By James J Puplava CFP, June 2, 2003
The next FOMC meeting is on June 24-25th. According to Dallas Fed Research Director Harvey Rosenblum, Fed members will discuss "unconventional" tools at their next meeting. Since implementing a series of rate cuts back in 2001, the Fed has been unable to engineer an economic recovery that is durable. The economic numbers are weakening again, or at best, flat despite numerous monetary and fiscal measures to jump-start the economy. Nothing has taken hold other than another asset bubble in housing. With the exception of housing, few areas outside of government spending are holding up the economy. Manufacturing remains weak with one out of four factories remaining idle. Companies continue to downsize as a means of controlling costs so the unemployment picture remains bleak. Furthermore, more companies plan to move their manufacturing and service operations overseas where costs are much less, and the regulatory climate is more favorable. So Fed policymakers are now contemplating what to do when the interest rate option for remedying a crisis runs out. The answer is to do something unconventional, something out of the ordinary in order to avoid appearing impotent and to keep the economy from falling into a recession, if not a depression.
The problem for the Fed is that it ignores the boom-bust cycle it has helped to create through its expansionary monetary bubble.
As the graph of M3 shows, since late 1994 the Fed has been pumping an enormous amount of money or credit into the economy and the financial system. The initial credit expansion gave us the boom, which was followed by the bust. And now we are headed for the inflationary consequences as the Fed tries to overcompensate for bursting bubbles. The only problem with a bursting bubble is that it leaves lingering after-effects in the form of too much debt, too much unused capacity, too much underutilized capital and excessive evaluations. So now we are faced with two side effects: both deflation and inflation.
When the Fed says it is worried about deflation, it means asset deflation, or in other words, bursting asset bubbles. We have already seen what happens when the stock market bubble bursts. Now they are worried about what happens when the mortgage-real estate-consumption bubble goes bust. There will then be real problems to contend with that won't be able to be remedied. The Fed has been fortunate in that it has been able to postpone the day of reckoning by creating multiple asset bubbles in the mortgage-real estate-consumption markets. What happens when these bubbles burst? Something that is sure to happen within the next one-to-two years. At that point, we may be facing hyperinflation, if not depression. I would venture to say the best that we can expect would be stagflation and the worst would be a hyperinflationary depression.
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Running Out of Options
What is becoming more apparent is that the Fed is running out of options and must now consider "unconventional" methods, or what I would prefer to call desperate measures. Stephen King at HSBC recently wrote a lengthy tome on possible Fed policy options to fight deflation. His piece, which is must reading, is called "Thinking the unthinkable." It is King's belief that the Fed and the US government are now in the process of implementing a Five Stage Strategy designed to prevent deflation from occurring and to cure it if it surfaces. According to King this policy will send yields on 10-year Treasury yields down to 2.5 percent from their present rate of 3.41 percent with the value of the US dollar spiraling against the Euro.
King believes that this five-stage strategy will fall short of achieving its mark because the Fed and the government have misdiagnosed the country's post-bubble problems. "We argue that the interest rate cuts seen so far, by failing to ward off deflationary fears, may have made matters worse. They have simply contributed to a further increase in private sector debt levels that will become increasingly burdensome should the US economy continue to proceed in its current, insipid, form."
No Way Out
King hits upon a key concept that has been lost by mainstream economists, government and Wall Street analysts, which is America's burgeoning debt problems. There are simply no easy solutions and no way out of America's debt predicaments. So the Fed and the government will do what they always do, which is to spend and inflate their way out of it. No politician wants to face up to the grim truth about America's debt problems and the fact that we are living beyond our means. This will not stop them from trying. We must now prepare ourselves for the damage they are about to wreck upon the economy and the financial system as they attempt to print and spend their way out of this mess.
The King analysis lists five policy options running the gamut from conventional to unconventional. These five options are as follows:
- Cut short-term interest rates swiftly and aggressively.
- Loosen fiscal policy, either through tax cuts or spending increases.
- Reduce interest rates further out the yield curve.
- Provide debt relief and bailouts to the private sector.
- Create inflationary expectations and buy assets like equities.
