The Longest Yard (Crescenzi)

Tuesday, July 31st, 2012

by Tony Crescenzi, PIMCO

• As the global slowdown progresses, we can expect central banks to deploy more policy tools – without limits – to stem the pace of deleveraging.
• In Europe, quantitative easing using ESM bonds could prove to be another bridge that buys politicians more time, but does not solve the root problem.
• We expect real economic growth in China to be muted. While some stabilization is possible later this year, it is hard to foresee a sustained recovery.

Saddled with debt and mindful of recalcitrant investors, nations in the developed world have lost their ability to solve their economic woes by adding more debt, leading them more than ever to rely upon central bank action. It is fantasy, however, to think that central banks can keep the game going for long. No central bank ever created anything tangible – you won’t find any stories about a Fed chairman discovering electricity or creating the light bulb. What central banks are best at creating is fiat currencies, and these are only as valuable as what they are backed by, whether it be gold, silver or the productive capability of a nation. Create or print too many of these and they will have no value to anyone, save for nerdy numismatists.

All that a central banker can do to add value to society is help foster financial conditions that facilitate the efficient use of capital, but even here central bankers can get it wrong and produce exactly the opposite result. The housing bubbles that preceded the onset of the recent financial crisis are proof; they were in fact at the heart of the crisis.

Central bankers today are striving valiantly to help smooth the deleveraging process by promoting conditions aimed at reflating the value of financial and real assets that would otherwise almost certainly fall in price. This isn’t easy to do because the world is striving just as valiantly to reduce its debt, taking actions that result in persistent downward pressure on asset values.

Central bank liquidity can’t turn the lights on in Italy

The orderly liquidation of debt requires economic growth. By boosting asset prices, central bankers have sought to promote economic growth and buy time for the fiscal authorities of the developed world to formulate and implement growth-oriented policies. Global investors have been patient, but the repeated failure of policymakers has their patience running thin.

No amount of central bank liquidity by the Federal Reserve, the European Central Bank (ECB) or any other central bank can possibly fix what ails the developed economies. The ECB, for example, can’t fix the fact that Italy ranks 109th out of 183 countries in providing electricity. Nor can it fix the fact that Spain ranks 133rd in the ease of opening a business. How about Greece?

Can the ECB reduce the size of government, improve tax collection or reduce the number of occupations Greece considers so hazardous that hairdressers, pastry chefs and clarinet players can retire in their early 50s? In the U.S., can the Fed reduce the outsized growth rate of the entitlement system? Central bankers can do nothing about these competitiveness issues, but the restoration of growth and competitiveness is essential to improving the ability to repay debt.

To use football vernacular – and here I mean American-style football – central bankers have taken the ball about as far down the gridiron as they can. To be sure, they can still do more; the Fed could implement another round of asset purchases, cap Treasury rates, cut the interest rate it pays banks on excess reserves, extend further its conditional promise to keep rates low, or perhaps consider some form of credit easing. If the Fed did any of these it would mark another courageous effort by The Decider, Fed Chairman Ben Bernanke, but it will never get the ball into the end zone.

To cross the goal line, to restore growth and competitiveness, the fiscal authority – not the monetary authority – must move the ball. This isn’t easy because the citizens of the world are voicing their objection to the changes necessary to do so. Try all you might, central banker, but at the 99th yard you will find the longest yard!

Unlimited global monetary policy – Ben Emons

In recent media debates, some commentators have pointed out that quantitative easing (QE) programs may have seen their effectiveness diminish. However, monetary policymakers in both developed and emerging markets continue to pursue easing measures. Different kinds of policies emerged, such as the Bank of England’s direct lending scheme, known as “credit easing.” The European Central Bank and the Danish central bank went another direction, cutting their deposit rates to zero or even negative. The lower zero bound is often viewed as a constraint, a limit in using conventional tools. The ECB and Danish central bank decisions to cut deposit rates showed how conventional policy is not necessarily limited. In fact, all central banks could cut deposit rates or rates on excess reserves in order to “force” out large cash balances held at the central bank to stimulate lending.

There could be “practical limits,” where QE or deposit rate cuts cause nominal and real interest rates to turn negative, affecting future income streams on savings accounts, pension funds and money market portfolios. The central banks’ growing market share in longer-term Treasury bonds and their low yields has added to the challenge. These practical limits are not necessarily seen as a barrier, evident by the recent string of actions by emerging and developed market central banks. Milton Friedman argued in his 1968 paper, “The Role of Monetary Policy,” how monetary policy should be based on limits. His view was that policy should not “peg” interest rates for a prolonged period of time or it may lead to structural inflation. Friedman pointed out that rapid monetary base growth was generally associated with high nominal rates, a sign in his view of easy policy, e.g., Brazil in the 1960s. Low interest rates were related to slow money growth, like the U.S. during the 1930s, which Friedman viewed as tighter monetary policy. Friedman saw the setting of rates connected to the amount of money growth the central bank would conduct to influence price expectations. When interest rates are pegged in an environment of seemingly stable inflation expectations, Friedman noted a risk of disconnect where the monetary base could become uncontrollable and lead to higher inflation.

In today’s environment of low interest rates, monetary base growth and stable inflation expectations, such disconnect is not seen as a risk, as debt deleveraging has been overwhelming. Since most major central banks see deflation as a bigger risk at this point, practical limits or those limits that Friedman spoke of do not seem to be tempering the willingness of global central banks to go further. In fact, as the global slowdown materializes further, we can expect more policy tools will be deployed to stem the pace of deleveraging, and without any limits.

