What the Fed Believes

Well, it’s clear at least, what the Fed thinks it can do to stave off deflation. Will it work? John Mauldin takes a stab at answering the $7 trillion dollar question…

Last week’s speech by new Federal Reserve Governor Ben Bernanke has received a lot of publicity for some of its speculations about potential Fed policy. Some analysts find very dire and immediate negative implications in the speech.

I, frankly, do not.

Let’s look at who Bernanke is: Dr. Ben Bernanke, prior to his recent appointment as a Federal Reserve Governor, was the Chairman of the Department of Economics at Princeton. He was the Director of the Monetary Economics Program of the NBER (National Bureau of Economic Research) and the editor of the American Economic Review. He co-authored a widely used textbook on macroeconomics. He is obviously well-respected in economic circles, and will be one of the more influential governors.

I believe this is his first major speech as a Fed governor. It was made to the Economist Club in Washington, which is not a small venue. Dennis Gartman referred to this speech as “…the most important speech on Federal Reserve and monetary policy since the explanation emanating from the Plaza Accord a decade and a half ago.”

We will look at the particulars in a few paragraphs, but we need to keep in mind that this is not a random speech. While Bernanke states that the views in this speech are his own, for reasons I will go into later, I believe this speech is indicative of the thinking of various members of the Fed, and was given to make unambiguous the Fed’s views on deflation. The title of the speech is very straightforward:

“Deflation: Making Sure ‘It’ Doesn’t Happen Here.” (You can read the full text of the speech here.)

Let’s take a look at the more ‘controversial’ parts of the speech. What are they (the Fed) willing to do to avoid deflation? This is the part that has raised the hackles of more than a few writers. I will quote:

“As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero – its practical minimum – monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

“What has this got to do with monetary policy? 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….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.”

Bernanke goes on to point out that the Fed could also supply interest-free loans to banks, monetize foreign assets, buy government agency bonds, private corporate assets or any number of things that could induce inflation.

Those words, taken out of context, could be seen as rather extreme, confirming the worst fears about central banks among certain groups and providing yet another reason to buy gold. There may be reasons in this speech to want to add a little gold to your portfolio, but these sentences are not among them.

Let’s look at what Bernanke really said. First, he begins by telling us that he believes the likelihood of deflation is remote. But, since it did happen in Japan, and seems to be the cause of the current Japanese problems, we cannot dismiss the possibility outright. Therefore, we need to see what policies can be brought to bear upon the problem.

He then goes on to say that the most important thing is to prevent deflation before it happens. He says that a central bank should allow for some “cushion” and should not target zero inflation, and speculates that this is over 1%. Typically, central banks target inflation of 1-3%, although this means that in normal times inflation is more likely to rise above the acceptable target than fall below zero in poor times.

Central banks can usually influence this by raising and lowering interest rates. But what if the Fed funds rate falls to zero? Not to worry, there are still policy levers that can be pulled. Quoting Bernanke: “So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure – that is, rates on government bonds of longer maturities…

“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.

“Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. 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.”

He then proceeds to outline what could be done if the economy falls into outright deflation and uses the examples, and others, cited above. It seems clear to me from the context that he is making an academic list of potential policies the Fed could pursue if outright deflation became a reality. He was not suggesting they be used, nor do I believe he thinks we will ever get to the place where they would be contemplated. He was simply pointing out the Fed can fight deflation if it wants to.

With the above as background, now we can begin to look at what I believe is the true import of the speech. Read these sentences, noting my bold, underlined words.:

“…a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

“The basic prescription for preventing deflation is therefore straightforward, at least in principle: use monetary and fiscal policy as needed to support aggregate spending…”

Again: “…some observers have concluded that when the central bank’s policy rate falls to zero – its practical minimum – monetary policy loses its ability to further stimulate aggregate demand and the economy.

“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.”

Now let us go to his conclusion: “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy’s underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.”

