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The link between commodity prices and monetary policy

As commodity prices continue to explore new high ground, I thought it appropriate to dig a bit deeper into the relationship between commodity prices and monetary policy. I've argued for a long time that rising commodity prices are a good sign of both economic growth and accommodative (e.g., inflationary) monetary policy, but I've never tried to say just which was the dominant factor. It may be a waste of time, but supply-siders like me simply can't shake our deeply held conviction that sensitive market prices are valuable and leading indicators of what's going on with monetary and fiscal policy—much better than official measures such as the CPI and GDP.

I frequently show a chart of the CRB Spot Commodity Index, an index I particularly like since it contains no energy prices and is representative of a broad range of basic commodities, many of which do not have associated futures contracts. The description below comes from the CRB website, and sheds further light on why the index is constructed as it is:

The Spot Market Price Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity.
The commodities used are in most cases either raw materials or products close to the initial production stage which, as a result of daily trading in fairly large volume of standardization qualities, are particularly sensitive to factors affecting current and future economic forces and conditions. Highly fabricated commodities are not included for two reasons: (1) they embody relatively large fixed costs which fact causes them to react less quickly to changes in market conditions; and (2) they are less important as price determinants than the more basic commodities which are used throughout the producing economy.

The commodities included in the index are burlap, butter, cocoa beans, copper scrap, corn, cotton, hides, hogs, lard, lead scrap, print cloth, rosin, rubber, soybean oil, steel scrap, steers, sugar, tallow, tin, wheat, wool tops, and zinc. There are two primary sub-indices of the CRB Spot Index, both of which are shown in the charts above (Raw Industrials 59% and Foodstuffs 41%). As should be apparent, no matter how you slice it, commodity prices are rising strongly across the board these days, and reaching new all-time highs almost daily.

The folks at CRB built their indices on the assumption that basic commodity prices were good leading indicators of changes in economic activity. What they missed, however, was that commodities can also be good indicators of changes in the effective stance of monetary policy.

When almost all commodities are behaving in a similar fashion, Occam's Razor would suggest that there is probably some simple, common denominator working behind the scenes. How easy is it to believe that the producers of almost every single commodity out there are failing to keep up with the demand for their product at almost exactly the same time?

An easier explanation is that monetary policy is the common denominator. As partial proof, consider the chart below, which shows that there has been a relatively strong inverse correlation between the value of the dollar and commodity prices. Moreover, the dollar started weakening, and commodities started rallying, right around the time (late 2001) when the Fed began lowering interest rates in earnest: the Fed funds rate was slashed from 6.5% in late 2000 to 1.75% by late 2001, and was subsequently lowered to 1% from mid-2003 through mid-2004. Monetary policy was unquestionably easy for five years, even as the economy picked up steam beginning in the second half of 2003. It should not be surprising, therefore, that the dollar collapsed, and gold, commodity and housing prices soared—it was a classic example of what happens when a central bank dumps tons of excess money into the market. Money loses its value, and the price of things goes up.

Scott Sumner—a rising star in the economics profession, in my estimation—has penned some insightful comments on the subject of commodity prices and monetary policy, and he is one of the very few competent advocates of the theory that the Fed should target nominal GDP instead of inflation. His logic leads him to assert that the huge drop in commodity prices in 2008 was a clear sign that monetary policy was way too tight. I happen to agree with him, even though that is a very controversial opinion to have held at the time. Although I never said the Fed was way too tight in so many words, I argued in Oct. '08 that the Fed's massive balance sheet expansion was a good thing, since it was an appropriate response to the huge increase in money demand that was behind the huge decline in commodity prices. I went on to say that the Fed's quantitative easing should "at the very least forestall or reverse any deflationary tendencies that might result from the current financial crisis." And indeed, commodity prices hit bottom in early Dec. '08; subsequently, the consumer price index started to rise in early 2009, and by June '09 the economy began to recover. I think there is no question but that the Fed acted appropriately, even though, in retrospect, they probably should have acted sooner than they did. Their delay in implementing a massive easing program most likely exacerbated the decline in commodity prices and deepened the panic/recession.

I would further note that the dollar rose at the same time commodities collapsed in late 2008, with both actions the logical result of a sudden and effective shortage of money relative to the demand for money.

