The "Neutral Rate"

By: Doug Noland | Fri, May 27, 2005
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Stocks continued to trend generally higher. For the week, the Dow and S&P500 added almost 1%. The Transports were unchanged, while the Utilities advanced slightly. The Morgan Stanley Cyclical index added 1%, while the Morgan Stanley Consumer index was fractionally lower. The broader market rally remains intact. The small cap Russell 2000 gained better than 1%, and the S&P400 Mid-cap index added 1%. Tech is strong. The NASDAQ100 rose 1.5%, and the Morgan Stanley High Tech, Semiconductor, and NASDAQ Telecommunications indices were up 1%. The Street.com Internet Index jumped 3%. The Biotechs were up 1%. Financial stocks were curiously unimpressive. The Broker/Dealers fell 1.5%, and the Banks dipped 0.5%. Bullion regained $2.80, as the HUI Gold index jumped 8%.

Treasury yields drifted lower. Two-year Treasury yields ended the week down 2 basis points to 3.64%. Five-year government yields sank 5 basis points, ending the week at 3.81%. The 10-year Treasury yield was down 5 basis points to 4.07%. Long-bond yields dipped one basis point to 4.43%. The spread between 2 and 30-year government yields widened one to 77. Benchmark Fannie Mae MBS recovered some recent underperformance, with yields falling 10 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note narrowed 4 basis points to 33, and the spread on Freddie's 5% 2014 note narrowed 3 basis points 33. The 10-year dollar swap spread dropped 3 to 42. Corporate bond spreads generally narrowed. The auto (and CDS) sector rallied somewhat and junk bond spreads narrowed slightly. The implied yield on 3-month December Eurodollars declined 4 basis points to 3.93%.

Corporate issuance jumped to a robust $18.1 billion (from Bloomberg). Investment grade issuers included CIT Canada $1.7 billion, Credit Suisse $1.2 billion, Lehman $1.0 billion, Wachovia $1.15 billion, Citigroup $750 million, Alcan $800 million, Enterprise Products $500 million, Ventas Realty $350 million, Jefferson-Pilot $300 million, Keycorp $250 million, Toll Brothers $300 million, KB Homes $300, Ingersoll-Rand $300 million, Aramark Services $250 million, Thermo Electron $250 million, Puget Sound Energy $250 million, Potomac Electric Power $175 million, Bank of Oklahoma $150 million, Plains All America Pipeline $150 million, First Citizens $125 million, Delmarva Power & Light $100 million, and Post Apartment Homes $100 million.

Junk bond fund outflows declined to $226 million (from AMG). Junk issuers included Teco Energy $200 million.

Convert issuers included Compucredit $250 million.

Foreign dollar debt issuers included Germany $5 billion, Brazil $2 billion, Grupo Televisa $600 million, Uruguay $500 million, Controladora $200 million, and Jamaica $300 million.

May 26 - Bloomberg (Karen Brettell): "Sales of collateralized debt obligations that bundle together default insurance contracts more than tripled in the first quarter from a year earlier, JPMorgan Chase & Co. said.... Collateralized debt obligations pool income from bonds, loans or other financial assets to pay investors. So-called synthetic CDOs package credit-default swaps, which earn an annual fee by offering insurance against a borrower failing to pay. Sales of synthetic collateralized debt sold in the first three months of this year were 3.8 times higher than in the first quarter of 2004..."

Japanese 10-year JGB yields declined 2 basis points to 1.24%. Emerging debt markets enjoyed a banner week. Brazilian benchmark dollar bond yields sank 37 basis points to 7.71%. Mexican govt. yields ended the week down 13 basis points to 5.51%. Russian 10-year dollar Eurobond yields dipped 2 basis points to 5.99%.

Freddie Mac posted 30-year fixed mortgage rates declined 6 basis points to 5.65%, (a 13-week low and down 65 basis points from one year ago). Fifteen-year fixed mortgage rates dropped 6 basis points to 5.21%. One-year adjustable rates declined 5 basis points to 4.21%. The Mortgage Bankers Association Purchase Applications Index rose 4.3%. Purchase applications were up 7.5% compared to one year ago, with dollar volume up 17%. Refi applications increased 6.4%. The average new Purchase mortgage increased to $239,500. The average ARM surged to $343,500. The percentage of ARMs increased to 34.8% of total applications.

Broad money supply (M3) declined $3.3 billion to $9.578Trillion (week of May 16). Year-to-date, M3 has expanded at a 2.7% rate, with M3-less Money Funds growing at 4.9% pace. For the week, Currency added $0.7 billion. Demand & Checkable Deposits dropped $12.7 billion. Savings Deposits gained $2.5 billion. Small Denominated Deposits rose $4.3 billion. Retail Money Fund deposits dipped $2.4 billion, and Institutional Money Fund deposits declined $2.8 billion. Large Denominated Deposits added $1.3 billion. For the week, Repurchase Agreements gained $7.0 billion (up $43.5bn in 5 wks), while Eurodollar deposits declined $1.2 billion.