The ECB can only provide a bridge – Andrew Bosomworth

The ECB can only provide a bridge for the European monetary union’s problems, not a solution. Its decision to cut all policy rates by 25 basis points (bps) earlier this month signaled the bank’s ongoing willingness to provide that bridge by creating time for political and fiscal agents to implement durable solutions. Judging by the gyrations in yields on southern European bonds since the ECB’s meeting, however, markets were evidently disappointed the ECB did not announce further unconventional measures to shore up Europe’s dysfunctional bond markets. Even after ECB president Mario Draghi’s “whatever it takes” statement on 26 July, we still have not seen yields on outer peripherals drop to sustainable levels.

Market expectations for unconventional measures derive from at least two sources. First, since the ECB crossed the Rubicon in 2010 by buying Greek government bonds, markets now believe the bank will do whatever it possibly can to prevent the Economic and Monetary Union (EMU) from breaking up; the costs of not doing so would be too great. Indeed, the ECB currently holds €211 billion in securities from previous forays into the bond market. Second, some market participants, policymakers and influential figures, like Italy’s prime minister and the head of the IMF, are lobbying the ECB to buy even more in order to drive southern European bond yields lower.

Such proposals are shortsighted and address the symptoms rather than cause of the EMU’s problem. Buying bonds without fixing the design faults in the EMU’s governance structure is a near-term fix whose beneficial effects, like painkillers, will soon wear off. Were the ECB to follow lobbyists’ calls and resume the Securities Market Program (under which it bought government debt in 2010 and 2011), it will not solve the governance structure problem. However, buying bonds to ward off deflation once conventional monetary policy has reached the zero lower bound is likely warranted.

The ECB usually refers to Article 123 of the Treaty on the Functioning of the European Union, which prohibits it from financing governments’ budget deficits. The ECB’s reasoning is not entirely clear, given the same European law (part of the Lisbon Treaty) governs both the ECB and Bank of England (BoE) yet the latter buys government bonds as part of its quantitative easing. We think the explanation lies in differences between the ECB and BoE’s perceived risk of deflation, the degree of trust between the monetary and fiscal authorities and the fragmentation of the EMU government bond market relative to the singularity of the United Kingdom’s government bond market owing to its centralized fiscal policy.

As credit to the EMU’s private sector declines – the natural consequence of deleveraging after a credit boom – the risk of deflation in Europe is likely to rise. We think deflationary forces will intensify, making a further reduction in the main refinancing rate to 0.5% likely and perhaps necessitating quantitative easing. Which government bonds might the ECB buy in those circumstances?

The ECB’s capital key (which reflects each member country’s proportional contribution to total capital) suggests about one-quarter and the largest allocation of purchases would be in German Bunds. But capital flight to Bunds has already driven their yields abnormally low, suggesting quantitative easing would achieve little. And the ECB would send mixed signals if it concentrated purchases in Italian and Spanish government bonds. Would the ECB do this to offset eurozone-wide deflation risks or to compensate for member states’ reluctance to centralize fiscal policy?

Purchasing the bonds of the European Stability Mechanism (ESM) could circumvent this dilemma. Unlike the ECB, the ESM is designed to provide member states with financial assistance subject to conditionality. While it lacks the same degree of democratic legitimacy as Europe’s parliaments, at least the ESM is a child born of the democracy. However, like its predecessor, the European Financial Stability Facility (EFSF), the ESM’s main weakness is that it is unfunded. We think the ESM will find it equally difficult to raise sufficient funds from the capital market at low enough yields to perform the job it is designed for. And even if it finds buyers, the ESM will likely crowd out demand for other government bonds from Italy, Belgium, France and Austria, thereby raising their borrowing costs. Quantitative easing using ESM bonds could thus prove to be yet another bridge that buys politicians more time but does not solve the root problem. When it comes to Europe there is only one thing we can say with certainty: This crisis is not yet over.

People’s Bank of China moves to counter weakening growth – Isaac Meng

Policymakers in China face different limitations today than those in the U.S. and Europe, but they too have had to respond to the strain in the global economy, especially as slowing global demand exerts downward pressure on China’s export-investment-driven growth model. In a surprise move, the People’s Bank of China (PBOC) cut its benchmark rate by 25 bps twice within a month. The PBOC also deregulated deposit rates, allowing a 10% float above the benchmark, which largely offsets the cut’s effect on deposit and lending rates.

Though one to two months earlier than the market expected, the latest rate cut is not surprising in light of weakening growth and a slowing inflation outlook. Second quarter growth at 7.6% is barely above target, and inflation risk is easing fast with CPI likely stay below 2.5% over the next two to three quarters versus the PBOC’s target of 4%. Even though rates were cut by 50 bps, China’s real rates are still rising because CPI is heading down toward 2%. If the PBOC targets positive real deposit rates as a floor in the medium term, then there is still room to cut another 25 bps to 50 bps. The 8% to 9% average lending rates remain too high for borrowers struggling to deleverage amid a deepening industrial slowdown.

With the Chinese yuan’s outlook and foreign flows turning to a more balanced stance, the PBOC needs to further unwind past foreign exchange sterilizations, most likely by cutting the Reserve Requirement Ratio by 50 bps per quarter to maintain money market rates in the range of 2.5%–3.0%.

Despite room for monetary easing, the PBOC still seems behind the curve in easing financial conditions. Chinese banks remain tight in credit and slow to cut their lending rates. Domestic Chinese borrowers have excess capacity to deleverage, and the yuan’s nominal effective exchange rate is rising amid a rigid foreign exchange rate regime. Thus, we expect real economic growth in China to be muted and slow, and while some stabilization is possible in late 2012, it is hard to see a sustained recovery.

