The Helicopter Pilot Speaks Up
In his first public speech since the September FOMC meeting and the introduction of 'Operation Twist,' Fed chairman Ben Bernanke reminded everyone again why he was chosen as Alan Greenspan's successor so shortly before the biggest credit bubble in all of history threatened to implode: he's prepared to use the printing press (a.k.a. 'the tool box') to prevent it from happening.
We have long thought that there is actually nothing much for him to prevent. The over-leveraged household sector and the moribund banking system are acting in concert to thwart the Fed's plans. The former is trying to reduce its debts, and the latter is, well, constantly teetering on the brink of insolvency. The banks are essentially 'zombified' and have been temporarily rescued in the main by accounting practices that are certainly not exactly what one would describe as 'conservative.' 'Beyond good and evil' probably describes them more accurately (see in this context also the recently reported inability of value investors to find anything worthwhile to invest in in the banking sector). Hence the often mentioned fear of 'deflation' (meaning 'falling prices' in the Fed's view of the world).
In addition to the above well known interaction between debt-plagued consumers and toxic asset plagued banks, one must occasionally 'look behind the veil of money' at the real economy. An entrepreneur entering the loanable funds market to finance an investment is after all not merely looking for money – he is ultimately looking for capital. It is easy to create money in unlimited abundance in a fiat money system. Alas, capital will nonetheless remain as scarce as ever, and the economy's pool of real funding will always be of a limited size. There is therefore a limit to the economy's production possibilities, aptly named the 'production possibilities frontier' (PPF) by Roger Garrison.
An economy in recession is an economy in which economic actors have realized that they have – due to an artificially lowered interest rate - mistakenly tried to erect a structure of production attempting to produce beyond the PPF, and usually in the wrong lines of production. Since capital is consumed due these entrepreneurial errors, the structure must be shortened again to return to within the limits proscribed by the PPF; at the same time, this means that the aim of production must be switched back to producing more of what there is not enough of – replenishing the pool of final goods that can be saved and will ultimately enable the economy to once again engage in more time consuming and more productive methods of production.
It is important to realize that it is impossible to escape or avert this process. The only question is whether it is allowed to proceed unhindered and fast, or if it is delayed by fresh inflationary measures – ultimately making the necessary adjustments that much more painful and leading to sheer endless economic malaise.
Interestingly enough, a number of economists and economic observers appear to believe that the Fed's 'tool box' is ineffective in terms of money creation. Alas, why should it be?
As we have mentioned occasionally in the past, the theory (supported inter alia by 'MMT' sympathizers like this site and also representing the latest re-interpretation of money printing preferred by the Fed chairman himself) that the Fed was 'merely swapping assets' when it engaged in 'QE' iterations one and two is conceptually wrong, and in the case of The Bernank himself, intellectually dishonest. The fact of the matter is that the Fed did create oodles of new money, both in the form of 'money proper' (bank notes in the fiat money system) and perfect money substitutes, i.e., fiduciary media in the form of deposit money. In fact it created more money than ever before in such a short period of time (we are specifically referring to the period 2008 – present here).
How all of this works we have laid out in two articles written a while back – one on the mechanics of 'QE' and another that discusses the crucial difference between money and credit, a difference that is often lost on observers of the fiat money based system due to the close linkage between the two.
In concert with massive deficit spending by the government, the Fed has also succeeded – so far – in preventing the collapse of the mountain of total credit market debt that hangs over the economy like the sword of Damocles. Essentially the reduction in private sector debt was countered by a more than commensurate increase in government debt, much of it monetized by the Fed.
So this is where we now are; alas, whenever the Fed stops inflating actively, the economy returns to its previous path of deleveraging, which would normally put pressure on money supply growth (it certainly vastly lowers 'inflation expectations,' whether or not money supply growth actually decelerates). This has e.g. happened in the euro area, where true money supply growth has collapsed to a mere 1.3% year-on-year as the ECB paused with its actively inflationary monetary 'emergency injections' into the banking system over the past year and sterilized its bond market interventions by draining equivalent amounts of money from the system.
