The Setting for Ben Bernanke's Speech at Jackson Hole

Anticipation is rising for the annual late summer speech given by the Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke.  The basic economic environment surrounding this speech is what I would like to touch on in this post.

This environment along with what the Federal Reserve does…or doesn’t do…is crucial to the possible “macro” position a person could in their investments and in their business decisions.

For example, John Paulson, the hedge fund investor, has apparently started placing his bets with respect to current economic and financial conditions and with respect to what the Fed can…or can’t do.  Mr. Paulson, according to recent regulatory fillings, has been re-arranging his portfolio…increasing his position in gold and reducing other positions…in anticipation of higher future levels of inflation.

Future inflation is certainly a concern and I will discuss this a little later, but there are also other issues that need to be discussed as well.

For example, dominating discussions about the current environment is the rate at which the economy is growing.  In the second quarter of 2012, real GDP grew at a 2.2 percent year-over-year rate.  I am expecting this growth rate to remain around 2 percent for the next year or so.  This expectation is backed up by other numbers, like that for industrial production.  Economic growth has been tepid, is tepid right now, and is expected to remain tepid for the near term. 

There are numerous reasons why economic growth is likely to remain slow.  I have reported on these in many recent posts.  A short list of reasons include continued deleveraging of the private sector; under-employment of eligible labor; residential mortgages being underwater; bankruptcies and foreclosures; commercial real estate losses; health of a large portion of the banking system; the financial condition of state and municipal governments; the uncertainty that exists with respect to government policy and regulation; the European recession and sovereign debt crisis; and the slowdown in other countries like China, Brazil, and India.

I believe the American economy will continue to grow but only at or below a 2 percent year-over-year rate.  This is an environment of stagnation with unemployment and under-employment staying high and capacity utilization of industry remaining historically low. 

Given this basic scenario, interest rates will rise over the next year or so.  There are, I believe, three reasons for this. 

First, interest rates in the United States are as low as they are because of the “haven” nature of US government debt.  Large quantities of “risk averse” funds have flown into American security markets escaping the mess in Europe.  As a consequence, the yield on 10-year US Treasury securities closed at 1.82 percent on August 17.

If one subtracts an “expected rate” of inflation from this figure, let’s use 2.00 percent (which is about what the inflation rate is in the United States using the year-over-year rate of increase in the GDP implicit price deflator).  Then an estimate for the “real” rate of interest is a negative 18 basis points.  This is not too far off the yield on the 10-year TIPS bond, which was a negative 45 basis points on August 17.

And, what “should” this real rate of interest be?  I have always argued that “the” real rate of interest should be somewhere around the level of the “expected” real rate of growth of the economy.  Thus, from the 1960s through the end of the century a 3.0 percent rate worked out to be a good working estimate of the real rate.  If we use my current “expected” rate of growth of the economy, 2.0 percent, then the “real” rate of interest in the United States should be in the 1.50 percent to 2.00 percent range. 

Therefore, as the “risk averse” money leaves United States shores, the yield on TIPS should rise fairly steeply.  Whether or not this rise will be resisted by the Federal Reserve is a question that remains unanswered at this time.  Resisting the rise will just cause to Fed to flood the banking system with more excess reserves, which may cause other problems.  But, this is something that the monetary authorities are going to have to face.

The second reason for a rise in interest rates is that there should be, sooner or later, demand pressure on interest rates due to a pick up in economic activity…or,  Right now, commercial banks are awash with funds while at the same time loan demand seems to be particularly weak.  Thus, there is little or no pressure for interest rates to rise.  This is certainly something we need to watch out for. 

However, we could see interest rates rise for a third reason…a rise in the expectation of future inflation.  This is something many people…like John Paulson…are worried about.  Never before has the commercial banking system had so many excess reserves “hanging around.”  In August 2008, before things fell apart, the excess reserves of the whole banking system amounted to less than $2.0 billion.  In the two banking weeks ending August 8, 2012, excess reserves in the banking system averaged $1.5 trillion. 

