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Soon, The Fed will Regret Recent Monetary Policy

September 17, 1999

After the Problems Of 1980s, The Easy Money 1990s Helped Create A Stock Market Bubble. Then, The Fed Got Worried.

In the 1980s, the U.S. Federal Reserve had its hands full. The inflation of the 1970s resulted in a tough Fed policy in the early 1980s, bringing on a severe recession that included depressed real estate prices and the bursting of the precious metals bubble. The stock market crash of 1987 gave newly-appointed Federal Reserve Chairman Alan Greenspan a run for his money, as had the bail-out of the U.S. Savings and Loan industry, LDC countries such as Latin America, and even Chrysler Corporation, during the decade of the 1980s.

The Savings and Loan problem was severe, and required that the entire banking system be liquefied in the wake of the 1990-1991 recession. Liquification, which occurred in part as a result of a steep yield curve engineered by the reversal in Fed policy to that of easy money, would also serve to restore confidence in the monetary system during the first half of the 1990s and encourage the creation of credit once again. High long-term interest rates were contrasted by very low short-term rates--the lowest in decades--in the early 1990s, culminating with a 90-day Treasury Bill yield of just below 3½% in 1993 and a long bond yield above 8%. This allowed the strained banking system to pay low interest rates for savings accounts and certificates of deposit while collecting high long-term rates, providing a huge profit margin for the U.S. banking system. The re-liquification strategy worked, as did the dissolution of 505 marginal or bankrupt S&L's, which served to clean up the U.S. system and allowed the U.S. to emerge with a healthy financial system in the second half of the 1990s.

But the reversal in monetary policy from the tight conditions of the 1980s to the easy money days of the 1990s created another bubble: the U.S. stock market. Like the 1920s when the same type of situation occurred, liquidity resulting from a loose credit policy allowed investors to buy stocks persistently at a record pace at the same time consumer spending soared. Worried that stocks were becoming overvalued and that investors were miscalculating risk, the Greenspan Fed began in late 1996 to try to talk investors out of becoming exuberant (Greenspan's famous "Irrational Exuberance" speech) and to be more realistic about assessing risk and corporate earnings potential. When that did not work and investors ignored the Fed Chairman, the Fed stepped up its rhetoric and, this year, began to tighten credit and reduce money supply growth under the pretense that there is the risk of inflation.

The Risk Is For Deflation, Not Inflation

Yet, also like the Roaring Twenties, the risk is not of inflation but of severe global deflation. This is difficult for many American investors to understand because food, energy, and real estate prices have been soaring, labor conditions are tight, and stocks did well until 1997. The United States is not yet registering the kind of deflation on the wholesale level that has been registered during the past two years along the Pacific Rim and in parts of Europe. Indeed, the United Kingdom registered a year-over-year rate of deflation on the wholesale level of over 8% in 1998, Germany 4½%. Wholesale prices declined 1.1% in the United States in 1998. Europe and the Pacific Rim still reported declining wholesale prices as of 1998, albeit at a slower rate. Wholesale prices will likely increase slightly in the United States during calendar year 1999.

Inflation and deflation are monetary phenomena, and asset price deflation itself—a difficult-to-understand concept for this generation of consumers (especially in the U.S.)—is a result of a monetary phenomenon involving contracting credit and illiquidity. Although broad-based deflation is accompanied by repeating cycles of depressed commodity prices, the phrase "global deflation" refers also to the contraction of credit, the debasement of currency, and the declining of asset values on a grand scale. As a byproduct of these factors, commodity prices cannot help but decline in U.S. or European currency terms. Banking systems cannot help but be strained as collateral on the books is destroyed by plunging asset prices, and as consumers of distressed economies default. Currencies collapse and financial assets plunge. Without these factors, true monetary deflation is not occurring even though commodity prices can also cycle down in price periodically during the ebb and flow of inflationary forces.

Deflation Explained

In terms of the effects on credit and available liquidity, deflation's effects are the opposite as those of inflation. During times of inflation, credit is easily created—not just by central bank policies but by the lending practices of banks that are on the present fractional reserve, fiat currency (not backed by gold or silver) system, as well as by the borrowing practices of consumers. During the months before the 1997 Pacific Rim collapse, many Hong Kong banks were lending 100% of the value of real estate collateral. This strategy only served to transfer the risk from the borrower to the lender. When the bubble burst and asset prices plunged, banks were immediately faced with losses and insufficient collateral as property prices declined well below the amounts lent to borrowers.

