Core Incompetency

Michael Pento’s Market Commentary

For years the Federal Reserve has told us that in order to detect inflation in the economy it is important to separate “signal from noise” by focusing on “core” inflation statistics, which exclude changes in food and energy prices. Because food and energy figure so prominently into consumer spending, this maneuver is not without controversy. But the Fed counters the criticism by pointing to the apparent volatility of the broader “headline” inflation figure, which includes food and energy. The Fed tells us that the danger lies in making a monetary policy mistake based on unreliable statistics. Being more stable (they tell us), the core is their preferred guide. Sounds reasonable…but it isn’t.

If it were truly just a question of volatility the Fed may have a point. But for headline inflation to be considered truly volatile, it must be evenly volatile both above and below the core rate of inflation over time. If such were the case, throwing out the high and the low could be a good idea. However, we have found that for more than a decade headline inflation has been consistently higher than core inflation. Once you understand this, it becomes much more plausible to argue that the Fed excludes food and energy not because those prices are volatile, but because they are rising.

If you talk about the grand sweep of Fed policy, it’s fairly easy to fix the onset of our current monetary period with the onset of the dot.com recession of 2000. To prevent the economy from going further into recession at that time, the Fed began cutting interest rates farther and faster than at any other time in our history. During the ensuing 11 years, interest rates have been held consistently below the rate of inflation. Even when the economy was seemingly robust in the mid years of the last decade, monetary policy was widely considered accommodative.

Over that time annual headline Consumer Price Index (CPI) data has been higher than the Core CPI 9 out of 11 years, or 81% of the time. Looking at the data another way, over that time frame, the U.S. dollar has lost 20% of its purchasing power if depreciated year by year using core inflation, and 24% if depreciated annually with headline inflation. The same pattern held during the inflationary period between 1977 thru 1980, when the Fed’s massive money printing sent the headline inflation rate well above the core reading. The empirical evidence is abundantly clear. When the Fed is debasing the dollar, headline inflation rises faster than core. The reason for this is clear. Food and energy prices are closely exposed to commodity prices which have a strong negative correlation to the falling dollar that is created by expansionary policies.

Data we have seen thus far in 2011 underscores the need to focus on headline inflation and to avoid the trap of relying on the relatively benign core. The difference between the core rate and headline rate of inflation was .6 percent in January and a full percentage point in February. If annualized those relatively small monthly disparities will become enormous.

It is shocking how few Americans, even those with economic degrees and press credentials, fully appreciate the Fed’s vested interest in reporting low inflation. With benign data in hand, Fed policy makers are given a free hand in adopting stimulative policies. Central bankers who shower liquidity on the economy earn the gratitude of their peers and the thanks of their political patrons. But once a central bank goes down the expansionary path to fight recession it is much easier to keep pumping money than to reverse course when inflation starts to bite into purchasing power.

The sad truth is that the Fed’s record low interest rates are once again causing food and energy prices to rise much faster than core items. Bernanke is focusing on the core just as we need him to focus on the headline. It’s time for the Fed to stop hiding behind flimsy statistical juggling and to start protecting the value of our dollar, which unfortunately is in free fall no matter what statistics one chooses to use.

Spending Your Stash

By Peter Schiff

While gold and silver coins are nice to look at, and there’s a certain sense of independence one gets from owning them, most purchasers buy physical precious metals with the goal of eventually spending them.

As they say, you can’t take it with you.

Unfortunately, many purchasers buy without ever knowing how to spend, and that can cause problems down the road. The reason I say “spend” instead of “sell” is that selling your coins for dollars (or euros, yen, etc.) is only one way to spend them. The other is to barter directly for goods and services. Whichever method you choose, it’s important to know all your options.

The Inflation Knuckleball

By Michael Pento

By its very definition, fiat money is something created out of thin air: the word “fiat” is Latin for “let it be done” (as in, by decree). But the convenience that such a currency system offers central bankers is paid at the expense of savers. With nothing of real or lasting value on which to anchor, the value of fiat currencies can always blow away like ashes on a windy day.

For the past 40 years or so, every country on the planet has relied on fiat money. To a very large extent, this means that the national economies are far more exposed to the whims of their central bankers than they have been in the past. So, if central bankers go off their meds, the danger to the currency becomes profound. Unfortunately, at America’s Federal Reserve, it seems the inmates are now running the asylum.

