Its True, Bad Policy Will Have Ugly Consequences

Wayne Wine­gar­den, Ph.D. Tennessee Opinion Bad Policy Will Have Ugly Consequences Basic Econ 1 courses teach that if a central bank (in our case, the Federal Reserve) purchases government debt, that this policy is called “monetizing the debt.” When a central bank monetizes a government’s debt, the result is massive inflation regardless of whether the country is Brazil, Argentina, Turkey or the United States. Calling a debt monetization program “quantitative easing” or even “QE2” does not change this basic fundamental fact. The Federal Reserve began a  huge  monetization pro­gram (what was called quan­ti­ta­tive eas­ing) in earnest around Sep­tem­ber 2008. The Fed has just announced an expan­sion of this pro­gram (what is being called QE2).

A mas­sive infla­tion prob­lem in the United States is now all but assured unless the Fed­eral Reserve quickly crashes the U.S. econ­omy in order to avoid it — an unlikely sce­nario. Exactly when the nation’s mea­sure­ment of infla­tion begins to detect the prob­lem is uncer­tain, but the adverse con­se­quences from the com­ing infla­tion are already here.

Most promi­nently, the com­ing infla­tion is tank­ing the U.S. dollar.

Due to the future infla­tion prob­lem, the dol­lar has declined 10 per­cent against the cur­ren­cies of our major trad­ing part­ners since the worst of the finan­cial cri­sis has passed. Because of the weak dol­lar and grow­ing infla­tion­ary expec­ta­tions, gold prices surged nearly 30 per­cent in the past year to more than $1,300 an ounce. Sil­ver is up 32 per­cent in the past year, and over­all com­modi­ties have been grow­ing at double-digit rates in eight of the past 12 months.

The lat­est read on prices that pro­duc­ers face show that price increases are begin­ning to adversely impact peo­ple and busi­nesses, too — over­all prices that pro­duc­ers paid in Sep­tem­ber were up 4 per­cent com­pared to one year ago. Gen­er­ally, when prices rise for pro­duc­ers, price increases for con­sumers are not far behind.

It is note­wor­thy that the decline in the U.S. dol­lar has occurred despite China’s cur­rency — the Yuan — remain­ing pegged to the dol­lar. Other Asian coun­tries are fol­low­ing China’s lead and are pre­vent­ing the dol­lar from depre­ci­at­ing against most Asian cur­ren­cies. An inter­na­tional cur­rency war is now brew­ing over China’s cur­rency peg and its “under­val­ued currency.”

The cur­rency under­val­u­a­tion prob­lem will soon solve itself, how­ever. In a purely self-interested move, China will break the peg and let the dol­lar depre­ci­ate in order to avoid the same infla­tion prob­lem that looms over the U.S.

But don’t think that fur­ther declines of the dol­lar will be good for the U.S. Pre­cip­i­tous declines in the dol­lar against the Asian cur­ren­cies will help ignite infla­tion. Other con­se­quences will include declin­ing busi­ness prof­itabil­ity, espe­cially for smaller busi­nesses, and con­tin­ued dif­fi­cul­ties for risk-averse savers (older Amer­i­cans liv­ing on fixed incomes) who will face lower or even neg­a­tive returns on their savings.

The results from bad eco­nomic poli­cies are never pretty, but they are often pre­dictable. The Fed­eral Reserve is imple­ment­ing bad eco­nomic pol­icy. The result will be fur­ther declines in the dol­lar and more eco­nomic hardship.

Matt Phillips writes in WSJ Blog article After the Helicopter: Translating Market Scribbles on the Fed, realtes Marta on the markets: “There is a danger with QE II, it lies in the creation of “bi-flation” (original author of the term unknown), in which dollar-based commodity prices continue to soar. However, given continued excess capacity in the U.S. economy, producers will be hard-pressed to pass the price increases along. The result will initially be a transfer of wealth within the economy from commodity buyers (companies and private citizens). That phase will be followed by a drag on the overall economy as most companies and consumers are squeezed and some wealth outright leaves the country for foreign producers. The result could look worrisomely like the stagflation of the ’70’s and ’80’s.” … Mr. Phillips comments: “With the Fed essentially creating dollars with its electronic printing press, the greenback looks like it is going to continue to weaken. That will drive the prices of commodities such as crude oil higher. Some say that higher prices for crude oil and other commodities could actually represent a drag on the economy. In a worst case scenario, we might see a repeat of “stagflation,” the combination of minimal economic growth and double-digit inflation that dogged the U.S. economy in the late 1970s.z”

