Fed Throws in the Towel on Its Fight Against Deflation
Staff Writer
Fall 2010
Fall 2010
Economics vs. Politics
As far back as 2001, Jim Shepherd began monitoring the decline in the rate of inflation and warned that if the conditions that created this decline could not be arrested, the U.S. economy could experience its first bout of deflation since the 1930s. In fact, Jim Shepherd was not the only one to identify the potential problems that falling inflation, accompanied by record levels of debt, could cause. During a speech on November 21, 2002 before the National Economists Club in Washington DC, Federal Reserve Governor Ben Bernanke discussed the specter of deflation and what tools the U.S. policymakers had in their arsenal to fight "significant deflation," one of which would doom the dollar.
During the last nine years, subscribers to The Shepherd Investment Strategist have been kept graphically informed (occasionally by Jim's use of charts taken from the Federal Reserve's own Web site!) about the persistent decline in "real inflation." That decline turned into dis-inflation and now appears to be ready to break through that ominous barrier to finally become deflation. If that happens, and if the rate of descent into deflation picks up enough speed, the U.S. economy will enter a deflationary spiral similar to that experienced between 1930 and 1932 when the value of equities declined by approximately 89 percent from their pre-depression highs.
The Federal Reserve, in its meetings, continue to fixate on the economy, its problems, and possible solutions, i.e. QE2. Unemployment remains "problematic" and "measures of underlying inflation are currently at levels somewhat below those the committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." An interpretation of "Fed Speak" would say: inflation is now below the Fed's preferred long-term range, and they're concerned the U.S. economy is about to enter a period of deflation.
So why has the population been continuously told that although inflation was still a threat it was being contained by the actions of policymakers? Why was there never even a veiled "Fed Speak" warning that deflation was actually a bigger problem than weak inflation and a bout of deflation could lead to the next Great Depression?
Perhaps the following will help explain what happens when economic policy is overwhelmed by politics.
The Government's "Three Monkey" Approach
There are several words that any government quivers at the thought of hearing. The word "recession" is one of these. As bad as this word is, the word "depression" is worse. Almost unspeakable, the word "depression" can, passing the lips of government officials, spell the end of an administration. When words themselves cannot be spoken, the ideas behind the words therefore cannot be addressed. The Fed must mimic the proverbial three monkeys, covering ears, eyes, and mouths, in the hopes that time will heal all. And they will simply be passed over, spared from the reality of having to cope with economic strife. And here, as we have seen playing out before our very eyes, is where our government has begun making decisions for the political good over those for the welfare of our nation's economy.
In times such as these, the government is simply interested in surviving this recession as unscathed as possible. However, we have elected government officials to solve national problems, not outlast them while the countries' populace suffers. Aware of this, the government has set up a regime of tactics meant primarily to convince the public that action is being taken, while internally they bunker down for the storm. The banks are allowed to "adjust" their balance sheets by not reporting bad loans and mortgages. The viewing public is treated to an endless wave of economic "experts" who assure us that all is well and recovery is imminent. And the truth is distorted by various economic data reporting agencies in the hope that things will turn for the better before the true state of the economy becomes evident.
Manipulated Market?
Beyond these ploys, there has been the rising fear that the market has been manipulated over the last several years to perform in a way that confirms the Fed's message for the economy. Though unconfirmed, various esteemed economists have broached this topic. Their credentials alone make it a subject not to be ignored. Two points to consider: the volume of trading increases on down days, while up days take place on very low volume, and, on down days, there is often a serious, unexpected move up that takes place in the last few minutes prior to the close that miraculously brings the market back up to flat or a few points up. This odd movement goes largely unnoticed. Most news agencies simply report the day's close, never pausing to reflect on the day's selling as a whole or, more importantly, compare that day's movements to days of past. Essentially, action by the Fed such as this would uniformly remove the word "free" from "free market."
Operation "Quantitative Easing"...and now a 600 billion QE2!
