Tag Archives: Federal Reserve System

Liars, Gamblers, and Suckers.

I just finished reading a piece by Goldman Sachs urging investors to charge into the housing market.

Here is what they said back in March of 2012:

Headline reads: The housing recovery will have to wait a little bit longer. Goldman Sachs just pushed back its estimated date of the bottom.

In December 2011 G-Sax published a new house price model for 147 metro areas that pointed to a decline of around 3% from mid-2011 through mid-2012 before stabilizing in the year thereafter. Since publication of the model–which was based on Case-Shiller house price data up to 2011Q2–the decline in house prices has reaccelerated slightly. In today’s (February 29) comment they updated their forecast in light of this and also used the opportunity to make a couple of technical changes to the model.

They now project that house prices will decline by around 3% from 2011Q3 until 2012Q3, and by an additional 1% in the year thereafter. As a result, the expected bottom in house prices is pushed out from end-2012 to mid-2013. Although the house price outlook has weakened very slightly, they go on to say that they believe that the house price bottom remains in sight.

That was in March, after predicting that we would hit the “bottom” in 3Q12. Here is what they said on Monday of this week. Headline: Goldman Sachs predicting ‘strong’ U.S. housing recovery. Construction up, existing home sale supply down.

Article goes on to say that U.S. home builders are an attractive investment as the housing market starts a “strong” recovery that may drive a surge in new-home sales, Goldman Sachs Group Inc. said in a report Monday.

Housing has a “long list of positives,” including rising prices, job growth, supportive government policies and a decline in the so-called shadow inventory of homes, Goldman Sachs analysts Joshua Pollard and Anto Savarirajan wrote in a note to clients. They raised their rating on the homebuilding industry to attractive from neutral.

As a gentle reminder, these are the same people (different suits) who urged investors to buy Collateral Default Obligations and Credit Default Swaps back in 2007. Anything sound familiar here?

For those not punch-drunk on Wall Street’s propaganda, here is what is actually going to happen:

Housing will not hit bottom until somewhere north of 2015. Why? Banks are holding a ton of shadow inventory that they dare not release to the market for fear of creating insane downward pressure on pricing. In addition, there are still tons (millions) of homes crawling their way through the foreclosure process. Are there pockets of good news? Of course. Just like the fact that not everybody lost their asses in the real estate or stock markets since 2008, there are real estate markets like Pebble Beach and San Francisco and Long Island that are still holding prices up. But, the real real estate market is in the crapper and will stay that way or get worse in the coming months.

Until the November U.S. presidential elections of this year, there will be a deceptive calm before the storm, as every major economy plagued with severe fiscal problems continues to kick the can down the road. Come 2013, there will be a convergence of several major negative metrics.

These include the worsening Eurozone debt crisis, leading to the exit of Greece from the monetary union. China will face a hard economic landing, and the United States — its economic growth and job creation performance already anemic — will face a very high probability of a renewed economic recession, particularly in a political environment favoring austerity.

In addition to those economic factors, there is one other element in the turbulent brew that comprises my prediction of a perfect economic storm in 2013: Iran. If the Iranian nuclear issue is not resolved peacefully, which at present seems highly doubtful, there is a high probability of a military conflict occurring in the region, which will add further strains upon the global economy, particularly if oil prices spike to highly elevated levels.

I am not alone in this view. A guy who got it right the last time has the exact same predictions for 2013. Nouriel Roubini, or Dr. Doom, has issued a characteristically gloom-laden warning about likely economic trends for 2013. Unlike the pontificators among the politicians, Wall Street glad-handlers and central bankers, Roubini’s analysis of future economic trends does have the virtue of reasoned logic as opposed to overly-optimistic rhetoric. Nouriel Roubini’s record in predicting future trends impacting the global economy and financial system has been inherently more reliable than the forecasts offered by the U.S. Federal Reserve, as well as by the policymakers in America and Europe.

He emerged in the months prior to the global financial and economic crisis that erupted in the fall of 2008, warning of a deadly convergence of troubling economic and financial dangers.

Roubini’s prediction that the contraction in housing prices in the U.S. housing market would metastasize into a devastating financial hurricane seemed so incomprehensively dire, the pundits and eternal optimists on Wall Street wrote him off. Was it because they insist on driving markets in spite of the realities before them? Do they care, as long as they are betting on the right side of the dice? Don’t forget, those traders who touted CDOs and CDSs were making a killing on insuring against their performance.

Will you listen to Goldman Sachs or Nouriel Roubini?





Go Ask Alice.

Is it only me, or does the whole global financial crisis seem like we have fallen down a rabbit hole and are sliding through a curious hall with lots of locked doors in many sizes?

According to Bernanke’s testimony to Congress last Thursday, the Federal Reserve “stands ready to act to protect the financial system and the economy in the event that stresses from the European crisis escalate.”, yet he failed to describe what acts they may take.

“The situation in Europe poses significant risks to the U.S. financial system and economy and must be monitored closely,” Bernanke said in testimony prepared for delivery to the Joint Economic Committee of Congress. Monitored closely?

