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I don’t know about you, but I am so fed up of the Greek debacle jerking around markets all day, I can’t bring myself to write about it again this morning. And as for the Chinese slow motion stock crash, that topic is saturating the financial press to the point where I never want to see another picture of a Chinese housewife staring at a computer screen in horror. Let’s talk about something else, something that might be slipping under the radar as everyone focuses on these other two big stories.

It was only a few weeks ago the topic of when the Fed would raise rates was dominating the financial news. I remember watching a CNBC interview with Jim Bianco and Jeffrey Gundlach (Jun 10/15 – The party is over Luke) where they both predicted the Fed would not raise rates in 2015. This call was definitely against consensus. At the time, the Fed was clearly readying the markets for a rate rise. This tweet by the Reformed Broker’s Josh Brown summed up the prevailing attitude:

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Yet even though the Fed was steering markets towards higher rates, the Fed has once again proved overly optimistic with their forecasts. Developments of the past month have pushed the Fed’s liftoff further into the future.

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The market is coming around to the Bianco and Gundlach view that there will be no rate rises in 2015. The near month Fed Funds future is trading at 99.87, so with the December contract trading at 99.74, this equates to 13 basis points difference. Assuming the Fed sticks to 25 basis point increases, this means the market is pricing in approximately a 50/50 chance the Fed raises rates by December. Think about that for a second. A month ago the Fed was trying to convince the market rates could possibly be raised as early as September, and now the market thinks there is an equal chance the Fed does nothing in 2015!

The infamous dot plots of the Fed’s forecast of future rates are becoming more and more of a joke.

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The red line is where the market is pricing future rates. The purple line is the average of Fed’s latest forecast. The dots represent individual FOMC member’s estimates. Have a look at 2016 and 2017. There is only one FOMC member who thinks the rate will be lower than where the market is priced (Kocherlkota). There is one FOMC prediction for the current expected rate, but then everyone else is significantly higher. And then for 2017 it is even worse! Not one FOMC committee member believes rates will be as low as the market is pricing!

Someone will be really wrong here. Either the market is in for a rude surprise, or the Fed is completely clueless.


James Rickards is one of the good guys (even with the strange old man mullet)

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I love to make fun of the gold bugs who find reasons to buy gold regardless of the news. With no sense of irony, they will sometimes use exact opposite market developments to argue gold has to go higher in each case. We all know these guys by name. CNBC and the other media outlets trot them out whenever markets start looking ugly.

However among them is an individual I give a little more respect to than the others. Although he is a bit of a shill when it comes to promoting his books, I give him a break because we all have to eat. On the whole, I find James Rickards to be someone you need to listen to. He might not always be right, but his ideas are often well thought out and outside the box.

Rickards recently wrote a piece (Daily Reckoning) about a recent conversation he had with former Fed Chairman Ben Bernanke. Although Bernanke is no longer setting policy, it is still instructive to listen to what he has to say.

According to Rickards, Bernanke gave some useful guidance when it came to future rate hikes:

Following this introduction, Bernanke then made a set of remarks that I found both surprising in their candor and refreshing in the extent to which he was willing to take issue with some of what his successor, Janet Yellen, has said recently on the subject of Fed interest rate hikes.

Yellen gave a speech just prior to my meeting with Bernanke in which she said, “I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate.”

In contrast, Bernanke told me, “The interest rate increase, when it comes, is good news, because it means the U.S. economy is growing strongly enough to bear the costs of higher rates without slowing growth.” Unlike Yellen, Bernanke did not tie himself to a particular month or year. He explicitly said the rate hike would come in an environment of strong growth.

Today the U.S. economy is close to negative growth and is nowhere near the kind of robust growth that Bernanke associated with a rate increase. The clear implication is that the Fed will be in no position to raise rates anytime soon.

Bernanke also warned that the rate increase had to be clearly communicated and anticipated by the markets. He said, “Markets are not as deep and liquid as they were before the crisis.”

The suggestion was that market expectations and Fed actions need to be aligned in order to raise rates without a market crash. He expressed the hope that “The rate increase may be an anticlimax because the markets anticipate it.”

That makes sense. The problem is that right now markets anticipate the first fed funds rate increase in early 2016, not in 2015. Bernanke’s warning about illiquidity and hope for an anticlimactic market reaction are further evidence that he does not see a rate hike coming before 2016, at the earliest.

