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June 21, 2008

Good Inflation?
by Doug Noland

For the week, the Dow was clobbered for 3.8% (down 10.7% y-t-d) and the S&P500 was hit for 3.1% (down 10.2%). The Transports rose 1%, increasing 2008 gains to 13.6%. The Utilities declined 1.2% (down 4.8%). The Morgan Stanley Cyclicals were hit for 3.7% (down 9.2%), and the Morgan Stanley Consumer index fell 3.3% (down 9.4%). The broader market was in better shape. The small cap Russell 2000 declined 1.1% (down 5.3%), and the S&P400 Mid-Caps fell 1.3% (down 0.4%). The NASDAQ100 declined 1.9% (down 7.5%) and the Morgan Stanley High Tech index 2.2% (down 6.4%). The Semiconductors fell 2.7% (down 6.1%), the Street.com Internet Index 2.8% (down 5.5%), and the NASDAQ Telecommunications index 2.3% (down 0.3%). The Broker/Dealers were hit for 3.0% (down 23.9%), and the Banks were slammed for 5.9% (down 29.2%). With Bullion rallying $31, the HUI Gold index rose 4.3% (up 1.5%).

One-month Treasury bill rates sank 41 bps this week to 1.48%, and 3-month yields fell 17 bps to 1.85%. Two-year government yields declined 13 bps to 2.89%. Five-year T-note yields fell 13 bps to 3.59% and 10-year yields 9 bps to 4.17%. Long-bond yields declined 6 bps to 4.72%. The 2yr/10yr spread widened to 128 bps. The implied yield on 3-month December '09 Eurodollars sank 21 bps to 4.335%. Benchmark Fannie MBS yields declined 11 bps to 5.95%. The spread between benchmark MBS and 10-year Treasuries narrowed 2 bps to 178. The spread on Fannie's 5% 2017 note widened one basis point to 71 bps, and the spread on Freddie's 5% 2017 note widened narrowed 2 bps to 70 bps. The 10-year dollar swap spread declined 1.25 to 69.25. Corporate bond spreads were mostly wider. An index of investment grade bond spreads widened 8 to 120 bps, while an index of junk bond spreads narrowed 16 to 549bps.

Investment grade issuance included Time Warner Cable $5.0bn, Johnson & Johnson $1.6bn, Thomson Reuters $1.75bn, Vulcan Materials $650 million, Tennessee Valley Authority $500 million, and South Carolina E&G $360 million.

Junk issuers included Source Interlink $465 million, Lender Process Services $375 million, and Visteon $206 million.

Convert issuance this week included Petrohawk Energy $800 million, Energy Conversion Device $275 million and MF Global $150 million.

International dollar bond issuance included Indonesia $2.3bn and Jamaica $350 million.

German 10-year bund yields dipped 2 bps to 4.62%. The German DAX equities index dropped 2.8% (down 18.5% y-t-d). Japanese 10-year "JGB" yields dropped 10 bps to 1.755%. The Nikkei 225 slipped 0.2% (down 8.9% y-t-d and 23.4% y-o-y). Emerging markets were mostly under pressure. Brazil's benchmark dollar bond yields jumped 15 bps to 6.64%. Brazil's Bovespa equities index sank 3.9% (up 1.1% y-t-d and 19.6% y-o-y). The Mexican Bolsa fell 2.9% (unchanged y-t-d). Mexico's 10-year $ yields declined 2 bps to 5.29%. Russia's RTS equities index gained 1.2% (up 4.1% y-t-d). India's Sensex equities index dropped 4.1%, boosting y-t-d losses to 28.2%. China's Shanghai Exchange index declined another 1.3%, pushing 2008 losses to 46.2%.

June 20 - Bloomberg (Shelley Smith): "Companies in Europe borrowed more money from bond investors in the past three months than in any second quarter on record, paying the highest interest costs in a decade on concern credit conditions may deteriorate further. Sales jumped to 252 billion euros ($391 billion) from 227 billion euros in the same quarter of 2007 and from 149 billion euros in the first three months of this year..."

Freddie Mac 30-year fixed mortgage rates jumped 10 bps to 6.42% (down 27bps y-o-y). Fifteen-year fixed rates rose 9 bps to 6.02% (down 35bps y-o-y), having now increased 107bps from January lows. One-year adjustable rates increased 10 bps to 5.19% (down 47 bps y-o-y).

Bank Credit declined $10.8bn to $9.364 TN (week of 6/11). Bank Credit has expanded $151bn y-t-d, or 3.6% annualized. Bank Credit posted a 52-week rise of $790bn, or 9.2%. For the week, Securities Credit fell $12.8bn. Loans & Leases added $2.0bn to $6.90 TN (47-wk gain of $576bn, or 10.1% annualized). C&I loans rose $4.0bn, with one-year growth of 18.7%. Real Estate loans gained $8.5bn (up 3.7% y-t-d). Consumer loans added $1.4bn, while Securities loans sank $7.7bn. Other loans fell $4.3bn.

