Submitted by Pater Tenebrarum of Acting Man blog,
Bernanke and the Financial Markets
It is amazing how big an effect a rambling, sleep-inducing speech by a chief central planner can have on financial markets in the short term. Ben Bernanke's Jackson Hole speech was of course widely expected to have such an effect, the main question was whether markets would be 'disappointed' or 'happy' with it.
In connection with the gold market we mentioned a week before the speech was delivered that one should be mentally prepared for disappointment if the gold price were to rise in the days leading up to the speech. However, precious metals prices actually corrected ahead of the speech, which lowered the chance of a disappointment somewhat. Gold is an especially useful indicator with regards to expectations about monetary policy, as it tends to be the market that reacts most forcefully when a fresh inflationary impetus presents itself. Moreover, it tends to lead other markets (a pertinent recent example is 2008-2009; gold bottomed several months before equities did, evidently in expectation of additional monetary stimulus).
Given that the speech was fairly long (this does not mean it contained anything new – in fact, it didn't. We have heard all of it before), it would take a human, even a speed-reader, some time to digest the relevant passages. These days there are computer algorithms that can analyze a speech very fast, looking for key terms and key phrases that are held to be important.
Apparently the algos initially tripped over Bernanke's longish list of the 'cost of non-traditional policies' and at first decided to sell. Then they advanced to the 'economic prospects' section and the conclusion of the speech and bought back. Still, it is important to realize that the content of the speech – in spite of what various Kremlinologists have concluded afterward – cannot possibly have been the 'reason' for any of the market moves observed last Friday. As noted above, absolutely nothing new was revealed.
Gold on Friday in the wake of Bernanke's Jackson Hole speech. Sell! No, buy! – click chart for better resolution.
Silver was similarly affected, but was subject to an even more pronounced price swing – click chart for better resolution.
We Can't Really Prove It, But We Did the Right Thing Anyway
Nonetheless, the speech contained a few interesting passages which show us both how Bernanke thinks and that people to some extent often tend to hear whatever they want to hear.
Bernanke noted that although he cannot prove it, econometricians employed by the Fed have constructed a plethora of models that show that 'LSAP's (large scale asset purchases, which is to say 'QE' or more colloquially, money printing) have helped the economy. In other words, although no-one actually knows what would have happened in the absence of the inflationary policy since we can't go back in time and try it out, the 'models' tell us it was the right thing to do.
Importantly, the effects of LSAPs do not appear to be confined to longer-term Treasury yields. Notably, LSAPs have been found to be associated with significant declines in the yields on both corporate bonds and MBS. The first purchase program, in particular, has been linked to substantial reductions in MBS yields and retail mortgage rates. LSAPs also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions.
“While there is substantial evidence that the Federal Reserve's asset purchases have lowered longer-term yields and eased broader financial conditions, obtaining precise estimates of the effects of these operations on the broader economy is inherently difficult, as the counterfactual – how the economy would have performed in the absence of the Federal Reserve's actions – cannot be directly observed.
If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy.
Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy.
For example, a study using the Board's FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.”
Of course such models are a prime example of 'garbage in, garbage out'. The Fed's own researchers can hardly be expected to provide proof that their bosses have not the foggiest idea what they are doing. Moreover, we need neither models nor 'counterfactual observations' to know that when a buyer with unlimited firepower shows up to buy securities, their prices will rise. So it is certainly true that the Fed can successfully manipulate interest rates for a while. Duh.
The question is really whether such a manipulation helps or hinders the economy. It is even believable that the 'level of output' has been higher in the short term than it would have been otherwise. This tells us absolutely nothing about the quality of said output and whether it has made us richer or poorer.
Falsifying Economic Calculation
Imagine Bernanke holding a similar speech in 2005 or 2006, looking back at the ultra-low interest rates the Fed imposed after the technology bubble had burst. He would have been equally correct to state that 'the level of output' was probably greater than it would have been otherwise.