The monetary base, the foundation of credit expansion in the United States, was around $2.7 trillion in the banking weeks ending August 8: it was at $842 billion in August 2008!

Few people believe that the Fed can withdraw a major part of these funds from the banking system once banks start lending again…and inflation starts to increase.  Inflation and credit expansion go hand-in-hand.   And, the lending could pick up even if real economic growth does not pick up.

A further question exists: how can the Federal Reserve withdraw funds while the federal government is still running annual budget deficits of $1.0 trillion or more?

So the third reason for interest rates to rise is that as inflation accelerates in the United States, the expectation of future inflation will also rise.  When this will begin and how fast will it take place is, of course, the big question.

There are other possible “macro” effects surrounding this picture.  For example, what will happen to the value of the dollar given this view of the world?  These will be addressed in future posts.

Does one get a sense of potential “stagflation” in what is written above?  Slow economic growth, rising inflation, and rising interest rates.  How does a central bank combat such a situation?

The situation that Mr. Bernanke and the Fed face is a very challenging one.  It is a situation that they have helped to create.  But, getting out of it will not be much fun for them.

As far as the private investor is concerned…a situation like this presents a ton of possible “investment” opportunities.  And, one should always ask, “How can I make money from a situation like the ones described above?” 

As one reads a book like “More Money than God” by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes.  The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes.  However, these “tools” are not available to most people.  Maybe that is why the distribution of wealth in the United States has become so skewed.    

US Industrial Production Continues to Expand

The US economy continues to grow but the pace of expansion is still modest.  Industrial production expanded in June at a 4.7 year-over-year pace.  This put the average rate of expansion for the quarter at 4.7 percent, year-over-year, up slightly from a 4.4 pace of the first quarter. 

Since the current economic recovery began in July 2009, the highest quarterly increase in industrial production came in the third quarter of 2010.  At that time industrial production was increasing at a 7.1 percent, year-over-year rate. 

As can be seen in the accompanying chart, the rate of increase dropped off from that date and seems to have settled in the three-to-five percent range, a rate that is rather anemic for this time in the business cycle, but a rate that is consistent with other current measures of economic growth.

Real GDP, for example, grew at a 2.0 percent year-over-year rate of growth in the first quarter of 2012, and has only average in the 1.5 percent to 2.0 percent range for the past year.

As reflected in almost all of the data, economic growth is taking place but not at a very rapid pace.

There are three reasons for this slow pace of economic growth in my mind.  The first reason is the huge debt overload that exists within the US economy.  I have written on this in "The Debt Crisis Goes On and On."  Individuals, businesses, and state and local governments, overloaded with debt at not able to spend as abundantly as in the past because they are attempting to get their balance sheets back in line.

Second, there is a great deal of uncertainty in the world these days.  Washington, D. C. is in a mess and there seems to be no leadership around, especially in the White House.  As Larry Summers stated during his recent term in Washington, “the parents are not at home.”  This lack of leadership in the US, combined with the economic crisis in Europe and the lack of leadership there, leaves us all wondering what is in store for us in the future.  And, unfortunately, what we contemplate for the future is not very optimistic.

Third, there are some serious structural matters in the economy that still need to be resolved.  For example, I believe that underemployment in the United States is still around 20 percent.  That is, one out of every four individuals of working age are either unemployed, employed in a part-time job but would like to work full time, or, have left the work force.  The workforce participation numbers are now back where they were in the 1960s.

And, we continue to get stories about how the American society is bifurcating.  David Brooks writes of "The Opportunity Gap" emerging in our country, a gap in which “the children of the more affluent and less affluent are raised in starkly different ways and have different opportunities.”  The ramifications of this split has been researched and discussed by numerous people now and it indicates that we need more than just economic stimulus and good intentions to solve the structural problems that are growing worse every day.

This structural problem is also seen in the data on the capacity utilization of American manufacturing.  The data just released indicate that industry is using just under 79 percent of its capacity.  Thus, capacity utilization continues to increase in the current recovery.