Past performance is not a guarantee or a reliable indicator of future results. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.

Copyright © 2012, PIMCO.

Tags: Asset Values, Central Banks, Downward Pressure, Economic Growth In China, Economic Woes, Efficient Use, Fed Chairman, Fiat Currencies, Financial Crisis, Global Slowdown, Gold Silver, Light Bulb, Longest Yard, Numismatists, PIMCO, Policy Tools, Productive Capability, Real Assets, Root Problem, Tony Crescenzi
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Bernanke Doesn’t Want Another Term?

Friday, June 8th, 2012

One of the popular theories on the internets (sic) is that Bernanke wants to goose the market to help get Obama re-elected since he wants to keep his job.  That due to the comments continuously heard during the GOP primaries about how every candidate wanted to replace Bernanke.  There is a piece in the WSJ overnight by Fed mole Jon Hilsenrath and while it is more dovish (by a degree) than his comments just 24 hours ago on CNBC (maybes someone at the Fed yelled at him), which has a very interesting blurb on this topic:

Mindful of his own legacy and the Fed’s independence, Chairman Ben Bernanke seems unlikely to allow the political calendar to sway his decisions. He appears especially immune from politics now, with just 18 months left in his term as chairman and little indication that he wants another.

Now if the U.S. is at a weak moment economically at the end of Bernanke’s term, and Obama is re-elected maybe Bernanke will be asked to carry on, but unlike a Treasury Secretary which might stay on an extra year while an economy is in a weak spot, once Ben commits he commits for many years.  So I found this paragraph very interesting in light of the commentary about Bernanke wanting to retain his job.  It would seen doubtful a President Romeny would come in and remove someone who at that time would only have 12 months left in his Fed chairman role.  Especially if that someone did not want a new term.

That said, if Romney wins it seems to kill the chances for the heir apparent Janet Yellen if indeed Ben wants out.  Yellen makes Bernanke look like a hawk.  Anyhow, thought I’d pass it along as it was news to me.

p.s. The last angle of course is someone who has no aspirations past 18 months certainly carries a lot more freedom in his/her actions than someone who does!

Tags: Aspirations, Ben Bernanke, Blurb, Cnbc, Fed Chairman, Gop, Gop Primaries, Hawk, Heir, Janet Yellen, Legacy, Mole, Nbsp, Paragraph, Political Calendar, Romeny, Treasury Secretary, Weak Spot, Wsj
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Deflation?

Monday, June 4th, 2012

From Mark Grant, author of Out of the Box

“The sources of deflation are not a mystery. 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. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending – namely, recession, rising unemployment, and financial stress.”

-Fed Chairman, Ben S. Bernanke

There was an argument, brought forth by several bright people; that the odds of Inflation or Deflation were about in balance for the remainder of this year. I think the needle has swung though and that Deflation, and perhaps serious Deflation, is just ahead of us. Every country in Europe is in a Recession with the exception of Germany but I predict that they are going to be dragged into the Club in the next quarter. The aggregate demand for goods and services is markedly declining all across Europe and the Target2 remedy to finance purchases is no longer providing the desired effect as financing only helps when demand is present and once demand has declined it makes very little difference as to the cost or availability of funding.

“Booms last longer because optimism is fed by slowly rising emotions involving hope and greed, which, because they are tempered by caution, can reach maximum intensity only over a long period of time and fulfillment only after prolonged effort. Busts are swifter because pessimism is fed by fast-flaming emotions such as fear and anger, which can be realized in a flash of destructive action.”
-Robert R. Pretcher

The banking system, not just in Spain, is in tatters and the lending in the domicile of the banks is eroding as signified by all kinds of data released recently. Lending outside of the domicile has declined even further so that growth is curtailed by the availability of funding and the further away from the national home of any European bank; the worse the problem. This is then why I am so negative on the Emerging Markets as a safe place to park money. The lack of available funds will dampen growth so that the European recession spreads worldwide as contaminated by the problems of the European banks which, in aggregate, are about five times the size of the American banks and much more active in global lending.

“The modern theory of the perpetuation of debt has drenched the earth with blood, and crushed its inhabitants under burdens ever accumulating.”

-Thomas Jefferson

We have recently witnessed a boom-and-bust cycle in Real Estate in Europe that overcame the banks of several nations including Ireland and Portugal. Now Spain is about to show up to be counted in my view. The issue all across Europe is that the sovereign does not have enough assets or capital to bailout their banks and many European banks are impaired; make no mistake. The first move was to lay off a lot of non-performing assets in securitizations at the ECB but the price always gets paid which will either be severe losses at the ECB requiring re-capitalization or the ECB handing back the collateral to the various banks which would probably bankrupt some of them especially in Spain, France and Italy. The ECB maneuver brought early success but now, as loans become due and as non-performance builds and losses must be recognized; the real truth forces itself upon balance sheets. There is a day when the auditors say, “Show me the money” and when it isn’t there the infamous “Oh My God” moment begins.

Now Bubba, when you use the screwdriver and release the air from the tires it causes all of those little lights on the dashboard to begin to flash and then if you try to drive the car it goes “bump-bump” down the road. No Bubba, get off of your knees and get your mouth off of the thingy; you cannot blow air back into the tires that way.

Mark J. Grant, is Managing Director of Corporate Syndicate and Structured Products for Southwest Securities, Inc.

