Economists in Denial?

Yesterday I went to lunch with a group of economists to discuss the recent disaster in the credit markets.

Here are the main concerns we discussed.

1. The effect of the Fed's purchase of more that $1 trillion of securities and the inevitable inflation arising from the injection of all that high-powered money.

2. The possible inflation coming unless the Fed can sell those securities promptly and reduce the monetary base.

3. The inability of the Fed to begin to sell the hundreds of billions of dollars while unemployment surges.

4. The effects on the falling value of the dollar for government borrowing. No one will want to own dollar denominated assets in this environment.

5. The effects on long maturity interest rates of Treasury borrowing, Fed selling, prudent risk managers not buying, and the dollar dropping.

In summary, most agreed that the situation is far from normal and will not return to normality until the economy recovers and the Fed can pull all this high-powered money out of the system.

That is a long way off.

Yet, three surprising opinions emerged.

1. The cause of inflation. Someone repeated the old confusion about inflation being caused by too much growth rather than too much money. It is astonishing to me that this debate has any credibility at the senior levels of macro analysis.

2. The effects of inflation on the bond and dollar markets. There was little concern over the disaster the US economy is facing and and underestimation of the time it will take to solve this problem.

3. The failure to place the blame for this disaster where it belongs: on Congress, Fannie and Freddie, the SEC, Greenspan's Tsunami in the Fed Funds market beginning in 2004, and unregulated Credit Default Swaps. This is most troubling for future disasters.

TACTICS FOR PORTFOLIO RISK MANAGERS
Brace yourself for higher long rates, a falling dollar, and continued high unemployment.

Extend the maturity of your liabilities as much as you can. The cost of borrowing farther out the curve - as much as 450 basis points - will deter many portfolio risk managers, but those who do will be favored when the yield curve flattens and rises.

It's time to tell senior management and the board that we're in for heavy weather.