What the Fed is worried about when it refers to deflation, I believe, is asset deflation because once it arrives, it can be difficult to control. Japan is a recent example of failed government attempts to resurrect a bubble once it deflates. It also may contribute to a downward spiral in economic activity. A Fed nightmare is what happens when fiscal and monetary stimulus fails to create a multiplier effect in the economy. This appears to be the situation we now find ourselves in today. Especially worrisome for the Fed is America's growing debt imbalances, which are the world's, if not history's largest. What happens to debt balances once the asset values that support them deflate? Debt burdens become more onerous due to the fact that debt burdens grow in magnitude as asset values deflate.
What doesn't seem to be acknowledged on the part of Washington and Wall Street officials is that rising asset values can be another form of inflation. This is one reason why economists and analysts have had problems recognizing the bubble even when visible signs are everywhere. When assets inflate, we don't call it inflation; we call it a bull market. This morning I heard a cable reporter refer to housing price increases in the first quarter as a sign that the bull market (inflation) in real estate is on firm footing. By focusing on rising asset values and a booming economy, Fed officials ignored the deeper problems occurring in the debt markets, which was the very credit bubble they were creating that was fueling the asset bubble.
This brings us to where we are today, which is a weak economy and rising debt burdens that have been made less onerous due to lower interest rates. However, it is exactly these very debt burdens that are preventing the stimulus effects from having their multiplier effects on the economy. The only impact so far is that the more the Fed pumps money, the greater the asset bubbles. The Fed and the government have already moved through the first two stages with rate cuts and fiscal stimulus. We are now about to move on to the next stage, and that is lowering long-term interest rates through outright purchases or Treasury securities or monetizing the government deficit. This could take interest rates down to the level King refers to at 2.5 percent. The Fed would simply start buying along the yield curve as shown in the graph above to bring down the whole curve.
Possible Buying Binge
There are other measures that King and Fed officials refer to as unconventional measures which is buying assets. I believe they are already intervening in the financial markets through the ESF or through back channels by buying in the futures market to support the market. This can be seen below with Mike Bolser's graph of the repo market and the Dow, which shows a strong correlation between the increase in repos and movements in the market. This best explains the market's defying activity that has taken both sentiment and valuations back to the extreme. The economic numbers have not only weakened, but they are also becoming more unintelligible thanks to statistical wizardry that make the economic numbers a joke.
Mike Bolser's Editorial on Financial Sense Archive
The Fed may be running into another problem that may be causing sleepless nights at the Fed. Despite pumping large doses of credit into the system, money velocity is starting to slow down. This means that investors, consumers and savers prefer to hold on to their cash. The importance of money velocity to spinning money through the system or creating a multiplier effect through government policy is explained below.
FOUR FACTORS THAT IMPACT THE VELOCITY OF MONEY
Four factors change people's preference for either spending or holding money:
Factor #1 Change in Price
The first factor is the change in price for goods and services. When prices rise rapidly, as they do in periods of inflation, consumers' desire for holding money diminishes. This is because they perceive money to be less valuable because it will buy less in the future. Therefore, there is a preference for spending money now before prices rise for goods. Inflation erodes the purchasing power of money, so there is a desire to hold less of it. Conversely, when the supply of money contracts and the prices of goods and services fall, there is a greater demand for money because falling prices enables money to buy more in the future.
Factor #2 Availability of Substitutes
A second factor influencing money velocity is the ability to find substitutes for holding money. Examples of substitutes are gold and silver and other tangible, hard assets. When the supply of money is rapidly increasing or eroding its purchasing power, there is a desire on the part of consumers to hold other assets such as commodities. In the same manner, if the supply of money is decreasing, then the demand for money increases along with its purchasing power. Therefore, consumers' desire to hold more cash during periods of depression or deflation by holding on to cash affords greater security. During times of depression and severe deflation, the individual is less confident in financial institutions and their solvency, so they prefer to hold on to their money, thereby decreasing its velocity or circulation within the economy.
Factor #3 Credit Supply
The other two factors that influence the demand for money are the supply of credit and the rate of interest offered on holding money. When credit is ample and easily obtainable, then there is less of a desire to hold money. Conversely, if credit is tight and the ability to borrow money is difficult, businesses and consumers will increase their desire and preference for cash. The supply of money in the financial system affects both the preference and the desire to hold or not to hold on to cash. When the supply of money is expanding and the financial system is flush with cash through rapid money creation, then money velocity increases. Loans and credit are amply available. The opposite situation holds true when the supply of money contracts as it does during a recession or depression. During a recession or depression, money supply contracts as a result of loan defaults, delinquencies, bank failures, and tightening credit standards. During a depression, consumers and businesses hold onto money because they desire the ability to meet their payment obligations when they come due. So, money velocity decreases as the desire to hold money increases, thereby lowering the velocity of money or its circulation within the economy.
