“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
– Ben Bernanke, Speech to the National Economist’s Club, November 21, 2002 (emphasis added).
A schism is developing among economists as to what will happen to the US Dollar as a result of the 2008 financial crisis and subsequent actions taken by the Federal Reserve. In my last letter, I focused on monetary inflation and why I think it could become a problem in the coming years, although the US will not likely face a situation of hyperinflation. This week’s letter explores the opposite: deflation. Notably, Nouriel Roubini and Marc Chandler (author of the popular “Gloom, Doom & Boom” report) feel that deflation is the current problem that the Federal Reserve must confront. Regardless of which group is correct, the fact of the matter is that the Fed’s actions of the past year are geared toward preventing deflation by all means possible. The background of Fed Chairman Ben Bernanke further illustrates this point. Finally, technical analysis of the US Dollar suggests that further declines in the currency are on the docket for the first few years of this decade.
Monetary deflation is often associated with extended economic contractions, which can lead to a vicious cycle of falling asset prices. Japan has experienced deflation since the early 1990’s (refer to Chart 1 and my subsequent comments), and indeed deflation was a major factor in causing the Great Depression in the 1930’s. After an economy enters a cycle of deflation, it often takes decades to break out of it. In calling for near-term deflation, Roubini and other economists point to the large gluts in housing, industrial capacity, etc. That being said, the response of the US Federal Reserve to the 2008 financial crisis has been the polar opposite to the response during 1930-32, which was lassiez-faire. The difference in response can be attributed in great proportion to one man: Federal Reserve Chairman Ben Bernanke. As perhaps the most respected scholar on the Great Depression, even before the 2008 crisis Bernanke made clear that aggressive central banking actions were necessary to prevent deflation. His responses to the crisis have made it clear that he intends to use every policy tool at his disposal to prevent deflation. Depending on one’s view of his actions, the fact that he is the Fed Chairman who faced the crisis is either a blessing or an unfortunate circumstance. I believe the American people are fortunate to have had his mindset and actions in charge during and in the immediate aftermath of the crisis. However, in the long run the forecast is not as rosy.
It is extraordinary that Ben Shalom Bernanke was appointed Chairman of the Federal Reserve two years before the broadest, most severe financial crisis since the Great Depression began. If Bernanke was not in the Federal Reserve, in my opinion he would have been at the top of the list of individuals to be consulted for advice on understanding the crisis and, more importantly, how to construct policy in response. Bernanke served on the Federal Reserve’s Board of Governors from 2002 to 2005, and briefly as the Chairman of the President’s Council of Economic Advisors before his appointment as Chairman of the Federal Reserve. As soon as he arrived from Princeton, his first speech as a member of the Board of Governors (on the occasion of the great Milton Friedman’s 90th Birthday), outlined his theories for fighting inflation. The ideas put forth in the speech have come to be known as the “Bernanke Doctrine.” The speech as a whole has become eerily prophetic in the aftermath of the 2008 crisis.
By late 2002, in the wake of the deflating technology bubble, Alan Greenspan had slashed short-term interest rates to 1%. Yet, uncertainty lingered in the aftermath of the 9/11 attacks and the Enron and WorldCom scandals. The Dow and NASDAQ did not bottom until October 9 of that year. Thus, over the course of 2002 deflation had been mentioned as a potential problem by several economists and economic policy groups. As mentioned, Bernanke took the opportunity of his first speech as a member of the Fed to address the potential problem and how to deal with it.
In his speech, Bernanke outlined seven steps to prevent deflation. First, increase the money supply (M1 and M2). This point was backed up by the quote that introduced this letter. Obviously, in 2002 the strength of the US Dollar was not a pressing concern, as is the case today. Bernanke went on to mention the prospect of the Fed purchasing US Treasuries (this was initiated in March 2009 by Bernanke in cooperation with Geithner’s Treasury), and also the implied purchase of stakes in companies using newly printed money (sound familiar to TARP and the GM Bailout?). Finally, Bernanke condoned a more direct method of devaluing of the dollar, to augment the printing of money. In extolling the Fed’s actions under Roosevelt in 1933, he said:
"It's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly."
