The Manchurian Chairman

July 10, 2013

If you thought that Ben Bernanke has been brainwashed by secret handlers intent on destroying capitalism in the United States, and this week lit the fuse for the economic bomb he buried deep in the financial markets way back in 2009, you might be correct to call him the Manchurian candidate. Bernanke revealed his true identity as the secret slayer of markets in his remarks at the conclusion of FOMC meetings on Wednesday. Although the Fed left rates unchanged and QE intact, the Chairman stated that the Fed could cut back the pace of its QE bond-buying as early as the end of this year, and be out of the bond-buying business by the middle of next year. Major Ben Marco barley blinked while he made these pronouncements, almost as if he were in a trance sparked by some hidden hypnotic cue.

The markets responded as if they had been hit by sniper’s round. Gold dropped nearly $100/oz, and the Dow fell nearly 600 points in two sessions following the Fed chairman’s remarks. And bonds sold off sharply, backing up the 10-Year yield to the 2.7 handle, a two-year high.

"In the know" Fed reporters such as Jon Hilsenrath and Robin Harding wrote up a storm about the Fed taper (without much accuracy yet the markets responded). The pundits were not the only ones focused on the potential shift in Fed policy. FOMC members have spoken out as well. In an unconventional rash of public statements, both opponent and proponents of the "taper" have taken to the airwaves. It appears the Chairman is having difficulty keeping all the dogs mushing straight in the traces.

Fed policy has not changed. The Fed continues to buy $85 Billion each month, and the interest rate target remains at 0.00– 0.25%. So why did the markets sell off?

Markets, particularly the equity markets are forward looking. Prices reflect future earnings, inflation and other factors. Studies show Dow prices look ahead six months or so. If the Fed does taper on Bernanke’s schedule, then the Dow is telling us removing the Fed subsidy will deflate that stock index 10-15%. Likewise, Treasury yields will climb to the 4-5% level.

Big Ben’s remarks turned the QE tailwinds into headwinds for gold. Investors hit the sell button to raise cash. Gold is now finding support at the 1200 level. Gold bugs know a bargain when they see one. Because the price of gold is reflects much more than supply and demand, gold is telling us that the ill effects of central bank quantitative easing will come home to roost.


The Fed exit is good news for investors. That’s because when the Fed quits intervening in the credit markets interest rates will normalize, the yield curve will steepen, and traditional risk /return premiums will return to all assets in the marketplace. Stocks prices will be driven once again by fundamentals, instead of floating up on Fed hot air. Bond yields may actually turn positive, restoring the risk fee return at the natural interest rate. Stocks will relinquish their Fed-induced role as substitutes for fixed income yield.

It will be a welcomed day when the Fed gets the heck out of the business of "managing the economy." Historians and economists will study Fed policy leading up to and throughout the Great Recession. It’s highly likely that the consensus will be that the ultra-easy monetary policy did little to halt the decline and less to stimulate the "recovery". In fact, Fed policy actually hindered the recovery by preventing the flow of capital out of malinvestments into productive segments of the economy. Progressive fiscal policy also contributed to economic failure.

 

That’s because continued large annual Federal deficits have created a massive national debt burden, which this year eclipsed the national output at $16.6 Trillion." It’s spending, stupid," that Standard and Poor’s cited when it cut the credit rating of the United States. It’s still the spending, stupid. The current regime has abdicated its responsibility to balance the federal budget. And it politicized its own budget sequestration plan, railing against it as if it were evil. The fact is sequestration is working, and more cuts the bloated federal budget are needed. Every Dollar the federal government does not collect in taxes or borrows from China helps the private sector to expand and flourish. That concept is lost on the Keynesians in power today.

Just before Ben Bernanke addressed the press at the conclusion of the June FOMC meeting, the president told Charlie Rose the Fed chairman "has stayed longer than he was supposed to". Now there’s a glowing exit interview assessment of the Fed Chief’s tenure. Poor Ben’s legacy will not be as burnished as he would have liked. But the fact remains, Bernanke’s monetary policy has failed to speed the US recovery. So long, Ben!

The bench of potential Fed Chief replacements is not very deep. What’s worse, all of the likely candidates are dyed-in-the wool Keynesians. Where is Art Laffer when you need him?