M2 (narrow) "money" supply declined $6.8bn to $7.688 TN (week of 6/9). Narrow "money" has expanded $225bn y-t-d, or 6.8% annualized, with a y-o-y rise of $454bn, or 6.3%. For the week, Currency added $2.0bn, while Demand & Checkable Deposits fell $7.8bn. Savings Deposits slipped $1.9bn, while Small Denominated Deposits added $0.8bn. Retail Money Funds were little changed.

Total Money Market Fund assets (from Invest Co Inst) jumped $34.4bn last week to $3.476 TN, increasing the y-t-d rise to $363bn, or 25.2% annualized. Money Fund assets have posted a one-year increase of $941bn (37%).

Asset-Backed Securities (ABS) issuance slowed this week to $3.3bn. Year-to-date total US ABS issuance of $104bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of the comparable level from 2007. Home Equity ABS issuance of $303 million compares with 2007's $191bn. Year-to-date CDO issuance of $14bn compares to the year ago $217bn.

Total Commercial Paper dropped $20.3 bn to $1.751 TN. CP has declined $472bn over the past 45 weeks. Asset-backed CP declined $7.6bn last week (45-wk drop of $4bn) to $753.4bn. Over the past year, total CP has contracted $381bn, or 17.9%, with ABCP down $402bn, or 34.8%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 6/18) jumped $12.9bn to a record $2.317 TN. "Custody holdings" were up $261bn y-t-d, or 26.4% annualized, and $311bn year-over-year (17.8%). Federal Reserve Credit expanded $3.9bn to $877bn. Fed Credit has increased $3.9bn y-t-d and $25.1bn y-o-y (3.0%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.408 TN y-o-y, or 26%, to $6.826 TN.

Global Credit Market Dislocation Watch:

June 19 - Financial Times (Stephanie Kirchgaessner and Hal Weitzman): "Federal investigators are homing in on 19 'large corporations' - including investment banks, credit rating agencies, accounting firms and hedge funds - as part of a broad probe into mortgage fraud. Robert Mueller, director of the FBI, did not identify the companies on Thursday, but said the majority of the large corporate cases involved accounting fraud, insider trading and failures to disclose - with criminal intent - the proper evaluation of securitised loans and derivatives. Mr Mueller said the FBI was working closely with the Securities and Exchange Commission and the justice department to 'evaluate criminal intent' Like the cases of Enron and Worldcom, and the savings and loan scandals of the 1980s, Mr Mueller said the cases were 'documents-intensive and complex'..."

June 17 - Financial Times (Francesco Guerrera and Ben White): "Investors who backed US financial companies' drive to raise much-needed capital are sitting on nearly $10bn in paper losses amid a continued slump in the sector's shares, a Financial Times analysis shows. The negative returns suffered by investors are likely to make it more difficult and expensive for US financial groups to tap equity markets if, as expected, the credit crunch forces them to raise more capital. 'Raising funds from equity investors is becoming increasingly complicated because the performance of financial stocks during and after the spate of fund-raisings has been so abysmal,' said a Wall Street banker who advises institutions."

June 19 - Bloomberg (Cecile Gutscher and Jeremy R. Cooke): "Banks face 'ballooning' balance sheets if they are forced to step in to buy variable-rate municipal debt guaranteed by MBIA Inc. and other insurers at risk of downgrade, Bank of America Corp. analysts said. The banks would have to buy back unwanted municipal securities if bond insurers' ratings fall below AA and the debt becomes ineligible for money-market funds, according to a research note... Standard & Poor's stripped units of MBIA and Ambac Financial Group Inc. of their top ratings earlier this month... Downgrades to less than AA 'may lead to a short-term ballooning of bank balance sheets,' ... analyst Jeffrey Rosenberg wrote... 'Such a potential event represents another source of unintended balance sheet expansion, this time via the municipal market.'"

June 20 - Bloomberg (Jeremy R. Cooke): "U.S. municipal bonds dropped, driving benchmark 30-year yields to the highest since July 2004, as local governments sought buyers for the heaviest debt calendar since October and investors sought to sell holdings."

June 20 - Bloomberg (Martin Z. Braun and William Selway): "Rates on short-term municipal securities guaranteed by MBIA Inc.'s and Ambac Financial Group Inc.'s insurance units surged after credit rating companies downgraded the guarantors. Bonds issued by Minneapolis, Minnesota-based Allina Health System, Louisville, Kentucky-based Baptist Healthcare and Houston-based Texas Children's Hospital insured by MBIA's insurance unit surged as high as 9%, almost doubling a day after the guarantor was downgraded five levels."

