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To print or not to print? Odds are that Fed Chairman
Bernanke has been contemplating this question while drafting his upcoming Jackson
Hole speech. The one good thing about policy makers worldwide is that they
may be fairly predictable. As such, we present our crystal ball as to what
the Fed might be up to next, and what the implications may be for the U.S.
dollar and gold.
 
First off, we may be exaggerating: on process rather
than substance, though. That is, Bernanke isn't just thinking about whether
to print or not to print as he is sitting down to draft his speech. Instead,
he considers himself a student of the Great Depression and has been pondering
policy responses to a credit bust for some time. Consider the following:
- Bernanke has argued that going off the gold
standard during the Great Depression helped the U.S. recover faster from
the Great Depression than countries that held on to the gold standard
for longer.
- Bernanke is correct: subject to many risks,
debasing a currency (which going off the gold standard was) can boost
nominal growth. Think of it this way: if the government takes your
purchasing power away, you have a greater incentive to work. Not
exactly the mandate of a central bank, though.
- Note by the way that by implication, countries
that hold on to the gold standard invite a lot of pain,
but have stronger currencies. Fast forward to today and compare the
U.S. to Europe. While neither country is on the gold standard, the
Federal Reserve's balance sheet has increased more in percentage terms
than that of the European Central Bank since the onset of the financial
crisis. Using a central bank's balance sheet as a proxy for the amount
of money that has been "printed", it shouldn't be all that
surprising that the Eurozone experiences substantial pain, but the Euro
has been comparatively resilient.
- Possibly the most important implication: Bernanke
considers the value of the U.S. dollar a monetary policy tool. When we
have argued in the past that Bernanke might be actively working to weaken
the U.S. dollar, it is because of comments such as this one. This is
obviously our interpretation of his comments; a central banker rarely
says that their currency is too strong, although such comments have
increasingly been made by central bankers around the world as those
pursuing sounder monetary policy have their economies suffer from
competitive devaluations elsewhere.
- Bernanke has argued that one of the biggest
mistakes during the Great Depression was that monetary policy was
tightened too early. Here's the problem: in a credit bust, central banks
try to stem against the flow. If market forces were to play out, the
washout would be severe and swift. Those in favor of central bank
intervention argue that it would be too painful and that more businesses
than needed would fail, the hardship imposed on the people is too much.
Those against central bank intervention point out that creative
destruction is what makes capitalism work; the faster the adjustment is,
even if extremely painful, the better, as the recovery is healthier and
stronger.
- If the policy choice is to react to a credit bust
with accommodative monetary policy, fighting market forces, and then
such accommodation is removed too early, the "progress"
achieved may be rapidly undone.
- We are faced with the same challenge today: if
monetary accommodation were removed at this stage (interest rates
raised, liquidity mopped up), there's a risk that the economy plunges
right back down into recession, if not a deflationary spiral. As
such, when Bernanke claimed the Fed could raise rates in 15 minutes, we
think it is a mere theoretical possibility. In fact, we believe that
the framework in which the Fed is thinking, it must err on the side of
inflation.
Of course no central banker in office would likely ever
agree with the assessment that the Fed might want to err on the side of
inflation. But consider the most recent FOMC minutes that read:
- An extension [of a commitment to keep interest
rates low] might be particularly effective if done in conjunction with a
statement indicating that a highly accommodative stance of
monetary policy was likely to be maintained even as the recovery
progressed
As the FOMC minutes were released three weeks after the
FOMC meeting, many pundits dismissed them as "stale"; after all,
the economy had somewhat improved since the meeting. Indeed, it wasn't just
pundits: some more hawkish Fed officials promoted that view as well. But to
make clear who is calling the shots, Bernanke wrote in a letter dated August
22 (the same date the FOMC minutes were released) to California Republican
Darrell Issa, the chairman of the House Oversight
and Government Reform Committee: "There is scope for further action by
the Federal Reserve to ease financial conditions and strengthen the recovery."
Various news organizations credited the faltering of an incipient U.S. dollar
rally on August 24 with the publication of this Bernanke letter.
For good order's sake, we should clarify that the Fed
doesn't actually print money. Indeed, printing physical currency is not
considered very effective; instead, liquidity is injected into the banking
system: the Fed increases the credit balances of financial institutions in
accounts held with the Fed in return for buying securities from them. Because
of fractional reserve banking rules, the 'liquidity' provided through this
action can lead to a high multiple in loans. In practice, one of the
frustrations of the Fed has been that loan growth has not been boosted as
much as the Fed would have hoped. When we, and Bernanke himself for that
matter, have referred to the Fed's "printing press" in this
context, referring to money that has been "printed", it's the
growth in the balance sheet at the Federal Reserve. That's because the Fed's
resources are not constrained; it's simply an accounting entry to pay for a
security purchased; that security is now on the Fed's balance sheet, hence
the 'growth' in the Fed's balance sheet.
Frankly, we are not too concerned about the environment
we are in. At least not as concerned as we are about the environment we might
be in down the road: that's because we simply don't see how all the liquidity
can be mopped up in a timely manner when needed. At some point, some of this
money is going to 'stick'. Even if Bernanke wanted to, we very much doubt he
could raise rates in 15 minutes. To us, it means the time for investors to
act may be now. However, talking with both existing and former Fed officials,
they don't seem terribly concerned about this risk. Then again Fed officials
have rarely been accused of being too far sighted. We are concerned because
just a little bit of tightening has a much bigger effect in an economy that
is highly leveraged. Importantly, we don't need the Fed to tighten: as the
sharp selloff in the bond market earlier this year (and the
recent more benign selloff) have shown, as soon as the market prices
in a recovery, headwinds to economic activity increase as bond yields are
rising. That's why Bernanke emphasizes "communication strategy",
amongst others, to tell investors not to worry,
rates will stay low for an extended period. This dance might get ever more
challenging.
In some ways, Bernanke is an open book. In his 'helicopter
Ben' speech a decade ago, he laid out the tools he would employ when
faced with a collapse in aggregate demand (the credit bust we have had). He
has deployed just about all tools from his toolbox, except for the purchase
of foreign government bonds; recently, he shed cold water on that politically
dicey option. Then two years ago, in Jackson Hole, Bernanke
provided an update, specifying three options:
- To expand the Fed's holdings of longer-term
securities
- To ease financial conditions through
communications
- To lower the interest rate the Fed pays on bank
reserves to possibly 10 basis points or zero.
We have not seen the third option implemented, but the
Fed might be discouraged from the experience at the European Central Bank:
cutting rates too close to zero might discourage intra-bank lending and cause
havoc in the money markets.
As such, expect Bernanke to give an update on his
toolbox in Jackson Hole. The stakes are high as even doves at the Fed believe
further easing might not be all that effective and could possibly cause more
side effects (read: inflation). As such, we expect him to provide a framework
as to why and how the Fed might be acting, and why we should trust the Fed
that it won't allow inflation to become a problem. For investors that aren't
quite as confident that the Fed can pull things off without inducing
inflation, they may want to consider adding gold or a managed basket of
currencies to mitigate the risk to the purchasing power of the U.S. dollar.
Axel Merk
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