“Action is needed to stabilize euro-area banks, calm market fears about sovereign finances, set in place a workable fiscal framework and lay the foundation for long-term growth,” Bernanke added, but failed to mention how anyone might go about doing that.

The Fed chief’s testimony was largely in line with expectations. Central-bank watchers did not expect Bernanke to show his hand about what the Fed might do at its next policy meeting. Ah, we wait for the next “policy” meeting. Apparently, as long as Bernanke never actually discusses policy, and only what the Fed is ready to do, then the markets will stay relaxed and avoid panic. Sort of like finding Alice’s “DRINK ME” bottle.

“Based on these comments, we do not believe the FOMC has made up its mind about the need for further stimulus,” said Michael Gapen, a senior U.S. economist at Barclays Capital. Yes, they’re still thinking, I guess.

Ian Shepherdson, chief U.S. economist at High Frequency Economics, said Bernanke only promised to act “if the sky falls.” That will be really great timing. God forbid we should act to actually prevent anything. I mean, are you KIDDING me?

Financial-market stress due to Europe and concerns about the loss of momentum in the U.S. economy has raised expectations that the Fed would do more to stimulate the economy. Last week, several key Fed officials said they were open to more easing if warranted. Nice. They’re open to it.

In his discussion of the domestic economy, Bernanke stuck to his April forecast that growth will continue at a moderate pace. He said the recovery had been bolstered by consumer spending, as consumers had more money to spend given the drop in gasoline prices. OK, average consumer drives 80 miles a week. Average car gets 22 mpg. Average price of gas is now $2.95. Average price was $3.45. Savings of $8/month. And, THIS is the “more money” consumers now have to spend?

Business caution continued to restrain the economy, he noted. That is Fed code for: austerity at the corporate level (not spending and no credit) is KILLING this country.

Bernanke suggested some of the apparent slowing in economic data, including last Friday’s weak jobs number, might be due to unusually warm weather this past winter, which may have brought forward some activity. Ah yes, it must be the weather. Couldn’t be because corporations are squeezing unprecedented productivity out of workers who are now doing two jobs instead of one? And, these are captive workers who have no other jobs to go to.

Bernanke also again called on Congress to set in place a sustainable fiscal policy. He said the severe fiscal tightening that will occur at the beginning of next year unless Congress acts — the so-called ‘fiscal cliff’ — would pose “a significant threat to the recovery” if allowed to occur. And …. ????

And then, he ate two more of those funny mushrooms that have been circulating through Washington this week, and wandered back down to the Eccles building to search for that “mad” tea party and the March Hare. I guess.

How Much Trouble Could Big Banks Be In? Lots!

The future of the Euro and the Eurozone is bleak and will likely look like a series of prolonged, rolling crises that slowly evolve to reveal just how critically the financial health of each country is affected by their individual sovereign debt and their failing banks.

The inevitable result will be severe Eurozone-wide stress, emergency liquidity loans from the IMF and the European Central Bank and politicians from all the countries involved increasingly attacking each other  over allegations of blame and corruption. To no good end.

Even the optimists now say openly that Europe will only solve its problems when there are no options left and time has run out. Less optimistic analysts increasingly think that the Eurozone will break up because all the proposed solutions are essentially Pollyannaish jokes. Let’s say the realists are right, and Europe starts to dissolve. Markets, investors, regulators and governments can stop worrying about interest-rate and credit risk, and start worrying about dissolution risk.

More importantly, they need to start worrying seriously about what the repricing of risk will do to the world’s thinly capitalized and highly leveraged megabanks. European officials, strangely, appear not to have thought about this at all; the Group of 20 meeting last week seemed to communicate a weird form of complacency and calm.

So, for all of the European officials and the U.S. bankers, here’s what dissolution risk means:  If you have a contract that requires you to be paid in euros and the euro no longer exists, what you will receive is not real clear. See? That’s dissolution risk.

Let’s say you have lent 1 million euros to a German bank, payable three months from now. If the euro suddenly ceases to exist and all countries revert to their original currencies, then you would probably receive payment in deutsche marks. You might be fine with this — and congratulate yourself on not lending to an Italian bank, which is now paying off in lira.

But what would the exchange rate be between new deutsche marks and euros? How would this affect the purchasing power of the loan repayment? More worrisome, what if Germany has gone back on the deutsche mark but the euro still exists — issued by more inflation-inclined countries? Presumably you would be offered payment in the rapidly depreciating euro. If you contested such a repayment, the litigation could drag on for years.

What if you lent to that German bank not in Frankfurt but in London? Would it matter if you lent to a branch (part of the parent) or a subsidiary (more clearly a British legal entity)? How would the British courts assess your claim to be repaid in relatively appreciated deutsche marks, rather than ever-less- appealing euros? With the euro depreciating further, should you wait to see what the courts decide? Or should you settle quickly in hope of recovering half of what you originally expected?

What if you lent to the German bank in New York, but the transaction was run through an offshore subsidiary, for example in the Cayman Islands? Global banks are extremely complex in terms of the legal entities that overlap with business units. Do you really know which legal jurisdiction would cover all aspects of your transaction in the currency formerly known as the euro?

Moving from relatively simple contracts to the complex world of derivatives, what would happen to the huge euro-denominated interest-rate swap market if euro dissolution is a real possibility? Guess what? No one really knows.

