Every now and then I need to take a step back, look at history and reset my brain. I think it is important right now to review the writings of the Fed Chairman Bernanke. Because what he has written about in the past is having a big impact on the present.
Deflation: Making Sure "It" Doesn't Happen Here
I want to start with the speech that put Ben Bernanke on the map. The first time I read it, I knew that it was a seminal event and I knew that this guy was going to be the next Chairman of the Federal Reserve.
I actually printed copies of this speech, highlighted the important parts and mailed the copies out to clients. I refer back to it often, because it layed out the tools the Fed might use to fight deflation over what I assumed would be the years 2002 - 2016/2018.
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
Do you even need to ask yourself where we are in history, when the expertise of the Chairman of the Federal Reserve is studying “The Great Depression”?
(Unless otherwise cited, all quotations are lifted directly from this Bernanke speech)
“It” is deflation.
Deflation is far and away the greatest threat to our economy. If you recognize this and learn about what tools policy makers may use to prevent or cure deflation, then you are way ahead of the game at figuring out how to position money.
“Deflation is defined as a general decline in prices, with emphasis on the word ‘general’.”
“Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.”
“Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”
Why is Deflation Such a Risk?
Deflation is such a risk to the US Economy, because the real value of debt actually increases during periods of deflation. If you owe $100,000 and have a deflation rate of -10%, then the real value of what you owe is $110,000 in year 2! So, by definition, deflation increases the cost of borrowing and of holding debt. Increased borrowing costs decrease economic activity.
When you get an economy with massive debt and you get deflation, what you end up with is what is called a “Deflation Death Spiral”. All this means is that deflation causes the cost of borrowing to increase, which leads to decreased demand, which leads to companies lowering prices to increase sales, which leads to deflation, which leads to the cost of borrowing – lather, rinse, repeat…
So deflation is causes by falling demand and deflation leads to falling demand. In the US Economy, the real cost of borrowing must diminish each year as the value of depreciating asset diminishes. This is done via inflation. In an economy which is designed to use borrowed money to purchase depreciating assets, deflation is incredibly destructive.
“In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.”
Deflation “impose(s) an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value."
“The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. … massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.”
How Do You Fight Deflation
This is the most important part of the speech. Remember, this speech was in November 2002. The tools he discusses were brought up as potential solutions 6 years ago! These guys knew this was coming and have been positioning things in preparation. for the inevitable.
The goal for defeating deflation is to “expand aggregate demand”. This phrase shows up a lot in his writings, so I think it is the key driver for all of Bernanke’s policy decisions. More on this later.
Cut Interest Rates
The Fed’s best tool for controlling demand is increasing or decreasing short term interest rates. They lower rates to increase demand, by making borrowing cheaper. However, sometimes rates get to effectively zero. Right now, the 3-month US Treasury yield is 0.565%. It is effectively zero right now!
Deflation: Making Sure "It" Doesn't Happen Here
I want to start with the speech that put Ben Bernanke on the map. The first time I read it, I knew that it was a seminal event and I knew that this guy was going to be the next Chairman of the Federal Reserve.
I actually printed copies of this speech, highlighted the important parts and mailed the copies out to clients. I refer back to it often, because it layed out the tools the Fed might use to fight deflation over what I assumed would be the years 2002 - 2016/2018.
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
Do you even need to ask yourself where we are in history, when the expertise of the Chairman of the Federal Reserve is studying “The Great Depression”?
(Unless otherwise cited, all quotations are lifted directly from this Bernanke speech)
“It” is deflation.
Deflation is far and away the greatest threat to our economy. If you recognize this and learn about what tools policy makers may use to prevent or cure deflation, then you are way ahead of the game at figuring out how to position money.
“Deflation is defined as a general decline in prices, with emphasis on the word ‘general’.”
“Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.”
“Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”
Why is Deflation Such a Risk?
Deflation is such a risk to the US Economy, because the real value of debt actually increases during periods of deflation. If you owe $100,000 and have a deflation rate of -10%, then the real value of what you owe is $110,000 in year 2! So, by definition, deflation increases the cost of borrowing and of holding debt. Increased borrowing costs decrease economic activity.
When you get an economy with massive debt and you get deflation, what you end up with is what is called a “Deflation Death Spiral”. All this means is that deflation causes the cost of borrowing to increase, which leads to decreased demand, which leads to companies lowering prices to increase sales, which leads to deflation, which leads to the cost of borrowing – lather, rinse, repeat…
So deflation is causes by falling demand and deflation leads to falling demand. In the US Economy, the real cost of borrowing must diminish each year as the value of depreciating asset diminishes. This is done via inflation. In an economy which is designed to use borrowed money to purchase depreciating assets, deflation is incredibly destructive.