Bank Credit expanded $4.2 billion last week, increasing the year-to-date expansion to $345 billion, or 13.3% annualized. Securities Credit is up $133 billion, or 18.1% annualized, year-to-date. Loans & Leases have expanded at an 11.2% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 19%. For the week, Securities added $0.7 billion. C&I loans jumped $5.0 billion. Real Estate loans dropped $9.5 billion. Real Estate loans have expanded at a 12.5% rate during the first 20 weeks of 2005 to $2.66 Trillion. Real Estate loans are up $287 billion, or 12.1%, over the past 52 weeks. For the week, consumer loans gained $3.9 billion, and Securities loans rose $5.8 billion. Other loans dipped $1.7 billion.

Total Commercial Paper rose $4.9 billion last week (up $34.6bn in 3 wks) to $1.519 Trillion. Total CP has expanded at an 18.5% rate y-t-d (up 13.1% over the past 52 weeks). Financial CP increased $2.0 billion last week to $1.365 Trillion, with a y-t-d gain of $81 billion (15.6% ann.). Non-financial CP rose $2.8 billion to $154 billion (up 28% in 52 wks). It is worth noting that Total CP has now increased $105.5 billion y-t-d compared to M3's $98.3 billion.

Fed Foreign Holdings of Treasury, Agency Debt rose $6.8 billion to $1.411 Trillion for the week ended May 25. "Custody" holdings are up $75.1 billion, or 13.9% annualized, year-to-date (up $200bn, or 16.5%, over 52 weeks). Federal Reserve Credit declined $1.0 billion to $786.6 billion. Fed Credit has declined 1.3% annualized y-t-d (up $42.9bn, or 5.8%, over 52 weeks).

ABS issuance ballooned to $23.5 billion (from JPMorgan). Year-to-date issuance of $269 billion is 15% ahead of comparable 2004. At $171 billion, y-t-d home equity ABS issuance is 23% above the year ago level.

Currency Watch:

The dollar index was down slightly for the week. On the upside, the Brazilian real gained another 1.7%. The Norwegian krone rose 1.7%, the Uruguay peso 1.1%, and the Polish zloty 1.0%. On the downside, the Thai baht dipped 0.8%, the Israeli shekel 0.5%, and the Hungarian forint 0.5%.

Commodities Watch:

May 26 - Bloomberg (Loretta Ng and Xiao Yu): "China spent 86 percent more in April to import oil than a year earlier, the Customs General Administration of China said, amid record prices. Higher costs may not damp the country's demand for fuels, refiners said... During the first four months of this year, costs jumped 43 percent to $13.8 billion, it said."

July crude oil jumped $3.20 to $51.85. Weather and drought concerns put a fire under the grains. For the week, the CRB was up 2.6%, increasing the y-t-d gain of 6.0%. The Goldman Sachs Commodities index jumped 4%, raising the 2005 gain to 14.3%.

b>China Watch:

May 24 - Bloomberg (Nerys Avery): "The Organization for Economic Cooperation and Development raised its 2005 economic growth forecast for China to 9 percent from a November estimate of 8 percent, saying strong exports are helping drive expansion in Asia's second-biggest economy."

May 25 - New York Times (David Barboza): "After construction workers finish plastering a replica of the Arc de Triomphe and buffing the imitation streets of Hollywood, Paris and Amsterdam, a giant new shopping theme park here will proclaim itself the world's largest shopping mall. The South China Mall - a jumble of Disneyland and Las Vegas, a shoppers' version of paradise and hell all wrapped in one - will be nearly three times the size of the massive Mall of America in Minnesota. It is part of yet another astonishing new consequence of the quarter-century economic boom here: the great malls of China. Not long ago, shopping in China consisted mostly of lining up to entreat surly clerks to accept cash in exchange for ugly merchandise that did not fit. But now, Chinese have started to embrace America's modern 'shop till you drop' ethos and are in the midst of a buy-at-the-mall frenzy. Already, four shopping malls in China are larger than the Mall of America... Chinese are swarming into malls, which usually have many levels that rise up rather than out in the sprawling two-level style typical in much of the United States. Chinese consumers arrive by bus and train, and growing numbers are driving there. On busy days, one mall in the southern city of Guangzhou attracts about 600,000 shoppers. For years, the Chinese missed out on the fruits of their labor, stitching shoes, purses or dresses that were exported around the world... 'Forget the idea that consumers in China don't have enough money to spend,' said David Hand, a real estate and retailing expert at Jones Lang LaSalle in Beijing. 'There are people with a lot of money here. And that's driving the development of these shopping malls.'"

