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Is the Fed’s
goal to debase the U.S. dollar? The Federal Reserve’s announcement of a
third round of quantitative easing (QE3) might have been the worst kept secret,
yet the dollar plunged upon the announcement. Here we share our analysis on
what makes the FOMC tick, to allow investors to position themselves for what
may be ahead.
We have heard policy makers justify bailouts and
monetary activism because, as we are told, these are no ordinary times:
extraordinary times require extraordinary measures. Acronyms are needed, as
we are told that things are complicated. We respectfully disagree. It’s
quite simple: we have had a credit driven boom; we have had a credit bust;
and Fed Chairman Bernanke thinks monetary policy can fix it. Merk Senior Economic Adviser and former St. Louis Fed
President William Poole points us to the fact that
the Soviet Union, Cuba and North Korea have one thing in common: monetary
policy could not have compensated for the shortcomings of the respective
regimes. The successor nations to the Soviet Union, as well as China had
economic booms because they opened up, not because of printing presses being
deployed. Monetary policy affects nominal price levels, not structural
deficiencies. In the U.S., the economy may be held back because of
uncertainty over future taxes (the “fiscal cliff”) and regulation;
monetary policy cannot fix these.
But the above experiences have something else in
common: they refer to lessons of recent decades. Bernanke, in contrast, is a
student of the Great Depression, the 1930s. Bernanke firmly believes that
tightening monetary policy too early during the Great Depression was a grave
mistake, prolonging the Depression. Never mind that there had been major
policy blunders by the Roosevelt administration that might have been driving
factors; Bernanke’s research squarely focuses on how history would have
evolved differently had his prescription for monetary policy been
implemented.
The reason why Bernanke thinks tightening too early
after a credit bust is a grave mistake is because a credit bust unleashes
deflationary market forces. Left untamed, a deflationary spiral may ensue
driving many otherwise healthy businesses into bankruptcy. Nowadays, we hear
“it’s a liquidity, not a solvency
crisis.” With easy money, the Fed can stem the tide. Whenever the Fed
has the upper hand, the glass is half full, “risk is on” as
traders like to say; but then it appears that not quite enough money has been
printed and, alas, the glass is half empty, “risk is off.” The
high correlation across asset classes is, in our assessment, a direct result
of the heavy involvement of policy makers. Sure, markets may move up when
money is printed; the trouble is everything moves up in tandem, making it
ever more difficult to find diversification, so that on the way down,
investors find protection. It’s for that reason, by the way, that we
focus on currencies: why bother taking on the noise of the equity markets if
investors buy or sell securities merely because they try to front-run the
next perceived intervention of policy makers? In our assessment, the currency
markets are a great place to take a position on the “mania” of
policy makers. Note that if one does not employ leverage, currencies are
historically less risky than equities.
So we know Bernanke wants low interest rates. But
there’s more to it: as we saw earlier this year, a string of good
economic indicators sent the bond market into a nosedive. Treasuries were
bailed out by subsequent mediocre economic news, allowing bond prices to
recover. The challenge here, in our assessment of Bernanke’s thinking,
is that the bond market can do the tightening for you. When Bernanke bragged
in his Jackson Hole speech in late August that a well-behaved bond market is
proof that his policies are well received, we had a more somber
interpretation: the reason the bond market is well behaved is because the
economy is in the doldrums. Let all the money that has been printed
“stick”, i.e. let this economy kick into high gear. Sure,
Bernanke says he can raise rates in 15 minutes (he can pay interest on
deposits at the Fed), but given the leverage in the economy, any tightening
that comes too early might undo all the “progress” that has been
achieved so far. Differently said – and we are putting words into
Bernanke’s mouth here – Bernanke has to err on the side of
inflation.
But how do you err on the side of inflation, without
the bond market throwing a fit? A central banker is most unlikely to ever
call for higher inflation. You do it with “communication
strategy”, a commitment to keeping interest rates low; you do it with
quantitative easing, i.e. buying Mortgage-Backed and Treasury securities; you
do it with Operation Twist, depressing yields by buying longer dated Treasury
securities. But, “when inflation is already low…” as
Bernanke stated in his 2002
“Helicopter Ben” speech, “the central bank should act more
preemptively and more aggressively than usual.” How do you do that?
First, you create an open-ended buying program, so that the market cannot
price in all easing within moments of the announcements. And more
importantly, you break the link between monetary policy and
inflation. Bernanke wants to make sure investors realize that
policy is now tied to a “substantial improvement in the labor
market” rather than its inflation target. It’s only then that the
Fed can go all out on promoting growth without having the bond market sell off.
Does it work? Judging from the initial market
reaction, no. Bond prices have fallen, inflation expectations as expressed in
the spreads between inflation protected Treasury securities (TIPS) and
underlying Treasuries have shot higher. It might be because the dust from the
Fed’s bombshell hasn’t settled; or it might be that the Fed
hasn’t had time to intervene in the market by buying TIPS (while not
extensively, the Fed has been buying TIPS on occasion) depressing inflation
indicators.
Either way, however, many observers have wondered
whether lowering interest rates a tad further is really the panacea the economy
needs. Part of it is that mortgage rates aren’t falling at this stage,
if for no other reason than banks have such dramatic backlogs, that they have
little incentive to open the floodgates even more for further refinancing
activity. But even without such backlogs, how many more projects are worth
financing with the 10-year bond trading at 1.6% versus 1.8%? Interest rates
are low, no matter how one slices it.
That leaves one other interpretation open.
Don’t take our word for it, but read the 2002 Helicopter Ben speech: “Although
a policy of intervening to affect the exchange value of the dollar is nowhere
on the horizon today [in 2002], it's worth noting
that there have been times when exchange rate policy has been an effective
weapon against deflation.” The argument here is that a
lower dollar boosts exports and thus the economy. Ignored is the fact that
Vietnam might try to compete on price, but an advanced economy should work
hard to compete on value added. As such, we are only providing a dis-incentive
to invest in competitiveness if the Fed’s printing press provides the
illusion of competitiveness. We use the term printing press because it is
Bernanke in the aforementioned 2002 speech that refers to the Fed’s
buying of securities (QEn) as the electronic
equivalent of the printing press.
So don’t let anyone fool you. Things are not
complicated. In our assessment, the Fed may be out to debase the dollar.
Investors may want to get rid of the textbook notion of a risk-free asset, as
the purchasing power of the U.S. dollar may increasingly be at risk. There is
no risk-free alternative, but investors may want to consider a managed basket
of currencies including gold, akin to how some central banks manage their
reserves, as a way to mitigate the risk that the Fed is getting what we think
it is bargaining for.
Axel Merk
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