THE “BERNANKE PUT” AND THE FED’S TRILEMMA

“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done” – JM Keynes, General Theory of Employment, Interest and Money

Now that the equity market has rallied back to its pre-Lehman Brothers levels it’s becoming fashionable to shower the Federal Reserve with praise for their actions over the last few years.? But let’s not forget that we’ve seen this movie one too many times before.

Over the last 15 years the Federal Reserve has essentially become a price fixing mechanism for an economy that has long struggled with severe structural problems.?? When problems have arisen in the economy the U.S. central bank has intervened to lessen the blow to the economy.? In theory, this was intended to reduce the volatility of the business cycle.? Unfortunately, many of their policies have simply exacerbated the problems or helped to generate even greater imbalances.

This all started well before the housing bubble or the Nasdaq bubble.? After the 1987 crash Alan Greenspan was quick to reassure investors that the Fed was there to bolster markets.? This “Greenspan put” was mastered with the bailout of LTCM as the Fed intervened in markets to make sure that losers didn’t have to become losers.? LTCM was the epitome of failed economic theory at work in markets.?? A group of brilliant economists believed they had discovered the path to minting money in financial markets.? On paper their equations appeared flawless.? In reality, they were a disaster waiting to happen.? In one fell swoop this collection of geniuses proved that EMH was flawed.? And not two years later the Greenspan Put helped contribute to a market bubble like the United States had never seen.? In the words of David Tepper, it was a “win win” market – or so they believed.

For 18 years Alan Greenspan ran the nations central bank based on theories and beliefs that he later referred to as being “flawed”.? Despite this, much of his work influences the current central bank.? In fact, today’s Fed is more involved in markets than Greenspan ever was.?? To some extent this tinkering with markets is justified.? The role of lender of last resort is important, but the modern day Fed has taken its role to an entirely new level.? They are no longer just the lender of last resort – they have become the bailout mechanism of the capitalist system and ultimately a plaque build-up in a system that is increasingly unhealthy.? The Greenspan Put has become the Bernanke Put.? And so the financialization of our markets continue.? In fairness to Mr. Bernanke I can’t entirely place the blame on him.? Due to political ignorance of our monetary system the Federal Reserve has been given the overbearing responsibility of being lender of last resort while also attempting to establish full employment and price stability.? Talk about a trilemma if there ever was one….

What these men haven’t stopped to ponder is whether any of this intervention was actually healthy for the markets.? Perhaps the market crashed in 1987 because an irrational 40% climb in 8 months had created instability?? Perhaps the Nasdaq never should have approached 5,000?? Perhaps LTCM needed to fail?? Perhaps housing was never intended to be a speculative asset?? Perhaps these assets needed to be allowed to decline??? The result has been a slow deterioration in the foundation of the system with each and every bailout.? I recently described why these imbalances continue to pose such a serious risk to the economy as we weaken the foundation from which each subsequent boom is built upon:

“What I fear most about the current cycle is that we have not allowed the markets to sufficiently clear.? If that is the case you can think of the global economy like an obese man who fights to lose weight in an effort to fend off what is an almost certain heart attack.? After a multi decade binge he suffers a massive heart attack (think LTCM circa 1998).? The doctors save him by intervening, but they don’t actually help the man fix his inherent problems (dying internal organs and lack of discipline).? In the case of the economy this is global imbalances, structural flaws in the banking system and a lack of regulation.? The man vows to lose 50% of his total body weight, but after losing 20% of his total body weight he decides the process is too grueling and is taking too long.? A fast food restaurant opens up next door (hello government bailouts!).? He once again feels the need to stimulate his lust for food.? So, he binges again (think Greenspan 2001).? A new boom occurs before he ever becomes fully healthy.? Over the ensuing 7 years his body weight doubles.? He’s now 60% heavier than he was in 1998!? Of course, this is unsustainable.? His body begins to breakdown.? Before you know it he is suffering a total system failure (think Lehman brothers).? But again, thanks to modern medicine (or incessant Fed intervention) the man is once again saved.? Over the following year he loses 25% of his body weight.? It’s an arduous process and certainly not enjoyable, but it must be done.? The good news is he’s 25% lighter.? The bad news is he’s 20% heavier than he was in 1998 when he had his first setback.? Nothing has changed inherently.? He has the same failing internal organs and the same failing disciplines.?? But his next binge begins from a weaker starting point and a more dangerous level. You can imagine how this story ends.”