We are being led to believe that falling prices are evil, and that only an increase in inflation can save our economy. From the moment the financial crisis took hold in 2008, Fed Chairman Ben Bernanke has looked to lower the dollar’s value and cause asset prices to rise – especially in real estate. But his pitch is wildly off the mark. The Fed can’t control the exact rate of inflation, nor can it direct where inflation will be distributed across the economy. In other words, inflation is like a knuckleball: once you let it loose, you’re never really sure where it’s going to go. And Bernanke’s pitches are so wild it would make Tim Wakefield jealous.

Thus, we are seeing rising prices everywhere except where Bernanke really wants them – real estate. Data released last week shows that the median price of existing homes declined 5.2% in February compared to the previous year, to $156,100. New home prices fared even worse; the median sales price dropped to $202,100 in February, from $221,900 a year earlier – a tumble of some 9%!

However, commodity prices provide the arena in which the the Fed’s lack of inflation control becomes most apparent. So far this year, gold is up over 4% and the CRB Index is up 8%.

Meanwhile, over the same period, the dollar has dropped over 4% against other fiat currencies, according to the Dollar Index. This has occurred despite global economic developments that would normally benefit a currency that has “reserve” status: Japan, the world’s third largest economy, has been taken off-line due to a catastrophic earthquake; the EU is facing another massive bailout bill as Portugal failed to pass austerity measures; and, a sandstorm of destabilizing revolutions is sweeping through the Middle East. Yet, instead of providing a safe haven for skittish capital, the dollar has recoiled.

It’s really no wonder that faith is waning. As the dangers of inflation become increasingly apparent, there is still no prospect for a change in policy any time soon. By all reasonable accounts, commodity prices will continue to surge as real interest rates continue to fall. Right now, the yield on the one year T-bill is .23%, while the YoY increase in inflation is 2.1%. And this is using the government’s twisted figures! I estimate real interest rates are somewhere close to -8.75%. Therefore, investors are being thrust into the arms of precious metals and away from dollar-based assets. There really isn’t much choice.

However, since the real estate market was in a prolonged and lofty bubble, it will be the last asset class to respond to the Fed’s dollar debasement strategy. Although Bernanke is noted for his Great Depression scholarship, it should be obvious by now that he never spent much time studying asset bubbles. If he did, he would have learned that gold took decades to recover from its crash in 1981. The NASDAQ is still 45% below its all-time nominal high set over a decade ago. And, unlike housing prices, these markets were allowed to clear themselves after their respective crashes. Prices dipped more than 70% before turning north in earnest. In contrast, home prices are being kept in a rump bubble by Fed stimulus. Amazingly, since 40% of the core CPI is owner’s equivalent rent, Bernanke will continue to miss the mark about the true level of the inflation he has created.

The aftershock of the real estate bubble has sent millions of homes into foreclosure, left 11% of homes vacant, and caused 23% of mortgage holders to be without any equity in the home. Unless the Fed starts to create credit to buy houses directly off the market, it will be very difficult to get real estate values to move higher.

It is clear that by trying to channel his inflation into just one asset class, Bernanke has placed the entire US economy in severe danger. He now faces a serious conundrum. Does he raise interest rates significantly to fight inflation at the cost of a second housing market collapse, or does he sit idly by and watch the broader economy become as unaffordable as a resetting Option-ARM mortgage? Neither choice is pleasant, but one thing’s for sure: if the bond vigilantes start to raise interest rates for him, we’ll know his knuckleball missed the strike zone.

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The Treasury Auction Shell Game

By Peter Schiff

Very few people have either the time or patience to sift through the data released by the Treasury Department in the wake of its bond auctions. But the numbers do provide direct evidence of the country’s current financial condition that in many ways mirror a financial shell game that typifies our entire economy.

Despite continued deterioration of America’s fiscal health, the Treasury is still attracting adequate numbers of buyers of its debt, even with the ultra low coupon rates. Market watchers take these successful auctions as proof that our current monetary and fiscal stimulus efforts are prudent. But who’s doing the buying, and what do they do with the bonds after they have been purchased?

Most people are aware that foreign central banks figure very prominently into the mix. They buy for political reasons and to suppress the value of their currencies relative to the dollar. And while we think their rationale is silly, we do not dispute that they will continue to buy as long as they believe the policy serves their own national interests. When that will change is harder to determine. But another very large chunk of Treasuries go to “primary dealers,” the very large financial institutions that are designated middle men for Treasury bonds. In a late February auction, these dealers took down 46% of the entire $29 billion issue of seven year bonds. While this is hardly remarkable, it is shocking what happened next.

