APRIL 2011                                                                         Download PDF Version

Time for New Text Books?                                                                             

In a speech on March 11th 2011 at the Queens Chamber of Commerce in Flushing, New York William C. Dudley, the President of the Federal Reserve Bank of New York, and the second most powerful man in the Federal Reserve System, casually stated:

“The banking textbooks that were written prior to October 2008 are obsolete”

To give us comfort he uttered:

“People are worried that these (large scale asset) purchases are going to ultimately be inflationary — and I don’t think they have anything to worry about....”

The speech itself can be viewed on Youtube and this portion is in the Q&A session at the end of the main speech; it has been viewed only 103 times so far (three of these times by me!). The event was picked up due to his later remark which was along the lines — ‘Let them eat iPads” (I paraphrase).

Ipad Bill is not worried about inflation due to a new tool in his monetary armoury — namely the ability to raise the rates of interest payable on excess reserves.  This means that even though the Fed has pumped massive amounts of liquidity into the banking system if they raise the rates of interest they pay on it then the banks will leave the money at the Fed rather than lending it into the system.  Ipad Bill during his speech pretty well admitted that this is exactly what the Fed will be doing and therefore will aim to control inflation by constraining money velocity by strangling credit.  The classic monetarist inflation equation holds that:


Money supply is massive and therefore the Fed can only hold down inflation by tackling the velocity side of the equation.  I would suggest that text books don’t need to be thrown away so much as suffer a small revision.

money supply                                                          money velocity


Whether the Fed will actually need to tackle credit directly is a moot point. Banks are not lending anyway and the US consumer is frozen. By now a large number of US consumers are either in default themselves or know someone who is in default — the psychological effect of this cannot be underestimated. Furthermore every time they are filling their cars up with gas or their shopping baskets with food they are seeing the cash register reach a higher and higher number. However, things are never so simple and William Dudley’s comment about Ipads is worth considering; the diagram below shows how the average US consumer unit spends their money.

This diagram shows a number of interesting things, however, you can understand why the Fed thinks inflation is not going to get out of hand when you see what a large portion of average expenditure is spent on housing; 34%.  Housing has been flat to declining, as seen in the Case-Shiller index (see graph below).

Inflation measures are not equally weighted across the socio-economic strata. Therefore for the affluent (top fifth) of the population the deflation in electronic goods and labour markets is making them feel richer; that they are paying more for food and petrol is not a major concern. For the majority of the population they do not care about the prices of flat screen TVs — they are neither thinking of upgrading to a new one nor employing someone to clean it; they are definitely feeling poorer. Moreover if they are not renting their property but own it directly they will also be living with the knowledge that their main asset, their house, has fallen substantially in value. So the world is unfair — it was always thus — but pointing it out as Ipad Bill did was certainly courageous (and not something his Egyptian or Tunisian counterpart would have dared).

QE 2.5 about to set sail?

This time last year QE1 was coming to and end.  To be precise QE1 ended on April 21st 2010 — the S&P 500 peaked at 1,217 on April 23rd 2010 and then fell till the event in Jackson Hole in August when Bernanke announced QE2 and low and behold the markets subsequently rallied by 20% for the remainder of the year.  In this context it is easy to understand why people are nervous as QE2 comes to an end and talk of QE3 (or 2.5) now begins to circulate. Even if the Fed believes that current levels of inflation are a temporary phenomenon to embark on QE 2.5 would be to risk its fragile credibility, the loss of which would be very dangerous.

QE has also highlighted again the general investment inequality of this current crisis.  If we look at the equity market and the housing market under QE (as represented below by the S&P for equity and Case-Shiller for housing) it is clear that QE1 and 2 worked absolutely fine for the equity markets and had zero effect on the housing market. If you further consider that only the top affluent 10% of the population own equities in any meaningful way while housing makes up the bulk of the asset base of the remainder population it is clear who has benefitted the most.


The legitimacy of the Fed is at risk due to the continued unconventional actions of Ipad Bill and his colleagues. In effect they are getting caught in a ‘credibility trap’.

In an environment like this it is easier to list what to avoid rather than what to rush to buy.

To avoid:

  1. Fixed Income: It is not providing a ‘real rate of return’ and carries considerable duration risk.

  2. ETFs / Index orientation: Buying index exposure may actually mean you are exposed to companies that you would rather avoid. This is a better market for active managers.

  3. Asia / BRIC: Although a very good long-term investment the next 12-24 months may prove tough for traditional allocations.

To analyse / invest in:

  1. Active, non-indexed and long-only managers: A perfect market for good and proven managers — especially with a value orientation.

  2. Global-Macro funds: In the huge universe that covers ‘Hedge Funds’ these funds have proven to be reliable and a true diversifier of risk with the portfolio. Emphasis to be placed on funds that can provide liquidity.

  3. Certain thematic investments: I will be writing more about such investment in the future, however, long-term themes that might take 3-7 years to ‘play out’.

Please do not hesitate to contact Christopher Andrew:

Christopher Andrew
Tel: +44 20 7060 1400




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