parsing the latest fomc statement

8/7/2019 Parsing the Latest FOMC Statement

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Lies, Lies, Damned Lies Parsing the 3 November FOMC

Statement 4 November 20101

Summary

This briefing has three main objectives:

Examine the latest Federal Open Market Committee (FOMC) statement(November 3, 2010),

Debunk its assertions regarding inflation, interest rates, the money supply, bondyields, and equity prices

Identify implications of Fed policy for investors.The Feds endgame is to preserve, through Quantitative Easing (QE), theattractiveness of US debt to China and other countries. The inflationary impact of QE

is expected to increase significantly the yield, and hence the appeal, of long-term US

debt at the expense of and to the detriment of American consumers.

The resulting devaluation of the US dollar and concomitant massive increase in

inflation will stifle US economic growth and further degrade our standard of living:

Higher bond rates will discourage corporate investment Higher mortgage rates will make home mortgages less affordable anddiscourage refinancing Higher inflation will put upward pressure on the price of commodities,

increasing the cost of foodstuffs, clothing, and other basic necessities while

decreasing disposable income.

These factors make the highly touted economic recovery increasingly unlikely.

Though some economists fear that QE will unleash a "high inflation" spiral, a

downward-spiraling economic disaster is more likely. Unless current fiscal and

monetary policy is immediately reversed, employment and productive investment willbe successively destroyed, aided and abetted by the QE-induced $2 trillion tax

increaseimposed by the Fed.

1Based in part on reporting by Karl Denninger (www.market-ticker.org) and Chris Whalen

(www.institutionalanalytics.com ).


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BillSims/GuermantesInc placetexpeririNovember4,2010

The FOMC Statement

Our analysis of the most recent FOMC statement identifies inexplicable

inconsistencies between financial market data and Fed claims. These apparent

anomalies cast doubt on the Feds statements about:

Inflation Interest rates The money supply Bond yields Equity prices.

In the next several pages well examine the likely impact of Fed policy on each asset

class.

Once weve identified and explicated inconsistencies between market data and Fed

claims, well assess the likely impact of Fed policy on financial markets and examine

the implications of Fed policy for investing.

Analysis

Wednesdays FOMC statement begins with the following claims:

TheFOMCdecidedthisweekthat,withunemploymenthighandinflationverylow,further

supporttotheeconomyisneeded

Today,mostmeasuresofunderlyinginflationarerunningsomewhatbelow2percent,orabitlowerthantheratemostFedpolicymakersseeasbeingmostconsistentwithhealthyeconomic

growthinthelongrun.

No, Mr Bernanke, inflation is notrunning somewhat below 2 percent. The latest

report on the GDP deflator, the Feds preferred measure of inflation, suggests that the

current economic climate is deflationary, not inflationary:


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The table shows that deflation is increasing. The entries above highlighted in pink

show a current annually adjusted deflation rate of 2.2%, compared with the previous

quarters2.0%.

Deflation, the result of the massive deleveraging of the US economy following the

2007 meltdown, has been increasing since the imposition of Q1in 2009.

The FOMC goes on to assert:

Thisapproacheasedfinancialconditionsinthepastand,sofar,lookstobeeffective

again.Stockpricesroseandlongterminterestratesfellwheninvestorsbegantoanticipatethemostrecentaction.


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This is canting nonsense. Data for the 10-year Treasury bond show that Quantitative

Easing correlates with rising bond yields:

Just look at the above chart of yields on 10-year US Treasury notes. Like the 30-year

note, rates on the 10-year note, which is most-closely linked to mortgage rates, went

up, not down, after the Fed announced its first round of Quantitative Easing.

Rates did notbegin to declineuntil Quantitative Easing was completed.

The takeaway? Fed policy is inflationary: QE causes long-term interest rates to

increase rather than decrease, and the new round of Quantitative Easing (QE2) will

do the same.

Lets continue testing Fed pronouncements against how the markets actually

responded.


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Undaunted by these inconsistencies, the Fed moves forward, further noting that:

Ourearlieruseofthispolicyapproachhadlittleeffectontheamountofcurrencyin

circulationoronotherbroadmeasuresofthemoneysupply,suchasbankdeposits.Nordidit

resultinhigherinflation.

Little effect on the currency in circulation? This is contemptuous and mendacious.

Rising interest rates caused by QE also known as inflation implicitly reduce the

value of the currency in circulation, and QE explicitly increases the money supply,

the apparent playpen of monetary policy. Note the quantum leap in the monetary

base following QE1:

From a money base of about $500 billion in 2000, the Fed increased the money base

to over $2 trillion, and they arent finished. Mr Bernanke is planning an additional

$0.6 trillion increase over the next several months. Given the inflationary nature of

QE, this hardly represents, as the FOMC maintains, Little effect on the currency in

circulation.


