Fed to discontinue publishing M3 - what gives?

The Fed announced with very little fanfare on Thursday that it will discontinue publishing the M3 monetary aggregate. From their release:

On March 23, 2006, the Board of Governors of the Federal Reserve System will cease publication of the M3 monetary aggregate. The Board will also cease publishing the following components: large-denomination time deposits, repurchase agreements (RPs), and Eurodollars. The Board will continue to publish institutional money market mutual funds as a memorandum item in this release.

This hasn't been picked up in the mainstream financial press (surprise, surprise) and it is not even clear that most participants in the investment community know or care about this. The fact that repo's (RPs) will no longer be published is also interesting, as these are the main tool of Fed open market operations. The Fed's total lack of an explanation for this action leaves us to puzzle out what is really going on here. Perhaps the Fed assumes that the academic and investment community believes, as their Chairman does, that monetary aggregates are no longer useful economic data.
Therefore, why continue to publish these useless statistics that no one seems to care about? We have a much more cynical explanation to offer. The Fed is laying the groundwork for a massive reflation that our new central banker, Ben Bernanke, will have the pleasure of overseeing shortly after coming into office. Maybe after taking over the throne, er, helm, he will raise the Fed Funds rates a few notches to earn the respect of a fawning Wall Street and Capitol Hill. Shortly thereafter, once the economic data starts turning sour, he will start making the policy a tad more "accomodative." Even while keeping short term rates a little bit high compared to Greenspan, fooling people into thinking monetary policy is "tight," perhaps Bernanke will experiment with some more subtle methods of pumping liquidity into the system. He can print money and use it to buy government bonds, which are in ever greater supply thanks to reckless deficit spending. This kind of technique would show up in the M3, of all places! Now of course he is aware of this, as we can see from his infamous speech on deflation:

There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Bernanke's "personally preferred" (so much for objective economic reasoning, by the way!) is to cap yields on Treasuries. Well we all know how attempts at price-fixing work out. The Fed will buy all the Treasury debt within a certain (sure to expand) maturity range if it has to in order to keep interest rates low! Sounds like monetizing debt (that is, printing money to finance government debt) to us. We believe that the Fed realizes that they will need more ammunition than ever to keep the economy afloat, and want to obscure the place in advance where their intervention (manipulation?) will most likely show up.
There is only one picture that needs to be shown here.. let's see the beast itself while we still can.

(Im)Balance of Payments

William Poole, the president of the St. Louis Federal Reserve Bank, recently denounced any concerns regarding the US current account deficit. Many economists in fact agree that there is no real concern for a ballooning current account deficit. They argue that it is a sign of strength in the US economy and high foreign demand for US assets. In the short term, this argument may hold as it did during the 1980s. But the real question is whether the current account deficit can be sustained over the long run.

Before we talk about the current account deficit, it is important to go over the definition of the balance of payments (BoP). The BoP accounting is simliar to most balance sheets, with every item booked as a credit or a debit. Post-gold standard BoP is always zero, and the "deficit" we hear in the news can only show up in the BoP's major sub balances.

CA (current account) = net trade in goods + net trade in services + net investment income + unilateral transfer
CF (capital/financial account) = capital imports - capital exports

BoP = CA + CF - ΔR = 0
BoP = CA + CF = ΔR (change in reserve account)

A current account deficit simply means that a country is spending more than it produces in a given period. This extra spending is only possible when there is a surplus in the capital account. Of course, a current account deficit may not be completely offset by a capital account surplus. During the gold standard, the capital account was strictly tied to the central bank's gold base, which provided an automatic mechanism for keeping the BoP of each country in equilibrium. Therefore a deficit in the BoP required readjustment in the current account, whereas today, ΔR is seen as a form of compensatory financing (negaitve sign in the equation because it implicitly represents capital exports).

Murray Rothbard on David Hume's price-species flow:

As the philosopher and economist David Hume pointed out in the mid-eighteenth century, if one nation, say France, inflates its supply of paper francs, its prices rise; the increasing incomes in paper francs stimulates imports from abroad, which are also spurred by the fact that prices of imports are now relatively cheaper than prices at home. At the same time, the higher prices at home discourage exports abroad; the result is a deficit in the balance of payments, which must be paid for by foreign countries cashing in francs for gold. The gold outflow means that France must eventually contract its inflated paper francs in order to prevent a loss of all of its gold. If the inflation has taken the form of bank deposits, then the French banks have to contract their loans and deposits in order to avoid bankruptcy as foreigners call upon the French banks to redeem their deposits in gold. The contraction lowers prices at home, and generates an export surplus, thereby reversing the gold outflow, until the price levels are equalized in France and in other countries as well.