Bernanke is clearly more in the Bianco and Gundlach camp. The important part of this exchange was Bernanke’s clear indication the Fed would not raise until the economy was showing strong signs of growth. According to Bernanke, the market is right to ignore all the talk from the hawkish FOMC committee members. The Fed will not get out ahead of the economy. They will not pre-emptively raise rates just to get off the zero bound.

In the past I have highlighted the fact no Fed tightening cycle has started with the inflation rate running below target. Although some Fed officials are nervous about the apparent tightness in the labour market, according to Bernanke, the Fed is not about to break that record anytime soon.

But the really interesting part of Rickards’ discussion with Bernanke was still to come…

Turning to the international monetary system, Bernanke was also candid and said, “The international monetary system is not coherent.” He explained that the current combination of floating exchange rates, fixed exchange rates and moving pegs means that trading partners have no confidence in their relative terms of trade and this acts as a drag on trade, foreign direct investment and capital expenditures.

He said, “Over time, it would be important for the countries of the world to talk more about how to avoid the mixture of fixed and floating exchange rates. We need new ‘rules of the game.’”

Of course, international monetary experts know that the phrase “rules of the game” is code for a reformation of the international monetary system, or what some call a global reset. Bernanke was explicit that this reset is needed to end the dysfunction of the current system.

Stop and think about that for a second. The former Fed Chairman says we need “new rules of the game.” This is a huge admission. Clearly Bernanke understands the extent of the instability of the current global financial system. It does not take a rocket scientist to realize when the world’s second largest bond market goes to 0.05% for a 10 year bond yield, things are not functioning correctly. Yet so far most government officials have mouthed soothing words and simply tried to apply bandaids to the most pressing problem. Bernanke’s frank talk about needing “new rules of the game” is a sign that behind the scenes, officials might be readying for something more dramatic. We all know the current situation is untenable. QE seems to solve some short term problems, but only at a cost of exacerbating wealth inequality and providing little actual economic growth. Not only that, with different countries doing quantitative easing in varying amounts at different times, the moves in exchange rates are being exaggerated.

Which brings me to Rickards’ last insight from his Bernanke talk. Above all else, the Fed needs to continue to try new things as we are in uncharted territory.

He said the three lessons of the Great Depression were that the Federal Reserve needed to perform as a lender of last resort, increase the money supply when needed and be willing to “experiment” in the style of FDR.

Bernanke defined “experiment” as being willing to do “whatever it takes” to head off deflation and depression. In summing up his own performance, he said, “We tried to do whatever it took. We don’t know yet what the long-term implications are.” His forecast was that “the Fed will be more proactive in the future.”

My impression was that Bernanke knows the jury is still out on his tenure as Fed chairman. There is no doubt that his actions in 2008 and 2009 prevented a worse result at the time. But they may have produced a more dangerous condition today.

There was good justification for QE1 in 2008 and 2009 as an emergency liquidity response to a global financial panic. This is consistent with the Fed’s role as lender of last resort, as Bernanke said.

But QE2 and QE3 were not in response to any liquidity crisis. They were in the category of “experiments,” as Bernanke defined them. Experiments are fine in the laboratory but much riskier in the real world. Experiments are a good way to advance science, but every scientist knows that most experiments fail to produce expected results.

Ben Bernanke was generous with his time and candid in his remarks. Still, I was left with an unsettling feeling that he knew that QE2 and QE3 were failed experiments, despite his public defense of them. Growth in the U.S. has been anemic for six years, and there is good evidence that we are sliding into a new recession.

I agree with Rickards’ conclusion the Fed has embarked on a monster science experiment, and we don’t know where it is headed. I believe the next crisis will see the Fed experiment with even more aggressive easing policies. I don’t know what they are, but I suspect they are already thinking about them. It could be monetizing student loans, or maybe even some more dramatic form of direct helicopter money to the people, but the legacy of a Fed willing to experiment with novel ways of easing will definitely be Bernanke’s legacy.

There are big changes coming. The system is starting to fray at the edges. Don’t assume the next crisis will look like the last. The Fed and other Central Banks are going to make new mistakes. It is key to listen to conversations like this one Rickards had with Bernanke to understand what those mistakes might look like…

Thanks for reading,

Kevin Muir

the MacroTourist