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Tuesday, 8 April 2008

The Future Actions of The Federal Reserve And US Govt Are Known

An Occasional Letter From The Collection Agency


An interpretation of The Deflation Bias and Committing to Being Irresponsible by G B Eggertsson


This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind.

I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future.

I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed.


Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future.

The Federal Reserve Makes a Choice.

We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome.

To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward.

Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view).

Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:

  • "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."

Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:

As GB Eggertsson put it:

  • "Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap."

If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke’s apology the first signpost on his intended path.

Many attribute Bernanke with the nickname "Helicopter Ben" in reference to remarks he made in a speech about how to combat deflation. It is oft used by those who rail against inflation to paint Bernanke as an inflationist. However, this is misplaced. Bernanke was in fact quoting Friedman. What many don't realise is that there is an assumption the Friedman was invoking Keynes in this approach. This isn't true. Keynes did not believe such an approach could work with low nominal interest rates whereas Friedman believed that changes to both fiscal and monetary policy could allow government control of prices.

Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system.

However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced.

Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:

  • "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.

As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.

The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.

Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow).

Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

  • The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation. At zero nominal interest rates higher inflation expectations reduce the real rate of return, and thereby raise aggregate demand and the price level. The two main assumptions underlying this result is that there is some cost of taxation which makes this policy credible and that (2) monetary and fiscal policies are coordinated.

Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures).

However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:

  • "Deficit spending has exactly the same effect as the government following Friedman's famous suggestion to "drop money from helicopters" to increase inflation. At zero nominal interest rates money and bonds are perfect substitutes. They are one and the same: A government issued piece of paper that carries no interest but has nominal value. It does not matter, therefore, if the government drops money from helicopters or issues government bonds. Friedman's proposal thus increases the price level through the same mechanism as deficit spending. Dropping money from helicopters, however, does not increase prices in a Markov equilibrium because it increases the current money supply. It creates inflation by increasing government debt which is defined as the sum of money and bonds. In a Markov equilibrium, it is government debt that determines the price level in a liquidity trap because it determines expectations about future money supply."

Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:

  • "The government, however, can increase its debt in several ways. Cutting taxes and dropping money from helicopters are only two examples. The government can also increase debt by printing money (or issuing nominal bonds) and buying private assets, such as stocks, or foreign exchange. Ina Markov equilibrium, these operations increase prices and output because they change the inflation incentive of the government by increasing government debt (money & bonds). Hence, when the short-term nominal interest rate is zero, open market operations in real assets and/or foreign exchange increase prices through the same mechanism as deficit spending in a Markov equilibrium."

As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk.

It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.

Since 2000:

  • The US Government has run an increasing deficit.

    The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.

    The loosening of regulatory oversight allowed a wider use of debt and increased consumption.

Since mid 2007:

  • The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.

    The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.

    The US Treasury does not rule out making the new Fed facilities permanent.

I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow).

The Future

We now turn our attention to the future. At this point we have to examine something previously mentioned in our article, a Markov equilibrium. Again from Eggertsson:

  • I analyze equilibrium under two assumptions about policy formulation. Under the first assumption, which I call the commitment equilibrium, the government can commit to future policy in order to influence the equilibrium outcome by choosing future policy actions (at all different states of the world). Rational expectations require that these commitments are fulfilled in equilibrium. Under the second assumption, the government cannot commit to future policy. In this case the government maximizes social welfare under discretion in every period, disregarding any past policy actions, except insofar as they have affected the endogenous state of the economy at that date (defined more precisely below). Thus the government can only choose its current policy instruments, it cannot directly influence future government actions. This is what I call the Markov equilibrium.

Essentially policy is either forward looking and adaptive or it works only in the "here and now" and cannot innovate.

Clearly my reading of the current situation is that the Fed and US Govt is committed to a future policy in its actions and has displayed the ability to be adaptive. Therefore we shall take that path to find what future developments may await us.

