International Perspective, by Marshall Auerback
Goldilocks Returns
April 27, 2004 (Prudent Bear)
We can all rejoice: “The worrisome trend in disinflation has presumably come to an end”, according to Federal Reserve Chairman Greenspan. Before one needs to panic, however, Mr Greenspan has also helpfully signalled that we are far from the stage at which the Fed need contemplate raising rates. Goldilocks, we might infer, has made her triumphant return.
Or has she? We would argue that this whole process of jawboning the markets is part of an elaborate confidence trick on the part of the Fed. The efforts of U.S. policy makers to avoid a full unwinding of the 1990’s stock market bubble through the encouragement of a credit bubble and a housing bubble has, despite something of a recovery, made both conditions worse. Given these debt burdens, the Fed has recourse to only one policy: a debt-confiscating policy of inflation. But it is a policy that must be pursued on the quiet so as not to spook the country’s growing legion of foreign creditors. The current policy is less Goldilocks, more Svengali.
As usual in these circumstances, Mr Greenspan’s Congressional testimony was quickly supplemented by his fellow Fed Governor, Benjamin Bernanke, who estimated in a recent speech to the Bond Market Association in New York that “core inflation has stopped falling and appears to be stabilising in the vicinity of 1-1/2 per cent, comfortably within my own preferred range of 1 to 2 per cent.” (“The Economic Outlook and Monetary Policy” – April 22nd, 2004)
Despite the reassuring tone of both figures, both the stock and bond markets reacted in somewhat volatile fashion. The bond market, in particular, appears to have lost its easy confidence that monetary tightening was a prospect likely left until well after the Presidential election and has accordingly begun the process of discounting more imminent interest rate hikes.
The sheer unease and resultant volatility manifested in the US capital markets is symptomatic of a loss of financial confidence in American monetary officials. The credibility of two of the leading actors of American monetary policy today is somewhat threadbare, to say the least. Alan Greenspan has promoted the “new age” thinking during the 1990s equity market high tech mania, and his more recent role in the inflation of the credit bubble has been even more direct. This was particularly evident last year when the Fed manipulated investors into buying bonds by hinting at direct intervention in the market to force down yields, a line of thinking also strongly encouraged by Mr Bernanke since his now infamous “electronic printing press” speech in November 2002.
Since that speech, the Fed had discussed so frequently the possibility of unconventional measures to prevent price inflation, including pegging bond prices and yields, that it encouraged market expectations of a bailout intervention for bond holders, no matter how high bond prices had risen (the so-called Bernanke Put). Concerned as it ostensibly was by the threat of deflation, the Fed successfully led many bond market participants to believe that it could peg long-term rates at whichever low level and as long as it desires by buying bonds, i.e., by expanding its own balance sheet and by printing money. In other words, the Fed sought to perpetuate the fiction that if and when the economy recovered, the US central bank would deliberately insulate bond yields from normal market forces until the economy was at a cruising altitude again.
But having gazed into the abyss of unconventional policy measures, the Fed ultimately concluded that the cure offered more problems then the disease. We have cited some of these difficulties previously. In offering to yield cap longer dated paper, the Fed risked having to peg the entire debt spectrum – private and public – in order to fulfill this objective. But the withdrawal of this “Bernanke put” resulted in one of the worst months ever recorded for bond investors. Once bitten, twice shy: after luring gullible traders into leveraged carry trades like a Pied Piper, the Fed has now had its credibility with market speculators deeply eroded.
Against this backdrop of increased leverage and unprecedented volatility in the bond market, it is somewhat disingenuous for Mr Bernanke now to claim that “market interest rates have generally responded continuously and in a stabilizing manner to economic developments”, or that “monetary conditions in the United States are in the process of normalizing”, as he did last week. To describe today’s volatile monetary conditions in the US as “normalizing” is akin to describing the temperature as “average” when a person places his feet into two buckets of water, one freezing cold, the other boiling hot. In fact, the current situation in the bond market is most unusual. Normally, the bond market doesn't begin to drop sharply (and certainly doesn't crash) unless the Fed is already in a tightening mode, and usually has been in one for some time. Historically, bond crashes have occurred when the Fed is already in motion and there is a sudden panic that the end-point for their tightening round could be much further out in time and magnitude than previously imagined (e.g., late 1987, late 1994).