As the deflationary chain reaction continued, collapsing currencies of distressed economies strained by the reversal from the period of easy credit to a period of tight credit conditions contributed to a situation in which demand for commodities worldwide plunged. To top it off, large discrepancies in currency values occurred between the currencies of distressed economies and those of economies which were not distressed. The currencies of Japan and China, constituting an enormous cross section of consumers in an economic region larger than that of the United States or Europe, had not collapsed and, as a result, the goods and services produced by those countries suddenly cost much more on a relative, and global, basis.

The same type of situation is presently occurring in South America, where the collapse of the Brazilian real last January has made goods and services produced by neighboring countries such as Argentina, Venezuela, and Ecuador, much more costly. Gross Domestic Product in those neighboring countries has plunged at an annual rate of over 6% the past few quarters, further straining Latin American economies and requiring more assistance from the International Monetary Fund.

U.S. Banks and Farmers Beginning To Feel Strain

That the U.S. banking system is exposed to Latin America much more than Asia is not the complete picture describing the implications for U.S. financial markets of the global economic turmoil of the past two years. Adding to that strain are the effects of severely depressed commodity prices—in real terms, the lowest prices in half a century—on U.S. farmers and their respective banks. Real estate values for a widening region of the U.S. Farm Belt are in a steepening decline, pressuring banks and causing in some cases farmers of large commercial farms to abandon their careers and take more conventional jobs in town due to falling property prices.

This situation, too, was occurring in the late 1920s during the time American Investors, not understanding the implications of the global problems of the time (then it was the U.K. and Europe in deflationary trouble, not Asia) and comprising a generation then, too, that did not understand deflation and what it could do, bought up stocks in the largest speculative bubble in decades. The Fed apparently did not understand global deflation in 1929 either, and their tight monetary policy in an attempt to curb stock market speculation only served to exacerbate the deflation and asset price collapse that was soon to engulf the United States, and served to drain liquidity just before the deflationary wave of the 1930s wiped liquidity off the books.

Fed Will Soon Regret Policy Of Bubble Economy Followed By Tightening

Today's Federal Reserve Board with all its statistical data which doubtless includes extensive information on the late 1920s appears to have created conditions that will soon be regretted. Favoring continued economic expansion at any cost, the 1990s Federal Reserve has repeatedly opened the monetary spigots when a crisis has developed. While this policy reduces the likelihood that severe financial failures will plunge the entire economy into economic contraction, it also serves to preclude the collapse of marginal and inefficient institutions, encouraging a more reckless and complacent attitude within a generation that has learned that those with failed strategies will be bailed out by the powers that be. This further serves to remove the incentive to operate companies efficiently and to accurately assess risk, instead encouraging more risk-taking and inefficiency—exactly what the Fed has attempted simultaneously to talk the market out of with its rhetoric the past two years.

Last fall, for example, the Fed not only panicked because it had failed to see the effects on the United States of the worsening wave global deflation and illiquidity, but it also punctuated its sudden easing of interest rates (three times in a month last fall) by expanding the money supply at an annual rate of 15%—nearly twice its perceived target band and its rate of expansion in the months prior to the autumn of 1998. This rapid re-expansion of the monetary base served to perpetuate the very bubble the Fed has been worried about and that had been bursting from the Pacific Rim to the United States during the year prior to the autumn of 1998. It has also served to encourage the U.S. consumer to take on still more credit card, mortgage, and securities debt. In the months following last fall's Fed panic, investors speculating on margin in stock accounts soared to record levels just ahead of a collapse of 50% to 60% in the value of the Internet stocks in which they were speculating. Credit card debt is at record levels.

Political & Economic Hot Spots, U.S. Bond Market Signal Trouble Ahead

Now, global political and economic hot spots are threatening another state of global crisis once again, but now the Dow Industrial Average is trading at 11,000, not at 7,400 as it was last October. Increasing global political and social turmoil serves to threaten the fragile rebound in the global economy, and to threaten large regions such as Indonesia which are involved in economic restructuring and an IMF bail-out plan as a result of their 1997/1998 collapses. The almighty U.S. bond market—the engine of the stock market, the ultimate supervisor of government policy and investor habits, and the point at which the buck really stops—has not only been declining since last October's monetary easing, but remains dangerously decoupled from the stock market.

