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Bernanke’s Bluff

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Financial markets around the world suffered a nervous fit on June 19th when Fed Chairman Ben Bernanke told the press that the US central bank may soon begin to reduce the amount of paper money it prints each month. The stock market fell, interest rates went up and speculators everywhere lost a considerable amount of money. That is exactly the outcome Bernanke had hoped for.

As I have written many times before, our economy is managed by the government rather than driven by market forces as it once was long ago. Bernanke’s goal was to check the recent stock market rally before it evolved into another potentially destabilizing bubble. He may have also sought to cool down the suddenly hot US housing market. To accomplish these goals he threatened to begin to “taper” the pace of Quantitative Easing (QE). I think this was just a bluff. I doubt if the Fed actually will begin to reduce the amount of money it prints each month – at least not this year. Let’s consider the circumstances and take a closer look at what the Fed chairman actually said.

The reality is that the US economy is very weak. During the first quarter, the GDP only grew at an annualized rate of 1.8%. The second quarter number is expected to come in even weaker. Income growth is necessary to fund consumer spending, which accounts for 70% of GDP. But during the first five months of this year, real disposable income has increased by only 0.8%. Consumer spending has continued to increase more than income, but only because consumers have eaten into their savings. That can’t continue indefinitely. The personal savings rate is only 3.2%, near an all time low. The Purchasing Managers’ Index (PMI) fell below 50 last month, which suggest that manufacturing activity in the US has begun to contract. The economy is so weak that imports into the US have begun to contract as well. And, as we have seen again and again, when the US buys less from other countries, the other countries buy less from the US – and from one another. Therefore, it should come as no surprise that US exports are also contracting and that the growth in global trade is slowing to a standstill. Making matters worse, deflation is once again becoming a threat. The PCE price index is up only 1% from one year ago and it seems set to move down closer toward negative territory over the next few months because of the recent sharp declines in commodity prices.

This is all bad news, none of which would give the Fed any reason to slow down its printing presses. If anything, this weak data suggests the Fed should print even more.

Managing the US economy is no easy task, however. The purpose of QE is to push up the value of stocks and property in order to create a “wealth effect” that allows consumers to spend more. This has been working. Unfortunately, it’s been working too well recently. The stock market rose 23% between November and May; and home prices are now 12% higher than a year ago. The Fed does not want to create massive new bubbles in stocks and property because it knows they would inevitably pop with destabilizing consequences for the economy and the financial system.

I estimate the Fed would like to see stocks rise by 10% to 15% a year and home prices increase by 5% to 10% a year. Those levels of appreciation would be sufficient to support consumption and economic growth, but would not be great enough to be unsustainable. The purpose of the Fed’s June 19th press conference was to bring the appreciation of stock and home prices back within the Fed’s ideal range without actually having to reduce the size of QE.

It really is very impressive how adept the Fed has become at manipulating market participants into doing what the Fed wants them to do, while leaving itself maximum room for maneuver as events unfold.

Bernanke began the press conference by saying that the Fed believes the downside risks to the economy have diminished. He said he and his colleagues expect the labor market and GDP growth to improve and that the rate of inflation will begin to move back up toward a more desirable level. And then he said if those expectations prove to be correct, the Fed would likely begin to taper the pace of QE later this year.

That was particularly clever because, realistically, it seems unlikely that those stated expectations will be met. So the Fed will be able to continue supporting the weak economy with the current pace of QE (i.e. $85 billion a month). However, by suggesting that it would begin to taper if those expectations were met, the Fed has succeeded in knocking the breath out of the stock market – and, quite possibly, out of the property market, too. In short, it was a very effective bluff.

It is uncertain how long the Fed will be able to continue successfully managing the US economy. There is a very real danger that this will all end very badly. For the time being, however, the key to investing successfully is to understand that the Fed is managing the economy and to anticipate correctly what the Fed will do next in order to achieve its goals. This is a very long way from the way things used to work. But, looking on the bright side, it should be easier to figure out what the Fed is going to do next than it was to correctly forecast what would happen next back when we had a capitalist economy driven solely by the forces of supply and demand.

Original publish date: July 01, 2013

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