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April 21, 2005

The Fed Embraces Public Perception in Place of Sound Monetary Judgment to Set Policy
by Axel Merk

Last year, Paul O'Neill in his book on his days as U.S. Treasury Secretary wrote that he had the TV business channel CNBC running all day in his office. There is nothing wrong with a Treasury Secretary observing the news, but he is the one who should be setting the news, not following it every minute of the day. His successor does neither, which is not particularly encouraging, either.

In the meantime, the Federal Reserve Bank system has been working on greater "transparency" with the public; their goal has been to communicate more effectively what their intentions are. However, it has become apparent that good intentions do not necessarily lead to good results. An ever larger section of the the Fed's meetings (as apparent from the FOMC minutes) are devoted to what the Fed believes how the public will perceive their statements.

There are two implications: first, it signals an ever growing influence of governor Ben Bernanke, who mentions at every occasion possible that interest rate policy is best set with words, that the right signals at the right time is the most effective way to manage the entire yield curve. Traditionally, central banks mostly control short-term interest rates, whereas rates for debt with longer maturities is set by the markets; Bernanke believes the entire yield curve can and should be managed. For now, Bernanke will leave his post as Fed governor and become Bush's chief economic advisor; we still believe Bush will appoint him as successor to Greenspan, but even if not, it is clear that he will continue to be highly influential in both monetary and fiscal policy.

The other implication is that those in charge of preserving our monetary system are now guided by their perception of how the markets will perceive them. This is a recipe for disaster: it is no different from stock analysts recommending a stock merely because it is attractively priced "relative to its peers," not because of some intrinsic value or potential; it is also no different from real estate brokers claiming that housing prices wil never go down because they "always" rise in the long-term. This time around, the Fed and the administration have artificially kept the consumer afloat in the post dot-com era (U.S. consumer spending never declined after the tech bubble burst), and it may well be a falling dollar that will deflate this one. If the yield curve is put into a corset, some other valve has to give. When managing a fragile psychology is more important than fundamentals, we are in trouble.

Greenspan is scared because he knows inflation is building up, but he cannot aggressively raise rates without sending an overly leveraged, and thus interest-rate sensitive economy into a downward spiral. The latest FOMC minutes claim that recent inflationary warning signs are only temporary. Average salaries, which decreased in 2004 for the first time in a decade, may be tame as corporations continue to accelerate their outsourcing as a result of global imbalances. But inflation is creeping up everyhwere, no longer just in the cost of healthcare and education. The only reason to state inflation is at worst a short-term issue is if one wants to have an excuse not to raise rates aggressively; Greenspan needs that excuse to keep the consumer afloat.

In meantime, the strains of the global imbalances are becoming more apparent. General Motors and Ford, the ultimate consumer-sensitive companies, can no longer reach their sales targets, and credit agencies are downgrading the quality of their debt. On the trade front, disputes are escalating, ranging from the Boeing/Airbus subsidy dispute with Europe to the escalating textile dispute with China. While the U.S. wants to re-impose quotas on textile imports from China, China is requiring technology firms to conduct their research and development in China if they want to sell to the Chinese government. For now, the U.S. may be winning the textile battle, but losing the high tech war. Trade wars can cause unstable systems to collapse, just as the depression in the 1930s was exacerbated through trade disputes. Setting economic policy based on public perception can only worsen the situation, taking us away from sound monetary policy.

Axel Merk
Axel Merk is Manager of the Merk Hard Currency Fund

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks - with the ease of investing in a mutual fund.

The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Funds shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund's portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund's prospectus. Foreside Fund Services, LLC, distributor.

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