In arguing that food inflation is not
the United States Federal Reserve's fault, Fed
chairman Ben Bernanke points the finger at
everyone but himself. Just as with a lot of
Bernanke's policies, his argument may hold in an
academic setting, but the real world is a bit more
complicated.
Summarizing the greatest
money printing experiment in monetary history,
Bernanke proudly stipulates that the program has
been "effective", because:
"equity prices have risen significantly"; and
"inflation compensation as measured in the
market for inflation-indexed securities has
risen."
Yet, when quizzed about whether
his policies contribute to commodity and food
inflation, Bernanke argues that the Fed's policies
have only influenced equity prices to the upside, not
commodity prices. While
that logic is unlikely to convince a preschooler,
the Fed chief goes on the defensive to defuse the
argument that his policies may actually be
destabilizing the Middle East and Asia, where a
high portion of disposable income is spent on
food. With regimes toppling left and right,
Bernanke must feel he is carrying the weight of
the world on his shoulders.
Why
Bernanke is right Bernanke argues that
countries concerned about inflationary pressures
stemming from food and commodities have plenty of
tools to address these. Amongst those tools
available to them are the ability to raise
interest rates or allow their currencies to
appreciate. Indeed, we have long argued that Asian
countries in particular may allow their currencies
to appreciate for exactly that reason.
However, Bernanke leaves out a small, but
important detail: with its second round of
quantitative easing, the Fed has dramatically
increased the stakes, placing the proverbial gun
to China's head, effectively telling China's
policy makers to allow the Chinese yuan to
appreciate, or else. Having said that, Bernanke
rightfully argues that the Fed's mandate is to
foster price stability and maximum employment, not
to look after whatever the ills there may be in
the rest of the world.
Why Bernanke is
wrong Trouble is, the very reason the Fed
may be engaging in its super-expansionary policies
is because it is trying to cure ills that are not
part of its traditional mandate. Many of the Fed's
policies since the onset of the financial crisis
have not been traditional monetary policies: a
central bank usually applies a very broad brush in
managing economic growth by controlling levers
such as interest rates or money supply.
However, when the Fed, for example, bought
mortgage-backed securities, it steered money to a
specific sector of the economy. That's fiscal, not
monetary policy, traditionally reserved for
elected policy makers in congress. Just like the
MBS program, many of the Fed's policies continue
to appear to be attempts at addressing the
"shortcomings" of congress.
A shortcoming
is naturally in the eye of the beholder - we may
like or dislike our politicians, but at least they
are periodically up for election. Bernanke has
felt, indeed testified, that one of the strengths
of the Fed is that it can react swiftly in times
of crisis. Bernanke has argued that without his
determined actions, the country might have fallen
into a depression. It appears to be a matter of
the ends justifying the means.
In our
analysis, however, the means employed are the
wrong ones. A key reason why Bernanke's policies
have been rather ineffective is because his
policies are fighting market forces. Consumers
would like to downsize further; such "downsizing",
however, means bankruptcies and foreclosures.
Policy makers would rather subsidize consumers
with massive fiscal and monetary stimuli - it's
simply politically more palatable. Because market
forces are fought, such stimuli are rather
ineffective, causing money to flow not to
consumers but to where there is the greatest
monetary sensitivity: precious metals, commodities
and currencies of countries producing commodities
may be the prime beneficiaries.
And while
congress has stepped up spending on a grand scale
in an effort to "stimulate" the economy, it's
little compared to the trillions the Fed can
print, creating money out of thin air.
It
doesn't have to be that way: traditionally,
central banks do not play cheerleader, but party
pooper. By keeping the leash tight on politicians,
real reform has to be enacted: look at how the
European Central Bank mostly allows the bond
market to impose reform on policy makers in the
eurozone; it's an ugly process, but a higher cost
of borrowing imposed by the bond market may be the
only language politicians understand. In contrast,
in the US, we appear to have decided that the
Fed's magic wand will cure all our problems,
allowing congress to go on with business as usual,
with the Fed seemingly financing everything,
including government debt.