In fact, he did perform a number of such back-patting speeches, beginning with his infamous 'The Great Moderation' speech in 2004. What all these premature victory laps omitted was the fact that 90% of said 'output gain' was a complete waste of scarce resources which were employed in various bubble activities. This inevitably resulted in a major economic bust once the bubble burst in the wake of a number of baby step rate hikes.
In fact, the last 'rescue' of the economy performed by the busybodies at the Fed almost led to a complete collapse of the financial system (that is of course not how the Fed's official history book has it; according to Bernanke it was the 'lack of regulation' in the most over-regulated sector of the economy that produced the bubble and subsequent crash. Manipulation of interest rates by the Fed can obviously only have 'good effects').
It should be clear to all but the most blinkered apologists of central planning that the long term effects of the post-2008 bust policies have yet to enter the scene. However, it appears already as though something is not quite going according to the interventionist playbook. After all we have thus far experienced what is widely held to be the 'weakest post WW2 recovery'.
As to the effect of the inflationary policy on stock prices, stocks are titles to capital they are no doubt among the primary 'beneficiaries' of inflation at present. The large increase in their prices should however be seen as a warning rather than a sign of success. This may be counterintuitive, but the reaction of stock prices to the inflationary policy is one of the manifestations of the fact that relative prices in the economy have been altered. In other words, Bernanke hails the fact that he has managed to create falsified price signals as a success of his policy – but that raises the question of how falsified prices can possibly produce an economic benefit.
The reality is that they invariably lead to a falsification of economic calculation. Economic calculation in turn is the main mental tool employed by entrepreneurs to estimate future conditions and arrange their production plans accordingly. We have just seen in the case of the housing bubble what a deleterious effect is has on the economy at large when economic calculation goes awry, resulting in large-scale capital misallocation.
Ben Bernanke: we can always print more…and maybe we will.
(Photo by Karen Bleier / AP)
Nothing Can Go Wrong
The portions of the speech that presumably led to the initial sell-off in precious metals as well as various 'risk assets' was probably the one in which Bernanke summed up the costs and benefits of 'non-traditional' monetary policies:
“In sum, both the benefits and costs of nontraditional monetary policies are uncertain; in all likelihood, they will also vary over time, depending on factors such as the state of the economy and financial markets and the extent of prior Federal Reserve asset purchases. Moreover, nontraditional policies have potential costs that may be less relevant for traditional policies. For these reasons, the hurdle for using nontraditional policies should be higher than for traditional policies.”
At this point, the sell buttons were probably pressed. This mention of the 'higher bar' for 'QE' and similar policies was however immediately followed by an assertion that shows the hubris of the planners - a hubris that is curiously quite persistent in spite of the evidence that their actions have set massive boom-bust cycles in motion:
“At the same time, the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant.”
Don't worry, it is all well in hand! We'll pull just the right levers when the time comes, no problem at all. Listening to this one almost gets the impression that the crash must have been part of the plan, since obviously nothing can possibly go wrong!
The S&P 500 in 2008-2009. Nothing bad ever happens? The central planners have everything under control? – click chart for better resolution.
Economic Outlook and Conclusion
Then Bernanke turned to the economic outlook, and it was likely this portion of the speech that emboldened the buyers. First he patted himself on the back for having avoided both deflation and inflation (for some reason he failed to mention that the true broad money supply has increased by over 80% since early 2008, which seems to us is a lot of inflation indeed), while obviously the economic data have improved from the nadir of the recession.
Again, we don't even want to contest the idea that the interventionist policy has produced a minor sugar high for the economy. Our point is that it is nothing but an inflationary illusion. Not an iota of wealth can possibly be created by increasing the money supply.
Then Bernanke noted that the recovery was not as good as has been hoped. Although he failed to supply an explanation for the phenomenon, this gloomy assessment was followed by an assertion that probably led all the Kremlinologists out there to conclude that more 'QE' is just around the corner:
“Some have taken the lack of progress as evidence that the financial crisis caused structural damage to the economy, rendering the current levels of unemployment impervious to additional monetary accommodation. The literature on this issue is extensive, and I cannot fully review it today.