June 16 - Bloomberg (Jeremy R. Cooke): "Interest costs on U.S. variable-rate municipal bonds insured by MBIA Inc. and Ambac Financial Group Inc. climbed after units of the two largest bond insurers lost their top credit ratings from Standard & Poor's. MBIA- and Ambac-insured variable debt is yielding as much as 6%, compared with last week's average of 1.64% for the highest quality debt with rates that reset weekly..."

June 19 - Bloomberg (Jeff Plungis): "High-net worth individuals, those coveted financial-services customers with at least $2 million to invest, are shifting assets from brokerages and large global banks... 'For the first time in my career, I saw concern about the location of one's assets,' said Robert Balentine, the head of Wilmington Trust Corp.'s investment management group. 'We've seen tangible evidence of very wealthy clients shifting assets out of brokerage firms in great numbers.'"

Global Inflation Turmoil Watch:

June 18 - Bloomberg (Leon Mangasarian): "Farmers, truckers and taxi drivers, protesting record oil and gasoline prices, converged on downtown Brussels today on the eve of a European Union summit to demand help for their fuel-reliant industries... 'Brussels is the epicenter of the crisis,' the newspaper Le Soir said, adding that up to 50% of the city's public transport may be affected by the protest."

June 19 - Bloomberg (James G. Neuger): "A day after truckers, taxi drivers and farmers blockaded Brussels to demand that the European Union fight the soaring cost of living, the EU will get to work on a plan of action. The trouble is that the plan responds to an entirely different crisis, one triggered by Ireland's veto of the bloc's new governing treaty. Disputes over the Lisbon Treaty's fate threaten to turn a summit starting tonight into a political-theory class, distracting the 27 leaders from the economy and stoking charges that the bloc is out of touch with its citizens."

June 18 - Bloomberg (William Sim): "A week-long strike by South Korean truck drivers has cost Asia's fourth-largest economy about $5.92 billion in lost trade, dealing a blow to the main growth driver... As many as 13,496 truck drivers, including members of the Korea Cargo Workers Union, stopped moving freight nationwide from June 11 to protest surging fuel costs, demanding higher transport fees and bigger government fuel subsidies."

June 19 - Bloomberg (Shinhye Kang and William Sim): "South Korean truckers reached an agreement for a 19% increase in transportation fees after a strike that cost the economy about $7.26 billion in lost trade."

June 16 - Wall Street Journal Europe (Johanna Symmons): "Rising inflation is posing an increasing threat to British pension funds but most of them have resisted the urge to hedge against it, saying hedging strategies cost too much. The amount most pension funds must pay to retired members goes up as prices rise."

Currency Watch:

The dollar index dropped 1.5% to 73.03. For the week on the upside, the Brazilian real increased 1.9%, the New Zealand dollar 1.5%, the Australian dollar 1.5%, the Euro 1.5%, the British pound 1.5%, the Danish krone 1.5%, the South African rand 1.4%, the Norwegian krone 1.4%, and the Canadian dollar 1.3%.

Commodities Watch:

June 17 - Bloomberg (Jeff Wilson): "U.S. Midwest crop conditions deteriorated to their worst since 1996 as flooding gripped Iowa, threatening to reduce production and cause food inflation to accelerate. Some fields in Iowa, the biggest U.S. corn and soybean producer, got more than 14 inches of rain in the past two weeks... Land devoted to corn and soybeans will drop by as much as 4 million acres, said Dan Basse, president of AgResource... Corn rose to a record $7.915 a bushel yesterday in Chicago, and has gained 72% this year..."

June 16 - Bloomberg (Alan Bjerga): "Cattle futures rose to their highest in at least 22 years as the surging cost of corn renewed concern that U.S. feedlots will reduce the number of animals available for beef production... Cattle futures are up 18% since March 31... 'An adjustment will have to be made to the structure of the industry,' said David Kruse, a commodity trading adviser with Commstock Investments... 'I find it hard to believe there will not be dramatic cutbacks in production.'"

June 19 - Bloomberg (Alan Bjerga): "The price of cereals, baked goods, sweets and poultry will rise this year by more than expected a month ago because of accelerating costs for grain and fuel, the U.S. Department of Agriculture said. The annual gain for cereals and baked goods will be 9% to 10%, up from 7.5% to 8.5% forecast in May and the most since 1980, the USDA said in a report set for release tomorrow. The estimate doesn't reflect flood damage to Midwest crops, which will be included in the July report, the USDA said."

June 16 - Bloomberg (Bernard Lo and Jean Chua): "High food prices 'are here to stay' as governments divert resources to make biofuels, amass stockpiles and limit exports, according to Peter Brabeck-Letmathe, chairman of Nestle SA, the world's largest food company. Food prices 'will establish themselves on a higher level but not at the peaks we have seen,' Brabeck...said... Finance ministers from the Group of Eight nations warned June 14 that surging food and fuel prices have replaced the credit squeeze as the biggest threat to the world economy. Corn, wheat, and rice have soared to records this year, putting millions in Asia at risk of hunger, according to the Asian Development Bank."