Fast forward seven years. When Bernanke speaks about the US Dollar today, his words are carefully crafted to finesse the point and to avoid creating volatility in the currency markets. After all, the mandate of the Federal Reserve involves, among other things, maintaining the strength of the US Dollar. Thus, he would likely not be so blunt today. Regardless, Bernanke’s philosophy toward fighting deflation was well-formed long before he assumed the office of Chairman of the Federal Reserve. Given his knowledge of the Great Depression, Bernanke appreciates more than anyone else what could happen if the United States were to fall into a deflationary spiral. Hence, it can be argued that he helped save the United States from what could have become a “Second Great Depression.” Yet, the actions of his Fed have greatly undermined the long-term health of the Dollar. These actions could lead to a weaker dollar and inflation during the new decade.
The argument against deflation is further enhanced via technical analysis of the US Dollar. The dollar is in the midst of a secular, multi-decade decline (refer to Chart 2). In my opinion, this decline was inevitable due to US output as a percentage of the global GDP gradually declining and the emergence of the Euro and other reserve currencies, among other factors. From a technical standpoint, this decline is not likely to stop. Of course there will be short-term corrections, this past month being a perfect example (refer to Chart 3 and my subsequent comments). Trading at the upper range of both the Bollinger Bands and Stochastic (50-Day over 200-Day Moving Average), the majority of this short-term correction has likely run its course. Keep in mind that the flight to safety that began in mid-2008 resulted in the Dollar Index jumping from 72 in July 2008 to about 90 in March 2009. This occurred while the Fed more than doubled its balance sheet and commenced quantitative easing. The decline that began last March was inevitable and will likely continue.
In my November 27 letter, I predicted that there would be volatility in the wake of the Dubai debt scare. At the time, I predicted the dollar would resume its decline “anywhere from two weeks to a month from now.” Beginning last month with Dubai and Europe’s exposure to their debt, and more recently with debt concerns in Greece and Spain, the Euro has been hammered against the US Dollar, falling from 1.50 USD to 1.43 on December 31. Due to the heavy weighting of the Euro within the Dollar Index, some currency specialists are predicting the bounce in the Dollar to continue into the early part of this year.
Regardless, I remain unconvinced that the recent dollar rebound is anything other than a temporary head fake. The Dollar Index has been treading water between 77.50 and 78.45 for the past two weeks. If several important technical barriers are broken early in the new year, we could see continued dollar strength for the next few months. However, with another $871 billion balance sheet expansion on the docket (the health care bill), barring a few countries in the Eurozone defaulting or another unforeseen geopolitical event (Iran, Israel, etc.), the dollar will likely continue to decline in 2010. A sustained climb in the Dollar Index would be a sign of deflation, but with a deflation watchdog like Bernanke running the Fed, it is not likely to happen.
Respectfully Yours,
Matthew R. Green
The full text of Chairman Bernanke’s speech can be found on the Fed’s Website:
www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm
Chart 1: Nikkei 225 Index 1965 – Present
This chart illustrates what a deflationary spiral can do to a country’s capital markets. The Nikkei peaked on December 31, 1989 and is today more than 70% below that. Granted, the US economy will likely never see a bubble on the scale of what the Japanese economy experienced from 1985-89. To illustrate my point, in late 1989 the Financial Times reported that the land in central Tokyo beneath the Imperial Palace and its grounds was more valuable than the entire state of California.
Chart 2: US Dollar Index 1986-Present
The USD’s fall in the mid-1980’s was a direct result of the 1985 Plaza Accords. This agreement was a planned devaluation of the USD vs. the German Mark and Japanese Yen (indeed, it contributed to the Japanese Asset Price Bubble). For Americans, the best part of the 1990’s was that the market was rising along with the value of our dollars. By contrast, in the 2000’s the market was volatile, ending the decade with little to no gain, while the dollar lost more than 20% of its value.
Chart 3: US Dollar Index - January 2005 to December 2009
The Dollar’s move in 2008 should be viewed as an aberration. Without it, the short (blue), mid (red), and long (green) term moving averages would all be lower. Notice that combined with the Dollar’s correction this year, the Long-term moving average is virtually unchanged since September, 2008. The rise in the dollar the past few weeks (the Dollar Index closed on 12/31 at 77.95), has allowed it to approach its mid- and long-term moving averages. This is an interesting circumstance. Normally, a security’s mid-term average crossing through the long term average on a downward trajectory is a bearish signal. However, dollar strength in early 2010 could result in the Dollar Index crossing both levels of resistance. This would be a bullish signal and likely pave the way to further dollar strength in 2010. At the same time, the short-term Stochastic and MACD indicate that the Dollar is overbought in the short term. Bottom line: the market will be keeping a close eye on the Dollar Index in the next few weeks for direction in 2010.
No comments:
Post a Comment