US inflation expectation and fiscal condition

http://www.gamblerdaily.com/?p=1730 Global Markets Daily 2/10/11

There are a lot of concern out there regarding US inflation expectation and fiscal condition. Here is my two cents…

Lets start with inflation. In 2008, when Fed expanded its balance sheet by hundreds of billion to take the “toxic” assets off banks’ balance sheet. A lot of people were concerned. My understanding: Fed “prints” money (either as create new liabilities Fed reserve notes or use banks’ reserve) to buy treasury from US Treasury and use the treasury bond exchange for the toxic assets 100 cents on a dollar or 80 cents on a dollar, so the bank got the treasuries on its balance sheet and toxic assets were transferred on Fed’s balance sheet. Banks are required to put a lot of those bonds as reserve in Fed. And they were willing to do it, because they got interest on reserves. So the money didn’t really circulate in the economy. Banks are holding 16 times as much reserve as they previously did. The only concern at the time would be that if those toxic assets on Fed’s assets side of the balance sheet become completely worthless. Then we might have inflationary problems. Again, lets take a look at the the Fed’s balance sheet below. Unfortunately, we won’t know the quality of those agency securities and MBS. Obviously they don’t do mark to market accounting on Fed balance sheet…

Weekly Fed Balance Sheet Assets (Week of Feb 9th): $2.48T v $2.45T prior; M1: +$34.2B v +$8.6B prior; M2: +$39.5B v -$33.2B prior - M1 y/y change: 9.0% v 8.4% w/w - M2 y/y change: 3.7% v 3.6% w/w - Fed holdings of Treasuries: $1.17T v $1.14T w/w - Fed holdings of agency securities: $144.6B v $144.6B w/w - Fed holdings of mortgage backed assets: $965B v $965B /w - Fed central bank currency swaps: $70M v $70M w/w - Foreign central bank holdings of US Treasuries: $2.62T v $2.61T w/w -

Another issue will be the velocity of money as the consumer lending decreases. Given the growth in normal GDP has decreased and the stock of money supply has unchanged (as explained above). The velocity of money has declined, which make sense. Consumer, and business credit and lending since the crisis has been declining. Banks has been taking much less risks. I am not an expert in economics. But intuitively speaking, if I can print dollar, just like Fed. I printed 2 trillion dollars (whether it’s electrically or I cut all the trees on west coast). Instead of spending it, I put in my vault, it obviously won’t cause inflation. On the other hand, I decide to put it all in a bank, the bank only does business 1 day per week and with lending limit up to 100 dollars. So now the money is in the system, but circulating at a very slow speed. It won’t cause much inflation. The latter example is not great, but you get the point. The media usually reports headline inflation which includes food and energy affected by commodities prices. As iterated many times by the Fed, the core inflation (without food and energy) is stable. Again, yesterday Fed Chairman Bernanke said Fed is “unwaveringly committed to price stability”.

Now fiscal condition, Bernanke said that Debt-to-GDP ratio needs to be held where it is now, would be a real concern if the ratio rose above 100% and that the US cannot grow its way out of fiscal imbalances. Few people would probably argue that Japan has 150-200 debt to GDP ratio and risk premium on JGB is extremely low. First, that is changing recently, S&P just lowered JGB grades and its yield has been moving up. Second, a lot of Japanese were hold by Japanese, as oppose to US, about 50% Treasury were hold by foreigners (if not higher, I believe).

Let me know what you thinking about those issues.