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In previous posts in my blog www.goatmug.blogspot.com we've outlined the role the Federal Reserve has played in causing each asset bubble in recent memory. Each crisis evokes the same Pavlovian response from our central bankers in that they reduce interest rates and flood the market with easy money. In the most recent economic event our Federal Reserve pulled out all the stops and intervened with unprecedented measures to buttress the financial system and save us from collapse. We heard over and over again that stabilizing housing would save us and all efforts and letters of the alphabet were employed to prop up declining markets with asset purchase programs and low interest rate give aways.
Why does the Federal Reserve seem to desire inflationary and fear deflation so much? Please find a 2002 speech given by our own Federal Reserve Chairman Ben Bernanke. If you ever wanted to know the play book of team Fed, here it is. As we read through the text it is now clear that they have used every bullet he described. As investors and traders it is critical for us to understand that the Fed will never give up and accept a deflationary scenario. Even eight months into a dramatic equity market rally, comprehending the Bernake strategy will provide us a concepual foundation for finding trades that will benefit from his unrelenting effort to inflate.
I originally had intended on writing my own text to outline the topic of deflation, but I'll be the first to state that Mr. Bernanke is much more capable to address the topic. Given the availability of his speech, I will make comments and outline themes that need further attention.
WHAT IS DEFLATION?
- BERNANKE – "The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand–a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending–namely, recession, rising unemployment, and financial stress."
- GOATMUG – HMMMMM SOUND A LITTLE FAMILIAR (Retailers, Auto Manufacturers, and Grocers drop prices)
WHAT IS SO BAD ABOUT DEFLATION?
- BERNANKE – Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be. To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.
- GOATMUG – So, people figure out that the money they save is MORE valuable tomorrow and therefore they opt not to purchase stuff based on a need for instant gratification. (Sounds like that would be real trouble for a consumer-based got to have it now economy doesn't it?)
IS IT A PROBLEM IF CENTRAL BANKERS ATTACK DEFLATION AND TAKE RATES TO ZERO?
- BERNANKE – "It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory."
- GOATMUG – Is this guy good or what? He was read to open a can of "non-traditional" back in 2002. Wow!
IF WE WERE TO EXPERIENCE DEFLATION IS THE FED POWERLESS?
- BERNANKE – "Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
- GOATMUG – ooh, ahhhhh, a printing press! I put this in for the gold bugs too. You can just see them brewing a theory that Bernanke is conspiring against gold just by the mention of its name!
WHAT ARE THE CURES FOR DEFLATION?
- BERNANKE – "Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities."
- GOATMUG – Of course they wouldn't give money to just anyone! You have to be in the right club to receive Fed money! Bernanke has done exactly what he's outlined here. He's used TARP and more to buy assets, he's made low interest loans, provided loan guarantees, and more.
- BERNANKE – "If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."
- GOATMUG – This is just a truly scary quote. It absolutely sounds like an arrogant guy married to a trade. We all know what happens to that guy. He ends up doubling or tripling down rather than cutting his losses and accepting that it was a bad trade.
WHAT HAPPENS WHEN RATES HIT ZERO, WHAT DO WE DO NEXT?
I call these the extreme measures list -
- BERNANKE – #1 "Treasury term structure–that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
- BERNANKE – #2 – Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).
OK, SOUNDS LIKE WE'VE DONE "EXTREME MEASURES" 1 & 2, WHAT HAPPENS NEXT?
- BERNANKE – To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities."
- GOATMUG – Try 2, 3 or 4 years worth of zero interest loans.
THERE CAN'T POSSIBLY BE OTHER TOOLS IN THE TOOL KIT CAN THERE BEN?
- BERNANKE – The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
- GOATMUG - Foreign debt? Currency swaps? Really?
COULDN'T THE PURCHASE OF FOREIGN DEBT AND OTHER INSTRUMENTS IMPACT OUR CURRENCY?
- BERNANKE – I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.
- BERNANKE – Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.
- GOATMUG – DID HE JUST SAY THAT INTERVENING IN THE CURRENCY MARKET CAUSED ONE OF THE BEST YEARS IN THE STOCK MARKET! He also failed to mention what happened in 1937 didn't he?
WHAT IF HOUSEHOLDS JUST DON'T STEP UP AND BUY STUFF?
- BERNANKE – "Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."
- GOATMUG – Are you getting this guys? The low rates in savings accounts and everywhere else are a mechanism to make you, me, and Grandma increase risk and buy assets we'd normally wouldn't purchase in this situation. The Fed is forcing you to move your money or you'll lose your purchasing power.
WHAT MAKES JAPAN'S SITUATION DIFFERENT (remember he's speaking in 2002)?
- BERNANKE – First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt.
- GOATMUG – Anyone want to bet me that there are some Japanese central bankers that are quite happy to see the USA right now given the tone of these types of comments?
- GOATMUG – He goes on to say that political will didn't exist to clean up the messes of deflation in Japan.
There is a tremendous amount to digest there. To summarize his thoughts, Ben Bernanke will do almost anything to avoid deflation. Deflation is nasty. People lose money and a deflationary environment tends to feed on itself as folks resist spending money on anything. To his credit, Bernanke has completed in some form all of the measures he discussed in this speech.
Mr. Bernanke is absolutely confident in the Fed's ability to use the device called a printing press to avoid deflation.
SOME WILL ASK, "GOATMUG, ARE YOU IN THE DEFLATION CAMP?"
The answer to that question is quite simply yes. Does that mean that I'm short the market since 670 on the S&P? NO! Clearly we are in the grips of a deflationary environment and we are experiencing the same issues that Japan was facing in Bernanke's speech. He said that Japan had a crippled banking system, troubled corporate sectors, and a large overhang of debt. I see a significant amount of similarities here even AFTER the heroic measures taken by the Federal Reserve.
Despite my belief that we are still locked in the grips of a long term deflationary spiral, I believe strongly that we need to position our investing and trading assets in vehicles that will profit from the efforts of the Fed as they attempt to rescue our economy from their worst fear. The strategies employed by the FED have had a HUGE impact in the financial markets as we only need to examine the 60% rally over the last 8 months.
Personally, I use this information to help me find swing or momentum trades that may last two months or longer. By understanding Bernanke's mindset, arrogance, and belief that the solution can be found in limitless printing, I can begin to develop strategies that play on the manifestation of inflation or simply the expectation of future inflation.
I find it very interesting that Bernanke addresses the USD and currency intervention in this speech. I believe that the Fed and Treasury viewed currency manipulation as the last option. I also believe that they have found it to be extremely useful in bolstering "confidence" and dealing with the cost of the bailouts. My opinion is that we have reached the end game where dollar devaluation is now the only reasonable course of action. The Fed, Treasury, and administration have their hands tied as political acceptance for more bailouts is low. As our deficit grows they will see that the only choice is a managed devaluation.
Although Bernanke didn't quite suggest that there are limits to our ability to wage war on deflation, I think he might confess that we are limited in how quickly they can devalue the currency. Our creditors will become more vocal in their protests as our policies create losses in their US treasury holdings and as we further damage exporting nation's economies. In my next post we'll discuss how the Fed and Treasury will continue to implement their plan to counter deflation through the use of currency devaluation, despite the protests of our creditors. We will also discuss specific trading strategies that anticipate the Fed's long term moves to devalue and also their mild and short term attempts to placate our international friends.