In-depth analysis on Credit Writedowns Pro.

Exploiting Bernanke

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009).

It is unfortunate the media does not make better use of an accessible resource: itself. Newspapers and financial TV are generally content to report what is being said today with no reference to the past. There seems to be no memory. A recent instance is Federal Reserve Chairman Ben Bernanke’s opinion that inflation is not a concern. In a sane world, his opinion would not matter much. We live in a more nonsensical atmosphere in which abstractions substitute for reality.

The Fed chairman’s inflation prediction is thought to reflect whether the Federal Reserve’s Open Market Committee (FOMC) will raise the Fed Funds rate from zero. It is not, then, Bernanke’s opinion about inflation that stirs imaginations (very limited imaginations, to be sure), but the train-of-thought that the global yield curve is a consequence of his purported wisdom. If the Fed Chairman’s public view changes, the residence of several trillion dollars will also change: carry trades, institutional asset mixes, and potential reallocations from stocks into money markets are examples of financial securities that are shipped from asset class to asset class according to the Fed chairman’s price-change gazetteer.

The real world today is repeating a pattern of a couple of years back. Prices are rising everywhere. This was also true when Bernanke became chairman of the Fed, in February 2006. Shortages, bottlenecks, black markets and prices were increasing when Bernanke became chairman. They continued to do so into late 2008. These conditions then retreated but are charging upward again.

To cut to the finale, a search through the files shows that Ben Bernanke was neither concerned nor understood the 2006 to 2008 inflation. It is certain, reading the evidence, that once again he will ignore (or remain malignantly ignorant, as the case may be) inflation until long after rice riots outside California supermarkets are a feature on the evening news.

To those unaccustomed to Fed-foolery, there is a motive for the chairman to day-dream through an inflationary swindle. The Federal Reserve wants to print money at will. An admitted problem with inflation would make it difficult to keep pumping money into the market.

Two conclusions can be drawn with near-certainty: the FOMC will not raise its zero-percent Fed Funds rate as long as Ben Bernanke remains Federal Reserve chairman. (A trivial 0.25% or 0.50% increase is possible.) Prices of things, particularly of commodities, will keep rising. This is an area to make money.

The Prosecutor’s Brief

In 2006, Bernanke had the excuse of being new to the job, without his predecessor’s experience at judging how every comment would be interpreted and analyzed. In the end, his inexperience with the media was not a disadvantage. (Discussed in the past tense, all of this is just as true today.) He talked in circles, made little sense, but criticism of the Federal Reserve Chairman’s remarks was confined to vocabulary. He could have bellowed his discontinuities of thought, of logic, of basic economics through the public address system before a full house at Yankee Stadium and the financial media would have remained deferential. An instance was his inflation commentary. An abbreviated sequence of Bernankeism follows.

Chairman Bernanke discussed inflation before the Joint Economic Committee on April 27, 2006. He sent written responses to the committee following his testimony. In this take-home exam, the new Fed chairman pronounced "inflation is overstated" and expectations are "well contained." His contentions were controversial, not for the obvious reason that crude oil prices had risen 50% since the beginning of 2005. Such comparisons between what is real and what Bernanke recites do not interest the media. Again, his economics are illogical. This was the real story, but was not discussed.

Instead, the press and financial TV grew aggressively neurotic when the Federal Reserve issued a statement, on May 10, that inflationary expectations are "contained." The media was consumed with the distinction from "well contained" in Bernanke’s April 27, 2006, statement.

On June 5, Bernanke, speaking at the IMF, admitted inflation, not inflationary expectations, was a problem. Again this distinction in vocabulary was front page news. Barely discussed were announcements in the same week that mergers and acquisitions for the year had already passed the record level of 2000 ($1.4 trillion), private equity in Europe was "loading companies with a record amount of debt," and home mortgage debt in the U.S. was increasing at a 12.2% pace (when the national income was rising at a 3% rate).