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If the FOMC truly believes that [QE did not] result in higher inflation, how to

explain QEs tight correlation over the past eighteen months with the price of oil? The

correlation is detailed in the chart below:

Using the price of oil as a proxy for inflationary pressure, we can gauge QEsinflationary impact:

The price of oil rises from just under $50 to $85 in lockstep with QE1 When QE1 ends, the price of oil falls to $70 As soon as QE2 is announced, the price of oil once again begins to rise, even

as the FOMC justifies QE2 by noting that the economic recovery is "soft."

Attend well: If the inflationary impact of QE2 is roughly proportionate to the changein oil prices during QE1, oil is headed to about $110 in the next three to six months,and gas to $4.00/gallon.


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Onward. Not surprisingly, the Feds next statement is exceedingly difficult to squarewith the evidence that weve presented thus far:

Wehavemadeallnecessarypreparations,andweareconfidentthatwehavethetoolsto

unwindthesepoliciesattheappropriatetime.TheFediscommittedtobothpartsofitsdual

mandateandwilltakeallmeasuresnecessarytokeepinflationlowandstable.

Not content, however, with misleading statements regarding interest rates andinflation, the FOMC moves merrily on to equities:

Andhigherstockpriceswillboostconsumerwealthandhelpincreaseconfidence,whichcan

alsospurspending.Increasedspendingwillleadtohigherincomesandprofitsthat,ina

virtuous

circle,

will

further

support

economic

expansion.

These assertions contradict the known relationship between inflation and equity

prices. Absent underlying growth in the business sector, increases in stock prices are

driven by inflation. Such price increases simply reflect an expansion of the multiple

paid for a dollar of earnings.

And Quantitative Easing has the same insidious impact in the currency markets:

adding more dollars to the market causes each dollar to become a smaller proportion

of the currency asset base, just as each dollar of share price buys a smaller

proportion of a dollar of earnings.

In the chart on the following page that tracks of the trajectory of US dollar prices. we

map the impact of QE on the value of the US dollar.


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The positive correlation between QE and changes in the value of the US dollar is

striking:

With the conclusion of QE1 in late April of this year, the value of the US dollarincreased by 10%. Yet beginning in June when the market began to anticipate QE2,the dollar has lost about 15% of its value.

And signs of this induced inflation are beginning to appear in input costs. Last weekKimberly-Clark announced that it is experiencing the worst cost-push pressures on itsinputs in the company's history.

Put another way: the recent run-up in equity prices has been driven by an inflationrate of 15% caused by the intentional devaluation of the dollar.

My point? Injecting high-grade heroin into the market place will not secure a lastingincrease in equity prices. In these engineered rallies, higher stock prices areunsustainable. Because the US dollar is sinking, the apparent price of stocks isincreasing, yet there is no structural basis for higher equity prices.


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The same deleterious effect of QE is reflected in the recent rapid increase in the priceof commodities. Since QE2 was announced in August, commodity prices have soaredby as much as 40%, reflecting expectations of higher inflation:

Whats Next?

As the value of the US dollar is eroded by Fed-induced inflation, we can expect theprices of clothing and foodstuffs to increase dramatically in the coming months. Atthe same time, real wages and our standard of living will decline.

Make no mistake: current Fed policy will notpromote economic growth:

Increasing mortgage rates will make home mortgages less affordable and willdiscourage refinancing

Higher bond rates will discourage corporate investment.QE is far from being, as the Fed would have it, a life preserver thrown to the US

economy. Left unchecked, QE will destroy the US economy.

Current Fed policy is a cynical gambit to:

Transfer wealth to the US government and the banks Ensure that US debt remains attractive to the Chinese and the rest of the world.


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The inflation that has been artificially induced by Fed policy will materially debase

our currency and thus our purchasing power, significantly diminish our living

standard, and ultimately destroy our economy.

QE represents a dollar-for-dollar asset transfer, which translates into an effective tax

increase for everyone in the country. For example, consider the numbers of miles the

US population drives in one year: the impact of a dollar increase in the price of

gasoline will generate $140 billion dollars annually in additional tax, ie a transferof

$140 billion from consumers to the Federal government.

Far from potentiating, as Mr Bernanke claims, a virtuous circle of economic recovery,

QE will have the opposite effect, a vicious circle of downward spiraling economic

contraction. Heres how QE will play out:

1. Inflation induced by QE decreases disposable income, reducing discretionaryspending.

2. Consequently, companies no longer need to hire people to providediscretionary goods and services. [We can thank QE1 in no small measure for

the current rate of unemployment.]

3. As a result of 1 and 2, demand for social services increases dramatically,requiring additional government spending for government assistance programs

(unemployment, Medicaid, food stamps etc).

4. But theres no money to fund the increased demand because increasingpersonal taxes to generate the additional revenue during a depression is

political suicide.

5. Instead the government again turns to the bond market and issues debt to fundincreased spending, despite continued high employment and deflated asset

prices.

6. The bond market reacts to this apparently unending deficit spending cycle byincreasing rates until the market clears, creating even more inflation.

