The Doom and Gloom Fed

John Mauldin | Thoughts from the Frontline
December 13, 2002

Today we explore the very interesting differences between what the Fed told us about its last interest rate cut and what they actually said in the meeting. Then we look at my analysis of how Japan can have deflation when the money supply grows 21%, which will annoy the gold bugs among my readership. Then we look at why gold is really going up, and why it will continue to do so, which will make gold bugs happy. All that and more, as along the way we look at why it is so hard to predict anything with any sense of confidence.

Smoke in The Fed's Eye

I was reminded today of the great line by Paul McCulley of Pimco: "Philosopher kings, like Mr. Greenspan, know that some things are best left un-estimated, un-forecast, and un-said. Unless, of course, there is no choice, in which case euphemism, obfuscation and smoke-blowing should be the tools of first resort."

We examine a case in point, where smoke is the tool of choice. The Federal Reserve Board meets 8 times a year. It is called the Federal Open Market Committee (FOMC). At the end of this meeting, they issue a brief statement, telling us what they will do about interest rates and giving us some hint as to their future policy. A little over a month later we get the minutes of the meeting where we can read what was generally discussed and said.

After the end of the November 6 meeting, the Fed cut rates 50 basis points and then gave us the following re-assuring words:

"In these circumstances, the Committee believes that today's additional monetary easing should prove helpful as the economy works its way through this current soft spot. With this action, the Committee believes that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are balanced with respect to the prospects for both goals in the foreseeable future."

Three weeks ago, I reported a conversation with and speech by Wayne Angell, former Vice-chairman of the Fed. He basically said the Fed cut rates because of its concern about deflation and that the "neutral stance" (that is what is meant by "risks are balanced") they took in their public statement was because they did not want to spook the markets. The implication was that conditions were actually worse than the statement, and that the Fed would cut again and again if necessary.

The Doom and Gloom Fed

Yesterday, Art Caslin of CNBC fame wrote me a quick email and said, "John, look at the difference between the Fed statement of Nov. 6 and the minutes they released today."

I went to the Fed site, and the minutes, as Art suggested, did not read liked "risks are balanced." In fact, if I used the minutes as an e-letter, I would be called excessively bearish. Caslin made the following points today in his private morning market letter. I quote:

"The concern of the FOMC for the fragility of the economy jumps off page after page. (I encourage one and all to go to the Fed website and read the minutes in toto.)

"And, as for the "soft patch", the minutes read more like they were worried about quicksand. We don't have room enough to reproduce all or substantially all the 12 page minutes. But here is a random sampling. Please take note of the verbs used.

" '.....economic growth had slowed....consumer spending softened.....industrial production slipped....labor market conditions weakened further....number of jobs.....continued to fall....hours worked.....moved down....softness in the manufacturing sector was widespread....in light of further weaker-than-expected incoming data.'"

After the above assessment that the economic data is "weak", let me just present the following excerpted phrases for you to get even more of the general picture. This is important, as this is the reasoning that Fed governors are using to set the policy which will affect your investments. (I cut it down from 12 pages to one. You can read the full document at: http://www.federalreserve.gov/FOMC/ ) Emphasis is mine.

"....an analysis cited at this meeting suggested that the stimulus embodied in current legislation had diminished considerably since earlier in the year. ....Some members observed that further federal tax cuts, should they be enacted, would likely take effect too late to foster much added spending over the year ahead. At the state and local government levels, efforts to control very large deficits likely would lead to tax and spending legislation that would offset at least part of the remaining stimulus inherent in the federal budget....Members commented that little if any stimulus could be expected from the export sector of the economy in light of current and prospective shortfalls in the economic performance of important U.S. trading partners. Indeed, recent forecasts incorporated downward revisions to the growth of overall foreign economic activity. " [This latter point will be taken up later- John]

"....the prospect of some persisting slack in resource use over coming quarters pointed to further disinflation. In this regard, some members referred to the possibility, which they viewed as remote, of a period of deflation in the event of a strongly negative demand shock ....the members were concerned that the generally disappointing data since the previous meeting, reinforcing the general thrust of the anecdotal evidence in recent months, pointed to a longer-lasting spell of sub-par economic performance than they had anticipated earlier ..." [Translation: previous rate cuts did not work as they thought they would.]