However, following every previous U.S. recession since World War II, the unemployment rate has returned close to its pre-recession level, and, although the recent recession was unusually deep, I see little evidence of substantial structural change in recent years. Rather than attributing the slow recovery to longer-term structural factors, I see growth being held back currently by a number of headwinds.”
If the economy's sluggish performance is not due to 'longer term structural factors', then it presumably follows that the Fed has good reason to intervene further.
Then Bernanke listed the 'headwinds', which in his opinion consist of the unusually sluggish housing market (err…there was a bubble in housing, remember, Ben? You and your buddies created it), various fiscal problems ranging from the fact that budgets are tight at the local and state level to the so-called 'fiscal cliff' situation, and finally the debt crisis in Europe. It seem the Fed cannot do much about any of these problems, which could be seen as a sign that Bernanke expects other policymakers to pull their levers before he is intervening again. However, his conclusion suggested otherwise.
“Early in my tenure as a member of the Board of Governors, I gave a speech that considered options for monetary policy when the short-term policy interest rate is close to its effective lower bound.
I was reacting to common assertions at the time that monetary policymakers would be "out of ammunition" as the federal funds rate came closer to zero. I argued that, to the contrary, policy could still be effective near the lower bound.”
That was of course a reference to the famous 'Helicopter Speech' of 2002, in which he gave voice to his deflation-phobia ('Deflation: Making Sure It Doesn't Happen Here'). Reminding us of this speech is probably a pretty strong hint (readers should look at the list of the Fed's non-traditional 'tools' mentioned in that speech; it is enough to make one's head spin).
“Now, with several years of experience with nontraditional policies both in the United States and in other advanced economies, we know more about how such policies work.”
No, 'we' actually don't 'know' any such thing. It's only been four years and the negative effects will only become obvious in the long term – although we suspect that the sluggishness of the recovery is already a glaring effect of the policies enacted thus far. Not according to Bernanke:
“It seems clear, based on this experience, that such policies can be effective, and that, in their absence, the 2007-09 recession would have been deeper and the current recovery would have been slower than has actually occurred.”
The opposite is probably the case. It seems likely that the initial downturn would have been more pronounced, as the liquidation of malinvestments wouldn't have been arrested and reversed so quickly – but in all likelihood a much stronger recovery would have followed. As we have pointed out many times, the recession of 1920-1921 was the last time both the administration and the Fed adopted a 'laissez faire' stance in the face of a major economic bust. It was over so fast that no-one remembers it today, but the downturn was actually more severe than the initial downturn of the Great Depression. The current 'never-ending slow-motion depression' is typical for an economic bust that occurs after a series of credit expansions has depleted the pool of real funding and the economy has been subjected to major interventions designed to counter the bust. It is a method to avert short term pain to some extent, but it tends to condemn the economy to an endless malaise.
“As I have discussed today, it is also true that nontraditional policies are relatively more difficult to apply, at least given the present state of our knowledge. Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain, and the use of nontraditional policies involves costs beyond those generally associated with more-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally: Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes.”
Another admonishment to the rest of the policy-making universe to do something. Although it is not specified what that something might be, the previously mentioned 'fiscal cliff' was a hint that Bernanke thinks more deficit spending is called for. In the end though, Bernanke gave us the boilerplate assurance that the 'Fed is standing by to do more', i.e., it will try to inflate us back to prosperity:
“As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.
Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
Bernanke is right to be concerned about the suffering and waste entailed by the weak labor market, but he has only himself and his colleagues to blame. After all, their policies created the mess in the first place. It is bizarre that he concludes from this that they should do more of the same, but there it is.
The SPX on Thursday and Friday (5 minute chart) – quite a bit of short term volatility surrounded Bernanke's speech, but stocks ended the day in limbo – higher, but not by a lot – click chart for better resolution.