May 25 - Bloomberg (Samuel Shen): "China's labor shortage, caused by economic expansion and pay disputes, will continue to hurt companies' output and profitability in the next few years, the country's central bank said... 'Shortage is severe in labor-intensive industries and small processing companies... Skilled physical workers are in short supply.'"

May 24 - Bloomberg (Tian Ying): "China's consumer prices still face pressure to increase because of rising raw material and oil costs, the head of the nation's statistics bureau said. 'You can't say inflation pressure is easing,' Li Deshui, director of the National Bureau of Statistics, said... 'Raw material and oil prices are still high.'"

May 26 - XFN: "Bilateral trade between Taiwan and China in the first three months of the year rose 17.8% from a year earlier to US$15.82 bln, the Board of Foreign Trade said. The figure accounted for 18.5% of Taiwan's total external trade..."

May 26 - Bloomberg (Marco Babic): "China's number of mobile-phone users rose to 353.7 million last month, the Ministry of Information Industry said... China added 4.7 million mobile-phone users last month..."

Asia Boom Watch:

May 24 - Bloomberg (William McQuillen): "Economic expansion in Asia is expected to slow to 5.25 percent in 2005 from 6.25 percent in 2004 as export growth subsides, the International Monetary Fund said in an in-house publication."

May 24 - Bloomberg (Theresa Tang): "Taiwan's export orders rose at the slowest pace in more than a year in April... Orders -- indicative of shipments in one to three months -- rose 15.4 percent from a year earlier to $20.8 billion..."

May 25 - Bloomberg (Lily Nonomiya): "Japan's exports rose at the fastest pace in four months in April, led by autos and steel, suggesting that overseas demand will support a recovery in the world's second-largest economy. Exports rose 7.8 percent from a year earlier, after gaining 6.1 percent in March, the Ministry of Finance said in a report today in Tokyo. Imports rose 12.7 percent as oil prices gained..."

May 26 - Bloomberg (Lindsay Whipp): "The International Monetary Fund raised its forecast for Japanese growth to more than 1.5 percent after the economy expanded faster than expected in the first quarter. 'The unexpectedly strong figures mean that growth this year will be significantly higher than we expected,' said Daniel Citrin, deputy director for the International Monetary Fund's Asia and Pacific Department..."

May 25 - Bloomberg (Stephanie Phang): "Malaysia's economy grew a faster-than-expected 5.7 percent in the first quarter, as domestic spending helped counter weaker overseas demand for the country's electronics exports."

May 25 - Bloomberg (Anuchit Nguyen): "Thailand's trade deficit surged to the highest in more than eight years as high crude costs caused the nation's oil bill to swell and industrial expansion boosted demand for imported steel and machinery."

Unbalanced Global Economy Watch:

May 25 - Financial Times (Chris Giles): "Poor prospects for economic growth in Japan and continental Europe alongside a robust US economy will exacerbate global economic imbalances, the Organization for Economic Co-operation and Development said yesterday... The Paris-based international organization, charged with improving the economic prospects of advanced countries, said in its twice-yearly economic outlook: 'These continuing divergences in domestic demand between Europe and some Asian countries on the one hand, and the US on the other, cannot be treated with benign neglect."

May 26 - Financial Times (Leslie Crawford and Ralph Atkins): "Spain's gravity-defying construction sector continued to drive the economy in the first quarter of the year, helping gross domestic product growth accelerate to 3.3 per cent from 3.2 per cent in the final quarter of 2004. The performance far outstripped other European countries' lacklustre economies in the first-quarter, but Spain's prolonged property boom is beginning to puzzle - if not worry - economists. In theory, supply should now be outstripping demand, with a record 700,000 new housing starts last year - more than the combined total of France, Germany and the Benelux countries. But neither house prices nor mortgage lending - up 24 per cent in the first quarter - show signs of easing."

May 25 - Bloomberg (Ben Sills): "First-quarter growth in Spain, Europe's fifth-largest economy, accelerated to the fastest rate in at least two years as record low interest rates fueled consumer spending. Gross domestic product, the measure of all goods and services, grew 0.9 percent from the previous three-month period and 3.3 percent from a year earlier..."

May 26 - Financial Times (Ralph Atkins): "German business confidence has tumbled to a near two-year low, triggering fresh demands for a cut in eurozone interest rates and highlighting the gloomy backdrop to Chancellor Gerhard Schroder's bid for re-election."

May 26 - AFX: "International air passenger traffic grew 8.7 pct year-on-year in the four months to April, while cargo traffic was up 4.7 pct, the International Air Transport Association (IATA) said."

