What The Fed Believes / The Daily Reckoning

verfasst von - ELLI -, 03.12.2002, 20:03

-->What The Fed Believes

The Daily Reckoning

Paris, France

Tuesday, 3 December 2002

*** Consumers are buying! Investors too! Tech stocks, no
less. Is it a NEW New Era?

*** Factories slide...Sell Intel? Or buy it?

*** Oh China! Oh no!...and more...

Hey, what's this? Consumers hit the après-Thanksgiving
sales pretty hard. Retailers report 11% more in sales
volume than last year. Wal-Mart says its sales were up
14%...

The end of the world as we have known it, EOTWAWHKI, has
been postponed indefinitely, or maybe at least until after
the holiday season. In the meantime, it's just like those
gloriously loony fin de bubble days of late 1999. Consumers
are happily spending their way to poverty...and investing
their way to insolvency. It is just like old times; they
are still buying the same gadgets and geegaws they can't
afford...and investing in the very same tech stocks that
nearly ruined them 2 years ago.

We're just waiting for George Gilder to remind us about
promethean sparks shooting across the universe and Alan
Greenspan to confirm that we now have a NEW New Era at
hand...and our happiness is complete.

The recent good news suggests that America"may have
sidestepped another double-dip [recession]," writes Stephen
Roach,"but in my view, there's little reason to conclude
that there won't be further such scares in the months and
quarters ahead."

"Americans spend as factories slide," warns the BBC.
Manufacturing is still in a slump, as Eric describes in his
report. Prices of manufactured goods are falling - thanks
largely to the huge supply coming from China and other low-
cost producers, (about which more below...) Remaining U.S.
manufacturers have no pricing power...so they gradually
slow down and finally padlock the parking lot gate.

This trend has been going on for a very long time. It's why
people who work in U.S. manufacturing have had no increase
to speak of in real hourly wages for the last 30 years. And
it's why America's factory towns are so gloomy and
depressed.

But maybe it will stop tomorrow. Maybe foreigners will
suddenly start building factories in America. And maybe
Americans will finally start earning more money. And maybe,
then, they'll be able to spend money without mortgaging
their houses...and even pay down their debts. And maybe
stocks will then have a reason to go up...

Or maybe not...

Eric?

-----------

Eric Fry in New York...

- Despite loading up on stocks throughout October and
November, investors showed up for the first trading day of
December ready to keep on buying. Thirty minutes after the
opening bell, the Dow had jumped 144 points to burst
through the 9,000-mark for the first time since August.

- But the post-holiday euphoria quickly faded, and stocks
coughed up most of their gains. The Dow finished 33 points
lower at 8,862, while the Nasdaq held on to a 6-point gain
at 1,484.

- Helping to crush the bulls' early enthusiasm was a report
from the Institute for Supply Management showing that the
manufacturing sector in November didn't belch as much smoke
as many economists had hoped. (Presumably, the folks living
close to the smokestacks didn't mind that manufacturing
activity was a little slower than the distant economists
had hoped).

- Over in tech-land - that wonderful, environmentally
friendly place that belches stock options instead of smoke
- two Wall Street analysts offered conflicting opinions
about the health of the semiconductor industry. There is no
debate, of course, about the health of semiconductor
STOCKS. They've been going pretty much straight up for
weeks.

- But conditions in the industry itself are not nearly as
rosy, unless you believe Dan Niles, Lehman's semiconductor
analyst. Yesterday, Niles boosted his ratings on Intel and
Advanced Micro Devices due to an anticipated - by Niles -
rebound in corporate technology spending."Going forward,"
says the upbeat Niles,"as IT budgets begin to loosen and
corporate profitability begins to trend upwards, we believe
there are subtle signs of a PC refresh cycle from the U.S.
corporate segment."

- If Niles is correct, the signs are so subtle that the PC
manufacturers themselves do not seem to see them.
Meanwhile, Merrill Lynch's Joe Osha reiterated his"sell"
recommendation on Intel yesterday, saying the stock was
ahead of itself."We think any reasonable improvement to
numbers, or in the business, is already more than
discounted in the stock price," Osha told clients.