By continually creating a “can’t lose” market we have instilled a belief in investors and speculators that prices will not be allowed to sustain any sort of decline.? In August Ben Bernanke panicked because jobless claims briefly hit 450K.? He implemented an emergency round of quantitative easing.? Since then, his attempts to control the long end of the curve have failed spectacularly and the economic data since has proven that QE2 was never necessary to begin with (not that it would have done anything anyhow).? But what Mr. Bernanke has reinforced is this David Tepper “win win” mentality.? And it’s nowhere more apparent than it is in the commodity markets today.? After all, with an equity market and real estate bubble in less than 10 years where else can these speculators reliably turn to implement their Bernanke Put?? Some people say the Fed is not creating imbalances again, but I beg to differ.? The following charts show the imbalances that have reemerged in recent months as the Fed ensures that there are no losers:

(CRB Spot Index)

(CRB Metals Sub-Index)

(CRB Raw Industrials)

(CRB Foodstuffs)

Of course, there is a component of economic strength here.? I am not attempting to downplay the recovery.? It’s real and it’s here.? But as the past has proven, a bubbly market combined with a Fed that won’t let losers be losers, is a potent mix and an environment ripe for imbalances and instability.?? It could take years for these imbalances to fully play out on the world stage, but they are building and the Fed’s constant interference in markets has only made matters worse.

QE2 has proven that the Federal Reserve can substantially influence market prices without creating the positive result? (in this case lower rates) that it so desires.? In my opinion, this is proof that the Fed’s interference is not furthering the prosperity of the private sector, but is merely interfering with natural market forces while creating market disruptions and imbalances.? In the end, this does not help to smooth the business cycle and only helps contribute further to its instability and volatility.

The Federal Reserve’s only true purpose in the marketplace should be to serve as lender of last resort at its target rate.? This rate should be permanently maintained at zero, the natural rate of interest, so as to maintain price stability and reduce market interference.? This would not only reduce the Fed’s role in markets, but would help ensure greater output, price stability, eliminate the Bernanke Put and would substantially reduce the volatility/imbalances in the business cycle that have been largely generated by the Fed’s intervention.

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The content on this site is provided as general information only and should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The opinions of all guest authors or contributors can and will differ from those of Mr. Roche. These opinions do not necessarily represent the opinions or investment decisions of Mr. Roche. The author(s) may or may not have a position in any security referenced herein and may or may not seek to do business with one another or companies mentioned via this website. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

A brief note on comments – The increase in users in recent months has resulted in an increase in unproductive comments. Any user who engages in the use of racial epithets or uses the comment section as a place to insult other users will be banned from the site. The comment section is welcome to all readers who are interested in asking pertinent questions and/or engaging in thoughtful, intelligent, and productive debate. In short, just be nice. Thanks.

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BERNANKE EXPLAINS WHY QE2 IS NOT MONEY PRINTING….AGAIN

6 December 2010 by TPC 25 Comments

Ben Bernanke appeared on 60 Minutes this evening and gave what I believe is an excellent interview.? He explains in great detail why he is still very concerned about deflation and the weak economy.? Perhaps most importantly, however, he explains why QE2 is in no way inflationary:

“Well, this fear of inflation is way overstated.? One myth that’s out there is we’re printing money.? We’re not printing money.? The amount of currency in circulation is not changing.? The money supply is not changing in any significant way.? What we’re doing is lowering interest rates by buying treasury securities.? And by lowering interest rates we hope to stimulate the economy to grow faster.”

