Testifying before the US Senate this past Tuesday, Fed Chairman Ben Bernanke made an extraordinary claim about its bloated balance sheet: "We could exit without ever selling by letting it run off." What Bernanke means here is that the Fed could simply hold its Treasuries and agency bonds until they mature, at which point the government would then be forced to pay the Fed back the principal amount. Through this process, the Fed's unprecedented and inflationary position will be gradually and placidly unwound.
Growing rumors last month of a potential "tightening" of monetary policy - seemingly confirmed by the Fed minutes released on Feb. 20th - have spooked the precious metals markets, leading to a 5.8% correction in gold and 10.2% in silver.
However, these fears are preposterous on two counts.
First, the Fed just spent the past year and a half extending the maturities of its entire portfolio. That was the entire purpose of Operation Twist. The average maturity of the entire portfolio is now over 10 years. That means any wind-down using the strategy Bernanke outlined would play out over the course of decades - not months or years.
Fortunately for hard asset investors, it is unlikely to play out at all.
The second reason these fears are unfounded is that there is no exit strategy. Listening to Bernanke's testimony, it was clear that here was a man simply speculating about when an exit might be undertaken - or perhaps ifit would ever be taken. Senator Corker from Tennessee accused Bernanke during the hearing of being "the biggest dove since World War II." "I think it's something you're rather proud of," the Senator continued. The Chairman's response to the charge of recklessly endangering the nation's currency? "In some respects, I am."
The Fed Chairman has been talking about tightening for some time. In 2010, he said, "As the expansion matures, the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures."
Back then, the same mainstream analysts were predicting recovery and a reversal of quantitative easing (QE). Instead, we have subsequently seen QE2, Operation Twist, and now QE3 to eternity.
While these mainstream commentators are at best guessing as to why or when the Fed might reverse course, I understand that it is extremely unlikely to do so for the foreseeable future. In fact, I've bet my net worth on it.
There is no exit strategy because the results of the Fed withdrawing its artificial support would be disastrous for the US Treasury and in the short-term, the US economy.
The Fed is expected to buy nearly 90% of new Treasury bonds in 2013, according to Bloomberg. This is a tremendous subsidy that has kept 10-year Treasury yields below 1.95% on average this year so far. Last year, with 10-year yields averaging 1.8%, the Treasury spent $360 billion on interest payments alone. That represented nearly 10% of all expenditures.
Let's assume a Fed tightening causes these rates to triple - not unreasonable for a government facing over 100% debt-to-GDP. If these rates triple by 2015, and another $2 trillion or so is added to the debt, then interest would make up over 30% of annual federal expenditures. Just interest. Then, there are principal repayments, Medicare/Medicaid, Social Security, the Armed Forces, and all the other entitlements for which the Treasury is responsible. Is Washington going to default on our creditors, our seniors, or our men and women in uniform?
I believe these assumptions are still rosy compared to what might actually happen if the Fed were to withdraw support. As I outlined in my January Gold Letter, the US sovereign debt market is a house of cards in which the Fed, foreign creditors, and domestic investors each play a part. If the Fed were to signal that creditors might face haircuts, then the reaction could be swift to the downside. If rates went above 10%, as they have in Greece, then over half of the federal budget would be committed to interest payments alone.
But that's not all. Higher interest rates would cause the shaky housing market to take another nosedive. Few Americans are in a position to buy a $300K house at 10+% interest. Rather, prices would have to decline to levels affordable for cash buyers and those willing and able to take out high-interest mortgages. That might mean another 50% decline or more, in real terms.
With housing taking a second bath, we can expect the banks not to be far behind. That sector remains bloated and dependent on various subsidies from the Fed. With loan rates higher than their customers can afford, banks would fail at a rate higher than 2007-8. This would trigger another round of bailouts from the Treasury; but without Fed assistance, where will the funds come from?
If there isn't a bailout, the major money-center banks would collapse, crippling Wall Street's reputation as the global financial center. The US dollar's reserve status might then be abandoned once and for all.
Quickly, one can see how the Fed's money-printing is the mask holding this charade together.
To see in real time what happens when the mask is pulled off, look to the Mediterranean. Greece has seen the Golden Dawn neo-nazi party win 7% of seats in the last two elections. Italy, meanwhile, just saw a comedian with no political background grab 25% of its parliament in a satirical candidacy. Street protests, unemployment, and other signs of instability are rampant. The protestors are not learning a tough lesson about the consequences of profligate spending; instead, they're simply angry that the money has stopped flowing.
No one in Washington - not least Ben Bernanke - has any intention of setting off a similar episode in the US. Yet, that's exactly what a tightening of monetary policy would do. So, at least as long as the CPI numbers can be fudged to make inflation appear "contained," the Fed is going to keep filling the punch bowl.
Returning to the latest Fed minutes that have hard asset investors so upset, it is telling that while there was some discussion of the dangers of money-printing, only one of twelve governors actually voted against continuing current policies. With no concrete actions being taken and an overwhelming majority still in favor of current policies, it seems gold bears are making much ado about nothing.
As investors realize this, they will once again put their pedals to the precious metals.
Peter Schiff is CEO ofEuro Pacific Precious Metals, a gold and silver dealer selling reputable, well-known bullion coins and bars at competitive prices.
Click here for a free subscription to Peter Schiff's Gold Letter, a monthly newsletter featuring the latest gold and silver market analysis from Peter Schiff, Casey Research, and other leading experts.
And now, investors can stay up-to-the-minute on precious metals news and Peter's latest thoughts by visiting Peter Schiff's Official Gold Blog.
With the announcement this week of its massive $5 billion lawsuit against ratings agency Standard & Poor's, the Federal Government took a bold step to squelch any remaining independence of thought or action in the financial services industry. Given the circumstances and timing of the suit, can there be any doubt that S&P is paying the price for the August 2011 removal of its AAA rating on U.S. Treasury debt? In retaliation for the unpardonable sin of questioning the U.S. Treasury's credit worthiness, the Obama Administration is sending a loud and clear message to Wall Street: mess with the bull and get the horns. Shockingly, the blatant selectivity of the prosecution, however, has failed to ignite a backlash. But as the move violates both the spirit of the Constitution and the letter of the law in so many ways, I can't help but look at it as a sea change in the nature of our governance. Call it Lincoln with a heavy dose of Putin.
