John Mauldin's Weekly Letter: What the Fed Believes
A Very Clear Fed Speech
Stimulating Demand
But How Will the Fed Prevent Deflation?
Long Term Rates Are Headed Down
Pushing on a String?
The Pleasures of Life
Mushrooms
By John Mauldin
Today we are going to look at a very important speech by new Federal
Reserve Governor Ben Bernanke. I think this is one of the more
important letters I have written in a while. The speech has received
a lot of publicity for some of it's speculations about potential Fed
policy. Some seem to find very dire and immediate negative
implications in the speech. I, frankly, do not.
However, I do think the speech is important because it gives us
insight into the nature of the operational (and visceral) beliefs
among the members of the Federal Reserve, and in giving us a roadmap
for future Fed actions. It also gives us some hints as to future Fed
actions.
But first, a quick look at the Muddle Through Economy. This week we
get a lot of good news. The Chicago Purchasing Manager's Index is
solidly up, which means the national numbers will be good next week.
Housing has bounced back this month. First time jobless claims were
down although announced lay-offs are still worrisomely high.
Consumer sentiment is edging back up. Business spending is up
nicely.
But bank credit card write-offs are up 35.6%, late mortgage payments
and foreclosures are up, factory utilization is still an issue as
business keeps putting off making new investments. Personal debt is
now almost 100% of disposable income.
It seems we grew faster in the third quarter than we had previously
though, at a blistering 4%, although a large percentage is
automobile related, with most of the rest from government spending.
It seems this quarter that the NABE (National Association of
Business Economists) is speculating that we will be closer to 1.4%
growth. While they are so habitually off it is hard to give them
total credence, other economists I do respect seem to be echoing the
opinion that this quarter will indeed be slow, perhaps showing as
little as 1% growth. No one seems to be forecasting a robust
Christmas sales period.
The European Central Bank shows they continue to have no clue, as
the headlines today suggest that ECB members are still focused on
fighting inflation as Germany is dangerously close to slipping into
recession, and the rest of Europe is flowing close on their heels.
But Malaysia reports record port shipments, and other parts of the
world seem to be moving goods, so world trade is not falling into a
black hole.
In short, we continue to be in the Muddle Through Economy. We shall
end this year, it seems, north of 2% GDP growth, which is nowhere
near the 3.5%-5% (or more) growth most mainstream economists
predicted this time last year, as we were supposed to be in a "V"
recovery. Nor is it the double dip recession others forecasted. My
muddle through conjecture of last January seems to be on target.
Right now, it seems like we will be in this same slower growth cycle
for the next few quarters at least. Let us be thankful. Slow growth
is better than no growth at all. We could be in Europe or Japan.
This "recovery" has been different from most other periods following
a recession. We are in a profitless recovery. And that is why I can
predict a slightly growing economy on the one had and on the other
maintain we are in a secular bear market. Investors and many
analysts seem to think that the good economic news is foreshadowing
a recovery of profits. But the good economic news is not in the
areas which suggest a recovery of profits. Ultimately, it will be
real profits, or the lack thereof, which will drive market
valuations.
Now, I want you to keep this thought of a slow growth, Muddle
Through Economy in the back of your mind as we analyze Bernanke's
speech. It will prove to be the key to gleaning the importance of
his words.
First, 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 "... in our opinion
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 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.
First and foremost, as Gartman wrote, "Dr. Bernanke has made it
clear that the Federal Reserve Governors are painfully aware of the
very severe problem that a pervasive deflation would manifest upon
the US economy and the US society, and they are not prepared to
allow that to happen. They will do what they must in order to
alleviate deflation, including erring openly upon the side of
inflation..."
On one level, this speech breaks no new ground from that of the
previous Federal Reserve white paper on the causes of deflation in
Japan, and what the US Fed and other central banks could do to avoid
deflation. I wrote about that paper several months ago, stating that
it was clear to me, at least, that the Fed understood the nature of
the problem and was telling us they did not intend to see the US
slip into deflation. This is one reason I believe the speech is
reflective of Fed thinking, and not simply Bernanke's thoughts.
A Very Clear Fed Speech
The difference between that paper and Bernanke's speech is two-fold.
The paper was presented in the framework of an academic exercise,
and had no official stamp of Fed governor approval. It could be
viewed as theoretical, although I and a number of other analysts did
not see it that way.
Secondly, this speech was actually delivered in very clear, well
written English. The average layman could read and follow the
thoughts. Bernanke thus disqualifies himself for the role of Fed
Chairman when Greenspan finally steps down, as it seems a
requirement for the job of Chairman is the ability to talk at length
and say very little that can be taken clearly.
You can read the speech at:
federalreserve.gov
First, let's go to 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 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 Feds fund rates 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."
Stimulating Demand
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 believes that is does.
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.
Last week, I wrote about the speech by former Fed Vice-chairman
Wayne Angell. He is still quite close with Greenspan. Angell spoke
to the National Public Pension fund Forum. In summary, he said,
"Deflation is bad. The Fed gets it. There are still things the Fed
can do to prevent deflation and they will do what it takes."
Bernanke is a Keynesian. Angell is basically a monetarist. (These
are schools of economic thought with differing views of how Fed
policy works.)
