Ahead of Jackson Hole

The entire economic and financial world is sitting on its hands ahead of Ben Bernankes Jackson Hole speech later this morning. The main reason is that at the event last year, he hinted that the Federal Reserve would do more in order to provide monetary stimulus to the economy. This ended up taking the form of QE2, a program in which $600 billion was introduced into the banking system in order to buy Treasury securities. It took a few days for markets to digest what he said at that meeting, but after Labor Day, the S&P 500 saw a 30% rally that essentially lasted the duration of QE2.

QE2 ended earlier this spring, and like last spring when QE1 ended, the economic fundamentals began to deteriorate. Growth slowed, retail spending slowed, housing slowed, unemployment remained stubborn. The S&P sold off and the bottom threatened to fall out. Then Bernanke showed up with more money, and the markets rejoiced. In truth, there are not many market observers who are expecting an explicit QE3 announcement this morning – after all last time he only announced measures that were at his disposal. It is possible that something similar happens today. So I’m in agreement with most that an explicit QE3 program will not be announced. However, some form of continued QE will happen at some point.

Ben Bernanke has been steadfast about doing any and everything to prevent prices falling. He is not going to sit idly by while it happens. He is a (failing) student of the great depression. His academic work suggests that he has a number of tools to use should the Deflation Monster make an appearance.  Prices almost certainly will drop without any more money printing, which is what QE boils down to, because the economic fundamentals suggest that is what will happen. Unemployment is getting worse, home prices are falling, manufacturing is slowing, GDP is flirting with negative territory, confidence and spending is down. Yet, precisely because the Fed has undertaken QE policies, prices haven’t fallen, with an official inflation rate of 3.6% year over year.

That fact is perhaps the major reason why new QE measures will not be announced today, and more likely language to the effect of ‘should things deteriorate further and the overall price level drop we can do X.’  Regardless of what is said, the last FOMC Statement on August 9 confirmed that the Fed is going to remain easy for at least 2 years.

The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

So for at least 2 years, the Fed Funds rate is going to be 0-0.25%, and for at least 2 more years the Fed will be potentially involved in buying more securities when it feels the need to do so. In other words, in order to keep rates at these historic lows, it will have to keep buying securities. The only thing that has not been announced is the type of security they will focus on.

In any event, any action the Fed takes to depress rates and to expand the money supply will done one thing – spur inflation. The economic outlook then will be a temporary boost to the data points and prices, temporary because all stimulus measures are temporary. They do not address the underlying problem in the economy, so once such stimulus wares off, the economy slowly regresses to its pre-stimulus state, with the difference being that prices are higher than they were pre-stimulus.

What Bernanke and so many others fail to understand is that the price level is the problem in that it is too high. The economy has been trying to delever itself and contract since 2008. This has been a necessary and correct reaction to the bursting of the housing bubble, and the result is lower prices. These lower prices, and higher interest rates would decimate the banking sector, which depended on housing prices rising in perpetuity. In fact, the economy as a whole relied on houses rising in perpetuity, given that roughly 70% of US GDP comes from consumer spending, which in turn came from debt, which in turn came from home equity that rose as a consequence of rising house prices.  That structure can not be revived, as it is based on an unsustainable bubble. The policies that have been undertaken since (including QE) have been initiated in order to mitigate the effects of the fallout. This is bad policy, because we are preventing the restructuring that must take place in order for true recovery to occur.

By adding more money into the economy, prices are prevented from falling. All this is doing is lifting the prices of assets, such as stocks and commodities. This is presenting an illusion of growth. What is really taking place is the squeezing of average income individuals. As commodity prices rise, so do costs of doing business. This means that business will have to raise end consumer prices in order to maintain a profit. If they can not raise end consumer prices, they will look to offset increased costs by decreasing other ‘internal’ costs, namely by firing people or slashing wages or slashing hours. This is why we are seeing an increased price level while wages are stagnating. This will continue with more QE, and one has to believe that the Fed knows this. Yet should it fully pull the plug on all stimulative efforts, the banking sector will implode. Because of this, it won’t fully pull the plug. It just won’t be as explicit about its stimulus, unless the stock market takes another nose dive. In that scenario, with further deterioration in conditions, we may see an increased outlay from the Fed. But that, like all other stimulative efforts fiscal and monetary, will end with nothing but higher prices and a worse economy as what little wealth average individuals have is slowly, but surely eroded.

 

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