"...A further reason cited by some members for a sizable easing move related to their perceptions of a diminishing stimulus from earlier policy easing actions and indications that overall financial conditions, including bank lending terms, had become more restrictive this year even though the nominal federal funds rate target had not been changed since late 2001."

"....The members agreed that monetary policy could do little to improve the performance of the economy in the near term , but some emphasized that a 50 basis point easing likely would feed through to some degree to market interest rates, with favorable implications for spending next year."

"...The economy probably would continue to underperform in the period immediately ahead , but in the absence of unpredictable adverse shocks this sluggish performance was more likely to be balanced by subsequent economic strength in light of the policy action.....In the view of many members, retaining the assessment that the risks were tilted toward weakness would raise the odds of an overreaction in financial markets , which might well misread the Committee's decision as a sign that the members were more concerned about the potential for greater economic weakness than was in fact the case and that therefore the Committee currently saw a likely need for further easing later...."

"....While the possible market response was not a primary factor determining the desirability of a policy action, the Committee needed to take it into account in gauging the potential effects of particular policy moves. "

Let me offer a translation. "The economic data is not encouraging. The economy is slowing down. There doesn't appear to be much inflation, there is still disinflation in the economy and there is some slight-small-not to be worried too much about- risk of deflation. As long as we do something about it now, it won't be a problem. We can't look to the rest of the world to help. Any tax cut Bush gets through Congress will be offset by local tax increases.

The effects from our last cuts have stopped working. If we don't do something, the economy will still underperform. If we cut again, it won't do much good in the short-term, but after awhile it should have an effect upon the economy. Let's cut and hope it works. And for Pete's sake, let's don't tell the public our concerns today. Firm hand on the tiller and all that stuff is the order of the day. The public will read the minutes next month when no one will care about old news."

These Fed minutes read pretty much as a description of the Muddle Through Economy. We are in for a period of slow growth in the next few months. Here is my continued prediction: Greenspan has not made his last cut. The "soft patch" we are in will prove frustratingly resistant to rate cuts, and there will be calls next spring for the Fed to once again "do something."

Let's switch to another related story by Andrew Kashdan of Apogee Research. Kashdan cites a study by the Levy Institute. This study is another way of looking at the rationale behind my case for the Muddle Through Economy. Essentially, (if I understand this correctly, Andy) the Levy Institute suggests that one can model the economy as a balance sheet where the private, government and foreign sectors all have to "balance." The government surpluses allowed the private sector (corporate plus consumer) to "invest" more and save less in the 90's. Now the private sector is on track to get back to a more neutral stance (less investing by business and spending by consumers and more savings by both sectors).

That means those economists looking for economic stimulus from consumers are going to be very disappointed, as that sector is running out of steam. To get the 3%-plus growth forecast by the Congressional Budget Office, this study suggest the government deficit would have to be almost 8% or around $800 billion, give or take a few hundred billion. "...this scenario implies an equal expansion in the current account deficit, making for "twin" deficits. And certainly, a current account deficit that amounts to 8% of GDP is unsustainable."

Kashdan then notes: "Under another scenario, if the private sector moves toward balance without such a large fiscal expansion, then GDP would grow only 1% per year between 2002 and 2006, with a substantial rise in unemployment to go with it. Finally, Levy's "dream scenario" entails an increase in net export demand to achieve growth without large government deficits. In other words, all sectors move towards balance. To arrive in Dreamland, the dollar has to depreciate by around 25% at the beginning of 2003, which would bring the current account to between 2% and 2.5% of GDP by 2006. The drawback is that even if the U.S. could pull it off, other economies would take a hit because the U.S. would no longer be importing so many goods."

Making Predictions

In a few weeks, I will write my annual predictions letter for 2003. The above scenarios illustrate the difficulty, if not the absurdity, of making any predictions. Nevertheless, I shall continue to make them, as I have done every year since 2000.

(So far, I have been pretty much on target [read lucky] in my calls. We will see if I can continue to flip heads with this next year's predictions.)

Think for a moment. To get to the Levy Institute's dream scenario, we need outsize government deficits coupled with a seriously dropping dollar and increased exports. But the Fed just told us that relief from foreign buying is not likely. I absolutely believe we will see larger deficits, but nowhere the level Levy implies we will need for 3% plus growth. It is just not politically feasible, nor even desirable.