In the post-gold standard economy, not only can deficit financing be achieved through foreign direct investment (FDI - raise equity), but the US can also discharge its deficit by accumulating debt through its own currency. The US "borrows" by selling dollars to foreign central banks (mainly Asian), who in turn buy US debt. These central banks will gladly stock up dollar reserves, as it is the international reserve currency and allows their domestic currencies to be artificially low (think RMB). These dollar reserves will eventually purchase dollar denominated US assets, especially US government bonds and agency debt (only 30% go into FDI). It is important to note here that foreign sales of US treasuries implies additional liquidity, as the US is tapping into foreign credit and not domestic savings. Furthermore, this type of expansion allows creditor nations (i.e. China) that stock up forex reserves to flood the global market with cheap goods, implying that instead of a price inflation, a bubble emerges in the asset markets. Indeed, the buying and selling of debt instruments are at the core of expanding global liquidity.

In today's dollar standard, a lagging capital account is offset by ΔR, which depicts central bank acquisition of dollars to achieve balance. Therefore, changes in market prices for currencies and interest rates are supposed to provide the necessary equilibrium mechanism for the BoP. This assumes that all countries have a floating exchange rate regime, which is in fact far from reality. The dollar has indeed depreciated since 2000, but this is only minimal considering the fact that most Asian countries, especially China, have their currencies hard-pegged to the dollar.


Finally, it is important to look into the somewhat neglected portion of the current account - international investment income. The first graph depicts US net international investment position (NIIP), where foreign investments in US assets were worth $2.5 trillion more than foreign assets owned by the US in 2004. Despite this massive gap, however, the US still earned $30 billion dollars more investment income than foreigners in 2004. This was possible because the US mainly invests in foreign equities, whereas foreign countries (i.e. Asia) mainly invest in US government bonds and mortgage-backed federal agency debt (a la Fannie Mae). Considering the massive gap in NIIP, however, this scenario will not last long. In the second quarter of this year, US income payment has already exceeded income receipt by $455 million. This red number is registered as a debit in the current account. Therefore, as the trade account continues its deficit, a negative investment income will exacerbate the current account deificit. Not only will this have a serious consequence on the value of the dollar, but it will also raise many doubts on the dollar's role as the international reserve currency.

On a side note, we believe that ΔR of the BoP formula may provide a good reference to global liquidity, and thus global demand. We have been hearing news of declining global demand based on year over year data. We therefore intend to formulate a difinition of money supply that incorporates M3 and ΔR in order to make sure that our long positions don't get squeezed by a fall in global demand.

Moneypulation by the Fed

It is becoming increasingly difficult to navigate through the financial markets. Indeed, there is no doubt that the US market has recently been showing some weak fundamentals. We have realized, however, that whenever the government reports any economic data (retail sales, unemployment etc.), or whenever the stock market dips really low, there is a subsequent miracle rally in the S&P later that day. At the closing bell, the mainstream would rationalize the miracle rally by alluding to "better than expected" government data or "unseasonably warm" weather, and so forth. Most people have heard of the government "Plunge Protection Team," but is this mere conspiracy? Well, we believe it may be possible. Afterall, the intended purpose of the central bank is to "stabilize" the markets.


If the Fed intervenes in government securities, currencies, and the US stock market, then what about the gold market? Gold is of particular interest to the Fed because it provides the market with a yard stick to measure inflation. 10-year bond yields are also supposed to reflect inflation, but we know that excessively easy money (created by the central bank) has put a firm foot over long term yields. Thus, considereing the fact that inflation expectations are still low, it must be that the Fed is manipulating gold prices as well. Of course, gold has enjoyed a nice rally in the past several years. We believe, however, that the spot price has been constantly depressed through central bank gold loans and gold swaps that attempt to flood the market with excess supply. Looking at Friday's intraday chart, one should think: who in the world could unload so much gold in a matter of hours, and also, why.