Given the nature of the U.S. economy during the housing mania of the last decade, charging S&P with fraud is like handing out a speeding ticket at the Indy 500. Like nearly every other mainstream financial firm in the world at the time, S&P believed that the U.S. economy rested on a solid foundation of accumulated housing wealth. By 2006, the housing market was closing out one of its best decades in memory. Developers, speculators, financiers, real estate agents, bankers and even ordinary Americans had become charmed by the easy wealth of serial home purchases. The party had been orchestrated by a cadre of politicians and regulators who wanted to keep the party going and take credit for the good times.
To a degree that few Americans understand even to this day, it was not irresponsible lending, bad ratings, or excess greed that finally doomed the mortgage market, it was the simple fact that national home prices started falling. As long as prices stayed high, refinancing would have been open to borrowers, and defaults would have been manageable. Among the hordes of analysts, academics, and reporters who covered the market there were few if any standing who believed that national home prices could fall of a cliff. I know this to be true because I spent many years trying, unsuccessfully, to warn them.
From 2005 to 2008, I made scores of appearances on national television and at investment conferences around the country in which I stated that national home prices were set to decline by at least 30% and that the resulting mortgage defaults would devastate the financial sector and bring down the economy. I may have just as well been arguing that pink unicorns were about to resurrect the Soviet Union. At the 2006 Western Regional Mortgage Bankers conference I told attendees that many highly rated mortgage-backed securities, including some rated AAA, would become worthless. My debate opponent claimed that such predictions only come to pass if "an atomic bomb landed on either Los Angeles, Chicago, or New York!"
The idea that home prices could decline at all, let alone by 30% was considered beyond serious consideration. The models used by the banks, investors, government agencies, academics, and rating agencies predicted that national home prices would continue to rise, or at least stay stable. They were ALL wrong. Calls for even a 5% decline would have put S&P in the extreme minority. I know because I WAS that extreme minority and would have noticed any company joining me. Absent such opinions, the analyses put out by S&P, Moody's, and Fitch were justifiable. So why pick on S&P? Perhaps because the other two agencies never downgraded U.S. government debt.
As proof of S&P's institutional culpability, the Justice Department provided a few e-mails sent by S&P analysts during the final stages of the housing bubble. The messages contain cynical awareness that the mortgage market was built on a house of cards. So what? To avoid guilt would S&P have to prove 100% agreement among all employees? The company readily admits that it reached its opinions through a consensus and that feelings within the firm varied. Opinions are, by definition, nuanced and varied. During the years before the crash I received emails from many people who agreed with me but who said that their friends and co-workers believed that they "were nuts" for harboring such fears. I lost count of how many people told me that I was nuts. Many of these e-mails could have come from S&P analysts.
At most, S&P was guilty of a culture of complacency and group think. Ironically that spirit was engendered by the bizarre regulatory environment created for ratings agencies by the government itself. In 1973, in order to "protect" investors from unregulated markets, the SEC designated certain ratings firms as "Nationally Recognized Statistical Ratings Organizations." Thereafter, only bonds rated by sanctioned firms could be purchased by pension funds and federally insured banks. Before that time the ratings agencies were paid for their advice by bond investors. As the rule change limited the abilities of investors to choose who to ask, the ratings firms began charging bond issuers instead. This arrangement meant that interests of investors would be subordinated. In any event, the law may have mandated who could perform ratings, but it did not require anyone to take them seriously. Any decent portfolio manager recognized this conflict of interest and performed their own due diligence.
The problem was when it came to housing mortgage bond buyers who were just as clueless as the ratings agencies. In fact, even those few buyers who knew the party would end badly, decided for themselves to keep dancing until the music stopped. It's completely hypocritical to sue the band after-the fact. Given that the SEC required investors to use these ratings agencies, should not the Justice Department be suing them instead?
The 2011 downgrade came as the government passed a weak and inconclusive patch to the debt ceiling crisis. Now, a year and a half later, we see that they have slithered out of that poorly constructed straight jacket. With the new debt piling up faster than ever, and the government showing itself to be blatantly incapable of making hard choices, it should be clear to anyone with a half semester of accounting that the Treasury debt should be downgraded. Yes the government has a printing press, but that only means that the value of the bonds will disappear through inflation rather than default. S&P was far too lenient.
Smaller ratings agency Egan Jones (which never had the official sanction of S&P) issued harsher reports about government debt, and they have also been duly punished for their candor. In 2011 the other major ratings agency, Moody's, argued that the fiscal cliff deal agreed to by Congress and the President improved the country's fiscal position and forestalled any need to downgrade Treasury debt. However, since we never actually went over that conveniently erected fiscal cliff, why has Moody's not responded with a downgrade? Perhaps they want to stay out of court?
Let's hope that it is still possible to get a fair hearing in a U.S. court of law, even when squaring off against the biggest and most powerful opponent the world has ever known. But even if S&P wins, we have all already lost. If it survives it will only do so after incurring huge legal bills and seeing its share price slashed. It's a foregone conclusion that no more downgrades will be coming.
Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.
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The financial world was shocked this month by a demand from Germany's Bundesbank to repatriate a large portion of its gold reserves held abroad. By 2020, Germany wants 50% of its total gold reserves back in Frankfurt - including 300 tons from the Federal Reserve. The Bundesbank's announcement comes just three months after the Fed refused to submit to an audit of its holdings on Germany's behalf. One cannot help but wonder if the refusal triggered the demand.
Either way, Germany appears to be waking up to a reality for which central banks around the world have been preparing: the dollar is no longer the world's safe-haven asset and the US government is no longer a trustworthy banker for foreign nations. It looks like their fears are well-grounded, given the Fed's seeming inability to return what is legally Germany's gold in a timely manner. Germany is a developed and powerful nation with the second largest gold reserves in the world. If they can't rely on Washington to keep its promises, who can?
Where is Germany's Gold?
The impact of Germany's repatriation on the dollar revolves around an unanswered question: why will it take seven years to complete the transfer?
