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Paul van Eeden, founder of Cranberry Capital, explains why the money supply created by the <b>US Federal Reserve</b>, doesn't necessarily boost the <b>gold price</b>.

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Finding Gold’s True Value (part two)

Posted on 22 January 2014 by MoneyMorning

An interview with Paul van Eeden, founder of Cranberry Capital

Yesterday, we published part one of an interview from our US sister publication, The Daily Reckoning America, with Paul van Eeden. He explained to you how he discovers gold’s intrinsic value; the key, according to him, is using his ‘Actual Money Supply’ measure, which he described yesterday. (If you missed Part One of the interview, you can read it on our website, right here.) Below, the conversation continues…

The Daily Reckoning: Today, we’re here again with Mr. van Eeden.

Paul, thanks for joining us.

Paul van Eeden: Thank you for having me again…

The Daily Reckoning: Since the Fed’s started inflating its balance sheet by trillions, there have been many calls, especially here in the DR, that, eventually, gold will have to shoot into the stratosphere. Why, in your opinion, has this ‘gold to the moon’ scenario not played out?

Paul van Eeden: That’s a very complicated question. One of the reasons is that the people who were expecting the gold price to go up dramatically were looking almost exclusively at the Federal Reserve balance sheet. They looked at the tremendous expansion of the Federal Reserve balance sheet and they said, ‘Well, if the Federal Reserve balance sheet goes from $500 billion to $3 trillion, what’s that – a sixfold increase? – then that should imply a sixfold increase in the value of gold.’

Well, no, it doesn’t. Because you have to look at how that money flows into the economy and into the ‘Actual Money Supply’ that’s available to the economy.

See, the Federal Reserve balance sheet counts deposits that commercial banks have at the Federal Reserve Bank. When the Federal Reserve creates money, they typically do so by buying US government Treasuries in the open market. So let’s say the Fed goes and buys $1 billion worth of US government Treasuries. The counterparty to the Fed is a bank. There’s a select group of banks that can be counterparties to the Fed.

So the bank is selling a government Treasury to the Fed, and the Fed pays the bank. But the money that the Fed pays doesn’t actually go into the bank’s general bank account, where it can spend it; it goes into that bank’s account at the Federal Reserve Bank. That money the bank has on deposit with the Federal Reserve is unavailable to the bank. The bank cannot draw on that money. It cannot spend that money. The only thing the bank can do is use that money as a reserve asset when it does its reserve asset calculations. That’s it. It cannot withdraw it ever.

The only way that money gets out of the Federal Reserve account is if the Fed sells any Treasury or debt instrument back to the bank. The bank can now use that money in its deposit account at the Fed to pay for that Treasury; that’s how the money comes out of the money supply.

So the creation and destruction of money, the mechanism by which the Fed is creating and destroying this money, is intimately tied to the commercial bank accounts at the Federal Reserve, called reserve accounts. But because that money cannot be spent by the bank or by you or by me or by anybody, that money isn’t functionally in the money supply.

Let’s say that an investment company has $1 billion worth of government Treasuries, and they want to sell these Treasuries. So the Federal Reserve buys $1 billion worth of Treasuries from the bank, that money gets into the reserve account; the bank buys a Treasury from an entity, from the investment company and pays the investment company. That money that was created by the Fed wasn’t created and went straight to into the economy; it got stuck there in the reserve accounts. So you cannot look at the increase in the reserve account balances and make an extrapolation or make a deduction as to what that means to the money supply. You have to actually count the money supply to see what impact it has, and that data is on my website. I update it every week.

So what went wrong for these guys is they looked at the Federal Reserve Bank balance sheet and they said, ‘My God, look at the money printing. This is massive, this is hyperinflation, this is Armageddon.’ But it wasn’t, because it wasn’t in the money supply. What the Fed was doing was actually changing the structure of Federal Reserve Bank balance sheets, and they were creating the ability for banks to create money in the economy.

The Daily Reckoning: So just to reiterate, the potential is there for the money supply to increase, but going off of your Actual Money Supply measure, which you explained yesterday, you just don’t buy the hyperinflation story.

Paul van Eeden: Right. But the banks cannot create the money if the demand for the money isn’t there or if the match between credit demand and creditworthiness isn’t there. So the other part you have to understand and think about is when the Federal Reserve prints money, as I said, it goes into the reserve bank account.

The entity that actually creates the money supply is not the Federal Reserve Bank. It’s the normal commercial banks. It’s when you take out a car loan, that creation of the loan is the creation of money. When you pay back a car loan, that’s deflation, that’s destruction of money. That’s how the money supply increases and decreases. So all the Federal Reserve Bank did was enable the banks to create a whole bunch of money. But the rate at which the banks actually created the money depended on the economic demand for that money. And we can measure what the increase in the money supply is very accurately. So while everybody was talking about this massive hyperinflation and the gold price going to $2,000, $3,000, $5,000 an ounce, I was looking at the money supply and saying there’s no basis for that.