However, note in the accompanying graph that capacity utilization was around 90 percent in the mid-1960s and has trended downward every since.  In fact, this trend matches, to a high degree, the increase in the underemployed in the United States.

Most obvious in the trend is that the peak utilization in every cycle seems to be lower than that achieved in the previous cycle.  Capacity utilization continues to increase in the current recovery but is still below the peak achieved in the 2003-2007 period…which was below the peak of the cycle in the mid-1990s. 

There are significant structural dislocations in the United States economy and a policy of government intervention and economic stimulus is not going to correct the situation.

Mr. Bernanke, in testimony before Congress today, seemed to be cognizant of the problems the US economy is facing.  “Mr. Bernanke’s cautious testimony underscored the Fed’s reluctance to ride once again to the aid of a plodding economy. The central bank has intervened repeatedly when the economy appears at risk of sliding back into recession, and Mr. Bernanke’s testimony Tuesday included his standard promise to maintain that vigilance. But the Fed has not acted with similar urgency to reduce the persistently high rate of unemployment when growth is merely lackluster.”

To me, this is about all the Federal Reserve can do right now. (See my post on "The Fed is Doing Enough For Now.") The economy is recovering but not at the speed we would like.  However, sometimes there is only just so much that can be done in terms of aggregate economic policy. 

The Federal Reserve is Doing Enough...For Now

The economy is recovering.  It is not recovering as fast as we would like, but it is recovering.

Within this recovery there may be only so much that government can do to speed on this recovery.  In my mind, we need to keep this thought in mind when considering what else the Federal Reserve can do at the present time. 

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, I believe that he is not saying much because he has said enough for the time being. 

The market is concerned about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point because he believes that the Fed is doing enough…for now! 

One part of the Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

But, some members of the Federal Reserve’s Open Market Committee are concerned about the weakness that still exists in the economy.

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There are other concerns at work, however.

There is real concern over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.  

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

In terms of the economy, the Fed has done about all it can do right now.  The major thing it has done…at least for the time being…is to stop any cumulative movement in the economy to a period of price deflation.  This is the big theoretical concern that exists in a period like this, the possibility that the economy will decline into a period of debt-deflation.

However, protecting the economy from a period of deflation does not eliminate the problem I discussed earlier this week, the problem of the extensive debt buildup in the economy.  The deleveraging of the economy is still something that needs to take place.

The deleveraging of the economy will still take some time.  For now, I would argue that the Federal Reserve has done and is doing about all it can to keep the expansion going.  The economy is recovering.  It certainly is not recovering as rapidly as we would like it to recover, but it is recovering.  Sometimes only so much can be done to assist a recovery and the rest must be accomplished by letting the system do its own part.  In the current situation, reducing the debt load is what the economy needs to do and it takes time for an economy to achieve this.     

Mr. Bernanke Needs to Speak Out About QE3...or, Has He?

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, he is staying pretty silent. 

The market concern is about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point for political reasons. 

He stated just the other day that the Federal Reserve is not swayed by political factors.

We can save the further discussion about the political nature of the Fed for another day.

The Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There is real concern, however, over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.

Can Mr. Bernanke tell us all of this in a way that will convince us?  Should Mr. Bernanke tell us all of this in an attempt to convince us?

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

Other than the fact that I don’t believe that “operation twist” can really be effective, I believe that Mr. Bernanke and the Fed are “spot on” concerning what monetary policy should be at this time.  To me, the primary thing that is currently impacting US Treasury rates is the “flight to quality” in financial markets that is taking place internationally and this is dominating what the Fed is doing and everything else.    

Federal Reserve Remained Quiet in April

As reported in my last review of Federal Reserve actions, all remains quiet on the monetary front. Right now, as far as monetary policy is concerned, there is not much for the Fed to do…and, to me, this is good.

Things are quiet in the banking system…except for the complaints of top bankers about new rules and regulations that are being discussed.  The FDIC closed only one bank this week, bringing the total for the year up to 23.  But, closers are going “smoothly”.

