In his recent speech, Ben Bernanke did a fantastic job exemplifying the new transparency of the Federal Reserve. What I find interesting is that all the reporters on CNBC are pointing out that he isn't saying anything new, and yet the markets are responding very favorably to his comments. This article will attempt to decipher Mr Bernanke's comments, and highlight why they are important to the markets.
This video highlights what I think is the major disconnect between "Fed Speak" and the financial markets, and why monetary policy seems to be so misunderstood by so many in the financial community. Mr Bernanke doesn't speak in financial terms, he doesn't have an MBA and he doesn't focus on the microanalysis applicable to individual firms or companies. Mr Bernanke doesn't speak about P/Es, P/Bs, EBITDA, EPS or how to value a bond. He doesn't care, he isn't a financial analyst, he is an economist. Economists live in a totally different world, a world with a macro view. Economists look at aggregate metrics not found on any balance sheet or income statement. They don't talk about earning growth, they talk about GDP. They don't talk about revenues and expenses, they talk about unemployment and inflation. Economists don't work with accounting spreadsheets, they work with econometric models.
In the highlighted video, Mr Bernanke highlights that unemployment is 7.6%, and states that he believes the number overstates the health of the labor markets because of the "participation rate" and other indicators of "underemployment." Those are concepts that don't easily fit into a spreadsheet or valuation model, and they are highly subjective whereas the financial community likes highly objective and standardized GAAP accounting metrics. Unlike most earnings reports, there is a lot of interpretation, flexibility and adjustments that go into that unemployment number. Restating an earnings number is a very rare event, whereas revising aggregate economic numbers like GDP and unemployment are standard practices.
Mr Bernanke's focus isn't on the stock market and valuing assets, it is on macro monetary policy that attempts to balance economic growth with stable prices. Those aren't financial terms and objectives, they are economic, and that is what I believe causes a lot of the friction between the Federal Reserve and Wall Street. Sometimes the goals and objectives of Wall Street and Main Street diverge, and outside being the lender of last resort, the Federal Reserve's main focus is Main Street.
In the video Mr Bernanke went on to mention that inflation is 1%, and below the target of 2%, and that combined with the understated unemployment statistics "both sides of our mandate...are saying that we need to be more accommodative." Contrary to popular opinion, the Federal Reserve doesn't just "print money out of thin air," and drop it out of a helicopter for amusement or to stuff the pockets of the mythological shadowy private "banksters" that own it. Monetary policy is tightly controlled by a regulatory body called the FOMC, empowered to administer the nation's monetary policy in a manner consistent with its "dual mandate" of full employment and low inflation. That is why the US doesn't have inflation after the Fed "printed all this money out of thin air" with QEfinity. The bond and stock markets simply trust that the Fed will remain faithful to its mandate and do what is necessary if inflation does develop in the economy. The moment the stock and bond markets lose faith, interest rates will adjust accordingly...and we will be in deep trouble.
One sub-culture of the investment community clearly does not share the faith in the Federal Reserve as the stock and bond market do, and that is the precious metals community. Gold/SPDR Gold Trust (GLD), silver/iShares Silver Trust (SLV) and other precious metals have discounted a huge amount of fear and expected inflation. Either the stock and bond markets and the Federal Reserve are wrong, and GLD and SLV are right or vice versa, but both sides can't be right. My bet is that the stock and bond market's faith in the Federal Reserve will ultimately be victorious. The bond market has an infinitely better understanding of monetary policy than the participants in the precious metals markets.
The other comment Mr Bernanke makes is the most important but most ignored and misunderstood.
Moreover, the other portion of macroeconomic policy, fiscal policy, is now actually quite restrictive, CBO estimates that current federal fiscal policy is subtracting 1.5% of growth from the US economy this year. So you can put all that together, and I think you can only conclude that the highly accommodative monetary policy for the foreseeable future is what's needed in the US economy.
I have written countless articles and posts about how the financial markets' obsessive focus on monetary policy was totally counter productive and misleading. QE fears shot gold all the way up to $1,900 and is now plummeting back to earth. Recent Fed comments sent the 10-year treasury rates from under 1.7% to over 2.7% a little more than 2 months, and it is now back down around 2.5%. Focusing on monetary policy is letting the tail wag the dog, and it will always be reactive instead of proactive. Bond prices react to changes in interest rates, so the way to make a decent return in the stock and bond market is to be able to anticipate the changes in interest rates.