The next chart shows how gold and commodity prices have moved together, with gold tending to lead. This is more evidence that big swings in commodity prices can have a monetary origin. Why should gold move in sync with or in advance of commodities, if the movements of both weren't the result of an excess or a shortage of money?

What does all this mean? For one, the strong upward trend evident in both gold prices and commodity prices is a signal that quantitative easing is working. Working with a vengeance, in fact. If the significant fall in gold and commodities in late 2008 was a signal that the Fed was failing to provide enough liquidity to the market, then the even greater rise in gold and commodity prices over the past two years is telling us that the Fed has by now provided more than enough liquidity. QE2 should be halted and possibly reversed. The risk we face, however, is that the Fed will be very reluctant to reverse course, fearful that all the "slack" still out there continues to pose a deflationary threat to the economy. Plus, tightening monetary policy at a time when unemployment is still sky-high would be fraught with difficulties from a political perspective.

So if the Fed continues to ignore the signals that it has eased enough (e.g., a very weak dollar, strong commodity and gold prices, rising forward inflation expectations and a very steep yield curve) does that mean the result will be hyperinflation? I'm not prepared to say that yet, but I do think that it implies one should have at least one oar in the water pulling in the direction of assets that will benefit from a rising price level. Treasuries are most definitely not one of those assets, but equities, corporate bonds, and inflation-adjusted bonds are.

While it's scary to see gold and commodity prices shooting higher, it's not necessarily the end of the world. In real terms, gold and commodity prices are still well below their historical highs. The dollar is very weak, but it's been this weak several times in the past without resulting in a catastrophe. It's also the case that while monetary policy can have an almost immediate and profound impact on commodity prices, it can take a long time for monetary mistakes to filter through the massive U.S. economy. For example, the Fed's aggressive tightening in the late 1990s didn't cause a recession until 2001—and a mild one at that—and we didn't see a meaningful decline in the inflation statistics until mid-2003. If took four years of super-easy monetary policy, beginning in 2002, to result in an unsustainable housing price bubble in 2006. Sometimes problems can persist for much longer than one might expect.

Meanwhile, I think the dominant themes of the past year or two will continue to play out. Deflation fears are vanishing, and confidence is slowly returning. The economy is improving, and growth can trump a lot of problems. Fiscal policy is in the process of improving meaningfully. Contrary to what you see in the press, even sharp cutbacks in federal, state, and local spending needn't be bad news for the economy; reduced spending by the public sector frees up resources for the far more efficient private sector. Starve the public sector beast and you feed the private sector job-creating machine. So I remain optimistic, especially since so many people are still so worried.

UPDATE: Ronald McKinnon (a great economist whose books I studied in 1979-80) has an excellent article in the WSJ which expands on the ideas discussed in this post.

Thoughts on the Phillips Curve

The Phillips Curve theory of inflation says that inflation is a by-product of strong growth. When an economy "overheats" and things are humming along at or close to "capacity," then supply can't keep up with additional demand and producers start raising their prices. Conversely, when the economy goes into a slump and a lot of economic "slack" develops, then everyone has spare capacity, there's lots of price competition, supply exceeds demand, and prices tend to fall. It's all very intuitive, but from a monetarist's perspective, its dead wrong.

It's true that if the supply of apples exceeds the demand for apples, then the price of apples is very likely to fall. But that's a statement about the relationship between the supply of and the demand for apples; it doesn't say anything about the relationship between the market for apples and the amount of money in the economy. Inflation is a condition wherein the supply of money exceeds the market's demand for money, so an excess of money tends to drive all prices higher. Imagine if the amount of dollars in circulation increased by 100% overnight: the price of just about everything in the economy would quickly start rising, and in the end, the price level would end up rising by 100% or so. Even if there were more apples on the market than people wanted, the price of apples would rise if the money supply doubled. I've lived in hyperinflationary times (the late 1970s in Argentina), and I know that prices can rise even if the economy is in a deep recession.

The Phillips Curve theory got a big boost in the 1970s, because the relationship between inflation and capacity utilization (see the chart above) was very tight. There was a reliable, 17-month lag between changes in capacity utilization and the inflation rate. That lag reflected the fact that it takes time for the economy to adjust to changes in underlying monetary conditions.

