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.