Latin America Watch:

May 20 - Dow Jones: "Latin American airlines carried 6.3 million passengers in March, 19.4% more than in the same month a year ago, the Miami-based Latin American Airline Association, or Aital, said Friday."

May 24 - Bloomberg (Guillermo Parra-Bernal): "The Brazilian federal government and state-owned companies said its budget surplus excluding debt payments almost doubled to 12.92 billion reais ($5.3 billion) in April from the previous month... The surplus for the first four months was 30.5 billion reais, or 5 percent of the gross domestic product..."

May 24 - Bloomberg (Heather Walsh): "Chile, the world's biggest copper producer, said the economy's expansion slowed in the first quarter as export growth lost momentum. Chile's economy expanded 5.7 percent from the first quarter of 2004, compared with 7.3 percent growth in the fourth quarter..."

May 24 - Bloomberg (Alex Emery): "Peru's April exports rose 35 percent from a year earlier, led by copper and oil sales."

May 27 - Bloomberg (Alex Kennedy): "Venezuela boosted government spending by 28 percent in March as surging revenue from record oil prices paid for bigger outlays for social programs."

May 24 - Bloomberg (Alex Kennedy): "Venezuela's economy grew for a sixth straight quarter in the January-March period as manufacturers such as automakers Toyota Corp. and General Motors Corp. benefited from a surge in consumer demand. Gross domestic product, the broadest measure of a country's production of goods and services, expanded 7.9 percent in the first quarter from the year-earlier period..."

Speculative Financial Bubble Watch:

May 26 - Financial Times (Peter Smith): "Blackstone is seeking to raise the world's largest buy-out fund in the latest sign of the growing power of the private equity industry and investors' hunger for superior returns. Its $11bn global fundraising launched this week, would exceed the previous record of $8.5 raised by Goldman Sachs just last month ...It comes amid a fundraising bonanza which is expected to see more than $200bn flow into the coffers of private equity houses this year. Although this would be below the estimated $250bn raised in the dotcom bubble of 2000, it is likely to be a record year for buy-out funds in the US and Europe."

May 23 - Bloomberg (John Fraher): "Bundesbank board member Edgar Meister said European countries should cooperate with other nations when introducing rules to regulate the hedge fund industry, Die Welt said... 'Going it alone either on a national or a European level doesn't make sense because then hedge funds will move their domicile to other countries...This can only be dealt with through internationally binding rules.' The accumulation of risk capital in the $1 trillion hedge funds industry has drawn scrutiny from central bankers globally and spurred calls for stronger control from politicians, including German Chancellor Gerhard Schroeder."

May 25 - Bloomberg (Andrew Pratt): "New Jersey's pension, with a shortfall estimated at $25 billion or more by state officials, plans to put money into investments such as real estate and hedge funds under rules approved yesterday by the retirement fund's board."

Dollar Consternation Watch:

May 23 - Bloomberg (Yanping Li): "China's top foreign-exchange regulator said the government plans to develop more investment channels for the nation's $659.1 billion foreign reserves, the world's second-biggest after Japan. The comment by Hu Xiaolian, director of the State Administration of Foreign Exchange, echoed earlier statements by officials including Deputy Director Wei Benhua."

May 27 - Market News: "Bank of Korea governor Park Seung called for global concerted action to resolve the US trade and fiscal deficits, which are symptomatic of imbalances in the international economy. 'There are limits in resolving trade imbalances through foreign exchange rate adjustment alone. In this light, we should broaden international cooperation for structural restructuring among nations,' Park said in an opening speech to a international conference on stabilization policy hosted by the Bank of Korea."

Bubble Economy Watch:

Personal Income was up 0.7% for the month of April and was up 7% from one year ago. Personal Spending was up 0.6% during April with a year-on-year gain of 6.9%. The F.W. Dodge Construction index rose 4 points in April to a new record high.

May 25 - The Wall Street Journal (Robert Frank): "The number of millionaires in the U.S. increased to a record last year, boosted by gains in stocks and global financial markets, according to two new studies. The number of U.S. households with a net worth of $1 million or more rose 21% in 2004, according to a survey released yesterday by Spectrem Group, a wealth-research firm in Chicago. It is the largest increase since 1998..."

May 25 - UPI: "The U.S. long-haul, heavy-duty truck transportation industry is short some 20,000 drivers, the American Trucking Associations reported... 'The driver market is the tightest it has been in 20 years,' ATA President Bill Graves said. 'It's a major limitation to the amount of freight that motor carriers can haul. It's critical that we find ways to tap a new labor pool, increase wages and recruit new people into the industry that keeps our national economy moving.'"

California Bubble Watch:

May 25 - Los Angeles Business Journal: "Luxury-home prices in the Los Angeles area jumped nearly a quarter since last year, with average prices topping $2 million for the first time as low interest rates helped drive purchases, according to a report from First Republic Bank. Los Angeles home values jumped 3.4 percent in the first quarter compared to the fourth quarter of 2004, and were up 23.1 percent from the like period a year ago.... The average luxury home in Los Angeles is now a record $2 million, up $384,000 from a year ago..."