In the US money supply growth has however re-accelerated post 'QE2,' which is mainly owed to the fact that dollar deposits have fled the euro-area's rickety banking system and are now parked at US banks instead.
Now let us see what Bernanke had to say. According to a Reuters report:
Federal Reserve Chairman Ben Bernanke said on Wednesday the central bank might need to ease monetary policy further if inflation or inflation expectations fall significantly.
In his first public remarks since the Fed launched a fresh measure aimed at keeping down long-term borrowing costs, Bernanke indicated a willingness to push deeper into the realm of unconventional policy if economic growth remains anemic.
"It is something that we're going to be watching very carefully," Bernanke said in response to questions from the audience at a forum sponsored by the Cleveland Fed.
"If inflation falls too low or inflation expectations fall too low, that would be something we have to respond to because we do not want deflation," Bernanke said.
The comment was made in response to a question about a recent decline in market-based inflation expectations, which policymakers see as a good gauge of future inflation trends. The gap between yields on 10-year Treasury notes and their inflation-protected counterparts fell to 1.70 percent last week, the lowest since September 2010. It has edged up slightly since then and last stood at 1.86 percent.
In an effort to stanch the deepest recession in generations and help the recovery, the Fed not only slashed benchmark interest rates to effectively zero, but also more than tripled its balance sheet to around $2.9 trillion.
Despite these measures, growth has remained quite soft, averaging less than 1 percent on an annual basis in the first half of the year. Bernanke signaled he remains concerned about risks to the economy, which the Fed described as "significant" in its September policy statement. "We have a lot of problems both in terms of recovery and in terms of longer-term growth," he said. [gee, we wonder why? ed.]
The parts we have highlighted above tell us several things. First of all, Bernanke continues to believe in and continues to act according to the plans he has laid out in his 'anti deflation' speech in 2002 (the very speech that in our opinion landed him the job as Fed chairman). In short, he is indeed going to “push deeper into the realm of unconventional policy”. Of course there is in fact nothing 'unconventional' about printing money. It is simply inflationism, as practiced by countless tinkerers through the centuries before Bernanke entered the scene. It should be noted that 'inflation expectations' (this is to say, expectations regarding the future path of CPI's rate of change) are indeed falling dramatically. We post a chart of 'inflation adjusted yields' almost every day in order to bring this point home. Here is a chart of Bloomberg's 'Five year forward inflation breakeven rate,' which has been constructed according to a research paper published by the Fed itself. As you can see, inflation expectations have lately collapsed.
We can also see that Bernanke's 'fear of deflation' remains rather pronounced and at the forefront of his thinking. How do you battle deflation? Easy, you print more money. Lastly, we see that he has still not paused to reflect on the failure of inflationary policy to gain traction to date. In short, he simply believes he has not 'done enough,' instead of realizing that what he has been doing is actually an exercise in futility and has made things worse.
Therefore we must fully expect him to 'do more' – or to bring it to not too fine a point: he's going to re-accelerate the money printing effort.
And this, dear readers, is the main reason why the stock market has not yet followed the copper price and collapsed in a similarly spectacular manner. The 'messy' chart of the S&P 500 (NYSEARCA:SPY) depicts the to and fro created by the realization that the global economy has slipped into recession and the expectation that a flood of new money is soon going to head our way. It therefore probably remains a good idea to keep holding on to one's gold.
(Click charts to enlarge)
The SPX reflects the battle between the realization that the real economy is in bad shape and the expectations of more money printing to come courtesy of all the major central banks (the Fed, the ECB and the BoE).
Measures of US money supply, via Michael Pollaro. As can be seen, US true money supply growth has been blistering of late, not least because dollars have fled the euro area banking system and found their way back home. If the Fed begins to employ more 'unconventional measures' soon, it will begin to inflate again at a time when money supply growth is already very brisk. 12-month growth of TMS-2 currently stands at a stunning 15.8%.
In the context of the above, we will look at Thomas Hoenig's final parting shot and Alan Blinder's recent defense of the Fed chairman next.
Charts by: StockCharts.com, Michael Pollaro