• Right now, required reserves at the Federal Reserve stand at ~$64 billion
• Excess reserves stand at slightly over $1 trillion, roughly equal to 7% of average GDP over the 2007-2009

In the Winter of 2008, the Federal Reserve faced a difficult decision:

• The overnight funds rate on reserves, the base rate the Fed controls, was set at 1%, but the traded rate was 0.14%. So, as predicted, the Fed slashed its rate by 0.75 points and starting paying interest on excess reserves.
• Today, the Fed pays interest on excess reserves equal to its targeted funds rate 0.25%. However, the effective rate trades between 0.10% and 0.2% according to market data from the FT, pointing to continued slack in the system.

What to do:

• GDP for 2007 was barely over $14 trillion. In 2009, it was $14.1 trillion. Assuming the US grows at 3% per year, mid-2010 GDP would have been roughly over $15.1 trillion. The difference between potential output and current GDP is the amount of money parked at the Federal Reserve, earning 0.25%.
• Stopping the payment on excess reserves could be a boost to growth of the economy. Banks will have to find a home for this money. However, faced with the uncertainty of the current economy, and an economy facing deflation, banks may simply continue to keep those reserves parked at the Fed.
• The only major use of this income in the short term, would be a new round of stimulus. Highly controversial, yet effective according to a new paper by Mark Zandi of Moody’s and Alan Blinder of Princeton. Consumers are saving more, 6.2% of their disposable income, equal to ~$700 billion. This is roughly $450 billion more than during normal times. Fair to say, this money is being parked at the Fed in the form of excess reserves.
• Suspending interest payments on excess reserves would almost certainly bring the effective rate to zero. Using the Taylor Rule, the difference between 0.1 and 0.0 would add 0.2% increase in GDP given current CPI - not much.
• Yet, cash earning zero would have to find a home. Maybe then it would be possible to fund a second stimulus. Ideas for this stimulus would be as follows:

1. Replacing all municipal buses and taxi cabs with clean burning natural gas buses and taxis made in the USA.  This would have a significant impact for both the natural gas industry as well as domestic manufacturing.
2. Expanding high speed rail for both passenger and freight transport (moving more post and parcel service onto high speed rail). Key links would be Chicago to Detroit and the East Coast as well as continued east coast service from Boston all the way thru Charlotte and Atlanta.
3. Increasing port capacity for greater exporting ability in Houston, New Orleans, Virginia Beach, Philly, New York and the entire West Coast.
4. Increasing rail capacity in the Midwest to make manufacturing easier (and cheaper) to move to the coastal parts of the country.

To be sure, the investments outlined above would be 2-5 years in duration, shifting the excess reserves to the right on the yield curve where the current 10 year treasury yield stands at 2.91%. But infrastructure investments are incredibly productive. All of these outlined above would for sure produce more than 2.91% over ten years in returns. It’s a bet worth making and funding worth investing.

Four data points (from the Market Data section of the Financial Times) start the discussion:

1. Today, the US Dollar to Euro exchange rate is ~$1.29.
2. The one year (longest published out) Dollar Spot Forward is ~$1.29 as well
3. The ~ 1 Year US Treasury Yield is 2,99
4. The 10 Year Yield on a German bond is 2.75

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0275)^10 = $1.32 to the Euro, suggesting the Euro is long term undervalued.

However, what about the following other Euro countries? Here are the following ten year yield and percentages of Euro Currency 2009 GDP:

• Austria - 3.13 (3%)
• Belgium - 3.36 (4%)
• Finland - 2.93 (2%)
• France  - 3.03 (22%)
• Germany - 2.75 (27%)
• Greece - 10.53 (3%)
• Ireland - 5.42 (2%)
• Italy - 3.99 (17%)
• Netherlands 2.94 (6%)
• Portugal 5.52 (2%)
• Spain 4.28 (12%)

By averaging the ten year yield based on the gdp of all Eurozone countries, we find the Eurozone 10 year yield is 3.57%

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0357)^10 = $1.22 to the Euro, suggesting the Euro is long term overvalued. Adjusting this calculation for % of Public Debt to GDP, the value of the Euro drops to $1.21 to the Euro

What is the explanation?