The dollar is going to drop, but by 25% over the next few years? While anything is possible, with every country in the world involved in competitive currency devaluation against the dollar, that alley looks awful black.

Let's go back to Levy's assessment: "...if the private sector moves toward balance without such a large fiscal expansion, then GDP would grow only 1% per year between 2002 and 2006, with a substantial rise in unemployment to go with it. "

In order to get back to a 90's type booming economy, every scenario I run involves some sort of action which just doesn't seem to be possible. If you push positively on this sector, you get a negative response from another sector. The stimulus that comes from tax cuts, rate cuts, deficits, Fed actions, etc. seems to serve to push things along but not to jump-start the economy. This is a prescription for the Muddle Through Economy: slow growth and sluggish employment.

Where's the Deflation?

Every week, I get letters from readers telling me that there is no deflation. Some suggest I should go back to Economics 101. They insist the money supply is growing and therefore, by definition, we have inflation. Well, as they say, not exactly.

This insightful quote is from Gary North's Remnant Review: "Let's begin with a definition of deflation. There are two. There is monetary deflation. This is a reduction in the money supply. Problem: there is no agreement about what constitutes the money supply. Price deflation is a reduction in the official price level. Problem: there is no official price level. So, from the beginning, we are guessing. So are the economists. So are the statisticians who collect data in terms of the economists' theories." (I have been reading North for 20 years. I sometimes, even often, disagree, but I always read. He makes me think. For subscription information write pmc701@aol.com.)

The Bank of Japan is doing what it can to create inflation. The monetary base in Japan is up a stunning 21% vs. a year ago. This is on top of large growth from prior years. By the reasoning of my weekly critics, there is and should be inflation in Japan. But yet there is clearly deflation in Japan. One reason is the following:

Today, Dennis Gartman tells us that "The Japan Daily Digest recently reported that in November in Japan the total of outstanding bank loans fell 4.7% year-on-year.... the 59th straight month of decline. As far as we know, this is unprecedented in any industrialized nation in modern times. For the "city banks," [large banks] their lending was down 7.4% y-o-y... and more astounding still is that this is the 75th straight monthly decline.

"...According to The Japan Daily Digest (and this is a truly preposterous figure, but nonetheless it is true) "So little money is being lent that the banks now have almost as much money on deposit--Yen 476.4 trillion--as they do on loan." To put it metaphorically, the transmission is slipping, and the car cannot move forward." (The Gartman Letter, $2500 or so per year, dennis@thegartmanletter.com. Must reading for serious traders.)

Looking at just one number or set of data and making predictions is often a fool's errand, if not a prescription for disaster. The complexities in the economic world are as great as those in the quantum world of physics. Physicists are hard at work on a Theory of Everything. They are trying to tie all the little disparities of physics into one neat package. I wish them luck.

While any one economic theory can be useful at times, there is no Theory of Every Economic Thing. Nothing explains the macro and micro economic forces in toto. You can be Keynesian, Monetarist, Austrian or (my favorite) from the Economic School of Hard Knocks. There is always an asterisk by any prediction or explanation. In the long run, I favor von Mises and the Austrians, but you can go broke waiting for his long run to come about.

There are just too many factors to take into consideration when making predictions. Each economic school emphasizes the importance of a different set of factors. That is why I like to drop back and try to get a bigger picture. It is also why I like to get a number of different viewpoints which lead me to the same conclusion. This is why I think we are in a secular bear market. There are half a dozen different factors which all point to the same conclusion, and none that I can find which argue against. (See my chapter on secular bear markets from my book-in-slow-progress, Absolute Returns , at www.johnmauldin.com)

Deflation in the US (and Japan) is more than simply about money supply. It is about the velocity of money, bank loans, trade deficits, and a host of inputs. Even if it was simply about money supply, as North notes above, which money supply? If you use M1, then how do you figure the huge flows of US physical cash to foreign countries? If you use M2, then that figure grows when investors move from stocks to money markets.

Deflation is a little bit like Judge Learned Hand's definition of pornography: I know it when I see it.

The Fed has told us they know what deflation is, and they don't like it. They are not going to let "it" happen here. That is why I believe that over the long haul, we are likely to see a re-emergence of inflation. Paul McCulley of PIMCO goes so far as to say there is a regime change at the Fed. The new regime is now committed to openly reflating the economy. In his words, they know where the keys to the printing press are.

