Global financial markets remain unstable, although U.S. markets somewhat stabilized. For the week, the Dow declined about 1%, while the S&P500 was about unchanged. The Transports and Morgan Stanley Cyclical index were also unchanged. The Utilities and Morgan Stanley Consumer index declined about 1%. The broader market remained on the defensive, with the small cap Russell 2000 and S&P400 Mid-cap indices both ending the week with losses of just under 1%. Technology stocks were unimpressive. The NASDAQ100 was about unchanged, while the Morgan Stanley High Tech index suffered a nearly 2% decline. The Semiconductors and NASDAQ Telecommunications indices lost 1%. The Street.com Internet index was unchanged, leaving 2004 gains at about 5%. The Biotechs posted a small decline, with y-t-d gains of about 3%. The financial stocks seemed to regain some composure, with the Broker/Dealers rising 1% and the Banks posting a small gain. And while bullion dipped another $2.10, the HUI gold index mustered a 5% gain.

Today's strong performance ended a volatile and nervous week for the bond market. Two-year Treasury yields declined 8 basis points this week to 2.54%, with 5-year Treasury yields down 6 basis points to 3.88%. Ten yield Treasury yields were unchanged at 4.77%, while long-bond yields rose 2 basis points to 5.49%. Benchmark Fannie Mae mortgage-backed yields declined 18 basis points, recovering from last week's dismal performance. The 10-year dollar swap spread declined 3 to 51.75. Agency spreads also narrowed after last week's widening, while investment grade and junk spreads widened further. Junk performed poorly. The implied yield on December 3-month Eurodollars dropped 14.5 to 2.44%.

Bloomberg tallied a slow $4.16 billion of corporate issuance this week. Investment Grade Issuers included Encana Holding Financial $1 billion, Brinker $300 million, Thomson Corp $250 million, EDS $200 million, Duquesne Light $200 million, and PPL Capital Funding $100 million.

Junk bond funds reported $2.15 billion of outflows for the week (from AMG), not far below the record $2.56 that left funds during the week of August 6, 2003. Companies including Revlon and Samsonite cancelled debt offering due to market conditions. Junk issuance included Milacron Escrow $225 million, Consolidated Container $200 million, Lazydays RV $150 million, Buffets $130 million, and Ainsworth Lumber $110 million.

Convert issuance included CV Therapeutics' $125 million.

May 14 - Bloomberg (Jennifer Ryan): "High-risk, high-yield European bonds had their worst week since February as a bear market forced companies to reduce sales of junk or scrap them altogether. Brenntag AG, a German chemicals distributor that was seeking funds to finance its purchase by buyout firm Bain Capital LLC, U.S. luggage maker Samsonite Corp. and Debenhams Plc, a U.K. department-store chain, pulled or cut sales worth about $1 billion in total. Companies are scrapping or scaling back sales of junk bonds as the prospect of higher U.S. interest rates prompts investors to shift funds away from fixed-income securities."

After last week's breach, Brazilian benchmark bond yields declined 38 basis points to 11.6%. Russian 10-year Eurobond yields declined only 4 basis points to 6.92%, with Mexican bond yields declining 24 basis points to 6.33%.

Freddie Mac posted 30-year fixed mortgage rates surged 22 basis points this week to 6.34%, the highest since the week of September 5. Long-term fixed rates were up 94 basis points in seven weeks. For the week, 15-year fixed-rate mortgage rates jumped 25 basis points to 5.72% (up 102 bps in 7 weeks). One-year adjustable-rate mortgages could be had at 3.90%, up a notable 14 basis points for the week (up 54bps in 7 weeks). The Mortgage Bankers Association Purchase application index rose 2% last week to the second highest recorded. Purchase applications were up 19% y-o-y, with dollar volume up 34%. Refi applications declined 13% to the lowest level since early January. The average Purchase mortgage was for $223,000, and the average ARM was for $290,100. ARMs accounted for 34.8% of applications last week, the highest since December 1994. The dollar value of ARM applications was up 42% from one year ago.

Broad money supply (M3) surged $58.3 billion, with two-week gains of $104.8 billion. Year-to-date (18 weeks), broad money is up $350.1 billion, or 11.5% annualized. For the week, Currency added $1.3 billion to $670.2 billion. Demand & Checkable Deposits billion surged $24.5 billion to $684.6 billion. Savings Deposits rose $17.5 billion to $3.3553 Trillion. Saving Deposits have surged $196.5 billion so far in 2004 (18.0% annualized). Small Denominated Deposits dipped $1.6 billion to $793.3 billion. Retail Money Fund deposits added $1.5 billion to $763.6 billion. Institutional Money Fund deposits declined $4.5 billion (to $1.1058 Trillion), while Large Denominated Deposits expanded $9.5 billion ($973.1bn). Repurchase Agreements gained $11.9 billion to $518.6 billion, with three-week gains of $26.3 billion. Eurodollar deposits added $400 million to $$297.5 billion.