Copyright © Mark Grant

Tags: Aggregate Demand, Banking System, Booms, Busts, Collapse, Deflation, Desired Effect, Destructive Action, Domicile, Economic Effects, Fed Chairman, Financial Stress, Greed, inflation, Mark Grant, Maximum Intensity, Optimism, Pessimism, Recession, Tatters
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Bernanke: Be Humble!

Tuesday, May 1st, 2012

Bernanke: Be Humble

by Axel Merk, Merk Funds

“Humble” is typically not an attribute associated with the Federal Reserve (Fed), especially in light of the trillions of dollars recently printed. Yet, in his latest press conference Fed Chairman Bernanke called for humility: we must be humble in setting monetary policy! The problem is, Bernanke’s definition of the word “humble” appears to be something entirely different from what – in our humble opinion – common sense might expect.

We have previously argued that the only reason the Fed gets away with printing so much money is because that money doesn’t “stick”. Technically, the Fed doesn’t actually print money, but buys fixed income securities with ever-longer maturities (mortgage-backed securities and Treasury securities). To purchase those securities, money is literally created out of thin air; a simple computer entry is all that is required to credit the account of a bank at the Fed in return for the purchase of a security. These purchases are reflected as an increase in assets on the Fed’s balance sheet, with an offsetting increase in liabilities (cash in circulation – Federal Reserve notes – are a liability for the Fed). When proceeds from a maturing security are re-invested, no new money is being created, but the balance stays at an elevated level; as such, when QE1 or QE2 “ended”, the amount of money that had been printed was still in the system. Some economists argue that such policies don’t amount to “money printing” because banks haven’t done much with the money they received (the velocity of money has not shot up). Our response to that argument has been that if you were to give a baby a gun, just because the baby doesn’t shoot anyone, doesn’t mean it isn’t dangerous. So, to us, being humble should focus on being most concerned about the potential side effects of monetary easing.

A key reason why all the money that has been printed hasn’t made it to the real economy is because major deflationary forces are present, as a result of the financial crisis. In our assessment, in the run-up to the financial crisis, the Fed had lost control over the credit creation process. That is, consumers used their homes as ATMs, creating their own money. Similarly, financial institutions found ways to create their own money, e.g. increasing leverage by creating special investment vehicles (SIVs). In the goldilocks economy of much of the last decade, it was only rational for investors to take on more risk, to increase leverage. After all, house prices could never fall. However, starting in 2007, risk came back to the markets. As a result, it became similarly rational for investors to reduce leverage. Unfortunately for investment banks Bear Stearns and Lehman Brothers, they didn’t have sufficient liquid collateral to downsize. Similarly, many consumers buried in debt have been unable to downsize, causing elevated numbers of defaults on their obligations (mortgages, auto payments, credit cards…) It’s because policy makers initially lost control on the credit creation side that we are now witnessing a gargantuan effort to stem against deleveraging, deflationary forces. We believe this is a key reason why, with all the money spent and printed, the U.S. can only generate lackluster economic growth.

In this environment, it’s likely that the Fed can get away with just about anything in terms of monetary expansion. But should these policies work, should all the money that has been printed make it through to the real economy, the Fed may find itself in a tricky situation. Bernanke argues that he can raise interest rates in as little as 15 minutes to contain any inflationary fallout that might occur. In the early 1980s, former Fed Chair Paul Volcker raised rates to 20% to beat inflationary pressures. In those days, people complained, but because there was so much less leverage in the economy, it was bearable. In today’s environment, 6% appears to be the threshold for countries such as Spain before commentators believe the International Monetary Fund (IMF) has to come to the aid of the government. Wait. Paying 6% interest is considered unsustainable? What type of world are we now living in? More importantly, will the Fed have the will to potentially crush the economy in order to contain inflationary pressures? Anyone reading this and even considering that the Fed may hesitate proves that the Fed has lost credibility. Credibility requires the perception that the Fed will not hesitate to beat inflation.

Tags: Amount Of Money, Computer Entry, Fed Chairman, Fed Doesn, Federal Reserve, Federal Reserve Notes, Humility, Income Securities, Maturities, Monetary Policy, Money Printing, Mortgage Backed Securities, New Money, Qe1, Qe2, Simple Computer, Thin Air, Treasury Securities, Trillions, Velocity Of Money
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Does Quantitative Easing Benefit the 99% or the 1%?

Sunday, April 29th, 2012

Forget Competing Theories … What Do the Facts Say about Quantitative Easing?

Paul Krugman says that QE, expansive monetary policy and inflation help the little guy (the 99%) and hurt the big banks (the 1%).

Of course, followers of the Austrian school of economics dispute this argument – and say that it is only the big boys who benefit from easy money.

As hedge fund manager Mark Spitznagel argues in the Wall Street Journal, in an article entitled “How the Fed Favors The 1%”:

The relentless expansion of credit by the Fed creates artificial disparities based on political privilege and economic power. [We have repeatedly pointed out that Fed policy increases inequality.]David Hume, the 18th-century Scottish philosopher, pointed out that when money is inserted into the economy (from a government printing press or, as in Hume’s time, the importation of gold and silver), it is not distributed evenly but “confined to the coffers of a few persons, who immediately seek to employ it to advantage.”

In the 20th century, the economists of the Austrian school built upon this fact as their central monetary tenet. Ludwig von Mises and his students demonstrated how an increase in money supply is beneficial to those who get it first and is detrimental to those who get it last. Monetary inflation is a process, not a static effect. To think of it only in terms of aggregate price levels (which is all Fed Chairman Ben Bernanke seems capable of) is to ignore this pernicious process and the imbalance and economic dislocation that it creates.

