Thursday, August 25, 2011

Tomorrow's Jackson Hole Speech

The financial world eagerly awaits Ben Bernanke, the Federal Reserve's chairman, when he speaks Friday at the Fed's annual symposium in Jackson Hole, Wyoming.

We first made this post back on July 13th, 2011 and we are reprinting it today.

Whether the Federal Reserve likes it or not, its unprecedented monetary polices over the last few years have conditioned the financial markets to expect a helping hand when the going gets tough.

With the stock market mired in a month-long slump and both the U.S. and euro zone economies in danger of sliding into recession, investors are bracing for a possible repeat of last year's performance, when Bernanke hinted the Fed would act if conditions deteriorated.

Two months later, the central bank began pumping $600 billion into the financial system through direct purchases of Treasury debt, a second round of stimulus that markets dubbed "QE2."

So there has been considerable debate about whether or not there will be a third round of Quantitative Easing by the US Federal Reserve.

Back in July US Federal Reserve Chairman Ben Bernanke appeared before Congress and here is how the appearance was reported:
  • While the Federal Reserve believes that the temporary shocks holding down economic activity will pass, the central bank is examining several untested means to stimulate growth if conditions deteriorate, including another round of asset purchases, dubbed QE3, Fed chairman Ben Bernanke said Wednesday in remarks prepared for the House Financial Services Committee. Bernanke discussed three approaches to further easing in his prepared remarks. One option, Bernanke said, would be for the Fed to provide more "explicit guidance" to the pledge that rates will stay low for "an extended period." Another approach would be another round of asset purchases, or quantitative easing, or for the Fed to "increase the average maturity of our holdings." Finally, the Fed could also reduce the quarter percentage point rate of interest that it pays to banks on their reserves, "thereby putting downward pressure on short-term rates more generally." Bernanke was clear to stress that easing was not the only option under consideration and that the next Fed move could well be to tighten.
You get a sense of how desperate things are getting when Bernanke starts talking about "several untested means to stimulate growth."

This phrase is important as it hearlds what is coming.

The weakening economy and upward pressure on interest rates due to oversupply will cause further Fed intervention, even if it isn’t called QE3.

At his post-Federal Open Market Committee (FOMC) press briefing in July, Bernanke indicated that if job growth falls below 80,000 per month, the Fed would likely intervene again. Well... job growth has now been below 80,000 for three consecutive months.

So what will Bernanke do?

Back in July Forbes took a look back at some of Bernanke's speeches and believes they have pieced together what is coming.

On November 21, 2002, Ben Bernanke gave a talk before the National Economists Club of Washington, D.C. entitled ‘Deflation: Making Sure ‘It’ Doesn’t Happen Here’.

In that 2002 talk, Bernanke ostensibly outlined all of the tools available to the Fed if the overnight (Fed Funds) rate hit zero. At the time of the speech, deflation wasn’t expected in the foreseeable future, so he would have no reason not to outline all the tools he could think of. Here are the 7 options Bernanke suggested and a look at each one:
  • #1: Expand the scale of asset purchases;
  • #2: Expand the menu of assets the Fed buys.
Both QE1 and QE2 used these tools. In QE1, the Fed purchased non-traditional assets for its portfolio, including mortgage backed securities (MBS) and derivatives. In both QE1 and QE2, the “scale” of asset purchases was dramatically increased.
  • #3: A commitment to holding the overnight rate at zero for some specified period.
This tool is currently in practice with the Fed’s “extended period” language in the Federal Open Market Committee (FOMC) minutes.
  • #4: Announcement of explicit ceilings on longer-maturity Treasury debt.
This isn’t new. The Fed did this in the 1940s and a version of it again in the 1960s. During a period of approximately 10 years ending with the Federal Reserve-Treasury Accord of 1951, the Fed “pegged” the long-term Treasury bond yield at 2.5%. And, during the Kennedy Administration, the Fed sold T-bills and purchased an equal amount of longer dated T-Notes in order to reduce long-term rates. Bernanke believes that the announced policy of pegging will cause arbitrageurs to keep yields near the announced peg, especially if the Fed intervenes several times to prove its commitment.
  • #5: Directly influencing the yields on privately issued securities.
Bernanke said, "If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets."  Think GM, Chrysler, AIG.
  • #6: Purchase foreign government debt.
The Fed would do this, Bernanke explains, to influence the market for foreign exchange, i.e., to weaken the dollar. He points to the dollar devaluation of 1933-34 as an “effective weapon against deflation”. “The devaluation and the rapid increase in the money supply it permitted ended the U.S. deflation remarkably quickly … The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market.” (While this is true, a mere two years later, after the withdrawal of government stimulus, a second severe recession began, one that would last until the U.S. geared up for World War II. And the 1937 slump in stocks was one of the largest on record.)
  • #7: Tax cuts accommodated by a program of open market purchases.
“A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money”, he said in the speech. (Hence his nickname – Helicopter Ben.) The extension of the Bush tax cuts along with the reduction in the social security payroll tax is a recent example of this policy.

These 7 tools are non-traditional, and Bernanke admits that by using them, the Fed “will be operating in less familiar territory” and will “introduce uncertainty in the size and timing of the economy’s response to policy actions”.

Nevertheless, Bernanke says, “a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition … A central bank … retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is zero.”

Today, any objective economist will tell you that, despite all of the monetary and fiscal stimulus, aggregate demand and economic activity has been minimally impacted. At the July post-FOMC press briefing, Bernanke admitted that he has no explanation as to why the economy has remained “soft”. Nevertheless, as stated above, in an election cycle, the Fed would be expected to do “something”.

Of the seven available tools, #1 appears to have been taken off the table, and #3 is presently employed. Tools #5 and #7 have been used, and may be employed again. #5 was heavily used in the financial crisis (GM, Chrysler, AIG), and #7 requires the cooperation of Congress (tax cuts).

The Fed said that it won’t reduce the size of its balance sheet in the near future, holding it steady like a rock, but will invest or roll any maturities or payoffs back into the market. Hence, the Fed has already embarked upon a policy of what we will call Rock ‘N Roll. As part of Rock ‘N Roll, we also expect the Fed to change the composition of its balance sheet to attempt to impact yields on private sector bonds (#5).

Over the past 2 years, Fed actions appear to have had little impact on aggregate demand. In 2002, when he outlined these non-traditional tools, Bernanke said he had no idea of the magnitude of their effectiveness.

Bernanke is now fully into speculation  mode when it comes to trying to 'fix' the economy.

This isn't a man implementing sound economic principles... rather what we now have is a sorcerer's apprentice practicing his craft.

He is experimenting... with no idea of what will - or won't - work.

Last month John Embry, Chief Investment Strategist at Sprott Asset Management, made an astute observation:
  • What’s been fascinating, and what was unappreciated by me in the early stages, was the enormous number of derivatives that have been created in the financial system. Because of the derivatives they’ve been able to keep this thing going for infinitely longer than any rational mind would have thought possible. You’ve been able to create leverage to the extent that you’ve never seen before and this is why I think the bubbles were able to get stretched out and last as long as they did. Because the balloon was blown up so much, I just think the aftermath in its finale is going to be extraordinarily unpleasant.”
Warren Buffet called derivatives "financial weapons of mass destruction" and as the economy continues to unwind, we are seeing just how accurate this description is.

The Federal Reserve has no real game plan for how to deal with it all.

Which is why so many believe the flight to Gold and Silver will only intensify from this point onward.

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