Total Bank Credit added $1 billion to $6.516 Trillion (week of May 5). Bank Credit is up $270.5 billion during the first 18 weeks of the year, or 12.5% annualized. For the week, Securities holdings declined $9.1 billion. Loans & Leases rose $10.1 billion, with Real Estate loans surging $19.9 billion. Real Estate loans are up $149.4 billion y-t-d, or a blistering 19.5% annualized. For the week, Commercial & Industrial loans dropped $7.6 billion and Consumer loans dipped $2.3 billion. Security loans added $3.5 billion. Elsewhere, Total Commercial Paper increased $3.5 billion to $1.3355 Trillion. Financial CP added $3.1 billion to $1.2213 Trillion, with Non-financial CP $400 billion to $114.1 billion. Year-to-date, Total CP is up $67.0 billion, or 14.5% annualized.

Fed Foreign "Custody" Holdings of Treasury, Agency debt dipped $1.6 billion to $1.193 Trillion. Year-to-date, Custody Holdings are up $126.0 billion, or 32.3% annualized.

Currency Watch:

The dollar index gained about 0.5%. Previously hot "emerging" currencies suffered further liquidation this week. The Indian rupee declined 2.5%, the Brazilian real dropped 5% and the Turkish lira sank 7%. Previously hot "commodity currencies" remained under pressure, with the Australian dollar down 4% and the New Zealand dollar declining better than 3%. The Japanese yen was hit for 3% this week.

Commodities Watch:

The CRB index declined 1.6% this week, reducing y-t-d gains to 5.4%. The Goldman Sachs Commodity Index, with its heavy energy component, gained 0.6% to trade to an all-time record (as far as I can tell). The GSCI index has a 2004 gain of 17.3%.

Central Bank Watch:

May 12 - Bloomberg (Julia Kollewe and Duncan Hooper): "Bank of England Governor Mervyn King comments on the prospects for the U.K. economy...On interest rates: If inflation and growth evolved as the bank forecast, 'then it would be likely that there would be further increases in interest rates. The forecast suggests that 'the view that the market has been taking that further interest rate increases are necessary is not an unreasonable view. 'There may be a time when we have to make bigger changes in interest rates. That may well happen. 'This is an unusually low level of interest rates' and you'd expect them to be higher.'"

China Watch:

May 13 - Bloomberg (Tian Ying): "China's broadest measure of money supply grew faster than the central bank's targeted rate for a 16th straight month in April, which may make the state more inclined to raise interest rates. M2, which includes cash and all deposits, expanded 19 percent from a year earlier in April, the same pace as in March, the Beijing-based People's Bank of China said... That's faster than the bank's 17 percent goal. Total lending increased 20 percent to 18.1 trillion yuan ($2.2 trillion)..."

May 14 - Bloomberg (Tian Ying): "China's inflation rate rose to a seven-year high of 3.8 percent in April, prompting the government to widen restrictions on investment to rein in price increases. The gain in the consumer price index compared with a 3 percent rate in March, the Beijing-based statistics bureau said on its Web site. Grain prices surged 34 percent as farmers shifted to more profitable crops and construction reduced the amount of arable land."

May 13 - Bloomberg (Matt Brooker and Tian Ying): "China posted its fourth monthly trade deficit in a row in April as companies took advantage of an expanding economy and strengthening currency to increase imports of aircraft, oil and factory equipment. The deficit totaled $2.26 billion last month, widening from $540 million in March, the Beijing-based commerce ministry said... Exports rose 32 percent from a year earlier to $47.1 billion and imports jumped 43 percent to $49.4 billion."

May 14 - XFN: "Growth in China's retail sales rose 13.2% to 400.2 bln yuan, compared with 11.1% in March and 7.7% in the same month last year, the National Bureau of Statistics said."

May 14 - XFN: "Auto sales and output in China hit the brakes in the first four months of the year as the market started to mature, the China Association of Automobile Manufacturers (CAAM) said. CAAM said growth in auto sales slowed to 28.62% for Jan-April from 38.45% for the same period a year earlier, while vehicle output rose 27.74% compared with a rise of 43.77%."

May 13 - Bloomberg (Tian Ying): "Foreign investment in China in the January-April period rose 10 percent, accelerating from the first quarter as overseas companies continued to spend on expansion even as the Chinese government tries to cool industrial growth. Direct investment climbed to $19.6 billion... That's a faster pace than the 7.5 percent growth in the first quarter. Contracted investment, a sign of future investment, jumped 54 percent to $47 billion."

May 12 - UPI: "An official from China's railway ministry said Wednesday the country's rail system cannot keep pace with demands put upon it by economic growth. Wu Qiang, director of the freight bureau of the Ministry of Railways, was quoted in China Daily as saying, 'The system is under increasing pressure and a great number of trunk lines operate at full or above capacity.' Despite a recent three percent increase in capacity, railway data indicates daily demand for freight carriages has surged to 300,000 cars, up from the average of 160,000 in 2003. China's rail network is designed to handle less than 100,000 cars per day."