In that very short video, Mr Bernanke tells the financial markets just how to do that. His message is to stop watching the Federal Reserve and start watching those who determine the Fed's actions, those controlling fiscal policy. Monetary policy is by far the weakest of the two macro tools used by the federal government to regulate the macro economy. Monetary policy is so weak it is often described as "pushing on a string." At best, monetary policy can be described as a "carrot." Fiscal policy on the other hand can be described as a "stick," and it isn't a "stick" being held by the altruistic free market invisible hand of Adam Smith, it is clenched in the grip of the Stalinistic iron fist of the command and control federal government. Fiscal policy is by far the most influential on the economy, and as the post 2008 economy proves, no amount of monetary policy can compensate for misguided, confusing, unstable and contractionary fiscal policy.
Mr Bernanke points out that fiscal policy is subtracting 1.5% from economic growth. I stress "subtracting." Fiscal policy is "subtracting" from economic growth when it should be stimulating economic growth. No one can argue that monetary policy has been anything but stimulative when stimulation was needed, and yet Ben Bernanke and the Fed are demonized, while the real culprit, fiscal policy, is given a pass. With fiscal policy "subtracting" from growth, fiscal policy drives monetary policy, not vice versa. Monetary policy will never dictate fiscal policy, yet fiscal policy will almost always impact monetary policy. Blaming the Federal Reserve for the weak economy is like blaming an ER physician for the patient's drunk driving accident. It is simply misguided and counter productive.
Unfortunately, analyzing the impact of fiscal policy is far more complicated than monetary policy. A spreadsheet can calculate the value of a bond by simply entering an interest rate. The consequences, often unintended, of fiscal policy can't be entered easily into a spreadsheet. Worse yet, analyzing fiscal policy can be offensive to the readers. While the financial media seems to have absolutely no problem whatsoever with unjustly, unfairly and often viscously attacking Ben Bernanke and the Federal Reserve for doing exactly what they are supposed to do, there is almost a complete silence on fiscal policy. Cutting economic growth by 1.5% when unemployment is conservatively 7.5% should be the dominate story, yet all we hear about is how irresponsible QE and monetary policy has been, and the need to "taper."
Why is that? Because you can't analyze fiscal policy without putting it in a political context. Financial writers won't write and journals won't publish analysis that covers fiscal policy because it can be considered political analysis and offensive to some readers. Considering that the federal government consumes over 20% of GDP, and passes regulations that have a tremendous impact on earnings and prospects, this is a huge disservice to the investing community. It is basically impossible to do a comprehensive analysis of any worth on a biofuels, solar, wind, energy, coal, pipeline, fracking, utility or healthcare company without analyzing the political risk, yet those risks are often totally ignored. Same can be said about investors in gold who have only been given the monetary story on which to base their decisions. Incomplete information can and often does lead to poor investments.
In this longer video, Mr Bernanke clarifies a few other misunderstandings about monetary policy.
1) The Fed has a "duel mandate" of "maximum employment and price stability." "Maximum employment" is not 0% unemployment, it is what is called the "natural rate of unemployment" which is the unemployment rate consistent with an economy where everyone who wants a job either has one or can easily find one. Healthy economies will always have some unemployment as people change jobs and industries become obsolete, but what are considered good forms of unemployment. The "price stability" mandate is why I claim the investors in gold are likely to be disappointed. It is highly unlikely that the Federal Reserve, which is mandated to maintain stable prices, will violate that mandate and create inflation at a rate that would be considered undesirable. If there is one thing the Fed knows how to do, it is fight inflation. Fighting inflation is the Fed's greatest strength, so a bet on gold is a bet against the Fed when it's playing on its home field.
2) QE has been implemented using 2 tools, asset purchases and rate policy and guidance. Both of those tools are administered in an effort to lower unemployment within the context of price stability. Historically price stability has been the Fed's main objective, and should always remain its main focus. Addressing unemployment is infinitely better managed through fiscal policy. Unfortunately fiscal policy is currently restrictive, so the US is addressing unemployment using its weakest and most ineffective tool by far.
3) The Fed will not raise rates until unemployment reaches 6.5% as long as "prices are well behaved." That 6.5% isn't a hard trigger, it is simply a level at which the Fed will re-evaluate its positions. Once 6.5% unemployment is reached, investors should not be anticipating an automatic rate increase by the Fed. The Fed is pretty clear that isn't the intention.
