First and foremost, much is said about “fiat” money and I believe that by now everyone agrees that dollars, euros, yen and yuan are accepted as legal tender because all of us “trust” the darn pieces of paper and the governments behind them. Then comes the “gold is money” and “gold is a store of wealth” arguments and once more I have the urge to address these two. Gold is not money, as a house is not money. Yet both are stores of wealth. Money is a unit of account that is representative of a nation’s economic value and gives one claim to that value, just like a deed gives one claim to a house. Two pieces of paper, similar purposes. I've even heard someone say that "fiat" means "fake," and I quickly asked him to pick up a dictionary.
One of the most advertised events is the fact that the Fed is printing "fiat” money and debasing the dollar. Then some will go as far as blaming Bernanke and his cohorts for everything under the sun - from a bubbling stock market to food inflation in developing nations - and soon enough the man will be responsible for everyone’s brown spot on their lawns. I’m not a Bernanke fan from a professional perspective, but not everything is his fault, although he’s trying to inflate something without much success. The rising U.S. stock market is caused by a shift in private capital.
What about QE2 and the side effects? Let’s first examine exactly what QE2 is doing in its simplest form and then we’ll look at inflation.
- The Fed expands its balance sheet by purchasing bonds from banks, thus injecting the banking system with cash, since lowering rates is no longer possible for obvious reasons.
- The process increases bank reserves enabling them to lend more.
- The goal is to lower interest rates through liquidity - or playing with the supply/demand equation - thus hoping to increase demand and inflate the asset side.
So far so good. But here’s the catch: Despite the ability to lend more, people are not borrowing, thus QE2 is an exercise in futility. I’m certain that the Fed’s primary target is to get housing back on its feet and is growing increasingly frustrated because there’s one core element not responding to the “free-money-for-all” approach: consumer confidence. Thus Bernanke can print all the money he wants, but unless the “fiat” money is actually used, inflation will not happen.
The “easy-money-inflates” process took place during the housing boom when the Fed failed to acknowledge the problem and consumer confidence was riding high. Now people are not buying into the charade because they’ve been burnt. I can inflate the supply of broccoli at my house but if my daughter won’t eat it, I’m stuck with the green substance and the only damage is the money I spent “printing” broccoli.
So at this juncture we have banks with plenty of cash but without borrowers. Furthermore, the lending criteria are very different, and banks have grown averse to risk, further filtering out who qualifies. Lastly, interest rates are rising - when they should be decreasing if QE2 was working - because the private investor is also more finicky about risk. As a little side note and looking back to December 24, 2010, “China Fails to Complete 91-Day Treasury Bill Sale, Traders Say,” for the second time in one month, according to Bloomberg, and paid 3.68% for a very short-term, 91-day security. Why would China, the globe’s savior, have trouble raising a few bucks, especially when the country is ready to help Europe get out of the crisis? China bought Portuguese and Spanish bonds, yet had a difficult time selling their own notes. Some may even ask “Why is China borrowing money when they have lots of it?” Oh, that’s a whole different story. Or is it that the GIPSI group (J.P. Morgan likes GIPSI too), along with the rest of the world, is competing for private funds?
As far as inflation is concerned, we’re all familiar with the traditional supply/demand curve. However inflation comes in different flavors and there are two distinct types: “supply-side inflation” and “demand-side inflation.” Assume for a second that while the demand of wheat remains constant, the supply decreases due to a drought - like the Chinese drought. The price of wheat will rise although everyone is eating the same amount of bread. This is “supply-side” and that’s what we are witnessing in developing countries. And to add insult to injury, Central Banks cannot do a thing about it unless all employees, economists included, put on some coveralls and hit the fields. Furthermore, if crops start to yield less on a sustained basis and we enter a starvation period, there’s no amount of anything - money, gold, wood - that is tradable for food because those holding the goods are not sure that they will be able to acquire more from somebody else.
