Anticipation is rising for the annual late summer speech given
by the Chairman of the Board of Governors of the Federal Reserve
System, Ben Bernanke. The basic economic environment surrounding
this speech is what I would like to touch on in this post.
This environment along with what the Federal Reserve does…or
doesn't do…is crucial to the possible "macro" position a person
could in their investments and in their business decisions. For
example, John Paulson, the hedge fund investor, has apparently
started placing his bets with respect to current economic and
financial conditions and with respect to what the Fed can…or can't
do. Mr. Paulson, according to recent regulatory filings, has been
re-arranging his portfolio… increasing his position in gold and
reducing other positions… in anticipation of higher future levels
Future inflation is certainly a concern and I will discuss this
a little later, but there are also other issues that need to be
discussed as well. For example, dominating discussions about the
current environment is the rate at which the economy is growing. In
the second quarter of 2012, real GDP grew at a 2.2 percent
year-over-year rate. I am expecting this growth rate to remain
around 2 percent for the next year or so. This expectation is
backed up by other numbers, like that for
Economic growth has been tepid, is tepid right now, and is expected
to remain tepid for the near term.
There are numerous reasons why economic growth is likely to
remain slow. I have reported on these in many recent posts. A short
list of reasons include continued de-leveraging of the private
sector; under-employment of eligible labor; residential mortgages
being underwater; bankruptcies and foreclosures; commercial real
estate losses; health of a large portion of the banking system; the
financial condition of state and municipal governments; the
uncertainty that exists with respect to government policy and
regulation; the European recession and sovereign debt crisis; and
the slowdown in other countries like China, Brazil, and India.
I believe the American economy will continue to grow but only at
or below a 2 percent year-over-year rate. This is an environment of
stagnation with unemployment and under-employment staying high and
capacity utilization of industry remaining historically low.
Given this basic scenario, interest rates will rise over the
next year or so. I believe there are three reasons for this.
First, interest rates in the United States are as low as they
are because of the "haven" nature of U.S. government debt. Large
quantities of "risk averse" funds have flown into American security
markets escaping the mess in Europe. As a consequence, the yield on
10-year U.S. Treasury securities closed at 1.82 percent on August
If one subtracts an "expected rate" of inflation from this
figure, let's use 2.00 percent (which is about what the inflation
rate is in the United States using the year-over-year rate of
increase in the GDP implicit price deflator). Then an estimate for
the "real" rate of interest is a negative 18 basis points. This is
not too far off the yield on the 10-year TIPS bond, which was a
negative 45 basis points on August 17.
And, what "should" this real rate of interest be? I have always
argued that "the" real rate of interest should be somewhere around
the level of the "expected" real rate of growth of the economy.
Thus, from the 1960s through the end of the century a 3.0 percent
rate worked out to be a good working estimate of the real rate. If
we use my current "expected" rate of growth of the economy, 2.0
percent, then the "real" rate of interest in the United States
should be in the 1.50 percent to 2.00 percent range.
Therefore, as the "risk averse" money leaves United States
shores, the yield on TIPS should rise fairly steeply. Whether or
not this rise will be resisted by the Federal Reserve is a question
that remains unanswered at this time. Resisting the rise will just
cause the Fed to flood the banking system with more excess
reserves, which may cause other problems. But, this is something
that the monetary authorities are going to have to face.
The second reason for a rise in interest rates is that there
should be, sooner or later, demand pressure on interest rates due
to a pick up in economic activity…or, right now, commercial banks
are awash with funds while at the same time loan demand seems to be
Thus, there is little or no pressure for interest rates to rise.
This is certainly something we need to watch out for.
However, we could see interest rates rise for a third reason…a
rise in the expectation of future inflation. This is something many
people-- like John Paulson-- are worried about. Never before has
the commercial banking system had so many excess reserves "hanging
around." In August 2008, before things fell apart, the excess
reserves of the whole banking system amounted to less than $2.0
billion. In the two banking weeks ending August 8, 2012, excess
reserves in the banking system averaged $1.5 trillion.
The monetary base, the foundation of credit expansion in the
United States, was around $2.7 trillion in the banking weeks ending
August 8: it was at $842 billion in August 2008! Few people believe
that the Fed can withdraw a major part of these funds from the
banking system once banks start lending again…and inflation starts
to increase. Inflation and credit expansion go hand-in-hand. And,
the lending could pick up even if real economic growth does not
A further question exists: how can the Federal Reserve withdraw
funds while the federal government is still running annual budget
deficits of $1.0 trillion or more? So the third reason for interest
rates to rise is that as inflation accelerates in the United
States, the expectation of future inflation will also rise. When
this will begin and how fast will it take place is, of course, the
There are other possible "macro" effects surrounding this
picture. For example, what will happen to the value of the dollar
given this view of the world? These will be addressed in future
Does one get a sense of potential "stagflation" in what is
written above? Slow economic growth, rising inflation, and rising
interest rates. How does a central bank combat such a situation?
The situation that Mr. Bernanke and the Fed face is a very
challenging one. It is a situation that they have helped to create.
But, getting out of it will not be much fun for them.
As far as the private investor is concerned, a situation like
this presents a ton of possible "investment" opportunities. And,
one should always ask, "How can I make money from a situation like
the ones described above?"
As one reads a book like "More Money Than God" by Sebastian
Mallaby, one observes that lots and lots of money is made off of
government mistakes. The problem is that generally the people that
make the money off of these mistakes are people that have the
information, the access, and the scale to take advantage of the
mistakes. However, these "tools" are not available to most people.
Maybe that is why the distribution of wealth in the United States
has become so skewed.
Silver: The Recent Advance Has Room To Run