In his latest Merk Insight letter, Axel Merk discusses the possible policy actions the federal reserver, via Ben Bernanke, make take, and although unlikely for now, one of the latest tool would be to lower the interest rate the Fed pays on bank reserves to possibly 10 basis points or zero.
Here's the full letter:
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| Official portrait of Federal Reserve Chairman Ben Bernanke. (Photo credit: Wikipedia) |
To print or not to print? Odds are that Fed Chairman Bernanke has been
contemplating this question while drafting his upcoming Jackson Hole
speech. The one good thing about policy makers worldwide is that they
may be fairly predictable. As such, we present our crystal ball as to
what the Fed might be up to next, and what the implications may be for
the U.S. dollar and gold.
First off, we may be exaggerating: on process rather than substance,
though. That is, Bernanke isn’t just thinking about whether to print or
not to print as he is sitting down to draft his speech. Instead, he
considers himself a student of the Great Depression and has been
pondering policy responses to a credit bust for some time. Consider the
following:
- Bernanke has argued that going off the gold standard
during the Great Depression helped the U.S. recover faster from the
Great Depression than countries that held on to the gold standard for
longer.
- Bernanke is correct: subject to many risks, debasing a
currency (which going off the gold standard was) can boost nominal
growth. Think of it this way: if the government takes your purchasing
power away, you have a greater incentive to work. Not exactly the
mandate of a central bank, though.
- Note by the way that by implication, countries that
hold on to the gold standard invite a lot of pain, but have stronger
currencies. Fast forward to today and compare the U.S. to Europe. While
neither country is on the gold standard, the Federal Reserve’s balance
sheet has increased more in percentage terms than that of the European
Central Bank since the onset of the financial crisis. Using a central
bank’s balance sheet as a proxy for the amount of money that has been
“printed”, it shouldn’t be all that surprising that the Eurozone
experiences substantial pain, but the Euro has been comparatively
resilient.
- Possibly the most important implication: Bernanke
considers the value of the U.S. dollar a monetary policy tool. When we
have argued in the past that Bernanke might be actively working to
weaken the U.S. dollar, it is because of comments such as this one. This
is obviously our interpretation of his comments; a central banker
rarely says that their currency is too strong, although such comments
have increasingly been made by central bankers around the world as those
pursuing sounder monetary policy have their economies suffer from
competitive devaluations elsewhere.
- Bernanke has argued that one of the biggest mistakes
during the Great Depression was that monetary policy was tightened too
early. Here’s the problem: in a credit bust, central banks try to stem
against the flow. If market forces were to play out, the washout would
be severe and swift. Those in favor of central bank intervention argue
that it would be too painful and that more businesses than needed would
fail, the hardship imposed on the people is too much. Those against
central bank intervention point out that creative destruction is what
makes capitalism work; the faster the adjustment is, even if extremely
painful, the better, as the recovery is healthier and stronger.
- If the policy choice is to react to a credit bust
with accommodative monetary policy, fighting market forces, and then
such accommodation is removed too early, the “progress” achieved may be
rapidly undone.
- We are faced with the same challenge today: if
monetary accommodation were removed at this stage (interest rates
raised, liquidity mopped up), there’s a risk that the economy plunges
right back down into recession, if not a deflationary spiral. As
such, when Bernanke claimed the Fed could raise rates in 15 minutes, we
think it is a mere theoretical possibility. In fact, we believe that the
framework in which the Fed is thinking, it must err on the side of
inflation.
Of course no central banker in office would likely
ever agree with the assessment that the Fed might want to err on the
side of inflation. But consider the most recent FOMC minutes that read:
- An extension [of a commitment to keep interest rates
low] might be particularly effective if done in conjunction with a
statement indicating that a highly accommodative stance of monetary policy was likely to be maintained even as the recovery progressed
As the FOMC minutes were released three weeks after
the FOMC meeting, many pundits dismissed them as “stale”; after all, the
economy had somewhat improved since the meeting. Indeed, it wasn’t just
pundits: some more hawkish Fed officials promoted that view as well.
But to make clear who is calling the shots, Bernanke wrote in a letter
dated August 22 (the same date the FOMC minutes were released) to
California Republican Darrell Issa, the chairman of the House Oversight
and Government Reform Committee: “There is scope for further action by
the Federal Reserve to ease financial conditions and strengthen the
recovery.” Various news organizations credited the faltering of an
incipient U.S. dollar rally on August 24 with the publication of this
Bernanke letter.
For good order’s sake, we should clarify that the Fed
doesn’t actually print money. Indeed, printing physical currency is not
considered very effective; instead, liquidity is injected into the
banking system: the Fed increases the credit balances of financial
institutions in accounts held with the Fed in return for buying
securities from them. Because of fractional reserve banking rules, the
‘liquidity’ provided through this action can lead to a high multiple in
loans. In practice, one of the frustrations of the Fed has been that
loan growth has not been boosted as much as the Fed would have hoped.
When we, and Bernanke himself for that matter, have referred to the
Fed’s “printing press” in this context, referring to money that has been
“printed”, it’s the growth in the balance sheet at the Federal Reserve.
That’s because the Fed’s resources are not constrained; it’s simply an
accounting entry to pay for a security purchased; that security is now
on the Fed’s balance sheet, hence the ‘growth’ in the Fed’s balance
sheet.
Frankly, we are not too concerned about the
environment we are in. At least not as concerned as we are about the
environment we might be in down the road: that’s because we simply don’t
see how all the liquidity can be mopped up in a timely manner when
needed. At some point, some of this money is going to ‘stick’. Even if
Bernanke wanted to, we very much doubt he could raise rates in 15
minutes. To us, it means the time for investors to act may be now.
However, talking with both existing and former Fed officials, they don’t
seem terribly concerned about this risk. Then again Fed officials have
rarely been accused of being too far sighted. We are concerned because
just a little bit of tightening has a much bigger effect in an economy
that is highly leveraged. Importantly, we don’t need the Fed to tighten:
as the sharp selloff in the bond market earlier this year (and the
recent more benign selloff) have shown, as soon as the market prices in a
recovery, headwinds to economic activity increase as bond yields are
rising. That’s why Bernanke emphasizes “communication strategy”, amongst
others, to tell investors not to worry, rates will stay low for an
extended period. This dance might get ever more challenging.
In some ways, Bernanke is an open book. In his ‘helicopter Ben’ speech
a decade ago, he laid out the tools he would employ when faced with a
collapse in aggregate demand (the credit bust we have had). He has
deployed just about all tools from his toolbox, except for the purchase
of foreign government bonds; recently, he shed cold water on that
politically dicey option. Then two years ago, in Jackson Hole, Bernanke provided an update, specifying three options:
- To expand the Fed’s holdings of longer-term securities
- To ease financial conditions through communications
- To lower the interest rate the Fed pays on bank reserves to possibly 10 basis points or zero.
We have not seen the third option implemented, but the
Fed might be discouraged from the experience at the European Central
Bank: cutting rates too close to zero might discourage intra-bank
lending and cause havoc in the money markets.
As such, expect Bernanke to give an update on his
toolbox in Jackson Hole. The stakes are high as even doves at the Fed
believe further easing might not be all that effective and could
possibly cause more side effects (read: inflation). As such, we expect
him to provide a framework as to why and how the Fed might be acting,
and why we should trust the Fed that it won’t allow inflation to become a
problem. For investors that aren’t quite as confident that the Fed can
pull things off without inducing inflation, they may want to consider
adding gold or a managed basket of currencies to mitigate the risk to
the purchasing power of the U.S. dollar.