Asia Inflation Watch:

May 12 - Bloomberg (Lily Nonomiya and Daisuke Takato): "Japan sold a record 14.8 trillion yen ($131 billion) to buy U.S. dollars in the three months ended March 31, according to...the Ministry of Finance in Tokyo. The sales were a record for a single quarter, a ministry official said. For the fiscal year ended March 31, Japan sold 32.9 trillion yen, also a record, the official said."

May 12 - Bloomberg (Cherian Thomas): "India's industrial production grew at its fastest pace in eight years as accelerating exports, the cheapest credit in three decades and a surge in farm incomes spurred demand for manufactured goods. Production at factories, utilities and mines rose 6.9 percent in the fiscal year ended March 31, the Central Statistical Organisation said... Exports rose 17 percent ..."

May 14 - Bloomberg (Koh Chin Ling): "Taiwan raised its economic growth forecast for this year after record exports helped the economy expand at its fastest pace in 3 1/2 years in the first quarter. Gross domestic product rose 6.3 percent from a year earlier after increasing 5.2 percent in the fourth quarter..."

May 12 - Bloomberg (Seyoon Kim): "South Korean consumer confidence rose to a 19-month high in April, suggesting that higher spending may boost growth in Asia's fourth-largest economy."

May 13 - Bloomberg (Laurent Malespine): "Thailand's economy may expand at about 7 percent, the lower range of the government's forecast, should oil prices remain high and interest rates rise, Thai Finance Minister Somkid Jatusripitak said."

May 13 - Bloomberg (Anuchit Nguyen): "Thailand's new vehicle sales rose 24.7 percent in April from a year earlier as Toyota Motor Corp., Honda Motor Ltd. and other automakers introduced new models and offered low-interest loans to attract buyers."

May 14 - Bloomberg (Francisco Alcuaz Jr.): "Philippine farm production grew 8.2 percent in the first quarter, its fastest in 15 years, as harvests of fish, rice and corn surged, Agriculture Secretary Luis Lorenzo said."

Global Reflation Watch:

May 11- "The residential mortgage-market boom under way in many parts of the world has extended to emerging-market countries, Standard & Poor's...said in a report 'Supportive Laws and Long-Term Funding Needed to Sustain Growth of Mortgage Lending in Emerging Markets'... 'Although the business of lending to individuals for house purchases is relatively undeveloped in most emerging economies,' said Standard & Poor's credit analyst Scott Bugie, 'the markets are changing, and growth in housing finance is explosive in most parts of the world.' The report explains that emerging-market banks have caught on to what banks in the developed world have known for years: compared with corporate banking, retail banking is usually more profitable, retail credit risks are more predictable and manageable, and retail growth prospects are better."

May 14 - Bloomberg (Mark Gilbert): "Growth in the market for derivatives traded outside exchanges slowed to 16 percent in the second half of last year from 20 percent in the first half, according to a report from the Bank for International Settlements. At $197 trillion, the derivatives market is more than 17 times the size of the U.S. economy."

May 14 - Bloomberg (Emma Vandore): "Economic growth in the $8.5 trillion economy of the dozen nations sharing the euro accelerated in the first quarter to the fastest pace in three years as exporters benefited from burgeoning demand in the U.S. and Asia. The economy expanded 0.6 percent from the previous quarter and 1.3 percent from a year earlier..."

May 14 - Bloomberg (Brian Swint): "China was Germany's fastest-growing export market last year, the Federal Statistics Office said, as a booming Chinese economy helped German companies boost sales by about 25 percent to 18.2 billion euros ($21.5 billion)."

May 13 - UPI: "The number of jobless people in Britain fell by 48,000 to 1.41 million during the first quarter, the lowest in 20 years, the government reported Wednesday. The British Office for National Statistics also announced average earnings rose 5.2 percent during March, up by 0.3 percent from the previous month, Sky News reported."

May 12 - Bloomberg (Sonja Dieckhoefer): "Inflation in Germany, Europe's biggest economy, accelerated this month to the highest in more than two years, as oil prices rose, the euro declined and the government raised the cost of health care. The inflation rate increased to 1.6 percent, the highest since March 2002..."

May 14 - Bloomberg (Joao Lima): "Portuguese consumer prices rose 1 percent in April, the biggest monthly increase in four years, leaving the annual inflation rate at 2.4 percent, the National Statistics Institute said."

May 13 - Bloomberg (Andrea Rothman): "European airlines' passenger traffic rose 14 percent in the week ended May 2, as demand on Far East and Australian routes rebounded from the effect of the SARS disease a year earlier, an industry group said."

May 12 - Bloomberg (Greg Quinn): "Canada's trade surplus widened to C$6.21 billion ($4.48 billion) in March, the biggest margin in almost three years, as exports rose for a second month because of increased global demand for wood, metal and cars."

May 12 - Bloomberg (Guy Faulconbridge): "Russia's trade surplus rose to a record $18.1 billion in the first quarter as high prices for oil and gas boosted the value of the country's biggest exports, according to...the central bank. Russia's trade surplus rose 19 percent in the first quarter from $15.25 billion a year earlier... Exports rose 20 percent to $37.29 billion in the first quarter while imports rose 21 percent to $19.20 billion..."