May 27 - San Francisco Chronicle (Kelly Zito): "The average luxury home in the Bay Area now runs a cool $2.7 million, up $329,000 from one year ago, according to a study...by San Francisco's First Republic Bank. The average price of luxury homes -- defined as homes with values above the $1 million mark -- rose about 6 percent between the fourth quarter of 2004 and the first quarter of 2005 and nearly 14 percent from the first quarter of 2004..."

Mortgage Finance Bubble Watch:

April Existing Homes Sales were reported at a stronger-than-expected and record 7.18 million annualized pace. With unit volume up 5.7% and average prices up 10.9% from one year ago, annualized Calculated Transaction Value (CTV) was up 17.2% to $1.83 Trillion. CTV was up 49% over two years (Volume up 23% and Prices up 21%) and 67% over three years (Volume up 27% and Prices up 31%). Year-to-date Existing Home Sales are running 8% above last year's record pace. April New Home Sales came in at 1.316 million annualized, up 13.3% from April 2004. Average (mean) prices were up 5.3% over 12 months to $283,500. Combined New and Existing Home Sales were at a record 8.496 million annualized pace, up 6.8% from one year ago. Combined y-t-d Home Sales are running almost 8% above last year's record pace. Combined annualized CTV was a record $2.2 Trillion, up almost 18% from what the time was a record CTV in April 2004.

California median home prices were up $12,680 during April to a record $509,230. Median prices were up $68,490 (12.5%) over 12 months, $145,300 (40%) over 24 months, $192,110 (61%) over 36 months, and $292,740 (135%) over 6 years. Condo prices were up 14.4% y-o-y to $401,830, with a remarkable two-year gain of 49% (up $131,560). From the California Association of Realtors: "Home prices increased by double-digits in nearly every region of the state, rising 37.9 percent in the more affordable High Desert region..."

May 24 - Florida Association of Realtors: "Different month, same story for sales of existing single-family homes in Florida in April: high demand, still-low mortgage rates and a short supply of homes available for sale, bringing the statewide median sales price to $218,600 -- a 26 percent increase over the April 2004 figure... In 2000, the statewide median sales price was $115,900, which represents a dramatic 88.6 percent increase over the five-year period..."

May 27 - Bloomberg (Kathleen M. Howley): "Stewart Rahr, chief executive of drug wholesaler Kinray Co., paid $45 million in February for a 25-room...mansion in the Hamptons, New York's summer retreat for Wall Street bankers and Hollywood celebrities. The price for that house...broke the record held by Seinfeld, who paid $32 million in 2000 for singer Billy Joel's 'Versailles.' These deals are at the high end of a market where the average price of a house sold in the five towns on the eastern tip of Long Island rose 27 percent in the first quarter to a record $993,269 from a year earlier, according to Suffolk Research Service Inc. Rentals for the 14-week summer season, which begins this Memorial Day weekend, are going for as much as $950,000..."

May 24 - Bloomberg (Alex Tanzi): "The value of new U.S. commercial mortgages rose in the first quarter, according to a survey released by the Mortgage Bankers Association. The total volume of new commercial mortgages totaled $31.4 billion in the first quarter, up $8.9 billion (39.6%) from the same period last year."

Freddie Mac posted a strong April. For the month, the company's Book of Business increased $18.3 billion, or 14.4% annualized, to $1.548 Trillion. This was the largest growth since June 2004 and increased y-t-d growth to 8.6% annualized. Freddie's Retained Portfolio expanded $5.3 billion, or 9.8% annualized, to $662 billion (up 4.2% ann. y-t-d). Fannie's Book of Business declined at a 4.3% annualized rate to $2.297 Trillion, while its Retained Portfolio shrunk at a 16.3% pace to $851.9 billion.

The "Neutral Rate":

From this morning's New York Times article "Running Out of Bubbles" by Paul Krugman: "In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. 'There is room,' he wrote, 'for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing.'"

Well done Mr. McCulley. So what do the inflationists do for an encore?

The problem with inflationism is always the difficulty (impossibility?) of controlling the process once it has gained momentum, inflation/speculative psychology has become entrenched, and inflationary boom has amassed an increasingly fervent (fanatical?) constituency. Truth be told, the inflationists are these days in a Mortgage Finance Bubble Analytical Pickle - although they will of course convey that they are at the top of their game. Recalling the history of John Law's experience, there is a thin line between revered financial genius at the height of the Bubble and repudiated monetary quack soon afterwards.