- Osha may have a point, and the point he makes is one that
also pertains to the stock market as a whole: even if the
economy is beginning a meaningful rebound, the stock market
is way ahead of itself. A strong economic recovery is, as
Osha would put it,"in the price." So what happens if the
economy fails to live up to expectations? We all know the
answer, and it isn't a pretty thing to watch. In fact, the
stock market may not be a pretty thing to watch even IF the
economy performs as well as hoped.

- That's why the current stock market rally seems more like
Icarus than Apollo. Just because the market is aloft, does
not mean that it BELONGS in the heavens.

- Remember, stocks zoomed higher late last year after the
post-9/11 sell-off, only to crash and burn several months
later. Now, once again, hopeful investors have slapped some
wax wings onto Mr. Market's back and urged him to soar
skyward. His flight has been awe-inspiring, if
unsustainable. To be fair, Mr. Market's wings aren't
exactly wax; they are a new-era composite known as
"Nasdaq."

- This aerodynamic composite provides awesome lift, thanks
to a special blend of particles known as tech stocks.
Unfortunately, this multi-tech-stock composite is
inherently unstable, and we suspect that stocks like
Novellus will compromise the integrity of Mr. Market's new-
age wings. The semiconductor equipment maker's stock sells
for an astounding 84 times estimated 2003 earnings despite,
as the company itself admits, lackluster demand for its
products. Who's buying this stock anyway, and what are they
thinking?...Are they thinking?

- In a rare display of candor on Wall Street, Bill Meade,
managing director at RBC Capital Markets, says that buying
Novellus at this valuation is"the fundamentally wrong
thing to do." Next time you see Mr. Market, he may be
cascading into the sea.

- Meanwhile, the bond market has been matching the stock
market, downtick for uptick. While the S&P 500 has powered
ahead more than 20% over the last two months, prices on the
10-year Treasury note have collapsed, driving the bond's
yield from an October low of 3.58% to the current yield of
4.21%.

- But what may be misery for bond investors should be sheer
delight for the subscribers to Resource Trader Alert. On
September 27, under the watchful eye of Andrew Kashdan, the
Resource Trader recommended buying put options on the 10-
year T-note. Within a couple weeks, a sell on the options
yielded a 49% profit. Then on November 13, after bonds had
rallied quite a bit, Resource Traders were urged to re-
enter the original trade. Since then, this second T-note
trade has jumped 88%. (For more information on The Resource
Trader Alert, see:
http://www.agora-inc.com/reports/RTA/ClickHereNow/

-----------

Back in Paris...

*** China is growing so fast, says the weekend
International Herald Tribune, that its economy will be
larger than Europe's in just 5 years - at about $12
trillion. A few years more and it will be larger than the
U.S.

***"Could disaster strike twice?" asks Canada's National
Post. The disaster to which the Post refers is a Japanese-
style, long, slow, soft recession...also the subject of a
book your editor is writing.

The National Post:"It can't happen here, [say economists].
That, of course, is exactly what the Japanese thought."

Your editor has noticed, too. Almost no one saw the long
slump in Japan coming, (except perhaps your editor, who
didn't write a book on the subject back in the '80s, but
thought about it.) And then, when it finally began, in
1990, almost everyone thought he saw it ending. End-of-the-
Bust sightings were common in '91, '92, '93, '94, '95, '96,
'97, '98, '99, '00, '01 and even '02.

But now, the End-of-the-Bust sightings are being replaced
by End-of-the-World visions. Over the years, for example,
estimates of the size of the disaster in Japan have
increased. Originally thought to be less than $100 billion,
more recently, Japanese banks are feared to have more than
$1 trillion worth of bad loans on their books. And many
large Japanese companies still are not profitable. Maybe
they never will be.

How could that be? The Japanese built their economy to
compete in making things. The strategy worked all too well
in the '70s and '80s. Japan could make all the things it
wanted and sell them to the Americans. By the late '80s,
the world seemed to want what the Japanese had, the yen was
rising and the whole country seemed to be rolling in money.
Who could blame them for getting a little carried away?
But in the '90s, the Japanese faced major problems...their
bubble economy had burst at the seams...their population
was getting older...and the Chinese were making things a
lot cheaper than they could. Time and time again, during
the '90s, stocks rallied, and people thought they saw the
good times coming back. But each time, the rally shriveled
up like a New Year's resolution and things seemed worse
than ever.