The “demand-side” is best described by the housing boom that is now a distant memory, and that is the one the Fed wants. But even then, inflation had three main components and unless all of them are present, inflation will never happen. And let’s not confuse inflation with hyperinflation, because they are distant cousins at best. Why? Where inflation takes place within a trusted monetary system, hyperinflation flourishes because the trust is destroyed. I list the components in order of importance, and use the word “Citizen” to emphasize that, unless consumers are engaged, businesses cannot pull the weight on their own.
1. Citizen Confidence
2. Citizen Credit
3. Citizen Consumption
So what is the Fed actually doing? Tackling item number 2, hoping for item number 3, and not realizing that item number 1 is missing. You can lead a horse to water, but you can't make it drink. However, most Fed speeches refrain from using the word “deflation” maybe because they’re catching on to item number 1. If one thinks that prices will go lower on housing, what’s the stimulus to go out and buy? Why does the Fed engage in QE? Because the bank cannot give into the perception that it is powerless and no other tools are available. It’s either give money or take it back! If the Fed's job is to control inflation, that task can be delegated to the Bureau of Labor Statistics and every time the CPI is published they push a button and adjust rates according to the a predetermined algorithm. That will build consumer confidence through government reduction and efficiency.
The word "credit" has its roots on the Latin word "credere" which means "trust," and everyone is a little light on that, especially when the ultimate storage of wealth for the average person - the home - turned out to be false and is a new phenomenon that hasn't occurred in several generations. Thus my premise is that the Fed needs psychologists, not economists.
So where are we? In a deflationary environment with high interest rates, and there’s no definition for it as far as I know. We know about inflation, deflation, hyperinflation and stagflation. But I’ll give it a shot and call it “hideflation" - high interest rates, high unemployment, and deflation. I know some will dismiss the whole thing as “hocus-pocus” but we’ll get a better feel in 12 months, or less.
I now refer to a Bloomberg article titled “Fed's Dudley Says Central Bank Stimulus Is Helping to Spur Economic Growth," pointing out the Fed governor said that “by contrast to the national picture, the regional economy appears to have paused in the fourth quarter, which was ‘disappointing.’” What exactly was he saying? Regional paused and National is moving along? That doesn’t make much sense, but I’ll take a guess: The regional bit refers to housing and that’s what’s worrying him.
The President of the Cleveland Federal Reserve, a non-voting member this year, was a little more explicit, according to Reuters, on February 15, 2011.
She cited strength in exports and manufacturing as reason for optimism, but added that the economy still faces significant headwinds, particularly from a downtrodden housing market and weak income growth. A survey of homebuilders published on Tuesday showed sentiment in the sector remains severely depressed. "This recession was much deeper and lasted longer than previous recessions, and we have a long way to climb back," Pianalto said.
Why housing? Because the Fed has a playbook to refer to: Japan. And whether I agree with the Fed or not, they are not stupid, and realize that the damage caused by the housing bubble is not in the same category as the dot.com or any other bubble for that matter - just like inflation is different from hyperinflation. If memory serves me well, properties in Tokyo were going for over $90,000 a square/foot in the late 80s —-or over $1 million for a typical 12x12 foot American kitchen - and Japan has been at this “quantitative easing” ever since. Twenty-Two years and counting.
The latest FOMC meeting minutes as reported by MarketWatch added a bit more information, and emphasizes that they don't know what to do:
None of the doubters of the asset buys, commonly called quantitative easing or QE2, pushed for changes at the January meeting, although some said they were “unsure” what effect the program was having. This was generally in line with speeches by Fed officials leading up to the meeting. As a result, the Fed kept the program unchanged. The Fed now sees growth in 2011 ranging from 3.4% to 3.9%, up from an earlier 3% to 3.6% view.
I’ll advance that if we can squeeze 2% out of GDP in 2011, we’re lucky. What does all this mean? Investing in the next 20 years, or longer, will be extremely challenging and when we think we have it all figured out, along comes that weird event out of left field that confuses the daylights out of everyone.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.