The Underlying Credit Crisis's Recent Effect on Market Prices

Once again, Doug Noland at Prudent Bear has come up with an answer I was looking for.

In this post from August 8, he offers one explanation for our current strange market conjuncture.

Commodity prices for things like food, petroleum, and oil ran up to record levels up until about mid-July for reasons that are unclear, but that economists have described as resulting from a mixture of:

1. Increased worldwide demand along with supply problems; and/or

2. Speculation that the US dollar would collapse.

In mid-July, along came the Freddie and Fannie problems (see this post for an explanation of the origin of their predicament, and this one for the latest dire news).

Then Treasury Secretary Henry Paulson issued this press release regarding the Treasury's intention to bail out Freddie and Fannie should problems arise.

We also learned of the Treasury's intention to bail out the FDIC (the government entity that guarantees some of your deposits at the bank) in case of need. (See this TickerForum.org entry explaining the FDIC situation, which forum, by the way, proves that ordinary citizens are not as dumb as some would think.)

These two government announcements blow both hot and cold. On the one hand, they reassure Freddie and Fannie bond holders and FDIC insureds that their investments will not disappear. This should be good news for the economy and for the market, and therefore for future demand for commodities.

On the other hand, they scream to market players that the US Government officials are really worried about Freddie, Fannie, and the banks. So what should be good news for market players and for future demand for commodities turns into a bad omen for the economy and thus for those same commodity prices.

Meanwhile, the signs of a recession are already evident. (See this American Institute for Economic Research post for the stats.)

So it would make sense that commodity prices would start to reverse big-time, which in fact they did in mid-July.

But--and here's the odd part--the stock market took a simultaneous leap upward, as did the dollar, counterintuitive movements under the circumstances.

Does this mean that the coming recession is somehow calming stock market nerves and inflation hawk fears? Perhaps so, because it might cause "inflation" (read "CPI price increase") to disappear just as the Fed predicted; and it will therefore allow the Fed not to raise rates to curtail such "inflation" (read "CPI price increases"). Low Fed rates mean, in the minds of some market players, that money will be available and things will improve.

BUT: I can't believe that such recessionary momentum will avert real inflation as that term is used in academic economics (read "excess money and credit"--see this post for an explanation of this word's definition problem), even though it may put a brake on CPI price levels.

I believe that real inflation will increase because:

The Fed and Treasury are taking unprecedented measures to avoid catastrophe, i.e. they have once again succumbed to the temptation to use the printing press to pay the monetary system's way out of trouble. They will use Treasury funds to bail out Freddie, Fannie, the FDIC, and--through the Fed's newly seized lending powers--any major failing commercial banks and other financial institutions. And these operations will be carried out on an unprecedented scale.

Remember, real inflation means more dollars running around than is necessary in a balanced monetary system. It means that you will be paying too many dollars for a particular thing, no matter whether the actual price of that thing rises, or whether the price just stays the same when it should in fact be falling in a deflationary market.

This also means that gold prices expressed in dollars (and perhaps other commodity prices as well) will not tend to decrease in the long run, because gold is a hedge against real inflation.

Doug Noland puts my theory into more appropriate financialese in his article. He offers a plausible explanation of how the speculative community has functioned under these unusual circumstances.

I particularly liked these two ideas:

"[I]t is not the nature of dislocated markets to let fundamentals get in the way of price movement. Markets, after all, live on fear and greed."

He is referring here to speculative markets, the ones he credits with causing both the run-up in commodity prices and the recent crashing of same.

And this one:

"The unwind[ing] of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis."

He is talking about the credit maladjustments that are taking place behind the scenes and that most of us never hear about. See this post for a description of these.

This should all play out by the end of this year. Hold onto your hats.

The Central Banker Credibility War

Every weekend I turn to three sources of bearish information, having been fed to the gills all week long with bullish Wall Street candy.

My three favorite permabears are:

PrudentBear.com
SirChartsAlot.com
The-Privateer.com

This week, it's this July 8 article by Gary Dorsch at SirChartsAlot.com that got my attention.

He points out that stagflation is here, just as we all expected it would be.

He also notes that today's global game is one of central bank credibility, a game that the US, the UK, and a few others are losing.

Back in the early 1980's, Paul Volcker, the then Fed Chairman, took the stagflation bear by the paws and wrestled it down to the ground in spite of the bitter deflationary medicine it required the US economy to take.

