Fed's Bizarre Tactics Target Weaker Dollar

By: Axel Merk | Tue, Oct 12, 2010
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Is the Federal Reserve (Fed) experiencing a midlife crisis? Ever since Fed Chairman Bernanke gave a speech in Jackson Hole, Fed behavior can be summarized as, well, bizarre. According to Bernanke, the market's inflation expectations may be too low. He considers three possible remedies:

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Here's the problem with quantitative easing: even many on the Fed's Open Market Committee (FOMC) doubt it will necessarily boost economic growth. What types of projects promoting economic activity will be initiated when extremely low interest rates are lowered further? One might argue that the problems faced by the economy is not that interest rates are too high, but that real estate prices have still not adjusted downward sufficiently. Instead of downsizing to homes mortgage holders can afford, consumers are subsidized to stay in their homes; there's no difference between subsidizing an ailing industry or an ailing consumer: subsidies are expensive and cause a drag on economic activity. However, given that the "downsizing" implies foreclosures and bankruptcies, it's political suicide to promote what may be most prudent for the economy as a whole.

Aside from having little effectiveness, quantitative easing also brings about substantial risks. For one, should the Fed indeed buy $100 billion in government bonds each month as is rumored, the Fed would be implicitly financing new issuance of government debt by printing money ("monetizing the debt"). For those not aware, when the Fed buys $100 billion in government bonds, it literally creates money out of thin air. All that is necessary to buy the bonds is an accounting entry on the Federal Reserve's books: a credit of U.S. dollars that the institution that sold the bonds now has a claim on. This "claim" may be exchanged for other goods and services where U.S. dollars are accepted; at the Fed, however, the "claim" may only be exchanged for a piece of paper confirming the claim.


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A major challenge with the Fed buying bonds is that the bond market is so enormous that the Fed is just one of many participants. $100 billion a month in purchases may not move the markets as desired, should market forces disagree with the Fed. This is why Bernanke has stated his second "remedy": communication. In our assessment, the cheapest Fed policy is one where a Fed official utters a few words and the markets move. The trouble is that since the onset of the financial crisis, with the Fed has had to employ much more than simple words: rates cuts were followed with emergency rate cuts in early 2008; these were followed with credit easing, then a mortgage backed security (MBS) purchase program in excess of $1 trillion; not to be outdone, the Fed is signaling that quantitative easing is to follow. Still, the Fed appears to be working hard to prepare the market through a blizzard of speeches by Fed officials. After all, if interest rates move based on a few well-timed speeches, a couple hundred billion dollars may not need to be printed; or so the thinking seems to be.

There's also another avenue; positioned as a joke, it is all but funny: in his Jackson Hole speech, Bernanke suggested that in an environment where inflation expectations are too low, should the public reduce its confidence in the Fed, the resulting increase in inflation expectations could become a "benefit". Since those comments, we have had a number of Fed officials make the case for quantitative easing. In the past, Fed policy was conducted at FOMC meetings; in the current environment, every avenue appears convenient to tell the public the market better price in higher inflation expectations. A secondary goal of such a communication frenzy may be to steamroll over dissenting voices at the Fed (see also our analysis Fed Crossing the Line?).

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In our view, the Fed knows quantitative easing may not be all that effective. We happen to think that the risks of quantitative easing outweigh the benefits, but we don't think the Fed necessarily thinks the benefits are all that great. The challenges we are facing must be addressed by politics, not monetary policy. Homeowners must be allowed to downsize; we must have a tax and spending policy that is sustainable and encourages investment. Sprinkling money on the problems only encourages that the can is kicked down the road, making the problems all the more difficult to solve.

If the Fed believes quantitative easing may not be the silver bullet, why may it be pursued anyway? To just try printing another $1 trillion, hit blindly and hope that it stimulates something? Worry about the inflationary fallout later? No. In our analysis, Bernanke may have a different agenda: to intentionally weaken the U.S. dollar. When the Fed prints dollars to buy government bonds, two things happen:

Bernanke, unlike his predecessors, seeks the currency discussion. There are two dimensions he openly talks about:

If you combine those statements with the Fed's activities, it appears clear to us that Bernanke may not only be interested in a weaker U.S. dollar, but that he is actively working on engineering one. Unfortunately, we believe the benefits may prove elusive, while the risks are enormous:

Because we believe Bernanke considers the U.S. dollar a monetary policy tool, we have also been far more optimistic on the euro than many others. Conventional wisdom has many believe that economic growth is the key to a strong currency; however, our analysis shows that this mostly applies to countries with current account deficits, such as the U.S. In the U.S., foreigners are more inclined to invest when there are prospects for economic growth, and thus help to finance the current account deficit. Conversely, a country that finances its deficits domestically does not necessarily need economic growth to have a strong currency. Japan is a good example of this. Similarly, the eurozone does not have a significant current account deficit. The eurozone may have disappointing economic growth on the backdrop of a strong currency, simply because the European Central Bank (ECB) shows more restraint, printing less money than the Fed; on the fiscal side, austerity measures may also lead to a strong currency in the absence of a significant current account deficit.

Please join us on Wednesday, October 20, 2010, in a webinar to discuss U.S. dollar implications of policies pursued in more detail (click here to register). We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.

 


 

Axel Merk

Author: Axel Merk

Axel Merk
President and CIO of Merk Investments, Manager of the Merk Funds,
www.merkfunds.com

Axel Merk

Axel Merk wrote the book on Sustainable Wealth; peek inside or order your copy today.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

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