Even with their differences, they both viscerally believe in the
ability of the Fed to stimulate demand and prevent deflation. That
is the lesson you need to take away from the Bernanke speech.
I have no quarrel with the view that a central bank can prevent
deflation. As Bernanke noted, there are ways to create inflation.
(He also correctly noted that there could be unknown consequences to
many of the actions he discussed, as there is no practical
experience with them in modern times.)
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 that the Fed
can stimulate aggregate demand with simple interest rate policies.
And as I have noted before, I am not certain 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 the 2001, when there has
been a disconnect between the markets and fed policy.
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
Reserves levers. But that does not mean the Fed will not pull them.
For Bernanke, "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."
The deflation that is threatening today will not come as a result of
a drop in aggregate demand, but as a result of excess production
capacity and the rising influence of China and other markets where
cheap labor is driving down production costs. It is acerbated by the
continued competitive currency devaluation upon the part of many of
the trade partners of the US. This is a tide of deflation that is
sweeping the world. It is a global phenomenon, and not isolated to
just one economy.
My concern is that the United States, in isolation, cannot prevent
global deflation from coming to our shores without help from the
rest of the world. And to date, we are not getting any help at all.
The Fed is between a rock and a hard place. If they allow deflation,
it could very well bring on a case of Japanese Disease: a
deflationary recession which is hard to get out of without serious
consequences. Bernanke listd what could be done to get out of
deflation should we find ourselves in it. He also noted that there
could be unintended consequences of these actions. It is not
something he, or anyone at the Fed, seriously wants to contemplate
doing. Therefore, they will not allow deflation to actually develop
if at all possible.
But how will the Fed prevent deflation?
If they create inflation by expanding the money supply at too high a
rate, it will cause interest rates to rise, thus slowing the
economy. The growth in US consumer spending starts to weaken as debt
mounts and people start worrying more about repaying their debts and
less about buying something new. If mortgage rates do not drop
further, the amount of money available from refinancing mortgages
drops. Most people are "cash flow" oriented. They have a budget for
their monthly expenditures. If lower mortgage rates allow them to
drop the monthly cost of the payment and pull out cash at the same
time, then they take the extra cash. Conversely, higher mortgage
rates mean higher monthly payments if they refinance to take out
cash.
A retrenchment by consumers will put us into a recession. Fed Policy
Lever: lower long term rates (thus mortgage rates) and stimulate
aggregate demand.
Bernanke tells us they still have levers to pull if we face
deflation. He also believes that the best way to combat deflation is
to stimulate aggregate demand. To me, his speech indicates that
means they will do what they can to lower long term rates and thus
mortgage rates, as this is the clearest way to stimulate demand.
(As an academic note, the Fed fixed long term rates in the 1940's at
2.5% and 90 day rates were 0.375%. In the 1960's, during the Kennedy
Administration, the Fed initiated something called Operation Twist
which attempted to drive down long term rates.)
I do believe that lower interest rates stimulate demand. I think
the reason we have not yet had a serious recession given the huge
debt problems we have, the bursting of the stock market bubble and
the global tide of deflation is partially due to the aggressive
Federal Reserve rate cuts. These cuts have made mortgages cheaper,
buoyed the housing market, help stimulate consumer spending, and
made the cost of financing cheaper for US business, thus offsetting
some of the negative effects of slower growth.
But between now and the next recession (and there will be a next
recession, there always is) I don't see today where the forces of
economic growth will come from that will allow the Fed to raise
rates so that they will have more bullets in their recession
fighting interest rate gun. Raising rates now will kill the US
economy by reducing consumer demand and guarantee deflation.
Therefore, this will not be done.
Therefore, we will enter the next recession with five or fewer 25
basis point bullets between current rates and zero. But the Fed
believes that in the face of a recession they must act to stimulate
demand. The policy lever at that point is to work to lower long term
rates. This will not be something they want to do, but will be done
when they think they have no other choice.
Let me summarize: We are in a Muddle Through Economy. 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 help avoid a serious recession.
Housing and consumer spending held up 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 US
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 deflation and/or recession.
Can I fault this policy? No, as a big recession would produce a
great deal of human misery, and not just in the US but worldwide. It
might be a few millions jobs in the US, but it is life and death in
many parts of the world which depend upon the cash flows from world
trade for their very survival.
Pushing on a String?
Will it work? I hope so, but there are a lot of economic problems
from then90's to deal with. There is a very real concern upon my
part 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 US economy and US consumers have always surprised on the
upside. If this was Europe, I would say, "Stick a fork in it. It's
done." We will have to wait and see, but meanwhile we muddle
through.
Long Term Rates Are Headed Down
Finally, I think this means that long term interest rates on
government bonds will go down even more. It will not be smooth, it
could even be more volatile than it has been in the past, but I
think the long term direction is as clear. It will also probably
take years for this to all play out. This is not a 2003 and it's
over process. As I said almost two years ago, Greenspan has raised
rates for the last time in his career. The question is how many more
times will he lower them.
I will stop here, as I could (and probably should in the future)
comment upon what Bernanke said about dollar policy. But it is time
to go eat turkey. |
