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Donuts To Dollars

As expected, the news event du jour was Chairman Bernanke’s semiannual Monetary Policy Report to the Congress (neé Humphrey-Hawkins). Before we get into the market’s reaction, let’s take a look at some portions of the report:

The economic expansion that began in the middle of last year is proceeding at a moderate pace, supported by stimulative monetary and fiscal policies. Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth…

An important drag on household spending is the slow recovery in the labor market and the attendant uncertainty about job prospects…

My colleagues on the Federal Open Market Committee (FOMC) and I expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years…The forecasts are qualitatively similar to those we released in February and May, although progress in reducing unemployment is now expected to be somewhat slower than we previously projected, and near-term inflation now looks likely to be a little lower…

Notably, concerns about the ability of Greece and a number of other euro-area countries to manage their sizable budget deficits and high levels of public debt spurred a broad-based withdrawal from risk-taking in global financial markets in the spring, resulting in lower stock prices and wider risk spreads in the United States. In response to these fiscal pressures, European leaders put in place a number of strong measures, including an assistance package for Greece and €500 billion of funding to backstop the near-term financing needs of euro-area countries…

Oh, whoops, sorry about that. That’s from the July 2010 MPC, not today’s. Guess I clicked the wrong link.

Anyway, it is comforting to see just what hath Ben wrought. By his own estimation in today’s presentation, the Fed’s $600bln purchase of Treasury securities managed to lower long-term interest rates a whopping 10 to 30 basis points. So I suppose it shouldn’t be surprising that, a year later, things are just about where they were a year ago. Oh, sure, the economy is two or three percent larger overall, and we’re no longer confronting deflation (although even last summer we knew that prices were going to bottom in Q4, so it wasn’t QE2 that did that).

The stock market leapt when the text of the Chairman’s remarks was released. Investors seized on the statement that the Federal Reserve is “prepared to respond” if stimulus is needed. This was breathlessly, if inaccurately, reported by CNBC (rarely the place to go for accurate news) as a promise that the Fed would supply more stimulus if needed. That wasn’t at all what he said. Here is what he said, verbatim:

“Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate.”

That seems reflexive to me: we will make an adjustment if we decide that we should make an adjustment, since the clause “remains prepared to respond” relies on “[if] economic developments indicate that [a change in policy] would be appropriate.” Well, I certainly hope that they are prepared to ease if easing is called for. And I hope that they are prepared to tighten if tightening is called for. Incidentally, he said that too, but you didn’t hear that reported quite as breathlessly.

The Chairman said the Fed could ease by buying more securities or by extending their commitment to low rates. There are two problems with those two approaches. Buying securities didn’t seem to work (oh, sorry, 10-30bps), and the market already is pricing in low rates for 3-5 years with the 3yr note yielding 0.62%. Do you have anything else in that bag of tricks, Felix?

“…The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs.”

So, here’s a confession. I screwed up in yesterday’s article. I talked about changing the reserve requirement, but a much more-direct way to ease further is through reducing or eliminating the Interest On Excess Reserves. That would actually be a much smarter move, because it’s almost guaranteed to release reserves (as I pointed out when I first noted that the “multiplier mystery” wasn’t a mystery at all, in September and Octoberfor example). It certainly makes more sense to do this than to buy more assets. All the money used to purchase assets is going into reserves, where they do nothing but scare us about the potential for reversing the “Dollars to Donuts” saying.[1] So purchasing more assets would be absurd.

The only problem with such a move, although it hasn’t bothered them so far, is that we have no idea how to calibrate that sort of action. Clearly, if all the M0 gets into M2 overnight, there’s a big, big problem. So there’s another tool in the Fed’s tool chest; the only problem is that they don’t know how to use it. It’s like giving me a lathe for my birthday. That would be really cool, except that I would probably remove my fingers since I have no idea how to work a lathe.Eventually, the stock market cooled. Perhaps it is because people started thinking about lathes and sharp knives in the hands of people with ham hands, or perhaps it’s because they noticed the Reuters headline saying “Greek PM says second bailout needed urgently,” or perhaps it is because the 221-basis-point rise in Irish 2-year yields (see Chart) and 62bps in 10-year yields reminded them that Super Ben has only part of the solution (or problem, depending who you talk to).

Ouch, that's going to leave a mark! Or a Euro.

U.S. yields were unchanged, but commodities jumped 1.6% led by Grains (+3.2%) and Precious Metals (+2.8%). Silver was up over 7%. The dollar was down 0.8%. I am impressed – talk about more quantitative easing ended up having limited effect on stocks and a strongly positive effect on real goods. That’s almost as if investors realize that inflation is always and everywhere a monetary phenomenon! The donuts-to-dollars move is on its way.

Tomorrow, the data in the U.S. consist of the PPI (Consensus: -0.2%/+0.2% ex-food-and-energy), Retail Sales (Consensus: -0.1%/+0.0%), and Initial Claims (Consensus: 415k from 418k), all of which are released at 8:30ET. The most-important of them is Retail Sales, but given what is going on in Europe and on Capitol Hill none of these ought to have lasting impact unless there is a real shocking outlier. I half-expect a shocking outlier from Retail Sales, but not enough to position on that basis.

Also be aware that the Treasury will announce the details of the upcoming 10-year TIPS issue, scheduled for auction next Thursday. A whole week to set up seems like a luxury, and the issue size of roughly $13bln doesn’t seem likely to pose much of a problem although the coupon (which would be 0.5% if the auction was held today) may cause some shudders. Those shudders didn’t hurt the 5y TIPS auction very much when in April the Treasury sold $14bln with a 0.125% coupon. Once everyone feels better about Italy, it will be harder for the Treasury to sell TIPS here, but in the meantime the ILB (inflation-linked bond) market is threatening to become more concentrated and most indexed investors will be hard-pressed to pass (although it bears noting that Italian ILBs rallied today).


If you have made it this far, I appreciate the time that you’ve taken to read today’s article. If you’re willing to go one click further, I would really appreciate it if you would be so kind as to click here and help in the evaluation of a new advertisement we have recently developed. Thanks in advance!

[1] I am told that the phrase “I’ll bet you dollars to donuts” has its roots in the 19th and early 20th century when donuts cost a penny or two – so the person uttering this phrase was saying that he considered the proposition a sure thing. Nowadays, however, this is close to an even-odds bet and doesn’t carry quite the same sting. With just a bit of inflation, it will be appropriate to reverse the phrase.

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