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.