But, what I am really talking about here is the balance sheets of the really big banks. For example, in recently released filings with banking regulators, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. JPMorgan’s total balance sheet is valued, under U.S. accounting standards, at about $2.3 trillion. But U.S. rules allow a more generous netting of derivatives — offsetting long with short positions between the same counterparties — than European banks are allowed. HA!

The problem is that the netting effect can be overstated because derivatives contracts often don’t offset each other precisely. Worse, when traders smell trouble at a bank that has taken on too much risk, they tend to close out their derivatives positions quickly, leaving supposedly netted contracts exposed. Remember the final days of Lehman Brothers?

When one bank defaults and its derivatives counterpart does not, the failing bank must pay many contracts at once. The counterpart, however, wouldn’t provide a matching acceleration in its payments, which would be owed under the originally agreed schedule. This discrepancy could cause a “run” on a highly leveraged bank as counterparties attempt to close out positions with suspect banks while they can. The point is that the netting shown on a bank balance sheet can paper over this dynamic. And that means that JPMorgan’s regulatory filings vastly understate the potential danger.

JPMorgan’s balance sheet, using the European method isn’t $2.3 trillion, but closer to $4 trillion. That would make it the largest bank in the world. Holy Moly!

What are the odds that JPMorgan would lose no more than $50 billion on assets of $4 trillion, much of which is complex derivatives, in a euro-area breakup, an event that would easily be the biggest financial crisis in world history? Slim. And, None.

No one on these shores seems to see the storm coming. In an effort to forestall the impending global crisis, the Federal Reserve should be insisting that big U.S. banks increase their capital levels by suspending dividends, and set up emergency liquidity facilities with an emergency and across-the-board suspension of dividend payments, but it won’t. The Fed is convinced that its recent stress tests show U.S. banks have enough capital even though these tests didn’t model serious euro dissolution risk and the effect on global derivatives markets.

The Fed is dead wrong about that, and the pending Euro-crisis is very real. Our mega-banks are in no position to weather even the known storm, let alone the real storm when all the European counter-parties pony up to the bar with their real exposures, and the true sovereign debt gets exposed. Then, what do you think that means for smaller banks? 

How do you think that might affect the U.S. economic recovery? What is gold trading at? $1,575 an ounce?  Hmmmm.

The (New) Great Depression (Part II).

The media’s popular narrative about the causes and cure for the Great Depression invariably start with the storyline that the stock market crash caused the Great Depression.

Herbert Hoover purportedly refused to spend government money in an effort to reinvigorate the economy. Franklin Delano Roosevelt’s New Deal government spending programs allegedly saved America.

This is a big lie.

The 1920s marked the beginning of mass production and the emergence of consumerism in America, with automobiles a prominent symbol of the latter. In 1919, there were just 6.7 million cars on American roads. By 1929, the number had grown to more than 27 million cars, or nearly one car for every household. During this period, banks offered the country’s first home mortgages and manufacturers of everything – from cars to irons – allowed consumers to pay “on time.” Installment credit soared during the 1920s. About 60% of all furniture and 75% of all radios were purchased on installment plans. Thrift and saving were replaced in the new consumer society by spending and borrowing. Notice any parallels? 

Encouraging the spending, the three Republican administrations of the 1920s practiced laissez-faire economics, starting by cutting top tax rates from 77% to 25% by 1925. Non-intervention into business and banking became government policy. These policies led to over-confidence on the part of investors and to a classic credit-induced speculative boom. Gambling in the markets by the wealthy increased. While the rich got richer, millions of Americans lived below the household poverty line of $2,000 per year. The days of wine and roses came to an abrupt end in October 1929, with the Great Stock Market Crash.

The Great Depression was caused by the Federal Reserve’s expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. Just like the early 2000s. When the Federal Reserve belatedly tightened in 1928, it was too late to avoid financial collapse. According to Murray Rothbard, in his book America’s Great Depression, the artificial interference in the economy was a disaster prior to the depression, and government efforts to prop up the economy after the crash of 1929 only made things worse. Government intervention delayed the market’s adjustment and made the road to complete recovery more difficult.

And, this is exactly what the IMF and the Central Bank are doing in Europe today. Pouring more capital into a failed banking system to avoid a runaway withdrawal panic is crazy. Where will bonds be when it is over? Every country in the Eurozone, save for Germany and the United Kingdom, are broke and their banks are failing. More of the same lunatic monetary policy will bring Europe to its own Great Depression, and it will happen next year.

The parallels between the 1930s and today are uncanny. Alan Greenspan expanded the money supply after the dot-com bust, dropped interest rates to 1%, encouraged a credit-driven boom, and created a gigantic housing bubble. By the time the Fed realized they had created a bubble, it was too late. The government response to the 2008 financial collapse has been to expand the money supply, reduce interest rates to 0%, borrow and spend $850 billion on useless make-work pork projects, encourage spending by consumers on cars and appliances, and artificially prop up housing through tax credits and anti-foreclosure programs. The National Debt has been driven higher by $2.7 trillion in the last 18 months.

