| It was a relatively quiet past five days. For the week, the Dow and S&P500 were about unchanged. Economically sensitive issues outperformed, with the Transports up 1.5% and the Morgan Stanley Cyclical index up 1%. The Utilities gained 1%, while the Morgan Stanley Consumer index was about unchanged. The broader market was flat, with the small cap Russell 2000 slightly positive and the S&P400 Mid-cap index slightly negative. Technology was this week’s loser. The NASDAQ100 dipped 1%, as the Morgan Stanley High Tech index was hit for 2.5%. The Semiconductors dropped 5%. The Street.com Internet and NASDAQ Telecommunications indices declined about 1%. The Biotechs bounced back this week for a 2% gain. The financial stocks were mixed, with the Broker/Dealers declining 2%, while the Banks were unchanged. With Bullion up a notable $10.30, the HUI gold index added 2%. The bond market was relieved by more dovish comments early in the week from chairman Greenspan. For the week, 2-year Treasury yields dipped 3 basis points to 2.78%, while 5-year Treasury rates declined 7 basis points to 3.93%. Ten-year yields dropped 9 basis points to 4.71%, and long-bond yields declined 9 basis points to 5.38%. Benchmark Fannie Mae MBS yields declined 8 basis points. The spread (to 10 year Treasuries) on Fannie’s 4 3/8% 2013 note narrowed 2 to 40, and the spread on Freddie’s 4 ½ 2013 note narrowed 2 to 38 basis points. The 10-year dollar swap spread was about unchanged at 48.5. Corporate spreads were little changed for the week. The implied yield on 3-month December Eurodollars dipped 4.5 basis points to 2.62%. Corporate issuance was a moderate $11.5 billion during the week. From Bloomberg’s David Russell: “Weekly corporate bond sales have slowed to an average of about $8.8 billion this quarter from $13.5 billion in the first three months of the year.” Investment Grade issuance included GE Capital $2 billion, Caterpillar $650 million, WPP Finance $650 million, KT Corp $600 million, Tyco $500 million, International Lease Finance $500 million, American Express $500 million, Pricoa Global Funding $400 million, Nationwide Life $350 million, Salt Creek Passthrough $325 million, Colonial Properties $300 million, Husky Energy $300 million, Con Edison $275 million, Westar Energy $250 million, Downey Financial $200 million, Emigrant Bancorp $200 million, Penn Mutual Life $200 million, Sonoco $150 million, and Commercial Net Lease Realty $150 million. Junk bond funds reported outflows of $126.5 million for the week (from AMG). Junk issuance included Tenet Healthcare $1 billion (up from $500 million), Huntsman LLC $400 million, Argo Tech $250 million, Plains E&P $250 million, Beverly Enterprises $215 million, Clean Harbors $150 million, Adesa $125 million, Cornell Co. $110 million, and Viskase $90 million. Convert issuance included Chiron $350 million, Advanced Medical Optics $350 million Four Seasons Hotels $220 million, Matria Healthcare $86 million, and Charles River $75 million. Foreign dollar debt issuers included International Bank of Reconstruction & Development $1 billion. Japanese 10-year JGB yields rose 8 basis points for the week to 1.86%, with yields yesterday at the highest level since September 2000. Brazilian benchmark bond yields dropped 36 basis points to 10.96%. Russian 10-year Eurobond yields declined 20 basis points this week to 6.43%, with Mexican govt. yields down 8 basis points to 6.24%. Freddie Mac posted 30-year fixed mortgage rates rose 2 basis points this week to 6.32%. Fifteen-year fixed mortgage rates added 3 basis points to 5.70%. One-year adjustable-rate mortgages could be had at 4.13%, down 1 basis point for the week (after rising 16 bps last week). The Mortgage Bankers Association Purchase application index gained 4.0% last week. Purchase applications were up 7.7% from one year ago, with dollar volume up 20%. Refi applications rose 8.5%. The average Purchase mortgage was for $222,200, and the average ARM was for $287,600. ARMs accounted for 34.7% of applications last week, with dollar volume at a notable 47.5%. Broad money supply (M3) rose $6.0 billion. Year-to-date (23 weeks), broad money is up $386.8 billion, or 9.9% annualized. For the week, Currency was unchanged. Demand & Checkable Deposits dropped $14.9 billion. Savings Deposits rose $9.0 billion. Saving Deposits have expanded $258.8 billion so far this year (18.5% annualized). Small Denominated Deposits were essentially unchanged. Retail Money Fund deposits declined $3.4 billion. Institutional Money Fund deposits dipped $3.3 billion, while Large Denominated Deposits added $8.7 billion. Repurchase Agreements jumped $10.9 billion. Eurodollar deposits dipped $1.1 billion. ABS issuance surged $13 billion (from JPMorgan), with y-t-d issuance of $257.9 billion 24% ahead of comparable 2003. Year-to-date Home Equity ABS issuance of $151.3 billion is running 68% above a year ago. Bank Credit jumped $24.4 billon, with three-week gains of $53 billion. Bank Credit has expanded $297 billion during the first 23 weeks of the year, or 10.8% annualized. Securities holdings increased $5.3 billion. Commercial & Industrial loans dipped $1.9 billion for the week, with a y-t-d decline of $8.1 billion to $874.7 billion. Real Estate loans jumped $13.8 billion for the week. Real Estate loans were up $167.3 billion y-t-d, or 17.0% annualized. Consumer and Securities loans each added $600 million. Other loans gained $5.8 billion. Elsewhere, Total Commercial Paper declined $5.9 billion to $1.3338 Trillion. Financial CP dropped $9.4 billion, with Non-financial CP up $3.5 billion (to the highest level since November). Year-to-date, Total CP is up $69.0 billion, or 11.8% annualized. Fed Foreign “Custody” Holdings of Treasury, Agency debt dipped $865 million to $1.2 Trillion. Year-to-date, Custody Holdings are up $160.6 billion, or 32.6% annualized. Currency Watch: The dollar was not as appreciative of