June 19 - Bloomberg (Alaric Nightingale): "The market for shipping grains, coal and other so-called dry-bulk commodities will escape a global economic slowdown because of increasing demand from China and India, Macquarie Bank Ltd. said. The Baltic Dry Index, a measure of shipping costs for commodities, reached a record May 20 and is still trading at more than three times its 10-year average."

Gold rallied 3.5% to $902, and Silver 5.1% to $17.40. July Crude slipped 24 cents to $134.62. July Gasoline declined 0.9% (up 38.5% y-t-d), while July Natural Gas rose 3.1% (up 74% y-t-d). July Copper surged 6.7%. July Wheat declined 1.8% and Corn 1.4%. The CRB index jumped 2.1% to a new record high (up 26.9% y-t-d). The Goldman Sachs Commodities Index (GSCI) added 0.4% (up 38.2% y-t-d and 72.5% y-o-y).

China Watch:

June 20 - Bloomberg (Wang Ying and Winnie Zhu): "China, the world's second-biggest oil-consuming nation, unexpectedly raised gasoline and diesel prices by at least 17% and increased power tariffs to rein in energy use, potentially driving up inflation."

June 17 - Bloomberg (Nipa Piboontanasawat): "China's spending on factories and real estate grew 25.6% through May, led by property development and boosted by reconstruction work after snowstorms in January and February. Urban fixed-asset investment rose to 4.03 trillion yuan ($585 billion) in the first five months from a year earlier... after gaining 25.7% in the four months through April."

June 16 - Bloomberg (Nipa Piboontanasawat): " China's industrial-production growth accelerated on rising exports, signaling that the world's fourth-biggest economy is weathering a global slowdown. Output rose 16% in May from a year earlier after gaining 15.7% in April..."

June 19 - Bloomberg (Kevin Hamlin and Nipa Piboontanasawat): " China's monetary policy may be overwhelmed by inflows of speculative capital if it doesn't allow greater exchange-rate flexibility, the World Bank said. ' China is too large an economy not to have an independent monetary policy,' Louis Kuijs, acting chief economist for China, said... 'To have that, you need more exchange-rate flexibility.' The World Bank today forecast inflation in the world's fourth-biggest economy of 7% this year, up from a February estimate of 4.6%. Record inflows of cash from trade, foreign direct investment and investors betting on more gains by the yuan threaten to fuel price gains. 'Excess liquidity is already a problem,' said Huang Yiping, chief Asia economist at Citigroup... 'The expectation of significant further appreciation of the yuan is encouraging more inflows.'"

June 17 - Bloomberg (Patricia Lui): "China is adding to its holdings of U.S. assets, data from the U.S. government showed yesterday... Total holdings of U.S. equities, notes and bonds among foreign investors rose by a net $115.1 billion in April from $79.6 billion the previous month... China's holdings of Treasuries gained $11.4 billion to $502 billion, holdings of U.S. agency debt rose $11.9 billion and U.S. corporate bond investments increased $6.9 billion..."

June 18 - Bloomberg (Chia-Peck Wong): "Hong Kong's underlying inflation rate may double from a year earlier, the city's de facto central bank said... Prices may gain 5.2% to 5.8% this year, up from 2.8% in 2007... Rising food and energy costs, rents and wages are fanning Hong Kong's inflation, along with a currency that is pegged to the declining U.S. dollar."

Japan Watch:

June 18 - Bloomberg (Mayumi Otsuma): "The Bank of Japan is watching the effect of higher commodity prices on global inflation and growth in the world's second-largest economy, meeting minutes show. Japan faces 'considerable downside risks including uncertainty regarding future developments in overseas economies and global financial markets,' members agreed at their May 19- 20 meeting... 'Inflation risks had been heightening worldwide given the high international commodity prices.'"

June 17 - Bloomberg (Aya Takada): "Japan, Asia's biggest wheat importer, may raise prices of the grain sold to flour millers by more than 20% from October, adding to production costs for bread and noodle makers. The expected gain, following a 30% increase in April, would reflect rising costs to import the grain..."

India Watch:

June 20 - Bloomberg (Kartik Goyal): "India's inflation accelerated to a 13-year high after record crude oil costs forced the government to raise retail fuel prices... Wholesale prices jumped 11.05% in the week to June 7..."

June 20 - Bloomberg (Anil Varma): "Money supply in India grew 21.4% in the two weeks ended June 6 from a year earlier, compared with 22.5% in the prior two weeks..."

Asia Bubble Watch:

June 17 - Financial Times (Sundeep Tucker): "The value of mergers and acquisitions within Asia is soaring as the region's leading companies take advantage of opportunities to build scale and secure resources in fast-growing markets closer to home. The aggregate value of announced cross-border deals between Asia-Pacific companies has totalled $54bn in the year to date, according to...Dealogic... This compares to $25.7bn during the corresponding period last year. Bankers report that deals currently in the pipeline should mean 2008 will be a record year for intra-Asian deals..."