The government has sustained insolvent Wall Street banks with $700 billion of taxpayer funds and continues to waste taxpayer money on dreadfully run companies like Fannie Mae and Freddie Mac. The government is prolonging the agony by not allowing the real economy to bottom and begin a sound recovery based on savings, investment, and sustainable fiscal policies. President Obama continues to exacerbate the problem by creating more burdensome healthcare, financial, and energy regulations. And, regulations are not the same as a single payer health care program, so please understand; these policies are hurting businesses and failing to help anyone.

Today’s politicians and monetary authorities have learned the wrong lessons from the Great Depression. The result will be a second, Greater Depression and more pain for the middle class. The investment implications of government stimulus programs are further debasement of the currency and ultimately inflation and surging interest rates.

And, at the end of the day, we will be forced to allow capital markets to sort it out without any additional government intervention after all, and, as they say in golf, take our medicine and play the next hole. But, we’re really bad at that, aren’t we?

Three Dangerous Myths.

I think someone said this a long time ago, but for some reason Andy Rooney gets credit for it, “People will generally accept facts as truth only if the facts agree with what they already believe.”

Somehow, the American public has gotten three “facts” into their brains and they have become the bedrock on which way too many decisions, fear, paranoia, political beliefs and prejudices are based.

Those “facts” are:

1)      Most of America’s oil comes from the Middle East. Therefore, we are held hostage by rich Arabs.

2)      Most of what consumers buy is made in China. We buy nothing made in America anymore.

3)      China owns most of America’s debt. They bought it on purpose to control us.

Now, I know the following actual facts are going to surprise those who are reasonable, anger those who are not, and confound and confuse those who distrust government statistics, but nonetheless, here they are:

1)      Only 9.2% of oil consumed in America comes from the Middle East.

Fact: The U.S. consumes 19.2 million barrels of petroleum products per day (USEIA). 49% of those 19.2 million barrels (9.4 million) is produced domestically. The rest is imported. Where from? The Persian Gulf region has created and imported 9.2% of the total petroleum supplied to the U.S. in 2011. Back in 2001, that number was 14.1%. So, we are less dependent on Middle Eastern oil every year.

The U.S. imports more than twice as much petroleum from Canada and Mexico than it does from the Middle East. But, this is still not good – it means we are dependent on other countries for over half our oil. Just not the Arabs, whom everyone seems to think controls our oil supply. But, I have never heard anyone curse the damned Mexicans or Canadians for holding us hostage to their oil.

Second inconvenient, yet actual fact:

2)      Only 2.7% of what we personally consume are goods made in China. Almost 90% of US Consumer spending goes to goods made in America.

Fact: Just 2.7% of personal consumption expenditures go to Chinese-made goods and services. 88.5% of U.S. consumer spending is on American-made goods and services. Now, of course, no one believes this as they can plainly see that almost everything in Wal-Mart is made in China. Remember that Wal-Mart generates $260 Billion in US revenue annually, but our total spending is close to $14.5 Trillion.

The Bureau of Labor Statistics tracks average American consumer spending in an annual report called the Consumer Expenditure Survey. In 2010, the average American spent 34% of their income on housing, 13% on food, 11% on insurance and pensions, 7% on health care, and 2% on education. Those categories make up nearly 70% of total spending, and are comprised almost entirely of American-made goods and services (only 7% of food is imported, according to the USDA). Want more proof? The U.S. is on track to import $340 Billion worth of goods from China in 2012, which is 2.3% of our $14.5 trillion economy.  That’s it.

And while we are on the subject, most of the skeptics will point to this equally wrong-headed notion that America’s manufacturing sector has been in steep decline. Another inconvenient fact is that America’s real manufacturing output is at an all-time high. What IS in decline is the number of manufacturing jobs required to create that output. Because we have figured out how to use technology, we now produce far more stuff with far fewer workers than we have done in the past. Sixty years ago, it took 30,000 people to produce 6 million tons of steel. It now takes 5,000 to produce 7.5 million.

All those jobs that have disappeared overseas? It seems they have disappeared in the exhaust of technology instead.

Third inconvenient actual fact:

3)      China only owns 7.8% of U.S. government debt. We own almost all the rest.

Fact: As of August of 2011, China owned $1.14 trillion of Treasuries. Government debt stood at $14.6 trillion that month. That’s 7.8%.

The largest holder of U.S. debt is the federal government itself. Various government trusts like the Social Security trust fund own about $4.4 trillion worth of Treasury securities. The Federal Reserve owns another $1.6 trillion. Both are unique owners: Interest paid on debt held by federal trust funds is used to cover a portion of federal spending, and the vast majority of interest earned by the Federal Reserve is remitted back to the U.S. Treasury. In other words it is free debt.

The rest is owned by state and local governments ($700 billion), private domestic investors ($3.1 trillion), and other non-Chinese foreign investors ($3.5 trillion). In fact, the combined holdings of Japan and the UK are bigger than China’s holdings. I have never heard anyone say that we are owned by Japan or the UK, have you?

Inflation and Small Business.

Inflation. Congress and government analysts tell us repeatedly that there is no inflation. The Fed is keeping interest rates really low to make sure we have no inflation. Well, guess what?