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You can view this week’s taper as the <b>Federal Reserve</b> takes its foot off the accelerator for a moment. But Yellen has a lead foot. There’s danger on the road ahead.

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The Federal Reserve Takes its Foot off The Accelerator

Posted on 02 January 2014 by Dan Denning

The taper has come and gone and the world still turns. Imagine that. The Federal Reserve’s decision to reduce its monthly bond purchases by $10 billion wasn’t a show stopper on Wall Street. It was a show starter.

The Dow Jones Industrials climbed almost three hundred points and nearly 2%. The S&P 500 went back over 1800. Not to be outdone, the ASX/200 sighed with relief and climbed over 2% to close above 5,200 again. What’s more, the gold price fell 3.4% in US dollar terms to a three-year low.

The reporting about the taper shows you how muddled investor thinking has become. For example, one local newspaper reported that since markets rallied after the taper announcement, it suggested that the US economic recovery would not ‘derail’ financial markets. Let’s leave aside the question of whether there really is a US recovery. Since when would a recovery in the economy ever derail stock markets?

If the economy were getting better, why would stocks ever get worse? This is the mental conundrum Fed followers are in. Stimulus in the form of quantitative easing, which is good for stocks (especially financial stocks) can only last as long as the economy (where the rest of us live) is bad. Thus, bad news for Main Street is better news for Wall Street.

What a relief it must have been for traders to realise that good news for Main Street (even if it’s made up) isn’t bad news for Wall Street. That’s what the reaction seemed to indicate. Or, perhaps investors had already priced in the taper and it was more a case of, ‘buy the rumour, sell the fact’. Another possibility is that traders are hell bent on buying stocks because it’s a cyclical bull market and any reason will do (or none is necessary). But check out the chart below.

New Highs on Narrow Breadth

Click to enlarge

The black line on the chart shows the number of stocks on the S&P 100 in a bullish point-and-figure pattern. The red line is the index itself. The right scale measures the bullish percent figure. The left scale measures the level of the index. What does it tell you?

Well, the S&P itself has climbed 50% in the last two years. But it hasn’t been a smooth ride. During that run, the bullish percent index has dropped to nearly 50 two times. When it reaches that number it means half the stocks are in a bullish point and figure pattern and half are bearish. Why is this important?

You can take this chart as a measure of the market’s real health. It’s both a measure of breadth and momentum. Most of the time, those measures are correlated with the trends in the underlying index. Except for now.

Look closely and you’ll see that this month, the index has made new highs even as breadth deteriorates. Fewer stocks out of the 100 are in bullish patterns. Yet the index keeps climbing. Breadth is deteriorating. This is a classic sign of a market with narrower leadership. More liquidity is piling into a smaller band of blue chip stocks. This creates self-fulfilling rallies. But they are not broad rallies. And that makes them fragile. How fragile? Now look at the chart below.

QE Pumps up American and Japanese stocks

Click to enlarge

The S&P 500 is up 165% from the low on March 9, 2009. And yes, I cherry picked that low. It’s what makes the gain so impressive. The 2009 lows were put in because the Federal Reserve committed to providing Wall Street firms with cheap credit to turn into trading profits. It has worked a treat.

By comparison, Japanese stocks didn’t really get going until the Bank of Japan pledged to double the monetary base in November 2012. It was a late start. But the red line shows it’s been an impressive game of catch up. As I wrote recently, a US dollar rally against the euro could make European shares the next cab off the rank in terms of QE-driven rallies (especially if money comes out of overvalued US stocks and into cheaper European stocks).

Australian stocks, as measured by the All Ordinaries, are up a respectable 63% since the 2009 lows. But without an ambitious plan of money printing from the RBA, local shares can’t compete with their blue-chip brethren overseas. And even if the RBA does print (unlikely), the weaker Aussie dollar and lower interest rates will erode Australia’s recent reputation as high-yield haven for foreign capital.

Fragile things break easily. All it takes is a wayward bump. The trouble with a bump like that is that you never see it coming until it’s too late. Stocks could fall by 15-20% in a matter of weeks, both in America and here in Australia. Be ready for that.

And keep your wits about you. The big takeaway from the Fed’s language recently is that it would keep interest rates low ‘well past the time’ US unemployment hits 6.5%. Interest rates are effectively dead as a tool for conducting monetary policy. That leaves asset purchases.

But when the Federal Reserve purchases government bonds or mortgage backed securities, it doesn’t stimulate the economy in the same way an interest rate cut might. It only stimulates financial markets, which is why they’re making new highs. More importantly, as my mate Greg Canavan pointed out, QE pushes stock prices higher by pushing the equity risk premium lower.

It’s a dangerous game that always results in investors taking too much risk. They take too much risk because price signals no longer communicate the real level of risk you’re taking in buying an asset or security. Investors become speculators and rush headlong into an increasingly narrow class of assets: stocks and financial stocks especially.

