Pittsburglive.com - "U.S. blind to Fed's bluff" .
August 23, 2009
The Federal Reserve continues to boost confidence by saying that things are improving.
On Aug. 12, the Fed said it would keep its benchmark short-term funds rate at 0 percent to 0.25 percent, enabling all member banks, including Goldman Sachs, to reap huge profits.
The Fed also announced it would extend its support for U.S. Treasury prices until the end of October, albeit at a decreased level.
These measures were justified by the view that the American economy showed signs of leveling off after 20 months of recession. Stock markets rallied immediately, believing the recession was ending.
A vital element of the Fed's goal is to encourage economic confidence. Bluff plays a key role. Could the Fed, with its privileged access to key economic information, be wrong? If so, the policy could result in serious damage to major sectors of the economy.
More important, could the Fed deliberately be misleading key sections of the economy in order to kick-start the economy by means of a massive bluff?
It is said that stock markets anticipate economic events. Therefore, the rising equity markets would indicate that the Fed is correct in forecasting an end to the recession. But these times are atypical and differ from post-1930s precedent. If stock markets are wrong, the American economy could be heading toward the financial catastrophe of hyper stagflation.
As forecast, the stock markets have shown a strong recovery from their lows of March 2009. This recovery was led by the financials. Their prices had been discounted drastically in anticipation of a financial Armageddon.
The Bush administration decided that the big banks they had allowed to grow were too big to fail. They were saved by the injection of vast TARP funds and access to zero-interest Fed funds.
For the first time, interest was paid on their reserves at the Fed. In addition, the "mark-to-market" accounting rules were changed to further camouflage the banks' holdings of toxic assets. As a result, the banks generated huge profits.
Eventually, it was clear that the government would salvage the banks at any cost. A banking collapse was averted and bank stocks looked cheap. Some investors were even encouraged to buy new stock in the banks.
Soon, market investors flooded in and the banks led a major bear market rally.
In addition, the Treasury Plunge Protection Team was effective at keeping the Dow above the key 8,000-level, below which the insurance industry would become threatened.
Also, it was effective in fueling investor belief in a market recovery. Meanwhile, the Fed manipulated Treasury yields downward, openly, while, collectively and covertly, central banks kept a lid on the price of gold.
Fired with investor enthusiasm and fanned by the Wall Street media, corporate stocks rose to recover 50 percent of their declines. This optimism occurred despite an average fall of about 30 percent in earnings, driving the S&P average PE ratio to the historically expensive level of 20.
Worse still, revenues fell 15 percent, severely eroding free cash flows.
Doubtless, the multitrillion-dollar injections of borrowed and synthetically created government funds have sustained some demand. But, with reduced sales, many companies cut staff and depleted inventories, boosting profits and the illusion of recovery.
Stocks were also boosted by a reduced trade deficit. Again, the optimism was misplaced. Naturally, with consumer demand falling, imports shrank and, with a weak dollar, exports rose.
Consumers are still in shock as the realities of true unemployment at 20 percent begin to bite. Meanwhile, the Fed talks of a jobless recovery. But, without a supportive asset boom, it is an oxymoron and bluff.
Looking forward, a massive $3.4 trillion commercial mortgage problem looms. Taken together with a rising tide of credit defaults, the banks suddenly look threatened. Having led the stock market rise, they could lead a second plunge.
The reality is that the economic future appears decidedly bleak, with flat L-shaped economic growth increasingly likely. In sympathy, stock markets should trace extended downward diagonal paths.
Following two or even more bear market rallies, the Dow could dip to 1,000, on an inflation-adjusted basis, or the price of one ounce of gold.
Facing such a prospect, the Fed might command support in its efforts to kick-start the economy.
But if the Fed is wrong, as it was in the lead-up to the recession, America could experience simultaneous financial inflation and economic depression or hyper stagflation.
In these circumstances, a stark difference will arise between political currency and real money or gold.
In the game of blind man's bluff, a player selected as "it" is blindfolded and must grope around the room trying to "tag" another player, who, if correctly identified, becomes the next "it."
It is one thing for children to be blindfolded in a game. It is quite another to blind Americans to the economic truth. The Fed's bluff is a game to avoid deleveraging. It has no winners.
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