According to analysis that appeared in Zero Hedge, nearly 53% of those bonds were then sold to the Federal Reserve on March 8, under the rubric of the Fed’s quantitative easing plan. While it’s certainly hard to determine the profits that were made on this two week trade, it’s virtually impossible to imagine that the private banks lost money. What’s more, knowing that the Fed was sure to make a bid, the profits were made essentially risk free. It’s good to be on the government’s short list.

Given that the Treasury is essentially selling its debt to the Fed, in a process that we would call debt monetization, some may wonder why it doesn’t just cut out the middle man and sell directly. But the Treasury is prevented by law from doing this, so the private banks provide a vital fig leaf that disguises the underlying activity and makes it appear as if there is legitimate private demand for Treasury debt. But this is just an illusion, and a clumsy one to boot.

One wonders how the market could be soothed by these results when they are so clearly manipulated. But the more important question is when the foreign governments reverse their currency policies, and when the investment banks are no longer guaranteed a quick short term profit, will there be anyone left willing to show up at Treasury auctions?

According to the Office of Management and Budget, the U.S. government is expected to run a $1.6 trillion deficit in fiscal year 2011 (which expires in September). The Federal Reserve’s current quantitative easing program is taking down a large share of that red ink. But “QE2” expires in July, and in fiscal year 2012, the Federal government is projected to run a $1.1 trillion deficit (that of course could grow if the economy weakens). An additional $1.1 trillion in Treasury notes and bonds will mature over that 12 month period. So in total, the Treasury will need to issue a total of at least $2.2 trillion in notes and bonds in FY 2012. This translates into quarterly borrowing needs of approximately $550 billion, more than double the average of the last two quarters. To put this into perspective, the entire U.S. personal savings rate is about $650 billion annually. Even if every dime of this amount were ploughed into Treasuries, we would still need to borrow or print another $1.6 trillion.

At the height of the financial crisis in Q4 2008, the Treasury issued a record $560 billion of notes and bonds. Fortunately for them, that spike corresponded neatly with huge inflows of funds into Treasuries as investors sought safety from collapsing equity and corporate debt markets. Will the Treasury catch that break once again? There may be another financial panic, but will investor reaction be the same this time around? Bill Gross, the founder and chief investment officer of PIMCO, the world’s largest private purchaser of bonds, recently announced that he is reducing his Treasury holdings to zero. It is not clear what would convince Gross to get back into the market with both feet, but one might expect at minimum it would take much higher interest rates.

If private investors stay on the sideline, how does anyone expect the Treasury to sell its inventory without the support of a quantitative easing program from the Fed? Do they expect the Chinese to reverse course on their current policy and start heavily buying U.S. debt once again, irrespective of the damage to their own economy? That seems extremely unlikely given the drift in Chinese currency policy. More likely the Fed will remain the only buyer, meaning QE3, 4, and 5, are all but certainties. There should be no remaining doubts…the U.S. Government intends to monetize its own debt. Of course, as bad as things will be if QE ends, it will be that much worse the longer it continues.

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Quake Response Puts Yen on the Line

By Peter Schiff

One of the immediate financial consequences of the catastrophic Japanese earthquake is that Japan needs to call on its huge cache of foreign exchange reserves to rebuild its shattered infrastructure. To pay for domestic projects, Japan will require yen – not dollars, euros or Swiss francs. As a result of these conversions, the yen rallied considerably after the quake struck.

Interest Rates Are on the Launch Pad

Michael Pento’s Market Commentary

A few months ago, the chorus sung by the recovery cheerleaders reached a crescendo when expanding consumer credit statistics and surging US trade deficits provided them with “evidence” of an economic rebound. In declaring victory, they overlooked the very nucleus of this past crisis: namely, the enormous debt levels and bubbling inflation that created fragile asset bubbles. If they had recognized the original problem, they would have remained silent. In reality, only a reduction in US debt levels or increase in the value of the dollar would have signaled a budding recovery; but, thanks to the Federal Reserve and Obama Administration, there is virtually no way those results will ever be seen.

