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In the past I have referred to Henry Kaufman as "The Master of Macro Credit Analysis." To state that I am a huge fan and admirer is an understatement. His 1986 "Interest Rates, the Markets, and the New Financial World," and 2001 "On Money and Markets: A Wall Street Memoir" are must read "classics." So it was a real treat yesterday to see him interviewed by Bloomberg’s Kathleen Hays. Many readers likely didn’t have the opportunity to catch it, so I will share the exchange this evening. I found his analysis characteristically exceptional and, I'm pleased to say, virtually in complete agreement with our view (and I certainly couldn’t have said it as clear or concisely!).

Bloomberg’s Kathleen Hays: "He is one of the world’s most respected economists and credited, in fact, as the founder of Fed watching – a very popular sport for the financial markets especially just one week before the Fed’s next policy meeting. With me now is Henry Kaufman…"

Kathleen Hays: "So let’s take a look at where the Federal Reserve is now, because there have been many people in the markets complaining loud and long about Ben Bernanke and his colleagues talking too much about inflation – worrying too much about inflation. When you put Ben Bernanke in context, when you think of Alan Greenspan’s first months on the job - when you think of Paul Volcker taking over as Chairman. How is he doing and do you share any of those complaints?"

Mr. Henry Kaufman: "I don’t think his job is any more difficult now than when either Paul Volcker or Alan Greenspan came in. Paul Volcker came in at a very difficult time, when the dollar was under attack, when the inflation rate was exceedingly high, when Federal Reserve credibility was not very high. Alan Greenspan came in at a time when interest rates were still relatively high – but not that high, but shortly thereafter the stock market declined 500 on the Dow on October 19^th. Both of those Chairmen initially served in a very turbulent period of time. And the time since Ben Bernanke has gotten into that assignment has been rather modest and comfortable, considering."

Kathleen Hays: "Well, except there’s been a big sell-off in commodities and a big sell-off in emerging markets the last couple weeks since he really came out stridently against inflation – signaling that he is going to fight inflation more than he is going to worry about economic growth – if I can paraphrase the Fed Chairman."

Mr. Henry Kaufman: "Well, I think it is very difficult to think about the economy without thinking about inflation here. The sell-off in all these market which you spoke about just now occurred against a substantial increase in the values of all of those commodities prior to that sell-off. And I think it is incorrect to believe that prices just go up and up and up without any kind of correction."

Kathleen Hays: "Some people are worried that Ben Bernanke is going to over do it - Ben Bernanke and his colleagues at the Fed - because they are going to keep raising rates in part because they have to prove they’re good, strong inflation fighters – they’re going to go too far and push the economy into recession. Do you worry about that?"

Mr. Henry Kaufman: "I don’t worry about that for the immediate future. I worry a little bit more about the probability that the Federal Reserve has missed its timing all along, and therefore whenever you miss your timing there is a penalty to be paid. But that is not in the immediate future in terms of the economy sliding into an economic recession."

Kathleen Hays: "When you talk about missing their timing… the Bernanke Fed or the Greenspan Fed?"

Mr. Henry Kaufman: "I think it started before Ben Bernanke. It started earlier – under the previous regime."

Kathleen Hays: "You’re saying that the Fed’s timing is off. Do you think the Fed has somehow gotten behind the curve? Not a lot of people arguing that it seems, but is that what you’re saying?

Mr. Henry Kaufman: "I believe the Federal Reserve is behind the curve. And it’s very difficult to get back on the curve without some problems. For example, you start with the year 2000 to the present. We’ve had a very substantial expansion in non-financial debt – the debt of households; of business; of corporations. The expansion in debt has been much greater than the increase in nominal gross national product. That (non-financial debt) increased 5%, 6%, 7%, 8%, 9% in each of those consecutive years and in the first quarter by 11%. Nominal GDP increased less than 50% of that. So, therefore, we’re seeing an event taking place that the Fed has not correctly calibrated. To get back into some normalcy and some adjustment - is going to be difficult. And I don’t think the Fed will attack that issue very quickly."

Kathleen Hays: "Should the Fed get more aggressive? Some people say there is a small probability that the Fed might do an increase of 50 basis points, twice what they’ve done in the past two years at least."

Mr. Henry Kaufman: "Well, the tendency for the Federal Reserve in recent years is to pursue two approaches: measured response and transparency. Measured response has meant 25 basis point increases in the funds rate after each meeting of the FOMC. Transparency has tried to tell the market what they’re about to do. That does not give you control over Credit creation. In the new financial markets that we’ve lived in over the last decade or so, financial markets are vibrant - they’re calculating. And when you tell an investment banking firm - a commercial banking firm – that it’s 25 basis points, there are many people who will analytically tell you what the risks are in the market along the interest-rate curve or in other Credit instruments, and will take the opportunity to leverage those positions and extend Credit. This is a dilemma that the Federal Reserve does not want to tackle."

Kathleen Hays: "Let’s really look at that, because you’re saying that if you signal it as Greenspan did – Greenspan started at 25 basis points, no surprises, measured pace – you’re saying they adjust and they go ahead and issue Credit anyway. And what the Fed is trying to do with higher interest rates is to stop the creation of Credit or slow it down. So you’re saying their own policy has made it impossible for them to do what they want to do?"

Mr. Henry Kaufman: "That’s right. This is one of the main reasons why the yield curve has flattened – where intermediate and long-term rates have not risen above the short-term interest rates. And that the Fed does not want to tackle, because tackling financial market behavior in a more direct way is far more difficult to do. It’s complex. And for most participants in the marketplace, it’s not desirable."

