The Fed’s Big Bluff

[powayseller]

The Fed’s Big Bluff by Peter Schiff, Euro Pacific Capital

QUOTE
This week, as the Fed came through with its highly anticipated pause, it conspicuously left the door open to future rate hikes. Apparently the rhetorical vigilance took most currency traders by surprise, sending many scrambling to buy dollars. However, given that any weaker statement would have caused a stampede out of the dollar, how surprising should the tough talk have been? Any indication that this was not a “wait and see” pause would have sent both long-term interest rates and consumer prices up, undermining the “benefits” of the pause. So in an apparent attempt to have its cake and eat it too, the Fed “paused” while pretending that it really had not done so.

The Fed’s claim that it is concerned about inflation, and that it will act decisively to contain it, is just a bluff. Any real commitment would have prompted the Fed to have already raised rates much higher. For the Fed to suggest that it stands ready to raise rates in the future, if the data warrants it, completely misses the point that the data warrants it right now!

The flawed CPI is nonetheless a lagging indicator of inflation. There is so much inflation already in the pipeline that its effect on consumer prices will be seen for years to come. For now, the Fed’s private concern is to keep the markets from understanding just how bad inflation already is, and how little resolve it actually has to do anything to contain it. Far from being concerned, the Fed likely views inflation as the only solution to America’s problems; a monetary “get out of jail free card.” The U.S. now owes so much to foreigners that not only is legitimate repayment impossible, but the very act of servicing the debt will soon become unbearable. Debt repudiation through inflation likely appears to be the most politically palatable “solution.”

Perhaps out of fear of being blamed for an economic downturn, the Fed’s overriding concern now appears to be keeping the U.S. from falling into a recession. Without a pause, this would likely be impossible, so pause it must, inflation be damned. My guess is that the Fed will continue to ignore evidence of worsening inflation, using growing signs of a weakening economy as cover for its complacency. All the while it will continue to brag about its “vigilance” and commitment to hiking rates further should inflation become a threat.

The $64 trillion question is just how long it will be before the markets call the Fed’s bluff. Once it shows its cards, we had all better batten down the hatches, in preparation for a monetary perfect storm. Though Greenspan may have sown the winds, it’s Bernanke and the rest of us that will reap the whirlwinds.
UNQUOTE – Peter Schiff

Remember stagflation? That’s what’s next. The Fed lost the inflation game. I now see it was tough talk, but no action behind it.

If they keep raising rates, the recession will be much worse. If they pause, inflation will gradually creep up, and the recession might be smaller.

What is the ultimate price for this decision?

[Anonymous]

Powayseller, rates are going up: with Tuesday’s Fed pause, at the auction of 30 year Treasury notes yesterday, the yield was 5.08%, up from 4.53% at the last auction of 30 year notes back in February. Why the big increase in yield? Because demand was down, as evidenced by a nearly 40% drop in bids. Why the drop in bids? Because of a nearly 70% drop in bids by the channel used by foreign investors. Why the drop by foreigners? Because they’re losing confidence that the Fed will effectively fight inflation, and are demanding a higher interest rate in exchange.

The Fed has allowed an unprecedented increase in the U.S. money and credit supply over the last decade. The only thing that has stopped such from resulting in rampant inflation to-date has been foreigners collecting those dollars and turning them back to the U.S. Treasury. The foreigners are stopping, now. The U.S. Treasury will have to pay ever higher rates to keep the Japanese and Chinese in the game. Those higher rates are going to kill the economy. We have a big recession coming up, whether the Fed raises short-term rates (which will more quickly move us to a big slow down), or not (in which case higher rates at the U.S. Treasury auctions will more slowly move us to a big slow down).

[powayseller]

jg, can you explain how fewer Treasuries purchased affects the dollar and the economy. Thanks for that very clear explanation. Also, where are you putting your money?

[HereWeGo]

Looks like investors were not thrilled with that 4.5% interest rate. Is it a regular occurence for the 30 year to sell at 91% of par?

Also, are there any sites that show the total amount of bonds offered at the auction, the total purchased, and the major purhasers?

