22 August 2008

Bernanke's Strategy: Painting the Roses Red.

Bernanke's strategy is obvious. It is obvious because he has few choices left. He must paint the roses red, and hope that this will hold off the destructive rage of the Mad Queen.

The Fed will continue to prop up the US financial system while encouraging the economy to muddle through this recession with negative real interest rates.

Inflation doesn't matter to the Fed while they think they can control the public perception of our true financial situation, and especially the consequences.

The Fed feels confident that they know how to fight even a seriously strong inflation so they will let it pass for now. This is a fatal policy error. Volcker was a smart and determined Fed chairman, but he was also lucky.

That means no rate increases until next year at the earliest. The Fed is hoping that nothing unexpected happens to upset their plans. A big bank failure might cause a panic, so Ben and Hank will be working overtime to keep the lid on the problem, and try workouts behind the scenes.

The challenge is to define what a big bank failure really is. Was Bear Stearns a 'big bank failure' or a successful bailout? This is of immediate concern regarding Lehman Brothers which is in an obvious death spiral. Korea DB will not buy them for the 20 percent premium that Dick Fuld demands. So, a hostile takeover by a Fed friendly bank, similar to JPM - Bear, is most likely.

This will give us a look at who the other captive bank of the Fed might be if there is one. If you wish to know what a Captive Bank does besides serving as a wastebasket for other broken banks, read the blog entry just below about the manipulation of the markets.

There may be a role for well-connected predator banks as free lance mercenaries for the Fed's and Treasury's policy decisions. You keep what you kill. This appears to be the ongoing strategy of Hank's alma mater, Goldman Sachs.

A sign that the strategy is at work will be the creation of yet another bubble. Where it will be we cannot know yet. It may be in equities again. Or bonds. The Fed and Treasury are using asset bubbles as instruments of policy to act as a channel of liquidity and to provide the appearance of financial health to an increasingly moribund economy.

Each time the Fed intervenes in the monetary system we get a bubble somewhere, in some 'real world' asset or liability. As we continue forward the interventions and double-talk may become increasingly bold and obviously untrue, especially to outside observers. These are intelligent men, but increasingly desperate and frightened, serving an administration best described as an odd collection of mediocrities and eccentrics. What behaviour they may rationalize together will probably exceed all rational expectations.

The last bubble (or anti-bubble if you prefer) will be an economic depression, and end in a re-issuance of the Dollar, unless the Fed gets very lucky in their friends. By re-issuance we mean that the dollar will be revalued and replaced by something else, whether the amero or a freedom dollar. The precise timing is unknown.

But we have reached the point where at least a de facto default on our debt obligations is the only option. The continuing devaluation of the dollar is running out of steam.

Although there may be a short term liquidity crunch in the unwinding of leverage, the notion that the spectacular dollar debts of 50+ trillions will be paid for with an increasingly valuable dollar through a sustained monetary deflation is a fantasy. No debtor nation that is democratic would choose that course unless it was dominated by foreign powers.

The endgame is default.

The strategy for the rest of the world varies depending on who you are in relation to ground zero for the financial collapse. The most obvious strategy for all will be to limit exposure to the US and its debt deflation.

At the point when the dollar and the debt decouple all hell will break loose, and the system will be tested to its maximum. What replaces the US dollar as the world's reserve currency is more than incidental: it is pivotal. Whomever prints the gold makes the rules.

The empire will be given up in due course. The trick for the bigger players will be to stay out of its way as it happens, and above all to avoid falling into a conflict with the US where the strengths, though diminished, are still formidable.

Ben and Hank are going to try and bluff their way out of this, avoid major failures, and play for time until leverage unwinds and liquidation occurs in an orderly manner, and the economy begins to grow. Some of the other central banks will actively cooperate with the Fed, and some may go down in failure with the US as a result. There will be civil wars and popular revolutions in some countries because of this. Others will merely stand aside and bide their time. The US financial system remains highly precarious.

If you keep this model in mind the next few months and years might make more sense.

Bernanke expects inflation to ‘moderate’
By Krishna Guha in Jackson Hole, Wyoming
August 22 2008 15:14

The decline in the price of oil and the recent strength in the dollar is “encouraging” Ben Bernanke said on Friday at the start of the Federal Reserve’s annual retreat in Jackson Hole Wyoming.

The Federal Reserve chairman said the US central bank had based its strategy of running low interest rates on the assumption that commodity prices would ultimately stabilise, in part due to “slowing global growth.”

Mr Bernanke remarks on oil are the strongest to date and suggest the US central bank – which was initially very wary of reading too much into its decline – is starting to put more weight on the notion that oil may now have stabilised.

But Mr Bernanke said the inflation outlook “remains highly uncertain” not least because of the possibility that oil could rebound.

He said the Fed would “monitor inflation and inflation expectations closely” and would “act as necessary” to secure medium term price stability.

The Fed chief said the “financial storm” that broke a year ago “has not yet subsided” and said its effects on the broader economy were “becoming apparent” in the form of “softening growth and rising unemployment.”

His language suggests that the impact of the credit squeeze on the real economy is still unfolding and it is not likely that the economy will pull out of this soon.

Taken together, his comments underscore that the US central bank has no intention of raising interest rates in the near term, and could stay on hold through the end of the year if growth risks remain high and inflation and inflation expectations ease as expected.

This represents a softening of the Fed’s stance since the May to July period, when policymakers turned hawkish amid growing inflation fears and hopes that the markets and the economy were turning the corner.

However, Mr Bernanke did not suggest that the Fed thinks the inflation problem is over simply because oil has moderated. He said the “jump in inflation” was “in part” the product of a global commodity boom – suggesting other factors could be at work as well.

The Fed continues to retain an underlying orientation towards inflation risk, in large part because policymakers feel they have already addressed growth risks through big pre-emptive rate cuts, but are not protected against any revival in inflation danger.

Policymakers view core inflation (excluding food and energy) and inflation expectations as too high, and will seek to ensure that they decline in the months ahead as the economy weakens.

The Fed chairman told the assembled central bankers from 43 nations that reforms were needed to strengthen the financial system, reduce systemic risk and thereby minimise the “moral hazard” that firms could operate irresponsibly in the belief that they would not be allowed to fail.

He called for a “migration of derivatives trading toward more standardised instruments and the use of well-managed central counterparties.” Mr Bernanke said the Fed was working on ways to strengthen the resilience of the triparty repo market.

Mr Bernanke said Congress should consider giving the US central bank explicit authority to oversee payment systems, while granting Treasury authority to manage a special bankruptcy regime for non-commercial banks.

He said a shift towards a more “macroprudential” approach to regulation – that would consider the systemic implications of market behaviour – was “inevitable and desireable” but said it was necessary to be “realistic” as to how this would work