Agora Financial’s Rude Awakening

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Dubai, United Arab Emirates

• The Central Banker conundrum – bail out the money markets or combat the big “I,”
• Gold floats in a world flooded by paper money - prepare your arc,
• Three charts with squiggly lines and more…

Joel Bowman, with a few quick words from the United Arab Emirates…

Inflation is a real bummer. Sam Ewing described best when he said, “Inflation
is when you pay fifteen dollars for the ten-dollar haircut you used to get
for five dollars when you had hair.”

Aside from the rising cost of living, one must also endure the proliferation
of hyperbolic stories from everyone older than you.

“Back when a carton of milk was a penny,” they start off. Or they’ll say
something like, “When I was young, you could buy whole house for what you
just paid for that front door.”

These lessons don’t make us youngsters feel any better about the cost of our
iPods or rent checks. The one saving grace of the whole thing is that one day
us kiddies will be old enough to bore our grandchildren with stories of,
“back when oil was a hundred bucks”…and, if current trends continue, we’ll
have the best stories of all.

In the column below, Adrian Ash of BullionVault takes a closer look at the
age-old Central Banker conundrum. Enjoy…

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The Great Flood…of Money
By Adrian Ash

“The economy has been hit by two shocks,” said Andrew Sentance, a Bank of
England policymaker, in a speech on Tuesday night.

He was talking specifically about the British economy, but these two shocks
have smacked policy-wonks square in the face across the developed world.

The two ugly fists are “financial market turbulence and a sharp rise in oil
and some other commodity prices.”

“[They] are operating in opposing directions in terms of their impact on
inflation,” says the Bank of England’s man. “So judging the appropriate
monetary policy response will not be easy.”

But who needs to judge the right response when you’ve got a printing press?

Growth in the European money supply hit a 28-year record in October, the
central bank reported today (Weds).

The broad M3 money supply – “which the ECB uses as a gauge of future
inflation,” as Bloomberg notes – rose 12.3% from Oct. last year, the fastest
rate of growth since July 1979. But this monetary inflation can only rise
faster when November’s numbers come out late in Dec.

Last week alone, the European Central Bank promised to supply the money
markets with an extra €30 billion ($44.27bn) in short-term funds, “another
indication that the credit crisis is far from over,” as Sean O’Grady reports
for The Independent in London.

On Wednesday this week, the ECB made its biggest loan of three-month money
since April 2001. These short-term loans are designed to help ease upward
pressure on free-market interest rates, which have jumped sharply during the
recent credit crisis.

Resolving tensions in the financial markets is only one-half of a central
banker’s task, however. His other key responsibility – and central bankers
are almost without fail always male, if not men – is defending “price
stability”. In other words, inflation must not be allowed to rise above some
target or other, decided over tea and biscuits in the hushed conference
suites where politicians and central bank wonks chew the cud.

The inflation target is currently set at 2% in both Europe and the United
Kingdom. On Tuesday this week, however, the Federal Statistics Office of
Germany announced that consumer-price inflation in the world’s third-largest
economy will rise by 3.0% in Nov. –the highest rate of price increases since
Feb. 1994.

“A sense of impending inflation is currently influencing German consumers,”
warns the highly-regarded GfK consultancy. “The positive factors currently
evident, such as the sustained improvement on the job market and rising
incomes, seem unable to prevent the evaporation of optimism.”

“Solid anchoring of inflation expectations is all the more important in a
period of turbulences associated with this market correction,” as Jean-Claude
Trichet, president of the European Central Bank, said in a speech on Monday
this week.

That neatly sums up the head-scratcher now costing central bankers their hair
the world over. You either bail out the money markets with a flood of
liquidity…or you keep a lid on inflation.

You can’t do both, not according to history. And every so often – not least
when you’re bruised and beaten by a fearful credit crunch on one side and a
hateful oil-price shock on the other – it seems you can’t achieve either.

Just ask Andrew Sentance at the Bank of England. In Tuesday night’s speech,
he ‘fessed up to an inflationary mess that looks a little like this…

The US Federal Reserve, meantime, is also presumed to be targeting 2% annual
growth in its Consumer Prices.

But just like the ECB too, it’s also pumping money into the New York credit
market at a record clip.

Can central bankers really have it both ways?

The US Fed is forever making short-term loans to the money markets. Adding
liquidity is nothing unusual.

The Fed offers money to the big New York banks in exchange for good-quality
securities – securities such as, say, US Treasury bonds or government agency
debt. And it will lend money for anything between one day and two weeks or
more.

On any one day, you might find the New York Fed making two, three or more of
these loans. And between the start of 2001 and the end of last month, the
average sum lent in each of these auctions was $6 billion.

Since the start of this month, by contrast, each of the Fed’s short-term
liquidity auctions has averaged $10 billion. The quality of the collateral
that the Fed is accepting when it makes these loans has changed dramatically,
too.

 
The Fed has not always been so eager to accept mortgage-backed bonds as
security for the short-term cash injections it makes.

If the New York interbank lending rate needs a little shot in the arm to cool
it down, AAA-rated mortgage-backed securities are just fine. But the big
banks stepping up to the Fed’s auctions have always been keen to use more
mortgage-backed securities (MBS) as collateral than the Fed would accept.

Indeed, the ratio of MBS submitted to MBS accepted averaged only 55% between
Nov. 2000 and the end of July ‘07. More times than not, the Fed said “no” to
home-loan backed bonds and demanded US Treasury notes or agency debt as
collateral instead.

Since the credit crunch first bit at the start of August, however, the New
York Fed has relented somewhat. The ratio of MBS submitted to MBS accepted
when bidding for the Fed’s cash has risen to 85%.

And while the size of the Fed’s injections – as well as the volume of
mortgage-backed bonds held against them – have both grown substantially, the
frequency of those injections has also soared. There were 29 temporary Fed
injections in the first 28 days of November alone.

Over the preceding seven years, the New York Fed averaged fewer than 25
injections per calendar month.

But it’s not only the Fed that’s supporting the local housing market by
accepting mortgage-backed bonds as collateral for new loans. Last week,
Australia’s central bank lent A$500 million – some US$435m – in a series of
re-purchase agreements based on mortgage-backed bonds. Sales of Australian
mortgage-backed bonds to private investors sank by 94% between July and Sept.
So the Reserve Bank is stepping to try to fill the void.

“This is the [Reserve Bank's] first high-volume activity ever in this market
and may encourage further investor participation,” reckons Warren Mellor, an
analyst at National Australia Bank in Sydney, talking to Bloomberg. It might
just encourage Australia’s financial firms to park as much of their home-loan
inventory at the Reserve Bank, too.

Clearly, the flood of money trying to wash away the current slump in world
credit markets is truly global. This flood is certain to produce an
inflationary wave that will sweep across the developed world.

Prepare your life rafts.

[Joel's Note: Formerly City correspondent for The Daily Reckoning in London
and head of editorial at the UK’s leading financial advisory for private
investors, Adrian Ash is the editor of Gold News and head of research at
BullionVault – where you can Buy Gold Today vaulted in Zurich on $3 spreads
and 0.8% dealing fees.

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Rude Endnote: A quick thanks to everyone who wrote in with their thoughts on
going ex-U.S. Remember, to comment on any column all you need do is pen your
thoughts and send them to the below address. We’re always happy to here them.

Cheers,

Joel Bowman
Rude Awakening