Again we rely on Eggertsson to lay out the groundwork:

  • "deflation can be modelled as a credibility problem if the government is unable to commit to future policy and it's only instrument is open market operations. This....illustrates how the result changes if the government can use fiscal policy as an additional policy instrument. I first explore if deficit spending increases demand. When the government coordinates fiscal and monetary policies it can commit to future inflation and low nominal interest rate by cutting taxes and issuing nominal debt. I then use the result to interpret the effect of open market operations in a large spectrum of private assets, such as foreign exchange or stocks."

It is without doubt the most forward looking statement I have seen. Or is it? Again we must look at this from behind Bernanke's desk to truly appreciate what we are reading. The statement is forward looking because it has been adopted as policy. We are living with these actions right now and we know that they will exist for at least 6 months as has been made clear in statements from the Fed. Expectations of a continuing inflationary bias must be deeply entrenched in the psyche of anyone connected to asset markets.

Eggertsson continues:

  • "Friedman suggests that the government can always control the price level by increasing the money supply, even in a liquidity trap. According to Friedman's famous reductio ad absurdum argument, if the government wants to increase the price level it can simply "drop money from helicopters." Eventually this should increase the price level-liquidity trap or not. Bernanke (2000) revisits this proposal and suggests that Japanese government should make "money-financed transfers to domestic households-the real-life equivalent of that hoary thought experiment, the "helicopter drop" of newly printed money." This analysis supports Friedman and Bernanke's suggestions. The analysis suggests, however, that it is the increase in government liabilities (money & bonds), rather than the increase in the money supply that has this effect."

  • "Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets).

  • It is often suggested that the central bank can depreciate the exchange rate and stimulate spending by buying foreign exchange (and similar arguments are sometimes raised about some other private assets and their corresponding price). Due to the interest rate parity (and similar asset pricing equations for other private assets), however, buying foreign exchange should have no effect on the exchange rate unless it changes expectations about future policy (since the interest rate parity says that the exchange rate should depend on current and expected interest rate differentials).

  • Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government.

If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.

Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.

The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.

Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation.

A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth.

Is the path hyperinflationary?

To be blunt, no. These are anti deflationary measures that will give the Fed credibility in fending off the dreaded scenario. The threat to the policies is an acceptance of deflationary expectations by private money and consumers.

Hyperinflation would be unable to form as an expectation as long as the Fed continues to display a hawkish approach to inflation. As we have seen the delivery of fiscal debt, in the form of "helicopter drops" would bypass the pricing mechanism. Expectations of hyper-inflation would be negated.

Conclusion. Is it working?

It is at this stage that I can happily say that it would be unfair for me to judge whether the policy is working or not. This because the whole scenario, the playing out of the policy, is to do with perception. The only way that it can be measured by individuals when attempting to answer the question is to screen what they see through this article (or G B E's Fiscal Theory). As the writer if I answer the question I might colour an individual's perception.

What I can say is that with the framework exposed and on public view we have the advantage of spotting potential failure of policy. The potential for failure is increased by discussion and the recognition of the long term policy objectives (avoiding deflation) if such discussion raises the expectation of deflation.

I should remind readers that this article is my interpretation of G B Eggertssons' work. I believe it is the blueprint being used by the Fed and US Govt. Therefore I claim no superior knowledge to Eggertsson, just an understanding and the ability to navigate.

What should be remembered is the title of G B Eggertsson's paper:

The Deflation Bias and Committing to Being Irresponsible

(Edit: The above link to the NY Fed stopped working, I have found another on line version at the IMF and linked to it. I have also downloaded a copy, just in case)

In other words the future actions of the Fed and US Govt may appear "wrong" unless we understand what they truly fear.

Sunday, 6 April 2008

The Weekly Report - 6th April 2008

The Weekly Report

5th April 2008

Welcome to the Weekly Report. This week, I stick my nose in where it ain't wanted. (again)We get down in the dirt about deflation and we look at some stocks and wonder why and I show you my long term indicators.

Now, I'm not one to boast, really I'm not. No one enjoys the likes of me stuffing "I told you so" remarks down reader's throats. There comes a time when it does become slightly unavoidable. Is it ego, a demand of recognition? Is it a desire to be kingpin, the ultra guru? Frankly my dear, I don't give a damn, as long as my readers get something that helps make life as an investor /trader easier then my attitude is "so what?"