The policies
pursued by the Fed foster ever more leverage at
the consumer level. Bernanke has pounded the table
that he wants higher inflation. We have no doubt
he will succeed, even as the markets are reluctant
to embrace his determination - not so different,
by the way, as the markets were reluctant in
taking former Fed chairman Paul Volcker seriously
when he announced in the early 1980's he would
fight inflation. Indeed, we don't think the Fed
will rest until home prices are firmly moving
higher - after all, that appears the only
politically acceptable way to bail out millions
(and a still growing number) of homeowners under
water in their mortgage. But what happens if and
when the Fed will want to mop up all this
liquidity?
We are rather concerned that
with all the leverage pumped back into the system,
any tightening will have an amplified effect,
causing the economy to plunge right back down.
That's why Bernanke has argued that possibly the
greatest mistake during the Great Depression was
to raise rates too early; so much for raising
rates within 15 minutes, as Bernanke has argued he
could.
In the early '80s, consumers
complained about high interest; however, if rates
were raised today to only a fraction of the 20%
Fed Funds rate of June 1981, the economy might
implode. And while the Fed may be in charge of
short-term rates, should the bond market get
spooked because of the policies pursued, it may be
impossible for the Fed to stem the tide.
A
weaker US dollar may also ensue; we have yet to
see a country that depreciated itself into
prosperity. It simply makes no sense for an
advanced economy like the US to compete on price:
the day the US will export sneakers to Vietnam
hopefully never comes.
What matters is
that inflation is real.
Just as Bernanke
takes it upon himself to implement aggressive
policies because congress may not act according to
his playbook, policy makers around the world are
also slow to react.
China, for example,
has taken many steps to be ready to allow its
currency to strengthen, from allowing its economy
to move away from competing on price alone (ie a
weak currency environment), to encouraging the
production of value added goods and services where
exporters may have more pricing power, necessary
to allow exporters to remain competitive should
the yuan strengthen; to allowing more
international trade to be conducted in China's
currency; to fostering the issuance of
yuan-denominated bonds in Hong Kong, amongst
others.
Chinese policymakers are
increasingly US educated; they read the same news
and share many concerns Westerners have. The key
difference is that Chinese policymakers act in
what they perceive to be China's best interest and
their decision-making processes are subject to a
Chinese set of political dynamics. As a result,
policy mills grind slowly.
Similarly,
policymakers in much of Asian and the Middle East
act slowly. Not necessarily because of choice, but
simply because that's how local dynamics play out.
Countries such as Bahrain or Saudi Arabia with
their centralized control may be acting more
swiftly, increasing food subsidies to pre-empt
social unrest. Ultimately, for many countries in
Asia, allowing their currencies to appreciate may
be the most effective tool to tame inflationary
pressures.
In the meantime, countries in
the Middle East may at some point come to the
realization that changing the government may not
lead to lower food prices. Unless the next
president of Egypt is a great farmer, social
instability may prevail for a long time.
Incidentally, while we are not threatened
with revolution in the US, discontent has been
growing from the fact that real wages have not
risen for a great number of people in over a
decade. If you have assets, you may love
Bernanke's policies, as he pushes up everything
from equity prices to [shh ... don't tell Ben]
commodities. However, many who have to work for a
living have seen their purchasing power erode.
Bernanke puts the blame on a lack of
education. However, his policies, in our
assessment, contribute more to the wealth gap than
policies of either Democrats or Republicans. In
such an environment, disgruntled citizens may
increasingly vote for populist politicians: in
today's world, if you can distill your political
message into a tweet, you may have a better chance
of being elected. This doesn't just help explain
the rise of the Tea Party on the right, but also
contributes to discontent on the left, with many
fearing President Barak Obama's policies are
betraying them.
What are the implications
of all this? In our view, the polarization of
politics will continue, making it ever more
difficult to find common ground on tough political
questions, such as entitlement reform. In the
absence of compromise, the government may
nominally pay entitlements as promised; it's just
that the purchasing power of what is paid may have
eroded due to inflation and a weaker dollar. As
these dynamics play out, investors may want to
position themselves to take the risk of a decade
of global political instability into account.
Axel Merk is manager of the Merk
Hard, Asian and Absolute Currency Funds. To learn
more about the Funds, visit www.merkfunds.com.
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