June 18 - Bloomberg (Soraya Permatasari): " Malaysia's vehicle sales rose 25% last month from a year earlier, the Malaysian Automotive Association said."

June 19 - Bloomberg (Wahyudi Soeriaatmadja): " Indonesia's automobile sales may rise by as much as 27% in June, Investor Daily Indonesia reported..."

Latin America Watch:

June 20 - Bloomberg (Jens Erik Gould): "Mexico's central bank unexpectedly increased its benchmark interest rate and said inflation may exceed its forecast this year and in the beginning of next. Banco de Mexico's five-member board voted today to raise the overnight lending rate by a quarter percentage point to 7.75%."

June 16 - Bloomberg (Alex Emery): " Peru's economy grew 13.25% in April, the national statistics institute said..."

June 16 - Bloomberg (Daniel Cancel): "Venezuelan bank lending rose 2.8% in May from the previous month... Lending rose 46.3% from the same month a year earlier..."

June 18 - Dow Jones: "Venezuela's retail sales increased 21.7% in March from the same month a year ago, the central bank said..."

Unbalanced Global Economy Watch:

June 17 - Bloomberg (Brian Swint and Jennifer Ryan): "U.K. inflation reached the highest since at least 1997 in May, and Bank of England Governor Mervyn King predicted it will exceed 4% later this year, adding to speculation that the economy will fall into a recession."

June 16 - Bloomberg (Rachel Graham): "Unite, the U.K.'s largest union, is seeking a 6% pay increase for farm workers, to attract more applicants and ease a labor shortage."

June 19 - Bloomberg (Jennifer Ryan): "The U.K. budget deficit widened to 11 billion pounds ($21.7 billion) in May, the second-biggest shortfall since records began in 1993, as a slowing economy eroded taxes. It compared with a gap of 8.5 billion pounds a year earlier..."

June 19 - Bloomberg (Brian Swint): "U.K. annual money supply growth slowed to the lowest pace in three years in May, according to Bank of England data. M4... rose 10% from a year earlier."

June 16 - Bloomberg (Fergal O'Brien): "European inflation accelerated to the highest in 16 years last month as food and energy costs soared, intensifying what finance ministers from the world's richest nations said is becoming a 'more complicated' dilemma. The inflation rate in the euro area rose to 3.7%, the highest since June 1992, from 3.3% in April..."

June 19 - Bloomberg (Sharon Smyth): "Land prices in Spain fell in the first quarter from the previous three months and from a year earlier. The average price of urban land dropped 9.4% from the fourth quarter and 7.7% from the first quarter of 2007..."

June 19 - Bloomberg (Flavia Krause-Jackson and Steve Scherer): " Italy's unemployment rate unexpectedly rose in the first quarter to the highest in more than a year... The jobless rate increased to 6.5%..."

June 19 - Bloomberg (Zoltan Simon): "Hungarian wages rose faster than consumer prices in April... The average monthly gross wage increased an annual 10.6% to 194,455 forint ($1,241), after climbing 9.9% in March..."

June 16 - Bloomberg (Alex Nicholson): "Russia's economy expanded an annual 8.5% in the first quarter, the second-fastest pace since 2000, as companies invested in their businesses to keep up with demand for consumer goods and new apartments. The growth rate followed an advance of 9.5% in the previous three months..."

June 19 - Bloomberg (Alex Nicholson): "The cost of living in Moscow rose 40% in the year through April, Vedomosti reported. The price of a standard 'shopping basket' of basic necessities advanced 25% on average nationwide in the period, the newspaper reported today, citing a yearlong survey of 8,500 people conducted by the Romir research service."

June 19 - Bloomberg (Nasreen Seria): "South Africa's current account deficit swelled to 9% of gross domestic product in the first quarter, the widest in 26 years, while foreign investment in stocks and bonds plunged, undermining the rand."

June 17 - Financial Times (Peter Smith): "The land of the long white cloud has enjoyed a 10-year economic boom driven by exports of milk, butter and cheese, a population riding a housing market boom and tourists eager to sample the landscapes depicted in Hollywood films such as The Lord of the Rings. But New Zealand is on the cusp of a downturn and risks seizing the dubious honour from the US of becoming the world's first developed nation to sink into recession..."

Bursting Bubble Economy Watch:

June 19 - Wall Street Journal (Kelly Evans): "In an increasingly gloomy assessment of the U.S. economy, the officers of major companies expect employment at their companies to decline in coming months and rising costs to pinch their profits, according to surveys released Wednesday. Chief executives polled by Business Roundtable... pared their expectations of economic growth to an annual rate of 1.3% in the second quarter of this year... Some 31% of CEOs said they expect employment at their companies to decline over the next six months. The group, whose outlook is usually relatively upbeat, has become pessimistic amid mounting energy prices and housing-market worries."