The battle ship in the Fed's attempt to curb this recession and prevent it slipping into a depression has been an approach called "quantitative easing." Essentially, the Fed will continue to bail out the big banks that landed us in this mess in the first place. However, this is failing to produce the desired effect (as will QE2 if passed). While flooded with revenue from the Fed, the banks continue their loan freeze to consumers and small businesses. Instead, they are hoarding these resources and using them to engage in risky trading activities that generate massive profits. It is shocking to think the Fed is now supporting a group of organizations in the very same tactics they were originally engaging in that led to the current economic crisis. When this behavior is questioned, former Federal Reserve Chairman Alan Greenspan states that "banks are afraid to lend right now because they are worried that they will not get paid back." And yet, loose lending practices that saw to it that anyone who applied for a loan was granted one, regardless of their credit history or current financial capabilities, was the very behavior that created the biggest debt bubble of history and its inevitable burst.
To make this scenario even more worrying is the method by which the Fed is continually bailing out these financial organizations. In essence, they are creating more money by buying up U.S. Treasury paper, thus expanding their balance sheets. If one considers that the reason the United States Treasury had to sell Treasury Bonds, Notes and Bills in the first place is to pay for expenditures the country could not afford, then the concept of creating money out of thin air to purchase these same instruments to give the illusion of more demand and liquidity is truly mind boggling! The illogic of this strategy is clear if one applies the same tactic to one's own financial dealings. After living a lifestyle that is not supported by your income and results in a substantial collection of debt, would you then think the most appropriate step is to simply sign up for more credit cards? Then, once you have paid off your old credit card bills with these cards, in the process increasing your overall debt significantly albeit in a different sector, pat yourself on the back for brightening your own financial outlook by doing this? I think not.
Sadly, History Does Repeat Itself
The truly perplexing matter is how history now seems to be repeating itself. Quantitative easing is not an original concept. In fact, it was created as a strategy to deal with an eerily similar scenario in 1932 during the Great Depression. One would have hoped that lessons can be learned from the past and not simply repeated. Included is an article excerpt detailing this history:
The term "quantitative easing" became popular jargon in 2009. After setting the target for the federal funds rate at a range of zero to 25 basis points on December 28, 2008, the Federal Open Market Committee announced its intent to purchase up to approximately $1.7 trillion of agency debt, agency-guaranteed mortgage-backed securities, and Treasury securities. The Treasury collaborated, buying for its own account approximately $220 billion in agency mortgage-backed securities during 2009. This policy was labeled quantitative easing. Few analysts recall, however, that this is the second, not the first, quantitative easing by U.S. monetary authorities. 1 During 1932, with congressional support, the Fed purchased approximately $1 billion in Treasury securities (half, however, was offset by a decrease in Treasury bills discounted at the Reserve Banks). At the end of 1932, short-term market rates hovered at 50 basis points or less. Quantitative easing continued during 1933-36. In early April 1933, Congress sought to prod the Fed into further action by passing legislation that (i) permitted the Fed to purchase up to $3 billion in securities directly from the Treasury (direct purchases were not typically permitted) and, if the Fed did not, (ii) also authorized President Roosevelt to issue up to $3 billion in currency. 2 The Fed began to purchase securities in the open market in April at the modest pace of $50 million per week. During the summer of 1933, as excess reserves reached $500 million, Fed officials' reluctance increased. Nevertheless, as Meltzer (2003) reports, President Roosevelt wished purchases to continue. On October 10, 1933, hoping to avoid a political confrontation, Fed officials decided to continue purchases. Yet, on October 12, these officials unanimously approved a statement to the president noting that (i) the System's holdings of government securities exceeded $2 billion, (ii) bank reserves had reached a record high, and (iii) short-term money rates had dipped to record lows. They halted purchases in November 1933. Quantitative easing did not end there, however: It instead shifted to the Treasury and the White House through gold purchases. The Fed's reluctance could be overcome with gold. President Roosevelt controlled both the nation's gold stock and monetary policy, so long as the Federal Reserve remained inactive. The president's most effective tool was the Gold Reserve Act, passed January 30, 1934, which raised the value of gold from $20.67 to $35 per ounce. The mechanism by which the Treasury gained control was elegantly simple. On August 28, 1933, Roosevelt called all outstanding domestic gold into the Federal Reserve Banks; on January 30, ownership was transferred, before revaluation, to the Treasury from the Federal Reserve Banks in exchange for (paper) gold certificates. When gold's price increased to $35 per ounce from $20.67, the Treasury realized a windfall profit of more than $2 billion. The Treasury, Meltzer (2003) reports, began purchasing gold "immediately" via the issuance of additional gold certificates-bank reserves and the monetary base expanded when the gold certificates later were received by the Federal Reserve Banks. (End of Excerpt)
-Richard G. Anderson
-Richard G. Anderson
1 This section draws on Meltzer, Alan H. A History of the Federal Reserve, Volume 1:
1913-1951. Chicago: University of Chicago Press, 2003.
