Rodney Johnson President, HS Dent an independent economic research company How the Fed Is Changing Our World.

Rodney JohnsonPresident, HS Dent

an independent economic research companywww.hsdent.com

How the Fed Is Changing Our World

The World Has Gone Crazy

If economic news is bad, the market goes up, and if the economic news is good, the market goes down.

Everyone assumes the dollar will fall as the Federal Reserve prints more money.

What is the Fed doing, and why?

The Problem - Deflation

Less spending

Falling prices

Lower employment

Less income

Less spending

This is AFTER $700 billion in bailout, then $800 billion in stimulus, then $1.25 trillion in Fed purchases, which was increased to $1.4 trillion.

We STILL have the hallmarks of deflation!

The Fed Solution – Use Tools toForce Spending, Raise Prices

Interest rates - Lower rates make borrowing cheaper, lowering bar for ROI, causing payments on mortgaged items to be lower, punishing savers

Printed money – adding liquidity frees up credit markets, devalues currency, forces rational decision to buy hard assets or otherwise put dollars at risk, and lowers interest rates on longer maturity government debt, causing entire yield curve to fall

Chairman Bernanke’s Explanation of Quantitative Easing

Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing.

The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets.

Such purchases should in principle both raise asset prices and increase the growth of broad measures of money, which may in turn induce households and businesses to buy nonmoney assets or to spend more on goods and services.

In a quantitative-easing regime, the quantity of central bank liabilities (or the quantity of bank reserves, which should vary closely with total liabilities) is sufficient to describe the degree of policy accommodation.

Bernanke, 10-08-09, FRB Conference on Key Monetary Policy Developments.

Chairman Bernanke’s Explanation of Quantitative Easing

Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing.

The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets.

Such purchases should in principle both raise asset prices and increase the growth of broad measures of money, which may in turn induce households and businesses to buy nonmoney assets or to spend more on goods and services.

In a quantitative-easing regime, the quantity of central bank liabilities (or the quantity of bank reserves, which should vary closely with total liabilities) is sufficient to describe the degree of policy accommodation.

Bernanke, 10-08-09, FRB Conference on Key Monetary Policy Developments.

We have printed over $1.7 trillion out of thin air, with more to come, effectively betting the country on “idea,” “hope,” “should,” and

“may”!

5,500

6,000

6,500

7,000

7,500

8,000

8,500

9,000

9,500

10,000

10,5001995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Real Personal Consumption Expenditures January 1995 through June 2010

Missing Growth

Source: Bureau of Economic Analysis

Real Monthly Retail Sales

Unemployment Rate January 1948 – August 2010

2

4

6

8

10

12

1948 1958 1968 1978 1988 1998 2008

Source: US Census Bureau

Un

emp

loym

ent

Rat

e

Out of Work 6 Months and Longer,as Percentage of Labor Force

Ignoring the Facts

Government policy is ignoring the situation and motivation of consumers/investors.

The individual goal is to repair personal balance sheets, not collect more stuff.

Who Spends What in the Economy 2010

70.5%

12.6%

20.5%

-3.7% PersonalConsumptionExpenditures

Gross PrivateDomesticInvestment

GovernmentConsumptionExpenditures

Net Exports

Source: U.S. Department of Commerce, Bureau of Economic Analysis

18-22

Single

22-30

Young

Married

31-42

Young

Family

46-50

Family,

College

Kids

50+

Empty

Nesters 60+

Retired

Changes in Spending at each Age & Stage of Life

Spending By Age

2,500,000

3,000,000

3,500,000

4,000,000

4,500,000

5,000,000

5,500,000

1930 1950 1970 1990 2010

Immigration Adjusted Birth IndexIm

mig

rati

on

Ad

just

ed B

irth

s

Household Debt as % of Disposable Income, 1946-2009

Household Debt as % Disposable Income1946 - 2009

0%

20%

40%

60%

80%

100%

120%

140%

30-Year, 10-Year, and Fed FundsJanuary 88 through April 2010

Adjusted Monetary Base

Data from Federal Reserve

Federal Reserve Balance Sheetas of 10/20/10 in $ millions

The Trend Lower in Consumer Spending is Here

Consumer Metrics - Daily Growth Index Real Time Measure of GDP

Source: Consumer Metrics

Change in U.S. Debt Outstanding 2000 - 2010

Source: Federal Reserve Flow of Funds Report (FRB Z1), including Domestic Financial Sector

(1,500,000)

(1,000,000)

(500,000)

0

500,000

1,000,000

1,500,000

2,000,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Financial SectorHousehold MortgagesFederal GovtCorporate DebtState and Local Govt

The Fed Is Pouring Money In

While Borrowers and Lenders are Leaking Money Out

Amount of Money in the Economy

The Money Supply Fight

Outcomes – Desired vs. Actual

Wanted –inflation expectations, increased borrowing and spending, falling unemployment, higher wages, asset inflation (reinflation).

Got –split prices – deflation in services and real estate, inflation in commodities – local vs. global.

Workforce is a local commodity, and oversupplied, price is falling. But global trade makes agribusiness international.

Source: Casey Research

0%

10%

20%

30%

40%

50%

60%

70%

80%

Select Commodity PricesOct 2009-2010 Year-Over-Year Change

Who Gets Helped, Who Gets Hurt?

QE favors real assets, hurts dollars, so the question becomes, what is more important to your household, real dollars (dividends, interest, paycheck) or assets such as stocks, metals, commodities?

Assets Income

Who Gets Helped, Who Gets Hurt?

Wealthy households tend to hold assets, poor households tend to rely on income. While higher food/energy costs might annoy rich households, the increase in their assets more than offsets the price difference. Not so for the poor.

Affluent households own more hard assets

Modest households rely on earned income

Percent of After-Tax Income Spent on Food and Energy by Income

Source: U.S. Bureau of Labor Statistics, CEX, 2009

The Results Are Painful

“Food Sellers Grit Teeth, Raise Prices”

“Apparel Makers to Raise Prices”

“Earnings Continue to Climb Despite Higher Costs”

“Oil Rallies, Hitting 6-Month Highs”

“Sugar Near 30-Year Highs”

“Wall Street Expects 5% Bonus Raise”

All headlines are from the WSJ on November 4, 2010

The Fed Is Printing A LOT More

• Federal Reserve to print an additional $600 billion, bringing total printed to $2.3 trillion since March 2009.

• Fed will effectively “monetize” US debt issuance from November 2010 through June 2011… NO NEW TREASURIES!

Where Does Money Go In The End?

The Fed prints $1.7 trillion, buys MBS, some USTs.

Now the Fed uses runoff from MBS to buy more USTs.

What happens when USTs mature on the books of the Fed?

The answer will hurt your brain.

What Happens If Securities Just Mature?

“In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Federal Reserve mature or are prepaid.”

Bernanke, 10-08-09, FRB Conference on Key Monetary Policy Developments

At the end of each year, all excess monies earned by the Fed are turned over to the US Treasury, and are thereby an offset to US debt. In 2009, the Fed earned over $46 billion, the highest in history.

This is a basic “forgiveness of debt” for the US Govt.

Where We Are

In an effort to bolster economy, Fed has devalued dollar, pushed food & energy higher, pushed stock market higher, and pushed bond prices higher. The wealthy made more and the poor pay higher prices for necessary goods

In the end, US Government will have hundreds of billions if not trillions of dollars of debt forgiven through a central bank accounting maneuver.

Rodney JohnsonPresident, HS Dent

an independent economic research companywww.hsdent.com