Poor old Janet Yellen has her work cut out of for her. Ben Bernanke will leave on a high. But the Yellen Fed will have only one tool left to address the next crisis: bigger asset purchases. You can view this week’s taper as the Federal Reserve taking its foot off the accelerator for a moment. But Yellen has a lead foot. There’s danger on the road ahead.

Best Regards,

Dan Denning+,
Contributing Editor, Money Morning

Ed Note: This article is an edited extract of an update originally published in The Denning Report.

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The <b><a href="http://www.moneymorning.com.au/category/financial-system/banks-and-interest-rates/the-federal-reserve" title="more on the Federal Reserve">Federal Reserve</a></b> is busy doing everything in its power to get credit (that is, debt) growing again so that we can get back to what it considers to be ‘normal’...

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The Federal Reserve Must Inflate

Posted on 04 December 2013 by MoneyMorning

The Federal Reserve is busy doing everything in its considerable power to get credit (that is, debt) growing again so that we can get back to what it considers to be ‘normal’.

But the problem is that the recent past was not normal. You may have already seen this next chart. It shows total debt in the US as a percent of GDP:

Source: Hoisington Investment Management Company
Click to enlarge

Somewhere right around 1980, things really changed, and debt began climbing far faster than GDP. And that, right there, is the long and the short of why any attempt to continue the behaviour that got us to this point is certain to fail.

It is simply not possible to grow your debts faster than your income forever. However, that’s been the practice since 1980, and current politicians and Federal Reserve officials developed their opinions about ‘how the world works’ during the 33-year period between 1980 and 2013.

Put bluntly, they want to get us back on that same track, and as soon as possible. The reason? Because every major power centre, be that in DC or on Wall Street, tuned their thinking, systems, and sense of entitlement, during that period.

And, frankly, a huge number of financial firms and political careers will melt away if and when that credit expansion finally stops. And stop it will; that’s just a mathematical certainty.

Total Credit Market Debt (TCMD) is a measure of all the various forms of debt in the US. That includes corporate, state, federal, and household borrowing. So student loans are in there, as are auto loans, mortgages, and municipal and federal debt.

It’s pretty much everything debt-related. What it does not include, though, are any unfunded obligations, entitlements, or other types of liabilities. So the Social Security shortfalls are not in there, nor are the underfunded pensions at the state or corporate levels. TCMD is just debt, plain and simple.

As you can see in this next chart, since 1970, TCMD has been growing almost exponentially.

Source: Mises.org
Click to enlarge

That tiny little wiggle happened in 2008–2009, and it apparently nearly brought down the entire global financial system. That little deviation was practically too much all on its own for the markets to handle.

Now debts are climbing again at a quite nice pace. That’s mainly due to the Federal Reserve monetizing US federal debt just to keep things patched together. As an aside, based on this chart, we’d expect the Fed to not end their QE efforts until and unless households and corporations once more engage in robust borrowing. The system apparently needs borrowing to keep growing exponentially, or it risks collapse.

One could ask why credit can’t just keep growing. But there are many reasons to believe that the future will not resemble the past. Let’s start in 1980, when credit growth really took off. This period also happens to be the happy time that the Fed is trying (desperately) to recreate.

Between 1980 and 2013, total credit grew by an astonishing 8 percent per year, compounded. I say ‘astonishing’ because anything growing by 8 percent per year will fully double every 9 years.

So let’s run the math experiment and ask what will happen if the Federal Reserve is successful and total credit grows for the next 30 years at exactly the same rate it did over the prior 30. That’s all. This is nothing fancy, and it is simply the same rate of growth that everybody got accustomed to while they were figuring out ‘how the world works’.

What happens to the current $57 trillion in TCMD as it advances by 8 percent per year for 30 years? It mushrooms into a silly number: $573 trillion. That is, an 8 percent growth paradigm gives us a 10-fold increase in total credit in just 30 years:

Source: Mises.org
Click to enlarge

For perspective, the GDP of the entire globe was just $85 trillion in 2012. Even if we advance global GDP by some hefty number, like 4 percent per year for the next 30 years, under an 8 percent growth regime, US credit would be twice as large as global GDP in 2043.

If that comparison didn’t do it for you, then just ask yourself: Why, exactly, would US corporations, households, and government borrow more than $500 trillion over the next 30 years?

The total mortgage market is currently $10 trillion, so might the plan include developing an additional 50 more US residential real estate markets?

So perhaps the situation moderates a bit, and instead of growing at 8 percent, credit market debt grows at just half that rate. So what happens if credit just grows by 4 percent per year? That gets us to $185 trillion, or another $128 trillion higher than today – a more than 3x increase. Again: for what will we borrow (only) $128 trillion for, over the next 30 years?