Today, "Mr. Volcker warned US Treasury chief Henry Paulson, and Fed chief Ben Bernanke against letting inflationary expectations become embedded once again." Unfortunately, neither "Strong-Dollar (Ha-Ha)" Paulson nor Helicopter Ben is listening.

Another inflation hawk, the Bank of International Settlements chief Malcolm Knight, said on June 24 that “'[t]here must be a forceful response to confront the danger that inflation expectations could rise appreciably, with all the attendant problems that would bring.... With inflation a clear and present threat, and with real policy rates in most countries low by historical standards, a global bias towards monetary tightening would seem appropriate, even though economic growth is likely to be hit harder than most observers expect....'"

He too is talking to himself.

Dorsch continues:

"So far, the Fed and US Treasury have ignored Volcker’s [and Knight's] advice, and instead, are pegging the fed funds rate at -2.25% below the inflation rate, while inflating the MZM Money supply at a +16.5% annualized rate, a prescription for hyper-inflation. [Meanwhile,] the Fed’s aggressive rate cuts have failed to stop the bleeding...."

Why are they ignoring such good advice? Well, here's one explanation: Apparently some of our Fed governors just don't get it:

"San Francisco Fed chief Janet Yellen told her audience ... 'I see inflation expectations as reasonably well anchored. There is little monetary policy can do about rising commodities prices. If rising commodity prices reflect supply and demand fundamentals, then the situation is not likely to turn around any time soon.'”

But what a big IF that is, my dear. There is a distinct possibility that people like Anna Schwartz and Milton Friedman are right, and that "inflation [rising prices] is always and everywhere a monetary phenomenon."

After all, why would food and energy prices suddenly and violently increase if they were caused only by supply and demand?

The increase in global demand for food and energy and the resultant tightening of supply are two forces that have been on the increase over more than a decade now, and that have been squarely in the sights of suppliers worldwide for at least that long. Why the sudden upward move over the last year?

The only credible answer is that the market is finally waking up to the fact that, Yes Dorothy, inflation IS, always and everywhere, a monetary phenomenon, and Yes, Dear, it's coming back with a vengeance.

Unfortunately, what our US and a few other central bankers seem to be losing is the only thing they ever had to bank on--lacking as they do any scientific foundation--and this is their credibility; and this loss is being hedged against by at least two who seem to have the guts our bankers lack: the central bankers of China and Europe.

China's bankers warned the stock market public that they intended to act no matter what; and they did.

Likewise in Europe, "on Dec 19th, 2007, Trichet was asked on German television channel N-TV if the bigger danger to the Euro zone economy was the banking crisis or inflation? 'The response is very clear. We have a mandate. The primary goal is to preserve price stability. We are alert, and everybody must know that we will do whatever is needed, to deliver price stability in the medium term, and be credible in that delivery. The single needle in our compass is price stability,' Trichet said."

Fortunately for him, the European Central Bank mandate is straightforward price stability, unlike our dual mandate of price stability and steady employment in the US. (For further discussion on this point, see this article of mine, Page 1, Page 2, and Page 3 at the Los Angeles Business Journal.)

On the other hand, "the ECB’s anti-inflation crusade is thwarted by the other G-7 central banks [Japan, UK, US, Canada], which are afraid to raise their interest rates to combat speculators in commodities. Legions of 'yen carry' traders have migrated over from the global stock markets to the crude oil markets, since the rescue of Bear Stearns in mid-March [and since Dorsch's article was written, they seem to be moving elsewhere]. A continuation of the 'Commodity Super Cycle' to new high ground could trigger another ECB rate hike to 4.50% in the months ahead, putting enormous pressure on Bernanke to lift the fed funds rate to defend the dollar, or surrender the last ounce of the Fed’s credibility."

The question is becoming, Does Bernanke have the economic argumentation, the political mandate, and/or the plain-old cojones to begin raising rates?

We'll see Tuesday.

My bet is, they'll forgo it "this time"; and they'll jawbone about the lurking dangers of inflation just in case anyone's listening. But market ears are becoming deaf ears; and soon, without action by the Fed, inflation will take over in earnest. Then, someone in that Naked Emperors' Court will be obligated to do something.

(Until then, don't sell your gold.)