Greenspan’s less “hawkish” comments. For the week, the dollar index dipped 1%. The Japanese yen gained 2%, rising to the highest level against the dollar since early May. The South African rand gained almost 4%, and the British pound 1.5%. The Philippines peso, Indian rupee, and Australian dollar were on the losing end, although declines were less than 1%. Commodities Watch: June 17 – Bloomberg (Matthew Craze): “Nickel rose to a nine-week high in London as stockpiles of the metal in London Metal Exchange warehouses fell to three-year lows. Metal prices all rose in London after a report yesterday showed U.S. industrial production rose in May, increasing demand for base metals… Nickel has risen some 55 percent in the past 12 months as demand for stainless steel grew. The gap between supply and demand grew to 21,000 tons in the first quarter of this year, according to industry consultant CRU International…” June 17 – Bloomberg (Soraya Permatasari): “The price of paper rose by an average of $10 to $20 a ton each month so far this year to between $850 and $900 a ton because of rising demand, Bisnis Indonesia newspaper reported, citing M. Mansur, chairman of the Indonesian Pulp and Paper Producers Association. The growing global economy and elections in several countries in the region this year prompted a sharp increase in the demand for paper…” June 17 – Bloomberg (Helen Yuan): “China’s wheat imports surged ninefold by volume in the first five months of the year compared with a year earlier, the Futures Daily reported, citing customs statistics. Exports of crude oil fell 32 percent in the first five months, while imports rose 38 percent…” Nickel traded today to a three-month high. The CRB index was unchanged for the week (up 5.7% y-t-d). The Goldman Sachs Commodities index added 0.5%, increasing y-t-d gains to 13.6%. Central Bank Watch: June 17 – Bloomberg (Anuchit Nguyen): “An inflation rate of 3 percent to 4 percent will benefit the Thai economy because it will stimulate domestic demand and boost private investment, said Bank of Thailand Governor Pridiyathorn Devakula. ‘Mild inflation is good for the economy because it shows there is consumer demand,’ Pridiyathorn told reporters at the central bank in Bangkok. ‘A rise in product prices also shows higher capacity utilization.’” Candid comments Wednesday by Federal Reserve Bank of Atlanta President Jack Guynn in response to a question from the audience: “What will be a more neutral kind of a policy setting is going to depend on all the other things going on in the economy. At the time, there is no one set point at which I think anybody will agree is a neutral setting. I think the important point, though, is the easing moves that we’ve made, and with policy being so accommodative at the current time, we are well below – several hundred basis points, at least in my own mind – what at least at the current time and with what I think lies ahead a more neutral kind of a setting. We have, in fact, got some work to do to get back to that more normal setting.” Things of Interest to Watch: June 17 – Financial Times (Andrew Ward): “The demilitarized zone between North and South Korea fell silent for the first time in decades yesterday, when the two countries halted propaganda broadcasts across their sealed border. Both Koreas delivered final, stirring messages to each other’s troops before the loudspeakers were turned off as part of efforts to improve cross-border relations. ‘We from one blood and using one language, can no longer live separated,’ said the North’s closing address. ‘Let’s embrace each other, laughing and crying out of joy and emotion, on the day of national unification.’ South Korea’s final broadcast thanked North Korean soldiers who ‘wished for peaceful reunification’ and said: ‘We pray for your permanent happiness.” June 18 – Bloomberg (Kevin Orland): “The drought in the Western U.S. could be the region’s worst in 500 years, and the arid conditions there may persist for several decades, according to a report from the U.S. Geological Survey. From 1995 through 2004, the average annual flow of water in the Colorado River was 9.9 million acre-feet, the study says. The period from 1584 to 1593 had the lowest average annual flow at 9.7 million acre-feet. The river, which runs through Colorado, Utah, Arizona and Nevada, is one of the main water sources for the western U.S. Warm water temperatures in the Atlantic Ocean tend to correspond with droughts in the U.S., said Greg McCabe, a Denver-based scientist for the U.S. Geological Survey. The Atlantic is warm now, similar to how it was during the Dust Bowl drought of the early 1930s, he said.” China Watch: June 16 – XFN: “China’s ex-factory prices, or producer prices for manufactured goods, rose 5.7% year on year in May and 0.2% month on month, the official Xinhua news agency reported, citing the National Bureau of Statistics. May’s year-on-year increase is the highest growth rate in at least three years… The growth in producer prices has been pressuring the consumer prices index, which rose by 4.4% in May, its highest level in at least seven years.” June 17 – Bloomberg (Tian Ying): “China’s property prices rose 11 percent in the first five months and investment surged almost a third, even as the government clamped down on loans and approvals as part of efforts to cool economic growth.” ‘We haven’t yet seen a significant slowdown in real estate investment although the government started to tighten up on the sector about a year ago,’ said Song Guoxiang, an economist at China Galaxy Securities Co. in Beijing. ‘China’s total investment still remains at the high end…” June 15 – XFN: “China’s car output in May fell by 24,400 units, or more than 10% from April, to 215,100 units, as manufacturers curbed production over fears of a continuing build-up of inventory, the National Bureau of Statistics (NBS) said. Although overall output during the