Thinking Things Over              January 29, 2012

Volume II, Number 4:   Obama and Bernanke are Not on the Same Page on Our Future 

By John L. Chapman, Ph.D.                                                                                                                     Washington, D.C.

The week just passed witnessed an extraordinary disconnect.  Tuesday night President Obama delivered his annual State of the Union address, and argued that the economy is “getting stronger.”  He pointed out that three million private sector jobs have been created in the last 22 months, jobs have been created in manufacturing (including 160,000 new auto industry jobs in a sector “saved” by the federal government), new trade agreements have been signed that mean “millions of new customers” for American goods (in Colombia, Panama, and South Korea), and smart government policies (e.g., fair trade enforcement vis-a-vis China, thirty years’ worth of government R&D dollars in shale rock drilling for natural gas deposits) have made expansion easier for business.  Mr. Obama went on to assert that new “rules” to prevent financial fraud (Dodd-Frank), toxic dumping (EPA mandates), and faulty medical devices (FDA “executive order” regulations) would “make the free market work better,” and lead to stronger growth in an “economy built to last.”  And, he added, he would be pursuing higher taxes on “the rich”, including a “Super-AMT” surtax on incomes over $1,000,000 to ensure they paid their “fair” share, employing the cheap theatre of having Warren Buffett’s over-taxed secretary (she reportedly makes at least $200,000 per year) in the gallery alongside Mrs. Obama.  Clearly Mr. Obama’s view now is that the economy is healthy enough to absorb significant tax increases in 2013, including the $100 billion hike for ObamaCare implementation alone.

But on Wednesday afternoon the Federal Reserve released its meeting minutes summary for its meeting this week, and Chairman Bernanke held his quarterly news conference.  For Mr. Bernanke, the 2011 GDP growth rate of 1.7% was hardly a sign of robust growth and expansion, and the Fed announced a decision to extend its zero-bound interest rate policy through the end of 2014.  Or, yet another 18 months beyond its previously announced target of mid-summer 2013.

There was further bad news from the Fed:

  • It followed through on its new practice of quarterly long range forecasts, but revised downward previous real GDP growth projections for the next three years — for 2012, its median expectation is now 2.45%, down from 2.7%.
  • Ominously, long-term GDP growth now has an expected range of 2.3% to 2.6% for Fed forecasters, well below the 20th century growth rate (and post-World War II growth rate) of 3.3%.  Growth for the next several quarters is to be “modest”.
  • The Fed evinced concern over the decline in business fixed investment, and reiterated that the housing sector remains depressed.
  • Unemployment is expected to remain “elevated” for a long time, barely breaching 8% (to 7.75%) two years from now.
  • Inflation targeting is now official policy at the Fed, with a long run goal of staying under 2% for personal consumption expenditures.  The Fed feels quite confident in meeting this goal because it all but states general business conditions would remain quasi-depressed for quite some time and thus “slack” demand would ensure no price rises.

Mr. Bernanke believes that his new “openness” in communications, from his press conferences (previously unheard of for a Fed Chairman) to the stepped-up public speaking of Fed officials to the new details on internal forecasts will help to “anchor” inflation expectations.  But this, we are convinced, is whistling past the graveyard.  For the Fed also announced on Wednesday a new willingness to expand the supply of money and credit in the economy if conditions warranted it, regardless of what it might portend for inflation:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary.  However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

The intelligent reader will of course wonder how we translate the above paragraph into sentiment expressing a certitude regarding future inflation (and the sluggish growth it implies), not least because there is an absurd level of contorted and obfuscatory phraseology here, particularly in the latter sentence (i.e., when the Committee judges that the objectives contained in its dual mandate of price stability and full employment are not complementary, it will take a “balanced approach” in promoting these two objectives).  Alas, we have been inside the Beltway observing the Fed for far too long, as this one was easy: this statement is bureaucrat-speak for admitting that since the Committee expects its inflation target will be met rather easily, “balance” will require it to emphasize what may well be a way-off target for employment due to sluggish growth.  It will therefore not hesitate to conduct further easings in order to stimulate spending and, it infers, aggregate demand.

Mr. Bernanke is counting on five items to ensure he can conduct inflationary monetary operations in the future if need be to promote greater employment without damage to the economy overall that might include higher prices:

  1. Continued (indeed, quasi-permanent?) slack demand in the U.S. will mitigate any inflationary pressures in the U.S. from further monetary easing.   Mr. Bernanke is a confirmed adherent of the Phillips Curve and believes that the trade-off between unemployment and inflation is very real, but only when the economy is already at full employment.  He does not worry that this will apply to the United States for many years to come.
  2. On a relative basis, things look so bleak in Europe and Japan, and will intermittently stall in Latin America, China and the rest of Asia in the years ahead, that the continuing appetite for safe-haven dollar-denominated assets will continue to prop up the trade-weighted value of the dollar.  At the least, Mr. Bernanke thinks, the rest of the world is in such poor shape that demand for dollars will remain strong enough to forestall increases in the domestic price level in the U.S.  This is in effect the seigniorage that accrues to the custodian of the global reserve currency, and the Fed sees no end to this status any time soon.
  3. Mr. Bernanke is preeminently confident in his own abilities.  He believes that while the Fed balance sheet has exploded from $800 billion to $2.6 trillion in the last 3 1/2 years, that at any time, if need be, these reserves can be drained back out of the system.
  4. Fed analysts believe that deflation due to household and corporate deleveraging will be ongoing for 3-4 more years, and this will continue to exert a deep drop in housing values.
  5. Lastly, Mr. Bernanke believes that reserves created by the Fed no longer temporally precede or cause the creation of new money and bank loans.  Indeed, a 2010 study by the Fed’s Seth Carpenter and Selva Demiralp of the University of Koc (in Turkey) showed that in recent years the creation of new reserves has followed the extension new loans, which were instead generated by increasing bank capital and another managed liabilities (e.g., large time deposits) against which loans could be made thanks to the Basel II accords.