Inflationism is a most slippery slope for analysts and policymakers alike, not to mention the financial system and economy. Lots of "vested interests"... The origins of today's boom are conspicuous, and the system's vulnerability to a mortgage debt and housing bust all too obvious. All the same, the imbalances, excesses and fragilities wrought by the inflationary boom will now be used to justify only further inflation. So be prepared for the inflationists to conceive of ever more creative analytical constructs to buttress the susceptible Bubble (and their analytical positions).

Many now argue that the Fed has reached the "Neutral Rate," and some even claim that monetary conditions are tight. There was an interesting exchange between ISI's Ed Hyman and chairman Greenspan during the Q&A session at last Thursday's presentation before the Economic Club of New York.

Ed Hyman: "I have a question generally regarding the "neutral funds rate" - the idea that "you know it when you see it." And some are pointing out that a number of developments that are occurring now would suggest that the Fed funds rate is already beyond neutral. For example, the stock market has been flat for about a year; money growth has slowed; there are some early signs of financial crisis in the auto industry; the dollar is up a little bit; gold is down a little bit; and there is some sign of the economy slowing, such as the Philly Fed. So my question is: what are they missing?"

Alan Greenspan: "The other side of the balance sheet. Ed, I don't want to get into the detail of this discussion and, obviously, I can't. In general, the notion of what constitutes a so-called neutral rate goes all the way back as you know to (Knut) Wicksell back in the 19th century. And it's a very interesting concept which essentially endeavors to say, What is the interest rate which so balances the economy that aggregative and supply demand remain in balance and the system moves forward without creating disequilibrium. It's an amorphous concept and, obviously, in a highly complex - to use another old economist's phrase - "creative destruction" - when you are in a context like that and the economy is churning, the markets are churning, it's very difficult to figure out exactly where balances are because there are always things no matter how wonderfully fine-tuned a system is; there are always significant parts of an economy that look out of balance. And so, it's a judgment as you and some people have put it correctly that we'll know it when we see it. That is probably correct, and the reason is we can't forecast it because it is such an amorphous, complex issue that trying not only to anticipate the events that will occur in a forecast, but also how they will affect the economy. So you essentially get down to the point that we will not know it until we are actually there. And maybe we'll miss it; it is conceivable. But at the moment we are not in agreement with those whom you quote."

The issue of a "natural" or "Neutral" interest-rate is of critical importance today, both conceptually and with respect to monetary management. Knut Wicksell conceptualized a "natural interest rate" back when a much simpler economic system was dominated by capital goods investment, production and the commodities markets. Investment in productive capacity was the prominent monetary transmission mechanism of finance to the real economy. Profits from production drove new investment, hence monetary expansion. Rates of return above borrowing costs engendered heightened investment, which would tend to inflate the economy's general price level. Heightened demand for borrowings - in a banking system intermediating a limited supply of available savings/loanable funds - would pressure rates higher, with market yields figuring prominently in the system's adjustment process. Rising interest rates and costs would reduce profit opportunities and, in the process, moderate investment (and monetary expansion!).

In my simplified analysis of the much less complex economic system of Wicksell's day, producer profits and commodities prices were viewed as key indicators of system price stability. Wicksell conceptualized that there was a single "natural" interest rate for the entire (production-based) economy, and that market rates should adjust toward this natural rate to ensure price stability and general economic balance and equilibrium. His focus was on systemic price stability, recognizing that cumulative processes would move an economy into a dangerous state of disequilibria if market rates were held artificially low over an extended period.

The concept of a "natural" or "neutral" interest rate should today be used with considerable caution. And I would argue passionately that it is being put forth improperly by the inflationists and boom proponents. Some - including Larry Kudlow - suggest the paltry yield available from the 10-year Treasury Inflation-protected Security (1.83% today) is tantamount to "the economy's natural interest rate." Others - with static analytical constructs incorporating parameters for potential aggregate GDP growth, full employment and resource utilization, and the stability of narrow consumer price indices - argue that the Fed has already pushed rates to neutrality. I argue that these are dangerous analyses.

First of all, any notion of a "neutral rate" must incorporate the peculiar realities of the contemporary economic and financial landscape. What is currently the key monetary transmission mechanism - how is finance predominantly infused into the real economy? Clearly, goods production is no longer the focal point of economic activities or the driver of growth. Capital goods investment does not play a meaningful role in Monetary Processes or the expansion of finance, so any pet fixation on indices of manufacturing activity to support "neutral rate" theorizing is misdirected analysis.