first five months rose 37.6% year on year to 1.03 million units, and May output was 30.5% higher from a year earlier…” June 15 – Bloomberg (Hiroshi Suzuki): “Annual drug sales in China will total 3 trillion yen ($27 billion) by 2010, double their size in 2002, as overseas companies increase investment… The drug market in China, which ranked fourth-largest in the world in 2002 with about 1.5 trillion yen of annual sales, is expected to grow at a yearly pace of 12 percent to 15 percent until 2010, said Seiji Miyazawa, an official in charge of international affairs at Japan Pharmaceutical Manufacturers Association at a press conference in Tokyo. ‘Affluent citizens in urban areas prefer to pharmaceutical products with foreign brands. Demand for drugs to treat diabetes and high cholesterol is expected to increase.’” June 18 – Bloomberg (Mark Drajem): “The U.S. Commerce Department slapped tariffs of as much as 198 percent on imported bedroom furniture from China, a decision that could cut the $1 billion a year of those imports and raise prices for consumers. Most of the largest exporters of furniture will pay tariffs of 24 percent or less, with 82 of the companies paying an 11 percent tariff… The case is the largest trade dispute of its kind between the U.S. and China…” Asia Inflation Watch: June 17 – Australian Financial Review (Corinne Lim): “US monetary policy decisions have a direct impact on the economies of heavily export-reliant Asian nations. While inflation is growing at a faster rate in many Asian nations than in the US, the central banks of these countries are unlikely to attempt to change this through their own local monetary policy measures. Rather, analysts say, the US Federal Reserve’s tightening measures will slow export growth for these nations, thus slowing consumption and investment without the need for interest rates to be adjusted locally. However, any shift away from export-dependence to greater domestic demand would lessen this effect.” June 16 – Bloomberg (Amit Prakash): “Singapore’s retail sales in April rose 14.4 percent from a year earlier, led by watches, jewelry and clothes, suggesting an export-led recovery in the island’s economy continues to fuel domestic spending. The rise in the Statistics Department's retail sales index compares with the 21 percent gain that was the median forecast…” Global Reflation Watch: June 16 – Bloomberg (Lily Nonomiya and Mayumi Otsuma): “The Bank of Japan said the economy is ‘gathering stronger momentum’ as rising corporate profits boost job creation. Governor Toshihiko Fukui said his bank would keep interest rates close to zero to support the recovery. ‘Rising production and corporate profits are starting to spread to the labor market,’ Fukui told a news conference… The bank’s monthly report today dropped the word ‘gradual’ from its description of a recovery for the first time since Japan’s asset price bubble burst in 1991.” June 18 – Bloomberg (Simon Packard): “French wages rose 0.8 percent in the first quarter, the biggest increase in two years, led by higher costs for construction workers… France's inflation rate rose to the highest in 12 years in May as higher oil costs led companies like Air France SA to increase ticket prices.” June 15 – Bloomberg (James Cordahi and Marc Wolfensberger): “Millionaires in the U.S. and Canada increased by 14 percent last year as the stock market rallied. Today, about one of every 130 Americans has more than $1 million of shares, bonds and other financial assets, according to a report by Capgemini and Merrill Lynch & Co. Their riches also rose 14 percent, to $8.5 trillion. That growth was stronger than in Europe, home to the greatest proportion of wealthy people, and in Asia.” June 17 – UPI: “India, once one of the world’s poorest countries, is earning the distinction of creating millionaires -- currently 61,000--faster than any other nation. A survey by Merrill Lynch and technology consultancy Capgemini, said the number of high net worth individuals in India rose 22 percent between 2002 and 2003, the Calcutta Telegraph reported.” June 18 – Bloomberg (Cherian Thomas): “The Indian government said it will seek to increase bank lending to farmers by 30 percent this fiscal year, as it attempts to meet an election pledge to boost agriculture. The government is targeting loans worth 1 trillion rupees ($22 billion) to farmers in the year to March 31, 2005, Finance Minister P. Chidambaram told reporters in New Delhi.” June 16 – Interfax: “Russia’s GDP has increased by 7.4% in the first quarter of 2004 against the same period last year, the Federal State Statistics Service reported…” June 17 – Bloomberg (Eliana Raszewski): “Argentina’s economy expanded more than 10 percent for a third straight quarter in the January-to-March period as domestic sales climbed for companies such as DHL Worldwide Express, matching a boom in exports. Gross domestic product, the broadest measure of a country’s output of goods and services, grew 11.2 percent in the first quarter…” California Bubble Watch: June 16 – Los Angeles Times (Jesus Sanchez): “Southern California homes prices in May took their biggest leap on record, jumping more than 26% as buyers rushed into the market in advance of surging mortgage rates, according to a real estate report today. The median price of all homes sold in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange counties in May surged 26.9% from the same month last year to a record high of $396,000, according to DataQuick… The year-over-year increase was the largest since DataQuick began tracking real estate information in the late 1980s… Orange County led the region in May with a whopping 36.4% annual increase in the median sales price to $543,000… The Inland Empire also reported significant gains, with the median price in Riverside County surging 31.5% in May (y-o-y)… and San Bernardino County reporting a 26.9% gain… In San Diego