May 12 - Bloomberg (Nick Benequista): "Mexico's industrial output in March rose at its fastest pace in almost two years, bolstered by growing U.S. demand for Mexican manufactured goods. Industrial production -- which includes manufacturing, construction, mining, and energy -- rose 6.36 percent from the same month last year..."

California Bubble Watch:

May 13 - San Francisco Chronicle (Michael Cabanatuan): "The cost of building a second Benicia-Martinez Bridge has swelled to more than a billion dollars -- nearly four times original estimates -- and the Bay Area will pay for the Caltrans overrun with $405 million in toll money that could have been spent on other transportation improvements. Regional transportation leaders reluctantly agreed Wednesday to recommend that the Bay Area Toll Authority pay for the cost overrun on the bridge -- but warned the state Department of Transportation not to ask for more. The authority is expected to accept the recommendation at a meeting later this month. Caltrans is building a new five-lane bridge on Interstate 680 across the Carquinez Strait that parallels the existing six-lane bridge. The new bridge is expected to open to traffic at the end of 2006."

May 13 - Los Angles Times (Don Lee): "A growing global economy and a cheap dollar are making 'Made in California' products a lot more popular. Exports of California-manufactured goods increased 25% in the first quarter compared with a year earlier, according to government trade figures released Wednesday. Shipments to China, where demand is booming, jumped more than 70%. California's export business fell harder than other states' during 2001 and 2002 because of the weakness in the technology sector. Now, rising global demand for computers, communications equipment and semiconductors is once again giving the Golden State an outsize share of the nation's shipments abroad."

U.S. Bubble Economy Watch:

May 13 - PRNewswire: "Advancing U.S. productivity -- fueled by technology and trade -- is transforming the economy, enriching the nation and altering skills Americans need to succeed in the workplace, according to the Federal Reserve Bank of Dallas' 2003 annual report essay. In 'A Better Way: Productivity and Reorganization in the American Economy," Senior Vice President and Chief Economist W. Michael Cox and economics writer Richard Alm find that 'as companies and workers achieve greater efficiency at the microeconomic level, they unleash a power that reorganizes the whole economy, spurring further productivity gains at the macroeconomic level.' The long-term result: bigger paychecks for workers and lower prices for consumers."

May 11 - Wall Street Journal (Ruth Simon): "After a torrid period of rising prices in virtually every other price segment, the lagging high end of the housing market is finally starting to heat up. In the Naples, Fla., area, sales of homes priced between $2 million and $5 million jumped 96% during the first four months of 2004 over the same time last year, while sales of homes priced above $5 million surged 157%. In Greater Seattle, 48 homes priced above $2 million sold or were under contract this year through April, up from just 13 during the same period last year. And in California, there's now about a four-month supply of $1 million-and-up homes on the market, down from a nearly nine-month supply in March 2003, according to the California Association of Realtors. At Sotheby's International Realty, a unit of Cendant Corp., which sells high-end homes in 22 markets, revenues rose 95% in the first four months of this year. It's not just markets like Beverly Hills and the Hamptons that are hot."

May 12 - PRNewswire: "Demand for single-family existing homes in Florida continues to climb with no peak in sight, even as the median price of those homes continues to rise. Statewide, resales activity increased 21 percent in the first quarter of 2004, according to the Florida Association of Realtors... The statewide median sales price rose 13 percent to $166,100 in the first quarter; a year ago, it was $146,900. In 1999, the first quarter statewide median sales price was $101,900, translating to a 63 percent increase over the five-year period."

May 12 - Bloomberg (William Selway): "U.S. state tax revenue rose 8.4 percent during the first three months of 2004 from a year earlier, the biggest gain in almost four years..."

The U.S. Trade Deficit jumped to a record $46.0 billion during March. Both Goods Imports and Goods Exports were new records. Goods Imports were up 11.9% y-o-y to $118.4 billion. Goods Exports were up a notable 15.2% y-o-y to 67.19 billion. Goods Exports would need to increase 76% to equal Imports.

Seven months into the fiscal year, our federal government has accumulated a deficit of $281.9 billion. Fiscal y-t-d Receipts are up 1.3% to $1.070 Trillion, while Outlays are up 7.5% to $1.352 Trillion. The revenue/expenditure gap is even more dramatic when compared to y-t-d fiscal 2002 data. From two years ago, 7-month Outlays are up 14.5%, while Receipts are down 4.1%. Examining 2004 y-t-d changes of major spending categories, National Defense is up 7.5%, Health & Human Services 11.6%, Medicare 8.9%, Social Security 4.4% and Income Security up 3.2%.

April Retail Sales were reported slightly under forecasts. Year-over-year comparisons nonetheless impress. Total Retail Sales were up 8.0% from April 2003, with Sales Ex-autos up 9.4%. By category, Furniture sales were up 9.8%, Electronics 12.4%, Building Materials 20.4%, Health & Personal Care 6.8%, Gasoline Stations 10.9%, Clothing 8.2%, General Merchandise 7.2%, Food & Beverage 4.2%, and Eating & Drinking Establishments 10.9%.