The popular explanation is that the Fed has already rehypothecated all of its gold holdings in the name of other countries. That is, the same mound of bullion is earmarked as collateral for a host of different lenders. Since the Fed depends on a fractional-reserve banking system for its very existence, it would not come as a surprise that it has become a fractional-reserve bank itself. If so, then perhaps Germany politely asked for a seven-year timeline in order to allow the Fed to save face, and to prevent other depositors from clamoring for their own gold back - a 'run' on the Fed.
Now, the Fed can always print more dollars and buy gold on the open market to make up for any shortfall, but such a move could substantially increase the price of gold. The last thing the Fed needs is another gold price spike reminding the world of the dollar's decline.
Speculation Aside
None of these theories are substantiated, but no matter how you slice it, Germany's request for its gold does not bode well for the future of the dollar. In fact, the Bundesbank's official statements are all you need to confirm the Germans' waning faith in the US.
Last October, after the Bundesbank had requested an audit of its Fed holdings, Executive Board Member Carl-Ludwig Thiele was asked in an interview why the bank kept so much of Germany's gold overseas. His response emphasized the importance of the dollar as the world's reserve currency:
"Gold stored in your home safe is not immediately available as collateral in case you need foreign currency. Take, for instance, the key role that the US dollar plays as a reserve currency in the global financial system. The gold held with the New York Fed can, in a crisis, be pledged with the Federal Reserve Bank as collateral against US dollar-denominated liquidity."
Thiele's statement can lead us to only one conclusion: by keeping fewer reserves in the US, Germany foresees less future need for "US dollar-denominated liquidity."
History Repeats
The whole situation mirrors the late 1960s, during a period that led up to the "Nixon Shock." Back then, the world was on the Bretton Woods System - an attempt on the part of Western central bankers to pin the dollar to gold at a fixed rate, while still allowing the metal to trade privately as a commodity. This led to a gap between the market price of gold as a commodity and the official price available from the Treasury.
As the true value of gold separated further and further from its official rate, the world began to realize the system was unsustainable, and many suspected the US was not serious about maintaining a strong dollar. West Germany moved first on these fears by redeeming its dollar reserves for gold, followed by France, Switzerland, and others. This eventually culminated in Nixon "closing the gold window" in 1971 by ending any link between the dollar and gold. This "Nixon Shock" spurred chronic inflation throughout the '70s and a concurrent rally in gold.
Perhaps the entire international community is thinking back to the '60s, because Germany isn't the only country maneuvering away from the dollar today. The Netherlands and Azerbaijan are also discussing repatriating their foreign gold holdings. And every month, we hear about central banks increasing gold reserves. The latest are Russia and Kazakhstan, but in the last year, countries from Brazil to Turkey have been adding to their gold holdings in order to diversify away from fiat currency reserves.
And don't forget China. Once the biggest purchaser of US bonds, it is now a net seller of Treasuries, while simultaneously gobbling up gold. Some sources even claim that China has unofficially surpassed Germany as the second largest holder of gold in the world.
Unlike the '60s, today there is no official gold window to close. There will be no reported "shock" indicator of a dollar flight. This demand by Germany may be the closest indicator we're going to get. Placing blame where it's due, let's call it the "Bernanke Shock."
It Takes One to Know One
In last month's Gold Letter, I wrote about the three pillars supporting the US Treasury's persistently low interest rates: the Fed, domestic investors, and foreign central banks - led by Japan. I examined how Japan's plans to radically devalue the yen may undermine that country's ability to continue buying Treasuries, which could cause the other pillars to become unstable as well.
While private investors and even the Fed might be deluding themselves into believing US bonds are still a viable investment, Germany's repatriation news makes it clear that foreign governments are no longer buying the propaganda. And why should they? If anyone should appreciate the real constraints the US government is facing, it is other governments.
Our sovereign creditors know that Ben Bernanke and Barack Obama are just regular men in fancy suits. They know the Fed isn't harboring some ingenious plan for raising interest rates while successfully selling back its worthless mortgage and government securities. Instead, the Fed is like a drug addict making any excuse to get its next fix. [See Bernanke's tell-all interview with Oprah where he confesses to economic doping!]
US investors should be as shocked as the Bundesbank about the Fed's deception. While we cannot redeem our dollars for gold with the Fed, we can still buy gold with them in the open market. As more investors and governments choose to save in precious metals, the dollar's value will go into steeper and steeper decline - thereby driving more investors into metals. That's when the virtuous circle upon which the dollar has coasted for a generation will quickly turn vicious.
Peter Schiff is CEO ofEuro Pacific Precious Metals, a gold and silver dealer selling reputable, well-known bullion coins and bars at competitive prices.
Click here for a free subscription to Peter Schiff's Gold Letter, a monthly newsletter featuring the latest gold and silver market analysis from Peter Schiff, Casey Research, and other leading experts.
And now, investors can stay up-to-the-minute on precious metals news and Peter's latest thoughts by visiting Peter Schiff's Official Gold Blog.
By upping the ante once again in its gamble to revive the lethargic economy through monetary action, the Federal Reserve's Open Market Committee is now compelling the rest of us to buy into a game that we may not be able to afford. At his press conference this week, Fed Chairman Bernanke explained how the easiest policy stance in Fed history has just gotten that much easier. First it gave us zero interest rates, then QEs I and II, Operation Twist, and finally "unlimited" QE3.
Now that those moves have failed to deliver economic health, the Fed has doubled the size of its open-ended money printing and has announced a program of data flexibility that virtually insures that they will never bump into limitations, until it's too late. Although their new policies will create numerous long-term challenges for the economy, the biggest near-term challenge for the Fed will be how to keep the momentum going by upping the ante even higher their next meeting.
The big news is that the Fed is now doubling the amount of money it is printing. In addition to its ongoing $40 billion per month of mortgage backed securities (to stimulate housing), it will now buy $45 billion per month of Treasury debt. The latter program replaces Operation Twist, which had used proceeds from the sales of short-term treasuries to finance the purchase of longer yielding paper. The problem is the Fed has already blown through its short-term inventory, so the new buying will be pure balance sheet expansion.
To cloak these shockingly accommodative moves in the garb of moderation, the Fed announced that future policy decisions will be put on automatic pilot by pegging liquidity withdrawal to two sets of economic data. By committing to tightening policy if either unemployment falls below 6.5% or if inflation goes higher than 2.5%, Bernanke is likely looking to silence fears that the Fed will stay too loose for too long. While these statistical benchmarks would be too accommodative even if they were rigidly enforced, the goalposts have been specifically designed to be completely movable, and hence essentially meaningless.