“In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.”
Deflation “impose(s) an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value."
“The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. … massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.”
How Do You Fight Deflation
This is the most important part of the speech. Remember, this speech was in November 2002. The tools he discusses were brought up as potential solutions 6 years ago! These guys knew this was coming and have been positioning things in preparation. for the inevitable.
The goal for defeating deflation is to “expand aggregate demand”. This phrase shows up a lot in his writings, so I think it is the key driver for all of Bernanke’s policy decisions. More on this later.
Cut Interest Rates
The Fed’s best tool for controlling demand is increasing or decreasing short term interest rates. They lower rates to increase demand, by making borrowing cheaper. However, sometimes rates get to effectively zero. Right now, the 3-month US Treasury yield is 0.565%. It is effectively zero right now!
The Fed “can no longer use its traditional means (rate cuts) of stimulating aggregate demand”, but it has by no means “run out of ammunition” for fighting deflation.
“When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.”
Expand Aggregate Demand
“(A) principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.”
The 2002 Recession and “Preventing Deflation”
“(T)he best way to stay out of trouble is not to get into it in the first place.”
“(W)hen inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates (Orphanides and Wieland, 2000; Reifschneider and Williams, 2000; Ahearne et al., 2002). By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.”
In 2002, the Fed implemented strategies to prevent deflation. Greenspan cut rates to 1%, thus making money cheap to boost consumption and they removed virtually all regulation from the mortgage industry to make sure that real estate prices increased.
“A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices.”
And thus we had the Bush Tax Cuts.
So deflation was avoided for several years – (Greenspan & Bush)) kick the can down the road, so the next guy (Bernanke & Obama) would have to worry about fixing things.
Curing Deflation
We are now knee deep in price deflation for assets – real estate, stocks, bonds. This has ground the economy to a halt. Moreover, we now have huge systemic risks which were not present in 2002. Look at what Bernanke was saying about the economy in 2002 –
“I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small…”
“A particularly important protective factor in the current environment is the strength of our financial system … our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.”
Things have clearly changed, as the banking system is now insolvent and the average consumer has too much debt, while the assets they own are losing a lot of value.
What I am concerned about now is what policies will Bernanke use to “Cure Deflation” and how do I defend money and try and make money as these policies are implemented.
The Goal!
The goal of Bernanke is to “expand aggregate demand” at all costs. Carve that like backwards into your forehead so you read it every time you look in the mirror.
Let me explain “expand aggregate demand”. There is a difference between Real and Nominal Demand. Real is what you can buy next year versus this year based on the effects of inflation on your purchasing power. Nominal is the actual price you pay.
So if you bought something for $100 this year and inflation is 10%, then your Real purchasing power next year is effectively 91% of this year, as you have $100, but now must pay the Nominal (Inflation-adjusted) price of $110.
When Bernanke discusses “expand aggregate demand”, what he means is that he wants to make sure that on a Nominal basis, the economy is always growing year over year.
Bernanke gave a speech in the past 6 months (I can’t find it right now) where he defines his goal for the economy. He wants the economy to grow in nominal terms, so that we do not have debt deflation. Here is his math –
In 2008 you sell 10 widgets for $1 each, or a total of $10
In 2009 you sell 1 widget for $11, or a total of $11
You have $100 in debt and need to pay $10 per year in interest.
So by driving prices up 1000%, you are able to make enough money to service your debt. Production is down and inflation in through the roof, but you were able to pay your debts and that is all that seems to matter to Bernanke.
The Printing Press
“… (U)nder a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.”
“DEFLATION IS ALWAYS REVERSABLE UNDER A FIAT MONEY SYSTEM”
Print enough money to cause enough inflation to make sure that the Nominal economic output goes up, regardless of how badly Real economic output falls.
“By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
“If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”
This is pretty sobering stuff, isn’t it?
Buying Assets Outside the Fed’s Mandate
“Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.”
“Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.”
How many programs have we seen in the last 12 months to buy assets from banks -
Money Market Investor Funding Facility (MMIFF) $250 billion
Term Auction Facility $476 billion
Commercial Paper Funding Facility $900 billion (not a typo)
Bear Stearns Bailout $30 billion
Freddie Mac Bazooka $100 billion + $25 billion per month
Fannie Mae Bazooka $100 billion + $25 billion per month
AIG Nationalization $85 billion +$35 billion
The Paulson Plan $700 billion
Do you think they are making this up as they go along?
You can check the Fed's balance sheet here -
I think the Fed's Balance Sheet is now at over $4.5 trillion ($2.5 trillion to foreign banks). Did you see where Paulson decided that they would keep this $4.5 trillion off the books of the US Government (can you say Enron and "off balance sheet" accounting).