When I run these numbers, I am entirely confident that the rate of growth in debt between 1980 and 2013 will not be recreated between 2013 and 2043. But, I’ve been assuming that dollars remain valuable.

If dollars were to lose 90 percent or more of their value (say, perhaps due to our central bank creating too many of them), then it’s entirely possible to achieve any sorts of fantastical numbers one wishes to see.

For the Fed to achieve anything even close to the historical rate of credit growth, the dollar will have to lose a lot of value. This may in fact be the Fed’s grand plan, and it’s entirely about keeping the financial system primed with sufficient new credit to prevent it from imploding.

Chris Martenson
Contributing Writer, Money Morning

Note: This originally appeared at Mises.org

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In my opinion The Great Credit Contraction has confounded many an <b>economist</b>. Deflating the credit bubble is deflating the <b><a href="http://www.moneymorning.com.au/economy" title="more on the economy">economy</a></b>...

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It Won’t Be Long Until Mainstream Economists Change Their Tune

Posted on 02 December 2013 by Vern Gowdie

The rationale for low interest rates and QE (money printing) is to achieve a lower unemployment rate and higher inflation. Well according to the recent Federal Open Market Committee (FOMC) they have so far failed to achieve their dual mandate. See the following extract from the FOMC 29-30 October 2013 meeting, with my emphasis added:

‘Although the incoming data suggested that growth in the second half might prove somewhat weaker than many of them had previously anticipated, participants broadly continued to project the pace of economic activity to pick up.

‘Participants generally expected that the data would prove consistent with the Committee’s outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months.’

The Federal Reserve acknowledges that growth is weaker, but is still sticking to the line that it will taper. Forever the optimists.

Two senior US Federal Reserve Bank economists, William English and David Wilcox, recently reinforced this message when they addressed the Annual IMF Research Conference. The papers they presented at the conference dealt with life after the Fed tapers – not if but when.

This was a clear signal (as opposed to Bernanke’s rather on/off signal) to the market that the Fed is set to reduce the level of monthly money creation from $85 Billion to a slightly lesser number. Prepping the market for a potential (and I stress potential) change in ‘medication’ is part of the new Janet Yellen communication strategy.

The other message from the Fed was ZIRP (zero interest rate policy) is here to stay until at least 2017. Remember ZIRP was a ‘short term’ measure introduced by the Fed in December 2008 to kick-start the US economy.

This is No Ordinary Recession

Money creation and low interest rates have worked a charm for all post Second World War recessions. But what the Fed and other central bankers (we’ll come to Europe shortly) are finding out is this is no ordinary recession  caused by a slump in the business cycle. This is an economic funk caused by a collapse in the credit cycle.

The Great Depression and Japan post-1990 are the only recent examples of a credit cycle slump…and neither of these make for pleasant bedtime reading.

Professor Paul Krugman (the Nobel Laureate economist and the Fed’s mainstream economic cheerleader) argues ZIRP and QE should be maintained because the US is mired in ‘depression’ conditions. The fact Krugman has acknowledged the depressive state of the US economy is a major departure on his previously stated position. Here are some excerpts from his column and my interpretations:

Krugman: ‘…if our (US) economy has a persistent tendency toward depression, we’re going to be living under the looking-glass rules of depression economics – in which virtue is vice and prudence is folly, in which attempts to save more (including attempts to reduce budget deficits) make everyone worse off – for a long time.’

GFW: To me this is The Great Credit Contraction at work. The more the economy and markets deflate, the greater the tendency to save and therefore the depression cycle continues to feed upon itself.

Krugman: ‘…evidence suggests that we have become an economy whose normal state is one of mild depression, whose brief episodes of prosperity occur only thanks to bubbles and unsustainable borrowing…’

GFW: No kidding Sherlock. The longer this goes on, the less mild the depression will be. The authorities creating bubbles based on unsustainable borrowings is not prosperity; it is lunacy.

Krugman: ‘Why might this be happening? One answer could be slowing population growth…’

GFW: Perhaps. But it could also be people have debt fatigue in addition to rising living costs and higher taxes from over-indebted governments.

Krugman: ‘Another important factor [for the mild depression] may be persistent trade deficits…’

GFW: This sounds like a call to arms for the currency war I mentioned last week.

In my opinion The Great Credit Contraction (GCC) has confounded many an economist. Deflating the credit bubble is deflating the economy.

The longer the GCC continues to tighten its grip on the global economy, the more I expect mainstream economic commentators to follow the lead of that other famous economist John Maynard Keynes, when he once said, ‘When the facts change, I change my mind. What do you do, sir?’

Vern Gowdie+
Chairman, Gowdie Family Wealth

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If <b>interest rates stay low</b>, odds are stock prices will keep going up. And right now money is flowing into <b>dividend stocks</b>…especially stocks that have shown a willingness to pay out higher <b>dividends</b>.