U.S. Financial Sphere Bubble Watch:

The Federal Home Loan Bank System reported consolidated first quarter earnings of $382 million, down 16% from first quarter 2003. And while earnings decline, assets and liabilities continue to balloon (not typically a healthy combination). Total Assets were up $76.7 billion, or 9.8%, from one year ago. During the quarter, Total Assets jumped $34.2 billion, a 16.6% annual rate. The paltry spread between Earning Assets and Interest-bearing Liabilities contracted another 5 basis points to 24 basis points. "At March 31, 2004, the FHLBanks had $756.9 billion total notional amount of interest-rate exchange agreements outstanding compared with $701.1 billion at December 31, 2003 and $672.1 billion at March 31, 2003." FHLB Total Assets have ballooned 140% since March 1998.

From Countrywide Financial's April Operational Data: "Loan fundings rose 11 percent over last month to $36 billion... Year-to-date fundings reached $112 billion." "Monthly purchase fundings reached a record high $14 billion, an increase of 45 percent over the same month last year... Adjustable-rate fundings reached a record $16 billion, rising 134 percent over April 2003, and up 13 percent over last month." Home Equity fundings were up 7% from March and 55% over April 2003 at a record $2.2 billion. Subprime fundings were up 129% from April 2003 at a record $2.8 billion.

The Bond Market Association yesterday released their May Research Quarterly: "New issue activity in the U.S. bond markets reached $1.46 trillion in the first quarter, about 15 percent lower than the same period a year ago and relatively unchanged from the fourth quarter of 2003. the year-over-year decline is attributable to slower mortgage market activity following three consecutive record years of mortgage-related security issuance...

"Gross coupon issuance of U.S. Treasury securities totaled $215.9 billion in the first quarter of 2004, a 37.2 percent increase over the $157.4 billion issued in the first quarter of 2003... Daily trading volume of Treasury securities by primary dealers averaged $479.6 billion during the first three months of 2004, up 23.7 percent from the $387.7 billion over the same period a year ago."

"Long-term issuance by federal agencies fell by 2.5 percent during the first quarter of 2003" to $1.04 Trillion.

"Total short- and long-term municipal bond issuance reached $93.4 billion in the first quarter of 2004, a less than one percent decrease from the same period of 2003...Not withstanding significantly higher rates in the second quarter, we expect a significant supply of municipal securities in the coming months."

"Building on a positive 2003, the supply of new corporate bonds increased significantly during the first quarter of 2004. Total issuance volume reached $219.5 billion, up 28 percent from the fourth quarter of 2003... After a prolonged period of restrained borrowing by nonfinancials, issuance grew noticeably during the first quarter reflective of the need to fund new capital investment... Reflecting both equity market performance and interest rates during the first quarter, total convertible bond issuance rose 6.4 percent on a linked-quarter basis... According to the Merrill Lynch corporate bond indices...the average investment-grade yield fell by 63.5 basis points during 2003 and by 34.8 basis points during the first quarter, making the investment grade index yield level the lowest in over a decade."

"New issue volume of non-convertible investment-grade bonds rose 31.3 percent, to $185.1 billion issued in the first quarter of 2004... Commercial banks, investment banks, and credit institutions boosted total combined new issue market shares to about 65 percent, compared to the average 2003 quarterly share of 51.7 percent."

"New issue volume of non-convertible high-yield corporate debt maintained its remarkable momentum. Total volume during the first quarter was $34.4 billion, almost doubling the high-yield issuance of $18.8 billion during the first quarter of 2003."

"The average daily corporate trading volume by primary dealers for bonds with maturities of greater than one year increased 20 percent in the first quarter, to $23.2 billion, up from $18.9 billion during the fourth quarter of 2003. This was the highest level since 2002..."

"The asset-backed securities (ABS) market maintained its remarkable growth through the first quarter of 2004. Issuance totaled $187.6 billion, up 38.3 percent from the $135.6 billion issued in the first quarter of 2003... The home equity sector was the largest component in the ABS market, accounting for 47.4 percent share of total ABS issuance in the quarter. New issue activity surged to $88.9 billion in the first quarter of 2004, a 74.3 percent increase from one year ago and 56.4 percent higher than the last quarter of 2003."

"Issuance of mortgage-related securities, which include agency and non-agency pass-throughs and CMOs, totaled $404.4 billion in the first quarter of 2004, considerably less than the $776.1 billion issued during the fourth quarter of 2003... After two unprecedented years of record issuance growth, mortgage-related volume decreased for the second straight quarter."

"The average daily volume of total outstanding repurchase (repo) and reverse repo agreement contracts totaled $4.49 trillion in teh first quarter of 2004, an 11 percent increase over the average daily volume of $4.04 trillion in 2003."