Now we've entered another decade...and now it is America's
turn. The bubble has popped...people get older...and China
is turning out geegaws and gadgets faster and cheaper than
ever. How long will it be before China begins making
automobiles...and the latest technology? How long before
people start delaying their purchases...and begin saving
cash for their retirements?

How long before we find out if it can happen here, after
all?

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---------------------

The Daily Reckoning PRESENTS: Well, it's clear at least,
what the Fed thinks it can do to stave off deflation. Will
it work? John Mauldin takes a stab at answering the $7
trillion dollar question...


WHAT THE FED BELIEVES
By John Mauldin

Last week's speech by new Federal Reserve Governor Ben
Bernanke has received a lot of publicity for some of its
speculations about potential Fed policy. Some analysts find
very dire and immediate negative implications in the
speech.

I, frankly, do not.

Let's look at who Bernanke is: Dr. Ben Bernanke, prior to
his recent appointment as a Federal Reserve Governor, was
the Chairman of the Department of Economics at Princeton.
He was the Director of the Monetary Economics Program of
the NBER (National Bureau of Economic Research) and the
editor of the American Economic Review. He co-authored a
widely used textbook on macroeconomics. He is obviously
well-respected in economic circles, and will be one of the
more influential governors.

I believe this is his first major speech as a Fed governor.
It was made to the Economist Club in Washington, which is
not a small venue. Dennis Gartman referred to this speech
as"...the most important speech on Federal Reserve and
monetary policy since the explanation emanating from the
Plaza Accord a decade and a half ago."

We will look at the particulars in a few paragraphs, but we
need to keep in mind that this is not a random speech.
While Bernanke states that the views in this speech are his
own, for reasons I will go into later, I believe this
speech is indicative of the thinking of various members of
the Fed, and was given to make unambiguous the Fed's views
on deflation. The title of the speech is very
straightforward:

"Deflation: Making Sure 'It' Doesn't Happen Here." (You can
read the full text of the speech at:
http://www.federalreserve.gov/Board...eches/2002/20021121/default.htm)

Let's take a look at the more 'controversial' parts of the
speech. What are they (the Fed) willing to do to avoid
deflation? This is the part that has raised the hackles of
more than a few writers. I will quote:

"As I have mentioned, some observers have concluded that
when the central bank's policy rate falls to zero - its
practical minimum - monetary policy loses its ability to
further stimulate aggregate demand and the economy. At a
broad conceptual level, and in my view in practice as well,
this conclusion is clearly mistaken. Indeed, under a fiat
(that is, paper) money system, a government (in practice,
the central bank in cooperation with other agencies) should
always be able to generate increased nominal spending and
inflation, even when the short-term nominal interest rate
is at zero.

"The conclusion that deflation is always reversible under a
fiat money system follows from basic economic reasoning. A
little parable may prove useful: today an ounce of gold
sells for $300, more or less. Now suppose that a modern
alchemist solves his subject's oldest problem by finding a
way to produce unlimited amounts of new gold at essentially
no cost. Moreover, his invention is widely publicized and
scientifically verified, and he announces his intention to
begin massive production of gold within days. What would
happen to the price of gold? Presumably, the potentially
unlimited supply of cheap gold would cause the market price
of gold to plummet. Indeed, if the market for gold is to
any degree efficient, the price of gold would collapse
immediately after the announcement of the invention, before
the alchemist had produced and marketed a single ounce of
yellow metal.

"What has this got to do with monetary policy? Like gold,
U.S. dollars have value only to the extent that they are
strictly limited in supply. But the U.S. government has a
technology, called a printing press (or, today, its
electronic equivalent), that allows it to produce as many
U.S. dollars as it wishes at essentially no cost. By
increasing the number of U.S. dollars in circulation, or
even by credibly threatening to do so, the U.S. government
can also reduce the value of a dollar in terms of goods and
services, which is equivalent to raising the prices in
dollars of those goods and services. We conclude that,
under a paper-money system, a determined government can
always generate higher spending and hence positive
inflation....If we do fall into deflation, however, we can
take comfort that the logic of the printing press example
must assert itself, and sufficient injections of money will
ultimately always reverse a deflation."

