BEST OF DOUG NOLAND

December 14, 2005

Considering the rather unequivocal ongoing massive Credit inflation, it is surprising how much I still read about deflation. Those adhering to this view these days point first to Treasury and global market yields. I certainly don’t want to dismiss these markets out of hand. Yet the "Flow of Funds" data rather pointedly illuminate ongoing historic Credit excesses, as well as the return of this unprecedented liquidity back to U.S. securities markets (largely Treasuries, agency securities, ABS, corporate bonds, and "repos."). Having studied and pondered these dynamics for some time, I believe a strong case can be made that we are in the midst of a marketplace liquidity dislocation. Perhaps market yields are today no more discounting prospective fundamentals than technology stocks and telecom bonds were back in 1999/early 2000. While unsustainable, these types of liquidity dislocations are nonetheless powerfully self-reinforcing – and just what we would expect from history’s greatest Credit Bubble.

Considering the unequivocal ongoing massive Credit inflation, it is also surprising how often we hear that the Fed has about wrapped up this tightening cycle. The Problem with Telegraphed Baby-Step Tightening-Lite is that it specifically operates to safeguard a Credit system that has become increasingly dysfunctional over the life of the boom.

There is absolutely no direct effort by the Fed to restrict Credit Availability or Marketplace Liquidity, only faith that somewhat higher funding costs at the margin will work their magic. But asset prices – the main driver of Credit expansion and liquidity excess – have been inflating much more rapidly than financing costs have been rising. Destabilizing boom-time Monetary Processes (securitizing risky mortgages, leveraged securities speculation, and the repo market – to name a few) that evolved to fuel recurring asset inflation/Bubbles are not only not repressed, they are harbored.

To be sure, we have been witnessing real-time the dynamics of monetary policy falling only further behind the curve. In a robust Credit Bubble environment, baby-step rate increases virtually guarantee that Inflationary Manifestations will be easily monetized. Credit-induced real estate inflation begets accelerating Credit growth (additional borrowings to finance more real estate transactions at higher prices). Continued Credit expansion fuels rising incomes (and certainly rising wealth disparities). These higher incomes then support ongoing real estate inflation, as well as broadening Inflationary Manifestations such as intractable Current Account Deficits and rising prices for energy, commodities, collectables, tuition, medical costs and a broad range of goods and services. As always, Credit excess begets Credit excess.

The white hot national housing market finally appears to be cooling somewhat. It is possible that the third quarter will mark the peak in mortgage debt growth. I remain, however, unwilling at this point to call a top in the Credit Bubble. I would be very surprised if mortgage Credit growth slows rapidly. Additionally, other sectors in the economy – notably energy, commodities, and exports – have heated up considerably, and appear poised to take up some of the potential Credit system slack a slowing housing market would provide. The Q3 2005 "Flow of Funds" argues very convincingly that the Fed still has plenty of work to do.