Process = Recovery ==> Transition ==> Normal

The present path to normalization is, and has been, a long one compared to past recovery cycles.

Fundamentally it looks as though we are exiting recovery and on our way to normalization. Confidence is the key to continuation. I suspect the economy (along with the market which seems to have got ahead of things a bit) will go through a choppy transition period before it comes out the other side to normalization.

How long the transition period lasts is anyone's guess. Given that it has taken extraordinary stimulus (both monetary and fiscal) to get us to this point, it is not unreasonable to assume that the transition will be more painful and volatile than normal.

The trajectory of the market has been significantly different from the trajectory of the economy. The likely tightening of fiscal and monetary policy will throw a spanner in the works for both market and economy.

Monetary Roulette

Another thought to be developed is monetary roulette.

This is the game the central banks of the world are playing with their credibility and the global monetary system on the line as they continue to roll the chambers adding new QE to the system.

By now, they may have bought their own line that it may not actually have an effect.

The key question for policy makers are, when will the market call their bluff, and how big is the problem when they do."

Paraphrasing Herb Stein, "if something can't go on forever, then it won't."

Playing with fire

From January 1941 through September 1981, per Bernstein's figures, U.S. Treasuries shed 67.3% of their real value.

At a 3% nominal yield and 2.5% long term average inflation…locking in 0.50% real return….if inflation really gets going then all bets are off...and that return doesn't even take account of taxes.

Here is the real risk. Catastrophic risk. I don't think it is deflation. That is because the central banks are already all in on that one. They have already told us in no uncertain terms that they will do everything they can to forestall deflation. Fine. I believe them. If deflation takes place then the CBs are going to combat it. I think the real risk is that they are skating on thin ice. They not only lack credibility (they have used much of it up) but they lack the capacity to expand the monetary base (it is already overextended/on borrowed time). The likely result is things flipping from deflation to hyperinflation as total trust and confidence in the system evaporates. They are skating a fine line right now. If they do manage to get us out of the fire, then they will have been incredibly lucky.

If we don't go into deflation again, then we risk rising inflation and potentially hyperinflation (although that would require a real shock to the system).

We have plastered over the cracks. The system is fragile. Our psyches are fragile. Confidence is fragile (although I think it is very much seeping into the system at the moment and could very easily take us to the next level). But the whole thing is a facade, an emperor with no clothes. No one knows when the music will stop again, but stop it will.

Playing With Fire

Central banks of the world really are playing with fire. Their margin for error is much reduced. Their capacity to expand their balance sheets is now more limited. All of which means their options are diminished.

What they really risk is the markets confidence in their ability to manage the process evaporating. If that were to happen, then all bets are off.

Japan looks to be the poster child for so much. First for the demographic shift the developing world will be experiencing over the next 20-40 years, but more presciently for how the market and economy respond to unlimited QE.

Short term, the effects of QE, whether in the US, Europe or Japan, have been impressive - at least from a market perspective. Each successive policy implementation followed by a surging market response only reinforces the belief that you "don't fight the Fed." And it doesn't hurt that there appears to be some causative correlation with economic improvement. In this environment it is easy to be lulled into a simplistic notion of cause & effect which misreads the visible immediate causes against the less visible long term effects. Beware. The longer term effects are still to be tallied.

I Guess We're Not In Kansas Anymore

The central banks have fled the coop and are in Oz. The markets are a bedlam of optimism.

As if unlimited monetary easing was not enough (I guess the zero bound puts a kink in a few models). Yesterday the Bank of Japan's adopted a 2% inflation target (nothing sensational, except the country has been stuck in the mire for two decades...an asset/debt bubble will do that to you) and unlimited asset purchases, joining its compatriots (in monetary crime) at the Fed and the ECB.

The potential for negative unknown and unintended consequences increases. The margin for error has decreased.

The cost of post-GFC bailing is accumulating in the system and at some point will hit a tipping point. The effectiveness of monetary policy is diminishing with each cast of the die.

Until then, party on Garth.

The New Normal

While the 'new normal' might have originally been invoked to describe a more subdued economic growth path as the economy absorbs financial deleveraging.

I was thinking perhaps a better use of the phrase 'new normal' is in describing the manner with which we have grown accustomed to extraordinary monetary measures. What five years ago would have been unfathomable, now passes without a blink.

The extent to which the Fed and the ECB have expanded their balance sheets and reduced their own lending standards is staggering.

And yet, in the new normal, it is, how should we say, 'normal'.

There Is A Price To Be Paid

No economic law is more immutable than, "there is no such thing as a free lunch!" Actually, a more immutable law (at least in my mind) is you can't spend more than you make (at least not for very long). Not surprisingly, the two laws are related. And the truth be told, there are such things as free lunches, but they usually come with strings attached (which is the usual application of the idiom). But in the economic realm, there is a simple reason why there is no such thing as a free lunch and relatedly why you can't keep spending more than you make. It is because the production of a lunch costs something. Whoever is handing out free lunches is limited by how much capital they have. Ergo, there are limits to free lunches (and deficits), and the economic law holds true.