Bernanke goes on to point out that the Fed could also
supply interest-free loans to banks, monetize foreign
assets, buy government agency bonds, private corporate
assets or any number of things that could induce inflation.

Those words, taken out of context, could be seen as rather
extreme, confirming the worst fears about central banks
among certain groups and providing yet another reason to
buy gold. There may be reasons in this speech to want to
add a little gold to your portfolio, but these sentences
are not among them.

Let's look at what Bernanke really said. First, he begins
by telling us that he believes the likelihood of deflation
is remote. But, since it did happen in Japan, and seems to
be the cause of the current Japanese problems, we cannot
dismiss the possibility outright. Therefore, we need to see
what policies can be brought to bear upon the problem.

He then goes on to say that the most important thing is to
prevent deflation before it happens. He says that a central
bank should allow for some"cushion" and should not target
zero inflation, and speculates that this is over 1%.
Typically, central banks target inflation of 1-3%, although
this means that in normal times inflation is more likely to
rise above the acceptable target than fall below zero in
poor times.

Central banks can usually influence this by raising and
lowering interest rates. But what if the Fed funds rate
falls to zero? Not to worry, there are still policy levers
that can be pulled. Quoting Bernanke:"So what then might
the Fed do if its target interest rate, the overnight
federal funds rate, fell to zero? One relatively
straightforward extension of current procedures would be to
try to stimulate spending by lowering rates further out
along the Treasury term structure - that is, rates on
government bonds of longer maturities...

"A more direct method, which I personally prefer, would be
for the Fed to begin announcing explicit ceilings for
yields on longer-maturity Treasury debt (say, bonds
maturing within the next two years). The Fed could enforce
these interest-rate ceilings by committing to make
unlimited purchases of securities up to two years from
maturity at prices consistent with the targeted yields. If
this program were successful, not only would yields on
medium-term Treasury securities fall, but (because of links
operating through expectations of future interest rates)
yields on longer-term public and private debt (such as
mortgages) would likely fall as well.

"Lower rates over the maturity spectrum of public and
private securities should strengthen aggregate demand in
the usual ways and thus help to end deflation. Of course,
if operating in relatively short-dated Treasury debt proved
insufficient, the Fed could also attempt to cap yields of
Treasury securities at still longer maturities, say three
to six years."

He then proceeds to outline what could be done if the
economy falls into outright deflation and uses the
examples, and others, cited above. It seems clear to me
from the context that he is making an academic list of
potential policies the Fed could pursue if outright
deflation became a reality. He was not suggesting they be
used, nor do I believe he thinks we will ever get to the
place where they would be contemplated. He was simply
pointing out the Fed can fight deflation if it wants to.

With the above as background, now we can begin to look at
what I believe is the true import of the speech. Read these
sentences, noting my bold, underlined words.:

"...a central bank, either alone or in cooperation with
other parts of the government, retains considerable power
to expand aggregate demand and economic activity even when
its accustomed policy rate is at zero.

"The basic prescription for preventing deflation is
therefore straightforward, at least in principle: use
monetary and fiscal policy as needed to support aggregate
spending..."

Again:"...some observers have concluded that when the
central bank's policy rate falls to zero - its practical
minimum - monetary policy loses its ability to further
stimulate aggregate demand and the economy.

"To stimulate aggregate spending when short-term interest
rates have reached zero, the Fed must expand the scale of
its asset purchases or, possibly, expand the menu of assets
that it buys."