"The outstanding volume of money market instruments, including commercial paper, large time deposits, and bankers' acceptances, totaled an estimated $2.58 trillion outstanding at the end of March 2004, an increase of 2.3 percent compared to the end of 2003."

In today's extraordinarily uncertain world, I feel especially drawn to theory. With this in mind, below are comments I transcribed from a recording of a speech given by Pimco's Paul McCully late last month at a symposium sponsored by the Money Marketeers of New York University.

"In a war against inflation, you should logically expect that the neutral real short-term interest rate will be above that which will prevail if you had won the war against inflation... What I think the Fed will ultimately come to on neutral (now that the war has been won) - this may take some time - is to think in terms of what its essential purpose is in preserving the purchasing power of money. If the data of the eighties and nineties can't be used to specify empirically a new reaction function in a new regime, then we have to go back to theory. And I will start with a very simple proposition: That money should hold its real value, but should not generate a real rate of return. Money - call it overnight repo collateralized at 102 percent - can we deal with that as the definition of money - that which is in a (Investment Company Act of 1940 Rule) 2a-7 money market fund. It has zero default risk, zero price risk and zero liquidity risk. Zero, zero and zero. You can redeem your money market fund tomorrow at a buck with certainty, with no bid/offer spread. I don't understand where the risk is in that instrument.

I think the nominal Fed funds rate should be sufficiently high to cover you for two taxes on money: an explicit tax and the inflation tax. And that if the Fed funds rate is held at a level that covers those two taxes, then the Fed has achieved its mission of preserving the real purchasing power of money. In some respects it's very similar to the old gold standard. When $35 would get you an ounce of gold today, tomorrow, a year from now or five years from now; for $35, one ounce of gold. Not $35 five years from now will get you 1.2 ounces of gold. The old fashioned gold standard was that money is a store of wealth not a generator of wealth.

During the 1980s and 1990s, when the Fed was fighting a war against inflation, money became an investment - a no-risk instrument - generated over the 1980s and 1990s a very positive real after-tax rate of return. Simply put, since the 1980s, the holders of money got rewarded for sitting on their ass. And that was essential and necessary in fighting a war against inflation. But when the war is over, I think the real short-term interest rate should essentially be the economy-wide marginal tax rate times the inflation rate, plus the inflation rate, for your nominal. If you have a 2% inflation rate, then you need approximately a two and one-half percent nominal Fed funds rate... Your after-tax real rate of return is approximately a donut. To me, that seems to be neutral money.

I don't think the Fed is going to adopt that anytime soon. But what I do think is going to happen is the Fed is going to try to signal to us, unlike it did in 1994, some zone of a neutral real Fed funds rate... So my second forecast is that before the Fed starts its tightening campaign that is coming up, they will try to inform us where it might end, from the standpoint of neutrality... Two forecasts, they don't tell us ultimately what the neutral real rate is. And ultimately, they are going to tell us what the definition of effective price stability is going to be. Both of those things tell me that short-term interest rates are going to be a lot lower then what most people in this room wants to forecast. The second thing it tells me is that the yield curve is going to be a lot steeper than what most everybody in this room wants to forecast... In this new brave world of price stability, you're going to end up with a very steep real yield curve, with the Fed honoring its commitment to preserving the purchasing power of money, but not money being a real return vehicle with a very steep yield curve. "

I much appreciate Mr. McCulley's determination to construct and expound an analytical framework. Yet I continue to find fundamental flaws with his analysis that go to the very heart of some serious fallacies that thrive throughout contemporary finance and economics.

Still, I am fascinated with Mr. McCulley's proposition that repurchase agreements and money market liabilities are indeed "money." Considering the long history of "money," this is a most notable departure from tradition. Yet financial evolution and the analysis of evolving financial institutions, risk intermediation, and Credit instruments are critical facets of proficient monetary analysis.

Money has traditionally provided a safe and liquid store of nominal wealth - "zero default risk, zero price risk and zero liquidity risk." Importantly, however, throughout much of history such characteristics and attributes were only associated with something "precious" - a much desired "thing" of generally recognized intrinsic value, as well as something of limited quantity, such as gold and precious metals. Later, government currencies and instruments backed by precious metals sufficed as money. Repos and money market funds do, at least for now, pass the "zero, zero, zero" "money test." These instruments, however, miserably Fail the "Precious Test." They are brazenly issued in unlimited quantities, and only the timing of "revulsion" is in doubt.

The great Mises addressed this critical issue at length, with his brilliant analytical framework incorporating the key role played by "money substitutes" and "fiduciary media." Importantly, these "substitutes" had the economic functionality of "narrow" real money, yet demonstrated a greater propensity (often because of the failure to appreciate the nature of more elaborate instruments) to be over-issued. Hence, they too often were especially instrumental in fanning inflation.

As remains the case today, when it comes to analyzing inflationary processes, it is critical to take a very broad view of "money," "money substitutes" and the broad spectrum of Credit instruments and intermediation. And especially considering the reality that the GSEs and Wall Street "structured finance" have come to dominate the Credit system, it is analytically imperative to appreciate the powerful dynamic of the "moneyness" of much of today's Credit instruments. With perceptions of safety and liquidity enveloping the entire American Credit-creating process, Credit can and is issued today in unparalleled over-abundance.