We’ve had an 8 percent increase in the cost of eggs over the past year. What do you think that is doing to restaurants and bakeries? Cotton’s up 14 percent in the last year. How do you think that impacts clothing manufacturers and retailers? And any business that sends somebody on a sales trip is bearing the brunt of an 18 percent increase in jet fuel or a 27 percent rise in in the price of gasoline.

Under “normal” circumstances, small businesses simply pass these costs along to consumers. You might not have noticed, but we have not had “normal” circumstances since 2007. Consumers want to pay less, not more for stuff, and small businesses are left with few if any options.

Most small businesses have seen travel costs rise 30 percent in the past year, after a 20 percent gain the year before. Rising fares, baggage fees and higher hotel bills are to blame. Large companies have leveraged travel budgets and deals with airlines, hotels and rental car agencies to help with the increased fees, while small business does not. It is almost as if the travel and hospitality industries have had a private peek at a coming Armageddon, and have jacked their prices so that they can get it all in now.

Many small businesses are doing sales training and company meetings through online seminars rather than in person.

The kind of numbers that small business deals with may surprise anyone who believes that the government’s Consumer Price Index tells the story of inflation. In the 12 months that ended in March 2012, the CPI rose 2.7 percent. Subtract food and gas as some economists do, and what’s left is called “core” inflation. It rose 2.3 percent. That’s close to the target of 2 percent set by the Federal Reserve, which sets monetary policy so inflation doesn’t get out of hand.

But prices that businesses pay for energy, raw materials, supplies and services have gone up much more sharply. And they’re expected to keep rising because demand for many goods and services is soaring in countries like China and India. That offsets slower demand in the U.S. and Europe and sends prices higher worldwide.

Raymond Keating, chief economist with the Small Business & Entrepreneurship Council, an advocacy group, expects inflation to keep rising as the economy improves and the Fed eventually lets short-term interest rates rise from their current levels near zero. He says of small-business owners, “a lot of people are worried about how high it (inflation) will go in the future.”

The impact of rising energy prices may not always be obvious. Regalia noted that airlines’ baggage fees, typically $25 per bag per flight, are the result of rising fuel prices. And energy costs factor into the prices of all goods and services.

Chad Moutray, chief economist with the National Association of Manufacturers, says small businesses are at a disadvantage because they can’t buy in bulk like larger companies can. That means a small cosmetics manufacturer can’t negotiate the lower prices that a company like Revlon can. And, he said, “They’re less likely to be able to pass along their higher prices to customers.”

Lorne Campbell, president of Occasionally Cake, two upscale bake shops outside of Washington, D.C., has refrained from raising prices since his company was launched in 2009. “A small business is about personal relationships. It’s about trust,” he says. “A large faceless corporation doesn’t have to look at their customers and say, Mrs. Smith, you and your daughter are going to have to pay extra for a cupcake today.”

Campbell estimates that he’s paying 10 percent to 12 percent more for ingredients and other supplies than he did a year ago. His fuel costs have doubled, although some of that increase is due to the fact he’s making more deliveries. Occasionally Cake has kept other costs down by holding back on hiring, and asking current staffers to take on more responsibilities and work longer hours. Sound familiar?

Other businesses can’t raise prices because they’re under contract to deliver goods or services at a set price. Campus Cooks, which provides dining services for fraternity and sorority houses in the Midwest, Florida and Texas, signs agreements that cover the entire school year. When wholesale food prices rise sharply when school’s in session, it’s time to get creative. “If chicken’s higher, you change the menu to more fish, pork and beef,” says Bill Reeder, president of the Glenview, Ill.-based Company. Campus Cooks will also buy in bulk. And if it has to serve, say, more pork, it will vary how the meat is prepared.

Reeder already expects his prices to rise 2 percent to 3 percent for the next academic year. But he’s not passing all the costs along. “We’re taking some of a hit on the profit end of it,” he says. He’s hoping to get another 10 to 12 customers signed for the next year, and the additional sales volume would help his profits.

Clothing stores are contending with higher prices — and consumers’ tendency to be frugal when they’re paying more for gas, food and other items. Jimmy Au’s, a Beverly Hills, Calif., men’s store, has paid on average 5 percent more for the clothes it stocked during the past year.

Alan Au, the store’s client relations manager, says prices for cotton, wool and silk have soared. Top-grade cotton has gone up as much as 14 percent over the past year. Au says the store laid off a sales person as demand fell, and that allowed it to keep most of its prices unchanged. It has raised prices on some high-end suits and on jeans that sell for $200. But for the most part, the store is telling customers, “We’ll bite the bullet for you because we appreciate your sticking with us.”

And there are thousands of other similar stories all across the US, but Martin Regalia, chief economist with the U.S. Chamber of Commerce, has only this response: “While overall inflation is not a real problem, the components of inflation that matter the most to small businesses — such as energy — are troubling.” Not a real problem? The “components” of inflation? Troubling? 

No Inflation? HAH!

Congress keeps telling Social Security recipients that because inflation is low, there won’t be a cost of living increase. Congress does this because they don’t want to give Seniors a cost of living increase, and also, because they don’t actually shop for gas and food, they wouldn’t know if there was inflation or not.