Barclays Capital Technical Research: “The FOMC meeting has come and gone and in the aftermath we note the shorter end of the U.S. yield curve remains bullish though the longer end is more bearish, keeping the 2s-30s spread steepening as inflationary expectations rise. Higher energy prices and a lower dollar will likely fuel these inflation fears in coming sessions and it is encouraging a more positive outlook in equities and FX risk as (emerging markets), and commodity currencies benefit. Markets turned risk friendly in Sep and have yet to deviate from that path.” … Mr. Phillips comments:  “The interest rates on long-term U.S. debt jumped after the Fed announcement, after the Fed announced it wouldn’t be buying many 30-year bonds. That pushed the price of the 30-year lower, and yields, which move in the opposite direction of prices rose. That resulted in the a “steeper” yield curve. Traditionally a steepening yield curve is interpreted as an indication of expectations for economic growth and inflation. So, the Fed’s announcement did change market expectations somewhat, and that’s another part of fending of deflation, as market expectations can be self-reinforcing.” … I comment that the Emerging Markets, EEM, and the Frontier Markets, FRN, soared on rising emerging market currencies, CEW, and commodities, DBC, rose on the commodity currencies, the Australian Dollar, FXA, the New Zealand Dollar, BNZ, and the South Africa Rand, SZR, as insiders became aware that QE 2 was coming. Those counseled by Barcalys got good investment advice where as the general public was left in the dark.

BNP Paribas: “The combination of a central bank aggressively insuring downside risk to the domestic economy through increased liquidity provision and an upturn in global growth could lead to a sustained rally in risky assets even as rates remain low. There are certainly risks to the strategy. Higher energy and agricultural prices are set to tax consumer purchasing power in the coming quarters which could crimp a nascent pick up.” I comment, well great, just great, the Fed’s actions helps keep banks liquid and maintains their huge storehouse of mortgage backed securities, MBB, from being deflated, and I have to bear the burden on less purchasing power as agricultural commodity prices, RJA, and food commodity prices, FUD, soar. This is a beastly thing.

Joe Weisenthal of Bloomberg relates: “By concentrating buying at the short end of the yield curve, Bernanke was punishing savers (pinning short-term rates to the mat) and bailing out banks (keeping the yield curve steep).” … I comment: The yield curve is a graph of what benchmark bonds such as US Government bonds are yielding across different maturities. The 30 10 US Sovereign Debt Yield Curve, $TYX:$TNX, exploded and steeped massively higher to 1.625 suggesting that peak investment value, that is peak credit, perhaps better said, peak debt was achieved November 4, 2010. The steepening yield curve inflated the financials; the European Financials, EUFN, rose 3.4%; American Express, AXP, 4.0%, Community Banks, QABA, 4.0%, Too Big To Fail Banks, RWW, 4.5%, Banks, KBE, 3.3%, India Earnings, EPI, 2.9%, and Mortgage Finance, KME, 4.6%.  The the small cap pure value shares, RZV, which are interest rate sensitive and carry trade sensitive, rose 3.1%,  I envision that the yield curve, will over time the yield curve will steepen from here. Some would say, that this would be economically stimulative, but, as the 30 year rate rises over the 10 year rate, then the longer out government and corporate bonds will fall in value, causing Governments to introduce austerity and corporations to cut back as interest rates rise. An ever steepening yield curve will cause the loan markets to dry up, and businesses will not take on new projects, there will not be economic growth but contraction; there will deflation like in Japan.  The US small cap shares, the Russell 2000, IWM, rose 2.5%; they have likely reached their maximum expansion. As the 30:10 US Sovereign Debt yield curve, continues to steepen, then these companies will be decapitalized by both a rising 30 Year US Government Bond Interest Rate, $TYX, and unwinding carry trade investment. Given the large amount of US Government Debt, and the dependency of these small companies upon a well functioning credit system, providing relatively low cost loans, America will be at the global epicenter of austerity and hardship.

TheAgonist writes QE2 Sets Sail on an Inflationary Binge:  The QE2 left New York harbor yesterday, on its voyage to ports all around the globe. Captain Ben Bernanke has promised to shower the inhabitants of such diverse locales as Brazil, India, and China with up to $600 billion of free money. Following his departure, central banks in these countries announced that they did not want the money and will enact regulations to forbid the QE2 to land in their country.

Such is the bizarre state of monetary policy in the United States that the second round of Quantitative Easing by the Fed is already being feared and rejected by economists and financial analysts around the world before it is even implemented. It may be that the market has come to realize that QE1 did not perform as promised. Job creation remained anemic, economic growth declined, commodity inflation accelerated, and bubbles popped up in a variety of markets.

A second matter of concern could be that Ben Bernanke this time around has pulled open the Fed’s cloak of secrecy to reveal a dirty secret: the Fed has been actively targeting a higher stock market as one of its monetary policy goals. In an op-ed published yesterday in the Washington Post, Bernanke wrote that a higher stock market has resulted merely from the speculation that QE2 would be implemented (this is true), and that because consumers will feel wealthier, spending will pick up (this is highly dubious not least because consumers have been ditching the stock market all year).

Then of course there is the fact that all this liquidity is supposed to wind up in the pockets of Americans, but it somehow does not. Through a mechanism called the carry trade, hedge funds and banks borrow super-cheap dollars and invest in Brazil, India, China, Australia and elsewhere because interest rates are so much higher in these countries. This is why Americans never see any of this money. The carry trade works well as long as the dollar deteriorates on the foreign exchange markets, which has been the case ever since the Fed announced it was thinking about QE2.