This decoupling, which began in 1997 and still has not yet recovered despite the recent global rebound from last year's crash lows, has historically been a precursor to financial market panics and collapses. Decoupling remains in place during financial panics, too, as assets fleeing panicky markets find solace in government-guaranteed Treasuries. It also indicates in part that bond traders are concerned about high stock market levels and persistently wide global credit spreads, which measure the difference between lesser quality debt instruments and U.S. Treasury securities. These spreads had widened substantially in 1997 and 1998, came back in a bit earlier in 1999, then widened again this past summer. The market, then, is signaling more problems ahead, requiring additional premium on non-U.S. Treasuries and on lower quality debt in order to attract investment capital. With respect to the Fed and the threat of inflation it sees, perhaps it has yet to observe that the global deflationary forces are keeping U.S. inflation at bay during this time of full U.S. employment. Tightening, then, is not needed at this time of low global liquidity and was not needed for the same reason in 1929. Rather, the Fed should have been dealing with the stock market bubble in other ways such as raising margin requirements (as is already practiced at times in the futures market), influencing the broker loan rate higher, and perhaps increasing bank reserve requirements temporarily during periods of excess credit creation and high consumer spending (exactly what the Fed currently worries about).

Bottom Line: The World Is Unstable, Yet Investors Remain Inflexible

The bottom line is that the world is in a state of flux and is very unstable politically, socially, and economically. The U.S. stock market appears to be discounting perfection as investors and the now-huge number of brokers, money manager, and other professionals attracted to the bull market of the 1990s attempt to sustain the old trends and deny new trends and the massive changes presently engulfing the globe. The fundamental background is not nearly as good as it was during the first half of the nineties, and the wave of global deflation and economic structural problems is far from over. New trends can emerge less painfully if investors and consumers do not hang onto the old ones for so long after their time has come, but absent the welcoming of inevitable change, panic and sudden collapse adds to the painful transition from The Old to The New.

Between the Old and the New is a period our Forecast '99: Investing During The Void report termed The Void, a rather crude but representative term describing the period of time that typically occurs after the death of an old system and before the birth of the new system. In the case of planet Earth coming into its calendar year 2000, a failing monetary system established during the post World War II reconstruction period and during the half century thereafter is wreaking havoc on a world of consumers dependent upon it. The fact that many governments of the world with their reputations tied to that failing system are attempting to hang on to it past its time, thereby failing to make the necessary structural changes required to bring in new solutions and a new, more stable and more modern economic structure, only makes matters worse and jeopardizes the entire globe—United States included—even further.

The present situation in Indonesia is case in point as a government sitting atop a failed economy in the midst of reconstruction refuses to change, in turn encouraging social rebellion and further collapsing the old structure. A deeper-than-necessary economic contraction then results, and this—a country containing the fourth largest population in the world—threatens to further destabilize an already unstable region that is beginning to have a deleterious effect on the largest country in the world: China. A devaluation of the Chinese currency in an attempt to prevent economic implosion (see also "Is China Headed For A Crash", September 1, 1999 Wall Street Journal article) would render the situation in the Pacific Rim and Asia virtually insurmountable and would deepen the global economic contraction that began in 1997 and that has, in the meantime, seen only a frail rebound absent significant structural change. Further social rebellion in the region would then seem inevitable. Key Chinese cities such as Shanghai have also suffered asset price deflation, real estate collapses, and 70% vacancy rates for office space.

Stability Of Dow, Benchmark Averages Threatened, Autumn Crash Likely

With the latest Merrill Lynch study (September 3) revealing that only 27% of all New York Stock Exchange Stocks and 23% of all NASDAQ stocks have exceeded their 1997-1998 highs this year (with a full 57% of NYSE and 73% of NASDAQ stocks 20% or more below those highs), the intermediate-term trend of deteriorating global fundamentals and a two-year bear market in one-third to three-quarters of the American stock market will likely threaten the stability of the popular benchmark averages still closer to record high territory. In fact, these factors plus many technical barometers are lined up in a rare "crash configuration"—a situation tantamount to an official Weather Service Hurricane Warning along the coast of Florida. With an actual Hurricane Warning, a hurricane has already formed and is expected to hit the warned area within 24 hours.

With respect to the U.S. stock market, as well as the global political and economic arena, our work has issued a "Crash Warning" as we approach the seasonal tendency for the market to weaken during the autumn months but, this autumn, the Dow sits at a very high level and global fundamentals have deteriorated substantially, as discussed in this report. A crash or severe collapse is expected within one to three months, and although hurricanes can change course and turn back out to sea, residents nonetheless batten down the hatches and take appropriate action when a hurricane is expected. Investors, then, should be taking appropriate action to remove from their portfolios the risk of an imminent stock market collapse. When the period of risk subsides, there will be plenty of time to scoop up any bargains after two years of declining stock prices and when the benchmark averages revalue themselves at more reasonable levels with respect to current and near-future fundamentals.

In the meantime, our work strongly suggests that investors batten down the hatches in response to the warnings that are readily apparent throughout the globe.

Pure gold is non-toxic when ingested.
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