Last week’s Flow of Funds report issued by the Federal Reserve clearly underlines the fact that we, as a country, haven’t just avoided deleveraging, but rather continue to accumulate debt. At the end of the last fiscal year, total non-financial debt (household, business, state, local, and federal) reached an all-time record high of $36.2 trillion. Not only is the nominal level of debt at a record, but also debt-to-GDP – a far more worrying statistic. In Q4:07, total non-financial debt registered 222% of GDP. In 2008 and 2009, it was 238% and 243% respectively. As of Q4:10, that figure had risen to 244% of GDP, For some perspective, look back to the turn of the millennium, when total debt-to-GDP was ‘just’ 182%. Even that level points to a sick economy, but today’s make you wonder how the patient is still breathing.

It is clear to me that the overleveraged condition which brought the economy down in 2008 still exists today – only worse. For all the suffering and displacement that has gone on, all we have accomplished is an unprecedented transfer private debt onto the Treasury’s balance sheet. Now that the Fed is (hopefully) just months away from taking the printing presses off overtime, the paramount question is how fast interest rates will climb. The Fed has been able to keep yields this low through relentless devaluation and a propaganda campaign that convinced the majority of investors that deflation was a credible threat (kinda like those phantom Iraqi WMDs).

But Washington’s ability to continue that ruse is coming to an end. The unrelenting growth of the Fed’s balance sheet, increasing monetary aggregates, surging gold and commodity prices, $100/barrel oil, soaring food prices, and trillions of dollars of new debt projected for the near future have served to vanquish the deflationists. Any echoes of those once prominent voices can barely be heard amid the thunderous roar of oncoming inflation.

So therein lies the problem for the Fed. Any further debt monetization by the central bank now becomes counterproductive. That’s because as inflation rates climb, bond investors demand higher interest rates. The lower real interest rates become, the less participation there will be in the bond market from private sources. If you don’t believe me, ask Bill Gross.

The Fed is now damned if it does and damned if it doesn’t. Interest rates have been artificially suppressed for such a long time that no matter what Bernanke does come June, interest rates will rise. If it enacts another iteration of Quantitative Easing, the Fed may find itself the only player in the bond market. Of course, the Fed could potentially buy all of the auctioned Treasury debt in order to keep rates low—as uncomfortable a position as that may be—but still all other interest rates, from bank loans to municipal debt, would skyrocket. Unless… the Fed decided to buy all that debt too. Hello Zimbabwe!

That scenario is still farfetched, but Bernanke’s logic eventually leads there. The truth is that only a central banker could afford to own bonds that are yielding rates well below inflation, and growing even more so. Even if Bernanke ceases firing dollars into the bond market, yields will still have to rise to the level at which they provide a real return. How much higher would rates go, you ask? Well, Mr. Gross has some thoughts on that:

“Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and, by that standard, are 150 basis points too low; (2) real 5-year Treasury interest rates over a century’s time have averaged 1½%, and now rest at a negative 0.15%!; (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP, and now rest at 475 basis points under that historical waterline.”

To the above I say: not a bad start, Mr. Gross, but these aren’t exactly average times. We have never had a Fed balance sheet anywhere near the $2.6 trillion that it is today. The nation has never faced the prospect of $1 trillion deficits as far as the eye can see. Nor have we ever had our total debt as a percentage of GDP reach 244%.

The bottom line is that a massive increase in the supply of debt coupled with a rising rate of inflation will always place upward pressure on interest rates. Once the Fed steps aside from buying 70% of the Treasury’s current auctioned output, it will leave a gaping hole. And for those Pollyannas who claim we are in an economic recovery, I would ask them the following questions: Who will supplant the Fed’s purchases of Treasuries at current yields? Since the level of debt in the economy has grown since the recession began, why won’t rising rates place us back into an economic funk? Can the Fed unwind its balance sheet before inflation ravages the country? And, if the Fed isn’t able to raise rates significantly, what will stop the dollar from collapsing?

Then again, I guess it all comes down to one simple question: do you believe the laws of supply and demand apply to US Treasuries? If you do, then watch out for soaring yields.

A Little Understanding Goes a Long Way

By Peter Schiff

As the world confronts one of the most critical periods of economic upheaval that it has ever seen, it is clear that our most influential economic stewards have absolutely no idea what they are doing. But, like kids with a new chemistry set, they are nevertheless unwilling to let that stand in the way of their experimental fun. As they pour an ever-growing number of volatile ingredients into their test tubes, we can either hope that they magically stumble on the secret formula to cure the world’s ills, or more pragmatically, we can try to prepare for the explosion that is likely to result.