The NY Fed has a very good piece on their blog this morning titled “Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?”   It helps shed some light on the current economic environment and shows why investors should not be too quick to assume that high inflation will result from the commodity price increases.  They say:

“In 1937, on the eve of a major policy mistake, U.S. economic conditions were surprisingly similar to those in the nation today. Consider, for example, the following summary of economic conditions: (1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.”


They go on to show how economists now focus on headline CPI and not the volatile parts that include commodity prices.  This helps “smooth” their outlook and avoid jumping to conclusions.  Interestingly, however, the current Fed may have made the exact opposite mistake in 2010.

In August 2010 the Fed panicked over the Euro crisis and a sharp spike in jobless claims that coincided with a few weak economic reports.  At the time, prices were in a strong disinflationary trend.  And they responded.  QE2 was the result.  The NY Fed described the 1937 period as a failed response to the rise in commodity prices at the time – in effect, they tightened when they shouldn’t have.  You can see the rise in commodities in the following chart:

Ironically, QE2 preceded the most recent surge in commodity prices.  And as the BOJ concluded, the Fed and speculation has likely contributed to this rise in commodity prices.  As I’ve stated before, this sort of misguided intervention can have a destabilizing effect on the economy.   So, interestingly, it’s not the response to the commodity price spike that may have been the policy error this time around  – it was the misguided response to price declines, resulting in QE2 that appears to have created the current air pocket in the global economy….


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • prescient11

    I know everyone here thinks the Fed is populated by pure morons, but I would beg to differ.

    They are setting up working papers to support long term low rates and QE and stimulus! Hell, the damn Fed should be buying corporates direct, screw the treasuries.

    I would say that the beast that BB is fighting is the absolute collapse of shadow money, and they are very much aware of this. The deflationary winds are massive… If he could figure something out on housing, they would be in much better shape.

  • T. Blazedman

    I agree. They may have an agenda not everyone agrees with, but they aren’t dummies. They genuinely will believe what they are doing is the best way to address priorities as they see them….

    That just may not happen to jive with the priorities of ‘the little guy’.

  • boatman

    the FED is using the only tool they have, with a list of bad side effects.

    seen the dow tanking on ISM numbers?….they will be using this tool directly again… and on at least til election day…..17 months.

    as long as real interest rates are below inflation precious metals go up.

  • Roger Ingalls

    Here’s something they could do on housing.

    1. Allow more lenient terms on no cash out refinances. Presently there is an enormous number of borrowers that have the demonstrated capacity and willingness to pay mortgages, but cannot qualify for a refinance. Examples would be those who do not qualify for HARP/underwater refis because their loan was not a Fannie or Freddie loan originally, and many (perhaps most) self-employed people that cannot document an adequate income to qualify for a refinance.

    2. Allow documented self-employed borrowers to qualify for purchases based on a more relaxed debt to income standard, using Fannie, Freddie and FHA guidelines and securitization. There is a demand for housing from self-employed borrowers. We used to be able to use stated income (and yes, it WAS clearly abused) to allow self-employed people to buy homes on decent terms. Sufficient safe-guards could be instituted to curb the abuse of the terms.

  • prescient11

    Unfortunately, the Fed does not lend to consumers. They are doing everything they can to help with our debt service – i.e., forced low rates, but that’s about all they can do there.

  • prescient11


    We should look at each other’s portfolios. The only wildcard here is election day. Someone like Christie gets into office and I take all risk cards off the table immediately except for true fundamentals, because then you will see the dollar rally like mad.

    While the clowns are running the show, up to maybe 4 months before the election, my strategy is long commodities and mining shares.

  • But What Do I Know?

    The Fed will do whatever it takes to justify their “This is 1937 meme,” but it’s important to account for the differences, not just the similarities–if one wants to be intellectually honest, and not just provide propaganda for BB and QE 3. Sure, there are some resemblances between now and 1937, but there are also some glaring dissimilarities as well. Let’s start with oil. In the thirties, oil prices had to be controlled by the Texas Railroad Commission because they were too low! The problem was not resource scarcity, but rather overproduction. Government spending was a small fraction of what it is now in proportion to the economy, the price of gold was fixed, we were at peace, the stock market was valued far below its recent peak, not at almost 80% of it, the dollar had strengthened against most foreign currencies in the last five years, the demographics of the population were vastly different, etc. I could go on and on, but to cherry-pick a few friendly facts to the exclusion of a multitude of unpleasant ones is the trick of a rhetorician and not the method of a scientist.

