by bank lending to the Government who produced enormous amounts of Japanese Government Bonds (JGB's) at very low yields to swap for the bank loans. Whilst this increased the monetary base along with the banks holding of Japanese Government Securities the money supply (M2 and CD's) moved only fractionally higher. The attempt to engender inflation through increasing the monetary base failed, the government could not direct the loaned cash in an effective manner despite massive infrastructure projects. Whilst it did enable banks to slowly rebuild their reserves the same effect could not be copied for consumers or business. Key to all of this was the ability to keep the yields on JGB's at very low levels, thanks to Japans export industry that kept a positive balance of payments account.

The US does not have the luxury of an export lead recovery:

With imports (blue) down near 40% the hope would be for an increase in exports to send the balance (black) positive. As we can see though exports (red) have fallen by around 33%. Whilst this has helped the trade balance it is still negative, the US is still spending more than it earns. More importantly is the lack of export dollars that can be recycled back by foreign central banks to purchase US Treasury or Agency debt. Therefore further debt issuance by the US will be viewed by foreign central banks, especially China, as an attempt to monetise debt.

The threat of monetisation will drive long end US Treasury yields higher as an inflation premium is built into the price. This is not compatible with ZIRP and thus de-rails the attempts at Quantitative Easing as the cost of servicing the increasing debt requires the US Government to increase revenues through taxation thus negating any fiscal spending or by restricting imports through protectionism.

So we come to the central question, will the current efforts of the US (and the UK for that matter) using the current medicine be enough to cure the illness that resides in the economy?

This untypical recession is the result of massive over-leveraged use of debt that inflated various asset bubbles. Now in the post bubble world credit is scarce and falling assets prices have resulted in huge losses. Attempting to use QE, ZIRP and an engendered expectation of future inflation is reliant on overseas buyers of debt accepting low yields whilst debt is monetised. I don't see it happening.

The true answer will be what it has always been, regardless of any reflation attempts, income will have to exceed expenditure and debt will either have to be paid off or written off and the losses accepted.

Welcome to a follow on article from last week. It's all my fault for not explaining my thoughts in full and an eagle eyed reader called me out on the matter. Why did I miss the point, or rather, expect a paragraph within last weeks article to have answered the question? Well, you will have to forgive me but sometimes I forget that the way I think isn't necessarily easy for others to understand. It can be easy for me to write something and expect you all to understand it, I try very hard not to do this but occasionally I do a bad job. So please accept my apologies and this week let's make that paragraph and the points sent in by a reader (hat tip David S) make proper sense. Indeed the more I think about it, the more important and central to the argument is the content of that paragraph.

So, here is the paragraph from last week:

• "This is a clever move as it subverts the need to increase the supply side of cash into the general economy to force inflation to rise. Instead inflationary expectations have been engendered by an increase in the demand side of the equation thus requiring a supply side response of an increase of cash to pay higher prices."
  

• "Hi there, I have been a subscriber for some time and really enjoy your perspective. (thanks)

  I wanted to point to you an important flaw in the reasoning about inflation expectations. An increase in expectations would have had positive actions in the Japanese market where consumers had a strong balance sheet with no debt and strong savings to expend. (True and it is the plan adopted by the Fed to counteract the current deflationary recession)

  On the other hand, the American consumer has no savings (the savings being shown now are either savings for emergencies or a pay down of debt) and his employment expectations are poor: not only the unemployed are depressed but the employed are getting 10% PAY CUTS across the board not only in private enterprise but also from State and Local governments in response to a loss of tax income. (True)

  At 500,000 per month real employment loses the effect is as follows every month: 250,000 home loans default and 2.5 million credit card accounts will default. In 12 months you get 3 million new foreclosures and 30 million credit card accounts and 6 million auto loans going into default. (Agreed, could be higher too)

  With the american consumer being 70% of expending facing this depressing reality the expectation of future inflation will have no effect in expending habits as the preservation instincts take over. (Disagree, and I'll explain why below)

  Business expending will follow the underliying problem of consumers not being affected by inflation expectations and capex expending will be nonexistent even if equipment prices are expected to rise in the future. (See above)

  Rates are going up because now US Treasury auctions are 100 billion each instead of 10 or 15 billion. Money is POURING into these auctions and the traders are white livid in panic as the money will have to come out of stocks, commodities and everything else to feed this big monkey. (Disagree, if Traders were panicking rates would be in double digits)

  The need this year seems to be 33 Trillion worldwide and everybody is talking of the big money in the sidelines ready to put to work, while forgetting that money is already in T-Bonds. So the printing press will be the ultimate solution, however it seems the bond vigilantes seem willing to put a lid on it. Scary. (The money is not in T-Bonds the way people think.....)