Jon Hilsenrath Chimes In
To briefly come back to what we wrote at the very beginning: nothing of what Bernanke said was actually new. It sure didn't sound to us like he actually promised 'imminent QE'. Rather, he concluded his speech with the same sentence that has been part of every FOMC statement since 2008: “The Federal Reserve will provide additional policy accommodation as needed.”
Here is the sentence that concluded the August FOMC statement:
“The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
This is the sentence that concluded the June FOMC statement:
“The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
You get the drift – it goes on like that, ad nauseam, if one tracks back through the statements to the beginning of the crisis. The only differences are minor points of inflection, but the substance is always the same.
In this sense we say that people simply heard what they wanted to hear. All Bernanke did was to confirm the preexisting 'easing bias', but it is not at all clear to us from his words that the current situation is sufficiently dire to surmount the 'higher bar' that according to Bernanke stands in the way of the implementation of 'non-traditional' policies. The stock market is close to a multi-year high, commodity prices have firmed and the US economy is officially still in expansion mode, even if the expansion is widely acknowledged to be weak.
However, there is Jon Hilsenrath, the Fed's favored media mouthpiece, who chimed in after the speech with the following:
“A defiant Ben Bernanke sought to shoot down criticism of the Federal Reserve's easy-money policies and strengthen the case for new efforts by the central bank to bring down what he described as gravely high unemployment.
Markets have been on edge for months about whether the Fed will launch another large bond-buying program. Fed Chairman Bernanke, speaking Friday at the central bank's annual retreat here, offered a vigorous defense of the Fed's $2.3 trillion in bond purchases since 2008, estimating they helped lead to more than two million jobs—and signaled that he is strongly considering another installment.
"A balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery" Mr. Bernanke said.
Mr. Bernanke acknowledged some of the hurdles he faces, noting, "It is true that nontraditional policies are relatively more difficulty to apply," he said.
But he left little doubt that he sees the benefits of trying. "Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation," he said, "and it is important to achieve further progress, particularly in the labor market."
This reminds us that a previous installment of Hilsenblather published just four days before the Jackson Hole speech weighed the 'costs and benefits of non-traditional monetary policy' in much the same way Bernanke did in his speech – and came to similar conclusions. Much of what Hilsenrath writes about the pros and cons as the various monetary bureaucrats see them can be deduced from their speeches and papers, but it is clear that he is the 'go to' man when they want to leak something. So when he interprets the speech as promising more money printing to come down the pike soon, one should probably take heed.
There is a considerable risk associated with going 'whole hog' when financial markets are already near their recent highs, as the concrete decision may still disappoint by dint of being seen as 'too timid'. In short, there could be a 'sell the news' event in store once the actual policy announcement comes. What would they then do for an encore?
As to the steps that might be adopted, James Bullard recently argued that the Fed may follow the example of Denmark's central bank and impose a negative interest rate penalty on excess reserves. This would be politically uncontroversial, but there could be a plethora of unintended consequences as the Fed's own researchers admit.
John Williams of the San Francisco Fed (who similarly to Eric Rosengren recently argued for 'QE without limit') wants to see 'at least $600 billion in asset purchases'. Contrary to his fellow über-doves Evans and Rosengren, Williams actually has a vote at the FOMC this year.
The ratio of durable goods manufacturing versus non-durable consumer goods production. This illustrates how during recessions, malinvested capital in the higher order goods production stages is liquidated, while production of non-durable consumer goods continues as before. The economy's production structure is temporarily shortened to restore a proper balance between consumer and capital goods production and allow the pool of real funding to recover.
As can be seen, the ratio has shifted upward and become considerably more volatile with the advent of the credit bubble and the massive expansion of the money supply it has fostered. At present yet another extreme has been reached, even faster than in the preceding bubble phases. It is a good bet that the production structure therefore ties up more consumer goods than it releases, an inherently unsustainable condition. Additional expansion of money and credit will only serve to exacerbate the imbalance – click chart for better resolution.