Saturday, 23 April 2011

"Arx tarpeia Capitoli proxima" or the recent US Downgrade threat and the Fed dual mandate issue

"Arx tarpeia Capitoli proxima"

The price of continued US lax fiscal policies has seriously risen with S&P putting the US economy under negative watch.
The Fed has now kept the benchmark at zero to 0.25 percent since December 2008 while proceeding to two rounds of Quantitative Easing.
Whereas in Europe, the ECB has started tightening. It is the first time ever the ECB has acted before the FED preemptively in relation to inflation concerns.

This is an important point, as it clearly shows the divide in policies between the US and Europe.

While Trichet and the ECB seems to be sitting in a more classical camp, Bernanke and the Fed, seems to believe in a Keynesian approach in resolving the difficulties faced by the US economy.

It is important to remind at that point the clear differences in mandates between the ECB and the FED. While the ECB's core mandate is of price stability, the FED has a dual mandate, price stability and maximum employment. Hence the current difficulties faced by the Fed. Targeting both unemployment levels and inflation levels is a near impossible task for the Fed currently. It has to promote both “maximum employment” and “stable prices. The Fed’s mandate was extended to "maximum employment" in 1978 as a way of forcing the central bank to "print money". This extension of the mandate made sure the Fed would always be under continuous pressure from the politicians. But, Paul Volcker initially in the early 80s did not play it that way. He clearly understood the risk in not taming the inflation beast. He knew he could not fight on two fronts and initially targeted inflation versus maximum employment. His policy of taming inflation with a rapid surge in interest rates led to a very severe recession but put back the US economy on track. The recession was short but indeed very painful which led Mr Volcker to be hated by both Republican politicians as well as Democrat politician.

One of the main reason of QE2, can be sourced to this ill-fated dual mandate.
The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, as well as lifting stock prices, playing on the wealth effect game. I criticised the wealth effect policy in February 2011 (Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth).

It is important at this stage to link this post to a previous one I have written: "The Hurt Locker". In this previous post I published in September last year, I discussed the fundamental flaws in Washington’s stimulus policies, linked to the flawed dual mandate imposed on the Fed.
Also, I quoted Jacques Rueff and his analysis of the failings of Keynesian stimulus policies:

"Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them."

What we are seeing right now is a Fed creating price inflation during the current slump ensuring the "poor schmucks" real terms wages are going down.

This is what happened during the big Stagflation period of the 70s:
"Between 1974 and 1984, real wages fell as much as 30%."

In Homage to Jacques Rueff, Bill Bonner added the following:

"But Rueff’s insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the US to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this “exorbitant privilege” will be “suicidal” for Western economies, he predicted."

Bill Bonner concluded:
"Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques Rueff must look on in amusement to see what happens next."

"Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered." This seems to be the position of the classical ECB while the Fed seems to be suffering from Retrograde Amnesia. "Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible."

It is very important to understand the game played by politicians in relation to creation of the additional mandate of the Fed, namely maximum employment and its fallacy.
Joseph Schumpeter, one the greatest economist we ever had, clearly understood's the role politicians played; He presented in the quote below as "The Intellectual in reality our politicians. I initially referred to Schumpeter in December 2009 in the following post: "Blue pill or Red Pill?"

"Capitalism’s Greatest Enemy: The Intellectual
"The proper role of a healthily functioning economy is to destroy jobs and put labor to better use elsewhere. Despite this simple truth, layoffs and firings will still always sting, as if the invisible hand of free enterprise has slapped workers in the face. Unsettling by nature, capitalism’s churn gives rise to a labor movement designed to protect workers from job loss. That movement is fed emotionally by displaced workers and others who blame the capitalist system for their troubles, but it is led psychologically by a whole other type of person—the intellectual. Intellectuals—with little to do owing to the success of the capitalist economic system but with an intense desire to be seen as caretakers of society’s general well-being—anoint themselves as leaders of the labor movement. They object to capitalism on moralistic grounds and seek its destruction and replacement by another system—socialism—which places them center stage."
"You could replace "intellectuals" in the quote in today's economy by politicians and you would not be far from what is currently happening in many countries today" I argued back in 2009.

Creative Destruction as defined by Schumpeter, is at the core of Capitalism. Politicians for the sake of getting elected or re-elected cannot accept this core feature of capitalism. One could argue that Schumpeter's view of the evolution of Capitalism towards Socialism, is in fact quite accurate in the description of the process.
But I digress, let's go back to the Fed's dual mandate issue and the current situation.

The Fed is trapped in its dual mandate enforced by US politicians. QE2 will make it extremely much tougher for the Fed to eventually reduce its gigantic balance sheet, therefore risking higher inflation.
While the ECB's mandate make it more easier to react to inflationary pressures, regardless of unemployment levels:

"In a clean discussion of what the appropriate role for a central bank is, I can see some merit in looking at a narrower objective," Chicago Federal Reserve Bank President Charles Evans.

