"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.
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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.
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It is in this context that we have urged policy makers to be humble. That is, to allow the excesses of the bubble to be corrected, which will in turn allow for a sustainable recovery. Rather than throwing trillions at an economy in a scatter gun approach, simply hoping that things work out as planned, policy makers could let free market forces do their work. The current environment might be painful, as inflationary pressures have crept up, although they have mostly been limited to items the Fed seems to consider "transitory". Oddly, countries that have a challenging time recovering from the financial crisis justify low interest rates by calling inflationary pressures transitory; in contrast, Singapore recently tightened monetary policy - in our assessment because they are in a strong enough position to be able to take measures against rising inflationary pressures. Humble monetary policy, in our assessment, means not walking on a cliff's edge, but to pursue sound monetary policy.
Not Bernanke. His view of being humble is rather different. In his press conference discussing the latest Federal Open Market Committee (FOMC) statement, he was asked to contrast the US and Japanese experiences. Bernanke argued that the US avoided the Japanese experience because,
- "We acted aggressively and preemptively to avoid deflation"
He also listed the fairly quick move to recapitalize banks. He suggests,
- "... that we will avoid some of the problems that Japan has faced. That being said, I think, it's always better to be humble and just to avoid being too confident, and we need to continue to maintain strong monetary policy support to make sure that the economy continues on a recovery path and returns to a more normal situation."
That is, Bernanke's view of being humble means not to assume that deflation has been beaten, but to continue to 'maintain strong monetary policy support.' It is very consistent with what Bernanke has argued in the past: that one of the biggest mistakes during the Great Depression was to tighten monetary policy too early. The reason is the same: take the foot off the gas pedal too early and the economy might fall right back down.
What about the fact that an increasing number of FOMC members now believe that interest rates will be raised earlier than the end of 2014? According to Bernanke, these personal forecasts of individual FOMC members are merely inputs to the committee's process. The result is that the Fed is committed to keeping rates exceptionally low until at least the end of 2014. When quizzed on whether 1% would still be considered exceptionally low, Bernanke said that different FOMC members have different definitions of the term, but his personal view is that exceptionally low refers to the current target range of between 0% and 0.25%.
To summarize, in our opinion, being humble means to have great respect for unintended consequences and rather err on the side of allowing market forces to play their course.
To Bernanke, being humble means to keep strong monetary policy support to avoid deflation.
This humbleness creates a lot of debt - whether that be out of thin air on the Fed's balance sheet, or potentially across the economy as consumers, businesses and the government alike are enticed to borrow evermore money. So far, businesses are not taking the bait. But the government and some consumers are. What we consider monetary largess, as well as fiscal unsustainability, may ultimately lead to deterioration of the purchasing power of the U.S. dollar. It's in this context that we have encouraged investors to take a diversified approach to something as mundane as cash. A basket of hard currencies or gold might serve to mitigate the risks of a declining dollar.
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