Economic growth, year-over-year, continues to be in excess of two percent, although not by much.  And, other data being reported contain some good information…and some not-so-good information.

The European crisis continues along with more stress being placed on the creation of growth rather than continuing “austerity.”  The question is how much the elections of the weekend will change the near term future for the eurozone.

And, with the presidential election in full swing, the Fed seems to be content with the above scenario.  There is little or nothing it can do between now and the election to change the trajectory of the economy before November.  It “stands by” in case there is any “fire” that needs to be put out in the meantime.  (For more on this see my post.)

Furthermore, it seems as if we have had the last of the “education” sessions put on by Professor Bernanke for a while.

Thank goodness!

In terms of the actions of the Federal Reserve over the past month, most changes that occurred on the Fed’s balance sheet seem to be “operational”.  That is, the Fed was just responding to general “operating” factors impacting the banking system. 

The largest “operating” factor that occurred in April was connected with the yearly tax collections.  Deposits at Federal Reserve banks rose in April by almost $80 billion.  This is a seasonal swing as funds are collected at tax time in “tax and loan accounts” at commercial banks.  Then, the Treasury transfers these balances to its account at the Fed, the account the Treasury writes checks on.  This movement absorbs bank reserves at the same time the Treasury writes checks, which will then go back into the banking system as the recipients of those checks deposit them.  This procedure minimizes disruptions to the amount of reserves in the banking system.  Hence, these actions are called “operational”.

Two other factors can catch our attention.  First, over the past four weeks, the Fed has increased its holdings of mortgage-backed securities by $11 billion.  This is the first increase in mortgage-backed securities for more than a year.  In total, this account declined by almost $80 billion from May 4, 2011 to May 3, 2012.  Some support for this sector of the financial markets?

The second factor is the decline in Central Bank Liquidity Swaps.  This account increased over the past year as the European sovereign debt crisis expanded into the fall of 2011.  But, these liquidity swaps began to decline since the second Greek bailout was accomplished.  Central bank liquidity swaps declined by about $19 billion over the last four-week period, and declined by over $77 billion during the last 13-week period.  As of May 3, 2012 there were slightly more than $27 billion swaps still on the Fed’s books. 

Reserve balances with Federal Reserve banks on May 3, 2012 stood at $1,481 billion ($1.5 trillion rounded off) only $8 billion more than existed on May 4, 2011.  Excess reserves in the commercial banking system, a two-week average, were $1,458 billion, just about what was in the banking system one year ago, $1,452 billion.

This relative stability on the Fed’s balance sheet was achieved despite substantial changes taking place within the banking system itself. 

Although the total reserves in the banking system only increased by a little less than 4%, required reserves in the banking system rose by about 32%.  The reason for this difference is that demand deposits at commercial banks, deposits that have the highest reserve requirements, increased by more than 41%.  Time and savings deposits at commercial banks, which have lower reserve requirements, rose by a little more than 8%.  Thus, there was a shift in the banking system from deposits with lower reserve requirements to deposits with substantially higher reserve requirements.

This shift from time and savings deposits to demand deposits has been going on for a long time.  I have been reporting on this for more than two years now.  The shift is taking place, not only because of the low interest rates being paid by banks (and thrift institutions), but because of the weak economy.  People out of work or on the edge financially transfer the wealth they have to “transaction” type of accounts so that they can live and pay their bills.  They don’t have the resources to “manage” their wealth across a spectrum of assets.  Thus, the growth in demand deposits, to me, is a sign of weakness in the economy and not a sign that monetary policy is working.

Another piece of evidence supporting this claim is the strong demand for currency outside the banking system.  Currency in circulation is increasing at a 9%, year-over-year, rate of growth.  This is an extremely high growth rate and a sign of a weak economy and not a strong one.

As a consequence of these demands, money stock growth continues to increase at a very rapid pace.  The M1 measure of the money stock remains in the high teens, growing at an 18% rate for the past year, while the M2 measure is growing at a pace slightly under 10%.