Countries in crisis (such as Portugal, Spain, Greece and even Italy) have taken advantage of Eurozone financing for government financing. This purchasing has negated the need to tap domestic and foreign capital markets for purchases. This lack of foreign exchange has created a void for deciphering where the euro is truly in demand. This is further evidenced by an officer of BBVA’s notorious quote earlier this summer.

What this essentially means is that current account surplus countries such as Germany are forced to help out current account deficit countries such as Greece and Ireland. Yet the Eurozone has a current account deficit. If Germany and German banks are bailing out Greece and Ireland, countries such as China are only buying German bonds. This makes German sovereign bonds the “on the margin” security denominated in Euros sold and traded in foreign currency and not just in Euros.

The “marginally available” security is probably the major explanation why the Dollar Spot is valued closer to the Covered Interest Parity Calculation using the German 10 Year Bond than the composite of European Bonds.

Martin Wolf, Economics Editor for the Financial Times, poses many questions on his Wolf Exchange.

I was particularly interested in Mr Wolf’s question on Current Account Deficits. I, like many others, responded to Mr. Wolf’s question. Here is Martin’s response, mentioning me, posted in his Exchange:

Current Account Deficits, I think, is one of the most important topics in economics. Therefore, here is my cleaned up version of his response.

Click on this link to view the response: avoiding-a-financial-shock-with-sustained-current-account-deficits. As I see it, the key is real productivity increases. In the long run, inflation and deflation won’t get you there. Would love to hear your thoughts.

The Fed mulls an inflation target, to stabilize the economy. Robert Shiller and George Akerlof, in their new book Animal Spirits, argue for a “credit target”, a level of lending to keep the economy near full employment. In the middle is an old question - Should Central Banks consider Asset Bubbles a form of inflation?

Look at the 2008 Commodities Bubble:

• January 2nd, 2008 - According to the Financial Times, One month Oil Futures on the NYMEX were $99.62
• July 2nd, One month Oil Futures were $144.26
• December 30, One month Oil Futures were $39.03

That the Fed insists on Core Inflation, excluding energy, made it miss how energy moves all consumers prices. Consumers pulled back on gasoline purchases in the short term and in the long term, terminated SUV purchases, crippling GM and Chrysler.

Yet during oil’s rise, the Fed had to reduce the Fed Funds rate as the effects of Bear Stearns was first on its mind. It’s not clear the Fed could have raised rates to prevent oil’s rise, without crippling the economy.

Preventing the Housing Bubble though could have eliminated what we currently witness: Global de-leveraging and massive reassessment of household wealth. The sheer amount of leverage also helped fuel stock market booms (of which some was real) giving consumer confidence in 401k statements. Add to this the house market boom, household behavior such as reverse mortgages, credit card spending, an overall negative savings rates would probably not have occurred.

Yet the Fed’s role in determining over-investment is tricky, politically controversial. Without world-wide coordination for world wide bubbles, false arbitrage opportunities such as the Carry Trade can wreak havoc on international trade/commerce.

What Shiller, Akerlof, and all concerned about asset bubbles really want is an economy where the Financial Sector does not a) contribute the most to GDP growth and b) rise too disproportionately in terms of total GDP. This was our economy prior to this crisis. The economy must have real growth, not growth due to paper assets. Once perception is pricked on over priced assets, no one knows an assets true worth, causing trust and lending stop.

