- Conducting additional purchases of longer-term securities (quantitative easing);
- Modifying the Committee's communication;
- Reducing the interest paid on excess reserves.
Aside from having little effectiveness, quantitative easing also brings about substantial risks. For one, should the Fed indeed buy $100 billion in government bonds each month as is rumored, the Fed would be implicitly financing new issuance of government debt by printing money ("monetizing the debt). For those not aware, when the Fed buys $100 billion in government bonds, it literally creates money out of thin air. All that is necessary to buy the bonds is an accounting entry on the Federal Reserve's books: a credit of U.S. dollars that the institution that sold the bonds now has a claim on. This "claim" may be exchanged for other goods and services where U.S. dollars are accepted; at the Fed, however, the "claim" may only be exchanged for a piece of paper confirming the claim.
A major challenge with the Fed buying bonds is that the bond market is so enormous that the Fed is just one of many participants. $100 billion a month in purchases may not move the markets as desired, should market forces disagree with the Fed. This is why Bernanke has stated his second "remedy:" communication. In our assessment, the cheapest Fed policy is one where a Fed official utters a few words and the markets move. The trouble is that since the onset of the financial crisis, with the Fed has had to employ much more than simple words: rates cuts were followed with emergency rate cuts in early 2008; these were followed with credit easing, then a mortgage backed security (MBS) purchase program in excess of $1 trillion; not to be outdone, the Fed is signalling that quantitative easing is to follow. Still, the Fed appears to be working hard to prepare the market through a blizzard of speeches by Fed officials. After all, if interest rates move based on a few well-timed speeches, a couple hundred billion dollars may not need to be printed; or so the thinking seems to be.
There's also another avenue; positioned as a joke, it is all but funny: in his Jackson Hole speech, Bernanke suggested that in an environment where inflation expectations are too low, should the public reduce its confidence in the Fed, the resulting increase in inflation expectations could become a "benefit". Since those comments, we have had a number of Fed officials make the case for quantitative easing. In the past, Fed policy was conducted at FOMC meetings; in the current environment, every avenue appears convenient to tell the public the market better price in higher inflation expectations. A secondary goal of such a communication frenzy may be to steamroll over dissenting voices at the Fed (see also our analysis, Fed Crossing the Line?).
In our view, the Fed knows quantitative easing may not be all that effective. We happen to think that the risks of quantitative easing outweigh the benefits, but we don't think the Fed necessarily thinks the benefits are all that great. The challenges we are facing must be addressed by politics, not monetary policy. Homeowners must be allowed to downsize; we must have a tax and spending policy that is sustainable and encourages investment. Sprinkling money on the problems only encourages that the can is kicked down the road, making the problems all the more difficult to solve.
If the Fed believes quantitative easing may not be the silver bullet, why may it be pursued anyway? To just try printing another $1 trillion, hit blindly and hope that it stimulates something? Worry about the inflationary fallout later? No. In our analysis, Bernanke may have a different agenda: to intentionally weaken the U.S. dollar. When the Fed prints dollars to buy government bonds, two things happen:
- Everything else equal, the supply of U.S. dollars increases, making the U.S. dollar less valuable versus other currencies;
- Government bonds are intentionally over-valued as the Fed intervenes, making them less attractive to rational buyers. Rational buyers, domestic or foreign, are likely to look overseas for less manipulated returns
- Bernanke has testified in Congress that countries going off the gold standard during the Great Depression recovered from the Great Depression faster than those countries that held on to the gold standard longer. This is in line with discussions by economists surrounding trading purchasing power for employment. It's not the mandate of the Fed to intentionally destroy purchasing power, but currency devaluation is a tool employed by central banks to spur economic growth.
- Bernanke has repeatedly argued that a weaker U.S. dollar is not necessarily inflationary. He points to past decades where a weaker dollar did not necessarily increase inflationary pressures.
- A weaker dollar may not spur growth as intended. In the short-run, earnings of U.S. based exporters may benefit as foreign earnings translate to more U.S. dollars in a weak dollar environment. However, an advanced economy simply cannot compete on price; the day the U.S. exports sneakers to Vietnam may be the day I see a pig fly past my window. Instead, a strong currency is an incentive for an economy to adjust to more value added goods and services with more pricing power; that incentive is missing when a weak dollar is pursued, eroding long-term competitiveness in exchange for perceived short-term gains.
- A weaker dollar may indeed be inflationary. Foreign exporters to the U.S. have an incentive to absorb the higher cost of doing business that results from a weak dollar through lower margins. However, there is only so much foreigners can absorb; profit margins in Asia are often razor thin. Chinese policy makers have been pointing to this challenge as a reason for taking their time in allowing the Chinese yuan to appreciate. However, when pushed, China and other Asian exporters will have to pass on the higher cost of doing business (less competitive exporters may go out of business). We saw this in the spring of 2008: at the time, it was not just the price of oil that soared to well over $100 a barrel; there were stories in New York of how dry cleaners had to pay twice as much for simple items such as coat hangers. The reason: there was no domestic producer that could jump in to keep prices lower. Asian exporters may have more pricing power than the statisticians at the Federal Reserve may recognize.
Please join us on Wednesday, October 20, 2010, in a webinar to discuss U.S. dollar implications of policies pursued in more detail (click here to register). We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.
Axel Merk is founder, president and Chief Investment Officer of Merk Investments LLCó"the Authority on Currencies" and a pioneer in the currency asset class. His SEC-registered investment advisory firm, which manages mutual funds specializing in international currencies, started out in Switzerland 15 years ago. Axel relocated the business to Palo Alto, California, in 2001. The Merk Hard Currency Fund, established May 10, 2005, with assets of $362 million (as of early September) invests primarily in Euros, the Norwegian Krone, Canadian and Australian dollars and gold. In April 2008, Axel added the Merk Asian Currency Fund, and already it has assets of nearly $64 million (in the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand). Known for offering understandable advice and an uncanny ability to predict market movements, Axel is a regular guest on CNBC and Fox Business, and is frequently quoted in Barron's, the Wall Street Journal, Bloomberg News, USA Today and the Financial Times. His book, Sustainable Wealth: Achieving Financial Security in a Volatile World of Debt and Consumption [SustainableWealth.org], synthesizes macro trends, explains their effects on individual wealth, and suggests ways to build and preserve financial security in a volatile environment. It will hit the bookstores in October.
The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.
This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.