Both of these rates of growth are high, historically, but can be explained by the shift in assets toward more liquid and more transaction-based accounts.  Only recently has loan growth started to increase and this may provide some reason for the money stock to continue to increase in the future.  If loan growth does continue to increase and if this creates a reason for the money stock to grow, this would be a healthy sign for a recovering economy. 

So, not much has changed on the monetary front from last month.  I believe that this is a good situation for the monetary authorities.  It doesn’t mean that the future will be easy.  The Fed is still going to have to deal with almost $1.5 trillion in excess bank reserves when the economy begins to expand more rapidly…the threat of rising inflation is real.  Yet, the past is past and we are where we are right now…and, to me, where we are right now is hopeful.   

Prospects for the Fed, the Presidential Election, and the Dollar

The jobs report released on Friday was not good.  Furthermore, when one examined the decline in the unemployment rate to 8.2 percent, one saw that the rate fell, not because the labor market was getting stronger, but because the number of people actively seeking jobs declined.  That is, the labor market shrunk…under-employment rose. 

Immediately, speculation grew about whether or not the Federal Reserve would go in for another round of monetary easing.

This discussion closely follows upon the conclusions that the Fed would not engage in any more quantitative easing following the recent meeting of the board of governors of the Federal Reserve System and countless speeches and lectures from the Fed Chairman. (http://seekingalpha.com/article/467561-ben-bernanke-please-understand-me)

It is my view that the Fed will not engage in another round of monetary easing in the near future unless the economy or the banking system or the international financial system experiences a major shock.  A “not-so-good” report on the labor market will not be the trigger for such an injection.

The economy is growing, although it is not a very setting the world on fire. (http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate)

The banking system is quiet and although commercial banks continue to disappear either through acquisition or FDIC closure, things seem to be peaceful with no expected surprises here.

Deleveraging in the private sector continues and restructuring continues to take place in housing, state and local government and the labor markets.  Again, there are no expected surprises in these areas.

And, it is a presidential election year.  It is highly unlikely that the Federal Reserve will engage in any actions that will leave it exposed to the criticism that it is playing politics.  In reality, Mr. Bernanke and the Fed has done about all it can to create a favorable economic climate in which President Obama can get re-elected. 

Given the lag-in-effect of monetary policy, there is very little that the Federal Reserve can do at this time to change the trajectory of the real economy before the election takes place in November. 

Therefore, I expect that the Federal Reserve will conduct a very benign monetary policy over the next six- to nine-months. (http://seekingalpha.com/article/472291-the-federal-reserve-was-quiet-in-q1-but-stands-ready-to-do-more) Otherwise, it will open itself…even more…to charges that it is playing politics and supporting the incumbent president.

Of course, the Fed cannot stand by if there is a crisis somewhere in the economy…in the banking sector…or in the financial markets…or somewhere else.  In such a case, the Fed will respond quickly and with sufficient force to avoid any breakdown.

Otherwise, I believe that the Fed will avoid any new initiatives this year.  Short-term interest rates will remain low.  The demand for money is weak and the Federal Reserve statistics indicate that there have been no new actions on the part of the Fed to keep them at current levels. 

If the real economy does pick up some speed and the demand for money begins to increase, some pressure may start to build for these short-term interest rates to rise.  My guess here is that if this scenario starts to develop, the Fed will allow these short-term rates to creep up.  In such a case, the Fed will not engage in a real active campaign to keep them in their current range. 

The key here is that the pressure for rates to rise will come from an economy that is strengthening.  This movement will be looked on positively by Federal Reserve officials.

The interesting market reaction to the Fed’s indication that it would not engage in another round of quantitative easing was that the dollar began to strengthen against the euro.  Through Thursday, last week, the dollar price of the euro had almost reached $1.30. 

Friday, with the release of the jobs report and the speculation that the Fed might engage in another round of quantitative easy, the dollar price of the euro rose slightly. 