7. This in turn induces the Fed to engage in more QE in the mistaken belief thatincreasing the money supply will spur employment and increase asset prices.

And so on until the Fed ends up being, for all intents, the entire government bond

market.

The more QE is used, the more jobs are destroyed because imposing an effective tax

on the entire economic systems will ultimately reduce margins to a point of no return.


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How Markets Responded to the FOMC Announcement

Thus far weve used the disparity between financial markets and statements by theFed to:

Scope out the Feds real policy objectives with QE Expose the Feds mendacious QE legerdemain.

Market Response

A markets initial response to policy changes often provides insight into the longer-term impact of the change. Lets now take a close-up look at how the markets reacted

the day following the FOMC announcement.

On Thursday, 4 November 2010, the markets responded to the 3 Novemberannouncement exactly as expected:

The US dollar fell The price of equities, oil, and US dollar-denominated commodities rose.

A Close-Up Look

The following five-minute charts provide an on-the-ground view of how each marketreacted to the QE announcement and how each is likely to respond going forward.


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Impact of the FOMC Announcement on the US Dollar and on US Equities

The US Dollar

After the 3 November FOMC announcement, the price of the US dollar crashed at thenext days market open, briefly flirting with its previous low of 74.97:

The US dollar lost nearly 3% of its value in a matter of minutes. This rapid erosion ofvalue strongly suggests that the value of the US dollar will decline further over thenext several months.

Equities vs the US Dollar

The impact of the FOMC announcement on equities was equally predictable. WhenEuropean markets opened the following day, stock prices rose commensuratelyagainst the falling US dollar. Scaled US dollar prices are represented by the whiteline in the S&P futures chart on the next page:


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The nascent but strengthening inverse relationship between equities and the US dollarsuggests that stock prices are being driven by inflationary expectations.

Impact of the FOMC Announcement on Commodity Prices

Oil, a key harbinger of inflationary pressure, rose by $2/barrel Despite a successful harvest corn prices jumped $2 The price of soybeans also increased significantly.

All of which boils down to one simple fact: the Feds strategy of transferring wealthby inducing inflation will

Significantly increase the cost of core consumer goods (food, clothing,gasoline)

Materially reduce the value of money and thus purchasing power Dramatically reduce disposable income.


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Conclusions and Investment Implications

No one knows what ultimate impact Quantitative Easing and the near-completemonetization of US debt will have on the US economy.

But we can infer at least part of the Feds endgame:

QE2 will unleash a massive transfer of wealth from consumers to the FederalGovernment and its agents in the financial markets

The Feds recently announced $600 billion capital infusion, along withearlier Quantitative Easing, will impose a de facto personal tax increase ofover $2 trillion dollars

This, the largest tax ever levied on the American people, will effect anunprecedented decline in living standards.And the Banks?

Our economic climate is immensely fragile, with the major banks technicallyinsolvent. Although the banks are being overwhelmed by bad debts, portions ofwhich have been funded by Quantitative Easing, Federal and State governmentscontinue to lack the political will to address the problems effectively..

It gets even worse: these titans of high finance also have over $400 billion worth ofHome Equity loans on their balance sheets. Seventy percent of the dollar volume ofthese loans is in the Sand States, where 50% or more of the homes are under waterand more than half of the loans are delinquent. Even though these second loans areworth zero if subordinate to a first loan that is subject to default and foreclose, thebanks are carrying the loans at 95 cents on the dollar.

The Macro Environment

The current economic situation is unsustainable.

Yet given the entrenched economic cabal in Washington, little is likely to changeuntil the Federal government inevitably is forced to put the banks intoreceivership.


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Absent an immediate reversal of fiscal and monetary policy and governance, thedreaded "high inflation" spiral will likely at some point morph into downward-spiraling economic disaster as employment and productive investment aresuccessively destroyed by the QE-induced $2 trillion tax increase.

Implications for Investors

So where do I invest my capital?

Strong Currencies, Precious Metals, US Dollar-Denominated Commodities

In an increasingly hostile economic environment, the value of the US dollar and thevalue of US equities will likely decline significantly.

As wealth is shifted to tangible hard assets, the price of US-dollar denominatedcommodities and precious metals will rise, barring economic disaster.

The imperative should be clear: bet against the US dollar. Protect your capital byinvesting in sectors that benefit from rising inflation. The safest choices are:

Strong currencies (the Swiss franc, the Canadian dollar) Precious metals (gold, silver, platinum) US-dollar denominated commodities (oil, cotton, soybeans, wheat etc).

What about equities?

Moving additional capital into equities is extremely risky. While short-term equitygrowth may provide some short-term gains, the aggregate value of this asset class islikely to decline significantly over the next two to five years:

The Fed-induced inflationary juggernaut will likely result in stagnant corporateinvestment, weak consumer demand, and virtually no consumer savings.

parsing the latest fomc statement

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