But then the relationship stopped working, starting in 1982. Capacity utilization rose through 2000, but inflation fell. Since then there has been a modest correlation between the two, but nothing like what we saw in the 1970s. My explanation for why the Phillips Curve worked in the 1970s is that the Fed was following a very reactive strategy: tightening after inflation rose, then easing after inflation fell. They were always adjusting to the realities of the economy after the fact; easing for too long, and then abruptly tightening after inflation was rising and entrenched.

But in the 1980s the Fed started pursuing a very tough line against inflation, proactively tightening even before inflation rose (e.g., the late 1990s). In 1998 and 1999 I started worrying that they had tightened way too much, and that deflation was a serious risk. By 2002 deflation was indeed a major concern for the Fed, and so from about 2003 on, the Fed became reactive again, easing in response to the fear of deflation, even as there were many signs that policy was too easy (e.g., rising commodity, gold, and housing prices), and so the correlation between capacity utilization and inflation has increased somewhat.

Still, the huge swings in capacity utilization and inflation in recent years has been nothing compared to the 1970s. But it remains the case that the Fed is once again behaving in a reactive, rather than proactive manner. The FOMC assigns much more importance to the relatively low rate of capacity utilization and the amount of economic "slack" there appears to be today, than to the impressive and ongoing rally in commodity prices and gold prices, or to the historically weak level of the dollar. (And recall that it was the collapse of the dollar in the 1970s that really got inflation going.) So it's reasonable to think that the recent surge in capacity utilization ought to be followed by at least a mild uptick in inflation.

Given the 17-month lag between capacity and inflation that played out so well in the 1970s, we may well have seen the low in the CPI for the next several years. And that is exactly what the Fed wants to see—higher inflation. Never doubt the Fed's ability to get what it wants.

Even though inflation is low, monetary policy is inflationary

The CPI rose 0.5% in December, somewhat more than expected. Most of the rise was due to a big jump in gasoline prices. Ignoring energy prices, the CPI rose a mere 0.8% last year, and the headline CPI rose only 1.3%; that takes us all the way back to the very low and relatively stable inflation rates last seen in the early 1960s.

These tame statistics don't tell the whole story however. In the past six months, the CPI has increased at a 3.1% annualized rate. More importantly, the CPI ex-food and energy has been rising steadily (albeit at a bit less than 1% per year) for the past several years, even as energy prices have been soaring. If the Fed were pursuing a policy of price stability (which they are not, unfortunately), then a big rise in energy prices would necessarily result in a decline in non-energy prices, thus leaving the overall price level unchanged. But that's not happening. By being accommodative, the Fed is allowing higher energy prices to occur, without forcing other prices to decline. This is a recipe for more inflation.

If nothing else, this fact—that monetary policy is definitely accommodative—all but rules out the risk of deflation. As deflation risk fades into obscurity, markets are waking up to the fact that it's possible to raise prices and get away with it. Thus, nominal growth expectations are rising, inflation expectations are rising, and the combination is driving higher earnings expectations, thus lifting stock prices. Inflation and inflation expectations are still relatively tame, thank goodness, but this we are not in a stable, long-term equilibrium condition. Facts and expectations can change dynamically, but we don't know whether the Fed can adapt with sufficient speed and determination to changing conditions. This is no time to be lulled into a sense of low-inflation security.

Retail sales very strong

December retail sales were a bit weaker than expected (up 0.6% vs. 0.8%), but they were still up by a significant amount. And as the chart above shows, retail sales have now fully recovered from the 2008-2009 recession, rising 7.9% in 2010. In the second half of last year, sales rose at a very impressive 11.2% annualized rate. This is indeed a recovery in every sense of the word.

But this recovery is a testament not to the indomitable U.S. consumer, but to the nature of this past recession. Much of the decline in the economy was the result of fear, which in turn caused people to hoard money instead of spending it. As fears have dissipated and confidence has slowly returned, money has been de-hoarded, driving up sales. This and other "forces of recovery" will continue to act in a virtuous cycle fashion, reinforcing themselves and continuing to drive the level of economic activity higher in the years to come.

Pulse of Commerce Index jumps

The Ceridian/UCLA Pulse of Commerce Index rose meaningfully in December, more than reversing the weak growth which we now know reflected a third quarter "soft patch." I show both the actual index (red) and the 3-mo. moving average here. The Index is based on diesel fuel consumption, and you can find more background color in Mark Perry's post here.