These are reasons enough to question the competence of Ben Bernanke and his fellow Fed governors and presidents who voted for QE2 (only one person dissented). Don’t these men know the nasty history of central banks which monetize government deficits as the Fed is now doing? Can’t they see the asset bubbles that are getting out of control in corn, copper, sugar, wheat and of course the precious metals? Don’t they realize a bubble is underway in the junk bond market, and the last time this occurred was right before the credit crisis of 2008? Haven’t they read the Flash Crash reports that show US stock markets are broken to the point that 70% of trades are done by computers and the average trade is now held for less than two minutes? Don’t they see that their favorite inflation indicator – the GDP price deflator – is at 2.2% and already exceeds the upper bound of their accepted range? What about the fact that real GDP itself came in during the third quarter at 2.0%, hardly a level justifying a dangerously speculative monetary policy? Is there anyone at the Fed who remembers the currency wars of the 1970s and how quickly they got out of control?

Either one of two things is going on here: the people running the Fed are grossly incompetent to the point of malfeasance, or they are fully aware of the risks they are running but are going ahead for some unstated purpose, probably having to do with the need to continue to pour capital into the Big Four American banks which are closer to collapse than the public is allowed to know. These are the banks, after all, which have been making hundreds of millions of dollars off free money and the carry trade, and these are the banks which are at risk of insolvency as the foreclosure crisis grinds on. ( I comment that these are traded by RWW)

As of this moment, the markets continue to be schizophrenic now that QE2 is official. Some markets dread the inflationary potential of this policy, which is why gold is up, the dollar is down, and the US Treasury bond market is selling off. Some US stock markets set new highs for the year yesterday, on the belief that only a fool would stand in the way of free money being poured into stocks by the Fed. “Don’t fight the Fed” has been a hallmark of stock traders for decades now, so why not follow what has always worked in the past, especially now that the Fed has explicitly stated that its goal is to get stock prices higher.

U.S. stocks have shot higher and higher since September 1 when QE2 was first announced, and there has been no significant correction to this advance.

More unusual still is the fact that corporate CEOs have been relentlessly selling their stock for months now; the ratio of insider stock sales to purchases each week has been running as high as 1,000:1, which has never been experienced before. Insider selling is always a reliable sign of a stock market at its peak. At the same time, retail Mom and Pop investors have been deserting this market every week since Spring, which is again a highly unusual circumstance and one the stock market would never have ignored in the past.

There are so many other unusual circumstances to this stock market that it is hard to pick out the most alarming, but one that everyone has noticed is that we have gone the longest period on record where the stock market is rising but the bond market is falling. Always in the past, the stock market could not advance if the bond market was expressing fear about inflation or the economy, which it has been for months now.

These type of discrepancies always get rectified, and the longer they go on the worse the reaction for the stock market. We are very overdue for that reaction by almost every technical and sentiment indicator that is published, and we have gone so long now without even a modest correction that the sell-off is going to be brutal. It is going to look as if the market is rejecting QE2, or at least it will look that way temporarily if the sell-off is a short term correction rather than a new leg down in a bear market.

Here are some of the things to watch for that could trigger a sell-off: a) a complete rout of the dollar leading to a currency crisis that can only be solved with higher interest rates in the U.S., b) a collapse in the U.S. bond market as traders respond to fears of hyperinflation, c) a blow-out acceleration of the price bubbles underway in commodities, d) a return to $100/bbl oil, which already crossed above the $85/bbl level yesterday, e) a major credit default affecting the junk bond market, f) a statement by the new House of Representatives leadership that Republicans will not vote for an increase in the debt ceiling, implying a possible default by the U.S., g) a massive lawsuit against a TBTF bank for tens of billions of dollars in damages due to fraudulent activity in mortgage securities transactions, h) capital controls imposed by a major country like Brazil, and possibly involving large-scale selling of Treasuries and agency securities (Fannie and Freddie) by these central banks, or i) a failure in Europe by Greece, Ireland or some other heavily-indebted country to roll over its public debt.

This list could be longer still, but you get the idea. So much could go wrong given how over-stretched these markets are around the globe. If any of these things happens, it will expose the fragility still extant in the markets and the global economy, and it will make people understand that QE2 isn’t able to solve these problems. That’s when the realization will dawn on everyone that the Federal Reserve is not simply powerless to improve the economy, it is making things much worse.


Keywords: competitive currency deflation, bi-flation, quan­ti­ta­tive eas­ing, monetization of debt, debt monetization, QE 2, QE 2 Flation, QE 2 Inflation, currency vigilantes, bond vigilantes, yield curve,


One Response to “Its True, Bad Policy Will Have Ugly Consequences”

  1. Dave Says:


    Picture perfect in relation to cheap dollars, weekly Eu/Au

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