What a week that was, Dow up, then down, up again…..stop! Hindsight - blah! This is the Collection Agency, we pride ourselves on looking forward, not back. Where do I look, how far forward? The Occasional Letter looks 6-18 months ahead, soon it'll be looking for some buy opportunities. The Weekly Report is more short-termism, with the aim of looking for opportunities in the next few weeks.

Speaking of readers it is time for an update. Now most of you know I'm a blogger, no fund to sell, no angle to push, I really don't care what you buy and sell. I'm not bothered. I'm googlable but I don't really exist beyond those that read me at some rather classy sites. Yes that was me being a creep.

Here is my world coverage over the past 2 months, remember, I'm an unknown, a blogger:

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If it's green, someone visited. I know, I'm amazed too, my grammar is awful! Around 16000 people have read my stuff in the past 2 months. Some may scoff at such figures, I don't. I would like to thank you all, I had no idea my "stuff" was that readable. As much as I can be, I feel slightly humbled.

"Enough" I here you cry and being one not to spit in the face of a crowd, lets get on with it.

There has been a war of words between Gary North and Steve Saville about whether the Fed is inflating or deflating. I have absolutely no connection with either writer and have no interest in badmouthing either of them. I am sure both have a loyal following and I do know both make interesting points.

Here is my roadmap, unchanged these past 5+ years:

  • "A recap of the scenario:
    bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation."

If you read that 5 years ago, you would have pegged me as a survivalist or a gold-bug. Now you can pick your appropriate position. How did I know such tremors were coming? Simple, I studied the very same things Ben Bernanke studied, he became a bald academic, I became a bald blogger. I am better looking though.

Back to the GN/SS spat. I looked on, an interested observer in all matters inflationary and deflationary and decided to strip the argument back to its core. From what I could see this was a difference between M1 and MZM as to which held the key to inflation/deflation signals. So I went to the Fed.

St Louis to be exact, mainly because I like Poole, his St L Fed site is excellent; I do hope his successor keeps the access to facts as open as Poole did. Its worth reading up on William Poole, he may well surprise you. I digress, again:


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This is a chart of MZM (green), M1(orange) and CPI(blue), using the base of 1982, as CPI was rebased in 1982/84 according to St L Fed statistics. Everything is based on the left side, pure figures. You know what's coming next:

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Same chart with CPI based on the left axis and M1 and MZM on the right axis with the same baseline of 1982. Astute readers can know see why I stick my nose into uninvited areas. Is any measure of "M" a worthwhile measure of inflation trends?

Inflation is not purely a monetary phenomenon. We all know if you over-print cash notes you encourage a debasement and a monetary inflation. What isn't so understood (except by some and believe it or not, the Fed) is that in a fiat monetary system, reliance on growth using leverage for the expansion of credit, is the true driver of inflation/deflation.

It's simple and easily understood if you think of greed. It is also why a fractional GOLD backed currency won't work.

I have $10, I lend it to my bank as a "savings" deposit. The Bank uses the deposit as an asset, lending on that asset by a factor of 10 (leverage). The bank lends out $100 backed by the original asset. The Hedge Fund borrows (credit) $100 from the Bank and utilising margin (further leverage), raises positions in markets notionally worth $1000.

The economy is booming, thanks to my $10. I am a capitalist hero. One day I decide to take my $10 out of the Bank to spend on a battery powered radio, to alleviate my boredom whist mowing the lawn.

Does the Bank have to unwind the leveraged lending based on my $10? No, it can count upon other deposits, savings, to replace the capital base.

This is all well and good during the good times. What happens when all my neighbours decide they would rather own assets than leave cash on deposit? We know already, thanks to the 3 day collapse of Bear Stearns. Banks fear above all else a run, where depositors decide they would rather have their cash in hand than in the Bank. You can see why they fear such a run, mass withdrawals would force the unwinding of leverage, a call on the loans made. That means the Hedge Funds would have to unwind their positions, to enable repayment to the banks. You get the picture. Another angle would be to look at productive workers, paid for their labour and depositing wages into the Bank. If the Banks had a shortfall of received wages the same problem would occur, Banks would no longer have the fractional base to enable their lending. Less workers, less deposits.