The Bureau of Labor Statistics doesn’t include food or energy costs in their index, which makes absolutely no sense.

CBS News recently reported that the rate of inflation, as calculated by the American Institute for Economic Research (AIER), clocked in at a whopping 8% over the past year.

This number is in stark contrast to the relatively modest inflation rate of 3.1% being reported by the government’s Bureau of Labor Statistics.

The AIER calculates what they refer to as an Every Day Price Index (EPI). The EPI only looks at the cost of goods the average household buys every month, and factors in only those costs which are subject to price fluctuation. For example, mortgages are typically stable over the course of a year so those numbers are ignored. They wouldn’t change unless a person moves or refinances, so they don’t act as a good measure of inflation from month to month.

Another measure of inflation comes from John Williams’ Shadow Stats. Williams calculates the consumer price index (CPI) using the same model as the government did prior to 1990. Williams also calculates the CPI using the same model as the government did prior to 1980. In each case, the government changed the way it calculated inflation in order to give the appearance of less inflation.

If we calculate the inflation rate the same way the government did prior to 1990, the inflation rate averages around 6.5%, which is basically double the official rate. However, if we measure inflation the same way the government did back prior to 1980, the inflation rate clocks in at a mind-numbing 11%, which I am sure is closer to the actual truth.

In the current official model, the state makes widespread use of hedonics and substitution to hide real inflation rates. It must do so in order to keep the interest it pays on Treasury Inflation-Protected Securities (TIPS) and Social Security cost of living adjustments low. If the government used real consumer inflation rates, it would become readily apparent that the U.S. is completely insolvent in much the same way Greece is insolvent today.

If other nations should catch on to this, they would begin dumping U.S. treasuries in order to protect themselves from a U.S. default, the same situation Greece is facing today. People don’t want to hold Greek debt because they fear they will not be paid back with money that has any value. In other words, they fear that the Greek state will simply print money to make the interest payments.

It appears that this situation may already be taking place with some major U.S. creditors. The Chinese have dumped over $100 billion worth of U.S. treasuries in the month of December, which is a continuation of a trend that has been going on since April of 2011. Chinese holdings of U.S. treasuries are down $300 billion since April of 2011.

This creates a dangerous situation for the U.S.. If enough governments dump U.S. treasuries because they fear the U.S. is insolvent,  interest rates will skyrocket – unless the Fed prints the money to buy those bonds. However, if the Fed buys the bonds, domestic inflation rates will skyrocket.

If you’re like many Americans, you may find the recent economic news somewhat perplexing. Government reports show the economy improving and inflation under control. And yet, it may well feel as though your standard of living is eroding, and you may be shocked by prices when you go shopping. Well, there’s a reason for the disconnect between  reported statistics and your personal experience – and much of it has to do with the nature of inflation.

The fundamental problem is this:  – economists and laypeople talk about inflation as though it can be measured accurately and represented by a single number. In reality, though, inflation is a judgment call and varies enormously depending on what part of the economy is under consideration. Thus the discrepancy between what you see in print and what you experience at the grocery store.

These discrepancies have been highlighted in recent weeks as various authorities reported economic statistics for 2011. The Consumer Price Index rose a modest 2.9% over the past 12 months. On the other hand, a report on Thursday by an independent research organization calculated that prices of “everyday items” rose more than 8% last year.

The latter report on everyday prices, by the American Institute for Economic Research, an organization with free-market leanings that originated at MIT in the 1930s, was particularly interesting in its details. On the plus side, there were double-digit price declines for televisions and computers, while some other kinds of consumer electronics declined at single-digit rates. But those improvements in affordability were massively overshadowed by the big price increases in 2011:

Meat and milk rose more than 9%

Coffee was up 19%

Peanut butter, a staggering 27%.

Heating oil climbed 18%.

Children’s clothes were up 6% for boys, 9% for girls.

Gasoline rose almost 34%.

With Oil at $120 a barrel, the cost of everything will be impacted from packaging to transportation. No wonder food prices have skyrocketed.

And, even those figures are only averages. Inflation is higher for the affluent (who at least can afford it). Indexes of luxury goods climbed anywhere from 6% to 15% last year. More serious, inflation for people age 62 and older is typically as much as two percentage points higher than the overall CPI, in part because of medical expenses.

This enormous variability in the inflation rate filters through to other economic statistics, as well.  So-called real growth in the economy or household incomes is calculated by subtracting inflation from figures in today’s dollars. The smaller the inflation adjustment, the higher real growth will appear, and the larger the inflation adjustment, the weaker real growth will be.

Indeed, the reported economic upturn in the fourth quarter can be attributed almost entirely to an unusually low inflation adjustment. Most measures show consumer prices rising at close to a 3% annual rate, and the inflation adjustment for GDP growth was at least 2.6% in each of the first three quarters of 2011. But in the fourth quarter, the inflation adjustment used to calculate real GDP was less than 1%. If fourth quarter growth had been based on the same inflation rates used earlier in the year, there would have been no upturn, which is what I believe actually happened – already weak growth would have slowed further between the third and fourth quarters.