  All these academics think that the yield curve makes the markets move and forget that the markets where there way before the yield curve was observed." (The curve is just price reflection of future expectation, hence why it inverts prior to "hard times", despite the calls of it being different that we heard in 2007)

The traditional thought on how to get inflation into a deflationary environment (remember the baseline these days is not what it was 18 months ago) is to inject cash into the consumer and business in the hope that some of the cash would be used for purchases and investment. The mechanisms used to move the cash was easier credit (lowered yields), tax rebates and breaks and increased fiscal spending by government.

Basically this is what happened in Japan, prior to the QE and ZIRP methodology, remembering the QE / ZIRP were last resort moves, not the initial approach taken by the Bank of Japan / Ministry of Finance. If we take 2000 as the top of the US economic cycle then we can see that the US is clearly following a very similar path to the Japanese experience from 1989/90 to the present. All that has happened to the Japanese has happened to the US with the US now at the QE / ZIRP event. The only difference in methodology was the US adoption of a deliberate inflationary stance, the irresponsible approach with a publicized level of future inflation targets.

This ground we have covered in-depth and well ahead of the mainstream media and fund manglers. We now see an almost constant stream of mainstream media talk of inflation, backed up by the goldbug talk of hyperinflation. Yet it hasn't happened.

As we said last week US T-bond yields are up in the face of strong anti-inflationary rhetoric from the Fed and Obama. We see no inflationary pressures in the economy with capacity utilisation and unemployment at depressed levels, David is quite right when he says wages are decreasing on voluntary cuts and lay offs. However we do know that savings are increasing, regardless of the reasons behind the increase.

As far as a Central Planner is concerned savings, for whatever reason, are not wanted during a deflationary scenario, it further reduces the quantity of money in the economy. It also means that there is a slack in demand for cash from consumers to pay goods producers.

Its not just consumers, we have seen a rebound in Corporate Bond issuance but we have not seen a bounce in corporate investment, in other words cash has been raised, either to fix borrowing at a lower rate or to replace withdrawn credit lines. We have not seen the cash put to work in the economy.

Banks. We come to the log jam in the flow of money, Banks are not using replenished capital to inject cash into the economy through credit. Rather that cash is being deposited with the Fed as excess reserves earning 0.10%. As Gary North noted Banks are willing to give up enormous profits from higher yield plays and leave their cash with the Fed at an overnight rate. There can be no surer sign of risk avoidance than such actions.

And here is where I made my mistake last week. As I showed in a recent article the FDR bounce in 1932/3 is comparable to the March 2009 bounce (the true benefit of being the producer of the world reserve currency). Both involved a credible (if irresponsible) inflationary approach to both fiscal and monetary expansionist policies. The reaction was a bounce in stocks and commodities as funds were used by Banks to start and maintain an uptrend, you can see it quite clearly in the March '09 charts of various commodities and stocks, all that is required is to draw in the line when the Fed and the US Administration announced "throttle up".

Why did this happen? The US Treasury and Fed became frustrated with the inability and flat out refusal of Banks to re-enter the credit game. Banks took a look at the risk to any future new lending and baulked at the thought (still thinking green shoots?). This lack of willingness to lend began to cause problems for the Fed reflationary plan, without the revival of the credit mechanisms the increase in the supply side of cash and credit was not being passed on to the economy.

My contention is that the Fed decided to change tack, if the supply of money in the economy could not be boosted because of the Bank log jam then demand for cash and credit had to be increased. Therefore banks were allowed / coerced into using bail out funds to buy commodities and stock futures. The move higher is supported by short covering as positions are closed and the up trend does what it always does and sucks in money to follow the move.

The Fed isn't particularly interested in the machinations of markets, rather it wants to see the prices of basic commodities rise. This rise will transfer to finished goods across the board forcing the demand for cash and credit to rise to meet the higher prices. This increased demand will have to be met, either through an increase in wages, the use of savings, use of credit and the reallocation of resources.