They know that the year they decide cut the accounting games, they will have to declare the number as a deficit for the year. How would you like to be running for office the year you pass a $2.5 trillion budget with a $4.5 trillion deficit?
Cap Interest Rates
“So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.”
“Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8% to 1.25% and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill.”
Take a look at the chart of the 30-year US Treasury Yield ($TYX = yield x 10) and you can see how the Fed has artificially held interest rates down in an effort to stimulate demand. At some point this changes and you had better not hold long-term bonds.
Here is a chart of the Price of the 30-year US Treasury. When the cap is lifted off of interest rates, the price of the 30-year bond will get smoked.
Buy Foreign Debt
“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.”
The US just bought Money Market Instruments for the Korean
The Fed has now injected money into 14 foreign markets and has REPO agreements (at least $450 billion and counting) with Brasil, Mexico, South Korea, Singapore, New Zealand, Japan, Switzerland, England, European Central Bank, Australia, Denmark, Norway, Sweden and Canada. the list grows each day.
Yesterday, the Fed announced the possibility of loaning $25 billion to a Korean Sovreign Wealth Bank...
Fiscal Policy
Outside of the Bush Tax Cuts of a few years ago, the next President will seek some sort of massive new stimulus plan. My guess is that it will be an Alternate Energy/Electric Automobile version of the Kennedy Man on the Moon mandate.
“(I)n lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets.”
Also look for the government to buy a lot of vacant Real Estate to prop up prices.
Japan
People wonder why Japan has done things so poorly for the last 20 years. Did you see that the Nikki hit a new 26-year low this week? So EVERYBODY who bought the Nikki since 1982 is DOWN!! Holy cow…
“Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt.”
The US has massive financial problems. We are overleveraged and insolvent.
“Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems.”
“(C)omprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy.”
Japan is still in their funk, because they never allowed the bankruptcies to occur and they never let unemployment spike. These are necessary pains in a nasty recession. If you have excess capacity, then you need to close it down – that means close factories and lay off employees.
I think that means we are in for nasty unemployment and a lot of companies going out of business.
My Point
The Fed has been taking action for at least 6 years to fix the current problem we face. I have been out of stocks for a long time, but I’m here to tell you that we are closer to the end than we are to the beginning of the Bear Market. Moreover, the economy is a long way into working through this mess.
I’m actually getting pretty optimistic that things will bottom in 2009. Because I think the policy makers get it. You will probably look back at the 2008-2009 bottom as a Once-In-A-Generation entry point for stocks. We’ll see.
Their goal is to increase spending. That means earnings go up and stocks go up with the.
Their goal is to increase asset prices via the printing of a lot of money. Again, that means asset prices go up.
It also means that inflation goes up and so will interest rates. So bond prices will fall and fall hard.
It’s amazing what you can figure out when you do a little homework…
Fiscal Policy
Outside of the Bush Tax Cuts of a few years ago, the next President will seek some sort of massive new stimulus plan. My guess is that it will be an Alternate Energy/Electric Automobile version of the Kennedy Man on the Moon mandate.
“(I)n lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets.”
Also look for the government to buy a lot of vacant Real Estate to prop up prices.
Japan
People wonder why Japan has done things so poorly for the last 20 years. Did you see that the Nikki hit a new 26-year low this week? So EVERYBODY who bought the Nikki since 1982 is DOWN!! Holy cow…
“Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt.”
The US has massive financial problems. We are overleveraged and insolvent.
“Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems.”
“(C)omprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy.”
Japan is still in their funk, because they never allowed the bankruptcies to occur and they never let unemployment spike. These are necessary pains in a nasty recession. If you have excess capacity, then you need to close it down – that means close factories and lay off employees.
I think that means we are in for nasty unemployment and a lot of companies going out of business.
My Point
The Fed has been taking action for at least 6 years to fix the current problem we face. I have been out of stocks for a long time, but I’m here to tell you that we are closer to the end than we are to the beginning of the Bear Market. Moreover, the economy is a long way into working through this mess.
I’m actually getting pretty optimistic that things will bottom in 2009. Because I think the policy makers get it. You will probably look back at the 2008-2009 bottom as a Once-In-A-Generation entry point for stocks. We’ll see.
Their goal is to increase spending. That means earnings go up and stocks go up with the.
Their goal is to increase asset prices via the printing of a lot of money. Again, that means asset prices go up.
It also means that inflation goes up and so will interest rates. So bond prices will fall and fall hard.
It’s amazing what you can figure out when you do a little homework…
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