Today, by contrast, we are in a highly unusual situation in that the Fed has done nothing but there is almost universal market agreement that a large tightening lies ahead, implying little confidence in the Greenspan/Bernanke reassurances. The problem for Messrs Greenspan and Bernanke is that the whole inflationary expectations game can only work when all members of the central bank are singing from the same hymnal (ironically, this alleged lack of unity, was one of the reasons cited for the euro’s recent drop against the dollar). But soon-to-retire Fed Governor Robert Parry recently said the neutral Fed Funds rate was 3.0-3.5 per cent, implicitly suggesting the Fed may be 200 basis points behind the curve.
These comments fly in the face of Parry’s recent advocacy of a LOWER Fed Funds rate (per the minutes of the most recently published Monetary Policy deliberations), and may simply constitute a belated attempt to restore his earlier reputation as “inflation hawk” before heading off to retirement. But even if Parry’s words do not match his recent actions, they raise all sorts of conundrums: the bond market could very well crash now without the Fed doing a blessed thing because some of its own members have now conceded they have a huge tightening job to do and haven't even started yet against a backdrop of historically unprecedented leverage. What happens if the Fed does raise rates in June? Who wants to be long bonds after the first 50bp hike when someone like Mr Parry has signalled to the market that there may be another 150-200bp coming right behind it? (This potential problem largely underlies the reasoning of Morgan Stanley chief economist, Steve Roach, who has made the case that the Fed might as well go to 3 per cent immediately, because at least then the market will have some possible belief that they are finished tightening and the next move could be an ease. It is hard to see market participants adopting that view in June or August if the FOMC moves rates up a mere 25-50bp.)
Parry and Roach are not alone. We note that highly astute market observers, such as Jim Bianco, have made a powerful case for a Fed tightening as early as June (leaving it to August or September would, Bianco suggests, make the Fed part of the election rhetoric) on the basis of a stronger than expected economy which is beginning to generate significant job growth.
But whilst we have profound respect for the views of Bianco, we believe he makes the mistake of assuming that the Fed is truly serious about dealing with today’s rampant inflationary credit bubble. Our view is markedly different: In today’s world, decades of government intervention and the massive expansion of moral hazard on the part of the Fed to prevent financial crises and price deflations have encouraged economic agents to accumulate the highest private debt burdens ever attained. Even without price deflation, these debt burdens are now acting to suffocate demand and threaten stagnation, recession and financial crisis. There is only one socially acceptable method left to eliminate these burdens – namely, through a debt-confiscating policy of deliberately engineered inflation.
This sort of policy is much easier to achieve explicitly (as many have repeatedly urged on Japan, for example) when the nation concerned controls its own economic destiny by virtue of its creditor status and accumulated assets. Not so in the US, where until recently, the apparent willingness of the part of the Fed to contemplate extreme monetization to the point of currency debasement has clearly discomfited its growing legion of foreign holders of treasury bonds and stocks. Both of these classes of market participants are very long these assets which makes the US capital markets highly vulnerable to rapid withdrawal of overseas portfolio flows in the event that the Fed were to pursue an explicit policy of inflation and concomitant currency debasement.
For all of Bernanke’s discussion of transparency as an aid toward engendering lower inflationary expectations on the part of the so-called “bond market vigilantes”, this is the sort of policy that has to be pursued on the quiet. Nobody in the Fed wants a repeat of the market reaction post Bernanke’s “electronic printing press” speech. Deception, not transparency, rules.
Hence, Mr Bernanke’s current celebration of the Fed’s success in achieving “normalized monetary conditions” in the US, which in turn has supposedly engendered a quiescent core inflation rate, thereby justifying little in the way of the tightening now demanded by observers such as Bianco (who cites multiple evidence to the contrary, in particular, a booming economy, increased job growth momentum, a 5-year highs in measured CPI, etc.).