4) Given the weakness in both inflation and unemployment, and the method in which unemployment is calculated and its dynamics and likely understatement, it is likely that the Fed will wait until the economy is well past 6.5% unemployment before it raises rates. Unemployment as a measurement is rather strange in that it is likely that unemployment will actually increase once the economy starts to show strength as "discouraged" workers are encouraged by their prospects and return to the labor force. The labor force participation rate is extremely low, representing a tremendous excess capacity that exists in the labor force that isn't being counted in the unemployment statistics.
5) Monetary policy's main channel is through making big ticket items more affordable like homes and autos. It also helps consumers "de-leverage" with refinancing. Those are the bright spots of the economy, and those are mostly due to monetary policy in spite of "very strong fiscal headwinds." Basically Mr Bernanke is saying that even with the fiscal boot on the neck of the US economy, monetary policy has to keep the victim breathing and the heart beating. Once again, "very strong fiscal headwinds" are his words, not mine.
6) The Fed stands to fight inflation from above as well as below. Everyone reading this article should watch the above linked video at the 6:35 point, especially the gold bugs. Mr Bernanke explains why low inflation and deflation are not good for an economy. This is one of the most difficult concepts to explain to people. I've found it impossible to explain to the gold bugs, but it is one of the most important concepts for investors to understand. Deflation is not good for an economy, yes, that is counter intuitive, yes, it makes no sense on its surface, yes, you will sound like a nut if you say it at a cocktail party, but it is the truth. Deflation is the death sentence for an economy because interest rates can't accommodate for deflation, and therefore real rates increase during a time when monetary stimulus is most needed, setting the economy into a downward spiral. Higher deflation means higher real interest rates which means slower growth that means even higher deflation which means higher real rates and so on and so on. Simply take out a spreadsheet and work out a 5-year pro-forma for a company that is 50/50 debt/equity that pays 7% interest on a loan and inflation goes from 3% to -10% for each of the 5 years. Also assume wages are "sticky" and 50% of the capitalization is inventory that is all paid for immediately and has a 1-year turnover rate. For a real world example just consider people that use the deflationary Bitcoin. A few months ago they bought their inventory when the Bitcoin traded for $260, now they are liquidating their inventory for Bitcoins that are worth less than $100. People who have homes that are "underwater" with their mortgage can also testify that deflation is something to avoid, not seek.
In conclusion, to fully understand monetary policy investors must understand fiscal policy. Monetary policy is a derivative of fiscal policy. Mr Bernanke is telling the markets that his hands are tied as long as the economy faces "very strong fiscal headwinds." Mr Bernanke will not increase interest rates until Washington gets its fiscal house in order, it is that simple. It makes no sense to "taper" or raise rates when there is a fiscal boot on the neck of the US economy. The US has had at or near record low interest rates since the 2008 crisis, and yet unemployment and economic growth are dismal. Worse yet, fiscal spending ballooned the deficit by trillions of dollars to the point where the federal debt is now greater than the entire US GDP. What was the result of all this spending? Slower growth and higher unemployment. Economic text books are being written as we speak to try to explain this apparent impossibility. If Keynesian economics wasn't dead before 2008, it sure should be after this unmitigated disaster.
Bottom line, if investors want to understand monetary policy, they must understand fiscal policy. If investors want to know when QEfinity and the "taper" will end, they simply have to study fiscal policy. Constantly delaying the implementation of Obamacare, actually implementing Obamacare, constantly tinkering with the banking regulations, constantly tinkering with the tax code, constantly tinkering with energy regulation and constantly tinkering with the spending and "sequester" are all the fiscal "headwinds" Mr Bernake is referring to. Businesses and banks don't like change, and they hate tinkering. Until all the rules are set in place, and businesses and banks can estimate the costs, they will simply sit on their hands while Washington figures things out. That will result in higher unemployment and lower prices, and because of that, monetary policy will remain accommodative. Fiscal policy changes like comprehensive tax, regulatory, entitlement, immigration, legal and labor reform would all likely turn the fiscal headwinds to tailwinds, and remove the need for accommodative monetary policy. So if investors want to know when the Fed is going to start raising rates, they should change their focus from the Fed and start understanding its boss.