If Central Banks can not politically prevent asset bubbles, then our government must improve its risk management program. Two logical improvements are as follows:

1. Regulation and oversight must increase. Madoff’s false profits now cause hospital wings  to go without funding. Mortgage Originators are forcing real family pain on false interest rate promises.  And we all witness a loss in market confidence.
2. Running government surpluses in healthy economic times. 90 years ago, John Maynard Keynes worried about this very issue we now face. Certainly, government surpluses up until now would reduce our worry over how much debt we must now raise.

Only a start, but planning for the future must occur to prevent a future colapse of this proportion.

Yesterday’s news was not encouraging. Home value declines will continue to make families and home owners second guess their net worth. In a recession, this prompts only one reaction: saving.

The macro economic accounting identity states savings equals investment. This static steady theory is becoming a large force against fiscal stimulus, now awaiting Senate Approval.

Let’s review the facts. With the Fed meeting today, Fed Funds ended trading at 0.18% according to the Financial Times. As rates are not able to go below zero,  interest rates are essentially fixed. And bank reserves held at the Fed increase. There thus is no further mechanism to force private investment to equal savings.

As savings not offset by investment (which would lead to new jobs) and unemployment increase, taxes decline. If government expenditures just stayed the same, our federal deficit would have to increase, even without fiscal stimulus.

Faced with the choice of

• Large Federal Deficit
• Infrastructure Investments => New Jobs and a Large Federal Deficit

Its best to choose jobs, new infrastructure and a large federal deficit.

Today’s news was even less encouraging. That jobs are lost in record numbers makes valuing mortgage bonds, even if simply constructed, even harder. Yet mortgage bonds are not simply constructed, they are incredibly complex.

Job losses will not decelerate for a while. It will take time for fiscal stimulus to take effect. This makes the idea of the “bad bank” incredibly complex. Many like Reich still hold out hope for a solution that protects the tax payer. The economic reality makes it impossible that mortgage assets still on the books are worth anything close to what they were previously valued. To unclog lending, we -the taxpayer- must further take it on the chin.

Yet as the fiscal stimulus and bad bank solutions work through the economy (and slowly), we must ask ourselves: what kind of economy do we want to now create? Should the Financial Sector contribute 31% of GDP as it did in 2006?

Which should we value more? Financial engineering or mechanical engineering?

This is again why infrastructure investment as the stimulus for tomorrow’s economy is so important: The only way long term balance will be restored (and one could measure this by the current account balance) is to choose engineering over financial engineering. The more we build (not out of paper) at home, the more our economy will grow in a balanced, mature way for generations.

As Congress released the second round of TARP funding this past week, anxiety grew that its original purpose is failing: banks are not lending.

To discern why, we must think about the relationship between the TARP funding requirements and Federal Reserve Monetary Policy.

With banks taking write downs during the fall of 2008, its plausible to assume TARP funding was the only new source of capital - all remaining bank liabilities and assets were matched after write downs, tied to existing economic activity. The only source of capital for new economic activity was TARP funding, now $700 billion. To give comfort to this assumption, add up the market capitalization of the largest US banks - far smaller than TARP.

By law,  TARP funding is preferred equity on a bank balance sheet, with a 5% annual dividend. Add on administrative costs, and a loan just to break even needs approximately 6%, just to service the taxpayer requirements of TARP. Yet through Open Market Operations, the US Ten Year Treasury currently yields 2.34%, according to the Financial Times and the effective Fed Funds rate is 0.18%. TARP funding requirements place this large source of new capital no where near this historically low yield curve, completely at odds with Open Market Operations.

Two years ago, overnight treasuries traded at 5%. When the economy grows at 3% per year, an inflation at 2%, a business owner merely switches on the lights to pay back a 5% interest bearing loan. Yet in today’s environment, 5% is expensive. In today’s environment -a ZIRP interest rate environment - a recessionary environment - a deflationary environment,  those willing to accept north of 5% (6%) is a classic adverse selection problem: The smart businesses horde cash as new cash is too expensive. The businesses accepting such a loan may not be able to pay it back.