June 20 - Bloomberg (Greg Bensinger): "Ford Motor Co.'s production cuts underscore how plunging prices for used pickups and sport- utility vehicles are deepening U.S. automakers' sales slide. Prices for used large pickups and SUVs fell at least 21% in May, according to... Manheim Consulting."

June 19 - Wall Street Journal (Christopher Conkey): "As Americans cut back on driving, they are paying less in gasoline taxes, jeopardizing the funding for critical transportation projects. Governments depend on tax revenue from gas purchases to fill the Highway Trust Fund, the main mechanism used to pay for public highway, mass transit and other transportation projects... Trust-fund revenue is projected to run a shortfall of at least $3 billion next year, meaning Congress faces a choice between cutting transportation funding and coming up with a fix."

Fiscal Watch:

June 17 - Market News International (John Shaw): "Congressional Budget Office Director Peter Orszag said... that the U.S. economy faces the long-term threat of 'collapse' unless major reforms on health care spending are instituted in the coming years. In testimony before the Senate Finance Committee, Orszag said the federal budget is on an 'unsustainable path,' as health care costs continue to grow much faster than the overall economy. 'When you are on an unsustainable path, bad things will happen,' he said. Unless this health care spending trajectory is slowed and then reversed, the American economy faces crippling problems that 'would make our current economic difficulties look tiny,' Orszag said. The CBO chief said the 'central long-term challenge' for the United States is controlling the growth of per beneficiary spending for Medicare and Medicaid. 'Future growth in spending per beneficiary for Medicare and Medicaid -- the federal government's major health care programs -- will be the most important determinant of long-term trends in federal spending,' Orszag said."

Central Banker Watch:

June 16 - The Wall Street Journal Asia: "The biggest problem in emerging economies isn't 'the credit crunch about which we hear so much . . . but inflation.' So said Glenn Stevens, Australia's central bank governor... It's too bad U.S. Federal Reserve Chairman Ben Bernanke wasn't in the audience. Unlike his Fed peer, Mr. Stevens has ruthlessly resisted inflationary pressures. Since taking office in September 2006, he has raised Australia's benchmark cash interest rate to its current 7.25% from 6%. That's a 12-year high, and it has elicited yelps from homeowners, most of whom have variable-rate mortgages. It has also ruffled political classes on both sides of the aisle who support easy money policies. Mr. Stevens pays no heed, explaining that monetary policy's 'proper restraining role' is to seek 'to head off further problems' as Australia's economy expands. 'This is why a tight monetary policy setting is essential,' Mr. Stevens noted. 'It is why the Reserve Bank [of Australia] has lifted interest rates, even as the Federal Reserve was reducing them.' Mr. Stevens sees more price pressure on the horizon in Asia, thanks to strong growth in China and 'very low' regional interest rates, which generally mirror those of the Fed. That's the key message of Mr. Stevens's speech: The Fed's actions are putting emerging-market policy makers in a tough spot."

June 17 - Dow Jones (Patrick Yoest): "A former Federal Reserve official said Monday the U.S. Congress may need to further regulate the Fed in order to constrain the central bank's powers. Vincent R. Reinhart, who served as director of monetary affairs at the Fed until the middle of last year, said that the Federal Reserve has overstepped its own regulations, and Congress may need to step in to provide outside regulation. Future policy prescriptions for the Fed "might include asking whether legislation is needed to bind its future actions," Reinhart said at an American Enterprise Institute event on Monday. Reinhart has emerged as a fierce critic of the Fed-engineered bailout of Bear Stearns Cos., in April calling it 'the worst policy mistake in a generation.' He maintained that tone Monday, stating that 'we've veered from ( U.K. economist John Maynard) Keynes' views that economists should become as confident and uncontroversial as dentists, to central bankers can become rock stars.' Reinhart also said that, in actions ranging from its infusion of cash into the troubled student loan market to Fed Chairman Ben Bernanke's recent pronouncements on the dollar, the Federal Reserve had become too closely aligned with political powers in Washington. 'I think the Federal Reserve has to consider ways of constraining its own portfolio choices in order to rule out future political influences,' Reinhart said."

June 18 - Bloomberg (Kim-Mai Cutler): "Former U.K. Chancellor of the Exchequer Nigel Lawson said Federal Reserve Chairman Ben S. Bernanke may be 'regretting' the fastest pace of U.S. interest-rate cuts since 1984 as global inflation accelerates. The Fed reduced its benchmark rate by 3.25 percentage points to 2% between September and April 30 to stave off a recession... The Bank of England... cut its key rate by 0.75 percentage point to 5%. The European Central Bank left rates unchanged at 4%... 'The Bank of England has been very cautious and careful and it has been much closer to the views of the European Central Bank,' Lawson...finance minister from 1983 to 1989... 'It has not gone conspicuously the way of the Fed, where I suspect that Mr. Bernanke's now regretting it.'"