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Why Dividend Stocks Are Still the Best Way to Profit from Low Interest Rates

Posted on 10 September 2013 by Kris Sayce

If you read enough of the mainstream financial press you’ve probably started to think that the dividend rally is over.

But we say that’s wrong.

In fact, our view is that many dividend-paying companies have barely started with paying out dividends.

And we’re not just saying that either, we’ve got proof.

We call it ‘Dividend Gaming’. We wrote to you about it a few months ago. Based on what we see in today’s market it’s as strong now as it was then…

Yesterday we explained that the US Federal Reserve had no intention of raising interest rates.

The Fed was just trying to manage market expectations by neither openly fuelling a stock bubble nor causing a crash.

The Fed’s goal is to see a steady rise in asset prices so everyone will feel happy! Just as some schools insist every kid gets a ribbon on Sports Day, the Fed wants everyone to win in stocks.

But while the Fed is being cagey, the Bank of England isn’t. It has let the market know exactly where it stands: rates will stay low for at least three more years…

Proof That Low Interest Rates Boost Stocks

Bloomberg News reports:

Carney, who became governor [of the Bank of England] on July 1, introduced forward guidance in August saying the BOE plans to hold its benchmark rate at 0.5 percent until unemployment falls to 7 percent from its current 7.8 percent. The bank doesn’t see that happening for another three years.

It’s as clear as day. Central banks want interest rates to stay low and they’ll do all they can to achieve it.

We don’t understand why so many people can’t see this. Look, we’re not saying it’s the right policy. And we’re not saying the central banks will achieve all their goals…because they won’t.

But it will do one thing: it will force investors to take bigger risks in order to boost their income.

The Bloomberg News article notes:

There is evidence that Britons are being driven to the stock market for returns. Investor sentiment on U.K. stocks is at its highest in six months, and equities are now the second-most-popular asset class after property…The U.K. benchmark FTSE 100 Index (UKX) has climbed more than 10 percent this year.

The evidence is there for all investors to see – stock prices have gone up. It’s that simple. And if interest rates stay low, odds are stock prices will keep going up.

That’s why the main US and UK indices are trading near record highs…while Australian stocks still need to climb 40% to take out the old high. But stay patient, because in our view it won’t be long before Aussie investors can celebrate a new record high too…

It May be Crazy, but it Works

Earlier we mentioned something we call ‘Dividend Gaming’. This is where companies use dividends as a way to attract investors.

They’ll use a number of tactics, all of them legal. The idea is to increase the dividend payout ratio as much as possible. One of the stocks we recommended three months ago in Australian Small-Cap Investigator has done just that.

It has increased its payout ratio from below 70% of profits to above 75% of profits.

It’s not the only company to do this. Other companies are taking ‘Dividend Gaming’ to another level. They’re paying out higher dividends to attract investors, and then getting some of the money back by issuing new shares.

Investors will go for that if they believe the company can use the money to grow the business and pay out higher dividends in the future.

Now, we know what you’re thinking. It doesn’t make sense if companies are paying out dividends and then raising capital. Investors are no better off. We get that. We understand it.

But tell that to the market. Because right now, crazy or not, the market loves companies that can pay higher dividends…and so do we.

Follow the Money into Dividend Stocks

Remember, we’re not saying we support low interest rate policies.

All we’re saying is that this is how things are right now. And if you want any chance of getting ahead and growing your wealth you’ve got no choice but to follow the money flow.

And right now money is flowing into dividend stocks…especially stocks that have shown a willingness to pay out higher dividends.

So, folks can carry on claiming that the dividend rally is over and recommend selling stocks. They can even say the market is too risky.

But we’ll put opinion to one side and stick with the evidence. The evidence tells us the dividend rally isn’t over. Foreign central banks have committed to keeping rates low and odds are the Reserve Bank of Australia will keep rates low too…and maybe cut them further.

If they do, everything is moving into place for investors to continue the surge into dividend stocks…and that means higher stock prices.

Nothing has happened to make us change our view that the Aussie market is heading towards 7,000 points in 2015. If you can handle the risk and you’re after a better-than-the-bank income stream, it’s still a great time to buy Aussie dividend stocks.


From the Port Phillip Publishing Library

Special Report: GET OUT AND STAY OUT

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This is by far the clearest explanation in his own words - of how Ben Bernanke thinks the <b>Federal Reserve</b> can promote growth through words and QE...

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No Profit in the Federal Reserve Divination

Posted on 12 August 2013 by Dan Denning

It is beneficial to your health to tune out the noise and clutter that passes for information in the financial markets.

A good example is trying to divine the importance of words uttered by US Federal Reserve Chairman Ben Bernanke. With China showing no signs of a stock-market-boosting stimulus plan, the punters will hang on the lips of the Federal Reserve chairman for clues about ‘tapering’.

But let me ask you this, do you think your investment plan can benefit from trying to guess what Bernanke is going to do next? Is there any advantage to be gained by correctly guessing his internal emotional state? If not, then why bother?