Bernanke said that in order to identify signs of true economic health, the Fed will discount unemployment declines that result from diminishing labor participation rates. It is widely known that a good portion of unemployment declines since 2009 have resulted from the many millions of formerly employed Americans who have dropped out of the workforce. But like many other economists, Bernanke failed to identify where he thinks "real" employment is now after factoring out these workers. So how far down will the unemployment number have to drift before the Fed's triggering mechanism is tripped? No one knows, and that is exactly how the Fed wants it.
A similarly loose criterion exists for the Fed's other goalpost - inflation. Bernanke stated that he will look past current inflation statistics and look primarily at "core inflation expectations." In other words, he is not interested in data that can be demonstrably shown but on much more amorphous forecasts of other economists who have drunk the Fed's Kool-Aid. He also made clear that rising food or energy prices will never fall into the Fed's radar screen of inflation dangers.
For as long as I can remember (and I can remember for quite some time) the Fed has stripped out "volatile" increases in food and energy, preferring the "core" inflation readings. But in the overwhelming majority of cases, the headline numbers are significantly higher than the core. In other words, Bernanke simply prefers to look at lower numbers. In his press conference, he made it clear that the Fed will avoid looking at price changes in "globally traded commodities," that are all highly influenced by inflation.
These subjective and attenuated criteria give Fed officials far too much leeway to ignore the guidelines that they are putting into place. If the Fed will not react to what inflation is, but rather to what it expects it to be, what will happen if their expectations turn out to be wrong? After all, their track record in forecasting the events of the last decade has been anything but stellar.
The Fed officials repeatedly assured us that there was no housing bubble, even after it burst. Then they assured us the problem was contained to subprime mortgages. Then they assured us that a slowdown in housing would not impact the broader economy. I could go on, but my point is if the Fed is as spectacularly wrong about inflation as it has been about almost everything else, will they be able to slam on the brakes in time to prevent inflation from running out of control? And if so, at what cost to the overall economy?
The Fed is committing to more than a $1 trillion annual expansion in its balance sheet, an amount greater than the total size of its balance sheet as late as 2008. Most forecasters believe that the Fed will have $4 trillion worth of assets on its books by the end of 2013, and perhaps more than $5 trillion by the end of 2014. If conditions arise that require the Fed to withdraw liquidity, the size of the sales that would be required will be massive. Who exactly does the Fed believe will have pockets deep enough to take the other side of the trade?
As the biggest buyer of treasuries, it is impossible for the Fed to sell without chances of collapsing the market. Surely any other holders of treasuries would want to front-run the Fed, and what buyer would be foolish enough to get in front of the Fed freight train? The bottom line is that it is impossible for the Fed to fight inflation, which is precisely why it will never acknowledge the existence of any inflation to fight.
But perhaps the most absurd statement in Bernanke's press conference was his contention that the Fed is not engaged in debt monetization because it intends to sell the debt once the economy improves. This is like a thief claiming that he is not stealing your car, because he intends to return it when he no longer needs it. To make the analogy more accurate, there could not be any other cars on the road for him to steal.
Without the Fed's buying, it would be impossible for the Treasury to finances its debts at rates it can afford. That is precisely why the Fed has chosen to monetize the debt. Of course, officially acknowledging that fact would make the Fed's job that much harder. Without the monetization safety valve, the government would have to make massive immediate cuts in all entitlements and national defense, plus big tax increases on the middle class.
As I wrote when the Fed first embarked on this ill-fated journey, it has no exit strategy. The Fed adopted what amounts to "the roach motel" of monetary policy. If the Fed actually raised rates as a result of one of its movable goal posts being hit, the result could be a much greater financial crisis than the one we lived through in 2008. The bond bubble would burst, interest rates and unemployment would soar, housing prices would collapse, banks would fail, borrowers would default, budget deficits would swell, and there would be no way to finance another round of bailouts for anyone, including the Federal Government itself.
In order to generate phony economic growth and to "pay" our country's debts in the most dishonest manner possible, the Federal Reserve is 100% committed to the destruction of the dollar. Anyone with wealth in the U.S. dollar should be concerned that economic leadership is firmly in the hands of irresponsible bureaucrats who are committed to an ivory tower version of reality that bears no resemblance to the world as it really is.
Journalists, politicians and economists all seem to agree that the biggest economic issue currently worrying voters is unemployment. It follows then that most believe that the deciding factor in the presidential race will be the ability of each candidate to convince the public that his policies will create jobs. It seems that everyone got this memo...except the voters.
According to the results of a Fox News poll released last week (a random telephone sample of more than 1,200 registered voters), 41% identified "inflation" as "the biggest economic problem they faced." This is nearly double the 24% that named "unemployment" as their chief concern. For further comparison, 19% identified "taxes" and 7% "the housing market" as their primary concern. A full 44% of women, who often do more of the household shopping and would therefore be more sensitive to prices changes, identified rising prices as their primary concern.
While these statistics do not surprise me, they should shock the hell out of the establishment. According to the Federal Reserve, inflation is not a concern at all. Time after time, in front of Congress and the press, Fed Chairman Ben Bernanke has said that inflation is contained and that it is below the Fed's "mandated" rate of inflation (whatever that may be.) The Bureau of Labor Statistics is saying the same thing. The measures they use to monitor inflation, such as the Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE), show annual inflation well below 2%. In fact, the GDP price deflator used by the Commerce Department to calculate the second quarter's 1.3% annual growth rate assumed annual inflation was running at just 1.6%.
In fact, Bernanke thinks inflation is so low that he is actually worried about deflation, which he believes is a more dangerous issue. As a result, he is recommending policies that look to raise the inflation rate, not just to combat the phantom menace of deflation but to boost the housing market and reduce unemployment. He mistakenly believes these problems are the ones that concern Americans the most.