Lending to the asset markets (most notably housing and debt securities) has become the commanding mechanism for monetary expansion. No longer do oscillating production profits and capital investment work to regulate either economic output or the overall price level. Rather, expected returns from buying homes, leveraging MBS, and playing spread trades are driving system liquidity creation, along with the nature of economic "output." And, importantly, no longer are market rates determined through the interaction of the demand for borrowings with a limited supply of loanable funds ("savings"). Contemporary finance has overcome all supply limitations. Furthermore, inflated "profits" in the Financial Sphere - as opposed to the real economy - are now the overwhelming driver of "investment," as well as having become the chief monetary transmission mechanism throughout the entire economy.

It is crucial to appreciate that key system dynamics were profoundly altered once Financial Sphere "profits" came to dictate system behavior. In salient contrast to Economic Sphere pricing mechanisms, rising asset prices incite only greater demand. And the longer prices inflate and the system evolves to accommodate this inflation, the greater the probability for a final destabilizing bout of manic speculative demand. Unless there is limitation placed upon the amount of finance available to the asset markets, the pricing mechanism is doomed. Indeed, the rising demand to borrow against inflating asset prices is a powerful liquidity creating mechanism for the entire system - increasing the supply of "loanable funds" and further distorting the market interest rate (Bubbles creating their own liquidity). Blow-off excesses see a surge in asset market transactions at spiking prices with increased leveraging that combine to create a liquidity onslaught and attendant pricing breakdown.

One manifestation of the distorted cost and availability of finance is to ensure investment excesses, along with seductively restrained consumer price inflation. However, it is important for analysts to recognize that bubbling asset markets - and not the seemingly innocuous index of consumer goods prices - are the key determinant of monetary and economic stability. There is no "general price level" for central bankers to attempt to manage, with asset prices both the primary mechanism for Credit and liquidity creation and the fundamental indicator of monetary stability. And signs of inflationary Bubble-induced heightened Monetary Disorder - notably sector imbalances (autos!) and financial fragility - are not justification (or an excuse) for a lower "Neutral Rate."

Any notion of a "Neutral Rate" must first ponder the realm of the main monetary transmission mechanism - today the financing of the asset markets. Is a housing mania consistent with rate neutrality? Is the fourth consecutive year of double-digit mortgage Credit growth consistent with a "Neutral Rate?" Is California, Florida, Manhattan, or national house price inflation compatible with system price stability? Is a $700 billion Current Account Deficit consistent with any reasonable concept of monetary equilibrium? Is there, today, any semblance of economic balance or the productive allocation of resources?

The bottom line is that the system is not anywhere in the ballpark of either interest rate neutrality or price stability. Worse yet, there is no rate today that would stabilize either the financial or economic system - and this is a momentous dilemma. The most we can ask for is to end this period of gross excess and commence the arduous adjustment process. The time to have theorized about the "Neutral Rate" was, say 1992/93, before finance completely commanded the system. Years of Financial Sphere Inflation and attendant asset Bubbles have now rendered the monetary pricing mechanism inoperable. Artificially low rates must be maintained to sustain the Credit Bubble and the illusion of stability. Yet such rates induce only greater speculative borrowing to finance real estate and security purchases. Powerful Monetary Processes dictate self-reinforcing speculative excess throughout the Financial Sphere, with ever greater Bubble maladjustments throughout the Economic Sphere.

Ironically, Pollyannaish notions of a 3% "neutral rate" fly in the face of the reality that today's market yields ensure Monetary Disorder, system disequilibrium, the misallocation of resources, and the corrosive breakdown of monetary and economic stability. Knut Wicksell was keenly aware that once a system fell out of equilibrium the process of adjusting back could be quite problematic - depending on the degree maladjustment. He could have never imagined today's Mortgage Finance Bubble or the U.S. Current Account Deficit.

And - deserving of its place in the historical record - from the Economic Club of New York Q&A:

Question: "What developments would lead you to conclude that there is a housing bubble in the United States?"

Alan Greenspan: "There are a number of things, which I think, suggest at a minimum that there's a little froth in this market. Let me start off by saying, however, that the American housing market is an extraordinarily heterogeneous market and it does not have the capacity to move excesses from one area to another like you have with commodities - and hence create a single market. We have a whole series of local markets - meaning, remember, that a market requires that you compete with different products and you may be able to arbitrage say aluminum prices between Portland, Maine and Portland, Oregon. But you can't do it with housing prices because you can't move the houses. So the problem here is that you've got a whole series of local markets. And because of that it's very difficult - especially with the very significant closing costs and transaction costs - in essentially creating realized capital gains. You don't move to speculative markets very rapidly or very extensively, at least on a countrywide basis. So we don't perceive that there is a national bubble but it is hard not to see that see, one, that there are a lot of local bubbles. And, indeed, even without calling the overall national issue a bubble, it's pretty clear that it is an unsustainable underlying pattern.