The price of gold is driven by demand, not supply. Unlike other commodities, gold is exceptional in that it is not exhausted like oil or steel. Pretty much all the gold that has ever been mined still remain above ground - mostly in the vaults of central banks. This immense stock of gold (8,000 tonnes) is what enables the Fed to manipulate the gold supply, and hence depress the spot price. Of course, we do not expect this short-term, supply-driven scheme to last for long. The oversupply may be able to hide inflation on a short term basis, but it also provides a buying opportunity for astute gold investors (Chinese and S. Korean central banks to name a few) - and they will eventually request physical delivery. This means that even if the Fed engages in "paper sale" of gold through swaps, its physical gold reserve will inevitably bottom out. Gold demand will only increase as real inflation continues to pop up around the market, and the Fed will not be able to "whack-a-mole" everytime. Looking at the way gold spot trends, trades, and trends again, we remain bullish on gold and expect the next rally to commence soon.

Perspective on the Housing Boom

As the Fed has raised interest rates from the lows of 1.00% in June, 2003 to the current rate of 4.00% in November, 2005, the housing market has raged on. How is this possible? From Peter Warburton's excellent book, "Debt & Delusion":

It is important to realize that gradual rises in interest rates during a property speculation are frequently ineffective. As long as property is appreciating in value at a faster annual pace than the interest rate paid by the borrower, the fire will keep burning. Only sudden rate increases inject sufficient fear into the market to challenge the predominance of greed.

The Fed has telegraphed its interest rate moves very clearly with the language of its statements, and its successive hikes have been all been anticipated by the market. The ability of market participants to accurately forecast Fed activity is a relatively recent phenomenon, and it has led to unprecented carry trading by hedge funds, proprietary desks, and other market participants. The unheralded amount of borrowing-short, lending-long has compressed long-term interest rates, keeping mortgage rates at historical lows for years. Homeowners have certainly taken advantage of this, and effectively transmitted the expansionary monetary policy the Fed begins at the short-end of the yield curve into rapidly rising housing prices.

As the spread between the Fed Funds rate and the benchmark 10 year Treasury narrows with each rate hike, what will happen? Things will really get interesting when the Fed is staring the decision to invert the yield curve in the face. At this point, there may be much less consensus in the market and surely some will be surprised whatever happens. Is the highly interest-rate sensitive housing sector ready? Let's look at US home mortgage borrowing.


The trend is clear-US households have been steadily ramping up debt, fueling the impressive gains seen in real estate prices. Perhaps we hear the maxim that real estate prices never fall significantly, or at least they maintain their value if the gains are not as impressive. We need only look at Japan to see how false that commonly believed statement is...

CPI, Inflation, and the Government Affair

Ahhh, the Consumer Price Index. The CPI is one of the most frequently referenced and utilized data in economics, finance, and politics. Because the index depicts the overall cost of our living, it provides a very crucial pivot for economists, producers, investors, and policy makers. Considering this significance, a careful look into the government index is warranted.

The headline CPI consists of a variety of categories. Food and energy costs weigh in for roughly 23% of the index, while housing cost (CPI - Shelter: rental equivalence approach) makes up 22% - the single largest component of the headline CPI.

From the Bureau of Labor Statistics:

Until the early 1980s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing. The asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good. Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach [OER] to measuring price change for owner-occupied housing.

What do they mean by "inappropriate results?" Looking at the graph above (posted here, thanks to contraryinvestor.com), one can see that the new OER method (CPI - Shelter) did not diverge much from the original asset price method until roughly 2000. Since then, however, the current method has failed to reflect real housing price inflation. Moreover, only 30% of the US population rent homes, while more than 60% currently own homes. People not only own homes (through mortgage loans), but they also borrow against their homes (against their mortgage loans) to buy even more homes! The CPI's disconnect from reality is exacerbated further by mainstream reliance on the supposed "core" CPI, which strips food and energy costs from the headline CPI. Ultimately, the core CPI fails to reflect nearly 50% (OER + no food and energy costs) of prices relevant to consumers. Clearly, the BLS does not believe this to be an "inappropriate result."

Similarly, the Fed seems to be turning a blind eye to the CPI's shortcomings, not to mention the incessant growth in M3. This tells us that bond investors are also not discounting for real inflation, thus keeping long term yields low. Of course, we do not expect this "conundrum" to continue forever. Seeing that the Fed's current interest rate hikes are not able to curb money supply growth (assuming M3), we expect the economic reality of inflation to dawn upon the market before long.