Goldman Sachs Says Fed's Next Money Printing Move is Imminent: "No Point in Doing Anything Less Than $1 Trillion"

Goldman Sachs chief U.S. economist Jan Hatzius yesterday said that the Fed is going to have to eventually print more money to tune of $1 trillion+.

In other words, the Fed's recently announced 'QE Lite' simply won't cut it. Hatzius figures are in line with estimates for QE 2.0 (the term that has become attached to the next massive round of Fed money printing) that I've been pointing towards for awhile.

In terms of the timing of QE 2.0, Goldman Sachs Chief Global Economist Jim O’Neill said "September might be a little bit soon, but by October I would say for sure if the data carries on being as disappointing as it’s been."

Given that market confidence is clearly deteriorating, why won't the Fed act sooner? I've recently wrote about my ideas on timing here. Ken Rogoff, the Harvard economist and author of the only economic history bestseller This Time is Different, recently appeared on Charlie Rose. He suggests that the Fed is hesitating because they're "nervous about overshooting". Aiming for 3% inflation, the Fed may miss their target badly and wind up with 30% hyperinflation. However, Rogoff states the "Fed will have to take that chance".

The U.S. dollar has held its ground so far, but concerns are rising about ongoing record budget deficits and what the government will do about the massive mortgage market problem that is Fannie and Freddie. The terrible housing figures are coming in spite of record low mortgage rates, housing prices 33% off their peak, and federal government subsidized mortgages for even Manhattan condos that require only 3.5% down payment. Perhaps most importantly, the now all but certain QE 2.0 makes the future value of the dollar anything but certain.

From an investment perspective, any move by the Fed to print more money is bullish for gold.

Today's Feast for Bears

Stock market bears were handed ample fodder today:

• Comments from Nobel Prize winning economist Joseph Stiglitz on how Europe is at risk of a "double dip" recession due to ill-timed government budget cuts. Professor Stiglitz  has been supposedly advising Greek officials nearly every day since their debt crisis erupted this spring -- ignore this insider's words at your own risk.
• The safe haven Japanese yen rallied to a 15-year high versus the U.S. dollar at 83.59, well beyond the psychologically important 85 level. The yen also hit a nine-year high versus the euro at 105.43. If the yen appreciates further towards 80 vs. the Dollar, the Bank of Japan will probably be forced to intervene with or (more likely) without G7 coordinated action. 
• While the yen is rallying the Japanese stocks are in a bear market, with the Nikkei down over 20% and under the psychologically important 9,000 level.
• Another safe haven currency, the Swiss franc, just rallied to an all-time high against the euro at 1.30 as once again it appears money is flowing out of the EU and into Switzerland.
• Unless you've been hiding under a rock today -- understandable if you've got a lot of equity tied up in the value of your home -- you probably already saw that July home sales figures were abysmal and indicate room for a much further decline in housing prices. Further significant declines in housing -- some estimating another 10-30% down -- may trigger a significant increase in strategic defaults.
• Money continues to pour into bonds as the yield on the U.S. 10-year note punched all the way up to 2.47%, the lowest level since the stock market was pricing in financial armageddon in March 2009.

What does this all mean?

Merle Hazard's "Double Dippin" Music Video

George Orwell vs. Aldous Huxley: Who Was Right?

Two of my favorite books from the 20th century are Aldous Huxley's Brave New World and George Orwell's Animal Farm. I also liked Orwell's 1984 but prefer Animal Farm, perhaps because I read it first.

If you're a fan of either author or simply interested in what they had to say, here is an interesting graphical/cartoon interpretation of their ideas.

Pay for Say? Outrageous Clip of Fed Governor Mishkin on Iceland's "Financial Stability"

Inside Job, a new documentary set for U.S. release on October 8, is Academy Award nominated Director Charles Ferguson's film about the financial crisis.

I haven't seen the film yet, but it will be worth checking out if the rest of it is anything like the following clip of Columbia University Professor and former Federal Reserve Governor Frederic Mishkin talking about his infamous Iceland report:

Herbertsson (left), Mishkin (right), unknown person (middle)

In the clip Mishkin responds to questions about a 2006 report he authored titled 'Financial Stability in Iceland'. The report was co-authored with Icelander Economist Tryggvi Thor Herbertsson (pictured right hunting with Mishkin in Iceland). Not long after Mishkin's and Herbertsson's report was published Iceland's financial and banking system collapsed.