And so it seems with the massive government and monetary interventions we have experienced in the post-GFC world. We have become desensitized to the scale and the scope of the operations, and don't think twice anymore about new initiatives or new "solutions," largely because we have not seen too many deleterious effects. It seems that because none of these actions have led to immediate calamity, then maybe they are alright (perhaps even a free lunch). People who would traditionally and historically have been aghast at the actions proposed and undertaken, are now much less squeamish about each new initiative. We are becoming more comfortable with and more complacent about government interventions. And if that doesn't sound familiar, you may like to remind yourself of the pre-conditions to a bubble* (comfort and complacency are important ingredients).

There is a cost to artifice, and there is a price to be paid for attempts at muting the laws of economics. You can't simply wish new liquidity into existence, or make interest rates whatever level you want, without some cost. We have yet to see or feel the full effects of those costs, and therein lies the danger. The bigger the cause, the greater the effect. Ultimately it will be the encroachment of the previously contingent liabilities that sink us (unless we make the necessary painful changes). Rather than smoothing over the effects, the passage of time may in fact accelerate our day of reckoning.

*Bubble is being used here in the sense of something that is isn't sustainable, and for which there is a rude awakening.

The Idea Behind POMO's

I don't think the Fed would articulate their monetary policy quite this way, but it seems to me that the theory behind their non-sterilized permanent open market operations (POMOs) is that by juicing asset markets they are promoting greater confidence in the future (via the wealth effect), thereby leading to increased consumption and greater business investment (economic growth).

Twill be interesting to see if any parts of that transmission mechanism misfire.

Getting a read on the Fed

The markets focus is upon working out when the Fed will begin its exit from quantitative easing.

Some would say that it has already begun with the dismantling of various "market support" programs. The critical element will be when they begin raising the Fed funds rate.

With the knowledge that any "real" exit could send the economy in the tank again, I wonder whether the reality is that the Fed has little intention of raising rates anytime soon (read that in the next couple of years).

Any increase in rates will weigh heavily upon the economy, the govt's expenditures, and the markets. In many ways, the Fed has no choice, but to try and keep rates at ZIRP until it is patently obvious that the economy is totally recovered. In the same way that the govt is "all-in" on the fiscal side (and is committed to doing whatever is necessary to keep things from going back down), the Fed is in a similar boat. In spite of it's credibility and reputation being on the line, the Fed has little choice, but to keep rates low. Any removal of the foot from the pedal stands a high likelihood of choking off recovery (all that ZIRP for nothing). It has to go "all-in" on the monetary side. Failure to put the economy back on an even keel means we are left in a worse position than when we started.

With the Fed's priority upon the recovery of the economy, it has to risk inflation and the debasement of the currency in order to get us through this period.

2010 - A Year of Reckoning

2010 figures to be a year of reckoning.

It was the best of times and the worst of times in 2009, but 2010 will be a time of transition, a time of honesty, a reality check. A time where the rubber meets the road. Gains will not be so easy. Cracks in the system are likely to be tested. Risk increases as expectations increase.

Govt's will try and pass the economy back to the private sector, while central banks will try and extract themselves from the market, all the while hoping they don't upset the applecart, or have their bluff called.

Fear and trembling dominated 1Q09, while hope and relief characterized the last half of 2009. Unmitigated reality awaits the market in 2010.

Controlling The Hydrant

Will the Fed act quickly enough to reduce bank reserves when the velocity of money normalizes? If they are like anyone else in the market, they won't. The problem is not a lack of knowledge or vision related to the risk (they are fully conversant of the risk). The problem will be a failure of timing due to human nature and political pressures. Just as most market participants failed to time their exit from the market with a crisis looming (and their entrance back into the market by the looks of things), the Fed is likely to fail in its attempt to time the withdrawal of reserves from the system.

The Fed is playing a high risk poker game. One that they have demonstrated little aptitude for based on historical precedent. The problem is compounded all the more by the ongoing decline in the duration of government liabilities and the split personality of balancing inflation with employment. The result is, they have a smaller window of opportunity to get things right before the the market dings them, and the costs of failure mount.

Inflation v Deflation? Yes!

Is it possible that we could get inflation in "hard" assets, and deflation in consumer prices?

I guess so.

It is hard to reconcile these two contrasting effects, but it may be possible. After all, all things are possible, but not all things are probable.

That having been said, a case could be made that monetary profligacy needs an outlet, and hard assets appear to be the place of choice. Conversely, it is also possible that a deleveraging economy based on a crippled consumer could lead to declining consumer prices.

We've already seen significant asset deflation (a 60% haircut is not much fun), but not much of an effect in consumer prices (stripping out energy and housing if you follow the core numbers...which I think is a joke but it suits the argument I am making here). With the market having bounced 39%, that looks like a correction to an overreaction, but we are still to see the follow-on deflationary effect on consumer prices take hold. I think its coming though. Rising unemployment, rising foreclosures (across the credit spectrum), less access to credit, rising savings all point to lower consumption.

Lower demand points to lower prices. After all it is still a competitive economy (just).