"It's interesting," he said in November. "The ECB (European Central Bank) has a price stability mandate ... The only thing a central bank can do in the long run is control the long run rate of inflation, so from that point of view it makes sense to have single mandate"
according to St. Louis Fed President James Bullard.

"With no explicit plan for when or how this quantitative easing will be withdrawn, the Federal Reserve could do more for the American economy by focusing singularly on maintaining the value of the dollar and protecting the purchasing power of Americans,"
Mike Pence, No. 3 Republican in the House.

It looks like Mike Pence care about the "poor schmucks" Jacques Rueff mentioned, who are seeing their real terms wages are going down with the US dollar...

Former U.S. Treasury Department undersecretary John Taylor indicated as well is wish for an end to the dual mandate of the Fed in January 2011:

It would be better for economic growth and job creation if the Fed focused on the goal of “long run price stability within a clear framework of economic stability,’”
Taylor told the House Financial Services Committee.

An excellent post from November 2007 on the blog published by Macro Man can be find below, relating to the subject of the dual mandate:

"Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.

It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc."
Recently Dr Hussman, wrote an excellent article related to the trap the Fed has put itself in with QE2:
"A week ago, Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should increase short-term interest rates to 2.5% "starting in the not-too-distant-future," preferably during the coming year. Given the robust historical relationship between short-term yields and the amount base money per dollar of nominal GDP, we can make a fairly tight estimate of how much the Fed would have to contract the monetary base in order to achieve a 2.5% yield without provoking inflationary pressures. While the monetary base will be over $2.5 trillion by the end of this month, a 2.5% interest rate would require a contraction of about $1.3 trillion in the Fed's balance sheet, to a smaller monetary base of just under $1.2 trillion.
In his comments, Plosser discussed a plan to sell about $125 billion in Fed holdings for every 0.25% increase in the Fed Funds rate. That overall estimate is just about right (ten increments of 0.25 each, with an overall contraction approaching $1.3 trillion in the Fed's balance sheet). So Plosser's estimates correctly imply that a 2.5% non-inflationary interest rate target would require the Fed's balance sheet to contract by more than 50%.
The problem, however, is that the required shift in the monetary base is not linear. It's heavily front-loaded. Based on the historical liquidity preference relationship (which explains about 96% of the variation in historical data), and assuming nominal GDP of $15 trillion, the following are levels of the monetary base consistent with a non-inflationary increase in short-term interest rates up to 2.5%. The non-inflationary provision is important. You can't just allow interest rates to rise without contracting the monetary base. Otherwise, as noted earlier, non-interest bearing money would quickly become a hot potato and inflation would predictably follow.
The upshot is that Plosser's estimate of about $125 billion in asset sales for every 0.25% increase in yields is an accurate overall average, but the profile of required asset sales is enormously front-loaded. The first hike will be, by far, the most difficult. In order to achieve a non-inflationary increase in yields even to 0.25%, the Fed will have to reverse the entire amount of asset purchases it has engaged in under QE2. Indeed, the last time we observed Treasury bill yields at 0.25%, the monetary base was well under $2 trillion.
In my view, this is a major problem for the Fed, but is the inevitable result of pushing monetary policy to what I've called its "unstable limits." High levels of monetary base, per dollar of nominal GDP, require extremely low interest rates in order to avoid inflation. Conversely, raising interest rates anywhere above zero requires a massive contraction in the monetary base in order to avoid inflation. Ben Bernanke has left the Fed with no graceful way to exit the situation."
Dr Hussman also added in this must read article:

"The first 25 basis points will require an enormous contraction of the Fed's balance sheet. Risky assets have already been pushed to price levels that now provide very weak prospective returns."
In relation to today's market environment, the outcome is likely to be a very significant risk of unstability and sharp volatility increase. Given the potential for the economy to come to a stalling point in the upcoming quarters due to external inflation pressures (oil prices high prices) already creating serious headwinds on corporate profit margins as well as consumption, it is extremely important to be well aware of the consequences of unbalances which has been generated by a reckless Fed in launching QE2.

Another surge in Gold was clearly expected, I agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011: "Gold, the Fed, Ron Paul and Napoléon Bonaparte"

"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."
The release of information related to the access to the discount window of the Fed, thanks to Bloomberg's tenacity in their lawsuit also underlines a very important point between the current relationship between the Fed and the ECB. Martin Sibileau in his post,goes further in the analysis of the access to the Discount Window of the Fed: loans to overseas banks including cross-currency swaps, and their implication in magnifying global leverage worldwide.

