DRAGONS AND OTHER FAIRY TALES / BARRON´S ( VERY HIGHLY RECOMMENDED READING )

THURSDAY, JANUARY 7, 2010

UP AND DOWN WALL STREET

Dragons and Other Fairy Tales

By RANDALL W. FORSYTH

The St. Louis Fed warns about inflation even as the FOMC frets both about rising prices and renewed weakness.


IF THERE WERE ANY DOUBTS that Goldilocks had left the building, last month's meeting of the Federal Open Market Committee should put them to rest.

We already knew from the Dec. 16 conclusion of the confab that the panel voted no change in monetary policy, keeping the federal-funds rate target at 0-0.25% and reiterating the key phase that "exceptionally low levels" of this key rate were likely warranted "for an extended period."

But after years of enjoying an economy that was just right, the minutes of last month's meeting released Wednesday showed some FOMC members worried that monetary policy risked being too cold while another fretted about it risking being too hot.

"A few members noted that resource slack was expected to diminish only slowly and observed that it might become desirable at some point in the future to provide more policy stimulus by expanding the planned scale of the Committee's large-scale asset purchases and continuing them beyond the first quarter, especially if the outlook for economic growth were to weaken or if mortgage market functioning were to deteriorate," according to the minutes' account of the too-cool contingent's worries.

Conversely, "one member thought that the improvement in financial market conditions and the economic outlook suggested that the quantity of planned asset purchases could be scaled back, and that it might become appropriate to begin reducing the Federal Reserve's holdings of long-term assets if the recovery gains strength over time," as the minutes described the concerns of the solitary solon who thought things risked getting too darned hot.

In the end, the FOMC wound up affirming the status quo unanimously. And odds are the Fed will hew to its plans to finish up its planned purchases of $1.25 trillion of agency mortgage-backed securities and $175 billion of agency debt by the end of the first quarter.

Adding to the debate was an article out of the St. Louis Fed, "Inflation May Be the Next Dragon To Slay." The piece from the traditionally monetarist Reserve Bank pointedly disagreed with the FOMC's stance, articulated in its policy directive: "With substantial resource slack likely to continue to dampen costs pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time."

The St. Louis Fed article, authored by Kevin L. Kliesen, took issue with the notion that this "slack" (or output gap between potential and actual gross domestic product) can predict inflation. Nobody knows for sure what that gap is. Moreover, future inflation may be influenced by the public's expectations more than the current slack in the economy.

The current monetary policy is "extraordinarily accommodative" and, as noted, the FOMC expects to continue that stance "for an extended period," the St. Louis Fed article continues. That assessment of Fed policy is reflected in the doubling of the monetary base (currency and bank reserves) and reduction in the fed-funds rate to near zero.

The failure to reverse the easy money in the last cycle resulted in sharp run-ups in oil and other commodity prices, Kliesen writes. The consumer price index accelerated from about 2.25% in 2001-03, to 3% in 2004-07 and 5% in the first three quarters of 2008 as oil prices surge to more than $130.

But, the article also notes that more than 100% expansion has resulted in less than a 17% in M2 money supply (consisting of currency, checking deposits and most consumer savings deposits.) Not mentioned is that GDP has shrunk over that time, indicating the velocity (or turnover) of M2 has fallen. In other words, households are sitting on the money, not spending it.

And, as Wednesday's column ("Follow the Money -- Into a Double-Dip," Jan. 6) described, the broadest measure of money, which is no longer published by the Fed, is now shrinking, both absolutely and even more so in real (inflation-adjusted) terms. That suggests money and credit are tight and getting tighter -- in contrast to the St. Louis Fed's assertion policy is "extraordinarily accommodative."

There is nothing new about this sort of disagreement. Robert Kessler, the head of Kessler Investment Advisors, a Denver-based manager of Treasury securities for wealthy individuals and institutions, observes the same debate raged in the 1930s.

In a missive to clients, he quotes none other than Ben Bernanke in Essays on the Great Depression:

"The growing level of bank liquidity created an illusion (as Friedman and Schwartz pointed out) of easy money; however, the combination of lender reluctance and continued debtor insolvency interfered with credit flows for several years after 1933."

(Milton Friedman and Anna J. Schwartz, authors of the monumental work, A Monetary History of the United States, 1867-1960, are who Bernanke cites there.)

The Great Depression and Japan of the 1990s offer the best historical guides to the current situation, Kessler contends. Just as now, fear of inflation ran high in the 1930s, even as prices fell overall during the decade. The recent back-up in Treasury bond yields implies the market looks for 3% annual increases in the CPI over the next 20 years.

Core inflation (excluding food and energy) currently is running at 1.4% and has never exceeded 2.7% in the last 15 years, Kessler points out. Japan's CPI averaged a 0.4% annual rate of increase since its stock market bubble burst 20 years ago. And in the U.S., CPI growth averaged about 1.5% in the 20 years following the 1929 Crash.

Kessler concludes that inflation is likely to recede substantially and, given the ongoing credit contraction going on, the 10-year Treasury note yield could fall to 2%, which it came close to hitting at the end of 2008 in the headlong flight to safety, and even lower, from 3.83% currently.

That sort of bullishness on Treasuries in the face of massive U.S. borrowing needs puts Kessler way out on a limb, especially after the market sold off hard Wednesday ahead of next week's massive supply of $85 billion in fresh notes and bonds. But he thinks Americans will increase their holdings of Treasuries as they increasingly value return of capital over return on capital, as Will Rogers put it during the 1930s, facilitating the financing of the deficit.

That said, like a dragon, inflation is surely to be feared. But as much as St. George is revered as patron saint of England, dragons still are the stuff of myth.

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