The Omnipotent Fed: If I Ever Lose My Faith in You
The following is an excerpt of our June newsletter. The entire newsletter is offered at no cost to those who subscribe through our website.
by Doug Wakefield and Ben Hill
The sharp declines in various markets over the last several weeks have been attributed to investors' reactions to the Fed's concerns about inflation. Headlines such as "The Bernanke Panic", "Fed's Bernanke Faces Tough Choice", and "Bernanke's Inflation Message Deflates Wall Street", combined with the markets' reactions, shown below, suggests that inflation is a very real concern.
In the last few years, all of these markets have trended up together. In the last few weeks, they have all turned down together. As diligent investors, knowing that the markets always forecast the future, we must ask ourselves, "What is the market telling us now? Is this just a reprieve before the trend continues or has something changed?"
We suggest that something has, indeed, changed. Normally disparate markets have floated higher on a sea of liquidity. Recently, they have all turned lower. Could this be signaling a contraction in credit?
Our public discussion of the inflation-deflation debate began with our May 2004 newsletter, in which we offered two definitions, which bear repeating. Webster's defines inflation as "an increase in the volume of money and credit relative to available goods and services resulting in a continuing rise in the general price level," and Webster's defines deflation as "a contraction in the volume of available money or credit that results in a general decline in prices." Clearly, since we first wrote on this issue, the increase in the volume of credit has manifested itself in inflating asset prices the world over.
I have long found Robert Prechter's "all the same markets" hypothesis interesting. His line of reasoning, which he explains below, is not without merit.
"In 2004, Pete Kendall and I wrote an article for Barron's in which we argued that all investment markets had begun moving together, not contra-cyclically as they had in the past. We theorized that late in the credit and economic cycle, liquidity is the motor of all investment markets. We showed a graph of the major markets, including stocks, junk bonds and precious metals, and called them 'all the same market.' The flip side of markets going up together is that when the reversal comes they all go down together." ¹
So, the basic idea is that when an inordinate amount of credit is introduced to the system, it floods into normally divergent markets and forces all of them up together. For example, stocks and commodities do not usually trend together, yet they have been lately. Is it possible that cheap labor in the global marketplace, causing consumer prices to stay relatively low, would create an ideal environment for a rapid expansion of credit that would drive the vast majority of markets higher?"
Since we have so obviously been experiencing an inflationary environment over the last few years, and since we have seen rampant credit creation drive our markets up for the last couple decades, many assume the deflation argument lacks credibility. Let's talk through this. The foundation of contrarian investing is that the majority is usually wrong, and as such, contrarians endeavor to think opposite of the crowd. Now, if the vast majority of all bulls and bears think that varying degrees of inflation is the core problem, and if the majority of all bull and bear arguments are built upon the presupposition that the Fed's actions will dictate the ultimate outcome of various markets and economies, then, as contrarian, we feel compelled to explore the validity of these assumptions.
For the remainder of this piece, we will investigate why so many assume that the Fed has unfettered power to expand credit, and whether or not the Fed does have such power.
The Great and Powerful Oz
"Do not arouse the wrath of the great and powerful Oz...Pay no attention to that man behind the curtain."
The financial culture is obsessed with Fed watching - whether or not the Fed used the word "measured" in its most recent communiqué. To make this point, I decided to go to a search engine and type in "Bernanke comments" and see what havoc he has been creating lately. We read, "Bernanke comments send markets tumbling", "US stocks soar after Bernanke comments, banks rise", "Bernanke comments boost yuan", "Dollar Continues to Ride Off Of Bernanke Comments", "Bernanke comments Sink Tokyo Stocks", and "Bernanke comments may have triggered some short covering." And, as if that's not enough, we now have to look for the hidden messages in what the Fed didn't say. For example, Jim Paulsen, chief investment strategist with Wells Capital Management in Minneapolis, Minnesota remarked, "The reason it's (the market) up isn't so much that (Bernanke) said anything; it's what he didn't say."
Yet, when we understand the true predicament of the Fed, we realize that a more appropriate comparison would be the man behind the curtain in the Wizard of Oz or the cartoon version of the Dutch boy and the dike. You know - the one where new holes keep spouting water and the dike wall begins to crack while Daffy Duck looks like he's playing twister in an attempt to keep it all together until the inevitable happens.
Many will say, "But the Fed has steered our economy through high winds and heavy seas since 1913. How is it that you can even suggest that it has now powerless to help us at this time?" Obviously, I have some explaining to do.
Our hypothesis is that the Fed is perceived to possess power that it does not have because many attribute, a priori, our standard of living and wealth to the Fed's actions when, in fact, this has been the effect of changes in our monetary standards. We have all heard that Mark Twain once said, "History does not repeat itself, but it rhymes." I have always preferred one of his lesser known quips, "Truth is our most valuable commodity, so let us economize."
In this brief synopsis of our nation's monetary history, we are likely to realize the truth in both of Twain's statements. Even today, the Great Depression is one of the most poorly understood periods in our nation's monetary history. After the rampant credit creation of the 1920s, our nation fell into its Great Depression. England reneged on its gold exchange standard in 1931, leaving America as the sole industrialized nation to retain any form of a gold standard. Whether we look at Roosevelt's work programs or the mobilization of our nation to World War II, when the US came off of the gold standard, in 1932, this allowed our nation to inflate even more, and that is how we came out of the Great Depression.
Since the Federal Reserve is clearly the most revered voice in the US financial system, let me start our discussion of this era by quoting from our most recently retired, "Wizard." With countless articles and books written about him, there is no doubt that the US and perhaps the world sees Alan Greenspan as one of the leading authorities on money. In his 1966 comments on the Great Depression, this is what Greenspan had to say.
"When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates. The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market - triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's." ²
Undoubtedly, most of us have heard a story that more closely follows what we are about to hear from Dr. Harvey Rosenblum. At a luncheon in 2004, I asked him, "What lessons has the Federal Reserve learned from the Great Depression?" As Head of Research for the Dallas Federal Reserve Bank, Dr. Rosenblum replied:
"As we know today, the Federal Reserve did not step in and expand the money supply when it was most needed. But remember, we can't be too hard on them because they didn't have the benefit of Keynes' General Theory at that time."
So who is right, Greenspan or Rosenblum? Was the Great Depression a result of the Fed expanding credit too rapidly, triggering a speculative boom that eventually went bust, or was the Great Depression a result of the Fed not giving enough credit to the markets and the economy when the bust set in? Was the Great Depression caused by events set in motion many years prior to the Crash of '29 or was it caused by events just before the market topped? A closer look at the historical record will help us answer these questions.
To read the entire June Newsletter, you can sign up, at no cost, through our website. If you would like a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds, visit our website. This will also give you access to archives of the same monthly newsletter titled, The Investors Mind: Anticipating Trends through the Lens of History.
The Elliot Wave Theorist, June 16, 2006, Robert Prechter, page 1