Of course, this all sounds very familiar to regular readers.? We’re clearly in the minority in believing (in fact knowing) that QE2 is not inflationary, but where I disagree with Mr. Bernanke is that he can actually control the long-end of the curve.? In fact, I believe the rising interest rates of the last few months are clear proof that QE is the non-event I have always maintained that it is and that it will not help the economy is any substantive way.

He goes on to explain why the government can always control short-term interest rates and why the economic recovery remains far from self sustaining.? He also says the deficit should not be cut in the coming year.? The one problem point in the interview comes when he discusses how the banking system caused the great depression.?? Although the credit markets were a clear contributor to the crisis and the Great Depression they were not the causes.? Both crises were human crises and not banking system crises.? Mr. Bernanke continues to misunderstand this.? The real fix needs to occur on Main Street and not on Wall Street.

He’s very humble and honest in admitting that he totally missed the financial crisis coming.? He admits that lending standards were too loose and comes close to admitting that the deregulation of the financial industry contributed to the crisis.? In addition, he says there is a growing divide between the rich and the middle class that is having a destructive effect on the country.? It’s baffling in many ways because he seems to grasp so many of the issues that are important here, however, his incessant focus on saving the banks is where his great flaw remains.? He appears to know that the financialization of this great country nearly destroyed it, yet he remains fixated on protecting these same companies that helped contribute so greatly to the crisis.? It should be obvious to him that there is a great flaw in his thinking…..

All in all it’s nice to see an open and honest perspective from the Fed Chairman.? I still don’t think Mr. Bernanke quite has policy action correct, but he’s certainly making strides in the right direction.? The full interview is attached:

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THE BERNANKE PARADOX

4 December 2010 by TPC 0 Comments

A little bit of weekend reading here for those wondering how Bernanke cares to rectify his monetarist actions with his recent Keynesian talk:

“This paper examines Federal Reserve chairman Ben Bernanke’s recipe for deflation fighting and the specific policy actions he took in the aftermath of the 2008 financial crisis. Both in his academic and policy work, Bernanke has made the case that monetary policy is able to stem deflationary forces largely because of its ‘fiscal components’, and that governments like those in the U.S. or Japan face no constraints in financing these fiscal components. On the other hand, he has recently expressed strong concerns with the size of the federal budget deficit, calling for its reversal in the name of financial sustainability. The paper argues that these positions are fundamentally at odds with each other and resolves the paradox by arguing on theoretical and technical grounds that there are no fundamental differences in financing conventional government spending programs and what Bernanke considers to be the fiscal components of monetary policy.”

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The content on this site is provided as general information only and should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The opinions of all guest authors or contributors can and will differ from those of Mr. Roche. These opinions do not necessarily represent the opinions or investment decisions of Mr. Roche. The author(s) may or may not have a position in any security referenced herein and may or may not seek to do business with one another or companies mentioned via this website. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

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BERNANKE DISCUSSES THE TWO SPEED RECOVERY, CALLS FOR FISCAL SUPPORT

Ben Bernanke delivered a superb speech this morning at the ECB.? He was eloquent, non-partisan and displayed an unusual understanding of the problems the global economy confronts.? The speech is an absolute must read as it provides an excellent overview of our current malaise.

The theme of the speech was the two speed recovery – the stagnant growth in developed economies vs the high growth in emerging markets – and how imbalances have been created that require differing policy responses.? He says:

“International policy cooperation is especially difficult now because of the two-speed nature of the global recovery… These differences are partially attributable to longer-term differences in growth potential between the two groups of countries, but to a significant extent they also reflect the relatively weak pace of recovery thus far in the advanced economies.”

The Chairman appears to have backed off his monetarist tendencies in favor of a non-partisan approach.? At one point he even admits that the recovery was largely due to fiscal stimulus:

“In the United States, the recession officially ended in mid-2009, and–as shown in figure 3–real GDP growth was reasonably strong in the fourth quarter of 2009 and the first quarter of this year. However, much of that growth appears to have stemmed from transitory factors, including inventory adjustments and fiscal stimulus.”