The trade picture brightens

The trade picture continues to brighten. In the three months ended last November, U.S. exports surged at a 18.7% annualized rate, while imports were basically flat. As Brian Wesbury notes, numbers like these could result in net exports adding more than 3 percentage points to fourth quarter GDP, possibly resulting in overall GDP growth of 5 or even 6% in Q4/10.

The strong rebound in exports (which as of the end of the year were probably only 2-3% below the all-time high set in 2008, thanks to 17% annualized growth from last year's low) reflects not only strong demand overseas, but very strong performance from our own economy. International trade is a win-win for everyone, so it's quite heartening to see that trade levels are returning to their former levels despite the massive dislocations wrought by the global financial crisis in late 2008.

Producer price inflation threatens to accelerate

Inflation remains very much alive and well at the producer level: producer prices rose fully 1.1% in December, and are up at a 7% annualized pace in the past six months. Not counting food & energy (a tough thing to do since energy prices are an unavoidable component of business costs), prices are up 1.4% over the past year, and have risen 11.3% in the past 5 years. I note also that the Producer Price Index reached a new all-time high in December, eclipsing its former energy-led high set in July '08.

However you slice and dice these numbers, there is no sign of, or even the threat of, deflation. On the contrary. As the second chart suggests, since early 2004 (about the time the Fed shifted into strong accommodative mode by pegging the funds rate at 1% for a full year) producer price inflation has been running at a 3.5% annual rate, about twice the pace of what we saw from 1983 through 2003 (years during which the Fed was actively fighting inflation). With oil prices now reaching new post-2008 highs, and no sign that other prices are declining, it's unlikely that overall inflation will slow, and more likely that it will accelerate from the levels of the past several years.

It's disturbing, to say the least, that the Fed remains so complacent about inflation risks in light of this evidence.

Continued improvement in labor market conditions

First-time claims for unemployment rose somewhat last week, but given the volatile nature of this series and the vagaries of seasonal adjustments—especially around this time of the year when layoffs are typically the highest—it's difficult to conclude that anything is amiss. The broader trend towards reduced layoff activity remains in place. In the third chart above, I note that the percent of the labor force receiving some form of unemployment compensation fell by almost 30% (from 7% to 5%) over the course of the last year.

Though unemployment is still quite high, these charts highlight some significant change on the margin. They also reflect increased hiring activity and increased incentives for the unemployed to seek and/or accept employment. Congress has been much more generous in handing out unemployment insurance this time around than ever before; while this is good from a humanitarian perspective, it undoubtedly has contributed to prolonging high rates unemployment by delaying the adjustments necessary to shift labor from shrinking sectors of the economy (e.g., housing-related industries) to the growing sectors (e.g., mining, technology, and manufacturing).

Budget update: continued improvement

The December federal budget deficit came in as expected, and the calendar year 2010 deficit ($1.28 trillion) was $194 billion lower than in 2009. Things are still awful, but they are getting better; thanks to rising incomes, higher realized capital gains, and higher corporate taxes, federal revenues have been rising at a 9-10% annual rate for most of the past year. As I noted before, if this keeps up the budget could be balanced in 5 years if spending were frozen at current levels. And there's no reason that revenues can't continue to grow at a 10% annual rate, as the next chart (below) shows. In fact, that's very typical in the wake of recessions. Revenue growth has in fact bounced back faster following the recent recession than it did following the 2001 recession.

It's also worth noting that the federal deficit is now about 8.5% of GDP, comfortably lower than the high of 10.3% that was reached one year ago. This improvement was due to 4.7% growth in nominal GDP, 7.9% growth in revenues, and a 1% decline in spending.

Credit spread update: room for more improvement

The top chart shows credit default swap spreads for short-term corporate debt, while the bottom chart shows option-adjusted spreads for the whole corporate debt market. Both show that spreads have declined significantly since the worst days of the 2008-9 recession, but they also show that spreads are still substantially higher than they have been during times of relative economic tranquility.