Now let us go to his conclusion:"Sustained deflation can
be highly destructive to a modern economy and should be
strongly resisted. Fortunately, for the foreseeable future,
the chances of a serious deflation in the United States
appear remote indeed, in large part because of our
economy's underlying strengths but also because of the
determination of the Federal Reserve and other U.S.
policymakers to act preemptively against deflationary
pressures. Moreover, as I have discussed today, a variety
of policy responses are available should deflation appear
to be taking hold. Because some of these alternative policy
tools are relatively less familiar, they may raise
practical problems of implementation and of calibration of
their likely economic effects. For this reason, as I have
emphasized, prevention of deflation is preferable to cure.
Nevertheless, I hope to have persuaded you that the Federal
Reserve and other economic policymakers would be far from
helpless in the face of deflation, even should the federal
funds rate hit its zero bound."

Let's forget for the moment the debate about whether Fed
policy can actually stimulate demand at all times and
places. The quotes above demonstrate that Bernanke and the
Fed board BELIEVE that it can. Beliefs will translate
themselves into action. The Fed, when faced with slowing
demand and deflation, will act in very predictable ways
based upon their beliefs. They will work to stimulate
demand.

I have no quarrel with the view that a central bank can
prevent deflation. As Bernanke noted, there are ways to
create inflation. I also have no quarrel with the view that
the Fed should work to prevent deflation. However, I am not
persuaded that in all circumstances, the Fed can stimulate
aggregate demand with simple interest rate policies. I am
equally uncertain that the price of preventing deflation
will not be stagflation, or worse.

In a typical business cycle, if the economy gets
"overheated" and inflation starts to rise, a central bank
can raise interest rates and tighten the money supply, thus
slowing business growth and profits and lowering demand and
therefore price inflation. If the economy gets into
recession, a dose of low rates and easy money is the
prescription."Don't fight the Fed" is a rule we have been
taught. It was a good rule to follow - until 2001, when a
disconnect between the markets and fed policy appeared.

My concern is that we are not in a typical business cycle.
Just as a number of different economic factors all came
together to cause the boom and then bubble of the 80's and
90's (disinflation, lower interest rates, lower taxes,
lower international tariffs, the demographics of the Boomer
Generation, stability, etc.), I think there are now forces
at work which may not respond to the Federal Reserve's
levers. But that does not mean the Fed will not pull them.

The Fed will not be able to raise rates without throwing us
into recession. Therefore, they won't. When the next
recession rears its head, it is likely to have deflation
written all over it. The members of the Fed viscerally
believe that it is their duty to stimulate demand to avoid
deflation, and they have the tools to do so. They will
lower long term rates.

Why do this? Because from their point of view, it is the
right thing to do. They believe (with some justification, I
might add) that the recent rapid round of rate cuts helped
avoid a serious recession. Housing and consumer spending
remained strong due to the stimulus they provided. Business
investment collapsed due to the excess capacity built up
during the 90's. The ability of corporations to raise
prices to increase profits was taken away.

The hope is that if they can keep the economy moving along,
even slowly, that excess capacity will eventually go away
and that U.S. businesses will regain their ability to raise
prices. The longer they can postpone the next recession,
even by excess stimulation, the more likely it is that
businesses will be in better shape. Hopefully, personal
debt will start to decrease as well, and we can slowly over
the next few years grow ourselves out of the current
problems.

The belief (or hope) at the Fed is that we can work through
the hangover of the 90's (debt, deflation, excess capacity,
dollar bubbles, trade deficits, etc.) before they run out
of interest rate/demand increasing bullets.

Rather than one very big recession which hits the reset
button on the above problems, they hope to slowly deal with
them one by one by growing our way out of the problems,
stimulating demand every time we slip nearer to
recession...and/or deflation.


Regards,

John Mauldin,
For The Daily Reckoning

P.S. Can you fault the Fed policy? No, as a big recession
would produce a great deal of human misery, and not just in
the U.S., but worldwide. It might mean a few million jobs
in the U.S., but it is life and death in many parts of the
world that depend on the cash flows from world trade for
their very survival.

Will it work? I hope so, but there are a lot of economic
problems from the 90's to deal with. There is a very real
concern that because of global deflation, the Fed is
pushing on a string with its normal policies, and that
ultimately the cure for deflation will cause discomfort.
The best thing the Fed has going for it is that the U.S.
economy and U.S. consumers have always surprised us on the
upside.

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gesamter Thread:

• What The Fed Believes / The Daily Reckoning - - ELLI -, 03.12.2002, 20:03