On the USD, gold, the Fed and interest rate cuts -- I took a trip down Memory Lane last night and revisited some old econ theory in an attempt to discern something potentially useful (from a trading perspective) of what might be travelling through Bernanke's neurons these days. IMO trying to gain some decent insight into BB is time well spent.
At the risk of boring some of the people who read this thread, some might want to consider reading (or re-reading as the case may be) Bernanke's "anchored inflation expectations" speech of July 10th that left more than a few Fed watchers scratching their heads as to WTF he was talking about. I watched the entire thing live on Bloomberg and have mulled it around in my head from time to time ever since. Here is the complete text -- federalreserve.gov
IMO the people who thought BB was just off doing some academic rambling (as I did too, at first) would have been better served to try and discern the 'why' rather than the 'what' for that speech, given my personal humble observations later that:
(a) BB is not as dumb as some (often) make him out to be;
(b) the Fed was/is not as unaware of the existence of a domestic housing bubble or of the negative implications of it bursting as some suggest, and;
(c) BB may very well have been telegraphing in the July 10th speech his planned approach for coping with the inevitable financial market fallout from the housing bust.
The tip-off here being, after years of official statistics and pronouncements stating that inflation is a non-problem, the Chairman of the Fed decided to deliver a very dry academic lecture on....you guessed it....the drivers of inflation. The inference being, that BB definitely saw the situation coming that he's in now, i.e. a post-RE bubble where he would be faced with pressure to cut rates while knowing that doing so will cause even bigger problems elsewhere. So in that sense, IMO the July 10th speech was set-up material to help prepare and justify some unpleasant actions to come later.
IMO the existence of a housing bubble has been plainly evident to the Fed for some time, no matter how much effort has gone into publicly downplaying the situation -- I mean, what did people expect the Fed to say? "Hey everybody, housing is collapsing, better sell your home right now before it drops any further?" -- engendering even more panic in that sector would hardly have been appropriate behavior.
So, if you're still reading this, join me on Memory Lane and revisit the Phillips Curve -- econ161.berkeley.edu --
NOTE: If you fall into the camp that believes that the Phillip's curve is useless junk, sobeit -- all that matters for the sake of this discussion is that the Fed utilizes variations of it in its deliberations, and based upon Mishkin's work, evidently derives policy and market responses based upon it -- I'm not about to trash or defend or debate it, because the validity of the curve itself isn't central to my point.
The definition of the curve used there is as good as any, i.e. "The Phillips curve is a relative relationship. Unemployment is considered low or high relative to the so-called natural rate of unemployment. Inflation is considered low or high relative to the expected rate of inflation" Note that bolded part, it's important.
Now let's marry Bernanke's speech about how inflation risk to the economy is a function of whether inflation expectations are "well anchored" (the inference being that such risks are greater when they are not). This is essentially a variation on the "perception is reality" theme, or "if you build it, they will come" (or conversely, if you don't build it, they will stay away -- like inflation for instance, or at least you hope). I therefore submit to you that Bernanke genuinely believes that fighting inflation is more about fighting the expectation of inflation than dealing with the actual inflation itself.
The premise being that, like the stock market, it's not about what's already happened, it's what people think is going to happen tomorrow that drives price. In some respects internalizing that dogma in dealing with inflation could be seen as highly practical, given that the inflation you've already experienced is effectively water under the bridge, whereas tomorrow's inflation is something you at least have a shot at controlling, not to mention that it's tomorrow's inflation which is more dangerous anyway because of its potential to accelerate in the days afterward if in fact you don't control it tomorrow.
So to return to the Phillip's Curve discussion, here is an excellent and almost laughingly ironic but accurate graphical presentation of the boxed-in situation that the Fed finds itself in 'right here right now' in Q3 2007 -- econ161.berkeley.edu -- complete with a classic description of being between the proverbial rock and a hard place.
Now, the current multi-trillion dollar question for at least the near term future of stock market prices, bond prices, gold prices, the value of the USD -- a lot of things actually -- rests largely on what the Fed will or will not do in this situation.
One last input to this equation -- it's worth keeping in mind that we have heard multiple times in the past few weeks about how the Fed's role is to control inflation for the good of the overall economy and not to bail out speculators who find themselves on the wrong side of the RE market, whoever they may be (presumably including the banks and mortgage brokers). I find it interesting that more than a few people have felt the need to publicly reinforce the premise that fighting inflation is Job #1 at the Fed, supposedly to the exclusion of all else.
So to get to the point of this long-winded discussion (my bad), IMO Bernanke either intentionally or unintentionally tipped his preferences about how he perceives inflation is to be combatted with his July 10th speech, i.e. that BB thinks you win that fight by maintaining 'well-anchored' inflation expectations looking forward -- to hell with anything that's already happened, because you can't do much about that anyway.
Now fast forward again to the present -- the market is currently discounting multiple and significant interest rate cuts, based in no small part upon a logic that to lower rates (and inflate) is the only way out of this mess, collateral damage to the USD notwithstanding. But in doing so, the market (especially gold) is also painting a very clear picture of the much dreaded rising inflation expectation (i.e. "not well-anchored", and in fact, about to escape the moorings completely).
This rising inflation expectation is consequently the very core of what BB believes needs to be eradicated or at least managed in order to prevent an upward inflation cycle from starting. That being the case, the stronger these expectations manifest themselves, the stronger the case for resisting them will become, meaning that in the name of fighting inflation BB may truly have no intention whatsoever of lowering interest rates.
Is the US stock market going to like that? I expect not. Nor will a lot of dollar-denominated PM speculators. Will holding the line on rates accomplish the goal of lowering inflation expectations? That's a tough call -- a US recession would presumably help at least dampen things globally. If nothing else, BB will surprise a lot of people if he doesn't cave in here and reduce administered rates, and instead sticks to other remedies for helping out WS, e.g. the NY dealers are making a killing here on LIBOR and Eurodollar carries now even without a US cut.
I also invite you to trash my 'no cut' prediction. Can't happen because BB is just a tool of the WS dealers and banks who want to keep the party going? Not enough national resolve to take the medicine before the patient kills itself of excess consumption? Too little too late no matter what Ben does because the damage already done is too great? I can envision and will concede the possibility of all of those scenarios.
To use the old saw, we live in interesting times, and this is a pivotal policy event IMO -- the Fed has to decide whether its mandate to protect the overall US economy is best served by trying to hold the line, or to cut and run for it. IMO what happens in the next few weeks could color life in the US for many years to come, which also has considerable implications for many others outside its borders
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