This morning, the dollar rose again against the euro and I believe that this will continue if the Fed continues to maintain its current monetary policy stance through the spring and summer of this year.  In fact, I believe that the dollar will crack the $1.30 price against the euro and will continue down as the European Central Bank (ECB) continues to follow its present policy position.  (For more on this see my earlier post about the dollar breaking the $1.30 price level earlier this year: http://seekingalpha.com/article/371691-the-euro-drops-below-1-30.)

The dollar will continue to appreciate against the euro if the Fed continues to keep things pretty much the way they are at the present time because Europe, in my mind, is still in the middle of a mess.  One only needs to mention what is going on in Spain and Italy and Portugal...and then there are the French elections that we must go through over the next couple of months.

So, I see the Fed remaining relatively quiet for a while (except for Mr. Bernanke’s efforts to inform the world on what he and the Fed have done over the past five years or so); I see the economy continuing its recovery; I see some pressure starting to build on short-term interest rates; I see the value of the dollar rising against the euro; and I continue to hope for the absence of any unfavorable shocks to the world. 

If we can achieve this over the next year I believe that we will have been very fortunate.     

Ben Bernanke: "Please Understand Me!"

“Please Understand Me,” the title to the 1984 book building on the Myers-Briggs personality-type tests, constantly comes to mind each time I hear a new effort by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, to “communicate” with the public.

Tuesday, Mr. Bernanke gave the third of his scheduled four lectures at George Washington University about Federal Reserve monetary policy.  This has followed efforts to get the minutes of the meetings of the Open Market Committee out to the public in a more timely fashion; efforts to have periodic meetings with the press to discuss the policies of the central bank; and the recent efforts to make the economic and interest rate forecasts of the members of the Open Market Committee available to the public. 

Now, Mr. Bernanke has felt the need to get out among “the people” and discuss the conduct of monetary in a series of four lectures aimed at expanding, within an academic environment, his rationale and analysis of what the Federal Reserve did and what the Federal Reserve has achieved. 

The continuously expanding efforts of Mr. Bernanke to get his personal viewpoint across only lends credence to the feeling that “the world”, especially the financial community, doesn’t understand what Ben is trying to do and how his efforts are succeeding. 

No one in such a leadership role that I can think of has felt the need to plead, within the community that he operates, to justify his actions, as Mr. Bernanke has.

Can you imagine Paul Volcker or William McChesney Martin (Fed Chairman from April 1951 to February 1970) publically defending their actions while they were still in office?

“The Fed’s efforts prevented a ‘total meltdown’ of the financial system at a time when fears of a second Great Depression were ‘very real,’ Mr. Bernanke said Tuesday…” (http://professional.wsj.com/article/SB10001424052702303404704577307800005459694.html?mod=ITP_pageone_1&mg=reno64-sec-wsj)

It was not pretty…what the Federal Reserve did…but it achieved its end.  A second “Great Depression” did not take place. 

Mr. Bernanke, a student of the Great Depression who learned a great deal from Milton Friedman, pursued a policy that was consistent with Friedman’s analysis of the events of the 1930s.  In the period 1929 to 1933, Mr. Friedman estimated that the Federal Reserve allowed the M2 money stock in the United States to decline by one-third!  The conclusion that Mr. Friedman drew from this is that the Federal Reserve should have done whatever was possible to have kept the M2 money stock from declining!  

This lesson did not escape Mr. Bernanke under the circumstances. The Fed’s policy during this period of financial crisis was to throw as much “stuff” against the against the wall as possible to make sure that enough of the “stuff” stuck on the wall that another Great Depression would be avoided.

What is there not to understand with this policy?

Sell Bear Stearns, rescue AIG, bailout the banking system, by mortgage-backed securities and so forth…. 

And, in a time of panic, when uncertainty reigned, anything was acceptable. (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

This was all “stuff” that was thrown against the wall. 