    And after all, if this is 1937, we must have been through a Great Depression in 2007-2008. If BB and the Fed economists couldn’t see that one coming, why should we trust them now?

  • But What Do I Know?

    Two more things: Their points (1) and (2) above are straw men: Who the heck outside of DC and NYC thinks the recession is over, and who the heck thinks short-term rates are expected to rise? Those two statements are pure BS. Garbage in, Garbage out.

  • Midwest FA

    From 1929 to 1932 the economy contracted by a total of 45%. Unemployment reached 25%. Combined with underemployment the figure totals up to a staggering 50%.

    A credit freeze followed by unwinding decades worth of over-indebtedness could easily have had the same result. We have roughly 2% or so inflation despite commodity price increases because we still have too much slack in the economy. Deflation remains the larger risk.

    While I am fond of pointing out the danger of thinking “This time is different”, in truth, every time is different. This time, we had a Fed Chairman with a PhD thesis on the causes of the great depression. We were never going to repeat it. But the potential forces of powerful contraction remain.

    I, for one, am glad that there are very intelligent, highly educated, caring people who are aware of history and doing their best to avoid a repeat.

    As for whether we are in a recession or not, it’s merely a matter of definitions. Is a recession over when growth starts anew? That’s the traditional description of the end of a recession. Using that description, you will be out of a recession, but not yet out of the whole it created, when you are at the beginning of growth.

    If, instead, one uses the description that I think the general public would relate to, that we are in a recession until GDP exceeds its old highs, then, maybe we are still in a recession. This too, however, is debatable. It depends on whether you use nominal or real GDP. The raw number, “real” GDP, has made new highs. But the average person is going to feel like it’s still a recession for some time to come for two reasons. First, we live in an inflation adjusted world, and that number, “nominal” GDP, has not yet hit new highs. Secondly, for the average American, it’s not going to feel better until we are earning as much as we did before, and our net worths climb back up to their old highs.

    The sad truth about depressions and recessions is that they tend to result in greater concentration of wealth and income. So while the economy as a whole is near its 2007 highs, income and wealth disparities have grown, and the average person has fallen farther behind.

  • Mediocritas

    My goodness….that quote was really from 1937? Wow.

  • prescient11

    we had a Depression, instead of a huge recession, because the dollar was gold back then and the whole of Europe defaulted.

    I do not see that in the cards this time, but who knows!

  • Mediocritas


    What really needs to happen regarding housing is to address the gap between price paid and market price today. This is the primary source of psychological malaise amongst the (underwater) middle class that is contributing to the death of the economy.

    Servicing interest on a overvalued principal leads to more defaults (many strategic). Adjusting interest repayment down to a level that reflects what would be owed on the current market value would be a big help (in other words, effectively reducing the principle), but I suspect the principle gap is the primary problem. People got sucked into a Ponzi scheme and it got so far out of hand that it is not feasible to say “buyer beware” and expect economic recovery. The correct way to repair any ponzi is to reverse all transactions as far back as possible, stripping the winners of their ill-gotten gains to make good the losers.

    In this case, stripping the winnings means stripping capital gains from people smart enough to sell into the housing boom. That’s not really fair or possible. So the better approach is to write down principles on existing loans to match market reality, leading to repaired owner psychology, a lesser interest burden and fewer defaults. Banks will take a big hit as they have to cover the gap, so the Fed should make them good (upon being furnished evidence of a write down) via an expansion of base money, then increase reserve requirements or tighten monetary policy to prevent a resurgence of general or targeted inflation.

    It’s quite possible that sufficient expansion has *already* been conducted as evidenced by excess reserves from QE1. Banks should already be able to start writing down principles, eating into QE1 cash to cover the gap. The unintended consequence might be that derivative holders (based on mortgage debt) will have to take a haircut, not in principle, but in yield, but that would happen anyway with loan interest modification (although this is a non-event for Fed-owned MBS). The complexities of potential cascades in the derivatives markets may be the reason loan mods have been so slow to occur to date.