Let’s forget for the moment the debate about whether Fed policy can actually stimulate demand at all times and places. The quotes above demonstrate that Bernanke and the Fed board BELIEVE that it can. Beliefs will translate themselves into action. The Fed, when faced with slowing demand and deflation, will act in very predictable ways based upon their beliefs. They will work to stimulate demand.

I have no quarrel with the view that a central bank can prevent deflation. As Bernanke noted, there are ways to create inflation. I also have no quarrel with the view that the Fed should work to prevent deflation. However, I am not persuaded that in all circumstances, the Fed can stimulate aggregate demand with simple interest rate policies. I am equally uncertain that the price of preventing deflation will not be stagflation, or worse.

In a typical business cycle, if the economy gets “overheated” and inflation starts to rise, a central bank can raise interest rates and tighten the money supply, thus slowing business growth and profits and lowering demand and therefore price inflation. If the economy gets into recession, a dose of low rates and easy money is the prescription. “Don’t fight the Fed” is a rule we have been taught. It was a good rule to follow – until 2001, when a disconnect between the markets and fed policy appeared.

My concern is that we are not in a typical business cycle. Just as a number of different economic factors all came together to cause the boom and then bubble of the 80’s and 90’s (disinflation, lower interest rates, lower taxes, lower international tariffs, the demographics of the Boomer Generation, stability, etc.), I think there are now forces at work which may not respond to the Federal Reserve’s levers. But that does not mean the Fed will not pull them.

The Fed will not be able to raise rates without throwing us into recession. Therefore, they won’t. When the next recession rears its head, it is likely to have deflation written all over it. The members of the Fed viscerally believe that it is their duty to stimulate demand to avoid deflation, and they have the tools to do so. They will lower long term rates.

Why do this? Because from their point of view, it is the right thing to do. They believe (with some justification, I might add) that the recent rapid round of rate cuts helped avoid a serious recession. Housing and consumer spending remained strong due to the stimulus they provided. Business investment collapsed due to the excess capacity built up during the 90’s. The ability of corporations to raise prices to increase profits was taken away.

The hope is that if they can keep the economy moving along, even slowly, that excess capacity will eventually go away and that U.S. businesses will regain their ability to raise prices. The longer they can postpone the next recession, even by excess stimulation, the more likely it is that businesses will be in better shape. Hopefully, personal debt will start to decrease as well, and we can slowly over the next few years grow ourselves out of the current problems.

The belief (or hope) at the Fed is that we can work through the hangover of the 90’s (debt, deflation, excess capacity, dollar bubbles, trade deficits, etc.) before they run out of interest rate/demand increasing bullets.

Rather than one very big recession which hits the reset button on the above problems, they hope to slowly deal with them one by one by growing our way out of the problems, stimulating demand every time we slip nearer to recession…and/or deflation.


John Mauldin,
For The Daily Reckoning
December 3, 2002

P.S. Can you fault the Fed policy? No, as a big recession would produce a great deal of human misery, and not just in the U.S., but worldwide. It might mean a few million jobs in the U.S., but it is life and death in many parts of the world that depend on the cash flows from world trade for their very survival.

Will it work? I hope so, but there are a lot of economic problems from the 90’s to deal with. There is a very real concern that because of global deflation, the Fed is pushing on a string with its normal policies, and that ultimately the cure for deflation will cause discomfort. The best thing the Fed has going for it is that the U.S. economy and U.S. consumers have always surprised us on the upside.

Editor’s note: As well as contributing frequently to The Daily Reckoning and The Fleet Street Letter, Mr. Mauldin is currently authoring a book entitled “Absolute Returns”, covering the hedge fund industry. This year alone, Mr. Mauldin is scheduled to speak at 6 major conferences on various aspects of hedge fund investing. He also spends much of his time cautiously examining several hundred hedge funds, searching for a few outstanding opportunities. If you are an accredited investor and would like free access to Mr. Mauldin’s findings, please click here:

The Accredited Investor Letter

Hey, what’s this? Consumers hit the après-Thanksgiving sales pretty hard. Retailers report 11% more in sales volume than last year. Wal-Mart says its sales were up 14%…

The end of the world as we have known it, EOTWAWHKI, has been postponed indefinitely, or maybe at least until after the holiday season. In the meantime, it’s just like those gloriously loony fin de bubble days of late 1999. Consumers are happily spending their way to poverty…and investing their way to insolvency. It is just like old times; they are still buying the same gadgets and geegaws they can’t afford…and investing in the very same tech stocks that nearly ruined them 2 years ago.