2 The legislation also permitted the president to devalue the dollar relative to gold by up to 50 percent. President Roosevelt signed this legislation and the same day ordered all domestically held gold in the United States be sold to the Treasury (including gold held by the Federal Reserve Banks).
3 See Bernanke, Ben. "Federal Reserve's Exit Strategy." Testimony before the Committee on Financial Services, U.S. House of Representatives, Washington, DC, March 25, 2010.
2 The legislation also permitted the president to devalue the dollar relative to gold by up to 50 percent. President Roosevelt signed this legislation and the same day ordered all domestically held gold in the United States be sold to the Treasury (including gold held by the Federal Reserve Banks).
3 See Bernanke, Ben. "Federal Reserve's Exit Strategy." Testimony before the Committee on Financial Services, U.S. House of Representatives, Washington, DC, March 25, 2010.
It has been bandied about between new agencies and government officials that a positive outlook is the best salvation for the country's economy. After all, a happy investor is an investor who will go out and buy more. With this in mind, the Fed has taken the stance that all efforts of deception are justified. But how can that be? While being told the economy is on the mend may offer temporary relief, when one steps out the door and is confronted with skyrocketing unemployment, a freeze on loans from banks, and homes being foreclosed left and right, that sun shiny outlook cannot help but evaporate. A realistic stance that looks today's economic troubles firmly in the face and moves to correct them must always be preferable to delusion.
Sound investment strategy necessary to profit from the coming downturn
The opportunity ahead offers profits that likely will never occur again in our lifetime, however, inexperienced investors will either sit out the market with cash holdings and watch their purchasing power dwindle, or, if back in now, will not know when to exit and get burned again. While capital preservation is extremely important, what's more important is steadily increasing your household's buying power, in up markets and down. The key to success in the coming years will not lie in knowing which stock to pick, but in knowing which sectors or asset classes to be invested in and knowing when the timing is correct to enter and exit those investments.
Profiting from a downturn is only possible if one dispassionately makes investment decisions based on a careful analysis of raw data - sifting for trends hidden behind market, government and media noise. Like everything else in life, the real winners will be those who keep the faith and patiently stick with their convictions even when the market appears to be going against them. Fear, uncertainty and doubt will constantly challenge one's convictions, and those who succumb will not see outsize returns while those who are patient will be appropriately rewarded.
There have been four large market losses in the last 30 years: 1987, 1998, 200-01 and 2008. Prior to each of these events, we gave our subscribers direction that allowed them to not only avoid losing money but also profit from three out of the four instances. And when most lost in real estate after 2006, our subscribers did not. We had warned them in early 2005 what was about to happen in real estate, which allowed them to sidestep any losses.
To learn more about The Shepherd Investment Strategist and its outstanding record of growth over 17 of 18 years (plus Mr. Shepherd's earlier 11 years of profitability) go to our Web site at www.investment-newsletter.com.