Global Central Bankers at Odds, but Gold Soars into Orbit
Global stock markets were gripped by extreme fear and panic on the morning of January 21st, with Asian markets under relentless selling pressure, then ricocheting to Europe and Latin America. Japan's Nikkei-225 melted down 18% and six trillion yuan ($830 billion) of market value on the Shanghai and Shenzhen stock exchanges was wiped out in the first three weeks of January, the worst correction in a decade.
Stunning losses in Asia spread to European bourses. Germany's DAX tumbled 7.2%, the French CAC-40 plunged 6.8% and Britain's Footsie-100 lost 5.5%, their biggest one-day slides since the Sept 2001 terror attacks, wiping out more than $350 billion of market value. The Dow Jones Industrial (DJI) futures market plunged 550-points in electronic trading, extending a vicious slide to the brink of a bear market, and conjuring up memories of "Black Monday", the crash of 1987.
Recessions in the US economy usually arrive about once every six years. Since the last recession ended in 2002, a downturn in the world's largest economy is probably due in 2008. Until now, the big threat to US household spending was focused on the slumping housing market, but history suggests consumers can withstand one serious blow to their wealth. But a double-barreled assault can be disastrous, so if the stock market keeps sliding, it would probably tip the economy into recession.
The US Treasury's "Plunge Protection Team" (PPT) operates in all three major trading zones - Asia, Europe, and America, always trying to jig the stock market higher, and working behind the scenes to prevent the emergence of a bear market. The key weapons in the PPT's arsenal include brainwashing thru the media, fudging the US inflation data, Fed rate cuts, massive Fed money injections, tax rebates, pork barrel spending, and intervention in the stock index futures markets.
Typically, the stock market trades with a six-month time horizon. But unrelenting intervention in the futures markets engineered by the PPT, coupled with big Fed money injections, and the endless flow of cheap capital from Tokyo, via the "yen carry" trade, enabled the Dow Jones Industrials (DJI) to float near record highs last quarter, even though the US economy was already slipping into recession.
When the DJI-30 tumbled towards its August lows on Jan 10th, Fed chief Ben "B-52" Bernanke wasted no time in telegraphing a hefty rate cut, trying to "jawbone" the stock market higher and prevent a slide below key chart support. "In light of recent changes in the outlook for and the risks to growth, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks," Bernanke declared.
However, with US stock markets off to their worst start in history this year, the illusion that PPT intervention can endlessly provide a "safety net" under the market has evaporated. After the Dow Jones Industrials plunged 550-points in electronic trading on January 21st, the rookies at the Fed panicked, and sliced 75-basis points off the fed funds rate to 3.50%, the largest single rate cut in 23-years.
The Fed's emergency rate cut to 3.50%, bolstered suspicions that Bernanke is following the blueprints of former Fed chief "Easy" Al Greenspan, pursuing a radical policy of "Asset Targeting", or adjusting interest rates in the same direction of home prices and the stock market. But so far, the Fed's 175 basis points of monetary morphine, (the "Bernanke Put") haven't eased the pain in the stock market. Instead, they have been as effective as "pushing on a piece of string".
Greenspan Lays out Blueprint for "Asset Targeting
In his last speech before the world's central bankers in Jackson Hole, Wyoming on August 28, 2005, "Easy" Al Greenspan said dealing with the end of the US housing boom would be the most immediate challenge for his successor. "The housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home-price increases will slow and prices could even decrease. Consumer spending will weaken as homeowners slow the pace at which they use home-equity loans to finance expenditure," Greenspan predicted.
Thus, "Fed policy will be increasingly driven by the configuration of asset prices, which are already an integral part of our evaluation of the large array of forces that influence financial stability and economic growth. But given our current state of knowledge, I find it difficult to envision central banks successfully targeting asset-price changes, such as rises or declines in prices of stocks and houses," he said.
The Fed focuses on so-called wealth effects, or how changes in stock and housing markets may impact business and consumer spending. On Jan 11, 2006 New York Fed chief Timothy Geithner laid out the central bank's strategy. "Once asset prices have changed, the Fed should respond. When policy makers have already witnessed a significant move in asset values, and are confident in what that move means for output and inflation, it should be prepared to adjust policy accordingly," he said.