Why Gold is Going Up Even More

There may be more than meets the eye with the recent change of the Secretary of the Treasury. John Snow is an influential member of the Business Roundtable. They have openly advocated a weaker dollar. Former Secretary O'Neill more or less favored a strong dollar. While the major emphasis of Bush's appointment is to get someone who will argue for his tax cuts and other policies, a weaker dollar is also the prescription that the Fed (see Bernanke's speech) advocates as well. If the administration wanted a strong dollar, they could have found someone who believed as much who also would forcefully argue for tax cuts.

My long standing view is that gold is a currency, nothing more or less, and thus floats in concert with whatever the relative value of any given currency is. Gold has dramatically risen in terms of yen as the yen has dropped 50% against the dollar. As the dollar begins to drop, we see gold rise. I became a gold bull early this year as I predicted the drop in the dollar against the euro. I suggested the dollar and the euro would be at parity at the end of 2002. We are now slightly past that point.

Given the Fed desire for a lower dollar, our trade deficits, a business desire for a lower dollar and now even a willingness at Treasury for the dollar to decline, it is likely the dollar will drop even more against the euro.

Every time we have approached $320 gold in the past, there has been selling on the part of central banks which has knocked it back. Today it seems that those sell orders have been lifted. Are central banks now gold bugs? Hardly. But they are money managers, and are obligated to try and get the best returns for their reserves as possible.

My guess is they still think of gold as a barbarous relic. They still want to sell. But the signals from the Fed, the appointment of a man at Treasury who likely will let the dollar drift and the trade deficit all suggest to them they can get more for their gold if they sell later. They read the charts, and the charts say wait.

The key for the price of gold, in my opinion, is the price of the euro in terms of dollars.

In a preview of my 2003 forecast, I will give you my likely prediction on the euro today: I think the euro and dollar will approach the original levels of the euro when it was introduced - $1.17 or so. That is another 15-17% from here, and could easily take gold to $380.

Ian McAvity, one of my favorite gold curmudgeons, and chartist par excellence, points out that we are now in a very important point in the technical charts of gold. If we move up over the current area, the next "resistance" is at the $380 level, which not coincidentally corresponds to a 15% or so drop in the dollar against the euro. (You can get McAvity's gold charts, plus his 24 page 2003 preview, for $49 with a four month subscription to his excellent technical letter. Email imcavity@yahoo.com for details.)

I could launch into why the dollar dropping will be harder than it looks, why the Fed minutes confirm my opinion that we are in a Secular Bear Market and the recent rally is a bear trap, but it's time to go home, so I will quit here. I will save a few bullets for the 2003 preview. I can confidently predict, however, that sushi and sake are in my very near term future.

Meet Me in Puerto Vallarta, and a Job Opportunity

I am looking for an editor/writer/researcher/assistant/productivity enhancer. Writing and editing skills are important (witness the mistakes in this letter), as are intellectual abilities, but whoever I hire will be researching and doing a little bit of everything. I assume you will have solid technical computer and internet abilities and love to work long hours while you are underpaid (just like all my staff). This is not glamorous, but will be fun and should be interesting. You will need to work out of my office (Fort Worth) and therefore live in the Dallas/Fort Worth area. Send me your resume if you are interested.

Next week is a lost cause for personal productivity. I have to go back to school in Dallas to study for yet another securities license. Two days of cramming on arcane details, one day of desperate study and then the test on Thursday. I will get to have dinner with David Tice and Marshall Auerbach of the Prudent Bear Fund on Monday, so there will be some fun as well. (Boy, have they been on a roll!)

I am going to take a needed week off after Christmas and go to Puerto Vallarta, Mexico, with my wife. Besides the all important time with my wife (I have promised no business!), I will sit in the sun, read books, play golf and contemplate the future. I will then come home and write my annual predictions. Maybe a few margaritas and long talks with my wife will make the outlook more promising than merely Muddle Through. If you are in the area, and want to play some golf, I can get a day pass to meet you at the Marina Golf Course. Discussing the markets between shots is not a violation of the no business zone.

I love this time of year. We will get all the kids back home for Christmas (all seven!), and my wife really knows how to decorate a home to make it feel special. I hope you are enjoying the time as well, and remember that there is no deflation in the value of time spent with family and friends. Even a central bank cannot destroy love. They do have limits.

Your raw fish eating and hot sake drinking analyst,

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