There may be valid reasons that inflation in the industrial economy measured very low for the fourth quarter. But that doesn’t necessarily reflect your own personal reality. For example, workers’ real incomes have risen slightly in the past few months, according to government inflation measures. But if those workers face continually rising prices at the grocery store and elsewhere, their own experience will be that the recession has not ended and that their standards of living are still falling.

Some commentators have tried to make current conditions sound rosier by pointing out that prices of a few key big-ticket items are falling, offsetting the price rises on everyday items. This argument is faulty for two reasons. First, big-ticket items such as housing and autos are highly cyclical. Their contribution to long-term inflation depends on their trend over time, not on temporary lows near an economic trough.

Second, people don’t buy cars and houses every day. Your monthly budget isn’t affected by what you might have paid for your home some years earlier. Indeed, this underlines the extent to which your own inflation rate depends on your personal circumstances. A renter might be affected by price trends in the real estate market, but someone with a long-term fixed-rate mortgage wouldn’t be.

There are, in fact, multiple difficulties in trying to account for cyclicals and highly volatile items such as oil when measuring inflation. But insofar as such things can be assessed, they suggest more inflation in the future, not less. Depressed home prices will likely rebound at some point if the economic recovery gains momentum. And current high oil prices will eventually factor into inflation as transportation costs get passed along for many goods. If Iran or Europe turn into the likely nightmares they will probably become, Oil could go to $400 barrel.

In the final analysis, what matters most to you is your own personal experience of the economy. And you’re probably feeling higher inflation and weaker growth than the economic statistics coming out of Washington would suggest. If you really want to know what’s happening to your own standard of living, go shopping for groceries.

Euro Banks Swap Cash for Trash.

Cheap loans being offered by the European Central Bank to help reflate the Eurozone are encouraging some banks to boost their profits by loading up on risky bonds.

Jan Stromme / Getty Images

Desperate attempts by the European Central Bank to pump air into the deflating Eurozone are also encouraging leading European banks to load up their portfolios with potentially risky debt. This could lead to big problems down the road if some Eurozone countries do actually default or force the banks to accept big writedowns on loans.

The problem is what’s known as the carry trade, a term that sounds like something out of Jane Austen: “Mr. Willoughby may not be a gentleman, but he is very rich. He has made a fortune in the carry trade, you know.” In fact, today’s carry trade is concerned with a different kind of unsuitability. In place of totally safe investments, bankers buy risky bonds and reap a substantial profit from “carrying” these hot potatoes. The enhanced earnings typically come from the fact that the yields on these bonds are a lot higher than the cost of borrowing the money to buy them.

But the carry trade has become a problem recently because the European Central Bank has started lending huge amounts of money on incredibly easy terms (sort of like mortgage loans in the U.S. a few years ago). The ECB’s new procedures, known as “crisis loans” or LTRO (long-term refinancing operations), are a bit complicated to explain. For a full-length treatment, you can read this article by Ambrose Evans-Pritchard, but here’s the short, oversimplified version:

The European Central Bank has two big worries. One is that countries with a lot of debt, such as Italy and Spain, won’t be able to sell bonds at reasonable prices to cover deficits and also to pay off old bonds that are coming due. The other is that major European banks will temporarily run out of cash and find that short-term loans aren’t available — either because the bonds they own won’t be good enough to be accepted as collateral or because other banks are cutting back lending generally.

The ECB’s solution has been to lend money to banks really cheaply while being extremely accommodating about the quality of collateral. In December, the ECB lent an enormous 489 billion euros to more than 500 banks at a rate of only 1% for three years, an unusually long period for this sort of loan. The U.S. Federal Reserve was also involved, making sure that dollars as well as euros were available. An even bigger such loan is scheduled for later this month.

(MOREWhy Europe’s Backdoor Bailouts Won’t Work)

This lending obviously solves European banks’ short-term cash worries. But it also has another clever consequence. Banks can borrow more than they actually need and use some of the money to buy high-paying debt securities and profit from the difference between the yield on the bonds they buy and the low cost of the loan from the ECB – that’s the so-called carry.

For the banks, the question is how much profit to reach for – and how much risk to take. The low yield on three-year German bonds (completely safe) would actually result in a negative cost of carry – in other words, a loss. Investing for 10 years in France (fairly safe) would earn 3%, or a profit of 2%. Ten years in Italy (somewhat risky) would earn a profit of almost 5%. Portugal (probably unsafe) would earn double-digit returns.

The ECB strategy has worked brilliantly, at least so far. Banks have the cash on hand that they need. They are also earning invisible subsidies by the grace of the ECB (and the Fed) by loading up on bonds that have varying degrees of risk. Just like, I dunno, a bubble?

There are just two drawbacks: First, few banks are daring enough to lend a lot to the most troubled countries, so while yields in Italy and Spain have come down, those in Greece, Portugal and maybe Ireland are still too high for those countries to escape eventual default.

Second, banks may be tempted to buy too much low-rated debt. If they do, and one of the countries defaults or is severely downgraded by credit-rating agencies, the banks could find that they have swapped cash for trash. The losses would cut into their required capital and possibly also leave them short of ready money. But such a squeeze could only happen if the bankers get reckless and greedy – and that could never happen, right?