Mishkin failed to disclose in his report that he was paid $124,000 by the Icelandic Chamber of Commerce to write (if in fact he wrote any of it) a stunningly inaccurate testament to Iceland's financial soundness. Mishkin also later renamed the report on his resume to 'Financial Instability in Iceland', an error he chalks up in the Ferguson interview as a "typo".

Here is the full trailer for Inside Job:

Update: Congratulations to Director Charles Ferguson for Inside Job winning the Academy Award for Best Documentary.

Why QE2 Won't Be Announced at Tuesday's Fed Meeting

Amid rampant discussion of further 'quantitative easing' the market's eyes will be fixed on the Federal Reserve when it meets on Tuesday this week.

In understanding why it is unlikely for 'QE2', as it is being dubbed, to be announced at this week's meeting it is helpful to briefly review the Fed's history and the political environment in which it operates.

Argument for Fed Independence

One of the key justifications for the creation of the Federal Reserve was to "keep politics out of monetary policy". In the Federal Reserve Act passed on December 23, 1913 Congress delegated its Constitutional authority over the nation's money supply ("to coin money, regulate the value thereof") to the newly created Federal Reserve System.

The Fed is free to make independent monetary policy decisions -- such as shrinking or expanding the money supply -- without the prior approval of Congress or the President. The logic behind thus empowering the Fed is that the nation is better off with its monetary policy entrusted to an institution that -- unlike Congress and the President -- is not directly accountable to the voting public. (Not exactly a strong vote of confidence in democracy!)

The theoretical problem with allowing elected politicians to directly control monetary policy can be illustrated through the following hypothetical example of a politician seeking reelection:

A politician might deem it advantageous to his reelection chances if there were a well-timed increase in the money supply. The reason? An increase in the money supply can (and often does) boost asset values (i.e., stocks, housing prices). A stock market rally -- prior to an election -- can in turn boost voter confidence. And more confident voters are less inclined to throw an incumbent politician out of office. While economic conditions may in fact make an increase in the money supply imprudent due to the post-election side effects (e.g., housing price crash), a politician's motivation to get reelected may trump economic logic. 

U.S. President Andrew Jackson vs. the Bankers

The above example can also be turned around to show how it can be politically advantageous to decrease the money supply. For example, in 1833 a reduction in the money supply was orchestrated in an attempt to cause President Andrew Jackson to lose reelection.

In theory, the Fed -- by virtue of its inoculation from public elections -- can base its monetary decisions (e.g., whether to shrink or increase the money supply) on the true economic conditions, and not the election calendar.

However, the Fed is not immune from politics. In fact, Fed Board members have their own mini-election gauntlet to run. To be elected to the Fed Board a person must be nominated by the President and confirmed by the Senate. And that final step, as recent events bear witness, is proving problematic.

Senate Stonewalling Fed Appointments?

In April of this year President Obama announced nominations for the three Fed Board openings and so far none have been approved by the Senate. In fact, the last time the Federal Reserve Board had all seven positions filled was back on April 28, 2006.

On Friday came news that Senator Richard Shelby (Republican, Alabama) had rejected President Obama's nomination of Peter Diamond for the Federal Reserve Board stating "it is not clear...that his background is ideally suited for monetary policy, especially given the current challenges facing the Fed".

Of note, Diamond is considered an inflation 'dove' and close Ben Bernanke monetary policy ally. Interestingly, Diamond was also one of MIT professors a then 25-year-old Bernanke thanked for supporting his doctoral dissertation. One perhaps not so outlandish interpretation of Shelby's move is that Republicans are trying to keep the Fed paralyzed.

Diamond's appointment would help Bernanke with what has proven to be a publicly divided Fed. In the face of significant Fed Board dissent, Bernanke's consensus orientation will make him reluctant to activate QE2.

Republicans Want QE2 Postponed Until After November Elections

I've written previously about Chairman Bernanke's well documented plan for dealing with the present challenge of deflation. Put simply, his plan is to print a lot of money.

The announcement of QE2 would likely trigger a rise in stock prices. An autumn stock market rally -- in addition to signaling that the 'Bernanke Put' is every bit as solid as the 'Greenspan Put' -- could be a reelection boon for a Democratic incumbent majority that is in deep trouble.

