Wednesday, July 10, 2013 - Trying to Make Some Sense of It All

Trying to Make Some Sense of It All

by Sinclair Noe

DOW – 8 = 15,291
SPX + 0.3 = 1652
NAS + 16 = 3520

10 YR YLD +.05 = 2.68
OIL + 2.64 = 106.17
GOLD + 12.20 = 1263.90
SILV + .20 = 19.57

Over the past couple of days, we've talked about the slowdown in the global economies; the IMF revised growth forecasts. We've also talked about the new capital reserve requirements for banks. Today, we got the minutes of the last FOMC meeting in June. Today, I'll try and put it all together and explain it so it makes a little sense. I'll try.

Everywhere around the world, economic growth is slowing; this is especially true in emerging markets. For example: growth in China is forecast to be 7.8 percent in 2013, a downward revision of 0.3 percent; growth in India is forecast to be 5.6 percent, down 0.2 percent, growth in Brazil is forecast to be 2.5 percent, down 0.5 percent;  growth in Russia is forecast to be 2.5 percent, down 0.9 percent.

There is still growth in the emerging markets, but the BRIC countries had been looking at really strong growth, now it's slightly sluggish growth, and the rate of change is the attention grabber. In China, there is considerable downside risk because they are facing a financial crisis brought about through a shadow banking system that financed unproductive investment and succeeded only in building credit risk. Now that risk is coming home to roost.

Japan is looking at an expanding economy, perhaps 2% growth for 2013; that represents a big jump, but it is still not what you'd call fast growth. I'll talk about Japan a bit more in just a moment.

In the Euro-zone, we'll probably see contraction of a negative 0.6%. This reflects serious downturns in Spain and Italy and low growth in the other core countries.

In the US, we're probably looking at 2013 growth in the range of 1.6% to 1.9%. You'll recall that we've seen some downward revisions to GDP.

So, generally speaking there is a slowdown in the advanced countries, and that leads to a slowdown in consumption and investments; and demand remains low, in large part because unemployment levels remain high. This is true in the US, even though private sector employment has picked up a little; it's been offset by declines in public sector employment. The unemployment problem in the Euro-zone is particularly bad, especially in the southern, peripheral countries. Exports can't overcome the weak internal demand.

In the US, we've been on the verge of a virtuous circle; that point where we see sustainable, productive growth, but we can't quite reach escape velocity. One reason is that fiscal policy has been a disaster. We have refused to invest in infrastructure; we refuse to invest in education; we refuse to invest in the future. Meanwhile, monetary policy has been a failure; at least it has been a failure in helping to achieve the Fed's mandate of maximum employment; it's been fairly successful in it's real, unstated purpose of propping up the big banks.

The Fed has had three rounds of Quantitative Easing plus Operation Twist since 2008; they've pumped more than $2.3 trillion into the banks. If they had pumped that money into the economy, we might be seeing different results, but they didn't pump the money into the economy. If they had pumped $2.3 trillion into the economy, we would see a very big spike in inflation. It just hasn't happened.

Even as the Money Supply has grown, the money actually ended up on the books of the banks; specifically the excess reserves of the biggest private banks have now increased to about $1.9 trillion. Back in 2008, the excess reserves were at almost zero. And the Basel III rules call for 3% reserves, but yesterday the Fed, the FDIC, and the OCC called for the big banks to hold at least 6% in reserves.

Following the financial meltdown in 2008, the Fed's mission was to prop up the banks. So far they have propped up the banks with $1.9 trillion in excess reserves and they still feel more reserves are needed, just to be on the safe side. The mission of the Fed is not maximum employment; it is to avert another financial meltdown and more bank bailouts. More bailouts are unacceptable because it might just wake up the average citizen and cause them to scream bloody murder, and put an end to the whole mess. The side benefit of building up banks' capital reserves is that the banks actually have money to lend, at least a little.