Kathleen Hays: "Global central banks raising their interest rates. Some people say they are sucking liquidity out and that could cause market instability and some sort of uglier times ahead."

Mr. Henry Kaufman: "The extent to which liquidity is being sucked out – so to speak – is very modest. In Japan, interest rates have been at zero. In Europe, they’re below 3%. In the United States, our interest rate structure from a historical perspective is still moderate. A Fed funds rate at 5%. Ten-year government bonds at 5.19% or 5.18% – wherever they are today. These are not extraordinarily repressive interest rates. Today, anyone who really wants to borrow can borrow. Today, anyone who wants to borrow creates Credit. And the Federal Reserve is not yet at that point where there is some pain in the system."

Kathleen Hays: "What is the main takeaway people should have right now from Federal Reserve policy and this interaction you’re talking about with the financial markets – where the Fed raises rates but it does it in such a way that the big financial institutions continue to create lots of Credit. So, even as we look and talk about rates going up and how the Fed’s tightening, you’re saying that’s not happening. What should the Fed be doing now? What should investors be anticipating as all these forces come together?"

Mr. Henry Kaufman: "The Federal Reserve is going to have to decide when to abandon this measured response of 25 basis points. That’s a very difficult chore for them, considering how long they have pursued this policy here in the past. Secondly, I think as financial market participants we will continue to create a lot of Credit until there is much more uncertainty in the interest-rate structure. I think there is going to be significant volatility in the financial markets over time. But for the time being, looking out into the rest of this calendar year and part of next year, economic expansion will continue, even though the volatility in the financial markets will probably pick up."

Kathleen Hays: "Final moments, how high do you expect the Federal Funds rate to go?"

Mr. Henry Kaufman: "I really feel that somewhere in the next twelve months we’ll head to at least 6%."

My brief comments: Yes, "the new financial markets…" As analysts, we must routinely remind ourselves of how we reside in an (unparalleled) Era of Unlimited Global Finance. Whether it’s much higher oil prices or higher rates, unrestrained and overheated global Credit systems will tend towards indifference when it comes to dynamics that in the past would have acted to induce lending, liquidity, and general financial market restraint.

Agreeing with Mr. Kaufman, "I think it is very difficult to think about the economy without thinking about inflation here." As long as prices (real and financial assets, products and services) are tending to inflate at a pace ahead of comfortably rising interest rates (or, in the case of Japan, near zero cost of funds), there is sound analytical basis for expecting (disparate) inflationary pressures to strengthen in the face of "telegraphed baby-step" rate normalization. Rising rates do not imply restraint, particularly in a Credit Inflation Bubble Environment characterized by asset-based lending. Excess surely begets excess until there is sufficient monetary pain meted out to pop financing and asset Bubbles, in the process quashing (what have evolved into highly intransigent) Inflationary Monetary Processes.

Today, these "Processes" include the Mortgage Finance Bubble, the global securities finance/leveraging Bubble, the derivatives Bubble, an increasingly global Bubble in "structured finance" generally, the global leveraged speculating community Bubble, The global M&A Bubble, the Global Dollar Reserves Bubble, the China Bubble, and myriad others. Quite problematically, these powerful inflationary forces are now deeply embedded into the global financial and economic landscape. As such, the notion of a coveted soft-landing has become contemptibly inapt. And a failure to act with determination and forcefulness on the monetary front is to only accommodate the current structure of gross excess and resulting imbalances. There really is no room left for compromise at this point – no letting the air out gently over time. Ironically, the professor that has blasted the late-twenties "Bubble Poppers" will, inevitably, have the unenviable distinction – one way or another – of having Bursting Bubble Turmoil Befoul his Fed chairmanship.

Bond markets have been buffeted of late by the recognition that even meaningful global equities and commodities markets downdrafts are likely to have little impact on general Credit Availability and Credit market liquidity. The hope that rising oil prices would slow spending has faded, as has the hope that a housing slowdown would do the trick. Instead, energized global economies maintain quite a head of steam, while frenetic financiers and market participants are in the mood to do anything but roll over and succumb to timid little monetary restraint. There are still perceptions of way too much easy "money" (financial "profits") to be made and little fear that the neophyte Bernanke Fed has the mettle to take on the markets.

Still, the previous consensus "worst-case" scenario of 5% Fed funds is giving way to a marketplace-troubling recognition that the rate outlook today is in the process of turning open-ended. If the Fed and global central bankers actually intend - or at some point become compelled - to impose major financial conditions restraint, how high might rates have to eventually go?

The Fed and global central bankers are not only behind the curve, they are in aggregate significantly behind the curve in the context of a highly unusual and uncertain financial and economic backdrop. Uncertainty now reigns over interest rate markets globally, which implies uncertainty in the currency markets and financial markets generally. In this age of unrestrained and integrated global securities finance, low interest rates in Europe and Japan act as a strong countervailing force to Fed rate increases. Yet the ECB and BOJ are hamstrung by an overall tenuous backdrop, forced to follow the Fed’s course of slow, measured rate increases. This might support the dollar in the short-term, but at a cost of an unanticipated and potentially destabilizing jump in U.S. yields.

To what extent the recent surge in yields has instigated a self-reinforcing unwind of leveraged trades – certainly including interest-rate derivative/mortgage hedging-related selling – is difficult to assess this evening. But if Fed funds are on their way to at least 6%, as Mr. Kaufman forecasts, then there is likely sufficient liquidation and market tumult on the horizon to pose a serious challenge to the indefatigable U.S. Credit Bubble. Extraordinary marketplace uncertainty and volatility is about the only safe bet for awhile.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.