"The behavior of asset prices will play an important role in the formulation of monetary policy going forward, perhaps more important than in the past," Geithner said. Robert Shiller, a Yale University economist, and co-founder of the CME's house-price index, predicted on Dec 31st, a possibility that the US economy would stumble into a Japanese-style recession, with house prices declining for years.
"American real estate values have already lost around $1 trillion. That could easily increase threefold over the next few years. This is a much bigger issue than sub-prime. We are talking trillions of dollars' worth of losses," he predicted. Chicago futures markets are pricing in further declines in US home prices, of up to 16 percent. In the third quarter of 2007, US homeowners withdrew $20 billion less in equity from their homes than in the prior quarter, and since housing prices have continued to tumble, and the outlook for cash-outs has continued to dim.
Déjà vu, Bernanke Exercises the "Greenspan Put"
"Easy" Al Greenspan had one formula for rescue operations during times of financial distress. From the stock market crash of 1987, to the S&L crisis of the early 1990's, to the Asian crisis and the collapse of LTCM, to the feared Y2k crisis, to the bursting of the tech stock bubble, Greenspan responded with massive doses of monetary morphine to bailout over-zealous speculators in the stock market.
However, the exercise of the "Greenspan Put" ultimately failed to turn the bearish tide in the S&P 500 Index in 2001-02, which lost half of its value from its peak in March 2000. Markets do not travel in straight lines, and the 2-year bear market was interrupted by several bargain hunting rallies, linked to Fed rate cuts, but the rallies eventually fizzled out before the market plunged to new lows.
But the outgrowth of the "Greenspan Put" was to stimulate bubbles in other markets, such as the housing bubble of 2001-05, engineered by suppressing interest rates at 1%, and providing the liquidity needed to create the housing and debt bubbles, and also by reducing investors' fear of losses after the bubble bursts, by creating the expectations that the Fed will always bail them out
The Fed's rate cut to 1% ignited the beginning of another bubble in US home prices in 2001, which eventually climbed by 54% to an average $219,000 in June 2005. Greenspan fueled higher home prices to pull the US economy out of a mild recession, a tactic developed by the Bank of England. Greenspan also ignited the "Commodity Super Cycle," which Bernanke then guided to all-time highs this month.
The housing market became the main driver of the US economy, accounting for half of overall growth and payroll jobs created from 2001 until 2005. Home price appreciation added $5.2 trillion to Americans' balance sheets during the bubble years, or 68% of all wealth creation. However, now that US home prices are projected to fall by double-digits in 2008, the Fed is exercising the "Bernanke Put."
Greenspan was able to pursue his high-octane policy of slashing interest rates to 1% to rescue the stock market, because global inflationary pressures were largely subdued. The gold market was dead in the water, languishing under $300 /oz. The Bank of England was dumping half of its gold reserves at an average price of $276 /oz, and central banks from Switzerland, Argentina, and Australia were selling their gold reserves and buying foreign government bonds.
Six years ago, crude oil prices had sunk to as low as $18 /barrel, on fears the stock market crash in Sept 2001 would usher in a major slowdown in the global economy. But conditions in the crude oil market have changed dramatically from six years ago, hitting $100 /barrel earlier this month. China is now importing half its crude oil consumption, and should log a 12% increase, or 400,000 bpd, in imports for 2008.
Today, gold is trading at $925 /oz, and US consumer prices were 4.1% higher last year, the largest annual rise since 1990, and producer prices were 6.3% higher, just below a 34-year high. The Fed has gone insane, slashing interest rates at a time when inflationary pressures are dangerously high, playing Russian roulette with the greenback, and guiding the US economy into the "Stagflation" trap.
On Oct 2, 2007, "Easy" Al Greenspan, the godfather of the $1.8 trillion sub-prime debt bubble, warned, "We're beginning to see the extraordinary period of disinflation and economic growth coming to a halt. We now have to be very sensitive to the fact that inflationary pressures could well get out of hand," he said. But in trying to clean up the mess that Greenspan left behind, the Fed is exercising the "Bernanke Put."
On Jan 15th, Saudi oil chief Ali al-Naimi said the Fed's cheap dollar policy is adding $20-$30 to the price of oil. "$20-30 is the outside influence on the price of oil. If you look at who is in the market, you'll find a lot of financial institutions, players who are speculating, using the market as a hedge," Naimi said. Soybean prices have tripled from six years ago, largely due to the bio-diesel connection and weak US dollar.