We believe the Fed Chairman is in error across the board on these issues, and that the U.S. economy may suffer as well, broadly speaking, with the advent of an inflation he cannot prevent, once unloosed.  In the first place, the 1970s disproved the thesis that no inflation could ensue during a period of slack demand.   Consumer prices rose 3.0% in 2011 and should increase even faster with a pick-up in activity volumes in 2012.

Second, the idea that the rest of the world will remain weak and nervous for the foreseeable future and thus maintain demand for dollars and dollarized assets is an unproven assertion.  Global demand for dollars in international cross-border settlement transactions was strong a generation ago: 91% of these deals were done in dollars then. Today that figure is down to 63% and the decline is secular.  If anything, one would expect it to accelerate during a period of explicit dollar weakness, and the volume of noise surrounding discussions of alternative trading currencies has risen dramatically in places like Moscow, Beijing, and Riyadh.

It is also unclear that Mr. Bernanke will be able to pull back from the Fed’s high-level of reserves painlessly in a reverse/drain operation, as he seems to think.  For one thing, if latent inflation is seen as rising, causing inflation expectations to become “unanchored,” a sell-off of the mortgage and Treasury portfolios would cause a potentially sharp spike-up in interest rates if it happened quickly enough, and this cold cause real problems in the real-estate and financial sectors, still down sharply from four years ago and undercapitalized.   Rising loan demand and price increases could be dealt with, alternatively, by increasing the Fed’s interest on reserves.  This is a palliative move with an expiration built into it: not only could that get very costly as a percentage of total Fed profits, but it would continue stoking high interest rates in the economy.   The Fed could also increase the banks’ reserve requirements and force the banking system to hold these assets indefinitely; this would hamstring the banks by essentially deadening their reserve base.

As far as the alleged deflation during deleveraging, again, 2010-11 give lie to this.  Current high-frequency indicators for the U.S. such as the Producer Price Index are up smartly, both in recent months and across the last year.  And finally, while we agree that bank capital requirements and liability management are now critical in determining the domestic price level via their influence on new money supply, the fact is that there can certainly be two-way causation on this, too; the reserves after all exist in huge excess amounts now, and if activity picks up marginally in the U.S. these will be drawn down fairly rapidly.

On this general theme, our colleague Thorsten Polleit at Barclays Capital in Frankfurt  has written an arresting article this past week on the “tug-of-war” between deflationary and inflationary forces in the U.S. and Europe, in which he examines possible scenarios in the wake of continuing torpor in Greece and elsewhere in the Eurozone.  His insights are excellent, so we quote him at length:  first, he looks at the collapse of credit in the wake of the panic in 2008 and explosion in Fed bank assets.

Chart I. Money and Credit Multipliers since 1960 in the United States

                Figure 1

                   Courtesy: Thorsten Polleit and the Ludwig von Mises Institute

This data is — there’s no other way to phrase it — incredible.  What Polleit found was that for every $1 in new base money created by the central bank by 2007, $211 was now available for lending (and magnitudes for M1 and M2 are similar, as shown).  The “multiplier” had increased over time thanks to continual increases in central-bank base money, ever-lower reserve requirements, and readily available bank-equity capital.   But then equally incredible was what happened in the aftermath of the economic collapse and explosion in Fed assets: the money multipliers all nosedived.  And they have yet to recover: commercial banks are not willing or in a position to produce additional credit and fiat money in a way they did in the pre-crisis period.  This is due, says Polleit, to “banks’ equity capital becoming scarce due to losses (such as, for instance, write-offs and creditor defaults) incurred in the crisis……banks are [also] no longer willing to keep high credit risks on their balance sheets. And third, banks’ stock valuations have become fairly depressed, making raising additional equity a costly undertaking for the owners of the banks (in terms of the dilution effect).”

Bank stock prices support this, vis-a-vis the U.S. and Eurozone equity markets:

Chart II. Equity Prices of Bank Stocks in the Eurozone and the U.S. since 2007

                  Figure 2

                        Courtesy: Thorsten Polleit and the Ludwig von Mises Institute

What is happening is that as bank equities have declined (by more than 75% in the Eurozone, and over 50% in the U.S.) ,  their deleveraging has ramped up because, as Polleit says, they no longer have the capital base to support further growth.

And this in turn will likely incite Mr. Bernanke to some sort of “QE3”; we think it will happen in 2012 and perhaps soon.  The dangerous game here is that the world’s big central banks (other than the Bank of Japan) have already headed down this path in recent years, as the next chart shows:

 Chart III. Central Bank Asset Growth since 2006 (Linear Scale Indexed)

                    Figure 3

                      Courtesy: Thorsten Polleit and the Ludwig von Mises Institute

What the foregoing suggests is that, at the moment, we may well be in a period of low inflation, or even deflation, in terms of commercial bank assets.  But our unswerving belief is that this cannot last, and indeed it is itself sowing the seeds for QE3.  The Fed is obviously very concerned about growth prospects and has now telegraphed this in unusually blunt terms.  QE3 is their default weapon of policy and may soon be at hand.  The direct monetization of debt even remains a possibility, fueled by Mr. Bernanke’s bet that he can control any untoward effects of the current policy.

We think QE3 will be good for stock prices in the near term, but not much else, and we greatly regret the Fed’s insouciance now with respect to the dollar’s value.  Our best guess now is for a few more years of inflation in the 3-5%, but then an uptick to stagflationary levels.  Investors are forewarned.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at  The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.  

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