Mr. Bernanke has followed the game plan.  The money stock did not decline in this instance.  However, the Fed does not control the money stock directly.  In terms of things it can control, like the monetary base, the Fed expanded the monetary base from about $850 billion in August 2008 to $1.7 trillion in January 2009.  In February 2012 the monetary base averaged about $2.7 trillion.  Excess reserves at commercial banks rose from about $2.0 billion in August 2008 a current level of around $1.6 trillion.

This expansion of monetary assets is historically unique!  The “stuff” got put out there!

And, the “stuff” will stay out there as long as there are weak spots in the economy and the financial system.  For example, the banking system is still extremely weak with more than 800 banks on the FDIC’s list of problem banks and more than that are on the edge of being problem banks.  And, this is with large numbers of home foreclosures in the future along with a continued weakness in the commercial real estate area.  Bank failures along with bank consolidations still proceed at a relatively rapid pace.   

Whether we get another round of quantitative easing or not, we will see the “stuff” around for some time yet.  Excess reserves in the banking system of around $1.6 trillion!  My guess is that we won’t see this declining by much until the banking system gets a lot healthier.

What is there not to understand about what the Fed has done and is doing?

Mr. Bernanke seems to feel that it continually needs explanation and justification.  I believe that this feeling is just Mr. Bernanke’s problem.   

Fed's Interest Rate Policy Distorts Money Stock Growth

The low interest rate policy of the Federal Reserve continues to distort the growth rates of the money stock. 

The year-over-year rate of growth for the M1 money stock for the thirteen-week period ending February 21, 2012 is 18.6 percent.  Note, however, that the year-over-year growth rate for the demand deposit component of the M1 money stock is just over 44 percent!

Because of the low interest rates on bank time and savings deposits and on retail money funds and on institutional money funds, people continue to move money from these assets to transaction accounts, primarily demand deposits.  However, people seem to be holding onto these transaction balances rather than spending them. 

The M2 measure of the money stock is rising by a 9.8 percent year-over-year rate of increase, but the non-M1 component of the money stock is rising by only 7.6 percent.  Again, the primary growth in this component is coming from the movement of money from non-bank interest-bearing assets to bank deposits. 

People are still not moving their assets around in order to increase spending. As just mentioned, a lot of the movement is coming because the incentive to hold interest bearing non-bank assets is not there.  And, individuals and families that are under-employed or otherwise uncertain about their future are transferring their assets into cash.  Currency in circulation is still increasing, year-over-year by a little less than 10 percent, an extraordinary high rate of growth.

The Fed has done very little to further stimulate the domestic economy over the past three months.  Looking at the Fed’s balance sheet, there are two factors that are particularly noticeable, neither one, however, representing any kind of an aggressive monetary injection. 

First, the Federal Reserve has responded to the European debt crisis by providing additional funds to central banks through swap lines.   Over the past three months, central bank liquidity swaps have increased by $105 billion.  This increase in funds represents almost the whole rise in reserve balances at the Fed, a figure that tracks very closely with the amount of excess reserves in the banking system. 

Second, the Fed has attempted to push the interest rates on mortgages even lower in an attempt to get the housing sector going again.  Whereas the Fed has allowed its portfolio of US Treasury securities to decline along with a continued decline in its holding of Federal Agency issues, the central bank has actually added a net of almost $14 billion to its holdings of mortgage-backed securities over the past thirteen week period.  The total amount of securities held outright declined by about $2 billion.

Consistent with the monetary testimony of Fed Chairman Ben Bernanke last week, the Federal Reserve has been doing very little to provide additional stimulus to the American economy. (http://seekingalpha.com/article/402751-mr-bernanke-stands-pat) People continue to move funds from low interest bearing market assets to the banks.  Mr. Bernanke and the Fed apparently hope that these individuals will at some time in the future begin to spend more from these assets.  Banks continue to hold onto their funds as excess reserves in the banking system track around $1.6 billion.  Most banks, especially the smaller banks, are not lending as they continue to work out the problems that exist in their loan portfolios.  According to Mr. Bernanke, this situation will continue to be supported by the Federal Reserve for the near term.