I've argued repeatedly that the current level of credit spreads is a good indicator that the U.S. financial market is not overly exuberant, over-priced, or in another bubble. The market is still priced quite conservatively, and this is not surprising since there are still many problems facing the U.S. economy that must still be resolved (e.g., the huge unfunded liabilities of social security and medicare; the very large federal deficit; the unprecedented expansion of the size of the federal government; the still-large inventories of foreclosed homes, and the millions of homeowners who are "underwater" on the mortgages). We are moving in the right direction, but there is still plenty of room for improvement.

By inference, corporate debt still offers attractive spreads over Treasuries, especially in the high-yield sector.

Full disclosure: I am long HYG at the time of this writing.

Fear subsides, equity prices rise

Yet again I post an update to this chart, which has captured quite well the underlying theme of the 2008-9 recession. The near-collapse of the global financial industry in late 2008 sent a tsunami of fear throughout the global financial markets and temporarily paralyzed global economies. Activity in many areas ground to a halt as consumers hoarded cash, institutional investors scrambled to sell risky assets, and everyone tried to deleverage. Fear was the common denominator, as captured by the Vix Index (the implied volatility of equity options), and it peaked in late October 2008. Equity prices continued declining, however, as new concerns were added, mainly the risk of a huge increase in future tax burdens caused by an unprecedented expansion of the federal government and a massive "stimulus" bill.

The past two years have been all about the unwinding of fear and the scaling back of the concerns over future tax burdens. Money has been "de-hoarded" to some extent, retail sales have recovered to their previous high, the economy is 18 months into a recovery, jobs are being added, industrial production is expanding, capital spending is rising, and federal revenues are growing at a double-digit pace, the Vix Index is back down to 16, only marginally higher than one might expect it to be during "normal" times, and Congress has a new mandate to sharply curtail spending and avoid new taxes. We haven't made a full recovery yet, but it is clearly visible on the horizon. The S&P 500 is only 18% below its 2007 high, but the CBOE technology index has already surpassed its 2007 high by 13%, and consumer staple stocks are only a few inches below their all-time high.

Two years ago the financial markets were priced to an "end-of-the-world-as-we-know-it" scenario. Today financial markets are beginning to realize that a return to "normalcy" is possible and within reach. We should all breathe a great sigh of relief.

Now, the Fed needs to realize this and plan its QE2 exit strategy ASAP. Otherwise we could find ourselves snatching defeat from the jaws of victory.

Commodity prices remain strong

No sign yet of any commodity price weakness. This measure of non-energy, basic industrial commodity prices is now at another all-time high, having almost tripled since late 2001. Prices likely are being driven higher by strong global demand for commodities, and by accommodative monetary policy. I don't think anyone knows how to sort out exactly how much of the price action comes from either of these sources, but no one can rule them out.

Blogging will be light today as I am being called to jury duty.

Rosenberg's Six Walls of Worry

As reported by Joe Weisenthal of Business Insider, David Rosenberg recently listed six major, looming problems that he thinks bulls like me are either ignoring or underestimating. I always welcome a challenge to my views, since I really hate to be blindsided by ignorance. So here is my response to Rosenberg's Walls of Worry:

Borrowed Growth "How much of 2011 growth [will be] borrowed from 2012?"

Rosenberg is correct in noting that since the payroll tax cut and bonus depreciation allowance are only temporary measures that expire this December, this is likely to result in some activity being brought forward to this year at the expense of next year (temporary tax cuts are always ineffective). But that doesn't mean the outlook for next year will be bad. There are a lot of things that could happen this year that could improve the long-term outlook (e.g., a de-funding of ObamaCare—or maybe even a partial repeal; a reduction in corporate income taxes; a broadening of the tax base in exchange for lower marginal income tax rates; meaningful reductions in federal spending; and a general shift to more growth-favorable fiscal policies). Just a few of those changes, coupled with the positive feedback of the ongoing forces of recovery and economic adjustment taking place already, could overwhelm (positively) the "borrowed growth" problem. In the meantime, and as I have been noting here in many posts, there are many signs that the economy is continuing to improve. 

Higher Energy Prices "If oil breaks above $100 and gasoline prices approach $3.50/gallon then expect the consumer to sputter. Every penny at the pumps drains $1.5 billion out of household cash flow."
Higher oil prices are not necessarily a significant drain on the U.S. economy, because oil producing countries can't spend their windfalls immediately on consumption goods—most of the extra money we spend on oil gets recycled back into the U.S. economy by oil producers in the form of investments. Paying an extra dollar a gallon for gas does not result in that dollar disappearing down a black hole. The way higher oil prices do hurt our economy is by making economic activity prohibitively expensive. Intolerably high energy costs can result in shuttered factories, cancelled projects and investments, and workers who have to turn down jobs because it becomes too expensive to commute. So the real issue here is whether gasoline at $3.50 or even $4 a gallon is going to result in a significant change in consumer or corporate behavior. I doubt it.

