Question: What is the Fed’s plan? See the answer at the end of the blog.
This is an excerpt form the book "Investment Strategies that Work" (2015) - by Brett Machtig & Josh Gronholz
Let’s look at the future and see how present market conditions impact investment strategies.The present time (as of the writing of this book) is circa May 2015. In 2015, here are the factors that are driving the stock market and other investments. They include: The Federal Reserve and the U.S. Dollar; commodities like oil, gold, metals and crops; and current interest rates. In this blog, we will focus on the Feds.
The Federal Reserve, Government Debt, and the U.S. Dollar
One of the most interesting stories is about the founding of the U.S. Federal Reserve system on December 23, 1913 by a group of men that included the wealthiest families of the day. Prior to that day, if the U.S. Government needed money, it had to go to other countries to borrow it.
After the formation of the Federal Reserve, all the Feds needed to do was to dilute our currency. For an excellent read about the creation of the Federal Reserve, we suggest reading, The Creature from Jekyll Island, By G. Edward Griffin. For more info, go to Amazon.com.
In Exhibit 1, you can see the dramatic dilution of our currency, according to the Federal Reserve.
Since 2009, the U.S. Government, and the Federal Reserve have been diluting our currency at an alarming rate. Why are the Feds doing this?
There have been 32 countries that have lost control of their currency and experienced hyperinflation in the last 100 years of which 21 have experienced it in the past 25 years and three in the past three years. For example, in the last 25 years the countries have experienced hyperinflation. Here are 12 of the 21 countries and the impact of hyperinflation on their currency:
- Argentina (1975-1991) in three separate currency reforms in 1983, 1985, 1990 where hyperinflation continued reaching a peak annualized rate of 4,923.3 percent in December 1989. The overall impact of hyperinflation: 1 new peso = 100 Billion pre-1983 pesos.
- Bolivia (1984-1986) Prior to the 1987 currency reform, the peso boliviano had an effective devaluation of 95% and was replaced by the boliviano that was pegged to the U.S. dollar.
- Brazil (1986-1994) By the mid-1980’s inflation was out of control reaching a peak of 2,000 percent. The overall impact of hyperinflation: 1 (1994) real = 2,700 Trillion pre-1930 reis.
- Mexico (1994) On 1 January 1993, the Bank of Mexico introduced a new currency, the nuevo peso that was equal to 1,000 old pesos. Since the Mexico Peso Crisis of 1994 the value of the Mexico peso has plummeted by almost 60%.
- Peru (1984-1990) Peru experienced two currency reforms, 1985 and 1991, the overall impact of hyperinflation: 1 nuevo sol = 1,000,000,000 pre 1985 soles de oro.
- Poland (1990-1993) Poland suffered two bouts of hyperinflation. The first occurred from 1922 to 1924 when inflation rates reached 275%. Three years of hyperinflation resulted in currency reform in 1994 in which 10,000 old zlotych were exchanged for one new zloty.
- Russia (1992-1994) Russia experienced 213% inflation during the Bolshevik Revolution and during the first year of Soviet reform in 1992 when annual inflation peaked at 2520%. In 1993, the rate was 840%, and in 1994, 224%. The ruble devalued from about 100 rubles to the U.S. Dollar in 1991 to about 30,000 rubles to the U.S. Dollar in 1999.
- Turkey (1990’s) Throughout the 1990’s, Turkey dealt with severe inflation rates that finally crippled the economy into a recession in 2001. In 2005, Turkey introduced currency reform, where the New Turkish Lira is equal to 1 lira = 1 million old lira.
- Ukraine (1993-1995) Inflation rates peaked at 1400% per month between 1993 and 1995 resulting in the karbovantsiv being taken out of circulation in 1996 and replaced by the hryvnya at an exchange rate of 100,000 karbovantsiv = 1 hryvnya.
- Yugoslavia (1989-1994) [Yugoslavia had the] second worst hyperinflationary period in recent history with a monthly inflation rate of 5 quintillion percent. At the end of it, one novi dinar = 1,300,000,000 Quadrillion 1990 dinars.
- Zimbabwe (1999 – 2009) The Rhodesian dollar inflation reached an absurd 231,000,000% in the summer of 2008. A ban on foreign currency trading was lifted in January 2009. By then, the American dollar had become Zimbabwe’s main currency, a position it still holds today.
Since so many currencies had gone into hyperinflation when their governments overspent or tried to dilute their currency too rapidly, CAG was concerned that Alan Greenspan’s forecast of double-digit inflation he made in his 2008 book, the Age of Turbulence could occur here in the United States. We initially believed this dilution was more connected to the uncontrolled spending of the U.S. Government than it was a means of fighting deflation.
After the stock market pullback in 2008, many governments were left in very poor shape. Banks, all over the world, were brought to the brink of bankruptcy. Investment liquidity seized. When the next G20 meeting took place in 2009, its members, the 20 major economies as a group decided to initiate worldwide Quantitive Easing Programs. Its members included Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom and the United States—along with the European Union (EU). One by one, many have diluted their currencies in an attempt to strengthen their banking systems, as well as each countrys’ balance sheets by implementing a “quantitative easing” program. Other countries have also diluted their currencies.