There are a couple of ways this shows up in the economy. First, there is basically no inflation. If you pump $2.3 trillion into the economy, you should have inflation. The spending of money -- and in particular the rate at which money changes hands -- is what creates inflation. Economists call this the "velocity of money." The velocity of money is at the lowest levels in more than 60 years. Money is not moving through the economy. It is stuck in the banks. It's kind of like burying you money in a coffee can. This is a way for the Fed to continue QE, without having the immediate concerns about inflation.

And so today, Fed Chairman Ben Bernanke said the economy continues to need highly accommodative monetary policy. Answering questions at a conference sponsored by the National Bureau of Economic Research Bernanke said that when looking at the Fed's dual mandate on employment and inflation more work needed to be done. He said the 7.6 percent unemployment rate probably "overstates the health of the labor market" and that inflation remains below the Fed's 2 percent target. Moreover, fiscal policy remains "quite restrictive."

Before Bernanke spoke, the Fed delivered the minutes from the FOMC meeting of June 18-19. The minutes showed that some Fed officials worried not only about the outlook for employment, but the pace of economic growth as well: "Some (officials) added that they would ... need to see more evidence that the projected acceleration in economic activity would occur, before reducing the pace of asset purchases."

Of the Fed policymakers who argued it would be wise to curtail bond purchases soon, two thought it should be done "to prevent the potential negative consequences of the program from exceeding its anticipated benefits."

The negative consequences some Fed policymakers worry about are what might happen if the banks start to use some of the capital reserves for something other than reserves. That's when things could get dicey. The easy thing to do is watch the velocity of money; if money starts circulating through the economy, it could quickly lead to nasty inflation, especially if it goes into the economy through the typical routes used by banks. For example, if they start easing up on underwriting requirements for mortgages, we could see the beginnings of an asset bubble in housing. If the banks start trading the money in the markets, we could see a financial asset bubble develop on Wall Street, or perhaps in the commodity markets, or the energy markets.

So, there is a bit of a trick to see the velocity of money increase, which would be beneficial to the economy, in that it could increase demand, and help guide us to the virtuous circle of a sustainable and productive economic growth – yet still avoid asset bubbles and inflation.

And that brings us back around to one of the few countries in the world that is seeing an increase in the rate of growth – Japan. The Japanese approach is called Abenomics, and it involves three arrows. The first arrow is fiscal stimulus, the second arrow is aggressive monetary easing, and the third is structural reforms. So far, we have seen the aggressive monetary policy – nearly twice as aggressive as the Fed's QE, at least on a percentage basis. Why have the Japanese been so extremely aggressive? Well, they are faced with a nuclear problem of truly epic proportions. The Fukushima nuclear reactor meltdown has threatened everything in Japan, including the economy. The Japanese were forced to take drastic action to rouse the economy out of a two decade slumber, or risk watching the economy slip into a long, dark nuclear winter.

Now, the Japanese still have to complement the monetary policy with a credible fiscal plan, and substantial structural reforms, otherwise they risk investors becoming nervous about debt sustainability and demanding higher interest rates.

We don't face the imminent threats of an economy badly damaged by radiation, however we face similar economic problems as the Japanese. The Fed runs the risk of nervous investors pushing up interest rates and making the Fed's balance sheet – which is rapidly approaching $4 trillion total – making the debt on the Fed's balance sheet unsustainable. And we just can't seem to get the other two arrows out of the quiver.

There is no credible fiscal policy coming out of Washington, and the only structural reforms are being determined by the banks; they are literally writing the legislation. If we don't make essential investments in the US economy now, then things will just get tougher down the road. Looming in the distance is a potential dollar meltdown. The dollar is the strongest currency in the global market; in large part because it is the reserve currency, but also because other currencies have been debased. Since January 2002, for example, when the U.S. Dollar Index stood at 120.22, the dollar has fallen by 31%. And that's after its recent two-year rise.

These are tricky times.