The most important words ever penned by Ben Bernanke with regard to deflation and the effectiveness of quantitative easing to ‘stimulate’ aggregate demand were penned in a paper he published with Vincent Reinhart and Brian Sack in 2004. It’s called Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment.

I encourage you not to read it. It’s absolutely insane. More importantly, in confirms that Bernanke has been reduced to trying to influence investor expectations through communication. This is what happens when you can’t pull the interest rate lever. You have to try talk therapy. The fact that Bernanke et al. dedicate so much of their paper to it is evidence of how deep down the rabbit hole they are in their monetary thinking. But let me show you some specific quotations, with my emphasis added:

‘Given that the ability to commit to precisely specified rules is limited, central bankers have found it useful in practice to supplement their actions with talk, communicating regularly with the public about the outlook for the economy and for policy. Even in normal times, such communication can be helpful in achieving a closer alignment between the policy expectations of the public and the plans of the central bank. If the central bank places a cost on being seen to renege on earlier statements, communication in advance may also enhance the central bank’s ability to commit to certain policies or courses of action…

‘Although communication is always important, its importance may be elevated when the policy rate is constrained by the ZLB. In particular, even with the overnight rate at zero, the central bank may be able to impart additional stimulus to the economy by persuading the public that the policy rate will remain low for a longer period than was previously expected. One means of doing so would be to shade interest-rate expectations downward is by making a commitment to the public to follow a policy of extended monetary ease. This commitment, if credible and not previously expected, should lower longer-term rates, support other asset prices, and boost aggregate demand.

‘Shaping investor expectations through communication does appear to be a viable strategy, as suggested by Eggertsson and Woodford (2003a,b). By persuading the public that the policy rate will remain low for a longer period than expected, central bankers can reduce long-term rates and provide some impetus to the economy, even if the short-term rate is close to zero. However, for credibility to be maintained, the central bank’s commitments must be consistent with the public’s understanding of the policymakers’ objectives and outlook for the economy.’

This is by far the clearest explanation – in his own words – of how Bernanke thinks the Fed can promote growth through words and QE. It’s quite impressive how much time and thought he put into using words to influence expectations once rate cuts were no longer a policy tool. The zero bound – where official interest rates were effectively zero in nominal terms and actually negative in real terms – was a long way away back then.

The Federal Reserve’s goal with QE is to keep 30-year mortgage rates low in the US by targeting the yield on 10-year Treasury notes. The 30-year mortgage rate is derived from the 10-year yield. As you can see from the chart above, 10-year yields were above 4% for most of 2004. That’s 400 basis points above zero.

When the rate cutting began in earnest in 2008, 10-year yields dove. Quantitative easing has since pushed them down to historic lows. But as you can see, the recent rise in yields is formidable. This is not an indication of Ben Bernanke’s success, where he allows rates to rise. It’s the markets repudiation of his attempt to rig the price of the most important security in the world.

Why does all this matter? The US Federal government is just one of many governments that cannot afford to service its outstanding debt at higher interest rates. If the bull market in government bonds that began in the early 1980s is over, then rates will head higher as bond prices fall, whether Bernanke likes it or not.

In fact, Ben Bernanke can talk until he’s blue in the face. Market participants will have rendered their verdict. QE is every bit as bogus as the actions of China’s communists to produce growth by command. It’s an exercise in intellectual arrogance with real world costs to savers. Its end is just beginning.

Dan Denning+
Editor, The Denning Report

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From the Archives…

Should You Still Buy Stocks Here? Yes, but…
09-08-2013 – Kris Sayce

The Secret to China’s $7 Billion Milk Market
08-08-2013 – Nick Hubble

RBA (Retirees Below Average)
07-08-2013 – Vern Gowdie

Have Australian Stocks Broken Free from China?
06-08-2013 – Kris Sayce

When Should You Sell Your ‘Loser’ Stocks?
05-08-2013 – Kris Sayce

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The theory is, ‘Surely with this much money being added to the system, <b>higher inflation</b> must soon appear on the horizon?’

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Why it’s Deflation…Not Inflation, that’s Heading Our Way

Posted on 25 July 2013 by Vern Gowdie

I don’t think the Fed can get interest rates up very much, because the economy is weak, inflation rates are low. If we were to tighten policy, the economy would tank. - Ben Bernanke’s response to a question from the House Financial Services Committee hearing held on Wednesday 17 July 2013

After increasing the money supply at a rate of 33% per year for the past five years, the best US Federal Reserve chairman, Dr Ben Bernanke can manage to achieve is ‘the economy is weak.

The sheer volume of newly minted dollars has financial experts and gold bugs searching the horizon for evidence of inflation and even hyperinflation. The theory is, ‘Surely with this much money being added to the system, higher inflation must soon appear on the horizon?’

Conventional wisdom suggests inflation should be a by-product of the central bankers’ efforts with the printing press.