Since its beginning, the Fed’s balance sheet expanded from about $850 billion to more than $4.4 trillion by October 2014. The positives of Quantitative Easing are supposed to lower interest rates for corporate bonds and mortgages; provide support for housing prices; create higher stock valuations; increase inflation expectation; increase job creations; and increase GDP. Its risks are: unpredictable inflation; adverse crowding out of emerging debt borrowers; and lowers interest rates and eroding buying power for those living on a fixed income.
Exhibit 2 shows a breakdown of the purchases by the Federal Reserve:
In October of 2014, the U.S. Federal Reserve stopped Quantitative Easing. Even though Janet Yellen replaced Ben Shalom Bernanke in February 3, 2014, the Fed is still following Ben’s “big picture” plan.
If there is mention about the dilutive effects of the Quantitative Easing, there is little mention of the enormous increase of assets the Federal Reserve System has on the books. As you can see, liabilities have grown via dilution, but so has the amount of supporting assets the Fed has on the books. Just as most do not know the huge ‘Troubled Asset Relief Program (TARP) bailout of 2008, was paid back to the Government.
So, what is the Fed’s plan or “big picture?” A simple answer is it has not changed, since Ben became Fed Chairman. It is to fight off deflation and expand the role of the Fed to include reduce unemployment. In a November 21, 2002 speech made before the National Economists Club in our nation’s Capital, Ben Bernanke outlined the big plan or the seven things he would do to combat deflation.
See blue text for his plan. Ben Bernanke’s basic prescription is …
“…the best way to get out of trouble is not to get into it in the first place. The Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero. For example, central banks with an explicit inflation target almost invariably set their target for inflation above zero, between one and three percent per year.
- Loan Money To Banks – Fed should take most seriously its responsibility to ensure financial stability in the economy. A healthy, well-capitalized banking system and smoothly functioning capital markets are an important line ofdefense against deflationary shocks.
At times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window to protect the financial system; as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks, [and later in 2008 when the Fed bailed out the banking system with TARP].
- Cut Interest Rates – As suggested by a number of studies, when inflation is already low, and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates. By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entail.
- Quantitative Easing – However, suppose that, despite all precautions, deflation was to take hold in the U.S. economy and, moreover, that the Fed’s policy instrument–the federal funds rate–were to fall to zero. What then? Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. Gold has value because it is scarce.
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. However, the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.
We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).
Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys [e.g.Quantitative Easing].
- Cooperate with Government on Tax Cuts/ Tax Credits – Alternatively, the Fed could make low-interest-rate loans to banks or cooperate with the fiscal authorities [to stimulate the economy with tax cuts / tax credits]. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
- Buy Foreign Debt to Stimulate Foreign Demand for U.S. Goods –The Fed can inject money into the economy and has the authority to buy foreign government debt, as well as domestic government debt [by buying foreign debt, the Fed can stimulate demand for U.S. goods overseas.] Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
It is worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.
Indeed, consumer price inflation in the United States, year on year, went from 10.3 percent loss in 1932 to 5.1 percent loss in 1933 to 3.4 percent in 1934. The economy grew strongly, and, by the way, 1934 was one of the best years of the century for the stock market.
If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.
- Loan To Businesses Directly – Each of the policy options I have discussed so far involves the Fed’s acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases [of direct loans to businesses] to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices.
Even if households decided not to increase consumption but instead rebalanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money. [This is where Ben got his nickname, “Helicopter Ben.”]
- Loan To Individuals Directly – Of course, in lieu of tax cuts or increases in transfers, the government could increase spending on current goods and services [by making direct loans to individuals] or even acquire existing real or financial assets [Feds buying stocks and bonds]. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”
Answer to the Question: What is the Fed’s plan?
I have included a large portion of Stan's speech to show that the Federal Reserve has a “playbook” and is following a plan to fight deflation. If what has been done doesn’t work, the Federal Reserve can do many more things to get inflation moving upward, like:
- Make direct loans to business or individuals;
- Have deeper individual or business tax cuts;
- Increase individual or business tax deductions;
- Provide loans to other countries to buy U.S. goods; or
- Continue to dilute the dollar with further Quantitive Easing.
For these reasons, as the Federal Reserve’s leadership has emphasized, prevention of deflation is preferable to cure. Nevertheless, the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation; even should the federal funds rate hit its zero bound.
by: Brett Machtig, & Josh Gronholz
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About the Authors:
Brett Machtig has authored several books and is the founding partner of The Capital Advisory Group, a private asset management and retirement planning services firm located in Bloomington, MN. Their firm manages more than $400 million in assets for 83 institutions and about 850 families as of December 31, 2014. He has been helping affluent investors execute financial strategies, meet income objectives and realize life visions for more than 30 years. Approachable, genuine and down-to-earth, Brett holds himself to a high standard of accountability and seeks to achieve positive financial results on behalf of each client. In this article, Brett shares the effectiveness of each strategy and how to improve it.
Josh Gronholzgraduated Summa Cum Laude from the University of Minnesota’s Carlson School of Management and is a Registered Asssitant. He has worked in asset modeling with The Capital Advisory Group Advisory Services and has spent the bulk of his career modeling various investment scenarios and assisting individuals along their way to financial success and personal wealth.
(1)finra.org/web/groups/industry/@ip/@reg/@notice/documents/noticecomments/p118980.pdfas of 8/2014
(2) www.sec.gov/divisions/investment/advoverview.htm as of 8/2014
(3) www.fi360.com/products-services/tools-overview, as of 8/2014, Results not guaranteed.
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