Factor #4 Rate of Interest
The final factor that influences the desire to hold or not hold money is the rate of interest offered on holding cash. A rapid increase in the supply of money can lower the rate of interest offered for money in the short-term. To prevent the rate of interest from rising requires a larger and more rapid rate of credit creation. This becomes a trap. In order to keep the rate of interest from rising, there is an increased requirement for even larger and larger amounts of money creation and credit to be provided to the system. Eventually, the only course of action is to allow the rate of interest to rise or the government risks the destruction of the monetary system. This is exactly the point where we are presently. As the graph of M-3 above clearly shows, the supply of money has been expanded at ever increasing rates to keep the system supplied with money, replacing the destruction of credit that has been destroyed through default, and prevented interest rates from rising.
We have now arrived at a situation similar to the one we were in between 1929-1933. Like the 1920s, the 1990s were a period of rapid money creation and credit expansion that actually began under the Clinton Administration in 1994. The increase in the money supply that began in 1994 reduced the demand for money and raised money velocity. The increased supply of money went into our financial markets as it did throughout the money and credit boom of the 1920s. Back then, the supply of money and credit could not be sustained. When the supply of money did not expand at a rapid rate, the velocity of money contracted as the demand for money increased. The result was spending on goods and services fell, thereby reducing revenues and income to business and consumers. This decreased the ability to service debts. Businesses and consumers defaulted on their debts, which led to bank failures and a sharp contraction of money and credit in the financial system. The contraction of the supply of money, the increase in the preference for money, the reduction in spending, and the fall in the stock market produced The Great Depression.
The Carry Tax Cometh?
Not to worry. The Fed is also considering unconventional means if money velocity shrinks. Fed senior vice president Marvin Goodfriend of the Richmond Federal Reserve branch first proposed a study of implementing a "carry tax." This tax would be imposed on cash if consumers don't spend the money as fast as the government wants it to. Essentially this tax would be designed to eliminate the problem of zero-bound interest rates. The tax would lower the value of the currency the longer it is held without making a transaction. In effect, it becomes a negative interest rate, which punishes cash holders for preferring to hold on to their cash. It would be designed to eliminate the Japanese problem where consumers and investors have preferred to hold on to cash as their assets deflated in the stock and real estate markets.
In my opinion, besides the constitutional problems this would present, it would most assuredly backfire. As the government continues to depreciate the currency, implementing a carry tax would force investors and savers into "things" as they see the value of their assets depreciate such as paper assets and real estate and the value of things they need go up in costs. People would simply put their money into "things" and avoid paper. The most valuable asset under these conditions would be the only real money that has ever existed throughout history: silver and gold.
We may soon be revisiting history as the alchemist take us back to the days of John Law, something I never thought I would see. However, it looks even more likely in the days ahead more of which will be written about in the future.
Back at the casino, the Dow and the S&P 500 rose after an ISM report showed a small improvement in manufacturing activity. Manufacturing is still contracting but it improved last month. All three markets rose like a flag only to give back most of the gains at the end of the day. The NASDAQ in fact went negative after being up almost 25 points for the day. The Dow intraday actually crossed the 9000 mark for the first time since last December. Despite sluggish economic news and dismal earnings reports, Wall Street strategists now believe that the markets resiliency in the face of poor economic and financial news is another sign that we have begun a new bull market. In the minds of prominent strategists on the Street, the bear market is over.
On a separate note, after the markets closed, IBM said that the SEC has begun a formal probe of the companies accounting practices for revenue for 2000 and 2001.
Volume hit 1.6 billion on the NYSE and 2.5 billion on the NASDAQ which is a sign of distribution. Market breath was positive by 2-1 on the NYSE and by 6-5 on the NASDAQ. The rose .53 to 22.23 and the VXN jumped 1.97 to 33.63.
Chart courtesy of Mike Bolser and Bloomberg
© 2003 James Puplava