Shelby's rejection of Diamond delays his appointment at least until Congress returns from recess in mid-September (Obama's other two Fed nominees are on ice until then as well). Don't be surprised to see the Republicans stall further until after November elections. As such, investors timing an imminent announcement of QE2 are likely to be disappointed.

The Yen: A Little Less Conversation, A Little More Action?

The value of the yen just hit its highest level against the U.S. dollar since Nov. 27 at 85.32, which is close to its 15-year high of 84.82.

While recent news from Japanese exporters has been relatively positive, a higher value yen could threaten Japan's fragile economic recovery. A strong yen makes the price of Japanese exports less attractive in key foreign markets, such as the U.S.

In the past simple jawboning by Japanese officials has proven effective at 'talking down' the yen. On cue Yoshihiko Noda -- Japan's eighth Finance Minister in the past three years -- said that he is “closely watching” the currency market and that the yen’s current movement “is a little one-sided”. And as I write the yen is trading off a bit to 86.24.

However, given the serious discussion of QE 2.0 or QE Lite in the U.S., will talk alone be enough to keep the yen from rising this time?

Some Japanese exporters already appear to be looking for 'a little less conversation, a little more action' from the Bank of Japan. Yesterday Nissan Motor Co. Chief Operating Officer Toshiyuki Shiga said "with the current rate there would be an impact on our orders for export. I hope each country will cooperate to minimize the impact of the yen’s strength, and I hope the government (Japanese) will make such efforts.”

The last time the Bank of Japan intervened in a significant way was in 2004. I recently interviewed Axel Merk, portfolio manager of the $500 million Merk Currency mutual funds. Merk contrasted the Bank of Japan's currency prowess with the recent ineffectual efforts of the Swiss National Bank (SNB), which failed miserably in its attempts to halt the rise in the Swiss Franc against the Euro. Unlike the SNB, the Bank of Japan can "do real damage" to the value of the yen. Earlier this year Merk removed the yen from his list of "hard currencies" when it appeared the government might finally get organized enough to put pressure on the Bank of Japan to devalue the yen.

I wouldn't expect Bank of Japan intervention unless the yen breaches the 84.83 level for a sustained period. For investors, there are several yen ETFs to choose from.

In the meantime, here's Elvis:

Colbert On the Current Tax Cut Debate and "Trickle Down" Economics Theory

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The Fed's Balance Sheet: More Room to Grow?

There is a lot of speculation and debate about what will happen to the Fed's balance sheet going forward. Recently St. Louis Fed President and FOMC voting member Jim Bullard has called to expand it further. Tonight the WSJ reports that the Fed is contemplating using the "cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually". This idea has been dubbed 'QE lite', as opposed to full 'QE2'.

Sometimes a good graphic really helps to put things in perspective. Courtesy of the WSJ's Real Time Economics blog is this interactive Federal Reserve assets chart.

The chart headline refers to the Fed's "balance sheet". But in small print you read that it is actually charting just the Fed's assets. The full Fed balance sheet would also include liabilities, which are not shown. (If you're curious about what the Fed's liabilities are comprised of take a look at the green paper in your wallet or purse, and you can learn more here and here.)

Why are the Federal Reserve's assets important? Simply put, the Fed's assets equal the money printed by the Fed. In other words, for an asset like a U.S. Treasury bill to wind up on the Fed's balance sheet it must be purchased by the Fed. And the money to purchase that Treasury bill is created (printed) by the Fed. Welcome to the only place in America where in fact money grows on trees!

Looking at the chart two things jump out:

1. The parabolic 'hockey stick' curve. Fed assets shot upwards from roughly $800 billion pre-financial crisis in 2007 to today's $2.3 trillion.
2. The increase in the different types of assets held on the balance sheet

Prior to the crisis the Fed's balance sheet was pretty simple: basically $800 billion in U.S. treasury securities. Now it contains everything from former AIG and Bear Stearns junk assets, to loans to other government's central banks, to who knows what until the one-time Fed audit is completed (see below video).

Looking at the value of the U.S. Dollar and U.S. government debt, so far the market's reaction to the the tripling in size of the Fed's balance sheet has been relatively benign. But can present values be sustained through another round of Fed "quantitative easing"?