As Mises protégé Murray Rothbard explained, monetary inflation is akin to counterfeiting, which necessitates that some benefit and others don’t. After all, if everyone counterfeited in proportion to their wealth, there would be no real economic benefit to anyone. [Remember, even Keynes himself - and Ben Bernanake - said that inflation is a stealth tax.] Similarly, the expansion of credit is uneven in the economy, which results in wealth redistribution. To borrow a visual from another Mises student, Friedrich von Hayek, the Fed’s money creation does not flow evenly like water into a tank, but rather oozes like honey into a saucer, dolloping one area first and only then very slowly dribbling to the rest.

The Fed doesn’t expand the money supply by uniformly dropping cash from helicopters over the hapless masses. Rather, it directs capital transfers to the largest banks (whether by overpaying them for their financial assets or by lending to them on the cheap), minimizes their borrowing costs, and lowers their reserve requirements. All of these actions result in immediate handouts to the financial elite first, with the hope that they will subsequently unleash this fresh capital onto the unsuspecting markets, raising demand and prices wherever they do.”

***

The Fed is transferring immense wealth from the middle class to the most affluent, from the least privileged to the most privileged. This coercive redistribution has been a far more egregious source of disparity than the president’s presumption of tax unfairness ….

***

Before we start down the path of arguing about the merits of redistributing wealth to benefit the many, why not first stop redistributing it to the most privileged?”

And Ben Bernanke himself said in 1988 that quantitative easing doesn’t work. As Ed Yardley notes:

Two economists, Seth B. Carpenter and Selva Demiralp, recently posted a discussion paper on the Federal Reserve Board’s website, titled “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” [Here's the link.]

[The study states:] “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found. The argument against the textbook money multiplier is not new. For example, Bernanke and Blinder (1988) and Kashyap and Stein (1995) note that the bank lending channel is not operative if banks have access to external sources of funding. The appendix illustrates these relationships with a simple model. This paper provides institutional and empirical evidence that the money multiplier and the associated narrow bank lending channel are not relevant for analyzing the United States.”

Did you catch that? Bernanke knew back in 1988 that quantitative easing doesn’t work. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.

Indeed, Fed policy itself has killed the money multiplier by paying interest on excess reserves. And a large percentage of the bailout money went to foreign banks (and see this). And so did most of money from the second round of quantitative easing.

Forget Theory … What Do the Facts Show?

But let’s forget ivory the tower theories of either neo-Keynesians like Krugman or Austrians … and look at the evidence.

Initially:

[The] Treasury Department encouraged banks to use the bailout money to buy their competitors, and pushed through an amendment to the tax laws which rewards mergers in the banking industry.

Similarly, former Secretary of Labor Robert Reich points out that quantitative easing won’t help the economy, but will simply fuel a new round of mergers and acquisitions:

A debate is being played out in the Fed about whether it should return to so-called “quantitative easing” — buying more mortgage-backed securities, Treasury bills, and other bonds — in order to lower the cost of capital still further.

Tags: 18th Century Scottish Philosopher, Aggregate Price, Austrian School Of Economics, Ben Bernanke, David Hume, Economic Benefit, Economic Dislocation, Fed Chairman, Fed Policy, Government Printing Press, Hedge Fund Manager, Ludwig Von Mises, Monetary Inflation, Money Supply, Murray Rothbard, Paul Krugman, Relentless Expansion, Spitznagel, Stealth Tax, Wall Street Journal
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MIlton Ezrati: The Fed Shifts Gears

Tuesday, April 10th, 2012

Tags: Ben Bernanke, Encouragement, Fed Chairman, Federal Reserve, Fourth Quarter, Gears, Good Reason, Harbinger, Industrial Loans, Inflation Fears, Labor Department, Lord Abbett, Milton Ezrati, Monetary Stance, New Approach, Qe, Recent Developments, Skepticism, Subtle Change, Sudden Interest
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PIMCO’s Gross: Market Has Bernanke in a Box, QE3 Still on the Way

Thursday, April 5th, 2012

Bond king Bill Gross is right along the same line of thinking as I am on this subject.  Unfortunately, moral hazard is now the name of the game, and rather than being dissipated, it has been enhanced.  To that end the top headline on CNBC is “Why Fed is likely to Intervene if Market Falls too far” – as if “stock market management” is part of their Congressional mandated duty.

Bernanke wants a wealth effect from equities since he is unable to reblow a bubble into housing, and the market knows it.  Hence the temper tantrums each time the market does not get what it wants.  Ben also sees how badly the market acted during periods the Fed was not supporting it the past few years.  You can imagine they are watching what has happened since 2 PM yesterday in horror.   Gross provides more color, and why the market overreacted to a few words yesterday.  Again, what that means for the market in the next hour or days or weeks, who knows.

• The stock market is overreacting Wednesday to what the Federal Reserve didn’t say about quantitative easing in the minutes from its March meeting, bond king Bill Gross told CNBC. It’s much ado about nothing or much ado about a little,” the founder of Pimco said.
• “We should think of the Fed as like a chess game where some of the pieces are more important than others,” likening Fed Chairman Ben Bernanke to the king, San Francisco Fed governor Janet Yellen to the queen and New York Fed chief William Dudley to the castle, with the rest of the governors the knights.  “You have a story when some of these major pieces, one of the three, basically concedes and says, ‘Check mate.’ But we haven’t seen that,” Gross said. “Until that happens this wordsmithing…is relatively unimportant.”
• But Gross thinks the Fed is very cognizant of the state of the stock market, and if it falls too much it may have to act with some form of easing. The Fed and other central banks have “got to keep going [with some form of stimulus] if they expect equity markets to continue…at this level,” he said.
• “When QE1 has ended, when QE2 has ended, basically the stock market has gone down by 1,500 points the next month or two,” Bill Gross, co-CEO of bond giant Pimco, said in a CNBC interview. “Is the Fed trapped in this conundrum of providing cheaper liquidity in order to pump up the stock market and risk markets? I think they are. I won’t argue…whether it’s good policy, but it’s necessarily policy based on where central banks have led us.”