He goes on to appropriately describe the disinflationary environment that currently rules the day and why this environment is likely to persist:

“Low rates of resource utilization in the United States are creating disinflationary pressures. As shown in figure 5, various measures of underlying inflation have been trending downward and are currently around 1?percent, which is below the rate of 2?percent or a bit less that most Federal Open Market Committee (FOMC) participants judge as being most consistent with the Federal Reserve’s policy objectives in the long run.¹ With inflation expectations stable, and with levels of resource slack expected to remain high, inflation trends are expected to be quite subdued for some time.”

Mr. Bernanke acknowledges that he has failed in his mandate of creating full employment, but makes vitally important comments regarding fiscal policy.? He seems to have made an about face in recent months and now understands that monetary policy is indeed a blunt instrument.? In addition to monetary policy Mr. Bernanke is directly calling for fiscal stimulus.? This is a crucial change in his stance as it shows an openness to the possibility that we are in a balance sheet recession and monetary policy simply won’t cut it:

“In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone. The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.”

He points out that, because the recovery has two differing speeds, it requires two differing responses.? In one region more support is required.? In the emerging markets it is likely that tightening phases are beginning.? This unevenness in the recovery is not a good sign and creates an imbalance that could pose a future threat:

“The two-speed nature of the global recovery implies that different policy stances are appropriate for different groups of countries. As I have noted, advanced economies generally need accommodative policies to sustain economic growth. In the emerging market economies, by contrast, strong growth and incipient concerns about inflation have led to somewhat tighter policies.”

Without naming names, Mr. Bernanke shows how a fully free floating exchange system would improve the global economy.? These are important comments in my opinion as the Chairman is emphasizing the fact that countries should not run persistent and large trade surpluses as these policies ultimately discourage domestic consumers from experiencing the benefits of what they sow:

“It is instructive to contrast this situation with what would happen in an international system in which exchange rates were allowed to fully reflect market fundamentals. In the current context, advanced economies would pursue accommodative monetary policies as needed to foster recovery and to guard against unwanted disinflation. At the same time, emerging market economies would tighten their own monetary policies to the degree needed to prevent overheating and inflation. The resulting increase in emerging market interest rates relative to those in the advanced economies would naturally lead to increased capital flows from advanced to emerging economies and, consequently, to currency appreciation in emerging market economies. This currency appreciation would in turn tend to reduce net exports and current account surpluses in the emerging markets, thus helping cool these rapidly growing economies while adding to demand in the advanced economies. Moreover, currency appreciation would help shift a greater proportion of domestic output toward satisfying domestic needs in emerging markets. The net result would be more balanced and sustainable global economic growth.”

These currency pegs also create internal costs that have never proven sustainable.?? Again, the Chairman notes that government should endorse monetary and fiscal policy which best supports higher living standards at home:

“Third, countries that maintain undervalued currencies may themselves face important costs at the national level, including a reduced ability to use independent monetary policies to stabilize their economies and the risks associated with excessive or volatile capital inflows. The latter can be managed to some extent with a variety of tools, including various forms of capital controls, but such approaches can be difficult to implement or lead to microeconomic distortions. The high levels of reserves associated with currency undervaluation may also imply significant fiscal costs if the liabilities issued to sterilize reserves bear interest rates that exceed those on the reserve assets themselves. Perhaps most important, the ultimate purpose of economic growth is to deliver higher living standards at home; thus, eventually, the benefits of shifting productive resources to satisfying domestic needs must outweigh the development benefits of continued reliance on export-led growth.”