County, the May median price increased 21.1% on a year-over-year basis to $454,000… The Ventura County median price rose 27.1% to $492,000…” June 16 – North County (San Diego & Riverside) Times (Dan McSwain): “North County’s housing market continued its astonishing surge in May as buyers were little deterred by rising interest rates and higher prices. The median price of an existing home was $518,000 in May, up 4.6 percent from April and up a staggering $133,000, or 34.5 percent, in a single year, according to figures released by the San Diego Association of Realtors…. The median detached, single-family house sold for $580,000, up 4.5 percent from the previous month and up 35 percent in a year. Used condominiums, traditionally the entry point of the housing market, cost a median $391,750, jumping 10.2 percent from April and 33.7 percent from May 2003. At the same time, market observers said they saw some signs that demand was cooling just a bit as higher interest rates pushed pricey homes out of reach of some potential buyers. ‘I hesitate to say this, but the market is softening,’ said Karen Peterson, president of the San Diego Association of Realtors… ‘We still have a supply problem, but instead of maybe 10 or 20 offers (sellers) are getting five.’” June 18 – PRNewswire: “The percentage of households in California able to afford a median-priced home stood at 20 percent in April, a 7 percentage-point decrease compared to the same period a year ago when the Index was at 27 percent, according to a report released today by the California Association of Realtors… The minimum household income needed to purchase a median-priced home at $453,590 in California in April was $102,550, based on a typical 30-year, fixed-rate mortgage at 5.42 percent and assuming a 20 percent downpayment. The minimum household income needed to purchase a median-priced home was up from $84,510 in April 2003…” U.S. Bubble Economy Watch: June 17 – Bloomberg (William Selway): “U.S. state tax revenue rose during the first quarter at the fastest pace since 2000, when stock prices hit a record high, lifted by a quickening economy and a jump in personal income, according to a study. U.S. state tax revenue rose 8.1 percent during the first three months of 2004 from a year earlier, according to a study by the Nelson A. Rockefeller Institute of Government in Albany, New York.” By state, tax revenue was up 11.1% in California, 16% in New York, 10% in Illinois and Florida. June 18 – Dow Jones (Janet Morrissey): “Second homes, once thought to be only for the rich, are now among the fastest growing home-buying sectors in America… Indeed, the report, released Thursday by a unit of homebuilding giant Centex Corp., found that second homes are no longer a dream but a reality among the upper middle class. The survey focused on people between the ages of 35 and 64 with household income of at least $125,000 a year. Of the more than 7,300 people surveyed, 63% said they had already taken steps to look into buying a second home, whether it was talking to a spouse, requesting brochures, speaking to a salesperson, or actually visiting a vacation community. And 25% said they planned to purchase a second home over the next two to three years, the report found.” May Housing Starts were up 12.5% y-o-y to an annualized rate of 1.967 million units. Starts were up 36.4% from May 1997. Single-family Starts were up 17.7% from one year ago to the strongest level since December. Building Permits were up 12.5% (single-family up 14.1%) from May 2003 to 2.077 million units, the strongest pace since 1973. Permits were up 47% from May 1997. Homes Under Construction were up 17.2% y-o-y to 1.228 million units, and were up 50.5% from May 1997. And after 5 months, Housing Starts are on pace for 2.12 million units. This would be up 15% from last year, which was up 25% from 1997 to the highest level since 1978. 2004 is on track for the second strongest year on record, trailing only 1972. There’s some significant inflation impacting economic data these days (retail, trade, etc.) May Retail Sales gained 1.2% from April and were up a blistering 8.9% from May 2003. Retail Sales Ex-autos were up 9.8% from a year ago, the strongest y-o-y gain in at least a decade. By category, Building Materials were up 16.6% from a year earlier, Gasoline Stations 22.5%, Electronics 9.9%, Health Personal Care 8.3%, General Merchandise 8.4%, and Eating & Drinking establishments 7.8%. The April Trade Deficit surged to a record $48.327 billion, despite Goods Exports having increased almost 15% from April 2003 (to $65.77 billion). Goods Imports were up 15% from a year earlier to a record $118.93 billion. It would require Goods Exports to increase 81% to match Goods Imports. By category, Capital Goods Exports were up 16.9% y-o-y, Industrial Supplies 15.7%, Consumer Goods 18.9%, Automotive 6.4%, and Food & Beverage 6.6%. On the Import side, Capital Goods were up 14.0% from a year ago, Industrial Supplies 20.3%, Consumer Goods 15.1%, Automotive 11.3%, and Food & Beverage 9.5%. The record first quarter Current Account deficit of $145 billion indicates that a $600 billion current account deficit is well within reach. And just wait until interest-rates rise and we begin paying our creditors a more reasonable rate of return. Treasury Secretary John Snow this afternoon on CNBC: “What does the trade deficit reflect? Fundamentally, it reflects the fact that the American economy is growing and expanding faster than that of our other trading partners in the industrialized world.” Mr. Snow confuses over-consumption for economic growth. The 1.1% increase in May Industrial Production was the strongest gain since August 1998. Industrial Production was up 6.3% from May 2003, the strongest y-o-y gain since May 1998. For comparison, May 2003 posted a 1.5% y-o-y decline and May 2002 at 1.2% y-o-y dip. Examining group y-o-y performance, Durables were up 9.4% (Wood Products up 9.0%, Machinery 12%, Computer & Elect. 