However, the fact is we aren’t in conventional times. Therefore the world as we know (or think we know) it may not act in its usual ‘Pavlovian’ way.

The following chart on UK inflation rates dating back to 1265 shows persistent inflation is only a 20th century phenomena.

Prior to 1900, the UK and other developed economies experienced the ebb and flow that happens when humans interact in a buying and selling process.

Supply, demand, greed, fear and a host of other variables drive our decision-making process. This in turn moves the economy in certain directions – positively and negatively.

Source: Credit Suisse

The negative period in the early 1900’s was a result of ‘The Panic of 1907′. This severe downturn gave the authorities and big banking interests an excuse to set up a central bank.

Lesson number one for the rich and powerful is ‘never let a good disaster go to waste’. They sold the central bank concept to the public as a tool to stabilise the economy.

Ever since then, central bankers have ‘controlled’ the economy. But the value of a dollar has been anything but stable. Inflation has all but vaporised the buying power of a dollar issued a century ago.

Due to central bank meddling intervention, inflation is all we have known for the past century. Little wonder we expect inflation – especially when the Fed now prints more money in a year than it did for the previous century.

Yet in spite of all we think we know about the economy, ‘inflation rates are low.‘ The following graph confirms Bernanke’s testimony.

The core personal consumption expenditures deflator (an indicator the US Fed watches closely) is at a fifty year low with just a 1% year-over-year change.

Bernanke is fervently following the manual written by those who went before him. However, it’s not producing the outcomes they achieved.

A hundred years is a long time for an experiment (and that’s what central banking is) to show consistent and reasonably predictable results. However, they can only repeat the results if the lab conditions are the same each and every time.

And that’s the subtle but key missing piece of the puzzle that most people have overlooked – the lab conditions aren’t the same.

  • World population quadrupled in the past century – finite resources mean this is unlikely to happen in the next century.
  • Population growth in the western world has stabilised compared to the growth rates of the past century.
  • Household balance sheets are dripping in red ink – capacity for more personal debt is declining.
  • Compared to a century ago, government welfare, healthcare and warfare obligations are ‘through the roof’. A sustained period of consumption (producing higher tax revenues) won’t rescue heavily indebted and over-obligated governments this time.

For the time-being the days of excess consumption are in the past.

The following chart (dating back to 1965) shows over the past five years there has been a 90% correlation between what consumers earn and what they spend.

Compare this to the 2002 to 2007 period (the credit bubble period) when there was next to no correlation between earnings and expenditure.

Why was that? This was when consumers treated their home as an ATM – using home equity loans to fund consumption.

The next chart on Mortgage Equity Withdrawals (MEW) shows the debt feeding frenzy that occurred from 2002-2007. Since the GFC hit it has been all downhill. The consumer focus has been on living within their means and repaying (or, defaulting on) debt.

Inflation is the by-product of money creation plus credit.

In the past five years the Fed has produced around US$2.5 trillion of new money. Over the same time, the private sector has cut debt levels by US$4 trillion.

There are a couple of other telltale signs of inflation that are pointing in the wrong direction. Commodities prices have trended down for the past two years, and the Baltic Dry Index (an indicator of global shipping activity) is down to levels last seen during the GFC.

The Great Credit Contraction is producing the equal and opposite effect of The Great Credit Expansion. The inner tube of the global economy has a puncture – more air is escaping then the central bankers can pump in.

When a tyre loses pressure it is DEFLATING.

But the deflationary outlook isn’t unique to the US. Look at this chart from a recent Societe Generale report:

Here is an edited version of the commentary accompanying the chart (emphasis mine):

Perhaps, though, the most decisive macro factor for all markets will be any slide into deflation in China…. The recent Q2 GDP data contains the surprising fact that China’s implicit GDP deflator had slowed to only 0.5% yoy – noticeably weaker than the CPI data… The fact that China is on the verge of outright deflation may prove more important than even Fed tapering.

But don’t worry. Bernanke has it all under ‘control’ – after all isn’t that what central bankers believe?

How’s this for supreme confidence. When asked how the Fed will exit its QE (quick & easy) money experiment he said:

We know how to exit. We know how to do it without inflation… We have all the tools we need to exit without any concern about inflation.

The only tools Ben has at his disposal are the other board members sitting around the Fed’s boardroom table.

Four years of money printing have done nothing but damage the integrity of markets. By distorting interest rates they have forced investors into high risk investments paying low returns. Let’s face it, for the average punter a few percent from anything looks a whole lot better than 0.25% in the bank.

The longer this experiment is allowed to continue (and Fed hubris means it will be for longer than anyone expects), the greater the dislocation in markets. When GFC Mk II hits, consumers will retreat even further into the cave of cautious spending and debt reduction or default.

The irony is the Fed’s money printing has increased the odds of a deflationary outcome.

A century of central bank meddling in markets has produced another type of inflation – in the form of central banker egos and belief in their abilities.