How will the markets behave with the new Fed policy in mind going forward? Well, the markets will stabilize without the Fed put in place. Stocks prices will climb, the bond market will correct, and then recover to healthy levels. Commodity prices will climb. All because the Fed has taken its thumb off the scale.

But that happy day is not coming anytime soon. Unless he resigns, Ben Bernanke will remain at the helm until January. And unless there is a sudden change at 1600 Pennsylvania Avenue, the fiscal policy of tax, borrow, regulate and spend, spend, spend will continue until 2014 or 2016.

If he keeps to his word, Big Ben will keep buying bonds until unemployment drops to 6.5%. But current unemployment is 13.8% (U-6 measure), and at the current rate of hiring the US won’t reach 6.5% until 2035. Inflation, according to the Fed central tendencies model is registering 2.0% inflation. So Ben has a lot of room for more QE before inflation becomes a problem. But the BEA understates inflation, which if calculated in the traditional manner, is hovering at the 7% level. GDP growth slowed 0.1% to an anemic 2.4% in May. What we have here is stagflation. And there is little on the horizon that will bring the positive change we need.

So, the Fed will keep buying lots of bonds. And the administration will continue to tax and borrow to overspend on its big government programs. The combination of continued deficit spending and ultra-easy monetary policy will continue to weaken the Dollar. Inflation will emerge as a leading drag on the economy.

The objective of the Fed’s bond-buying program, known as Quantitative Easing, is to stimulate economic activity by adding liquidity (cash) to the banking system. Helicopter Ben has believed from the beginning bankers would lend out the free cash he continues to provide. His belief can be traced back to Keynesian theory. But we know that inflation is always and everywhere a monetary phenomenon. At this point in time, all the new money the Fed has created out of thin air should have pushed general prices well above the 2.0% inflation rate. What’s going on?

The reason inflation is so low, even after flooding the banks with $3 Trillion in new cash, is the banks are hording the stuff. Rather than lending out to new homeowners and businesses, Fed member banks are sitting on over $1.8 Trillion in "excess reserves". A major reason is the Fed Chairman is paying the bankers interest on the funds they hold. The major banks can reap risk-free profits without the risk of lending to new homeowners or businesses facing uncertain demand. It’s as if the Fed Chairman suffers from multiple personality disorder or is actually under hypnotic control of some hidden handler.

We can see from data compiled by the St Louis Fed, major banks are hording over $1.8 Trillion in excess reserves. If the Chairman stopped paying interest on these idle funds, the banks would this capital to work.

One way to track economic activity is by measuring the rate at which money changes hands. Economists call this the velocity of money, which is measured by M2. This metric should be much higher than numbers show, mainly because the banks are hording cash. But eventually, the banks will lend in earnest again to make money on the spread between higher long term interest rates and lower short term rates. Banks will make money the old fashioned way, taking advantage of the normal, steeper upward sloping yield curve.


Even Ben Bernanke cannot hold natural interest rates from rising. Ask Bill Gross, who is losing billions by sitting firmly on the wrong side on the bond trade. This week, 10-year Treasury yields backed up over 2.7%. Investors are bailing out of Treasurys, in the start of the Great Rotation.

When bond yields normalize, Ben Bernanke’s adventure in credit intervention will be over. Inflation will accelerate high powered money floods out of the banks and into the broad economy. Dollar denominated commodity prices will shoot higher. As a result, general prices will rise while real wages decline, leading to economic contraction.

These are the conditions for a classic death spiral. We have seen this dynamic play out in history. This was the case in the 1970’s under Carter. It took a free-market president to turn that recession around. Reagan cut tax rates for individuals and corporations and cut the federal red tape that hindered small business growth. Reagan created 21 million jobs in the second longest economic expansion in US history. Bill Clinton cut taxes too, which helped create private sector jobs, while adding hundreds of billions to federal revenues.

The country needs Reagan-like policies (and a Reagan-like president) to stage the type of robust recovery that will restore the nation to the light of the world, the "shining city on the hill". Until that time comes, citizens should protect their wealth and their families against the ravages of the central planners and the great leviathan.

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Scott Silva is Managing Director of The Gold Speculator, an investment newsletter based on Austrian theory focused on gold and gold stocks. Mr. Silva holds a Bachelor of Science and MBA, and was a licensed Investment Advisor for top tier Wall Street firms before founding a private investment advisory firm.  Visit his website at www.thegoldspeculatorllc.com.

Gold is found in nature in quartz veins