What we are witnessing is not a shortfall in the ability of innovative structures to enable credit. What we are seeing is the beginning of the destruction of the fractional base of Banks. I could go on, mentioning the shortfall in expected corporate profits over the next quarter or 2 as judged by the S&P500. My astute and clever readers have already jumped ahead to that conclusion.

Back to the central question, is the Fed inflating or deflating? Amazingly, it is doing both, thanks to the newly introduced "Facilities":

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Above is something I rustled up earlier in the week. To my eye, the Fed is inflating the amount of Treasuries available to both Banks and Primary Dealers and debasing their worth by swapping them for cheaper assets. On the other hand the Fed has been extremely active with the Permanent Open Market Operations, selling treasuries and absorbing cash from the markets. The Fed is walking along a very loose tightrope, where each step is producing vibrations that affect all market participants.

It would seem the Fed is set on a course to provide solvency to Banks and Primary Dealers, by lending assets that can be used to raise/roll borrowing from Banks who are only willing to lend on AAA assets. This is far beyond the ability of MZM and M1 to measure. Such slow moving indicators are unable to capture the true intentions of the Fed as it provides the replacement for the Commercial Paper markets.

Let us gaze upon the graphs for M1, M2 and MZM:

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Where M1 has remained in a tight range for the past 11 Quarters, the sudden acceleration in M2 and MZM points to a reflation BEYOND cash.

  • M1 is defined as all coins and currency held by the public including travellers cheques, checking account balances, NOW accounts, ATS accounts and balances in credit unions.
    M2 is defined as all of M1 plus savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts.
    MZM is defined as all of M2 minus time deposits but including money market funds.

Yes, we are back to the Fed and its Facilities again. M2 and MZM include overnight repos at commercial banks. Since the credit crisis burst open in the summer of '07, the Fed has made ample use of repos. Indeed when the crisis intensified in October '07 and again in January '08 the Fed enlarged the amounts and frequency of repo arrangements.

It is quite clear that M2 and MZM are reflecting this. M1 does not include such actions as those carried out by the Fed. Repos can only be viewed as credit, newly created by the exchange of assets. Cash itself is not printed, there is no need. All that happens is a bank can swap assets to increase the notional amount it holds in its reserve and meet reserve requirements. Only if the repo was made permanent, with assets remaining at the Fed, could the Bank issue currency.

It is at this point I agree with Gary North, consumers are not seeing a reflation in wages or income, actual cash in the economy has been remarkably stable over the past 3 years. If one considers the loss of spending power of each dollar, then without an increase in the amount of physical cash, consumers are already in a deflationary cycle as the amount of cash after liabilities is falling. An inflation of prices must never be confused with an inflation of monetary supply, consumers are suffering a deflationary lack of cash when compared to the requirements demanded by an increase in the PRICE of goods.

For the consumer this is clearly unsustainable. Eventually the consumer will hoard resources and only use cash to pay for essentials. Regardless of the Fed pumping assets into Banks and Primary Brokers who use the largesse to fund their own borrowings, the consumer will find it extremely difficult to access credit. Without credit consumers will be unable to expand spending as reliance on increasing wages is obviously misplaced.

Here we have the roots (and they run deep) of a major deflationary period. I have opined before that I saw a two track America, one where consumers where crushed by deflationary forces whilst "International USA" continued to offer acceptable returns in exchange for it debt. That moment may well be playing out in front of us now.

Here is a chart of 2 inter-related phenomenon; Consumer Prices (blue) and Total Retail Sales (red):

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Here is a classic example of prices rising when goods are in demand. If you look closely, you can see that retail sales lead CPI, dips in sales slows and at times reverses CPI.

An adage I have for this is it doesn't matter how high prices go if there is no demand for goods. The goods will either be re-priced lower to stimulate demand or the production of the goods is stopped if the venture becomes unprofitable. It is the lack of cash that causes (spending and therefore) sales to drop. How the amount of cash consumers own is decreased is important. If more cash is required to pay taxes or service debt then the expenditure is onerous on the consumer balance sheet, no asset is exchanged. If the consumer chooses to spend more money buying assets, then at least there is an asset owned. If however the asset is depreciating in value, including assets bought using debt then the net worth of the consumer suffers a double blow.