Faced with the prospect of new bad loans, it is no surprise banks are not lending. They would rather preserve capital to plug foreseen bad loans in the coming year. Further, to achieve 5%, M&A is a preferred method, scooping up the right loan packages at the right price.

A Solution:

This page has long argued TARP dividends should be a rolling average of the yield on treasury bills/notes - the opportunity cost of taxpayers funding the banks. If yields are low, economic activity is weak, keeping dividend payments manageable. If yields are higher, (assuming no runaway inflation) economic activity has increased as treasuries were sold for corporates, again making dividend payments manageable. We hope the new administration makes this change.

Much concern exists over Obama’s proposal to make tax cuts a major portion of fiscal stimulus.  Through a tax cut, we (the government) are increasing the income of those still employed. Hopefully, tax savings will buy goods and services, increasing GDP. In today’s environment, we’re not enacting a stimulus to buy goods, we’re enacting a stimulus to buy jobs.

GDP = government spending + investment + consumption + net exports. The marginal dollars in a tax cut will either be saved or spent.

While savings should be encouraged in the long term, a savings glut currently exists. Fed Funds rate trades near zero, while cash reserves within the Fed have ballooned.

More damaging, marginal spending could be directed at imported goods. From Martin Wolf to Warren Buffet, many shudder at no improvement in our trade balances. Dollars used for imports are either locked up as foreign reserves or exchanged for investments in future US cash flows. Those future cash flows are either US tax receipts or profits distributed as interest or dividends. Those tax receipts could have put new teachers in the class room. Those profits could have built new factories. Those cash flows will never to be re-invested in the US.

By definition then, an increasing current account deficit means the same standard of living - GDP - costs more. If this is not the purest form of inflation, I do not know what is.

Many believe  too great a mismatch exists between jobs lost and jobs needed for “shovel ready”.  Cokie Roberts on “This Week” opined on finance professionals helping on infrastructure: “Well maybe instead of going to their personal trainers, they can actually get out there and start digging.”

The purchase of infrastructure projects buys jobs across the food chain.  Almost every project will go out for private competitive tender. Forget defunct residential home construction (shovel ready employees), companies bidding will require talent to prepare bids, obtain financing, manage payroll, and review costs. Every contract guarantied by the government (state or federal) will give lenders the confidence to finance, spurring new growth.

The long term benefits (aside from jobs) are then improved transportation, reduced energy costs and reduction of barriers to education. Thus reduction of risks for future runaway inflation - those risks prevalent in increasing current account deficits. Faith in government is presently difficult yet now we must make our congress the direct investors of last resort.

The Yield Curve is increasing in discussion as a predictor of the US Economy.

First, in defense of the Yield Curve, it is a good predictor of future short term interest rates. Let’s take the UK and the US current short term Yield Curves, courtesy of the Financial Times.

The UK Yield Curve:

The US Yield Curve:

• The official UK Central Bank interest rate stands at 2.00%
• The Fed Funds target rate stands at 0.25%

With similar economies -troubled financial sectors, and nerve racking current account deficits -there is almost no question the UK will mimic its “special relationship” counter part and further slash interest rates to boost its economy. Hence, the UK curve slopes down in the short term.

Recovery:

Now, let’s read the yield curve tea leaves for the US economy:

• The Cleveland Fed votes yes
• Paul Krugman votes no

Paul is right. That the “effective rate” of Fed Funds trades at 0.14%, mirroring overnight Treasury Bills means the yield curve can only slope positively (The UK curve highlights why Paul is correct). Two years ago, life was much different.

• Fed Funds “effective rate” was 5.30%.
• Overnight 3m Treasury Bills traded close to 5.00%.

That the 30 Year Treasury Bond trades today at 2.81% shows a very weak economy, regardless of the slope of the curve. Further, it shows a long time until economic recovery. Larger economies require larger yields to balance the supply and demand of money.