21.8%, Motor Vehicles 6.8%). Non-durables were up 2.8% y-o-y (Textiles down 3.4%, Chemicals up 5.7%), Utilities were up 9.4%. June 18 – MarketNews (Gary Rosenberger): “U.S. farmers, flush after banner harvests and rising crop and livestock prices in 2003, have been plowing their newfound gains into new tractors, combines and other farm machinery, report producers and distributors of agricultural equipment. Signs pointing to the final days of historically low interest rates, along with new accelerated depreciation rules, may have further prompted an urgency to buy capital goods earlier in the year, they say. Soaring costs for steel, energy, fertilizer and other inputs have forced surcharges and other forms of price increases at wholesale and retail -- and that is a matter of growing concern going forward, they add.” The Producer Price Index was up 5.0% over 12 months, the highest y-o-y gain in the PPI since December 1990. The CPI was up 3.1% from one year ago, the strongest y-o-y gain since June 2001. Capacity Utilization, at 77.8, was the highest since May 2001. U.S. Financial Sphere Bubble Watch: It was yet another slow month for Fannie Mae. The company’s Book of Business dipped $1.3 billion (0.7% annualized) to $2.199 Trillion, reducing the year-to-date growth rate to 3.7%. The Retained Portfolio declined at a 2.8% annualized rate to $878.4 billion (y-t-d down 5.3%). Outstanding MBS expanded at a 0.7% rate to $1.35 Trillion, with a year-to-date gain of 10.3%. “Lower liquidations coupled with current levels of mortgage commitments are consistent with a return to positive portfolio growth in June.” From Lehman Brothers: "Net Revenues (total revenues less interest expense) for the second quarter were $2.9 billion, up significantly, 28%, from $2.3 billion for the same period in fiscal 2003… In debt underwriting, industry-wide softness in U.S. investment grade issuance was more than offset by an increase in leveraged finance and asset-backed transactions, in addition to heightened investment grade origination in Europe… The Firm’s Capital Markets segment had revenues of approximately $2.0 billion, a 19% increase from the prior year’s quarter… The Fixed Income business posted a 21% revenue increase over the prior year, driven by continued growth in customer flow activity across most products, including derivatives and mortgages… A 16% increase in Equities revenues reflected strong results in equity derivatives…” Compensation and Benefits expenses were up 16% y-o-y to $1.457 billion. Net Income for the quarter was up 39% y-o-y to $609 billion. Total Assets were up $15.0 billion during the quarter, 18.3% annualized, to $342.0 billion. Total Assets expanded at a 19.2% rate over the past two quarters and were up 13% y-o-y. From Bear Stearns: “Net revenues up 17.8% to $1.7 billion from $1.5 billion in 2nd quarter 2003.” “Fixed income net revenues were a record $844.4 million, up 10.4% from $765.2 million… Fixed income reported its best ever quarterly results with the mortgage area operating at record levels and interest rate product areas continuing to provide strong results. Mortgage related revenues were driven by active customer flow in the ARMs, non-agency and commercial mortgage markets.” “Investment Banking net revenues were $254.9 million in the second quarter of 2004, up 14.1% from the $223.4 million…” “Wealth Management net revenues for the quarter ended May 31, 2004 were $176.5 million, up 41.9% from $124.4 million in the second quarter of 2003.” “Institutional Equities net revenues were $252.0 million, up 33.1% from $189.3 million for the second quarter…” Net Income for the quarter was up 24% y-o-y to $347.8 million. (Assets were not reported) Monetary Instability and Lessons Not Learned from the History of the Fed Vacation gave me an opportunity to finally dive into Allan Meltzer’s A History of the Federal Reserve. Coupled with Paul McCulley’s latest, I am thinking that we are no worse off for attempting to refine our analysis of some key parallels between the contemporary environment and that from the “Roaring Twenties.” Mr. McCulley, Fed governor Bernanke and others are increasingly vocal in their call for the Fed to adopt of some variation of a “price rule” to guide monetary policy. Their analytical focus remains on a narrow measure of consumer prices, with a view that our policymakers, having won the long war against inflation, can now direct their policy attention towards sustaining “Price Stability.” But it is reasonable to trumpet the achievement of “price stability” (from the aggregate performance of “core” consumer prices) when the average price of a home in California has inflated $136,470 (43%!) to almost $454,000 over the past 24 months – when NASDAQ (and global equity markets generally) has fluctuated wildly over the past 5 years; when economic growth and corporate profits have vacillated unusually; corporate debt markets have swung from near dislocation to incredible liquefication; and global currency markets have experienced extraordinary seesaws and unstable market conditions (with many episodes of dislocation and crisis over the past decade)? “Price Stability” is a Red Herring. Instead, the issue today should be Monetary Stability, an admittedly, but necessarily, imprecise measure of the general financial AND economic environment – and the appropriateness of monetary policy. The focus must begin with Credit systems (domestic and global) and lending, and data should be analyzed both in aggregate and by sector. And while a narrow measure of consumer prices may indicate “Price Stability” to some, a nearly doubling of Total Mortgage Credit over about 7 years, a ballooning financial sector, a ballooning global leveraged speculating community, a U.S. primary dealer repo position nearing $3 Trillion, an annual U.S. Current Account Deficit approaching $600 billion, ballooning global central banks, and a net liability position to foreigners surpassing $5 Trillion are rather irrefutable indicators of Acute Monetary Instability. It is my view that the late 1920’s was similarly a period of Acute Monetary Instability. There is certainly nothing extraordinary in this assertion, at least when placed in the context of much that was written by the contemporaries of that period. But as time and those individuals passed on, Historical Revisionism purposely filled the void. Led by Milton Friedman and Anna Schwartz, the view was sold that the exceptional policy of the twenties gave way to incompetence and failure. Some of the most astute observers of Credit and speculative finance have somehow come to be villainized. And the Great Depression was not the consequence of 1920’s excesses and imbalances, but was largely the result of the failure of the Fed to expand the money supply. Friedmanite Dr. Bernanke has assured us that this great lesson has been learned and will not be repeated. From Dr. Meltzer: “In retrospect, we know that the years 1923 to 1929 were one of the best periods in the first eighty years of Federal Reserve experience.” (Page 261) He does, however, take a somewhat different tack from Friedman, directing his attention to the flawed adherence to the “real bills doctrine” (see below) as largely responsible for the Fed not ameliorating deflationary forces. And while I take strong exception with the gist of Dr. Meltzer’s analysis (finding it dangerous), his lengthy and detailed book is often excellent for illuminating both sides of debates and presenting various perspectives. The book also provides useful data, noting the exceptional gains in corporate profits, stock prices, and economic growth. Yet, Dr. Meltzer comes from a “Price Stability” analytical framework, asserting that if legislation mandating price stability would have instead passed in 1928, “The Federal Reserve could not have permitted deflation during the Great Depression…” The analytical focus is on the monetary base (narrow money) and consumer prices (narrow inflation), and Meltzer (erroneously) asserts that the Fed ignorantly followed tight policies during the late twenties. At the same time, Dr. Meltzer fails to recognize indications of the monetary disorder that came to wreak increasing havoc on the financial system and economy. Importantly, without a sound analytical framework, it may be very difficult to differentiate an environment demonstrating roaring profits, surging asset prices, strong growth and consumer “price stability,” from precarious Credit and speculation-induced Monetary Instability. This was the case in the late twenties, as it is today. “From the end of 1924 to September 1929, Standard and Poor’s index rose at a 21 percent compound annual growth rate. The Dow Jones industrial average, at its peak of 381 in September 1929, had doubled in less than two years… Real GNP and corporate profits rose at annual rates of 4 percent and 12 percent…” Page 252 “These data suggest that the so-called speculative boom of 1927-29 was driven by rising profits and, most likely, by anticipations of further increases to come.” Page 252 “The belief spread that the Federal Reserve had learned how to maintain prosperity, damp recessions, and prevent inflation. The return of many countries to the gold standard in 1927 reinforced the view that the world economy was on a stable foundation and that inflation and deflation were unlikely to occur. In the 1920s, low inflation, sustained growth, and technological change convinced many that the United States had a ‘new economy.’ At the time, Irving Fisher commented that the stock market ‘went up principally because of sound, justified expectations of earnings…’ He credited increased profits to the application of science, technology, and new management methods. Annual rates of inflation (consumer price index) remained negative from July 1926 to May 1929… The twelve-month moving average of monetary base growth fell below 1 percent in November 1926, turned negative in May 1928, and remained negative through June 1929. In this period of rapid economic growth, monetary policy was deflationary.” Page 253 “Federal Reserve records show that the 1929 increase in output and fall in prices was known at the time. The United States economy had a spectacular performance in the first half of the year. Corporate earnings increased about 30 percent in the first nine months: ‘Large corporate earnings, together with the ability of corporations to float stocks at high prices…put them in possession of funds with which to complete contemplated expansion programs’ (comments from the Fed)… It reported industrial production 26% above the trough in the 1927 recession.” Page 254 “Far from being the expansive agent that (Fed Governor Adolph) Miller and others alleged, the Federal Reserve followed a generally deflationary policy from mid-1927 on. Growth in the real value of the monetary base increased briefly in spring 1927, but it reversed quickly.” Page 256 “Federal Reserve policy remained deflationary in the 1920’s when judged by growth of the nominal monetary base… Real GNP rose 9.2 percent during these years. Rising output with slow or falling money growth produced deflation.” Page 257 “By mid-1927, stock exchange speculation began to take a more prominent place in policy discussions. Common stocks returned 37.5 percent in 1927, one of the largest returns on record. Returns in 1928 were larger still, 43.6 percent… (“The stock market increase occurred worldwide…”) The Board and the reserve banks faced a question that has often plagued central bankers: Should they respond to large increases in asset prices or confine their attention to prices, output, money, or foreign exchange rates.” “The preliminary (Fed) memo described the 8 percent growth in bank credit in 1927 as the largest in three