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Volcker vs. Bernanke

Paul Volcker vs. Ben Bernanke in the Fed's battle against first inflation and now deflation...

IN THE EARLY 1980s, writes Gary Dorsch of Global Money Trends, the Federal Reserve's headlines figures for the growth in money supply – measured by the M1, M2, and M3 aggregates – flashed at the top of trader's radar screens, and jolted US Treasury-bill rates by 50-basis points within minutes.

Inflation was raging at a 10.7% annualized rate, and repeated attempts to cure it with voter-friendly policies had failed. So the Fed's then-chief, Paul A.Volcker, was doggedly pursuing a radical monetary policy that led to skyrocketing interest rates and two back-to-back recessions.

Volcker vs. Bernanke: Monetarism vs. Inflation

Volcker's strategy was designed to curb inflation, by controlling the growth rate of the money supply within established target ranges for M1, M2, M3, and bank credit. However, if one money supply measure grew faster than its targeted range, while another measure grew slower than its targeted range, it was difficult to predict if the Fed would lift the Fed funds rate (its key lending rate) to slow the growth rate of the rapidly growing aggregate, or instead, lower interest rates to speed-up the lagging one.

When Volcker became Fed chief in August 1979, M1 was growing at an annualized 9% clip, compared to the Fed's target range of 1.5% to 4.5%. M2 was expanding at a 12% rate, compared with its target range of 5% to 8%. With Volcker's focus on monetary control, the federal funds rate was immediately hiked 50-basis points to 11.75%, and by April 1980, the fed-funds rate averaged 17.5%. Three months later, and with Gold Prices down by one-half from their top of Jan. 1980, the Fed funds rate then tumbled to 10%.

But the rollercoaster ride did not end there. By November 1980, the fed funds rate was pushed back-up to 17%, destroying Jimmy Carter's re-election bid. During Ronald Reagan's first year in the White House, US interest rates reached a record 20% in June 1981. A new recession began in July, one that saw the unemployment rate reach 11% by the end of 1982, the highest since the Great Depression.

The devastation was particularly acute in the industrial Midwest, where steel mills, auto plants, and coal mines were shut down.

Volcker's tough-medicine untangled "Stagflation", the dreaded combination of stagnant economic growth and high inflation that persisted through the late 1970s and early 1980s. Inflation, which averaged 14.6% in the year from May 1979 to April 1980, had fallen to below 4%. During Reagan's first term, the stage was set for strong growth and the bullish stock market of the 1980s. Volcker stepped down from the Fed in August 1987, with the Dow climbing to record highs just two months before the October "Black Monday" stock market crash that marked Alan Greenspan's first "easy money" response to financial turmoil.

Once again today, Paul Volcker is summoned to rescue Wall Street, tapped by President-elect Barack Obama on Nov. 25th to lead a new advisory panel, dedicated to stabilizing the markets. Volcker will be a key figure in Obama's inner circle of economic advisors, alongside Obama's Treasury chief Timothy Geithner, White House chief economist Larry Summers, and forming the next "Plunge Protection Team" (PPT).

What challenges does Volcker-the-inflation-fighter now face? While government commentators are still trying to assure the public that there will be no repeat of the 1930s Depression, the financial markets are telling a different story.

So far, every government intervention and G20 central-bank rate cut has failed to stem the economic meltdown. The American, Chinese, and European leadership are crafting stimulus packages of a combined $1.2 trillion, but that's only a small fraction of the $30 trillion that's been lost in global stock markets to date.

Volcker vs. Bernanke: Quantitative Easing at the Fed

Whereas Volcker pursued "Monetarism" to defeat double-digit inflation – targeting the actual supply of money to support its value – current Fed chief Ben Bernanke is signaling a diametrically opposite strategy, "Quantitative Easing" (QE).

Quantitative easing is designed to head-off deflation in the US economy, which if left unchecked, could generate a downward spiral of corporate earnings, production cuts, mass layoffs, and greater difficulty for companies to pay-off debts.

Yields on speculative-grade US corporate junk bonds surpassed 20% in November on fears the recession will leave a glut of companies unable to meet their debt payments. "Our nation's economic policy must vigorously address the substantial risks to financial stability and economic growth that we face," Bernanke declared on Dec 1st.

Bernanke said a further reduction in the federal funds rate, now pegged at 1%, is "certainly feasible," and telegraphed the Fed's intention to use more unorthodox measures to flood the markets with ultra-cheap money.

"Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Fed's quiver remains effective," he said. Now the Fed will purchase long-term US Treasury and government-sponsored agencies notes, in order to manhandle the credit markets, and force bond yields lower. US Treasury prices rose sharply on his remarks, pushing yields to their lowest in five-decades, on expectations that a long period of ultra-low interest rates, similar to Japan's, lies on the horizon for the United States.

"The Fed can backstop liquidity not only to financial institutions but also directly to financial markets, as we have recently done for the commercial paper market," he said, referring to recent Fed moves to act as a market maker, or buyer of last resort, for securities that no one-else wants to buy. The Fed is widely expected to lower the fed funds rate by a half-point to 0.50% at its next scheduled meeting on December 15-16, while simultaneously engaging in "Quantitative Easing".

The Fed's money-printing operations are showing up in the explosive growth of the US monetary base, which includes banknotes and coins in circulation, plus commercial banks' reserves held at the Fed.

The monetary base has soared by $630 billion in the past three-months, or 76% higher from a year ago. Between August 1987 and November 2005, even under "Easy" Al Greenspan, the monetary base rose from $233 billion towards $782 billion, or a mere 6.8% annualized rate of expansion.

The Fed's portfolio of securities has expanded by $1.2 trillion over the past seven weeks, to a record $2.1 trillion. Banks are on the receiving end of the Fed's money injections, but are afraid to lend to the private sector. Instead, banks are hoarding the excess cash to fix their balance sheets, or depositing the excess funds with the Fed itself, or buying Treasury bills and notes, at the lowest yields in history.

Under a new law, the Fed is allowed to pay interest on excess bank reserves, currently offered at 1.15%. That's higher than the 1% fed funds target rate, and higher than the 0.01% one-month T-bill rate. The Fed's ability to pay interest on bank reserves, allows it to flood the banking system with unlimited amounts of money, without pushing the fed funds rate to zero-percent. The Fed might avoid a Zero-Interest-Rate-Policy (ZIRP), in order to prevent money market yields from turning negative, after deductions are levied for annual operating expenses.

The Fed has signaled a historic shift to "Quantitative Easing" in a desperate bid to stop the unrelenting slide in the US housing and stock markets, which have lost a combined $12 trillion of value, over the past 13 months.

A common estimate is that every Dollar's change in wealth causes people to change their spending by 5 cents. If so, the hit to consumer spending could be $600 billion ($12 trillion X 0.05). Even this might be too optimistic if leveraged households decide to pay down debts.

Home prices have been on a steep decline, with 20 major markets plunging a record 17.4% in September from a year earlier, according to the S&P Case-Shiller Home Price Index, after tumbling for 26 consecutive months. A total of 936,000 homes have been lost to foreclosure since the housing crisis flared-up in August 2007. Furthermore, the inventory of unsold homes has risen to 11 months, and a record 2.9 million vacant homes are up for sale.

On Nov 26th, the Fed and the Treasury unveiled the next step into the murky world of quantitative easing – a plan to purchase $200 billion of asset backed securities (ABS) secured by risky credit cards, car loans and student loans. The Fed will also purchase $500 billion in mortgage backed securities (MBS), and another $100 billion in direct debt issued by Fannie Mae and Freddie Mac. The Fed succeeded in driving the 30-year mortgage rate a half-point lower to 5.50% last week, enabling millions of homeowners to re-finance their monthly payments.

Bernanke's latest gambit – Japan-style Quantitative Easing – is designed to force yields on two, ten, and 30-year Treasury debt to the lowest since 1955. Fed chief Ben "Helicopter" Bernanke confirmed on Dec. 1st that the central bank will target long-term interest rates to combat the deepening recession, knocking the 10-year yield to 2.65%, and the 30-year bond yield to 3.18%.

Just like the Bank of Japan when it tried quantitative easing after a lost decade of deflation and grinding recession, the Fed is now expected to target the 10-year yield in a tight range next year. And the mechanics of "QE" has turned conventional logic upside down.

Treasury yields are plunging to record lows, even at a time when the supply of marketable US federal debt outstanding soared to $10.6 trillion in October, up from $9.3 trillion in February. During the lifetime of the Bush administration, the federal debt has mushroomed by nearly $5 trillion, yet 10-year Treasury-note yields have moved sharply lower, from around 5.50% in January 2001, to 2.70% today.

This year's fiscal budget deficit could easily top $2 trillion, due to the regular operating deficit, TARP and other bailouts, and a $500 billion stimulus package. That would far exceed the previous record deficit of $450 billion. But with the Fed printing unlimited quantities of US Dollars out of thin air under the QE framework, so far, Washington has been able to issue massive amounts of debt with impunity.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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