When investors resume believing in corporate bonds, the yield curve will start to increase in slope. Treasuries will be sold and corporates will be bought. The key to economic recovery will not be the purchase of existing corporates - most of those were sold when yields were low. Rather, the key will be when new corporates are issued and issued cheaply (low yields). This will start putting new profits (more return on equity) back to companies for investment and further economic growth. Unfortunately, it has been a very light fall and continues to be a light winter for new debt issuances.

What will 2009 look like? This blog offers key spreads to examine routinely for signs of economic recovery. In chronological order

• The Fed Funds Effective vs. Target Spreads.
• The TED Spread
• LIBOR vs. Investment Grade Bonds

Fed Funds Spread

The Fed Funds Spread, the difference between the “Target Rate” and the “Effective Rate” for Federal Funds is essentially the measure of slack in the economy. Today, the Target Rate is set to 0.25% and the “Effective Rate” for overnight funds trades at 0.11%: banks can not find enough opportunities (or see too much risk) to lend. Instead, banks choose to keep excess funds within the Federal Reserve.

This is the first spread to watch. When the “effective rate” trades at the “target rate”, the economy is performing to its potential in the current interest rate environment.

The TED Spread

The TED Spread, the difference between three month LIBOR and three month US Treasuries, is essentially the measure of trust between the private and public sector. According to the Financial Times, three month LIBOR trades at 1.47%. Three-month Treasuries trade at 0.0014% (zero). That’s a big spread.

This spread can not converge until overnight LIBOR -which mirrors the Fed Funds “effective rate” - trades at the Fed Funds Target rate: Effective Rate vs. Target Rate convergence implies upward pressure on treasury yields, making overnight treasuries trade at a minimum of 0.0025%.  This is the start to redeeming trust in the private sector vs. the public sector.

LIBOR vs. Investment Grade Bonds

This spread measures competition and confidence in the private sector’s ability to earn income. Today, one year LIBOR trades at 2.09%. Reviewing Global Investment Grade Bonds from the Financial Times, most trade at ~6.00% yield.

global-investment-grade

This is the final spread that will show uptick in the economy. When this spread converges, trust in corporate earnings is restored: the public market respects corporate earnings enough to offer a suitable substitute to banks as a source of debt funding.

The LM Curve as Perspective

Reviewing the LM curve, demand for money equals the supply money at a given output and interest rate - in this case a zero interest rate environment.  Output could increase in a zero interest rate environment, with expansion of the money supply (as the Fed is currently doing) and with expansion of the government spending (as Obama is planning). Given we are in a contractionary economic environment, one could argue the US has only slid down the LM curve - money supply expansion has not worked -, awaiting a shift in the IS curve with new fiscal expansion.

However, a healthy economy has demand for money at positive rates. For this we look to the convergence of the spreads listed above.

Preparing for 2009, this week marked a terrific example of de-leveraging in practice.

• As of Friday, December 19th, according to the Financial Times One year US Libor was 2.09%
• As of Friday, December 19th, according to the Wall Street Journal, no Treasury expiring prior to 2015 yielded more than 2%.
• And, as of Friday, December 19th, according to the Financial Times, the Fed Funds effective rate was 0.11%

So, there has never been a cheaper time to borrow, right? Only if you have an FDIC (taxpayer) stamp next to your offering. Take a look who issued debt this past week, courtesy of the Financial Times.

Financial Times: Week ofDec-19th-bond-issues-us

One side note: Even John Deere Capital got into the FDIC mix! So don’t tell GM and Chrysler they can’t have taxpayer loans.

According to the WSJ, this week was the final week in 2008 for private bond offerings. The lack of Corporate Debt issued should provide guidance that the US Economy (by force or by choice) is continuing its de-leveraging.

Final side note: According to the Wall Street Journal, The Illinois Finance Authority is set to offer $500 million in bonds on December 26th. Though it is independent of the State, this should be an interesting post-Christmas verdict on Governor Blagojevich.