If inflation really is as subdued as the government claims, how is it that so many people are concerned? It's not as if the media or political candidates are fanning the fears of rising prices. In fact, given the media's preoccupation with the housing market, the fact that nearly seven times as many Americans worry more about rising food prices than falling home prices shows just how large the inflation problem must be. Yet most economic observers continue to swallow the government's inflation propaganda hook, line and sinker. In fact, although the Fox poll came out last week, I did not read or hear a single story on this topic, even from Fox news itself, which appears to not have noticed the significance of its own data.
For years my critics have always attempted to discredit my inflation fears by pointing to government statistics showing low rates. However, I have long maintained that such statistics under-report inflation, and the results of this poll seem to confirm my suspicion. There are only two possible ways to explain the disconnect. Either the government is correct and consumers are worried about a non-existent problem, or the consumers' concerns are real and the government's statistics are not. From my perspective, it seems that it is far more likely that consumers are in the right. If so, we are in a lot of trouble.
If annual inflation is actually higher than 3%, which would certainly be the case if consumers are so worried about it, then we are already in recession. Had government used a 3% inflation deflator (rather than the 1.6% that they actually used) to calculate 2nd quarter GDP, then growth would have been reported at negative .1% rather than the positive 1.3%. I believe that if the government used more accurate inflation data over the past several years, it is possible that we would have seen no statistical recovery from the recession that began in the fourth quarter of 2007. This would help explain why the "recovery" has failed to create jobs or lift personal incomes.
The Fed's zero percent interest rate policy is predicated on the assumption that there is currently no inflation. If this is not accurate, then they are making a major policy mistake. The Fed is easing when it should be tightening. If inflation is such a major concern now, imagine how much bigger the problem will become once the Fed achieves its goal of pushing the rate higher. More importantly, how much tighter will future monetary policy have to be to put the inflation genie back in her bottle? If inflation becomes so virulent before the Fed realizes its mistake, then it may be forced to raise interest rates significantly. U.S. national debt is projected to reach $20 trillion within a few years. As a result, a 10% interest rate (which would be needed to combat 1970's style inflation) will require the U.S. government to pay about $2 trillion per year in interest on the national debt. This will absolutely upend all economic projections.
Since 10% interest rates will likely crush the economy, not to mention the banks and the real estate market, tax revenues will plunge and non-interest government expenditures will go through the roof. Assuming we try to borrow the difference, annual budget deficits could go much, much higher from the already ridiculously high levels that they have reached during President Obama's term. Annual deficits of $2 trillion, $3 trillion, or even $4 trillion, would result in a sovereign debt crisis that would force the Federal Government to either default on its obligations or inflate them away. Given the tendency for politicians to prefer the latter, voters who think rising prices are a problem now should just wait until they see what is waiting down the road!
Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.
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There never really could be much doubt that the current experiment in competitive global currency debasement would end in anything less than a total war. There was always a chance that one or more of the principal players would snap out of it, change course and save their citizenry from a never ending cycle of devaluation. But developments since September 13, when the U.S. Federal Reserve finally laid all its cards on the table and went "all in" on permanent quantitative easing, indicate that the brainwashing is widely established and will be difficult to break. The vast majority of the world's leading central bankers seem content to walk in lock step down the path of money creation as a means to economic salvation. Never mind that the path will prevent real growth and may ultimately lead off a cliff. The herd is moving. And if it can't be turned, the only thing that one can do is attempt to get out of its way.
The details of the Fed's new plan (which I christened Operation Screw in last week's commentary) are not nearly as important as the philosophy it reveals. The Federal Reserve has already unleashed two huge waves of quantitative easing (purchases of either government securities or mortgage-backed securities) in order to stimulate consumer spending and ignite business activity. But the economy has not responded as hoped. GDP growth has languished below trend, the unemployment rate has stayed north of 8%, and the labor participation rate has fallen to all-time lows. In the meantime, America's fiscal position has grown significantly worse with government debt climbing to unimaginable territory. Despite the lack of results, the conclusion at the Federal Reserve is that the programs were too small and too incremental to be effective. They have determined that something larger, and potentially permanent, would be more likely to do the trick.
However, in making its new plan public, the Fed made a startling admission. At his press conference, Ben Bernanke backed away from previous assertions that printed money would be effective in directly pushing up business activity. Instead he explained how the new stimulus would be focused directly at the housing market through purchases of mortgage backed securities. He made clear that this strategy is intended to spark a surge in home prices that will in turn pull up the broader economy. Such a belief requires a dangerous amnesia to the events of the last decade. Despite the calamity that followed the bursting of our last housing bubble, economists feel this to be a wise strategy, proving that a poor memory is a prerequisite for the profession.
But now that the Fed is thus committed, the focus has shifted to foreign capitals. Not surprisingly, the dollar came under immediate pressure as soon as the plan was announced. In the 24 hours following the announcement, the Greenback was down 2.2% against the euro, 1.6% against the Australian Dollar, and 1.1% against the Canadian Dollar. A week after the Fed's move, the Mexican Peso had appreciated 2.7% against the US dollar. Many currency watchers noted that more dollar declines would be likely if foreign central banks failed to match the Fed in their commitments to print money. On cue, the foreign bankers responded.
It is seen as gospel in our current "through the looking glass" economic world that a weak currency is something to be desired and a strong currency is something to be disdained. Weak currencies are supposed to offer advantages to exporters and are seen as an easy way to boost GDP. In reality, weak currencies simply create the illusion of growth while eroding real purchasing power. Strong currencies confer greater wealth and potency to an economy. But in today's world,no central banker is prepared to stand idly by while their currency appreciates. As a result, foreign central banks are rolling out their own heavy artillery to combat the Fed.
Perhaps anticipating the Fed's actions, on September 6th the European Central Bank announced its own plan of unlimited buying of debt of troubled EU nations (however, the plan did come with important concessions to the German point of view - see John Browne's commentary). On September 17th, the Brazilian central bank auctioned $2.17 billion of reverse swap contracts to help push down the Brazilian Real. The next day, Peru and Turkey cut rates more than expected. On September 19th, the Bank of Japan increased its asset purchase program from 70 trillion yen to 80 trillion and extended the program by six months. It's clear we are seeing a central banking domino effect that is not likely to end in the foreseeable future.