8 minute video

Tags: Bill Gross, Central Banks, Check Mate, Chess Game, Chief William, Cnbc, Fed Chairman, Fed Chief, Fed Governor, Gross Market, Market Management, Moral Hazard, Name Of The Game, New York Fed, PIMCO, S Gross, Temper Tantrums, Wealth Effect, William Dudley, Wordsmithing
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Bernanke’s Problem with the Gold Standard

Wednesday, March 28th, 2012

by Axel Merk, Merk Funds

In his new lecture series, Federal Reserve (Fed) Chairman Ben Bernanke is going out of his way to discuss the “problems with the gold standard.” To a central banker, the gold standard may be considered “competition,” as their power would likely be greatly diminished if the U.S. were on a gold standard. The Fed, Bernanke argues, is the answer to the problems of the gold standard. We respectfully disagree. We disagree because the Fed ought to look at a different problem.

Bernanke lists price stability and financial stability as key objectives of the Fed. Focusing on the latter one first, the Fed was established to reduce the risk of financial panics. Bernanke points out:

“A financial panic is possible in any situation where longer-term, illiquid assets are financed by short-term, liquid liabilities; and in which short-term lenders or depositors may lose confidence in the institution(s) they are financing or become worried that others may lose confidence.”

Bernanke goes on to blame the gold standard for the panics. While he is certainly not alone in his view – indeed, his very lecture to students at George Washington University is promoting that view to a new generation of economists -, we beg to differ.

Banks – by definition – have a maturity mismatch, making long-term loans, taking short-term deposits. As such, banks are prone to financial panics as described by Bernanke. To mitigate the risk of financial panics, central banks can do what the Fed is doing, namely to be a lender of last resort. Alternatively, central banks can focus on the core issue, the structural “problem of banking.” Following the Fed’s approach, there are inherent moral hazard issues – incentives for financial institutions to increase leverage, to become too-big-to-fail. To address a panic that might happen anyway, the Fed would double down (provide more liquidity), potentially exacerbating future banking panics. After yet another crisis, new rules are introduced to regulate banks. The resulting financial system may not be safer, but it will increase barriers to entry, further bolstering the leadership position of existing, too-big-to-fail banks. With all the government guarantees and too-big-to-fail concerns, banks might then be regulated in an attempt to have them act more like utilities. Ultimately, that might make the financial system more stable, but will stifle economic growth. Financial institutions, as much as we have mixed feelings about their conduct, are vital to finance economic growth, as they facilitate risk taking and investment.

The problem of all financial panics is not the gold standard – otherwise, the panic of 2008 would not have happened. The problem of financial panics is – again – that “longer-term, illiquid assets are financed by short-term, liquid liabilities.” Missing from Bernanke’s definition is a key additional attribute, leverage. A maturity mismatch without leverage might cause a lender to go bust, but – in our interpretation – does not qualify as a panic when a limited number of depositors are affected. The “panic” and the “contagion” may occur when leverage is employed, as it creates a disproportionate number of creditors (including consumers with cash deposits).

There’s a better way. To avoid having financial institutions serve as “panic” incubators, regulation should address the core of the issue. Bernanke shouldn’t use gold, as a scapegoat for all that was wrong with the U.S. economy previously, to justify a license to print money. First, failure must be an option; individuals and businesses must be allowed to make mistakes and suffer the consequences. The role of the regulator, in our opinion, is to avoid an event where someone’s mistake wrecks the entire system.

The easiest way to achieve a more stable financial system is to reduce incentives for leverage. A straightforward method is through mark-to-market accounting and a requirement to post collateral for leveraged transactions. The financial industry lobbies against this, arguing that holding a position to maturity renders mark-to-market accounting redundant. Consider the following example, which highlights the implication: assume a speculator before the financial crisis took a leveraged bet that oil prices – at the time trading at $80 a barrel – would go down to $40 a barrel. In the “ideal world” according to the banks, this speculator would not have been required to post collateral and would have been proven right when oil (briefly) dropped to $40 a barrel after the financial crisis. In reality however, as oil prices soared to $140 a barrel before declining, the typical speculator would have been forced to post an ever larger amount of collateral; likely, the speculator’s brokerage firm would have closed out the position, as the speculator ran out of money. The speculator lost money because he was unable to meet a margin call; importantly, though, the system remained intact. The speculator might complain: the price ultimately fell to $40! But such whining is futile because the rules of engagement were known ahead of time. As such, the speculator had an incentive to use less (or no) leverage. The bank’s attitude, in contrast, incubates panics. In this example, regulated exchanges exist. But even without regulated exchanges or easily priced securities, similar concepts can be developed.

Another way to make financial firms more panic prone is to require them to issue staggered subordinated debt. Rather than relying heavily on short-term funding (retail deposits or inter-bank funding markets), banks should be required to stagger the maturities of their own funding over years. If, say, each year 10% of their loan portfolio needs to be refinanced, then – in times of financial turmoil – it might become exorbitantly expensive for a bank to finance that 10% of their loan portfolio. A bank should be able to shrink its loan portfolio by 10% in a year in an orderly fashion, without jeopardizing the survival of the firm or spreading excessive risks throughout the financial system. Note that this is a market-based mechanism to police the financial system.