[North County Jim]

Remember stagflation? That’s what’s next.

I couldn’t disagree more. It’s important to remember what drove the stagflation of the 1970’s. Hint: It wasn’t oil although oil certainly didn’t help. It was an upward spiral in wages and prices that took a major recession to correct.

Do you see any upward pressure on wages? I don’t.

Do you see inreased demand for credit? I don’t.

I expect in the aftermath of the housing bubble, credit demand will decline despite anything the Fed may do.

Where do you expect credit demand to come from?

[powayseller]

Stagflation – isnt’ that inflation plus recession? We have rising prices and a slowing economy: stagflation. Or am I using the word wrong?

Inflation is at 2.9%, but the Fed paused. Inflation will keep rising, because oil prices are rising. Wages are not, but commodities are rising. A recession is coming up too.

Does it matter if inflation is caused by rising wages or rising oil? Isn’t it inflation either way?

Credit demand is still rising, if we look at last week’s report. People are using credit to make up for flat wages in the face of rising inflation, and to pay for gas.

[Diego Mamani]

PS: High inflation is defined as a sustained increase in prices (wages included). One-time jumps in oil prices, for instance, don’t result in sustained price increases.

Stagflation in the 70s was a result of a desperate and failed attempt of improving the economy by printing money. Fortunately, the Fed today is light-years ahead of their predecessors back then.

The only way for inflation to be a problem in the next months is if the economy picks up, exerting pressure on limited resources (labor, capital). To the extent that the Fed saw minor symptoms of am economic slowdown, it decided to pause its (short-term) interest rate increases. That’s precisely the right thing do. Unnecessary monetary tightening would create a recession, which nobody wants.

[bubba99]

Remember that the fed has a special credit position. If the fed buys US govt debt itself, the loan is placed, the purchase goes into an account, and money supply increases by the amount of the purchase – the only loser is holders of US govt debt. This is the fed printing money to pay current account liabilities.

Of course the dollar slides against foreign currencies, but that is already happening. There is some room for the fed to postpone a recession by just printing money – covertly, but just printing it just the same.

[powayseller]

Recession is coming in Q1 07. Inflation is here, too. High oil prices are here to stay. Oil started rising 2 years ago; it has NOTHING to do with Israel. So yes, we have a sustained increase in prices, namely oil (and copper and other building supplies). Inflation is at 2.9% annual rate, yet the Fed paused. They are afraid of the recession, why else would they pause in the face of ever-rising oil prices and ever rising consumer spending? Consumer credit rose in June/July ? to the highest level. I don’t know if the Fed is light years ahead; they are better at fooling us, that’s for sure. They stopped publishing M3, so now we don’t know how much money they are printing.

The dollar keeps losing its value against other currencies. When we went to Germany in July 2001, 1 dollar was 1 euro. Today, you need $1.27 to buy one euro. That’s a loss of almost 30% in the value of the dollar against the euro. More losses are coming, if the hints by foreign central banks to diversify (and today’s disappointing Treasury auction) are any indication.

I think if we didn’t have China competing for all these resources, the prices of oil, copper, steel, concrete, lumber would be lower.

As long as inflation is above 2% while the economy is slowing, that is stagflation in my book.

Schahrzad Berkland

[PerryChase]

I believe that the Chinese (and others) have an interest lending us money so we can buy their stuff. America is still the engine of world economic growth. If the American consumers stop spending then China wouldn’t need to make all the consumers products to sell to us. China has an overcapacity as it is. If the US economy goes into recession, commodity prices will drop.

Bush should fire Condi Rice and give Henry Kissenger the job. He’ll make a pragmatic (rather than ideological) deal with Iran thus solving the Middle East problems in one swoop. That’ll bring stability back to oil prices. I was listening to Dr. Kissinger on Charlie Rose and it seems to me that if we could make a deal with Iran, we’d neutralize Hezbolah, Syria and the Shiites in Iraq all at once. If your can’t fight your ennemy, make him your friend.

So, if things work out, with low priced consumer goods and lower oil prices, we would withstand a recession quite well.

