The Fed will continue fighting its war on deflation until housing prices begin recovering.
At least, that's what Bernanke would like to accomplish.
In some of my earlier posts I said that the Fed would push quantitative easing to the limit - beyond the event horizons reached by the BOJ in earlier attempts to dig itself out of the speculative credit hole. Bernanke's grand plan involves "fixing" housing loans. Consumer credit (auto/credit card/student loans/etc.) are also on the list but housing remains the priority.
This can be accomplished through either
a)Lengthening loan maturities to 50 years or more; and/or
b)Rewriting loan terms through Bankruptcy Code revisions.
I originally covered only Option A).
B) is something that is currently being attempted in Congress but will result in further loan writedowns from the banking sector and an increased reluctance to initiate new lending.
The immediate effects of such a Bankruptcy provision being rammed through Congress will be the blatant re-writing of debt covenants that will punish bond holders. This is not a desirable effect either. Bernanke WANTS to push investors back into more risky asset classets. And if he punishes fixed income, the more conservative asset class, you can imagine the kind of message he will be sending to equities.
Solution? The Fed will step in to backstop or guarantee the debt. This should ensure the fixed income rally will last for a while since housing has virtually no hope of recovery this year.
So, will this plan actually work? It might.
EXCEPT...for the exogenous factors
The Fed's plan relies on an inherently flawed assumption - that the US continues to live in a unipolar world.
Here are some factors that can, either independetly or together, re-ignite the inflationary wildfires:
a) Foreign Creditors - their reluctance to buy Treasuries continues to grow. EVERY single one of America's creditors has their own economic problems and is ALSO running a quantitative easing plan of its own. The 800 lb gorilla here is of course China which has its own unique problems (to say the least).
b) Commodity Supply Bottlenecks - Commodities crashed hard in the latter half of 2008 and continue to fall as of this writing. However, supply bottlenecks are already being formed. Industrial metals and energy are selling below cost for many producers. Farmers lack access to credit (there are also fewer farmers b/c of demographic trends). Weather conditions in the Pacific for La Nina are also developing.
c) Trade Wars - Competitive devaluation will take on a whole new meaning in 2009 as export dependent nations desperately debase their own currencies to attract the attention of jaded 1st world consumers. Protectionist sentiments will also continue to grow in 2009. Backlashes against foreign imports will become increasingly common.
d) Demographics - America's ranks of aged continues to grow. Their numbers are putting a strain on government benefit mandates. Already Social Security and Medicare comprise nearly 40% of the US budget.
e) Actual Wars -Political volatility remains very high. As energy prices continue to crater, the probability of energy exporters initiating actual or proxy conflicts escalates. This is particularly true of the Middle East and Russia.
f) Terrorist/Cyber Attack - See above but not exclusively limited to energy prices. America's foreign policy remains . . . . controversial in many parts of the world.
Basically inflation will not pick up until we begin to see a recovery in housing prices OR one of the exogenous events I write about above occurs. The deflationary momentum remains strongly skewed by housing prices and are dictating the Fed's actions.
Friday, January 9, 2009
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