We’re just waiting for George Gilder to remind us about promethean sparks shooting across the universe and Alan Greenspan to confirm that we now have a NEW New Era at hand…and our happiness is complete.

The recent good news suggests that America “may have sidestepped another double-dip [recession],” writes Stephen Roach, “but in my view, there’s little reason to conclude that there won’t be further such scares in the months and quarters ahead.”

“Americans spend as factories slide,” warns the BBC. Manufacturing is still in a slump, as Eric describes in his report. Prices of manufactured goods are falling – thanks largely to the huge supply coming from China and other low- cost producers, (about which more below…) Remaining U.S. manufacturers have no pricing power…so they gradually slow down and finally padlock the parking lot gate.

This trend has been going on for a very long time. It’s why people who work in U.S. manufacturing have had no increase to speak of in real hourly wages for the last 30 years. And it’s why America’s factory towns are so gloomy and depressed.

But maybe it will stop tomorrow. Maybe foreigners will suddenly start building factories in America. And maybe Americans will finally start earning more money. And maybe, then, they’ll be able to spend money without mortgaging their houses…and even pay down their debts. And maybe stocks will then have a reason to go up…

Or maybe not… Eric?


Eric Fry in New York…

– Despite loading up on stocks throughout October and November, investors showed up for the first trading day of December ready to keep on buying. Thirty minutes after the opening bell, the Dow had jumped 144 points to burst through the 9,000-mark for the first time since August.

– But the post-holiday euphoria quickly faded, and stocks coughed up most of their gains. The Dow finished 33 points lower at 8,862, while the Nasdaq held on to a 6-point gain at 1,484.

– Helping to crush the bulls’ early enthusiasm was a report from the Institute for Supply Management showing that the manufacturing sector in November didn’t belch as much smoke as many economists had hoped. (Presumably, the folks living close to the smokestacks didn’t mind that manufacturing activity was a little slower than the distant economists had hoped).

– Over in tech-land – that wonderful, environmentally friendly place that belches stock options instead of smoke – two Wall Street analysts offered conflicting opinions about the health of the semiconductor industry. There is no debate, of course, about the health of semiconductor STOCKS. They’ve been going pretty much straight up for weeks.

– But conditions in the industry itself are not nearly as rosy, unless you believe Dan Niles, Lehman’s semiconductor analyst. Yesterday, Niles boosted his ratings on Intel and Advanced Micro Devices due to an anticipated – by Niles – rebound in corporate technology spending. “Going forward,” says the upbeat Niles, “as IT budgets begin to loosen and corporate profitability begins to trend upwards, we believe there are subtle signs of a PC refresh cycle from the U.S. corporate segment.”

– If Niles is correct, the signs are so subtle that the PC manufacturers themselves do not seem to see them. Meanwhile, Merrill Lynch’s Joe Osha reiterated his “sell” recommendation on Intel yesterday, saying the stock was ahead of itself. “We think any reasonable improvement to numbers, or in the business, is already more than discounted in the stock price,” Osha told clients.

– Osha may have a point, and the point he makes is one that also pertains to the stock market as a whole: even if the economy is beginning a meaningful rebound, the stock market is way ahead of itself. A strong economic recovery is, as Osha would put it, “in the price.” So what happens if the economy fails to live up to expectations? We all know the answer, and it isn’t a pretty thing to watch. In fact, the stock market may not be a pretty thing to watch even IF the economy performs as well as hoped.

– That’s why the current stock market rally seems more like Icarus than Apollo. Just because the market is aloft, does not mean that it BELONGS in the heavens.

