Federal Reserve raised key short-term interest rates Wednesday [today]
for the first time in more than four years, launching a risky campaign
to suppress inflation without stamping out economic growth,”
MSNBC’s Chief economics correspondent Martin Wolk reported on June 30, 2004. A few months earlier, Bill Gross of PIMCO wrote his classic post stock market bubble reflation era analysis The Last Vigilante(PDF)
about the Finance-Based Economy, from which this piece takes its
name. In it he pondered what might happen when the Fed
direction after running short-term rates well below the rate of
inflation for more than three years to keep the deflation at bay that
hit a trough in 2001 following the collapse of the stock market
bubble. During those years, a U.S. centric global economic and
financial system that had over several decades increasingly become
dependent on credit was
after years of low interest rates additionally dependent on cheap
credit. Once the result of the flood of
free or nearly free money started to show up in all-goods prices as
inflation, the Fed was sure going to start raising rates. Can the
Fed raise rates fast enough to tame inflation without imploding the
Back in the days when Paul Volcker stomped on the brakes and raised
interest rates into the high teens to tame double digit inflation
starting in 1980, the world economy was a very different place.
iTulip.com refers to the new world that’s developed since then
variously as the Bubble Cycle Economy and Frankenstein Economy.
The Bubble Cycle Economy refers to the series of asset bubbles that
have become the primary engine of the so-called “real economy" in
economics parlance, although where the “real” economy ends
and the “unreal” economy begins is now a broad stretch of
gray philosophical terrain. The Frankenstein Economy
refers to the results of the loss of personal accountability for credit
risk in household lending and dependence on foreign borrowing to
Whatever you want to call it, ours is an economy that requires nearly
twice as much public and private sector debt to generate
national income as in Volcker's day. Total debt (government debt,
including federal and state and local governments, domestic and
international, and federal debt to trust funds; plus private debt,
including households, business and financial sector debts): about $12
trillion and national income $5 trillion in 1980 when inflation averaged 18% and
Volcker was clobbering the economy with surprise 1% rate
hikes. The economy carried $2.4 of debt per $1 of GDP in those
days. In 2001, national income had grown to about $10 trillion
and total debt to about $40 trillion. Nearly twice as much
debt was carried by the economy in 2001 per $1 of GDP when Greenspan
needed to start to tame inflation in 2004 as when Volcker faced an inflation
problem in 1980. With twice the need for credit, smaller rate moves are
likely to have larger unintended consequences now than in Volcker's
After the 2000 stock market crash, an economy already heavily dependent
on debt became dependent on cheap credit. Short term interest
rates declined from 5.5% in 2000 when the stock market bubble burst to
1.25% in 2004. Sustained low interest rates over the period at
the household level created the Monthly Payment Consumer.
After several years of “No Money Down!” and “Zero
Interest for Six Months!” financing, not to mention interest-only
and negative amortization mortgages, consumers got used to the
idea that credit is nearly free and in nearly infinite supply.
Consumers no longer think of purchases in terms of total price of a
product or service but as a monthly payment that is a portion of
income. The monthly cost of a home that went for $1 million in
purchased with a $3.3% ARM carried the same monthly cost as a $500,000
home in 1995 purchased with a 6.6% fixed rate mortgage. The two
homes are equally affordable. Problem is, the two prices often applied to the same house but ten years apart.
Even though the home did not increase in value (utility) over that time, the
capital gains income earned by speculators and home owners from the
price inflation when selling these properties (tax free up to $500,000
in Massachusetts) enabled by cheap financing was happily counted by the
government as part of GDP growth.
Low interest rates also allowed
companies to sell $30,000 cars in monthly payments that used to apply
to much less expensive cars. In fact, everything from flat panel
TVs to washing machines to stuff into those $1 million homes became
more affordable on a monthly payment basis when the money lent to
consumers cost them nothing or next to nothing. When the 0%
monthly rate on a new credit
card jumped to $14% after the "introductory rate period" ended,
homeowners merely refinanced their homes, took
cash out of their inflated home price and used the difference to paid
off the credit cards. The result is putting cars, furniture, consumer
electronics and other rapidly depreciating assets on 30 year
mortgages. Aside from the horrifically bad household finance that
this behavior represents, this process was inflationary, supporting
ever higher goods prices. This is one of the ways that sustained
low interest rates have fueled inflation.