June 17 - Bloomberg (Kathleen Hays and Timothy R. Homan): "Former St. Louis Federal Reserve President William Poole urged U.S. central bankers to raise interest rates to head off an inflation spiral as energy costs soar. 'We should be moving sooner rather than later' on increasing borrowing costs, Poole, who retired in March, said in an interview today with Bloomberg Television. 'I don't think you can interpret what's happening with energy as a temporary shock.' Poole warned that the Fed must prevent higher inflation expectations from feeding through to a surge in wages."

Mortgage Finance Bubble Watch:

June 20 - Bloomberg (Josh P. Hamilton and Erik Holm): "Triad Guaranty Inc. plunged 40 percent and became the first mortgage insurer to stop selling policies after Freddie Mac disqualified the company as a guarantor of new home loans."

June 18 - Bloomberg (Laura Marcinek): "Investment in U.S. commercial real estate fell 70% in the first quarter from a year earlier as banks curtailed credit, the National Association of Realtors said... Investors spent $48.2 billion on commercial properties in the period, down from $157.8 billion in the same period last year..."

Muni Watch:

June 16 - Bloomberg (Jeremy R. Cooke): "Municipal borrowers including the University of Maryland Medical System shifted out of another $3 billion of auction-rate debt last week, leaving the market about half as big as before its collapse four months ago. States, local governments, hospitals and colleges have converted, refinanced or said they would redeem at least $81.3 billion of the $166 billion in municipal securities whose rates are set at dealer-run bidding, typically every week or month..."

California Watch:

June 13 - Bloomberg (Michael B. Marois): " California lawmakers likely will miss a constitutional deadline to pass a budget for the coming fiscal year amid an impasse over how to close a $17 billion deficit."

June 16 - Bloomberg (Daniel Taub): "Southern California house and condominium sales dropped 15% last month to the lowest level for a May in two decades as prices plunged to 2004 levels, DataQuick... said."

Speculator Watch:

June 18 - Hedgeweek: "Net hedge fund industry inflows slumped to $2.62bn during the first quarter of 2008, according to the latest Lipper Tass study. Combined with a net performance loss of some $36bn, this resulted in estimated net hedge fund industry assets falling to $1.75trn at the end of March... First quarter inflows fell by 81%..."

Crude Liquidity Watch:

June 17 - Bloomberg (Matthew Brown): "United Arab Emirates inflation accelerated to 11.1% in 2007 from 9.3% the previous year, led by rent and housing costs, risking an erosion of the country's competitiveness. Rent and housing, which has a 36% weighting in the consumer price index, increased by 17.5% in 2007... Inflation rates have surged above 10% in five of the six Gulf Cooperation Council states..."

June 15 - Bloomberg (Matthew Brown): "Bahrain M3 money supply growth, an indicator of future inflation, slowed to 32% in April, from a record 39% in March..."

June 16 - Bloomberg (Matthew Brown): " Oman's inflation rate rose to a record 12.4% in April from 11.6% in March as growth in the price of food accelerated. Food prices rose an annual 22%..."

June 16 - Bloomberg (Abdulla Fardan): "The economies of the Gulf Cooperation Council members, including Saudi Arabia and the United Arab Emirates, may expand as much as 7.5% this year as oil prices remained at high levels, the state-owned Saudi Press Agency reported."

Good Inflation?

"And the essential fact right now is that the American economy needs an inflation rate above the Fed's comfort zone." Paul McCulley, "A Kind Word for Inflation", June 16, 2008

I have elevated the status of my old "analytical nemesis" to that of the most dangerous monetary analyst in the country. He has been preaching inflationism for years now, and the more obvious the flaws in his framework the more creative he becomes in crafting his sermons. And he's become so adept at this game that many might actually buy into his flawed yet seductive logic.

Essentially, if I am reading McCulley correctly, he is arguing that because of an unusual "trade shock" from rapidly escalating energy costs, the Fed must employ negative real interest rates to avoid a "modern day depression." I will continue to espouse the view that today's ridiculously low interest rates are part of the problem rather than the solution.

Back in 2001/2002, the Inflationists were keen to monetize the wreckage from the technology bust through the inflation of mortgage Credit. Not uncharacteristically from a historical perspective, this inflation ran out of control and amuck. Now, with much greater and generalized financial and economic post-Bubble wreckage, the unbowed Inflationists are subscribing more generalized consumer price inflation as part of the medicine to ensure asset prices and the real economy avoid sinking into a deflationary spiral.

A book could be written explaining why the Inflationists are so wrong. This evening I'm limited to the briefest synopsis.

Today's inflationary forces have been developing over a period of many years. Importantly, the key dynamic is one of a highly unusual strain of acute global inflation. The impetus for this inflationary backdrop has been the massive inflation of dollar financial claims, in particular a Bubble in Wall Street asset-based lending that spawned unprecedented distortions to both the U.S. Credit system and underlying "Bubble economy" (and, increasingly, the global economy). This massive dollar Credit inflation ("currency" debasement) opened Pandora's Box for similar unfettered expansions in domestic Credit systems across the globe.