years… Loans on stocks and bonds showed the most rapid increase.” Page 228 “(By May 1928) bank credit was 9 percent above the previous year, production 2.5 percent. This was far from the norm…” (Page 229) “Credit had increased 8 percent in 1928 and output only 3 percent. The Board believed much of the credit had financed stock purchases on margin.” (Page 236) The S&P index jumped more than 10% during the 1929’s first quarter. “Gold continued to flow to the United States, much of it from Germany.” In August, business now “appears on a sound basis.” But “Britain continued to lose gold to France and Germany. New York bought sterling bills to stabilize the pound.” (Page 243) “…the monetary base declined at an average annual rate of 1.3 percent in the year ending June 1929. These indicators suggest that monetary policy was deflationary. The Federal Reserve considered policy expansive, based on the 43 percent increase in stock prices in 1928, the use of credit to support leveraged positions, faster growth of credit than of output, and the large volume of member bank borrowing. Misled by its indicators, it believed the challenge as 1929 started was to restrain ‘speculation.’” (Page 235) “October 24 was ‘black Thursday,’ a day of climactic decline in share prices.” (page 243) According to Dr. Meltzer, “The rapid fall in stock prices in late October suggests a rather sudden shift in anticipations about future profits and economic growth.” Yet, his own work suggests that a historic unwinding of speculative leverage played a prominent role in the collapse. Interestingly, table 4.5 “Loans to Brokers and Dealers, 1929” illustrates that “Other” (non-bank) lending to the broker call loan market contracted 36% ($1.411bn) to $2.464 billion during the final two tumultuous weeks in October. Bank lending to the call market actually increased, as total loans to broker/dealers declined $1.263 billion (19%) to $5.538 billion. Securities leveraging had grown to unprecedented levels, financed through the ballooning broker call market (a large portion provided by non-banks). As was feared by knowledgeable members of the Fed and others, credit abuse and speculation left the financial system and economy acutely vulnerable. The critical flaw in Dr. Meltzer’s analysis is to categorize all individuals warning of the dangers of speculation as adherents to the revisionist's whipping boy, the “real bills doctrine.” “The conflict over policy in 1928 and 1929 was part of the continuing struggle between the Board and the reserve banks and mainly between New York and Washington. (New York Fed’s Benjamin) Strong was convinced of the correctness of his policy views and his ability to manage the system. The Board, particularly Adolph Miller, wanted to use the supervisory powers granted in the Federal Reserve Act to gain control of policy decisions… Disputes were not limited to personal and power conflicts. Miller, other board members, and several reserve bank governors accepted the real bills doctrine…(page 263) The central tenet of the real bills doctrine is that increases in credit achieved by discounting real bills financing production and output (was non-inflationary)… Credit expansion based on government securities (or real estate) is speculative credit. No new production results, so the expansion is inflationary… The major difference and substantive source of dispute concerned the ability of a reserve bank to control the volume of credit or money, hence inflation, by limiting discounts to real bills.” “The board felt the pressure from members of Congress, many of whom, like Carter Glass, believed that credit was financing speculation, not commerce and agriculture. Higher rates, they believed, would deprive legitimate users of credit without deterring speculators… Both sides in this dispute were misled by the rise in interest rates, particularly call money rates, the relatively high volume of discounts, and the growth of loans to finance securities. Based on these indicators, they regarded policy as highly expansive and inflationary… Growth of the monetary base or money stock tells a different story. These indicators implied that policy was deflationary… Misled by the level of discounts and the growth of borrowing, the System forced further deflation instead of moderating policy to prevent deflation. The evidence suggests that a less restrictive policy that avoided deflation would have ameliorated or possibly prevented the 1929 recession…” If it had given attention to deflation instead of the booming stock market, the Federal Reserve could have recognized the symptoms of an excess demand for money and increased the money growth.” Page 265 That one set of analytical eyes can see “highly expansionary and inflationary” policy environment while another “deflationary” is a rather fascinating phenomenon the late twenties has in common with the early years of the New Millennium. It is certainly indicative of the type of extreme price divergences and general disorder associated with a prolonged period of Monetary Instability. Importantly, both periods are characterized by an extraordinary expansion of speculative and non-productive Credit. Asset-based lending and resulting asset Bubbles evolved to the point of providing the instrumental source of systemic liquidity creation. There is no dearth of sound analysis of the causes of the Great Depression, although Dr. Meltzer and his contemporaries would surely dismiss their pertinence with respect to the current environment. I won’t. “(George) Harrison (CEO of NY Fed after the death of B. Strong) stated the quantitative guide: When credit expands faster than trade or business, the Federal Reserve System should raise rates, ‘whether the expansion is due to speculation in real estate, securities, or commodities, or whether it is due to abnormal growth of business.” (Page 250/251) “Harrison acknowledged two mistakes in 1928-29: ‘First we raised our rate the first time too late, and second, we did not raise it fast enough...” Harrison went on to blame the ‘bootleg banking system’ through which corporations and individuals lent to brokers and dealers outside the regular banking system.’ J. Herbert Case (chairman of the New York Fed) also testified about the New York bank’s position. He explained the collapse was regarded as inevitable because speculation in farmlands during the war and postwar inflation were followed by speculation in Florida real estate and, finally, in the stock market, ‘which adversely affected the general business of the country. These movements have each in turn culminated as they inevitably must in a deflation.” (Page 252) “Paul Warburg was critical of Federal Reserve policies from a technical perspective. (He was) a thoughtful representative of the real bills view… He saw the principal flaw as short-term investment in call loans instead of real bills. The problem was that call loans made the banking and financial system depend on the stock exchange. Since call loans could be called daily, a sudden decline in stock prices would weaken the banking system.” From a footnote: “Kindleberger recognizes that prices were not at extraordinary levels relative to profits. Like Warburg, he located the problem in financing on the call money markets: ‘The danger posed by the market was not inherent in the level of prices and turnover so much as the precarious credit mechanism that supported it.’” Page 254 “For Miller, the way to provide economic and price stability was to prevent speculation based on credit. The Federal Reserve must ‘stop and absolutely foreclose the diversion of any Federal Reserve credit to speculative purposes… The threat to good Federal Reserve policy came from bankers, not politicians: ‘…I am not at all afraid of politics getting into the Federal Reserve Board because the Federal Reserve Board has headquarters in Washington. I would be afraid of banking and financial interests getting undue preponderance in the deliberations of the board if the board were located in one of our great financial cities.” “I am of the opinion that open market operations have been the cause of almost as much mischief in credit and economic situations as good.” Page 188 Also from Miller: “By early 1929, ‘the rate of speculative expansion had attained such speed and the thirst for credit had attained such intensity… [that] control through discount rate increase…is best to be regarded as a frail reliance and a dubious expedient.” (page 249) Meltzer sees it differently: “The mistake, according to Miller, was to expand reserves (during 1928/29) when there was no demand for additional reserves… The money flows into the stock market and broker’s loans in the call money market. Miller’s statement reflected the theory he and other relied on (“real bills”)… the implication he drew was incorrect. Monetary expansion encourages stock purchases and raised stock prices by changing expected (nominal) earnings and lowering interest rates… He was wrong to oppose monetary expansion for this reason and to assert the real bills position…” (page 237) Miller was not wrong. Apparently, contemporary economists – most prominently Messrs. Greenspan and Bernanke – have learned from the mistakes of the Fed’s Adolph Miller, George Harrison and others. Accordingly, our policymakers know today to ignore credit abuse and speculative excess. They were ready to inflate aggressively to mitigate any risk of “deflationary” pressures. Yet, there is a major analytical flaw: what are interpreted as deflationary forces are, in reality, manifestations of prolonged credit inflation and speculative excess, and resulting monetary disorder. Further inflation will only exacerbate speculative excess, asset Bubbles, and economic distortions – as Miller and others appreciated during the late twenties. Furthermore, when the inevitable day arrives and speculative flows reverse, increasingly fragile financial and economic systems will be acutely vulnerable to any abrupt disruption of (speculative) liquidity. Importantly, in an environment of Monetary Instability, additional inflation can only render the system more fragile. And a focus on consumer price indexes and “Price Stability” leaves one in analytical and policy-making desolation. The great irony is that Adolph Miller and others appreciated these dynamics. Miller “emphasized accommodating the needs of commerce and preventing speculative uses of credit” but he appreciated there was no panacea or magic formula. He was no “real bills” ideologue, but a policymaker that understood and astutely feared Monetary Instability. “No credit system could undertake to perform the function of regulating credit by reference to prices without failing in the endeavor.” “… it is important to realize that no two situations are identical. They do not repeat themselves with such accuracy that the method by which you successfully deal with one situation will insure an equally satisfactory result in another situation.” “Miller thought that the price index was the wrong target. Price increases came late. ‘To the extent that the Federal Reserve System can do something useful and constructive… it has got to have a far more competent guide than the price index offers. Assuming that we want price stability – I prefer to put it as I have already put it, economic stability with price stability as a concomitant or resultant of that – in order to obtain it we have to look at things closer to the source or beginning of troubles than the price index… If you are to have competent control of credit, you cannot wait until inflationary developments register themselves in the price index. By that time the thing will have already gotten considerable momentum.” (page 186/187) Lessons Not Learned. |
Saturday, September 6, 2014
06/17/2004 Monetary Instability and Lessons Not Learned *