And while contemporary "Austrian" analysis tends to take (erroneously, in my opinion) a very narrow, banking-centric view of "money," I would argue that Mr. McCulley's inclusion of repos and money funds as contemporary "money" is certainly appropriate. After all, they possess "money substitute" attributes and, importantly, play an instrumental role in contemporary inflationary processes. Money is as money does. And no longer do banks hold a monopoly position in money creation, and no longer do Fed mandated reserve requirements have any bearing on money creation. Money is created by myriad financial intermediaries, with the historically anomalous situation of there being absolutely no effort to control either the quality or the quantity of Credit instruments comprising our "money" supply.

But for my definition of "money," I include the word "perceived:" Money is a perceived safe and liquid store of nominal value. This is a critical distinction. As long as there is the perception that a Credit instrument - or, more importantly, a class of instruments - exhibits the key attributes of money, there is basically insatiable demand for it. And with that highly unusual attribute of insatiable demand comes the heightened risk of over-issuance. The powerful role of money - as history has demonstrated on numerous occasions - is its capacity to fuel spectacular inflationary booms through gross over-issuance.

The classic gold standard was a monetary regime constructed to preserve financial and economic stability. Specifically by implementing a mechanism to limit monetary expansion, lending excesses would be restrained and severe economic imbalances avoided. Members of this regime were committed to the stability of the system, and viewed a disciplined approach to monetary and economic affairs as a prerequisite to sustainable growth and prosperity. That chairman Greenspan and others can today contend that contemporary central banking has evolved to the point of accomplishing similar results as those propagated by gold-backed monetary regimes is among the most outrageous propaganda ever espoused in the annals of finance. At the very minimum, it misses the very essence of the gold standard's role in nurturing general monetary stability. Today's unstable system of "Global Wildcat Finance" is the absolute antithesis to a sound gold-backed monetary regime.

In the mirror image of last fall, money supply over the past few months has been exploding, with M3 expanding at a rate of almost 12% for far this year. Curiously, this development garners scant attention, as opposed to the rumpus of pontification over the fourth quarter's monetary contraction.

It is today worth recalling that during periods of keen preference for risk-taking - this past autumn providing an extreme example - there is rotation away low-yielding "money" to instruments with perceived higher returns and yields. Contemporary financial institutions - operating largely through actively traded debt and derivatives markets unlike anything previously experienced - have the capacity to easily adjust to enhanced risk appetites. Investment banks simply sell riskier debt instruments, allowing corporations and others to pay down short-term obligations. Financial intermediaries readily adjust the composition of their liabilities. Banks, for example, aggressively issue bonds and securitize loans to fund growth, rather than relying largely on deposit growth. The GSEs issue long-term debt instruments and more aggressively sell mortgage-backeds, limiting their growth while paying down short-term borrowings.

Issuers of "structured instruments" (collateralized debt obligations, collateralized mortgage obligations, and Asset-backed securities, for example) also modify the nature of instruments issued, selling more longer-term and/or riskier securities (and "tranches"). And if market participants believe that a period of low short-term rates and a steep yield curve will persist, then Wall Street securitizers and derivative players will easily structure a pool of loans (or securities) to create instruments (often with leverage) to profit handsomely from such an environment.

And while "money" supply sank during the fall and has skyrocketed of late, I doubt the underlying rate of Credit growth (lots) or the composition of lending (mostly mortgage) has varied all that much during these two periods. Rather, there has been a profound difference in the nature of the liabilities issued throughout the financial sector in two divergent risk-perception environments.

Today, as risk aversion inevitably takes hold once again, there will be significantly less demand for risky assets. There will, then, be fewer junk debt issues, less marketplace demand for long-term agency debt, and reduced demand for longer-dated and higher-risk structured products. Many of the aggressive players, having bet wrong on the environment, will unwind trades and "de-leverage." At the same time, there will surely be accentuated demand for bank deposits, short-dated agency securities, commercial paper, repos and less risky "structured" products. And, importantly, there may likely even be a resumption of flows into money market mutual funds (after a major disintermediation).

The financial intermediaries, having previously merrily off-loaded risk and leverage to the speculators, will now have little alternative other than expansion and heightened leveraging - The Flip-side of Speculator De-leveraging. This, as I believe we are already witnessing, will necessitate the significant accumulation of risk assets, financed by the aggressive issuance of monetary liabilities ("money").

I, today, have many concerns with the entire process and will return to Mr. McCulley's analysis as I try to address a few of them. First of all, after years of spectacular growth, we could very well now be entering a period of parabolic expansion in "money" - repos, bank and money fund deposits, agency debt, and structured instruments. Instrumental to this issuance boom, the perception that these instruments enjoy "zero, zero, zero" risk is stronger-than-ever. Yet it is simply impossible to sustain such massive over-issuance of any monetary instrument without severely compromising the risk profile of "money" and systemic risk overall (the soundness of "money" being the foundation of system confidence). And, by the way, what assets are backing this monetary explosion?