Although the Fed is directing its fire towards the housing market, the needle they are actually hoping to move is not home prices, but the unemployment rate. Until that rate falls to the desired levels (some at the Fed have suggested 5.5%), then we can be fairly certain that these injections will continue. This will place permanent pressure on banks around the world to follow suit.
All of this simultaneous money creation will likely be a boon for nominal stock and real estate prices. But in real terms such gains will likely not keep pace with dollar depreciation. Inflation pushes up prices for just about everything, so stocks and real estate are not likely to prove to be exceptions. Even bond prices can rise in the short term, but their real values are the most vulnerable to decline. In fact, even nominal bond prices will ultimately fall, as inflation eventually sends interest rates climbing. But prices for hard assets, precious metals, commodities, and even those few remaining relatively hard currencies should be on the leading edge of the upward trend in prices.
While I believe the Fed's plan will be a disaster for the economy, the silver lining is that it provides investors with a road map. As the policy of the Fed is to debase the currency, those holding dollar based assets may seek alternatives in hard assets and in the currencies of the few remaining countries whose bankers have not drunken so freely from the Keynesian Kool-Aid. We believe that such opportunities do exist. Some broad ideas are outlined in the latest edition of my Global Investor Newsletter, which became available for download this week. I encourage those looking for ways to distance their wealth from the policies of Ben Bernanke to start their search today.
Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.
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With yesterday's Fed decision and press conference, Chairman Ben Bernanke finally and decisively laid his cards on the table. And confirming what I have been saying for many years, all he was holding was more of the same snake oil and bluster. Going further than he has ever gone before, he made it clear that he will be permanently binding the American economy to a losing strategy. As a result, September 13, 2012 may one day be regarded as the day America finally threw in the economic towel.
Here is the outline of the Fed's plan: buy hundreds of billions of home mortgages annually in order to push down mortgage rates and push up home prices, thereby encouraging people to build and buy homes and spend the extracted equity on consumer goods. Furthermore, the Fed hopes that ultra-cheap money will push up stock prices so that Wall Street and stock investors feel wealthier and begin to spend more freely. He won't admit this directly, but rather than building an economy on increased productivity, production, and wealth accumulation, he is trying to build one on confidence, increased leverage, and rising asset prices. In other words, the Fed prefers the illusion of growth to the restructuring needed to allow for real growth.
The problem that went unnoticed by the reporters at the Fed's press conference (and those who have written about it subsequently) is that we already tried this strategy and it ended in disaster. Loose monetary policy created the housing and stock bubbles of the last decade, the bursting of which almost blew up the economy. Apparently for Bernanke and his cohorts, almost isn't good enough. They are coming back to finish the job. But this time, they are packing weaponry of a much higher caliber. Not only are they pushing mortgage rates down to historical lows but now they are buying all the loans!
Last year, the Fed launched the so-called "Operation Twist," which was designed to lower long-term interest rates and flatten the yield curve. Without creating any real benefits for the economy, the move exposed US taxpayers and holders of dollar-based assets to the dangers of shortening the maturity on $16 trillion of outstanding government debt. Such a repositioning exposes the Treasury to much faster and more painful consequences if interest rates rise. Still, the set of policies announced yesterday will do so much more damage than "Operation Twist," they should be dubbed "Operation Screw." Because make no mistake, anyone holding US dollars, Treasury bonds, or living on a fixed income will have their purchasing power stolen by these actions.
Prior injections of quantitative easing have done little to revive our economy or set us on a path for real recovery. We are now in more debt, have more people out of work, and have deeper fiscal problems than we had before the Fed began down this path. All the supporters can say is things would have been worse absent the stimulus. While counterfactual arguments are hard to prove, I do not doubt that things would have been worse in the short-term if we had simply allowed the imbalances of the old economy to work themselves out. But in exchange for that pain, I believe that we would be on the road to a real recovery. Instead, we have artificially sustained a borrow-and-spend model that puts us farther away from solid ground.
Because the initials of quantitative easing - QE - have brought to mind the famous Queen Elizabeth cruise ships, many have likened these Fed moves as giant vessels that are loaded up and sent out to sea. But based on their newly announced plans, the analogy no longer applies. As the new commitments are open-ended, quantitative easing will now be delivered via a non-stop conveyor belt that dumps cheap money on the economy. The only variable is how fast the belt moves.
Fortunately, the crude limitations of the Fed's only policy tool have become more apparent to the markets. If you must stick with the nautical metaphors, QE3 has sunk before it has even left port. The move was explicitly designed to push down long-term interest rates, but interest rates spiked significantly in the immediate aftermath of the announcement. Traders realize that an open-ended commitment to buying bonds means that inflation and dollar weakness will likely destroy any nominal gains in the bonds themselves. To underscore this point, the Fed announcement also caused a sharp selloff in Treasuries and the dollar and a strong rally in commodities, especially precious metals.
Given that 30-year fixed mortgages are already at historic lows, there can be little confidence that the new plan will succeed in pushing them much lower, especially given the upward spike that occurred in the immediate aftermath of the announcement. Instead, Bernanke is likely trying to provide the confidence home owners need to exchange fixed-rate mortgages for lower adjustable rate loans - which would free up more cash for current consumer spending. He is looking for homeowners to do their own twist. If he succeeds, more homeowners will be vulnerable to increasing rates, which will further limit the Fed's future ability to increase rates to fight rising prices.
The goal of the plan is to create consumer purchasing power by raising home and stock prices. No one seems to be considering the likelihood that unending QE will fail to lift bond, stock, or home prices, but will instead bleed straight through to higher prices for food, energy, and other consumer staples. If that occurs, consumers will have less purchasing power as a result of Bernanke's efforts, not more.
The Fed decision comes at the same time as the situation in Europe is finally moving out of urgent crisis mode. While I do not think the ECB's decision to underwrite more sovereign debt from troubled EU members will work out well in the long term, at least those moves have come with some German strings attached [For more on this, see John Browne's article from earlier this week]. As a result, I feel that the attention of currency traders may now shift to the poor fundamentals of the US dollar, rather than the potential for a breakup of the euro.
In the meantime, the implications for American investors should be clear. The Fed will try to conjure a recovery on the backs of currency debasement. It will not stop or alter from this course. If the economy fails to respond to the drugs, Bernanke will simply up the dosage. In fact, he is so convinced we will remain dependent on quantitative easing that he explicitly said he won't turn off the spigots even if things noticeably improve. In other words, the dollar is screwed.
