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The Fed's Next Move

Preparing for the coming policy shift...

CASEY RESEARCH partner and managing editor of The Casey Report, David Galland, talks to Casey Research colleague Louis James about what he believes will be the next big move from the Federal Reserve.

Louis James: David, in recent editorials you've warned of what could be an important shift in US Federal Reserve policy – can you fill us in?

David Galland: There is growing evidence that in the next month or two, we will head into a very dangerous period. The Fed has been extremely supportive of the US government's insane spending, polluting its own balance sheet by buying up toxic loans by the hundreds of billions and by pumping enormous quantities of cash into the money supply.

You don't have to look very hard to understand why we have seen some small recovery in the economy, much of which has been driven by the financial sector that has been the recipient of so much largesse – it was bought and paid for by the government, working hand in glove with the Fed.

But there is about to be a fundamental change in this arrangement. It appears that the Fed has decided that it's time to take a step back from its monetization – or quantitative easing (QE), as they now term it – in the hopes that the market will step in to fill the large gap it will leave.

They can't know how that's going to work out, but if they don't stop pumping money into the economy, they never will know if the quantitative easing has worked.

Based on a lot of statements from a number of the voting members of the Federal Open Market Committee, the change just ahead is that they are serious about stopping QE in June.

As they won't wait until the last minute to confirm the end of their Treasury buying, I would expect their intentions to be made clear following their end-of-April meeting, the full minutes of which should be released in early May.

Louis James: To be clear, do you mean no QE3, or that they cancel the portion of QE2 they haven't spent yet?

David Galland: They may leave themselves a bit of wiggle room by holding back some of the funds slated to be spent as part of QE2, in the hopes of demonstrating a high level of confidence in their decision to stop the monetization.

That would also give them a bit of powder to use should the need suddenly arise, without exceeding the mandate of QE2. The important point is that I am increasingly sure they won't just roll out QE3, and that will have consequences.

Louis James: Are you saying, no QE3 at all?

David Galland: No. I think there will be a QE3, but it won't materialize until after a relatively lengthy period during which the Fed stands aside in order to give the market the opportunity to adapt and adjust to their exit from the Treasury auctions. In other words, once they stop, I wouldn't anticipate them jumping right back in at the first sign of trouble – say, if the stock market crashes.

In time, however, as the ponderous problems weighing on the economy come back to the fore and return the economy to its knees, the Fed will be forced to reinstitute the monetization, though they will likely try to come up with a moniker other than quantitative easing to describe it.

Louis James: Why are you so sure there will be a QE3?

David Galland: Because the problems that made the economy stumble in 2008 have not been solved. As I said before, most have gotten worse. Have the impossible levels of sovereign debt and trillions in unresolved bad mortgages embedded in the balance sheets of Fannie, Freddie, the Zombie Banks – and now even the Fed itself – been resolved? Hardly.

Is there any real sign coming out of Washington that the deficits will be substantively tackled? You don't have to be as skeptical as I am to understand that the deepest spending cuts being discussed don't even scratch the surface of the $1.5 to $2 trillion deficit. 

As for the $60 trillion or so in debt and unfunded obligations, forget about it.

The US government and the governments of most large nation-states are fundamentally bankrupt. In time, they will have to default on their obligations. While there will be some overt defaults, I expect most of them to follow the path of least resistance, which is to try to inflate the problem away. And that means QE3.

For now, however, the Fed will claim victory over the economic crisis and follow suit with many other central banks – switching to a less accommodative monetary policy.

Louis James: They've done their job and now it's time for back-slapping and cigars.

David Galland: Yes.

Louis James: Consequences?

David Galland: If you look at a chart of the Dollar, you'll see that it has been bumping along the bottom recently. Logically, if the Fed stops monetizing the Treasury's spending, we should see a rebound in the Dollar. The big traders – the big institutional money out there – are going to use the change in Fed policy as a clear signal that it's safe to get back in the US Dollar.

It would be wrong to underestimate the amount of money that needs to find a home, and the liquidity advantages offered by the US Treasury market. If the river of money redirects into Treasuries, it could – at least for a time – offset the Fed's exit and push the Dollar up, maybe significantly so. And if the Dollar comes roaring back, commodities, including gold and silver, would likely take a fairly hard hit.

Again, this is a short-term view. The longer-term trend for the precious metals is absolutely intact, because the fundamentals are entrenched – namely that the sovereign debt and spending is out of control, and politically uncontrollable.

Louis James: Let's talk about that for a moment. These people – the big money – are financial types. Bankers. They know about all the bad debt they have, even if new reporting rules allow them to keep some of their problems off the books. They must know that a so-called jobless recovery is not a recovery.

They are well aware of all sorts of dirt they don't discuss in public – how could they be letting the Fed convince them the economy is healthy when their own information tells them it isn't?

David Galland: First off, "they" are not one guy. They are a lot of people with a lot of different perspectives and a lot of different objectives. Right now, for example, people look at the lack of yields in bonds and the potential for inflation in bonds, so they've been easing back on bonds and getting into equities more, in the hope of generating some kind of return.

If you're a fund manager or a large institutional trader, you're not paid to sit on your hands. You've got to "do something," even though there are times – and I think this is one of those times – when doing nothing is exactly the right thing to do. So, I wouldn't say they are being stupid, it's rather that they've made their own calculations and concluded that US equities are still safe – a position that is supported by the very low levels of volatility. 

Even the troubled financials have seen strong gains of late, despite the fact that nothing has been fixed. Of course, if you look under the hood, you find they've benefited substantially from the cheap money and rigged deals the government has orchestrated to bail them out.