    They never tried this in Japan.

    Anyway, my 2 cents.

  • But What Do I Know?

    >>>I, for one, am glad that there are very intelligent, highly educated, caring people who are aware of history and doing their best to avoid a repeat.<<<<

    Rather than repeat the same "mistake" they will no doubt make different "mistakes." As for being highly educated and intelligent–well, IMHO, all the education and intelligence amounts to is being able to better justify and obscure their biases. Recession and a falling stock market are not the worst things that could happen.

    BTW, did anyone else notice the proof of MMT in today's Daily Treasury Report? The checking account went up by about $60 billion with no increase in debt (and it wasn't due to tax receipts). . .

  • Mitch83

    Hi Mediocritas,

    I generally agree about the current negative forces / psychology / balance sheet problems etc., but…

    “the Fed should make them good (upon being furnished evidence of a write down) via an expansion of base money”

    …the Fed can’t inject “capital” (equity) into the banks. You had to change the laws to allow it actual “money printing”.
    Even at the end of 2008 the Fed basically just made markets in illquid instruments (it swapped “toxic” MBS for reserves). But it can’t make markets in housing.

    Only government spending can inject “capital” (net financial assets) into the private sector in the current situation to repair balance sheets. Government spending is also better than your proposed “helicopter drops” for banks because it additionally spurs aggregate demand (the private sector has to provide real output, e.g. building infrastructure).
    But of course even these “helicopter drops” were more helpful than nothing atm.

  • Mediocritas

    I understand the mechanisms of asset swaps but I think people aren’t looking at things the right way. Sure, swap “assets” for reserves and net money supply does not change, but it’s not technically correct to say no printing was involved. A swap involves a trade of money quality (not quantity). Credit (vanishing) is being swapped for base money and so base money must expand to offset the removal of credit from the system (as the Fed takes ABS onto its books). Semantics maybe, but one can’t look at base money and deny this. The Fed made banks good in QE1 by printing base money and calling it reserves. It had no net effect on net money supply because it wasn’t expanded into credit due to a balance sheet recession and the assets acquired by the Fed were effectively removed from the system canceling out the money that was spent to acquire them in the first place.

    The Fed is now sitting on a huge unrealized loss. ABS acquired by the Fed were taken on board at original market value, a massive overpayment for something worth very little. Had the Fed allowed natural market forces to mark this garbage to market while still on the books of banks and then managed to get our money supply into the same state it is today, nobody would have any doubt that the Fed had engaged in a huge amount of “money printing” to offset bank losses. All the Fed did was be clever and short-cut the process but the mechanism is essentially the same. One way, as you point out, is legal, the other is not, which is a pretty crazy aspect of our system, like saying it’s illegal to drive above the speed limit, but it’s OK to do so if the car is in reverse. Wordplay. The law can be changed (and would be if needed). But point taken, as it currently stands, if the Fed is going to push money into the system, there has to be an equivalent reverse flow (that can be temporally offset) as there is under an asset swap.

    So if banks won’t voluntarily engage in principal writedowns because they don’t believe the Fed will be able to legally make them good, then they should invent some new paper, swap it to the Fed and let the Fed make the writedowns. There’s no precedent for the Fed taking such massive losses on the books, and I’m not sure of the legal ramifications of the Fed simply doing it rapidly and wiping losses away as if they don’t exist (which is essentially the same as just flat-out printing money and helicopter dropping it to banks), but there is a more obvious solution. The ABS swap is a REPO. The Fed is simply taking the heat out of the system for as long as necessary and, I’m assuming, can sit on an unrealized loss indefinitely, allowing banks to trade/earn their way back into a position where a reverse swap can be afforded concomitant with a realized loss, maintaining system equilibrium while reducing amplitude.

    If the economy stinks so badly that banks don’t have any mechanism by which to earn their way to the uber-REPO (balance sheet recession), then the Fed engages plan B, flushing money into the system via OMO, handing primary dealers free commission in the process and allowing the government to distribute cash into the system so that banks can try to earn it back. All above board because the process is zero sum (QE2).