Oil is inarguably the most important commodity in the world. The massive ongoing inflation in energy prices is and will continue to have momentous economic, financial, and geopolitical consequences. Comparisons to the seventies and seventies-style inflation, however, miss key aspects of today's inflationary dilemma.

There are three inter-related dynamics that are driving current inflationary forces. First, there is the massive flow of dollar liquidity inundating the world. Despite huge dollar devaluation, a major Credit crisis, and economic downturn, our system is on track for yet another year of $700bn plus Current Account Deficits (and this doesn't include the massive speculative outflows to participate in the global inflation). Global economies, especially booming Asia, are awash in dollar liquidity to use to bid up the prices of oil and other strategic resources. Second, today's massive dollar flows have increasingly gravitating to speculative endeavors (hedge funds, sovereign wealth funds, commodities speculation, etc.) - each year ballooning the "global pool of speculative finance" that by its very nature chases rising prices ("liquidity loves inflation"). Third, the confluence of the flood of global liquidity and unfettered domestic Credit systems has exerted its greatest stimulatory effect upon the highly populated countries of China, India, and Asia generally. This, then, has created a historic inflationary bias throughout the energy, food and commodities complexes.

McCulley and others prefer to "monetize" the current oil price "shock" through ongoing artificially low interest rates, arguing that recent price effects are a temporary phenomenon. This short-term jump in inflation is said to be, in the words of Mr. McCulley, "Good Inflation." Supposedly, it will help buttress the general prices level and generally help support asset prices, while tepid wage growth ensures that a 70's-style wage price inflationary spiral will be avoided. Yet such analysis seems oblivious to the nature of the underlying risks associated with the current inflation.

As should be obvious by now, the current hyper-inflation in energy and food prices risks global chaos. There is today such a robust inflationary bias in globally priced necessities that spectacular (NASDAQ1999) price moves have become the norm rather than the exception. As such, U.S. monetary policy that accommodates $700bn Current Account Deficits and massive speculative outflows to the world is courting Monetary Disorder Disaster. To be sure, the current trajectory of U.S. financial outflows ensures an acute inflation problem for key things everyone wants and needs. Or written differently, efforts to "monetize" mortgage losses and energy inflation here at home will be invalidated by a global push to exchange excess dollar (and other currencies) liquidity for real things of necessity and tangible value.

A major flaw in the "Good Inflation" argument is that surging fuel, food and other costs in reality are administering a further crippling blow to the over-indebted U.S. consumer. Grossly inappropriate short-term U.S. interest-rates are today directly stoking serious price inflation, in the process reducing consumer discretionary income and the capacity to service enormous debt loads. The collapse in SUV and truck prices (see Bursting Bubble Economy Watch) - and the resulting huge "negative equity" in auto loans - is the most obvious example of household sector creditworthiness taking a direct inflationary hit. This has created a major additional burden for millions that bought a big new home out in suburbia. And because of the worsening Credit backdrop, mortgage and consumer debt borrowing costs are rising in spite of Fed rate cuts. Moreover, households are suffering further from the sharp reduction in returns on their savings, not to mention the inflation-related decline in many stock prices.

The seventies inflation saw consumer prices rise, incomes rise, home and asset prices rise, and wage-based inflation spiral higher. The current inflation dynamic is a different beast. Sinking home prices and surging energy and food prices are causing bloody havoc on general creditworthiness, a huge dilemma for the faltering financial sector and finance/consumption-driven Bubble economy. The bust in Wall Street finance is driving a major shift in economy-wide spending patterns, putting downward pressure on wages, incomes and profits in some sectors, while other sectors enjoy huge inflationary boosts. The breakdown in Wall Street "alchemy" has ensured that the Fed-orchestrated reflation bypasses home prices as it hastens problematic inflation elsewhere. A very strong case can be made that the nature of the Wall Street finance and asset-based lending boom nurtured a degree of financial and economic imbalance and vulnerability unlike the wage-based inflation of the seventies.

And while headline inflation numbers today may not be approaching the 70's double-digits rates, I would argue that an even more problematic economic adjustment is in the offing. I simply see no way around the necessity of sharply reducing the amount of new Credit and imports required to sustain the U.S. economy. I see no alternative than a long and wrenching adjustment period while the household balance sheet is repaired, financial sector stability is restored, and some semblance of economic balance is achieved. Students of the sordid history of massive inflations are familiar with the inevitable pleas for just a little bit more inflation and a little more and a then lot more... McCulley wants us to believe the Fed is doing the right thing by providing us some "Good Inflation." This really upsets me. I've repeated over a number of years a lesson learned repeatedly throughout history: Inflationism is a "Road to Ruin." This road has become all too visible.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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