I proffer that we are commencing a period of acute "money" adulteration. For the economy as a whole, the quality of Credit creation is these days at a dismal end-of-cycle low. Years of cumulative monetary disorder ensure an unprecedented degree of mal-investment. The Great Mortgage Finance Bubble is over-financing new construction and historic self-reinforcing asset inflation. Years of Credit excess and consequent distortions to the market pricing mechanism have nurtured dysfunctional monetary processes and a wholesale misallocation of resources. Perceptions as to the soundness of money and the general system are significantly lagging real developments.

I strongly argue that we are experiencing an unprecedented degree of non-productive Credit growth in a general environment of unmatched total Credit expansion. The rising percentage of non-productive Credit in a "blow-off" stage of excess then creates an exponential rise in systemic risk. More specifically, heightened systemic risk will increasingly concentrate in our "risk intermediaries" including the major banks, GSEs, Wall Street firms, and the "derivatives marketplace." These are the institutions that have seemingly no option today than to balloon their holdings of very risky assets, shouldering this risk as they issue perceived safe liabilities ("money").

In a normal functioning marketplace, such heightened risk would evoke a rising risk premium for these intermediary liabilities - as we are witnessing today in emerging debt and, somewhat, junk markets. Rising yields would then work to temper the supply of these new Credit instruments, working to dampen attendant excesses. But none of these crucial dynamics have anything whatsoever to do with contemporary "money" and central banking. Today, the Fed pegs the interest rate for "money" - "overnight money" including repos, Fed funds, and other vehicles that then anchor interest rates for Trillions of dollars of short-term instruments (and to an only somewhat lesser extent, yields for all Credit instruments). For years, these rates have been pegged at an artificially low rate, and in the process the Fed has nurtured unprecedented excess, along with financial innovation. And these dynamics - pegged low short-term rates and their effects - go right to the very heart of today's myriad financial and economic Bubbles.

Somehow, the Fed, Mr. McCulley and others mistakenly celebrate "effective price stability" when the issue is something radically different - unsustainable monetary disorder. Moreover, after supposedly having won the war on inflation, the Fed now has the capacity to keep rates artificially low - "after-tax real rate of return approximately a donut." So we savers are to receive a zero real rate of return, thus extending an effective zero real cost of funds to borrowers? But the borrowers and their excesses are the problem and further accommodation is no solution.

And this gets right to the crux of the issue: Most of contemporary "money" supply is comprised of liabilities created in the process of speculative leveraging. Our money is not backed by anything precious or even sound investment representing true economic wealth. Rather, our "money" (repos, money market assets, bank deposits) is largely the residual of endemic leveraged speculation. And our money, having fueled historic asset Bubbles, is now hostage to Bubble dynamics.

I do recognize why the Fed and Wall Street analysts would today argue convincingly and passionately that rates should remain relatively low in the current environment of generally mild CPI inflation. But there is a serious dilemma associated with the status quo of artificially low and pegged interest rates: it only further accommodates increasingly dangerous speculation and Credit excess in an environment of broadening inflationary pressures at home and abroad. After all, financial speculators are not borrowing to speculate in CPI, but rather various real and financial assets with much higher perceived return potential. The status quo may for now ward off speculative de-leveraging, but it perpetuates dangerous financial sector leveraging and Bubble dynamics.

Throughout the entire economy - especially mortgage finance - "investors" and speculators see great reward from leveraging purchases of inflating assets at today's low rates. Inflationary psychology is becoming deeply ingrained, which is another way of saying it will require only increasingly punitive interest rates to quell speculative impulses. And, with the return of risk aversion, a large part of these risky Credits will be concentrated among our vulnerable banks, GSEs, and Wall Street firms.

And, yes, these are the very same risk intermediaries whose liabilities, guarantees, and derivative contracts play the central role in transforming our economy's (increasingly) risky loans into a surging flow of perceived safe money. And, sure, the U.S. does have a huge competitive advantage when it comes to contemporary "money" creation - the "moneyness" of U.S. Credit instruments - with possible short-term benefits to the dollar. But if I am correct in my view that we are likely commencing a dangerous "blow-off" stage of "money" issuance excess, I am anything but sanguine on the dollar's intermediate and long-term prospects. This "blow-off" will instigate an increasing concentration of risk within key U.S. Credit intermediaries, thereby exacerbating acute systemic fragility.

And when the marketplace comes to contemplate that critical issue "perceived" - as in "perceived safe money" - well, there will be an immediate problem. The Fed's experimental monetary regime of pegged artificially low interest rates could be at risk of dislocating. I have always believed that the loss of control of currency pegs - with catastrophic consequences for derivative markets, risk intermediaries, and Credit systems generally after several years of associated leveraging and speculation - was the key dynamic that fomented the domino Asian Tiger crises. I fear similar dynamics could, at some point, be unleashed when the Fed loses control of its "peg" on the expansive and defiled U.S. market in "money."