This is not a U.S.-only phenomenon. As The Economist pointed
out a year ago near the top of the global housing bubble in mid 2005,
housing price inflation had hit 18 major
economies, including South Africa, Hong Kong, Spain, France, New
Zealand, Demark, China, Italy, Belgium, Ireland, Britain, Canada,
Singapore and The Netherlands; and anywhere you have a
housing bubble you also have the Monthly Payment Consumer.
Economics is about behavior, and one of the behaviors of consumers
(formerly known as citizens) that global central bankers need to worry
about after years of low interest rates is that consumers do not pay
much attention to the list price of a good when affordability is
determined by the monthly payment, even for those products tortured
via hedonic pricing
into a price range that conforms to the Fed's models. Consumer
confidence is intended to measure consumer spending expectations and is
strongly correlated to future expectations of disposable income.
That used to be driven mostly by future job prospects, but I’d bet
consumer confidence has become a mostly a measure of consumers’
expectations of future access to cheap credit, as credit has since Volcker's era filled the gap for lower incomes and the declining purchasing power of income. Consumer
confidence has been declining
along with the rise in the cost of borrowing, suggesting that the
Fed’s tightening may in fact be starting to change the expectations
of consumers. Or maybe consumer confidence is getting hit by imploding home prices, now in decline via a predictable deflationary process, limiting households' access to cash-out refinancings.
Far from Main Street, low interest rates fueled financial leverage
games in the markets, from commodities, to emerging markets, to the yen
carry trade (e.g., borrow 1,000,000 yen from a Japanese bank, exchange
for U.S. dollars, buy bonds for the money. If the
bonds pay more than the amount you owe the bank for borrowing the
money when the loan comes due, as determined by both interest rates and
the exchange rate between
yen and dollars, you pocket the profit). These sources of GDP
growth are also at risk if a less than elegant down-shift in the credit
is not managed the same finesse James Bond uses to talk his hot adversaries into the sack in a 007 movie. Here the change in investor behavior can, as iTulip.com contributor John Serrapere points out in Peak Risk, be very dramatic.
Four months after Gross’ Last Vigilante piece appeared, so did the first rate hikes. Turned out that the Fed did not plan to clumsily hammer inflation by surprising the market with occasional
half or even full point rate hikes the way Bill Murray attacked gofers with explosives in Caddyshack, both
in 1980. Likely out of awareness of the risk of crashing the
Finance-Based Economy, the Greenspan Fed in 2004 attempted to sneak up on inflation.
By the end of November 2005, the Fed had hiked rates in ¼
point steps 14 times. Each hike arrived with all the terror
inducing surprise of the Who Dies Next scene in Scream 3.
If this approach succeeded in keeping the bond market from crashing as
it did in the early 1990s when Greenspan hit the brakes too hard and fast,
if also failed to slow inflation. Prices of non traded goods and
services -- including health care, insurance, energy, education and
housing that consume nearly all household income – went through
Not officially, though. The government stats
story was low inflation and strong GDP growth. To the man and
woman on the street, by the time the real inflation story started
to show up in the press (PDF), he and she had all but given up on the Bureau of Labored
Statistics' and other intellectually dishonest government reports of GDP, inflation and unemployment. They were too busy
trying to pay their fast rising gasoline, heating, insurance, food, and tuition
bills with their declining real incomes.
The delta between the inflation reality on the street and the official numbers
created a market for alternative economic statistics, such as John
used by corporations that have trouble wedging the official square peg
to fit into their economic round hole models. ShadowStats'
analysis puts Q1 2006 inflation close to 7%, unemployment near 12% and
Continued low long
bond yields and high prices implied that the bond markets were buying
the official line on inflation and GDP growth. But, in reality, high bond prices and
low yields were being maintained via purchases by The Three Desperados: Asian central banks, OPEC, and U.S. corporations; and by the speculators that Greenspan so appreciates, hedge funds.
Chart by Steve McGourty
Low interest rates were and are not
fuel for inflation. The full Keynesian post-bubble
included tax cuts and deficit spending that started in 2001.
While the Fed has been hitting the brakes on interest rates since 2004,
of tax cuts and deficit spending intended as a short term measure to
prevent the U.S. economy from falling into a Japan 1990s and U.S. 1930s
deflationary depression are nowhere to be seen.
Keynes is spinning in his grave. Deficit
spending, originally intended to blunt the impact of the
collapsing stock market bubble, has become ideologically
institutionalized by the
Bush administration with the argument Deficits Don't Matter,
with as much fabricated evidence as the administration provided to
prove the existance of
Weapons of Mass Destruction in Iraq. The addiction to deficit
spending to promote political aims is so strong that hitting printing
press peddle has
become the Republican Congress' Pavlovian response to any financial
pain experienced by voters, such as the proposed idiotic $100 coupon to
help consumers pay for that weekly $60 SUV fill-up with $3.00 gasoline.