It's true, of course, that in real terms, oil prices today are a bit higher than they were in the early 1980s, but even then historically high energy prices failed to prevent the economic boom which began in 1983. I note also that thanks to more efficient technology and an impressive increase in overall energy efficiency, the U.S. economy today requires less than half as much energy as it did 30 years ago to produce a unit of output. The combination of these developments means that energy today consumes less than 6% of consumer spending, compared to 9% in the early 1980s. Energy is simply much less important today. As a result I think gas prices would probably have to rise to $4.50 or $5/gallon before energy became expensive enough to materially slow the U.S. economy.

Spending Cuts "The GOP-led House is pressing for $100 billion of spending cuts for this year. If enacted ... this could cause GDP estimates to be trimmed."
It is amazing to me that so many economists and commenters automatically accept the proposition that a cutback in federal, state, and local budgets will hurt the economy. It apparently never occurs to anyone to challenge that assumption, even though everyone worries so much about the rising deficits that result from higher spending. Yet if it were true that less spending is bad for the economy, then the $1 trillion of extra spending last year should have sent the economy through the roof. But of course it didn't, and there is no evidence to suggest that the "stimulus" did anything at all to help the economy, especially since it consisted primarily of transfer payments and inefficient spending projects. 

Simple logic says that transfer payments (taking money from A and giving it to B) cannot create growth, because they don't increase aggregate demand or supply, and they create perverse incentives (i.e., rewarding people who don't work and penalizing those who do). The public sector is notorious for spending money less efficiently than the private sector, and any money spent by the government must either be taxed away or borrowed from the private sector, which then has less money to spend on things that could be more productive. 

Indeed, there are good reasons to believe the stimulus spending probably hurt the economy, since it a) drained significant resources from the more efficient private sector, b) spent those resources wastefully and inefficiently, and c) created real fears of a surge in future tax burdens, thus discouraging private sector investment. If fiscal "stimulus spending" is unproductive and probably even bad for the economy, logic drives you to the conclusion that fiscal cutbacks ought to be a good thing. Bring them on, please!

Obama Might Get Re-elected "Obama just enhanced his 2012 re-election chances by appointing Daley as his chief of staff. Either he is really going to move to the center, or he is trying to cement the next election."

If, under the likely pro-growth guidance of Daley, Obama moves to the right by enough to improve the economy's prospects, then I would have no problem accepting his re-election. The biggest problem we have faced over the past two years is Obama's woeful lack of understanding of how free markets work, and his almost total lack of appreciation for the entrepreneur and the power of incentives. He's been about as anti-growth as anyone could have possibly imagined. If he can overcome those deficiencies and promote growth-oriented policies as a result, then he would deserve re-election and the nation likely would breathe a great sigh of relief.

Improving Jobs Market "Everyone believes that a better employment picture will brighten the stock market’s prospects even more but in fact the opposite will happen as margins get squeezed by rising labour costs."
For the past two years, unit labor costs have been declining, and this has likely contributed to stronger corporate profits. Unit labor costs typically rise over the course of an economic recovery cycle, but we are still in the very early stages of the growth cycle. It could take a long time before unit labor costs rise by enough to squeeze corporate profits. Meanwhile, wages typically lag inflation, and until the swollen ranks of the unemployed are thinned meaningfully—a process that could take several years—it will be difficult for many wages to rise significantly. Plus, corporate profits today are at all time highs—there is plenty of room to absorb higher labor costs. In any event, this is a problem for the future, not a problem for this year or even next year.

No QE3 "I am hearing that the Fed is moving further away from entertaining the notion of a QE3 program in the second half of the year. [The second quarter is when] the concern list will likely start to grow; lagged impact of China tightening shows through, big European refinancings, signs of no more QE, and the debt-ceiling issue hitting its peak."