Bianco may indeed be correct that the market is “losing patience” with the Fed. All the more reason to rein in inflationary expectations through the soothing rhetoric of Messrs Greenspan and Bernanke; the reality, however, is that the odds favour the Fed continuing to pursue an inflationist policy highly inimical to foreign holders of US dollar assets.
The same delicate balancing act applies in regard to the dollar. From its low of 84.92 on February 17th, the dollar has now rallied 7.3 per cent. Yet over the same period, bond market yields have risen. Superficially, it appears to be quite a perverse state of affairs, since the traditional bear case for US bonds was that a precipitous drop in the value of the dollar would prompt a revolt on the part of external creditors, who in turn would demand higher equilibrating rates in order to offset the loss of capital implied by a huge devaluation. One would also think that the corollary would apply: a stronger dollar would tend to attract greater speculative capital into stocks and bonds (the oft-stated strategy of former Treasury Secretary Robert Rubin), and thereby drive rates lower.
So what is the underlying paradox at work here? As we have discussed previously, a gently declining dollar has actually provided a far greater cushion to the US bond market than a rapidly strengthening greenback. Asia’s leading central banks, in particular, have in effect acted as a buffer between private speculative capital (which continues to wash its collective hands of the dollar), and the Asian and American industrialists, which are deriving benefits from a slowly declining currency, but who would be the first casualties of a dollar collapse (given the deflationary impact of the latter through the sharply higher long rates it would ultimately produce). Both China and Japan are prodigious financiers of US consumption--the two largest foreign holders of US Treasury bonds--despite the weak returns they get from low US interest rates. China and Japan are willing to do this because they calculate that sustaining their own industrial output and employment is worth more than seeking stronger financial returns elsewhere.
Ironically, should the very recent spate of dollar strength continue, it might begin to unravel this “happy” state of affairs insofar as it removes the incentive for foreign central banks to continue to buy US dollar bonds (as well as overseas speculative capital, which has begun to re-accumulate long term US securities over the past 6 months), as the need for dollar support operations diminish. We use the word “happy” guardedly, since it is clear that even if the dollar resumes its decline, the underlying problem of indebtedness remains, as does the inherent volatility in the bond market. The Fed, and its partners in crime in the Asian official sector, has pushed things so far out of control that they can't ever practically tighten. Consequently, the bond market will be left to swing wildly to accomplish this task for them. This is an environment when volatility protection should be at a premium, yet there is very little evidence this is so in either bonds or stocks.
By accommodating the Fed’s largesse, therefore, the Asian official sector has helped to sustain growing American financial and monetary profligacy, thereby accentuating underlying financial fragility in the US economy. Which brings us back to the Fed’s delicate balancing act: the US central bank must occasionally put grit on the dangerously slippery slope of dollar devaluation and continue to pretend that it can and will tighten to deal with incipient inflationary pressures when the time is right. In so doing, it hopes to retain the status quo of an economy kept afloat by enormous foreign lending so that consumers can keep buying more imports, thus increasing the bloated trade deficits.
This lopsided arrangement will end when those foreign creditors--major trading partners like Japan, China and Europe, or overseas portfolio capital--decide to stop the lending or simply reduce it substantially. To forestall this eventuality, the Federal Reserve has to continue to control inflationary expectations, as Governor Bernanke disarmingly conceded. It is part of an elaborate confidence trick on a country sinking into financial dependency--dangerously indebted to rival nations that are holding its debt, collecting the interest on Treasury bonds and private bank loans, or repatriating the profits from companies that used to be American- owned. A very wealthy nation can tolerate this negative toll for many years, but not forever. Unless the historic meaning of debt has been repealed, no nation – even one with a reserve currency – can borrow endlessly from others without sooner or later forfeiting control of its destiny, and also losing the economic foundations of its general prosperity. Messrs Greenspan and Bernanke can slow the process (to the country’s longer term detriment), but they cannot forestall the ultimate outcome. Gritting icy roads provides but a temporary respite, not a permanent solution against crashes. |