I still however think that we’ll have a housing crash regardless of the overall economy. As was mentioned before, assets prices have nothing to do with economic growth.

[bubba99]

The fed no longer reporting M3 is a big deal. This is/was the only real measure of “everything”. M2 excludes CD’s over $100k, and repos, eurodollar and other big institutional money instruments.

If the fed were just printing money, we could no longer tell.

[Anonymous]

Powayseller, the (1) Federal government runs a deficit on the order of $300B annually and (2) consumers increased their debt by $1.2T in ’05 (see http://www.federalreserve.gov/releases/Z1/Current/z1r-3.pdf). As Americans are no longer net savers as of late, we borrow that $1.5T from overseas folks. When overseas folks are slower to lend us money, we must pay higher interest rates to induce them to do so. Those higher interest rates result in fewer home purchases, fewer business investments, etc., slowing the economy.

As of 1 1/2 years ago, all of my money is in two buckets: (1) home downpayment in a U.S. Treasury money market fund (no U.S. government agency debt, as I think FNMA, GNMA et al. are in for tough times) and (2) all of my savings in the Vanguard Precious Metals Fund (closed to new investors, but U.S. Global Investors World Precious Minerals Fund looks like a highly attractive alternative). I think that the U.S. is heading for a major recession (depression — drop in GDP of 10% — is quite possible), and with that investors will move out of dollars and into gold. If you think gold is going to move up, the best place to be is in gold mining stocks: due to operating leverage (i.e., fixed costs), the increase in the value of their gold reserves multiplies their profitability (look at Barrick’s Q2 ’06 earnings release for evidence).

So, that’s my bet. Based on my analysis of the Federal Reserve Z-1s, I feel very comfortable that there’s a big debt overhang for Americans to pay, and my wager is that the Japanese, Chinese, Brits, et al. will move out of dollars in an orderly fashion, but out nonetheless.

Sure, the Japanese and Chinese would like us to keep buying their stuff, to keep their folks employed, but they also want their folks’ savings, now well invested in U.S. Treasuries, to be worth something come time for retirement. The Japanese and Chinese are losing confidence that the Fed will effectively prevent inflation, and are unwinding their U.S. Treasury positions. If you expect that the paper that you hold will be greatly reduced in value in 5 to 10 years, why hold onto it (kind of like sitting on an overvalued San Diego home, when you don’t have to!)?

[Diego Mamani]

You think inflation is high now?
You should look at these Historical Inflation Rates.

Inflation now is at 4% (core inflation is below 3%). Historically, such numbers are not high at all. We’ve had double-digit inflation in 1974 and again in 1979-81, with rates well over 5% in the intervening years. For stagflation we would need high inflation and slow growth. We may have the latter in the near future, perhaps, but we are really far from high inflation.

[Anonymous]

It takes time for inflation to come to the fore: I’ve plotted changes in CPI vs. growth in money supply (M2 and M3) and changes in CPI vs. household and Federal borrowing, and up until the 90s, increases in money and supply and borrowing resulted in inflation (sometimes massive, e.g., mid 70s, late 70s) 2-3 years later. Plot growth in M2/M3 over ’71-’75 and over ’77-’80; then plot changes in CPI three years later: nice tight fit, with CPI at 11-14%!

We’ve had similar growth in M2/M3 over the 90s, but no growth in CPI. Why? Have the laws of economics been suspended? Nah. Just plot net foreign purchases of U.S. Treasury notes and bonds: negligible, until ’95 and beyond. When those purchases stop, all heck is gonna break loose. We’ll see inflation of 11-14%, then, just like in the mid and late 70s.

[Anonymous]

HereWeGo, here are the links for the results of the Wed. auction for 30 year bonds:
http://www.publicdebt.treas.gov/of/releases/2006/ofn0810061.pdf
http://www.publicdebt.treas.gov/of/releases/2006/ofstats0810200601.pdf

Here’s the link to monthly net foreign purchases of U.S. Treasury securities (next update on 8/15):
http://www.treasury.gov/tic/tressect.txt

Here’s who holds our debt; Japan is number one, but steadily moving down:
http://www.treasury.gov/tic/mfh.txt

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