Gold is a reliable harbinger of inflation and is setting all-time highs, as the Fed pushes interest rates far below the inflation rate. The dollar is hovering at a record low against the Euro and a basket of foreign currencies. Flooding the market with more dollars will drive up the price of foreign imports. The Fed wants to inflate the stock market, but the money injections drive up food and energy costs.
Last week, Stephen Roach, the head of Morgan Stanley Asia observed, "Policy-makers are reaching back to the same play book that created this mess in the first place. They're saying we are there to clean up after bubbles burst, rather than to prevent them. It's a dangerous, reckless and irresponsible way to run the world's largest economy. We have a market-friendly Fed injecting a lot of liquidity in the system which will set us up for another bubble economy. Excessive monetary accommodation just takes us from bubble to bubble to bubble," he explained.
ECB Shifts from Policy of "Asset Targeting"
Hopes that the Fed's emergency rate cut to 3.50% would be followed by a easier European Central Bank policy, were dashed last week, when ECB chief Jean "Tricky" Trichet said he would not cut Euro zone interest rates in line with the meltdown in European stock markets. For many years, the ECB had been targeting its repo rate in line with the direction of European stock markets, while allowing the Euro to climb higher against the US dollar to help contain the cost of raw materials.
After the benchmark German DAX Index plunged by roughly 15% last week, in reaction to meltdowns in Asia and Wall Street, European stock market speculators were hoping for the instant exercise of the "Trichet Put", to bail them out of a tough situation. Instead, "Tricky" Trichet signaled a hard-line stance, in sharp contrast to the rookies at the Bernanke Fed, saying he is focused on fighting inflation, even in the face of a big stock market meltdown.
"In demanding times of significant market correction and turbulences, it is the responsibility of the ECB to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets. At this stage I think we have to look at what's happening in the real economy, we have a base scenario and at this stage I'm not going to modify this base scenario," Trichet said.
"There is one needle in our compass and it is price stability. There is no contradiction between price stability and financial stability. The market correction, which the ECB and other central banks had warned over a year go, was now taking place and it is significant. But under the capital market system it was natural for risks to emerge and central banks" main job was to solidly anchor inflation expectations."
"What is extremely important is to offer a steady hand as possible. First, price stability and then solidly anchor inflation expectations. If risks did not materialize you would not be living in a market economy, you would be living in the Soviet Union," Trichet explained on Jan 24th. He was backed up by the Bundesbank's Juergen Stark on Jan 22nd, "Our main worry is the high inflation rate of 3.1% in the Euro zone. Volatility on global stock markets is not helpful, but recent developments are an overreaction and their importance should not be exaggerated," he said.
On Jan 28th, Austrian Chancellor Alfred Gusenbauer said what was right for the US was not necessarily right for Europe. "You can't just go and say, we'll do the same thing as the Fed. Despite the pressure, we shouldn't cut interest rates and we ought to get towards an inflation rate of around 2% in the Euro zone," he said.
We're witnessing the reincarnation of the old "Tricky" Trichet, harkening back to a speech he gave on April 23, 2002 to the Federal Reserve Bank of Chicago and the World Bank. Then, Bank of France chief Trichet warned that central bankers must be cautious in considering volatile asset prices such as the stock market and housing prices when setting monetary policy.
"My feeling is that we should remain extremely cautious about it, because it would be like opening Pandora's Box if we started setting our key policy rates according to asset price changes. Not only could the large swings, misalignments or even bubbles of assets prices endanger price stability, which is the main objective of most central banks, but also they could impinge upon financial stability," he warned.
Bank of England takes Middle of the Road Approach,
The Bank of England is a disciple of "Asset Targeting," and nowadays, British interest rates are largely moved by the direction of UK home prices. On Nov 23rd, the BoE's Rachel Lomax indicated the central bank faces a tricky balancing act. "While current stock market woes could hit British property prices, there are always risks in easing policy at a time of rising energy prices."
"This is all the more so after a year when inflation measures remains uncomfortably high. On the other hand, we need to be very alert to the risk that the economy may be slowing too abruptly. At current interest rate levels monetary policy may be on the restrictive side," Lomax said. Two weeks later, the BOE lowered its base rate a quarter-point, to 5.50%, the first rate cut in over 2-years to shore-up the UK housing market in the face of a global credit crunch.