"These loans and cross currency swaps are the “leverage of the leverage”, so to speak. With them, other central banks give up their sovereignty and the Fed effectively becomes the world’s lender of last resort. For instance, when the Fed loans US dollars to a German bank, as it did, the European Central Bank can no longer act as lender of last resort, should the German bank default on its obligations with the Fed. But, would this in reality occur? Of course not! If the German bank was not able to repay its US dollar denominated loans, the Fed would simply roll over the liquidity line. This is a very troubling scenario because the Fed in fact expands the supply of US dollars worldwide (global leverage), without any counterbalancing reduction of credit in the US currency zone.

In our view, these “global” discount window operations are the necessary (but not sufficient) step towards the collapse of fiat money. If we are ever going to see the end of fiat money, it will be thanks to global loans from the Fed. Without them, other central banks will always retain their sovereignty and become alternatives to the US dollar. But with them, once the loans are out and a wave of defaults is triggered, the Fed becomes the easy prey for the collective gold longs."
Like Martin Sibileau, I sit in the same camp, outcome will be stagflation.  We both believe in strong stagflationary forces being at play in the current environment.

What will happen when Asian countries as well as Oil rich countries, gorged with USD reserves and facing the rising threat of inflation, will decide it is not wise anymore to invest these reserves in US Treasuries, but to invest in gold, tangible assets and more yielding assets?
As I wrote previously you cannot expect China to bow to American pressure and start revaluating the Yuan versus the dollar. China has learnt the lessons from Japan: Revaluation of Japanese Yen, a historical lesson to draw: analysis - This is an article on the seventh page of People's Daily, September 23, by Pro. Jiang Ruiping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

Chinese government officials have stepped up the rhetoric game with the USD stating they might have to diversify their USD 3 trillion of currency reserves away from U.S. dollars. Who would blame them, given the sinking value of the USD, therefore the sinking value of their chips in the game of marbles?

The dollar is 5% away from its all-time low, touched in March 2008, as tracked by the dollar index, which dates back to 1971.

The recent action led by S&P relating to its concern on the US economy, is a stark message sent to the US politicians, they need to put the US house in order and begin to show some long term fiscal discipline.

On the subject:

"Only under the rules of what Jacques Rueff scathingly termed the 'childish game of marbles' by which the winners (the Chinese) return their spoils (the excess dollars) back to the American losers at the end of each round - by buying US Treasury and Agency bonds, in the main - and as a result of what the great Frenchman also dubbed the 'monetary sin of the West' - the fact that the dollar hegemony allows the US to go on mindlessly inflating and blaming others for its own lack of financial virtue - can the Chinese be held culpable for what is at work here."
Sean Corrigan also adds in his article:

"Emphatically, the only 'risks associated with deflation' are those which come from clinging too long in the naive faith that the value of one's money will be preserved by a central bank which can still talk about such an eventuality while the malign effects of its inflationary policies are everywhere increasingly undeniable."

"In a West already displaying symptoms of the extirpation of the middle class, in favour of the governing military-political elite and at the cost of buying off its feckless urban proletariat with a higher dole and more spectacular circuses, the more the state expands in this way, the more success it will enjoy in the only one of its wars on abstract nouns which it wages unremittingly and a outrance - its War on Capital."
The Dollar Standard which succeeded Bretton Woods in 1971, following its collapse, has allowed the deficit countries like US, to consume more than they produce. Whereas surplus countries, such as China, Singapore and others, have been able under the new system to produce more than they consume, therefore accumulating vast USD reserves accordingly.
Between January 2004 and the beginning of 2008, worldwide international reserve assets more than doubled. Asian countries have boosted their reserves by acquiring export dollars. These dollars then moved back to the US, where they funded most of the excesses: subprime mortgages, leveraged buy-out, structured credit markets and so on.

QE2's wealth effect, it can be argued, cannot be branded as a success. The surge of US stock prices has been a mere reflection of the decline of the US dollar, hence the rise in Gold in the process.

The excellent David Goldman clearly illustrates the point:

"The last two weekly unemployment claims prints above 400,000 show how weak the labor market is. I’ve been saying for two years (pardon the broken record) that an entrepreneurial economy can’t do that well as long as there are no entrepreneurs in the picture. If that’s the case, why are stocks doing so well?

Part of the answer is that stock prices reflect the declining dollar: overseas profits increase when translated back into dollars, and American cash flows look cheaper to foreign investors."
Trade Weighted Dollar vs. S&P 500, April 20, 2008 to April 20, 2011

In relation to the current situation, the recent warning shot fired towards the USA by S&P, is an important inflection point as we moved towards what I have previously called relating to Chess, "The Endgame - Fin de partie":
An endgame is when there are only a few pieces left. We are close to the point.

"Artistic endgames (studies) – contrived positions which contain a theoretical endgame hidden by problematic complications".
This is the situation the Fed is currently in.

"You have a choice between the natural stability of gold and the honesty and intelligence of the members of government. And with all due respect for those gentlemen, I advise you, as long as the capitalist system lasts, vote for gold."
George Bernard Shaw

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