Is the Federal Reserve (Fed) experiencing a midlife crisis? Ever since Fed Chairman Bernanke gave a speech in Jackson Hole, Fed behavior can be summarized as, well, bizarre. According to Bernanke, the market’s inflation expectations may be too low. He considers three possible remedies:
• Conducting additional purchases of longer-term securities (quantitative easing);
• Modifying the Committee's communication;
• Reducing the interest paid on excess reserves.
Here’s the problem with quantitative easing: even many on the Fed’s Open Market Committee (FOMC) doubt it will necessarily boost economic growth. What types of projects promoting economic activity will be initiated when extremely low interest rates are lowered further?
One might argue that the problems faced by the economy are not that interest rates are too high, but that real estate prices have still not adjusted downward sufficiently. Instead of downsizing to homes mortgage holders can afford, consumers are subsidized to stay in their homes; there’s no difference between subsidizing an ailing industry or an ailing consumer: subsidies are expensive and cause a drag on economic activity. However, given that the “downsizing” implies foreclosures and bankruptcies, it’s political suicide to promote what may be most prudent for the economy as a whole.
Aside from having little effectiveness, quantitative easing also brings about substantial risks. For one, should the Fed indeed buy $100 billion in government bonds each month as is rumored, the Fed would be implicitly financing new issuance of government debt by printing money (“monetizing the debt”).
For those not aware, when the Fed buys $100 billion in government bonds, it literally creates money out of thin air. All that is necessary to buy the bonds is an accounting entry on the Federal Reserve’s books: a credit of U.S. dollars that the institution that sold the bonds now has a claim on. This “claim” may be exchanged for other goods and services where U.S. dollars are accepted; at the Fed, however, the “claim” may only be exchanged for a piece of paper confirming the claim.
A major challenge with the Fed buying bonds is that the bond market is so enormous that the Fed is just one of many participants. $100 billion a month in purchases may not move the markets as desired, should market forces disagree with the Fed. This is why Bernanke has stated his second “remedy”: communication. In our assessment, the cheapest Fed policy is one where a Fed official utters a few words and the markets move.
The trouble is that since the onset of the financial crisis, with the Fed has had to employ much more than simple words: rates cuts were followed with emergency rate cuts in early 2008; these were followed with credit easing, then a mortgage backed security (MBS) purchase program in excess of $1 trillion; not to be outdone, the Fed is signaling that quantitative easing is to follow. Still, the Fed appears to be working hard to prepare the market through a blizzard of speeches by Fed officials. After all, if interest rates move based on a few well-timed speeches, a couple hundred billion dollars may not need to be printed; or so the thinking seems to be.
There’s also another avenue; positioned as a joke, it is all but funny: in his Jackson Hole speech, Bernanke suggested that in an environment where inflation expectations are too low, should the public reduce its confidence in the Fed, the resulting increase in inflation expectations could become a “benefit.”
Since those comments, we have had a number of Fed officials make the case for quantitative easing. In the past, Fed policy was conducted at FOMC meetings; in the current environment, every avenue appears convenient to tell the public the market better price in higher inflation expectations. A secondary goal of such a communication frenzy may be to steamroll over dissenting voices at the Fed.
In our view, the Fed knows quantitative easing may not be all that effective. We happen to think that the risks of quantitative easing outweigh the benefits, but we don’t think the Fed necessarily thinks the benefits are all that great. The challenges we are facing must be addressed by politics, not monetary policy. Homeowners must be allowed to downsize; we must have a tax and spending policy that is sustainable and encourages investment. Sprinkling money on the problems only encourages that the can is kicked down the road, making the problems all the more difficult to solve.
If the Fed believes quantitative easing may not be the silver bullet, why may it be pursued anyway? To just try printing another $1 trillion, hit blindly and hope that it stimulates something? Worry about the inflationary fallout later? No. In our analysis, Bernanke may have a different agenda: to intentionally weaken the U.S. dollar. When the Fed prints dollars to buy government bonds, two things happen:
• Everything else equal, the supply of U.S. dollars increases, making the U.S. dollar less valuable versus other currencies;
• Government bonds are intentionally over-valued as the Fed intervenes, making them less attractive to rational buyers. Rational buyers, domestic or foreign, are likely to look overseas for less manipulated returns.
Bernanke, unlike his predecessors, seeks the currency discussion. There are two dimensions he openly talks about:
• Bernanke has testified in Congress that countries going off the gold standard during the Great Depression recovered from the Great Depression faster than those countries that held on to the gold standard longer. This is in line with discussions by economists surrounding trading purchasing power for employment. It’s not the mandate of the Fed to intentionally destroy purchasing power, but currency devaluation is a tool employed by central banks to spur economic growth.
• Bernanke has repeatedly argued that a weaker U.S. dollar is not necessarily inflationary. He points to past decades where a weaker dollar did not necessarily increase inflationary pressures.
If you combine those statements with the Fed’s activities, it appears clear to us that Bernanke may not only be interested in a weaker U.S. dollar, but that he is actively working on engineering one.
Unfortunately, we believe the benefits may prove elusive, while the risks are enormous:
• A weaker dollar may not spur growth as intended. In the short-run, earnings of U.S. based exporters may benefit as foreign earnings translate to more U.S. dollars in a weak dollar environment. However, an advanced economy simply cannot compete on price; the day the U.S. exports sneakers to Vietnam may be the day I see a pig fly past my window. Instead, a strong currency is an incentive for an economy to adjust to more value added goods and services with more pricing power; that incentive is missing when a weak dollar is pursued, eroding long-term competitiveness in exchange for perceived short-term gains.
• A weaker dollar may indeed be inflationary. Foreign exporters to the U.S. have an incentive to absorb the higher cost of doing business that results from a weak dollar through lower margins. However, there is only so much foreigners can absorb; profit margins in Asia are often razor thin. Chinese policy makers have been pointing to this challenge as a reason for taking their time in allowing the Chinese yuan to appreciate. However, when pushed, China and other Asian exporters will have to pass on the higher cost of doing business (less competitive exporters may go out of business).
We saw this in the spring of 2008: at the time, it was not just the price of oil that soared to well over $100 a barrel; there were stories in New York of how dry cleaners had to pay twice as much for simple items such as coat hangers. The reason: there was no domestic producer that could jump in to keep prices lower. Asian exporters may have more pricing power than the statisticians at the Federal Reserve may recognize.
Because we believe Bernanke considers the U.S. dollar a monetary policy tool, we have also been far more optimistic on the euro than many others. Conventional wisdom has many believe that economic growth is the key to a strong currency; however, our analysis shows that this mostly applies to countries with current account deficits, such as the U.S. In the U.S., foreigners are more inclined to invest when there are prospects for economic growth, and thus help to finance the current account deficit.
Conversely, a country that finances its deficits domestically does not necessarily need economic growth to have a strong currency. Japan is a good example of this. Similarly, the eurozone does not have a significant current account deficit. The eurozone may have disappointing economic growth on the backdrop of a strong currency, simply because the European Central Bank (ECB) shows more restraint, printing less money than the Fed; on the fiscal side, austerity measures may also lead to a strong currency in the absence of a significant current account deficit.
Please join us on Wednesday, October 20, 2010, in a webinar to discuss U.S. dollar implications of policies pursued in more detail. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.
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