While no one can say when the shift out of equities and back into Treasuries and lower-risk assets will begin, in my view the Fed's exit from quantitative easing sets the stage for that to happen. After that, it will just be a matter of time before traders are going to wake up and decide equities are not safe, and they'll start leaving in droves.

Remember, however, that the stock market and the economy are by nature very complex systems. There are so many variables; you just can't know which variable is going to rule the day at any given time. But given the importance of the Fed's intervention and the government spending that has helped engender, its policy shift is certainly a variable to keep an eye on.

Louis James: I find the capacity of bankrupt financial companies to defy gravity truly amazing. Disbelief sustained for such lengths of time makes me dizzy.

David Galland: You're not alone. The vast ocean of bad debt out there is just as big as ever. Everything I hear from people in the financial industry is that the banks' debt profiles are not getting any better. People are not getting on top of their debts. They are not paying down their mortgages. Default rates are still astronomical…

Louis James: How could it be otherwise? Unemployment is still high.

David Galland: Unemployment is still stubbornly very high, though if you buy into the government's figures, it is moving steadily in the right direction. Of course, the government has no reservations about jiggering the data to suit itself. That makes it important – if you want to get a more realistic picture – to look at the topic from different angles.

One telling statistic is unemployment as a percentage of the employable population, which screens out many of the government's self-serving adjustments to its official figures. Looked at that way, you can see that unemployment is continuing to rise, even though the government is reporting that it's falling markedly. 

You could even say we have another deficit, one in government accountability. Clearly, it's very politically important that unemployment be perceived as declining, therefore, voilà, it is.

Louis James: Okay, let's back up a bit to the debasement of the Dollar. You mentioned that as a given, almost in passing, but there are a lot of people who don't see it. 

David Galland: Well, anyone who can see beyond the tip of their nose can see that inflation is going up. Just pull up a chart of the CRB Index for commodities – the real stuff required for life – and one can see it has been on a steep upwards trajectory. Inflation is very much here and alive.

Louis James: John Williams's Shadow Stats chart shows inflation at nearly 10%, while the Bureau of Labor Statistics is reporting 2.1%.

But even Williams' statistics don't report real inflation; they just report what it would be if the government reported inflation the way it used to, before it started "improving" its reporting in the 1980s. It's still an incomplete view, because the government's original reporting was flawed to begin with.

David Galland: Right. And one of those flaws is the way they weigh housing. It plays a big, big role in CPI, and in 2008 housing was dealt, if not a death blow, at least a blow that put it in the hospital. 

And it will be there for a very long time, because government policies encouraged bad decisions on the part of both lenders and borrowers. This has left trillions of Dollars of bad debt hanging out there.

The retracement of housing prices, as a component of official CPI, pulls the official inflation figures down, even though those figures don't sync up with the actual cost of living. Of course, a low CPI gives the government cover for continuing to monetize its debt.

Louis James: The net of this for inflation is that the crushing of the housing sector makes the CPI drop, making it look like life is getting cheaper, whereas the reality is that people's hard-earned wealth put into real property has taken a beating at the same time as the things they consume on a daily basis cost more. Life has gotten a lot more expensive even as savings have been wiped out. Not good.

David Galland: Right. And the government is trying to get people to ignore the signs of inflation, saying everything is all right. But recently, several Fed governors have been saying outright that there is a problem and that they need to cool off the money creation and start dealing with inflation. This is why I think there isn't going to be an immediate QE3.

Louis James: So, what happens next?

David Galland: Consider Japan as an example of an advanced economy that has been struggling to deal with the aftereffects of a collapsed bubble in real estate and stocks for many years – well before the recent earthquake.

If you look at what happened when they did their equivalent of QE after the initial stock market crash, the spending stimulated a fairly significant recovery in Japanese equities, taking the market back up about halfway to the bubble's top; but the rally didn't last.

Once the Japanese government put an end to its quantitative easing, the Nikkei plummeted. The government resisted reinstating quantitative easing for two years before throwing in the towel and once again cranking up the money engines in an attempt to break the economy out of the doldrums.

The long-term result is a Nikkei still well below the crash level (even before the earthquake), and all the spending has caused Japanese government debt to rise to 200% of GDP. While no two situations are identical, I think the US is following a very similar script.

Louis James: If the Fed decided to hold off on QE3, do you think it could take as long as two years for them to feel forced back to it, forced to do something?

David Galland: It could. It would depend on how sharp the downtick is. There are so many factors at work here that it's really unknowable at this point. Nearer-term, all the signals are that the Fed will hold off on QE3 at their next meeting. And, as I have tried to make clear, that will have consequences – for equities, for the Dollar, for the commodities sector.

If I'm right, and commodities – including precious metals – sell off, and mining stocks sell off even more, there will be some fantastic opportunities to take advantage of. The people who are paying attention will be able to clean up.

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Doug Casey is a world-renowned investor and author, whose book Crisis Investing was #1 on the New York Times bestseller list for 29 consecutive weeks, a record at the time.

He has been a featured guest on hundreds of radio and TV shows, including David Letterman, Merv Griffin, Charlie Rose, Phil Donahue, Regis Philbin, NBC News, and CNN; and has been the topic of numerous features in periodicals such as Time, Forbes, People and the Washington Post.

His firm, Casey Research, LLC., publishes a variety of newsletters and web sites with a combined weekly audience in excess of 200,000, largely high net worth investors with an interest in resource development and international real estate.

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