And what we see is a number of forces which are, as far as I can judge, not infinitely projectable. First of all, still the vast majority of homes that are sold are bought and sold by owner-occupants. And as I have always said in the past, one of the considerable barriers to achieving realized capital gains on the sale of a home is if you live there you have to move. And that's a formidable barrier that has really been a major factor why - until very recently - we've had very little in the way of frothy markets of the type we currently have.

One issue that we have observed that is different to this particular period is the very significant acceleration in turnover of existing houses - meaning the ratio of existing home sales to the stock of existing homes. That ratio has gone up significantly, after being rather stable for a very significant period of time. On the basis of preliminary analysis that we have been involved with recently - endeavoring to segregate the owner-occupied sales from those which are second homes, either for investment, vacation or otherwise - having done that, what is very clear is that a very substantial part of the acceleration in turnover are second home purchases. And second home purchases do not have the inhibition that owner-occupants have because you can sell without having to move, obviously. The transaction costs are still quite high, but there is a good deal of accelerated speculation - there is no better word to use - in the markets.

And we are also seeing it in the mortgage market, because as a number of you are acutely aware there is a major move in mortgage originations now to interest-only and all sorts of adjustable-rate mortgages with very hybrid, very imaginative constructions. People are reaching to be able to pay the prices to move into a home, and this clearly is beginning to stretch the general pressures in the marketplace, which leads me to conclude that this big price surge is going to soon simmer down. And because of the heterogeneity of the market and inability to get a really major reduction in prices in this country, we don't perceive of it as a serious macro economic issue. Although it will, if it occurs - and eventually it will in one form or another - reduce the fairly large and still accelerating degree of extraction of equity from existing homes. And this has been a major force in financing consumption expenditures through the mortgage debt market. The number of occasions in which the average level of prices in the United States has actually gone down are very rare. And one of the reasons is that there is a fundamental uptrend that exists in home prices. And the reason is that because we are all looking for our own special types of idiosyncratic homes the chances to get a very significant amount of productivity going in the building of home is inhibited, so that even though there is a lot of technological advance, residential construction productivity has significantly lagged over the decades the average productivity in the United States, which means that there's a gradual increasing upside tendency for residential house prices to rise relative to the general price level. So there is a very considerable unlikelihood of a major decline when you are running up against this type of trend. But I might just say, finally, that even if there are declines in prices, the significant run up to date has so increased equity in homes that only those who have purchased just before prices actually, literally go down are going to have problems. So the presumption that there are a lot of bankruptcies out there doesn't seem credible to any of my associates and myself."

It is becoming more challenging for Mr. Greenspan to downplay the significance what has developed all; throughout the nation's "local" housing markets. And, right along with his fellow inflationists, the environment is forcing him into increasingly clever analytical nonsense. There is clearly a national Mortgage Finance Bubble and a Nationwide Housing Mania. As such, it is today disingenuous to split hairs on the moot issue of a "national housing Bubble."

Why on earth would anyone care to" arbitrage" home "prices between Portland, Maine and Portland, Oregon"? The easiest way to speculate on continued housing inflation is to buy the most expensive home one could possibly afford, or to buy as many of as possible. And there is ample evidence that this is being done in excess in communities throughout the country. And the rationalization that "one of the considerable barriers to achieving realized capital gains on the sale of a home is if you live there you have to move" ignores today's reality that speculators can easily extract inflating "equity" with the help of their accommodating banker or mortgage broker.

Perhaps "nonsense" is too strong, so I will use "wishful thinking" to describe the very non-central banker-like comment that "People are reaching... which leads me to conclude that this big price surge is going to soon simmer down." That's particularly poor Bubble analysis, Mr. Greenspan. With respect to housing inflation, mortgage rates are significantly below any notion of a "Neutral Rate." Expect the Mortgage Finance Bubble to continue to surprise and amaze.

And, back to nonsense rationalizing, Mr. Greenspan's theorizing that desire for "our own special types of idiosyncratic homes" as a factor helping to explain housing inflation falls rather flat with respect to the 50% two-year California condominium price spike and the spectacular Miami condo mania. And history will not be kind to the view "that even if there are declines in prices, the significant run up to date has so increased equity in homes that only those who have purchased just before prices...go down are going to have problems." The confluence of atypical price spikes, enormous and unrelenting equity extraction, huge churning (originations likely surpassing $2.5 Trillion this year), and risky late-cycle borrowing terms assure the coming proliferation of underwater homeowners.

And to the comment - "the presumption that there are a lot of bankruptcies out there doesn't seem credible to any of my associates and myself" - I can only suggest that it is too early in the game to be so sanguine. It's like saying in mid-1999 that warnings of massive losses in technology stocks and telecom debt collapse lacked credibility. The extent of losses that arise with the bursting of Bubbles has very much to do with the degree of excess and duration of the speculative blow-off period. We all better hope and pray that the Fed doesn't buy into the inflationists "Neutral Rate" fallacy.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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