Mr. Bernanke concludes with a comparison to the Great Depression.? Although he emphasizes that this is certainly not a depression he shows how there are similar problems.? Interestingly, he uses an example involving the gold standard and how such a policy can in fact have recessionary tendencies.? I can’t be certain that this is a subtle jab at the recent nonsense regarding the revival of the gold standard, but it looks that way to me:

“As currently constituted, the international monetary system has a structural flaw: It lacks a mechanism, market based or otherwise, to induce needed adjustments by surplus countries, which can result in persistent imbalances. This problem is not new. For example, in the somewhat different context of the gold standard in the period prior to the Great Depression, the United States and France ran large current account surpluses, accompanied by large inflows of gold. However, in defiance of the so-called rules of the game of the international gold standard, neither country allowed the higher gold reserves to feed through to their domestic money supplies and price levels, with the result that the real exchange rate in each country remained persistently undervalued. These policies created deflationary pressures in deficit countries that were losing gold, which helped bring on the Great Depression.³ The gold standard was meant to ensure economic and financial stability, but failures of international coordination undermined these very goals.”

All in all, this is some of Mr. Bernanke’s finest work.? It appears to me as though he is displaying a more flexible and open opinion with regards to monetary and fiscal policy.? That’s a nice change and a positive development. In addition, he exhibits an unusual understanding for what is occurring on Main Street instead of his persistent focus on Wall Street.? Let’s hope he will use his influence to follow thru and rather than consistently helping bankers, help Main Street for once.

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The content on this site is provided as general information only and should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The opinions of all guest authors or contributors can and will differ from those of Mr. Roche. These opinions do not necessarily represent the opinions or investment decisions of Mr. Roche. The author(s) may or may not have a position in any security referenced herein and may or may not seek to do business with one another or companies mentioned via this website. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

A brief note on comments – The increase in users in recent months has resulted in an increase in unproductive comments. Any user who engages in the use of racial epithets or uses the comment section as a place to insult other users will be banned from the site. The comment section is welcome to all readers who are interested in asking pertinent questions and/or engaging in thoughtful, intelligent, and productive debate. In short, just be nice. Thanks.

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BEN BERNANKE: QE IS ALREADY WORKING

In an opinion piece published in the Washington Post this evening Ben Bernanke says that QE is already working, but makes an absolutely crucial admittal in the article.? He says QE adds no net new money to the system (sound familiar?) and will therefore not be inflationary.? He also goes on to say that he is directly targeting higher equity prices and lower interest rates:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.”

The keys here are several:

• First, notice that Mr. Bernanke admits that QE is just an asset swap.? It does not add net new money to the system.? Therefore, there is no reason to believe it is inflationary. I agree with the Fed Chairman.? This policy will not cause inflation (wait, isn’t that the whole goal?).
• Second, he claims it has worked in the past by achieving lower interest rates.? But in all three cases in the UK, Japan and the USA interest rates ROSE throughout the entirety of the programs.
• Third, the Chairman admits that he needs help.? He most certainly does.? In my opinion, the Fed Chairman has essentially admitted here that QE is a non-event aside from the psychological herding of investors into equities and corporate bonds.? He needs fiscal help if he’s going to cause real inflation.? After all, a helicopter drop isn’t even technically in his arsenal and he knows it.

Mr. Bernanke is claiming victory before the program even technically begins….This Fed Chairman will either go down as the genius of all Central Bankers or will be known as the man who caused the Federal Reserve to lose its independence.

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The content on this site is provided as general information only and should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The opinions of all guest authors or contributors can and will differ from those of Mr. Roche. These opinions do not necessarily represent the opinions or investment decisions of Mr. Roche. The author(s) may or may not have a position in any security referenced herein and may or may not seek to do business with one another or companies mentioned via this website. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

A brief note on comments – The increase in users in recent months has resulted in an increase in unproductive comments. Any user who engages in the use of racial epithets or uses the comment section as a place to insult other users will be banned from the site. The comment section is welcome to all readers who are interested in asking pertinent questions and/or engaging in thoughtful, intelligent, and productive debate. In short, just be nice. Thanks.

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