Welcome to the Weekly Report. Let me take you on a journey to explain what Ben Bernanke said and why he said it. We look at yields, what they are telling us and why we should listen. Finally we show evidence that the carry trade is crumbling. You will require a hot beverage, peace and quiet and probably a light snack.
Its time for An Occasional Letter From The Collection Agency and this week I am delivering it to your door. We start off by looking at the recent remarks by Ben Bernanke that seemed to catch the markets unawares. Before that though I want you to realise that Bernanke was not speaking "off the cuff", indeed his remarks are part of the well organised execution of what I called the Eggertsson Theory, explained in "The future actions of the Federal Reserve are known. Eggertsson re-visited a question that The Federal Reserve has been mindful of for some number of decades and one that Bernanke himself studied in-depth:
- "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."
Now I wouldn't blame you for looking at such a question and thinking "more inflation?" but the title of Eggertsson's work is "The Deflation Bias and Committing to Being Irresponsible". It laid out the groundwork for an approach to defuse deflationary forces and how to re-inflate the economy. From my point of view, Bernanke is not worried by inflation but he is absolutely petrified about a deflationary event. The actions of the Federal Reserve have for some years (and well before last summer) been a consistent copy of the steps laid out by Eggertsson in how to avoid a deflationary episode. Bernanke's recent remarks are just another step in that plan. Allow me to quote from the link above:
"Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:
"The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"
At face value the remarks above would seem to support the Keynesian approach that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.
Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.
The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.
Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow)."
To be honest, you really do need to read "The future actions of the Fed etc" in full to see the whole picture. (it's on my old blog, not the website) but because human nature is what it is and most of you are pressed for time, I'll plough on regardless.
Again I quote from "The future actions etc":
"It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.
The US Government has run an increasing deficit.
The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.
The loosening of regulatory oversight allowed a wider use of debt and increased consumption.
Since mid 2007:
The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.
The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.
The US Treasury does not rule out making the new Fed facilities permanent."
A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth.
Many writers connect the bursting of a previous bubble and the actions of the Fed/Treasury in the aftermath of such a bust as causing the next bubble. It is not unreasonable to think that the Fed/Tsy are aware that each "bubble" is not a separate and distinct event but can and do interact. For instance the LTCM debacle led to the issue of a lot of 10 year paper that matures this year. If the debt isn't rolled then the principle has to be repaid, causing pressure within the credit system.
The Fed would be aware of the timetable, even if many other investors had forgotten, and may well have been planning for an LTCM debt redemption failure scenario. With investors being reassured that the financial system was "just fine" after the Amaranth collapse (which was nearly twice the size of LTCM) many would have glossed over the LTCM debt maturing. (As an aside, put 2016 in your diary....) Interestingly Bear Stearns did not get involved in the LTCM bail-out but they did hold a lot of CDS exposure, I'm not directly connecting the LTCM debt and Bears CDS portfolio directly but the coincidences are rather neat.
Back to the point, as I have covered here and in full in the article "The future actions etc" Bernanke was obliged to raise the rhetoric about inflation and inflation expectations as part of the plan to avoid a deflationary scenario. The raising of such a topic by Bernanke had to be seen as credible for it to work and that could only be achieved by prior Fed/Tsy inflationary actions being reflected in the actions and expectations that consumers and business displayed.
By continuing to talk up inflation, either through prices or by mentioning (finally) the dollar connection, he now has room to ready the US and the World for a series of hikes accompanied by a continuing delivery of cash and nominally priced assets. His hope is that the re-flation will stimulate growth whilst the yield curve remains steep but moves higher, especially the long maturities.
This, he believes, will encourage...
To read the rest of the Weekly Report, click here.