The pending market upheaval will hopefully deflate these puffed up theorists.

Vern Gowdie
Editor, Gowdie Family Wealth

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From the Archives…

Why Invest ‘Hard’ When You Can Invest ‘Easy’?
19-07-2013 – Kris Sayce

Read This Before You Buy Another Stock or Bond…
18-07-2013 – Murray Dawes

Could Uranium be the Best Investment in 2013?
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Asteroid Mining and the Commercialisation of Space
16-07-2013 – Sam Volkering

Why the Australian Share Market is Heading Even Higher
15-07-2013 – Kris Sayce

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The ‘end’ of <b>QE</b> might just be the thing that ensures it remains a part of the financial lexicon for years to come.

Tags: , , , , ,

No End to QE to See

Posted on 11 July 2013 by Greg Canavan

Federal Reserve Chairman, Ben Bernanke said this in a recent Bloomberg article:

“If you draw the conclusion that I just said that our policies — that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy,” he said. “If the economy does not improve along the lines that we expect, we will provide additional support.”

The market isn’t listening to what Bernanke says…it’s panicking. Just about everything got hit as a result. Equities, bonds, commodities, precious metals, all were slammed as the US dollar rallied. The Aussie dollar collapsed 2 cents…that’s a massive move in FX land.

The speculators got it wrong. They positioned for a soothing Bernanke statement. But they just got more of the same. That is, if the economy moves into a sustainable expansion, we cut out the asset purchases…if it falters, we’ll ramp them up.

That sounds pretty straightforward, but it led to a massive unwind of leveraged bets in anticipation of the beginning of the end of easy money.

Is it really though? The ‘end’ of QE might just be the thing that ensures it remains a part of the financial lexicon for years to come.


Well, bond yields are on the rise. The US 10-year bond yield, a benchmark for the global cost of credit, traded around 1.6% at the start of May. Following another sharp sell-off overnight, it’s now at 2.33%, the highest level in over a year.

In general, global market interest rates follow the lead of the US 10-year Treasury bond. So rising rates represent a tightening of monetary conditions in financial markets. Which means the US economy, for years heavily dependent on easy money, will come under pressure soon as higher interest rates begin to bite.

And if the US economy comes under renewed pressure, Bernanke won’t cut QE anytime soon. So no end to QE…long live QE!

But what if the US economy really is recovering? And what if this recovery DOES end QE sometime next year and then interest rates move back to normal in subsequent years?

Years of zero interest rates have robbed the system of real savings. In its place, the level of total debt has ballooned to keep up the façade of healthy and sustainable growth. And in the meantime, the structure (industry, incomes, employment, profits taxes etc) of the economy grows around this ongoing provision of cheap and easy money.

If you try to take it away, the economy will fall in a heap. That shouldn’t be a big deal but we’re talking about the world’s largest economy, and consumer of last resort here. The US’ ongoing propensity to consume more than it produces is made possible by easier and easier money.

As money becomes cheaper, debt levels grow to fund consumption. The whole economic structure of the world economy grew out of this falling US interest rate/rising debt/excess consumption model.

You think we’re going to get out of it easily? You think the Fed can all of a sudden put an end to this multi-decade trend without major problems?

Throw in the world’s second largest economic zone, (Europe) which is in the throes of its own painful structural adjustment…and the world’s second largest economy, China, which is about to experience what it’s like when a credit bubble goes bust, and…well, Houston, we have a problem.

So if QE can’t really end, where to from here?

If confidence in the Fed and Bernanke is receding, then liquidity will soon follow. One of the most beneficial impacts of QE is that it instils confidence. Confidence creates liquidity which creates asset price inflation.

In the Q&A following the press conference, someone asked about sharply rising bond yields over the past few weeks, and how that reconciles with the Fed’s view that it’s the stock of assets it holds on its balance sheet that determines yields.

Bernanke responded ‘we were puzzled by that‘, and then tried to explain it away by citing other factors like potential optimism about the outlook for the economy (optimism not shared by any other asset class, by the way).

When you admit to being puzzled by the effects of the largest monetary experiment in history, which you implemented, it’s a confidence drainer. And with confidence goes liquidity.

Greg Canavan+
Editor, The Daily Reckoning Australia

[Ed Note: To read more of Greg’s in depth macro-economic analysis, click here to subscribe to the free daily e-letter The Daily Reckoning.]

From the Archives…

The Power of Low Interest Rates Coming to the Aussie Market
5-07-2013 – Kris Sayce

S+P 500 Downtrend Looms? Counting Down The Days…
4-07-2013 – Murray Dawes

Here’s Your Six-Point Stock Buying Checklist
3-07-2013 – Kris Sayce

Are the Credit Rating Agencies at it Again?
2-07-2013 – Kris Sayce

Why This Could be Another Great Year for Australian Stocks…
1-07-2013 – Kris Sayce

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