– Remember, stocks zoomed higher late last year after the post-9/11 sell-off, only to crash and burn several months later. Now, once again, hopeful investors have slapped some wax wings onto Mr. Market’s back and urged him to soar skyward. His flight has been awe-inspiring, if unsustainable. To be fair, Mr. Market’s wings aren’t exactly wax; they are a new-era composite known as “Nasdaq.”

– This aerodynamic composite provides awesome lift, thanks to a special blend of particles known as tech stocks. Unfortunately, this multi-tech-stock composite is inherently unstable, and we suspect that stocks like Novellus will compromise the integrity of Mr. Market’s new- age wings. The semiconductor equipment maker’s stock sells for an astounding 84 times estimated 2003 earnings despite, as the company itself admits, lackluster demand for its products. Who’s buying this stock anyway, and what are they thinking?…Are they thinking?

– In a rare display of candor on Wall Street, Bill Meade, managing director at RBC Capital Markets, says that buying Novellus at this valuation is “the fundamentally wrong thing to do.” Next time you see Mr. Market, he may be cascading into the sea.

– Meanwhile, the bond market has been matching the stock market, downtick for uptick. While the S&P 500 has powered ahead more than 20% over the last two months, prices on the 10-year Treasury note have collapsed, driving the bond’s yield from an October low of 3.58% to the current yield of 4.21%.

– But what may be misery for bond investors should be sheer delight for the subscribers to Resource Trader Alert. On September 27, under the watchful eye of Andrew Kashdan, the Resource Trader recommended buying put options on the 10- year T-note. Within a couple weeks, a sell on the options yielded a 49% profit. Then on November 13, after bonds had rallied quite a bit, Resource Traders were urged to re- enter the original trade. Since then, this second T-note trade has jumped 88%. (For more information, see: Resource Trader Alert .)


Back in Paris…

*** China is growing so fast, says the weekend International Herald Tribune, that its economy will be larger than Europe’s in just 5 years – at about $12 trillion. A few years more and it will be larger than the U.S.

*** “Could disaster strike twice?” asks Canada’s National Post. The disaster to which the Post refers is a Japanese- style, long, slow, soft recession…also the subject of a book your editor is writing.

The National Post: “It can’t happen here, [say economists]. That, of course, is exactly what the Japanese thought.”

Your editor has noticed, too. Almost no one saw the long slump in Japan coming, (except perhaps your editor, who didn’t write a book on the subject back in the ’80s, but thought about it.) And then, when it finally began, in 1990, almost everyone thought he saw it ending. End-of-the- Bust sightings were common in ’91, ’92, ’93, ’94, ’95, ’96, ’97, ’98, ’99, ’00, ’01 and even ’02.

But now, the End-of-the-Bust sightings are being replaced by End-of-the-World visions. Over the years, for example, estimates of the size of the disaster in Japan have increased. Originally thought to be less than $100 billion, more recently, Japanese banks are feared to have more than $1 trillion worth of bad loans on their books. And many large Japanese companies still are not profitable. Maybe they never will be.

How could that be? The Japanese built their economy to compete in making things. The strategy worked all too well in the ’70s and ’80s. Japan could make all the things it wanted and sell them to the Americans. By the late ’80s, the world seemed to want what the Japanese had, the yen was rising and the whole country seemed to be rolling in money. Who could blame them for getting a little carried away? But in the ’90s, the Japanese faced major problems…their bubble economy had burst at the seams…their population was getting older…and the Chinese were making things a lot cheaper than they could. Time and time again, during the ’90s, stocks rallied, and people thought they saw the good times coming back. But each time, the rally shriveled up like a New Year’s resolution and things seemed worse than ever.

Now we’ve entered another decade…and now it is America’s turn. The bubble has popped…people get older…and China is turning out geegaws and gadgets faster and cheaper than ever. How long will it be before China begins making automobiles…and the latest technology? How long before people start delaying their purchases…and begin saving cash for their retirements?

How long before we find out if it can happen here, after all?