These concepts reduce leverage in the system. And that’s the point, as leverage is the mother of all panics. The concepts presented above will not solve all the challenges of banking, but blaming “the problem of the gold standard” for financial panics is – in our analysis – premature.

Modern central banking is not the answer to mitigate the risk of financial panics because the cost for this perceived safety is enormous. As a result of responding to each potential panic with ever more “liquidity”, entire governments are now put at risk when a crisis flares up.

Beyond that, central banks have done a horrible job in containing inflation. The wisdom of central banking is that 2% inflation is considered an environment of stable prices. At 2%, a level often touted as a “price stable environment”, the purchasing power of $100 is reduced to $55 over a 30-year period. It’s a cruel tax on the public. What’s more, in practice, countries with a fiat currency system have generally been unable to keep long-term inflation below 2%.

Bernanke warns of deflation. To the saver, deflation is a gift. Not to the debtor. In a debt driven world, deflation strangles the economy. Governments don’t like deflation as income taxes and capital gains taxes are eroded. In a deflationary world, governments would need to rely more on sales taxes (or value added taxes): gradually reduced revenue in a deflationary environment would be okay as the purchasing power of those tax revenues would increase. That assumes, of course, that the government carries a low debt burden — deflation would be a good incentive to limit spending. Get the picture why governments don’t like deflation?

Read John Butler’s new book
The Golden Revolution: How to Prepare for the Coming Global Gold Standard

With inflation, people have an “incentive” to work harder, to take on risks, just to retain their purchasing power, the status quo. What about the pursuit of happiness? The idea that if you earn money and save, you can retire and live off your savings? We consider it quite an imposition that unelected officials have such sway over our standard of living.

Bernanke also attacks the gold standard for causing havoc in the currency markets. Please subscribe to our newsletter to be informed as we provide food for thought about the relationship between gold and currencies. We will also discuss what investors may want to do in a world that has moved further and further away from the gold standard. Subscribe to Merk Insights by clicking here. Also, please click here to register for the Merk Webinar: Quarter 1 Update on the Economy and Currencies which will take place on Thursday, April 19th at 4:15pm EF / 1:15pm PT. We manage the Merk Funds, including the Merk Hard Currency Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard Currency Fund, Asian Currency Fund, Absolute Return Currency Fund, and Currency Enhanced U.S. Equity Fund, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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Tags: Ben Bernanke, Central Banks, Core Issue, Depositors, ETF, ETFs, Fed Chairman, Financial Institutions, Financial Panic, Financial Panics, Financial Stability, George Washington University, Gold Standard, Hazard Issues, Illiquid Assets, India, Key Objectives, Lecture Series, Lender Of Last Resort, Long Term Loans, Moral Hazard, Price Stability, Short Term Deposits, Term Lenders
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The Economy and Bond Market Radar (March 5, 2012)

Sunday, March 4th, 2012

The Economy and Bond Market Radar (March 5, 2012)

Treasury bond yields were mixed this week as the short end of the yield curve fell slightly while the long end was essentially unchanged.

Global economic data was mixed with a slight positive bias. Purchasing managers indices (PMIs) were released in many countries around the world this week with PMIs improving in China, but U.S. manufacturing cooling in February. The European Central Bank completed another round of Longer-Term Refinancing Operations (LTRO) funding this week, lending over $700 billion in 3-year loans to eurozone financial institutions.

The effects of the LTRO program can be seen in the chart below, which shows the yield on the 10-year Italian government bond. The first tranche was issued in late December and effectively eliminates a near-term liquidity event as banks are able to lock up as much funding as needed with the relatively long term 3-year loans. The drop in yields is remarkable and also coincides with the “risk on” trade in equities.

Strengths

• China February PMI is at 51, indicating economic expansion.
• U.S. auto sales were very strong in February with Chrysler’s sales rising 40 percent and Ford’s rising 14 percent.
• Retail sales were also generally better than expected as warm weather helped lift sales.

Weaknesses

• January durable goods orders fell 4 percent, which was the biggest drop in three years. Orders were likely pulled into December due to tax incentives that expired at year end.
• India’s GDP grew 6.1 percent in the fourth quarter but that was the slowest growth in three years.
• The ISM manufacturing index fell to 52.4 in February. While still growing, it was the first decline in three months.

Opportunities

• Fed Chairman Ben Bernanke spoke to Congress this week and effectively indicated no change in monetary policy, which implies continued low interest rates for the foreseeable future.

Threats

• Coordinated global easing from the world’s central banks should eventually create inflation.

Tags: Ben Bernanke, Central Banks, Durable Goods Orders, Economic Expansion, Fed Chairman, Government Bond, Ism Manufacturing Index, Italian Government, Liquidity Event, Low Interest Rates, Market Radar, Pmis, Purchasing Managers, S Sales, Tax Incentives, Term Liquidity, Treasury Bond Yields, U S Auto, Warm Weather, Yield Curve
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Journey to the Center of the (Fed’s) Mind (Sonders)

Friday, January 27th, 2012

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

January 25, 2012

Key Points

• The Federal Reserve opted to keep short-term interest rates on the floor and extended the period of time during which rates are likely to remain near zero.
• Newly published forecasts show slightly better growth, a bit less inflation and a lower unemployment rate.
• Fed Chairman Ben Bernanke got hit with a lot of questions about the risks of extending zero-rate policy for 2 ½ more years.