    Now the problem I have with this, and a core criticism of QE2 is that allocation via government spending creates biased benefit towards that sub-section of the private sector that does business with the government, promoting inefficiency and hampering recovery. (I discussed this extensively in a prior thread, but it’s way too hard to find past articles in the blogosphere). As I said back then, and have maintained from the start of this crisis, the helicopter drop should have been unbiased and the government should stay the hell out of deciding where the cash gets spent. Instead leave that to millions of minds to decide by simply crediting them, because they’ll do a better job. Deficit spend to fund citizen dividends. Simple. As it stands, government administrators are meddling too much and doing a bad job of allocation, as central planners always do. QE2 had the potential to be a good idea, but the govt messed it up.

    The Australian government actually did the citizen dividend (helicopter drop) and it worked well:

    Where I was critical of the Australian govt is that the citizen dividend was actually a smoke screen to hide a larger backstopping of the four main banks (and to provide deposit insurance which hadn’t existed prior). Plus, the oz economy wasn’t so weak that it actually *required* such an event in the first place (Chinese commodity demand remained strong).

    If I were somehow in charge of the US economy back in 2008 I would have simply let it all come down and hand out a regular citizen dividend (fortnightly) to all registered taxpayers (individual and corporations) at an amount proportional to prior tax paid (this way hands the most money to individuals with the best track record of actually being productive (and honest)), at a rate that offsets credit destruction. The financial sector would have plenty of opportunity to earn that cash from the private sector in order to offset losses, the weak would die out, the strong would pick the carcasses clean. The prudent would be rewarded, the reckless would have to fight hard to stay afloat (not just in the financial sector). The result would be a healthier economy in the end, without having to experience a catastrophic deflation. A sovereign currency issuer can do this. There may be some noise in bond markets as some participants failed to understand what was going on, but in the end, if done properly, and net money supply was managed well, recovery would occur faster than it is now and bond markets would be healthy.

  • Cullen Roche

    Good comment.

    The only thing I disagree with is regards to ABS and money printing. You can only call it money printing if you assume the assets were worthless. And I refuse to believe that all that paper backed by FNM & FRE was worthless. That is essentially saying that govt paper can go bad. That’s not accurate in my opinion.

  • james

    has the fed ever gotten it right?

  • Mediocritas

    I think of it as “temporally displaced money printing” and consider it so even if ABS have value, but that value is less than what the Fed paid (and the Fed has no real chance of swapping back at original price). If a perfect unwind occurs (which *is* actually possible I think) then yes, at that time, there would be no residual, no money printed.

    I don’t envy the Fed its task here. We had huge inflation, it just wasn’t seen in CPI because it clustered in dense pockets (housing, stocks, etc). To fix the economy, the Fed needs to deliberately cause deflation in those same pockets without it leaking out. Principal writedown is the way to go, but banks have to ultimately wear it to keep deflation contained. That’s going to be a hard sell for the banking union representative (aka Fed).

  • Cullen Roche

    I agree. It’s partly why I sympathize with the Fed. So much is demanded of them, but they don’t have the tools to deal with it all. They’re in a tough spot now.

  • Otto Maddox

    I don’t disagree that there are a lot of VERY smart people at the Fed. The real question is whether they are smart enough to centrally plan an economy via monetary policy. It looks to me like they’re failing. As Hayek said:

    “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

    Let’s not get carried away with the notion that a very smart person or group of very smart people can organize and direct the economic behavior of hundreds of millions.

  • Blobby

    True, I don’t doubt the Soviet Union had a similar pool of intelligence.
    They beat the US into space remember.
    Their central planning was a disaster.

  • Andrew P

    It probably wouldn’t work, and they would have to do it again and again. It is better to let all underwater mortgages be foreclosed, the banks go bust, and the FDIC can sell all the real estate in bulk to the Fed. The Fed then becomes the world’s biggest landlord for the next 50 years, after which time the houses are sold for their salvage value.

  • Willy2

    A load of BS. In 1937 FDR increased dramatically taxes and that has put the break on the CPI. (=less demand).