U.S. Growth Quickens in Q4, but 2012 Looks Awful.

The U.S. economy grew at its fastest pace in 1-1/2 years in the fourth quarter, but a strong rebuilding of stocks by businesses and weak spending on capital goods hinted at slower growth in early 2012.

U.S. gross domestic product expanded at a 2.8 percent annual rate, the Commerce Department said on Friday, a sharp acceleration from the 1.8 percent clip of the prior three months and the quickest pace since the second quarter of 2010.

It was, however, a touch below economists’ expectations for a 3.0 percent rate.

“The economy ended 2011 on a fairly positive note, but the composition of growth in the last quarter is not favorable for growth early this year,” said Ryan Sweet, a senior economist at Moody’s Analytics in West Chester, Pennsylvania.

Sweet made the comments before the report was released. For the whole of 2011, the economy grew 1.7 percent after expanding 3 percent the prior year.

Growth in the fourth quarter got a temporary boost from the rebuilding of business inventories, which was the fastest since the third quarter of 2010, after they declined in the third-quarter for the first time since late 2009.

Inventories increased $56.0 billion, adding 1.94 percentage points to GDP growth. In other words, excluding inventories, the economy grew at a tepid 0.8 percent rate, a sharp step-down from the prior period’s 3.2 percent pace. So, take out the inventory re-build and what do we have? Less than 1% GDP growth in 4Q.

The robust stock accumulation suggests the recovery will lose a step in early 2012.

Also pointing to slower growth, business spending on capital goods was the slowest since 2009, a sign the debt crisis in Europe was starting to take its toll.

Expectations of soft growth led the Federal Reserve on Wednesday to say it expected to keep interest rates at rock bottom levels at least through late 2014.

Fed Chairman Ben Bernanke said the central bank, which forecast growth this year in a 2.2 percent to 2.7 percent range, was mulling further asset purchases to speed up the recovery.

The Fed warned the economy still faced big risks, a suggestion the euro zone debt crisis could still hit hard.

#43: Greece

“The Fed is attempting to shield the economy from a potentially more severe recession in Europe,” said Sweet. “Even though the economy improved last quarter there are a number of headwinds and a lot of uncertainty surrounding Europe, emerging markets and also U.S. fiscal policy.”

Treasury Secretary Timothy Geithner told the World Economic Forum in Davos the U.S. economy still faced big challenges.

“We’re still repairing the damage done by the financial crisis. On top of that we face a more challenging world. We have a lot of challenges ahead in the United States,” Geithner said.

Consumer spending, which accounts for about 70 percent of U.S. economic activity, stepped to a 2 percent rate from the third-quarter’s 1.7 percent pace – mostly driven by pent-up demand for motor vehicles. Take that out and you have a unsustainable 1% growth rate.

The Japanese earthquake and tsunami had disrupted supplies early in the year, leaving showrooms bereft of popular models.

Spending was also lifted by moderate inflation.

A price index for personal spending rose at a 0.7 percent rate in the fourth-quarter, the slowest increase in 1-1/2 years, after rising at a 2.3 percent pace in the July-September period.

A core inflation measure, which strips out food and energy costs, increased at a 1.1 percent rate after rising 2.1 percent in the third quarter.

The increase last quarter was the smallest in a year and put this measure well below the Fed’s 2 percent target. We need to become realists, not optimists. These prediction shortfalls are not healthy to the collective zeitgeist.


Sluggish income growth amid an 8.5 percent unemployment rate, which has prompted households to tap savings and credit cards to fund their purchases, is expected to weigh on consumers as the new year unfolds.

The saving rate came in at a 3.7 percent rate in the fourth quarter, slowing from the prior period’s 3.9 percent pace.

“Though the unemployment rate has improved, the jobs market remains a major challenge. Part of the decline in the unemployment rate is due to the fact that … people have stopped looking for work,” said Adolfo Laurenti, deputy chief economist at Mesirow Financial in Chicago.

“The high level of people out of the workforce and underemployed people show there isn’t really much income generation to contribute to a better spending pattern.”

About 23.7 million Americans are either out of work or underemployed.

The shrinking labor force suggests the economy’s long-term growth potential has slipped below 2.5 percent.

A sustained growth pace of at least 3 percent would likely be needed to make noticeable headway in absorbing the unemployed and those who have given up the search for work.

Business spending grew at a sluggish 1.7 percent rate, pulling back sharply from the third-quarter’s 15.7 percent pace. WOW. 15.7% down to 1.7% – doesn’t that scare anyone?

Though exports held up despite slowing global demand, an increase in imports left a trade gap that sliced off 0.11 percentage point from GDP growth.

Despite an anticipated slowdown in growth this year, analysts do not believe the economy will fall into recession. Really???

“The United States has enough momentum to offset the losses coming from Europe,” said Laurenti. Come-on, Man.

Unseasonably mild winter weather helped home construction post its fastest growth pace since the second quarter of 2010, with much of the increase going to meet rising demand for rental apartments.

Spending on nonresidential structures fell. Government spending shrank for a fifth consecutive quarter, reflecting a large decline in defense and still weak state and local government outlays. Really uplifting news, eh?