Housing is suffering from the same effect. Now we see it in retail sales. You can see why tax rebates have been lined up, it is an attempt to stave off a deflation in sales. If it works it will have a lagging inflationary affect on CPI.

The problem though is whether consumers will spend tax rebates or save them. If rebate cash is used to pay down debt or placed on deposit there will be no stimulation to sales. CPI will drop. Here is a close up of the same chart:

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The tax rebate effect can only be temporary even if it does stimulate spending. Without an expansion of credit or an increase in wages sales will continue to drop. What are the chances of credit conditions changing in the medium term or wages increasing during a recession?

The interesting part of all this is if consumers do save the tax rebate then M1 will not increase as savings and small time deposits are calculated in M2/MZM. Thus savings could cause a display of supposedly inflationary tendencies in M2/MZM. M1 would only increase if the savings ( or the tax rebate itself) were used to buy goods or services.

The actions taken by the Fed and the US Treasury will either distort CPI or cause a misreading of inflation if M2/MZM are used. The latter would be a grave mistake as the consumer would not have increased their spending power. The increase in M2/MZM would be a combination of increased use of credit by banks and an increase in savings by consumers.

The following chart shows the relationship between Sales and Industrial Production for Durable Consumer Goods:

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Sales and Production are linked, it shows that the compensation given to workers for their labour is used to buy products, amongst other uses. The correlation is particularly noticeable prior to 1991. However since 1991 an inequity between spending power and production has appeared. It is my contention that increased productivity was a function of the slowdown of compensation in real terms and spending was boosted by an increase in the use of credit allowing sales to continue to rise.

This is a form of mal-investment, were credit has replaced true efficiencies in production. Purchases were not made from savings (workers earnings) but from earnings of yet unrealised worker compensation with a forward CPI and risk premium added.

With the standards for credit now at much tighter levels seen since 1991 this mal-investment is beginning to bite. Although this has consequences for consumer spending power, the real problem will lie within Corporate balance sheets. Reduced income will make the servicing of corporate debt much more difficult as we have seen in the Financial Sector. "Liquidity injections" from overseas investors have high rates of interest and with income streams falling, increased productivity and the ability to service debt can only be achieved by lowering costs.

If a production system is reliant on the use of credit to expand and that facility is removed then the results of previous bouts of debt fuelled expansion cannot be carried forward and offset against expected future income. Either the debt is repaid or defaulted.

Can increased productivity re-light consumer spending? It would appear not:

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And it's a tactic that's already been tried. Notice the increase in productivity in 2007 did not re-ignite sales. It's most likely that the 2007 increase was a function of cost savings, rather than expansion.

On a more practical front, how can an investor use such information to aid their strategy?

Avoid debt on company balance sheets. An investor should get into the habit of checking the ratio of company debt to income and reserves. If you can find a company selling essential products that carries no debt on its books you are on the right lines. If you can find a company that also has saved its profits and is only willing to expand using its savings you may have found a good opportunity.

We finish off with a look at some charts and wonder why investors are buying financial sector stock. Is the recent rebound in financials worth buying into or watching? I leave that decision up to you, I don't do recommendations but as you have read, my filter for acceptable buys would discount the sector. You may well have a different take on the situation, my only advice would be to do your research with extra diligence. I have no positions in shares in the following charts and will not take a position on them for some time.

Firstly my Dow Daily Chart, used for long medium length trends:

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We are near the top of the sideways trading range(down arrow) that has been in force since January. For the first time in 4+ months we have a neutral reading, with 3 days of support at the pink, median line (up arrow). Whilst calling direction from here would be a bit silly, at least with a neutral scenario we can take cues from breaks of support/resistance from here.

Citi, I have removed the down channel as we have broken out. Citi is trying to break above the MA but might be forming a rising wedge:

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Goldman is at the upper end of its down trend channel and finding resistance at the MA. Strong support at $163:

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Gold, an update from last week. The down arrow shows the attempt last Monday to regain the MA which failed. Gold found support in the $885 area on a closing basis. This level now becomes important support for future moves. I would need to see a higher high and support from the MA before looking for upside:

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That's it for this week.