Have no doubt about this, we are in a reflationary period, driven by the Fed / US Treasury to increase the quantity of money circulating through the economy. If the Banks refuse to restart a credit bubble by loosening credit standards then the Fed will ensure that prices are forced higher (probably by edict to the Banks with the help of friendly forces, the usual suspects) creating a higher demand for cash.

Combine this approach with the not so quiet threat to move toward fiscal responsibility, a refocusing on base rates and hints about withdrawing the Fed special schemes and a future shortfall in cash is quite probable.

During an inflationary environment the yield curve shows the required return needed to make lending to the government worthwhile, the inflation premium. However during a deflationary period (and we are talking about the availability of funds, not prices) the yield curve shows the required price government has to pay to gain access to private funds. Let us not forget that Chinese exports are down 26%, the availability of excess dollars for the Chinese to recycle will be down by a similar amount.

Taking the deflationary reading of the yield curve and we see it is correctly pricing the cost of money for the government to borrow. The short end of the curve is showing that there is a sufficient supply of cash and pricing power in the form of higher yields is restricted. That makes sense, the Fed has made noises about withdrawing special schemes but the markets are saying it will not be a significant withdrawal for at least a year. The same with fiscal stimulus, the markets are saying there is sufficient supply over the next year. Thereafter there is doubt about the continuing supply of cash, either as stimulus or Fed credit. In the face of rising commodity prices the expectation is for an increased demand for cash, and an increase in supply has not been guaranteed by the Central Planners.

The Fed is turning the screw on the Banks and attempting to force a re-allocation of their reserves from the safe haven of Fed overnight holdings (I expect the overnight rate to be zero'd or even made negative by applying fees) to the credit markets to meet the demand caused by higher prices. Both consumers and Business will also be faced with a need to use reserves (savings) to meet higher costs. From a Central Planner perspective this would be a much more efficient use of surplus funds. Concurrent with the required need to spend savings, business and consumers will demand higher recompense for their efforts, leading to higher prices and demand for higher wages.

What of the effect upon on those who cannot gain access to an increased supply of cash? We need to zoom out and look at this from a macro-economic point of view. As far as the Fed and US government are concerned, the damage is already done to a minority of participants in the economy. Even if official unemployment reaches 10-12-15% the vast majority would still be contributing to the expansion of the economy and the eventual success of the reflation would sweep up those left behind and make them once again a positive asset to the economy.

Am I saying that the unemployed, bankrupt, dispossessed and poverty ridden parts of the economy are not the reason for the bail outs? Of course I am, worse they are considered collateral damage. As I speculated over a year ago if you wanted to save the credit derivative markets and stop the consequences then the bail out money should have been used to support the asset prices, not the derivative price. A hand out to each mortgage holder of about 10% of their mortgage (via the mortgage originator of course) would have allowed an all round orderly re-pricing. It would probably have been cheaper too. Still that was then and I am not in the Fed.

As mentioned last week, if as I think, the rise in commodities is through the use of bail out money then the price inflation is artificial (stories about the mass storage of oil and a lack of further storage capability would make sense) then the withdrawal of the bail out funds would cause an unwinding of the positions, lowering prices.

The risks of using a demand side increase in prices to cause an increase in the demand for money are real and cannot be ignored.
If the plan is successful then price inflation will be lowered even though the quantity of money had been increased, allowing further expansion of the economy by increasing spending power.

The plan is reliant on belief. The Banks have to believe that future lending has a low risk of failure, if the Banks decide that risk is still too high then they will tighten credit standards, leading to a 1937 scenario as the refuse to replace fiscal and monetary stimulus withdrawn as a "responsible" approach is taken by the Fed, Treasury and Government.

Further the whole plan is based on a continuation of the credit based fiat currency system. That system is reliant on the belief of consumers (and business) that credit is good and can be used to bring forward future income to purchase assets now, hoping that a rise in asset prices covers the costs and makes a profit.

That confidence has been undermined in a way not seen since the '30s. Whether business and consumers return to pre-2007 spending and borrowing patterns is not a given, the attractiveness of a debt free life style and business model, especially after surviving the current deep recession, could change the way the US conducts itself.

Hopefully I have properly explained my thoughts from last week and answered the questions David posed. It wouldn't surprise me if I have got some of the mechanisms wrong but I believe the main thrust, that the Fed is ramping up the demand for cash by forcing prices higher, is correct.