This past Friday, as Fed Chairman Ben Bernanke delivered his annual address from Jackson Hole - the State of the Dollar, if you will - I couldn't help but hear it as an incumbent's campaign speech. While Wall Street was hoping for some concrete announcement, what we got was a mushy appraisal of the Fed's handling of the financial crisis so far and a suggestion that more 'help' is on the way.
It is important to remember that it's not just President Obama's job on the line in this election; in two years time, the next President will have the opportunity to either reappoint Bernanke or choose someone else. So we must understand what platform Bernanke is running on, as his office has an even greater effect on global markets than the President's.
Bernanke has been the perfect tag-team partner for George W. Bush and then Barack Obama as they have pursued an economic policy of deficits, bailouts, and stimulus. Without the Fed providing artificial support to housing and US debt, Washington would have already been shut out of foreign credit markets. In other words, they would have faced a debt ceiling that no amount of bipartisan support could raise. Fortunately for the politicians, Helicopter Ben was there to monetize the debts.
As far back as his time as an academic, Bernanke made clear that when the going got tough, he wouldn't hesitate to fire up the printing presses. He specialized in studying the Great Depression and, contrary to greater minds like Murray Rothbard, determined that the problem was too little money printing. He went on to propose several ways the central bank could create inflation even when interest rates had been dropped to zero through large-scale asset purchases (LSAPs). Sure enough, the credit crunch of 2008 gave the Fed Chairman an opportunity to test his theory.
All told, the Fed spent $2.35 trillion on LSAPs, including $1.25 trillion in mortgage-backed securities, $900 billion in Treasury debt, and $200 billion of other debt from federal agencies. That means the Fed printed the equivalent of 15% of US GDP in a couple of years. That's a lot of new dollars for the real economy to absorb, and a tremendous subsidy to the phony economy.
This has bought time for President Obama to enact an $800 billion stimulus program, an auto industry bailout, socialized medicine, and other economically damaging measures. In short, because of the Fed's interventions, Obama got the time and money needed to push the US further down the road to a centrally planned economy. It is also now much more unlikely that Washington will be able to manage a controlled descent to lower standards of living. Instead, we're going to head right off a fiscal cliff.
The Fed Chairman even admitted to this reality in his statement. Here are two choice quotes:
"As I noted, the Federal Reserve is limited by law mainly to the purchase of Treasury and agency securities. ... Conceivably, if the Federal Reserve became too dominant a buyer in certain segments of these markets, trading among private agents could dry up, degrading liquidity and price discovery." [emphasis added]
"...expansions of the balance sheet could reduce public confidence in the Fed's ability to exit smoothly from its accommodative policies at the appropriate time. ... such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability." [emphasis added]
So we all agree that the prospect of inflationary depression was made worse by the Fed's actions - but at least Ben Bernanke has pleased his boss. As a guaranteed monetary dove, Ben Bernanke appears to be a shoo-in if Obama is re-elected.
Meanwhile, Mitt Romney has pledged to fire Bernanke if elected. While I am not confident that Mr. Romney has the economic understanding to appoint a competent replacement - let alone pursue a policy of restoring the gold standard or legalizing competing currencies - he may well be seen as a threat not only to the Fed Chairman's self-interest, but also to his inflationary agenda.
Given this background, let's look at Bernanke's quotes that have been the focus of media speculation for the past week: the US economy is "far from satisfactory," unemployment is a "grave concern," and the Fed "will provide additional policy accommodation as needed." These comments seem designed to reassure markets (and Washington) that there will be no major shift toward austerity in the near future. The party can go on. But they also hint that Bernanke might be planning to double down again. I have long written that another round of quantitative easing is all but inevitable. It now seems to be imminent.
In reality, when the money drops may have more to do with politics than economics. The Fed may not want to appear to be directly interfering in the election by stimulating the economy this fall, but there are strong incentives for Bernanke to try to perk up the phony recovery before November and deliver the election to Obama. However, if Romney wins, Bernanke can at least fall back on his appeal as a team player as he lobbies for another term.
For gold and silver buyers, either scenario is likely to continue to stoke our market in the short- and medium-term. As the past week's rally indicates, there is no longer a fear that the Fed has had enough of money-printing - in fact, it looks prepared for much more.
Peter Schiff is CEO and Chief Global Strategist of Euro Pacific Precious Metals.
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There is an ongoing three way debate between those who believe the Fed should do more to strengthen the recovery, those who believe that the recovery is strong enough to continue on its own, and those who believe that the economy has been so fundamentally altered by the recession that no amount of stimulus can succeed in pushing unemployment down to pre-crash levels. As usual, they all have it wrong (although some are more wrong than others).
The false conclusions are being made by the likes of bond king Bill Gross, who has suggested that the economic fundamentals have changed. They argue that a "new normal" is now in place that sets an 8% unemployment rate as a floor below which we will never fall. This is absurd. America can once again prosper if we put our trust in first principles and let the free markets work. Unfortunately, that is not happening. Government is taking an ever greater role in our economy where its efforts will continue to stifle economic growth. A close second in cluelessness comes from those who believe that we are currently on the road to a real recovery. I'm not sure what economy they are looking at, but in just about every important metric, we continue to be essentially comatose.
More accurate are the opinions of those who believe that without a more serious intervention from the Fed, which can only mean another round of quantitative easing (QE III), the current quasi-recovery will soon fade and the tides of recession will overtake us once again. They are correct. And even though this time the water will be rougher and deeper than it was four years ago, it does not mean that the Fed will do the economy any good by breaking out its heavy artillery once again.
In his widely anticipated speech at Jackson Hole last week, Fed Chairman Ben Bernanke sounded a supremely optimistic note: "It seems clear, based on this experience, that such (easing) 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 simple truth however, is that our economy has a disease that all the quantitative easing in the world can't cure. And while the wrong medicine may make us appear healthier in the short term, we will continue to deteriorate beneath the surface. Not only should the Fed not provide additional QE, but it should remove the accommodation currently in place. Although these moves would most certainly send us back into recession, it would simultaneously provide a needed course correction that would put us finally on the road to a sustainable recovery.