First, the statement

The Federal Reserve was more explicit in its statement today, which accompanied the finale of the Federal Open Market Committee’s (FOMC) two-day meeting today.

“…the Committee decided today to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

The reference to 2014 was an extension of the Fed’s previous pledge to keep rates low at least until mid-2013. Although several Fed officials have said even further easing (read: quantitative easing round three, or QE3) is needed to revive hiring and housing, there was one notable dissent today: “Voting against the action was Jeffrey M. Lacker [Richmond Federal Reserve Bank President], who preferred to omit the description of the time period over which economic conditions are likely to warrant exceptionally low levels of the federal funds rate.”

The Fed did say it would continue its “Operation Twist” program, which has been extending the average maturity of its $2.6 trillion securities portfolio.

Frankly, I have reservations about the two-and-a-half year span during which the Fed expects to keep short rates effectively pegged at zero. Much can and will likely happen between now and then, be it economic conditions and/or inflation trends. Given that the Fed has often been criticized in the past for being behind the curve, it almost guarantees it will do it again by this effective promise. And, it can also be seen as yet another hit to savers and retirees.

As noted by High Frequency Economics, “they are now too cautious, expecting only ‘modest’ growth as far as the eye can see. We see no mention of the sustained surge in bank business lending, the rebound in survey data, the upturn in every housing indicator and only a tangential reference to the plunge in the pace of layoffs. The markets face two dangers if these emerging trends persist. First, the Fed might have to renege on its ‘promise’—the word ‘likely,’ after all, is not a solemn vow—or, second, they might tighten by reversing QE, while sticking to zero rates. Either way, fingers get burned in the markets.”

Second, the forecasts

Shortly after the release of the FOMC statement, the Committee released expectations of the five Fed board members and 12 district bank presidents. Of these 17 Fed officials, nine expect short-term interest rates to remain below 1% by the end of 2014, while six expect rates to remain at zero into 2015. The Fed also lowered its estimates for growth and inflation this year, a move consistent with its statement as noted above.

These projections are new for the Fed—it’s the first time in FOMC history that it’s explicitly laying out its forecast for growth, inflation and rates. Assuming an increase in rates sometime in late 2013 or 2014, it would be the first rate hike since June 2006. Think about that: as noted below, there are two Committee members that think the first hike should come in 2016—if that’s the case, it would mean a full decade of no rate hikes.

There was no unanimity with regard to the pace at which the Fed should raise rates:

• Three officials believe they should begin rising this year.
• Another three believe they should begin moving higher next year.
• Five say they should go up in 2014.
• Four say 2015.
• And two even believe the first hike shouldn’t come until 2016!

By the way, the Fed

It’s estimated that US economic growth, as measured by real gross domestic product, will be between 2.2% and 2.7% (from the fourth quarter of 2011 through the fourth quarter of this year). For 2013, US growth is forecasted to be between 2.8% and 3.2%. (The forecasts are calculated using a “central tendency forecast,” which excludes the three lowest and highest projections.)

As for inflation, it’s projected to drop below the Fed’s newly stated goal of 2%, with the majority of officials expecting inflation in a range between 1.4% and 2.0% through 2014. These are marginally lower inflation projections than those published last November.

And, in keeping with the recent traction seen in job growth, the Fed’s forecasts for the unemployment rate have also ticked down and now sit at between 8.2% and 8.5% for 2012, 7.4% and 8.1% for 2013 and 6.7% and 7.6% for 2015. These forecasts are below the prior forecasts published last November.

(For a more detailed look at the Fed officials’ economic projections, see the full chart in today’s Fed release.)

Third, the press conference

My friend Steve Liesman, from CNBC, asked the first question, and it was a good one. He essentially wanted to know whether the Fed was doubting the economic improvement that’s been seen in the past few months. Bernanke did acknowledge improvement in some areas, but “mixed results” in others; specifically: “We continue to see headwinds emanating from Europe, coming from the slowing global economy.” He also said, “I don’t think we’re ready to declare that we’ve entered a new, stronger phase at this point. We’ll continue to look at the data.”

There were additional questions that got to this subject. One asked whether there was risk of a backlash from the Fed’s new information, particularly by hurting confidence by suggesting the economy is weaker than people think. Bernanke’s response: “Those considerations are outweighed by the need to maintain accommodative conditions,” so it’s attractive for companies to invest and hire, and for people to buy houses.

Bernanke did address the fact that the individual forecasts don’t have names attached to them. He indicated that they aren’t disclosing the identities for a reason—to ensure discussion at meetings and to depersonalize monetary policy.

Bernanke did not escape politics in the questioning, and was asked about the hostility toward the Fed during many of the Republican debates. In particular, he attempted to fight back against the criticism that Fed policy is crushing savers and retirees: “The savers in our economy are dependent on a healthy economy in order to get adequate returns.”

Finally, the Chairman was asked about his confidence in the Fed’s forecasting abilities. At least he was honest when he replied, “Our ability to forecast three and four years out is obviously very limited. Nevertheless we have to make a best guess, a provisional plan,” much like companies do. “It’s certainly possible we will be either too optimistic or too pessimistic,” which suggests the Fed may have to adjust to the realities of the actual data.

We think that’s a real possibility.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Bank President, Ben Bernanke, Charles Schwab, Chief Investment Strategist, Fed Chairman, Fed Officials, Federal Funds Rate, Federal Open Market Committee, Federal Reserve Bank, Journey To The Center, Lacker, Liz Ann, Open Market Committee, Qe3, Resource Utilization, Senior Vice President, Target Range, Twist Program, Unemployment Rate, Zero Rate Policy
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