Finally, many thanks to David S for taking time to write the email, without the input of readers it's easy for me to drift into some real econo-babble that leaves everyone behind.

Welcome to An Occasional Letter from The Collection Agency. The Occasional Letter (rather than the Weekly Report) is often used to interpret the intentions of central banks and government and how their actions will affect macro-economic conditions in the future.

Amongst this work are a series of Letters that interpret the work of New York Fed economist GB Eggertsson. I believe his work is central to the plan that the Federal Reserve, US Treasury and the US government have followed in their attempts to lead the economy out of a deflationary environment caused by the contraction of the availability of credit.

I have no doubt that the current situation is the desired result of the previous actions of the Fed, US treasury and government. With the collapse of credit availability the US was faced with the same reality as one would if faced with a reduction of actual cash. Indeed the reduction of credit has dwarfed the increase in cash or nominal cash (bonds that have no or minimal interest rate premium compared to inflation). The vast majority of the expansion in GDP has been a result of the use (and the effects) of credit in all its forms.

We now live with the effects of the reduction (deflation) of credit. We have seen what happened to those Banks that required short term borrowing to fund long term lending; we have seen the destruction of conglomerates as they became persona non gratis at the lending desks, unable to roll over the old debt used to keep busted business models alive. Investment has ground to a halt as profits are either not available or large enough to allow businesses to change their approach. Only recently have we begun to see corporate bond issuance pick up as a willingness to buy debt has returned.

However the purchase of bonds and stocks are reliant on the availability of funding methods supplied from the Fed, Treasury and Congressional approval. We still see savings increasing and credit availability for consumers and business at depressed levels.

We are in a zero bound liquidity trap, where according to Keynes any increase in cash and cash like assets cannot affect prices and therefore cannot induce inflation and allow interest rates to rise from the zero bound condition. However Friedman disagreed, saying that helicopter drops of cash, backed up by fiscal action carried out by government could cause a rise in future inflation expectations.

Japan followed Friedman in their attempts to break out of a zero bound liquidity trap but the efforts resulted in little, if any, success.

Eggertsson believed that Japan should have accepted the suggestion of Krugman and adopted an implicit, advertised target for inflation, in the region of 5% over 15 years. As long as the actions of the Bank of Japan and the Japanese Ministry of Finance were perceived to be aimed at such a result, a credible expectation of future inflation would be engendered. This would cause the saving, investment and spending habits of business and consumers to change accordingly. The result would allow cash and credit to flow and interest rates could be raised under the auspices of an anti-inflationary move. The raising of rates would be expected and accepted as part of the actions a central bank carries out during an expanding supply of cash and credit. This would negate a 1937 scenario, where a tightening stance was perceived as a negative, leading to a reduction of spending and investment and an increase in savings, resulting in a recession that prolonged the extent of the '30s depression. Here is how Eggertsson lays out the requirements needed to breakout of a zero bound liquidity trap in a deflationary environment:

• " I show that deflation can be analyzed as a credibility problem if the government has only one policy instrument, money supply carried out by means of open market operations in short-term bonds, and cannot commit to future policies. I propose several policies to solve the credibility problem. They involve printing money or nominal debt and either (1) cutting taxes, (2) buying real assets such as stocks, or (3) purchasing foreign exchange. The government credibly "commits to being irresponsible" by using these policy instruments. It commits to higher money supply in the future so that the private sector expects inflation instead of deflation. This is optimal, since it curbs deflation and increases output by lowering the real rate of return."

  "the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation. At zero nominal interest rates higher inflation expectations reduce the real rate of return, and thereby raise aggregate demand and the price level. The two main assumptions underlying this result is that there is some cost of taxation which makes this policy credible and that (2) monetary and fiscal policies are coordinated."

Indeed many point to the US Treasury yield curve as proof that the expectation of future inflation is now embedded into the psyche with a higher premium demanded at the long end of the curve:

The thought behind the shape of the curve is that the short end is seeing a safe haven bid and Fed manipulation and that the middle and long end of the curve are showing the need for a premium against future levels of inflation.

I am worried that this simple view is mis-placed. The current environment is one of deflationary forces being fought by the methods outlined earlier in a zero bound liquidity trap. In such an environment cash (and credit) are no longer just transmission methods for the exchange of goods and services, cash itself becomes an asset and is priced accordingly.