On Jan 23rd, the BOE hinted at another quarter-point rate cut to 5.25% in February to safeguard home prices, but aggressive cuts of the kind initiated by the rookies at the Bernanke Fed are not on the cards. BoE chief Mervyn King said Britain's economy faced its most challenging year in a decade, but suggested that rapid-fire interest rate cuts were not the answer to financial market woes.
Most BoE members are worried that rapid-fire rate cuts would send the wrong message and fuel expectations of higher inflation in the future. Sterling's recent slide below $2.00 is also exacerbating price pressures. "Movements in the yield curve and the depreciation of sterling had already provided some further monetary easing," the 8-1 majority of the committee argued.
Interestingly enough, BoE chief King issued two warnings of an impending global stock market crash in November and in December, mostly ignored by over zealous stock market operators, until a panic sell-off hit in January. "The re-pricing of risk we have talked about for some considerable time hasn't really fed through to markets such as equity markets, and if there were to be an adjustment of risk premiums in equity markets, with a fall in asset prices, then that could have a bigger impact on the world economy," King warned on Nov 14th.
"It's very striking that despite developments we've seen in the last three months, equity prices are on average higher now than they were in August. This is true around the world and in emerging markets, they're 20% higher. There must be some downside risks there," King told reporters at a news conference.
On Dec 18, Mr King warned of more bad news to come for the financial sector, "The problems in the financial sector remain with us. A painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets. Banks' reluctance to lend will lead to a sharper slowdown in the United States. That concern is a serious one because it does hold out the prospect that there will be a self-reinforcing downturn in credit and activity," King told the UK's parliament's Treasury Select Committee.
Ironically, BoE rate cuts weakened the British pound against the Japanese yen, and triggered the unwinding of "yen carry" trades. The BoE's massive injections of monetary steroids into the UK banking system also destroyed the purchasing power of the British pound by 35%, when measured in gold terms. It's a signal that BoE rate cuts will lead to faster money supply growth and higher inflation.
Yet on Jan 28th, the BoE's radical inflationist, David Blanchflower said in an interview with the Guardian newspaper, that the current level of UK interest rates at 5.50% was too restrictive. "Worrying about inflation at this time seems like fiddling when Rome burns. There are risks to the upside to inflation, but the greater risks are to activity on the downside. Evidence from the housing market and especially the commercial property market is worrying," he said.
However, BoE hawk Andrew Sentance warned that market expectations of several more rate cuts were ignoring rising price pressures. BoE chief Mervyn King pointed to a balanced approach between slowing growth and rising inflation. "Although central banks can and will respond to the consequences of strains in the banking system, the solution to the underlying problem does not rest with them, but with the banks and financial markets themselves," King said on Jan 23rd.
Bursting of Shanghai Red-chip Bubble?
While the Bernanke Fed is slashing interest rates at a frantic pace, and the ECB holds a steady hand, the Chinese central bank is moving in the opposite direction, and tightening liquidity in the Shanghai money markets. On Monday, the mighty Shanghai red-chip index plunged 7.2% to 4,435, its fourth biggest drop this decade, that left it 28% below its record intra-day high, hit in October.
China's central bank has poured cold water on the idea that the country's juggernaut economy can decouple from the United States. "China's exports will be badly hit if US consumption weakens," said Zhang Tao, of the People's Bank of China. "If US consumption really comes down, that's bad news for us. That will have a pretty severe impact on our exports," Zhang warned.
On Jan 4th, China's central bank vowed to further tighten monetary policy in 2008, aiming to prevent inflation from spreading across the broader economy. With food accounting for a third of China's consumer price basket, the 18% surge in Chinese food prices last year is a ticking time bomb, where fuel price increases touch off violent protests. If the inflation problem gets out of hand, it could have devastating implications for the economy, and China's political stability.
The Bernanke Fed's embrace of "Asset Targeting," and its complete disregard for the inflationary consequences of its actions, has caught the attention of major players overseas. On Dec 27th, Hu Xiaolian, director of China's Foreign Exchange warned, "If the US federal funds rate continues to fall, this will certainly have a harmful effect on the US dollar exchange rate and the international currency system," Hu wrote.
Bernanke is risking a disastrous replay of the 1970's, when high oil prices fueled double-digit inflation. Every time the Fed lowered rates to boost job growth, inflation took off, causing a vicious price spiral. The Fed let the disease rage for so long that it took a strict monetarist approach by Paul Volcker in the early 1980's to finally defeat inflation. The price was a deep recession, with unemployment hitting 11% in 1982.
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