How about an additional $3.00 gasoline tax and tax incentives to
buy smaller cars?
Click for Details
The impact on
the U.S. dollar from this kind of irresponsible spending has on all other nations that behave this way has been
diminished by the purchases of U.S. financial assets by foreign exporters and lenders
desperate to keep the U.S. economy going and themselves in power.
If not for purchases in 2005 by Japan ($685 billion), Mainland China
($257 billion), the United Kingdom ($234 billion), Caribbean Banking Centers ($111 billion)
and Taiwan ($71 billion), the Poom phase of Ka-Poom Theory would likely have happened in 2006 as initially forecast here.
Chart by John Serrapere - Click to Enlarge
Meanwhile, over the
period, sustained high energy prices have started to drive up all-goods
prices and squeeze corporate earnings.
Q4 2005: Stagflation Godzilla Strikes
The collapsing housing bubble, higher short
term interest rates and rising inflation from various sources led to the Attack of
Stagflation Godzilla. He hit the scene in technicolor in Q4 2005.
Global Central Banks Send Anti-Inflation King Kong to Fight Back!
April 4, 2006 our Daily News section ran a piece from Telegraph UK No mercy now, no bail-out later:
”As Ben Bernanke knows all too well, monetary policy is like
pulling a brick across a rough wooden table with a piece of elastic.
Tug, tug, tug: nothing happens. Tug a little harder: it leaps off the
surface and knocks your teeth out.”
The Fed had been tugging for years yet visible signs of inflation,
notably in gold and oil as priced in dollars, continued to show that
inflation was becoming an serious problem. Starting earlier this
year, the Fed finally got some help. The world’s central
banks embarked on a concerted effort to tame global inflation.
The brick didn’t fly off the table until May 2006, as
central banks in Canada, Chile, Switzerland, Sweden, Australia, Hong
Kong and Thailand increased their interest rates by a quarter
percentage point in April and May and China hiked rates by 0.27
percentage points in April. The European Central Bank (ECB) hiked
its key rate by a quarter percentage point to 2.75 percent on June 8,
India raised its key rate a quarter percentage point the same
day. Quarter points, all. While the steps are small, taken
in unison they amount to a mighty attack of an Anti-Inflation King Kong against Stagflation Godzilla, with the fate of the Finance-Based Economy hanging in the balance.
The epic battle between Stagflation Godzilla and Anti-Inflation King Kong started
to hit the markets in mid
May, three months after iTulip.com re-opened after a four year hiatus
to warn readers that big events were about to take place.
What's happened so far
to the markets underfoot? Let's take a look.
The charts below show the results of the
battle in three areas over the three months starting in mid-March when
iTulip.com returned: the U.S. stock market, the UK stock market (as
indicative of EU stock markets), EEM as an indicator of emerging
markets and copper as an indicator of commodities prices.
Dow Jones: Down in May
FTSE: Down in May
Emerging Markets Index: Down in May
In the first Godzilla movie, the monster destroys Tokyo during an unstoppable rampage. In the end, he is encased in ice by the Oxygen Destroyer, a weapon used by its inventor against the beast to save the world from
destruction. The inventor himself dies in the attack. At the end of the next movie in the series Godzilla Raids Again, Godzilla is released from his iceberg and in the next movie King Kong vs. Godzilla, the monster once again rampages through Japan. When King Kong is brought to Japan, he encounters Godzilla and both creatures fight for supremacy. An earthquake sends both creatures into the depths of the ocean, but King Kong later resurfaces and returns to his home island, victorious.
Copper Spot Price: Down in May
Paul Volcker single handedly succeeded in encasing Stagflation Godzilla
in ice by hiking rates to 19% in 1980 and sending the U.S. economy into
an on-and-off again three year recession. Starting in 2001, three
years of low interest rates, tax cuts, deficit spending, rising energy
costs followed by gradual rate hikes by the Fed melted Stagflation Godzilla's iceberg where Volcker left him frozen in 1983. Stagflation Godzilla came ashore in late 2005, bent on economic rampage. Global central banks brought Anti-Inflation King Kong from his island to fight Stagflation Godzilla in 2006. In May, the two started rolling over the markets as they fight to the death.
Who will win? Can the Finance-Based Economy be saved? Will it survive the battle?
Next Week: Stagflation Godzilla Greases King Kong with the Oil Destroyer (pdf)
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