Taking this into account, rather than the inflation premium approach, it is the availability of an asset and the future supply that fixes the price, in this case the cost of borrowing is shown as an increase in yield paid to the lender.

In other words I am saying that rates are rising because the future supply of money will not meet demand. Sounds barmy doesn't it? Well, we must remember we are discussing the natural rate, not the attempted imposition of a Fed band, a scheme that seems to be struggling. We have to deal with market forces and future expectations as Bernanke is discovering.

On the 3rd June Bernanke gave a clear signal that bond markets took to heart. The speech was typical of the news feed in the current environment, a concentration on the "green shoots". However Bernanke also said this:

• "Certainly, our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to those challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance . Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8-1/2 percent of GDP today to 10 percent by 2020 and 12-1/2 percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands."
  

• WASHINGTON (MarketWatch) -- Rising yields on long-term Treasury debt is a signal that the Federal Reserve should being raising interest rates, said Thomas Hoenig, the president of the Kansas City Federal Reserve district bank on Wednesday. The higher yields are a signal that the market is concerned with the inflationary pressure from the high federal budget deficit and "very" accommodative monetary policy, Hoenig said in a speech in Wyoming. "I suggest strongly that we need to be alert to the markets' message and begin in earnest to bring monetary policy into better balance before inflation forces get out of hand," Hoenig said.
  

• " In this environment, we anticipate that inflation will remain low . The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation. "

This is a clever move as it subverts the need to increase the supply side of cash into the general economy to force inflation to rise. Instead inflationary expectations have been engendered by an increase in the demand side of the equation thus requiring a supply side response of an increase of cash to pay higher prices.

However if the Fed (and others) decide to announce a clawback of their largesse it will result in a selling pressure on commodities thus lowering prices. It also means that the quantity of cash will also be reduced.

Therefore one would expect bonds to react as though high inflation is not a problem in the future:

I have highlighted the yields along the curve after Bernanke spoke. Yields have leapt.

In addition we have supporting evidence from the UK. Below is the Bank of England's best guess at future inflation:

Along with M4:

• Between 2004 and 2007, M4 and M4 excluding intermediate OFCs both grew rapidly. But since the onset of the financial crisis, the two measures have shown very divergent trends (Chart A). That is because changes in market behaviour have led to sharp rises in the money holdings of intermediate OFCs.

  For example, SPVs previously sold securitised bonds to other non-banks in the United Kingdom. But with no market for securitised assets, banks have instead retained securities issued by their SPVs. In turn, SPVs have been holding the proceeds from this issuance on deposit. That has boosted OFCs' money holdings and, therefore, M4. Excluding these, and other transactions which have artificially raised headline M4, growth has fallen sharply.
  

The inflationist argument is struggling to justify the rise in yields, price inflation in the UK (CPI) is benign and remains so for at least another 3 years, especially with the increase of M4 in the general economy remaining at very low levels.

That says to me that those lending (i.e. buying bonds and gilts) are asking for a higher price for their cash in the form of increased yield, because the quantity of money is going to reduce in the future. Cash, treated as an asset, will see a lowering of supply whilst demand remains high.

Is all the above just the ramblings of your favourite deranged writer? I leave you with this quote from Money in Historical Perspective by Anna J Schwartz, Michael D Bordo and Milton Friedman:

• "Recent studies have shown that, while interest rates are initially lowered by increasing the quantity of money, this action produces income and price effects which will offset the reduction within several months. Conversely for decreases in the quantity of money."

Indeed it is difficult to see why the inflation premium portion of the yield would be increased when the expectation is for a future reduced supply in the quantity of money and low levels of price inflation. What we can say is that Friedman et al may well be right, as we saw on the announcement of the intention to claw back the stimulus (decreasing the quantity of money) that an initial rise in yields occurred. If the effects on income and prices remain true, then prices and income should offset the rise within several months. As the rise in commodity prices have been enabled by that stimulus, then on its withdrawal, or in anticipation of said withdrawal, prices should drop.

If this does play out then it confirms what Eggertsson said, that the credible expectation of future inflation requires the policies to continue even after the recovery is in place and inflation is increasing. Attempting to front run the rise in inflation will cause the expectations to change back to a deflationary stance, defeating the aim of the policy.