Remember those Road Runner cartoons when you were kid? The hapless Coyote chased the Road Runner, laying trap after trap for him which all failed in some spectacular fashion with the Coyote inevitably bearing the brunt of the destruction. In almost every episode there came a time when the Coyote found himself rushing toward a cliff, the edge of which he always over ran, finding himself with nothing beneath his feet except open air. I know this will sound odd, but that is what went through my mind as the Fed announced its latest attempt to catch more rapid economic growth. Ben Bernanke has just rushed past the edge of the monetary cliff. How long it takes for economic gravity to kick in is an open question but as the Coyote always found out, gravity works.
Ben Bernanke delved deeply into the ACME catalog of monetary tricks last week and like the Coyote, ordered up a complicated weapon that is likely overkill for his intended prey. Just as the Coyote discovered every week that ACME products rarely work as advertised, I suspect Mr. Bernanke will soon discover there are some unintended consequences associated with his weapon of choice. The jobs market is the intended target of Quantitative Easing Part III but like most ACME produced weapons it is more likely to strike the hunter than the hunted. Mr. Bernanke may be aiming at real growth but my guess is that he is more likely to destroy what is left of his and the Fed’s reputation.
The announcement by the Fed that it will maintain loose monetary policy until growth improves puts the Fed in uncharted waters. The primary mission of the Fed is to maintain the purchasing power of the dollar and in the long run that is the only metric over which it has direct control. Bernanke is betting the Fed’s inflation fighting credibility – and the pocketbooks of average Americans – that he can create jobs in the short run while forestalling inflation in the long run. Further expanding the Fed’s balance sheet to accomplish the former just reduces the probability of accomplishing the latter. Inflation, at least as measured by the CPI, has been fairly benign as the Fed’s balance sheet has expanded because market participants believe the Fed will be able to shrink it in the future. While I believe that was a dubious assumption from the start, the larger the balance sheet gets the less likely the market continues to believe it. And at the point where the market accepts that the expansion of the monetary base is permanent, the result will be inflation well beyond anything currently expected.
Indeed, that may already be starting to happen even as Mr. Bernanke is still reading the instruction manual for the latest delivery from ACME. Inflation expectations were already rising prior to the announcement with TIPs yields falling and nominal bond yields rising. Since one of the goals of Bernanke’s policy is to reduce interest rates it would appear that the policy may be failing even before it is fully implemented. Of course, the same can’t be said of junk bonds which hit all time lows in yield last week so at least one of the goals of QE is a bona fide success – forcing investors to take more risk. Whether it is appropriate or moral to force grandma to buy junk bonds to get a decent yield is an entirely different question and one that Bernanke apparently believes he doesn’t need to consider.
Further confirmation of the failure of the new policy can be found in the currency markets where the US dollar is once again falling even against a currency whose future existence is in doubt – the Euro. Currency devaluation is the last refuge of economic scoundrels and is most definitely not a policy implemented by countries with healthy economies. The dollar is also falling against gold, an indication that investors are interested in maintaining their purchasing power even if the Fed isn’t. That will make the Fed’s new goal of economic growth that much harder to achieve since capital laid up in gold markets isn’t available for productive investment unless one counts investment in mining capacity. Other commodity prices are also on the rise with oil briefly piercing the $100 mark last week. The unrest in the Middle East certainly deserves part of the credit for that but the role of the dollar is not insignificant.
Stocks responded positively to the new policy rallying 2% on the week and there may be some justification for that in the short term. A weaker dollar – which is the goal of the policy regardless of what Bernanke says publicly – will make foreign profits more valuable in dollar terms so an increase in the dollar earnings of US multinationals is not an unreasonable expectation. Whether that will improve the US economy is a longer odds bet though since most of these companies keep foreign profits outside the US to avoid US corporate taxes. Improvement in the US economy is dependent on investment and investment is dependent on available capital. Unfortunately, the Fed’s new policy is antithetical to attracting new capital to our shores. Previous incarnations of QE have resulted in the opposite with capital flowing to Asia and other emerging markets. For investors, QE N+1 provides a tailwind for non dollar denominated investments.
A preference for foreign investments and commodities was apparent even before the policy was announced. The EAFE index of foreign stocks has been outperforming the S&P 500 since early June and the CRB has been outperforming since about mid June. Emerging markets only recently started a similar trend and whether it continues likely depends more on what happens in China than the US but with stimulus now a global phenomenon, it seems likely.
The Fed’s new open ended easing program has been embraced by some very smart economists and I agree that a move to Nominal GDP targeting – which the program closely resembles – if done correctly could produce a better outcome in the long run than the previous inflation/interest rate targeting regime. However, the short term effect is a different story and the policy is most likely to raise inflation and reduce growth over the foreseeable future. Inflation will rise as the dollar falls and the associated increase in commodity prices will reduce consumer purchasing power and domestic corporate profitability. The worst part of the new policy is its emphasis on the purchase of mortgage bonds. Over investment in the housing market is the nominal cause of our recent difficulties and directing capital back to this sector will limit future gains in productivity and therefore growth. It also smacks of fiscal policy which is most definitely not part of the Fed’s mandate.
It must be said in defense of Bernanke and the Fed that this policy was only made necessary by the fecklessness of our politicians who refuse to address the structural problems with our economy. Real growth is a function mostly of the policies that are not labeled monetary. The Fed’s role, as I said above, is to provide a stable purchasing power for the dollar. If they accomplish that goal and we still have weak growth or too much inflation it is the fault of those other policies. I guess that could be one positive side effect of the Fed’s open ended easing. If they succeed in raising the nominal GDP growth rate and it all turns out to be inflation instead of real growth, we’ll certainly know who to blame. And it won’t be our Wile E. Coyote Fed Chairman. The politicians forced him into this so if it turns out badly, they are the ones responsible.
One last thing I would like to mention is that the picture of Wile E. Coyote floating in air near the cliff may also describe the stock market. I am old enough to remember the crash of ’87 and while that crash was blamed on many things, the most likely cause was a rapidly depreciating dollar. Alan Greenspan was the new Fed chairman and made the mistake of commenting on the value of the dollar which he felt needed to fall. The market took that as a signal to sell dollars. That and some new fangled computer trading programs sent the market down 20% in 1987. Now another Fed Chairman is pretty openly rooting for a cheaper dollar and while this is not a prediction, a stock market crash resulting from a rapidly falling dollar and the chaos created by high frequency trading bots is not an insignificant possibility. History may not repeat but it does rhyme as the saying goes. I hope this feeling I have about the markets right now is nothing more than indigestion but it feels a lot like deja vu.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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