In a Wall Street Journal op-ed last Monday, and in congressional testimony
later in the week, Federal Reserve chairman Ben Bernanke reassured all that
thanks to his accurate foresight and deft use of the Fed's policy toolkit, he
could maintain near 0% interest rates for an extended period without creating
inflation. With supernatural powers such as these, one wonders if Ben would be
better employed by the Justice League rather than the Federal Reserve.
Bernanke's game plan is apparently simple: once he determines that the economy
is on solid ground, he will use the monetary equivalent of Superman's laser
vision to strategically evaporate all
the excess liquidity that he has recently created without endangering the
recovery. Don't try this at home, kids.
In other words, as he did just a few years ago when the subprime fiasco began
to emerge, Bernanke is assuring us that inflation is contained. He is just as
wrong now as he was then.
The idea that the inflation genie can be painlessly rebottled has no historic
precedent. Even mainstream economists, who've never met a fiscal stimulus they
didn't like, agree that central banks must act preemptively with regard to
inflation.
Bernanke is making the case that the new set of liquidity tools, hastily
developed in the panic of late 2008, will act just as well in reverse. But
liquidity is a lot like liquid, it's a lot easier to spill than to un-spill.
The chairman believes that his new gadgetry will allow him to perform a feat of
monetary magic no other central banker has managed to pull off. But given his
history of getting it wrong, why should we assume that this time he will get it
right?
The bottom line is that Bernanke has no exit strategy. He can talk about it all
he likes, but when it comes time to actually pulling the trigger, his nerves
will buckle. The current communications campaign is simply an attempt to calm
the markets. I doubt few citizens or members of Congress had any hope of
understanding the exit strategy mechanisms that Bernanke described. Many likely
place their faith in his seeming mastery of financial minutiae. Sadly, as with
the mythical "strong dollar policy", confident talk may be the sum total of the
chairman's strategy.
He senses that the villagers, in the form of currency traders and bond market
vigilantes, are becoming a bit restless. To sooth their concerns, he must
pretend that he has the situation under control. Like Jack Nicholson in A Few
Good Men, he knows full well that markets simply "can't handle the
truth".
But make no mistake, in order to mop up all the excess liquidity, the Fed will
need to raise interest rates substantially to attract buyers for all the bonds
that the Treasury must sell. Fed officials know that our economy is completely
dependent on cheap money and limitless government credit, and can't tolerate
the loss of either.
Of course, the longer the monetary spigot remains open, the more addicted to
low rates we get, and the harder it will be to kick the habit. If the Fed could
not remove the punch bowl during the years before the bust, how will they do so
while the economy is far weaker? Even if they do start the process, the minute
the "recovery" seems in jeopardy, look for the Fed to turn the showers back on.
Also, paring down the Fed's bloated balance sheet will require selling hundreds
of billions of dollars of toxic assets, such as bonds backed by subprime
mortgages, credit card debt, and auto and student loans, back into the market.
Finding buyers for such sludge without crushing the market is a trick that
Houdini himself would be reluctant to attempt.
The Fed's assumption that the assets will no longer be toxic by the time it
sells them is farcical. The economy at large has not yet suffered the full
weight of the recession because these assets have been largely quarantined at
the Fed. Reintroduce these toxins back into the economy and the reaction could
be lethal.
Bernanke also mistakenly expressed optimism that a strengthening global economy
would aid our recovery. Unfortunately, a global resurgence will force
Bernanke's anti-inflation hand, and will thereby cause more pain to the US
economy.
Few appreciate how the global panic of 2008 actually benefited the US by
causing a flight into US dollars and Treasury bonds. The resultant flows put a
lid on consumer prices and kept interest rates low. As growth overseas resumes,
and these flows reverse, both consumer prices and interest rates will rise.
Further, as current policy prevents the structural imbalances underlying our
economy from being corrected, US unemployment will continue to rise. Combined
with higher interest rates and rising consumer prices and the Misery Index
(inflation + interest rates + unemployment) will be a big issue in the 2010
mid-term elections, and an even bigger one in 2012.
Peter Schiff is president of Euro Pacific Capital and author of The
Little Book of Bull Moves in Bear Markets. Euro Pacific Capital commentary and
market news is available at http://www.europac.net.
It has a free online investment newsletter.
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