The major impact of quantitative easing to date has been to erase the specter of deflation that was haunting markets, and that is clear from the 100 bps increase in forward inflation expectations embedded in TIPS prices. Beyond that, it has done little or nothing to stimulate growth, and little or nothing to boost the supply of money in the economy or the amount of new borrowing. Instead, it has created an additional source of uncertainty for markets that worry about the prospect of higher inflation and the lack of clarity surrounding the Fed's endgame. It has helped keep the dollar weak, and has likely contributed to driving gold and non-energy commodity prices to new highs.

Canceling or failing to renew QE2 later this year may rekindle deflation concerns, but those could easily be offset by a stronger economy. But no QE3 would most likely be welcomed by financial markets since that would reduce inflation anxieties. Already there are many, in addition to myself, that are arguing that QE2 is no longer necessary.

As for China, the degree of monetary tightening that has been implemented so far is relatively puny and poses little or no threat to Chinese growth. Since China remains pegged to the dollar, the biggest factor influencing monetary policy conditions in China is Federal Reserve policy, and it remains extremely accommodative. China's revaluation of the yuan to date has been relatively tiny, and not nearly enough to offset the general weakness of the dollar or the Fed's super-accommodative policy stance. 

As for European debt problems, the market has had plenty of time to understand and price in the likely outcome of sovereign debt restructurings (e.g., by driving down the price of Greek debt). Meanwhile, the Euro and the European stock markets show no sign of any impending catastrophe despite the growing likelihood of default. We've seen huge sovereign debt defaults and restructurings many times in the past (Argentina comes to mind) without there being any meaningful disruption to global growth. The sub-prime mortgage crisis of 2008 was a very different animal, since at its core were many thousands of securities, worth many trillions of dollars, and backed by tens of millions of individual properties that were extremely difficult for the market to understand, value and trade. That is not the case with the handful of countries that are high on the likely-to-default list today.

As for the federal government's debt ceiling, the federal deficit is clearly a very big problem since it is symptomatic of out-of-control spending and an unprecedented growth of the public sector which ultimately threatens the health of the private sector. It must be addressed somehow; not addressing it at all would be the worst possible outcome. Cutting spending to lower the deficit is not a problem for me (see above), but raising taxes in an attempt to lower the deficit would be. In that regard, the November elections sent a very clear mandate to Washington to cut spending and not raise taxes. I would be shocked and very disturbed if the new Congress were to ignore that message.

An important monetary inflection point

This chart shows Commercial & Industrial Loans by all U.S. banks, a good measure of borrowing by small and medium-sized businesses—those too small to access the credit markets directly. It reflects both the appetite for credit among smaller businesses and the willingness of banks to extend credit. This measure of lending fell by 25% from the end of 2008 until hitting a low last September. It has now moved up a bit, and shows flat growth since last August. Bottom line: the great develeraging and credit contraction that began in the wake of the financial crisis of 2008 has apparently ended.

Many have argued that deleveraging is a major factor limiting the economy's ability to grow, but I disagree. I note that the economy grew strongly starting in mid-2003 even as bank credit continued to contract, and the recent recovery started in mid-2009 even as bank credit was in free-fall. The extension of credit by itself cannot create growth (you can't grow an economy by printing money, you can only "grow" prices), but bank credit can facilitate growth by making the economy more efficient; by channeling funds from savers to borrowers in ways that individuals could not manage by themselves. Rising bank credit can also signal rising confidence, and that is symptomatic of an improving economic climate.

If, as it appears, bank lending is once again starting to expand, I think that reflects a combination of factors: businesses have finished deleveraging; businesses feel confident enough about the future to expand their borrowings; and banks feel confident enough about the economic climate to expand their lending activity. Put another way, this chart shows that the demand for money has passed an important inflection point—instead of rising, it is now beginning to decline. (If money demand is strong, then the demand for loans is weak; if money demand is weak, then the demand for loans is strong. On the margin, businesses now want to be "short" money instead of being "long" money.) So there is a combination of factors at work here that reflects an improving economic climate (more confidence on the part of banks and businesss) and a change in the monetary dynamics of the economy (the beginnings of a decline in money demand). With the Fed still very willing to extend credit to the economy, and the economy now becoming more willing to borrow, monetary policy could start gaining "traction" in a meaningful way: both economic growth and inflation are likely to pick up.

HT: David Gitlitz