The recession the Fed is trying so desperately to prevent must be allowed to run its course so that the economy that we have developed over the last decade, the one that is overly reliant on low interest rates, borrowing and consumer spending, can finally restructure itself into something healthier. By enabling this diseased economy to overstay its welcome, QE does more harm than good. To recover for the long haul, the market must be allowed to correct the misallocations of resources that resulted from prior stimulus. Additional stimulus inhibits this process, and exacerbates the size of the misallocations the markets must eventually correct.
In the interim, any GDP growth or employment gains that result from stimulus actually compounds the difficulty in restructuring the economy. Any jobs created as a result of cheap monetary stimulus are jobs that won't be able to survive absent that support. They will require a continual misallocation of resources in order to survive. Unfortunately, these jobs must ultimately be lost before a real recovery can actually begin.
Holding rates of interest far below market levels (which is the goal of stimulus) alters patterns of consumption, savings, and investment. Fed intervention short-circuits the market driven process that resolves misallocations. The more stimulus that is provided, the harder market forces must work to try to restore equilibrium. As the misallocations grow over time, the efficacy of monetary measures diminishes. In the end, the market will overwhelm the Fed. The only question is how long it will take.
The Fed is trying to build skyscrapers on a bad foundation. Each subsequent structure it builds not only collapses, but also weakens the foundation that much more. The result is that subsequent structures collapse at increasingly lower heights and require more effort to build. Instead of trying to build, the Fed could concentrate on repairing the underlying foundation. That might delay construction, but in the end the buildings will be much sturdier.
Because the Fed has kept interest rates too low for too long, Americans have saved too little and borrowed too much; consumed too much and produced too little; and imported too much and exported too little. Too much of our labor is devoted to the service sectors and not enough to goods production. Too much capital goes to Wall Street speculators and not enough to Main Street entrepreneurs. We built too many homes but not enough factories. We have developed too many shopping centers, and not enough natural resources. The list of Fed induced misallocations goes on.
By trying to preserve the jobs associated with this old economy, the Fed prevents the market from creating the ones we actually need. Unfortunately no one seems to understand that, and we continue to chase blindly after failed economic models. Look for such misunderstanding to be on high display this week in Charlotte as Democrats gather to call for even greater intervention to perpetuate a failed economic model.
The past week provided clear lessons not just in how central bankers have a limited ability to positively influence the economy but also how they are limited in their capacity to deliver the shortsighted policy actions that investors currently crave. The developments should provide new reasons for investors and economy watchers to abandon their faith in central bankers as super heroes capable of saving the economy.
The employment report released on Friday confirmed that the U.S. economy is stagnating at best and actively deteriorating at worst. While the numbers of jobs created in July was actually better than many economists expected, it was still far below the levels that would indicate a growing economy. But more important than the official unemployment rate (which ticked up to 8.3%) or the number of jobs created, is the number of people who have left the workforce out of frustration or despair. This number continues to head higher. The labor force participation rate, which is the percentage of healthy working age Americans who actually have jobs, is at one of the lowest points since women first started working en masse in the 1970's. It's also instructive to add back into the unemployment rate those who want full time jobs but who have had to settle for part time work. This figure, reported under the "U6" category, currently stands at 15.0%. This is just a 12% decline from the 17.1% high seen December 2009. In contrast the "official" (U3) unemployment figure has declined 17% from its peak.
In explaining these bad results, most economists simply look at the stimulating effects of monetary and fiscal policy, not at the problems that those measures create. As a result, it is assumed that not enough stimulation, in the form of quantitative easing or federal deficit spending has been applied to the economy. The next logical assumption is that if the measures of the past few years had not been applied, we would have seen much weaker results over that time. In other words, no matter how bad things are now, defenders of the status quo will always describe how bad things "could have been" if the Fed hadn't stepped in. This counterfactual argument gets increasingly threadbare as the years wear on.
Rather than admit that its policies have failed, the Fed statement last week gave all indications that it will continue with its current inflationary policy to the bitter end. These are the same errors that inflated the stock and real estate bubbles and ultimately resulted in the 2008 financial crisis and our continuing economic malaise. Without any fresh ideas, Fed press releases have become a Groundhog Day repetition of the same pronouncements and diagnoses. Oddly, many market watchers are frustrated that the Fed has not telegraphed that more stimulus is forthcoming. While it should be obvious that our current "recovery" is dependent on monetary support, it should be equally plain that the Fed can't actually admit that fragility without spooking markets. To be clear, QE III is coming, but the markets should not expect Bernanke to supply a precise timetable.
Without question, if the Fed had not stimulated the economy with zero percent interest rates, two rounds of quantitative easing and operation twist, the initial economic contraction would have been sharper. But such short-term pain would have been constructive. By not taking away the cheap-money punch bowl, the Fed has delayed the pain and prolonged the party. But to what end? So far all we have received is a tepid phony recovery that has sown the seeds of its own destruction.
In contrast, real economic restructuring would have resulted if the Fed had withdrawn its monetary props. This would have paved the way for a robust, sustainable recovery. Instead, the Fed helped numb the pain with unprecedented (and apparently permanent) liquidity injections. Its actions merely exacerbate the underlying imbalances that lie at the root of our structural problems, and thus act as a barrier to a real recovery. So long as the Fed fails to learn from its prior mistakes, the phony recovery it has concocted will continue to fade until we find ourselves in an even deeper recession than the one we experienced in 2008.
Those who believe that artificially low interest rates are needed now, fail to see the price that will be paid down the road. By keeping rates too low, the Fed continues to lead an overly indebted economy deeper into the financial abyss. However, its ability to maintain rates at such low levels is not without limits. Just as real estate prices could not stay high forever, interest rates cannot stay low forever. When rates finally rise, the extent of the economic damage will finally be revealed.
The sad fact is that no matter how impotent and dishonest Fed officials become, their elected rivals on Capitol Hill (who control the fiscal side of the equation) have become even less significant. The complete lack of any political conviction to take steps to confront our fiscal imbalances means that Ben Bernanke and his cohorts are seen as the only cavalry capable of riding to the rescue. But no matter how often they blow their bugles, our economy will continue to deteriorate until we stop waiting for a savior and instead fight the battle for prosperity ourselves.
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