On June 15, 2006, Bernanke spoke about expectations (not inflation, as he had on June 5). He believed expectations remained within historic ranges, which seemed to be consistent with his May 10 statement, but he was chastised for "giving mixed signals," maybe because he discussed expectations rather than inflation, though this was not clear, and who cared other than the panting, breaking-news media and the trading desks that might unwind billion-dollar arbitrage positions in reaction to the media’s portrayal of the Fed chairman’s word choice?

On November 28, 2006, he told the National Italian American Foundation that inflation expectations were "contained." He repeated this assessment on many other occasions. The chairman may have thought his personal contentment would sooth the masses. Whatever the case, Simple Ben applied the formula to any topic that popped into his head. On March 28th, 2007: "At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained."

In his November 2006, address to the National Italian American Foundation, Bernanke talked in clichés that had lost all meaning. He would "continue to monitor the incoming data closely." The FOMC is "prepared to take action to address inflation if developments warrant." The chairman, at best, made glancing references to what he was monitoring, when the FOMC would take action, and what form the action might take. 

Seven months later, in July 2007, Bernanke finally gave a speech devoted to the Federal Reserve’s measurement of inflation: "First, how should the central bank best monitor the public’s inflation expectations?"  Bernanke’s description of the Fed’s methods could not be refuted, since there was nothing to refute: "The Board staff employs a variety of formal models, both structural and purely statistical, in its forecasting efforts. However, the forecasts of inflation (and of other key macroeconomic variables) that are provided to the Federal Open Market Committee are developed through an eclectic process that combines model-based projections, anecdotal and other ‘extra-model’ information, and professional judgment. In short, for all the advances that have been made in modeling and statistical analysis, practical forecasting continues to involve art as well as science." This means nothing. Dan Quayle was ransacked for misspelling "potato," yet the media adored Bernanke for sounding like an idiot savant.

He went on to ask critical questions (e.g.: "Do we need new measures of expectations or new surveys?"). There were no answers. Bernanke described some of the inputs to the Fed’s models, but then crushed hopes of those who were trying to understand how the Fed measures expectations: "[T]he model specifications employed differ considerably in their details, including how lagged inflation enters the equation, how resource utilization is measured, and whether a survey-based measure of inflation expectations is included. In principle, formal econometric tests could determine how much weight should be put on the forecast of each model, but in practice the data do not permit sharp inferences…." In the end, he confirmed what Fed skeptics already believed – the Federal Reserve is a Works Project Administration for failed statisticians: "Because of these considerations, as I have already noted, the staff’s inflation forecasts inevitably reflect a substantial degree of expert judgment and the use of information not captured by the models."

Others disagreed. In April 2007, Harry Landis, 107 years old, a World War I veteran, was interviewed by the St. Petersburg (Florida) Times: Landis had "lived through the invention of airplanes, televisions, interstate highways and cell phones. But the biggest change? ‘Money has decreased in value,’ he said. ‘There is so much more of it.’"

Not according to Simple Ben. On July 10, 2007, Bernanke addressed current inflation, then dismissed it: "The steep run-up in oil prices in recent years has not triggered either high inflation or recession, in large part because consumers and businesses expect price increases to remain tame." Three days before Bernanke spoke, Lehman Brothers (R.I.P.) released its food ingredients cost index for the first 6 months of 2007. It had risen 14.9%.

The value of stuff was rising against dollars and against paper assets in general. Detachment of prices from previous levels leads to poverty, desperation, and crime.

California suffered a copper crime wave. Irrigation systems were stripped from farms; their replacement had cost $2 billion in 2006, a 400% increase from 2005. Value investors "pulled plaques off cemetery plots, raided air-conditioning systems in schools, yanked catalytic converters from cars." The copper in a penny was worth more than one cent; the Treasury Department decided melting pennies for the copper was a crime with a sentence of up to five years in jail. In Britain, Monopoly, the board game, cut costs by replacing paper money with a calculator. In the United States, those who lacked formal education knew best: Twenty-two percent with a high school education or less named the economy as the country’s worst problem, compared to eight percent with college degrees. Through history, inflation first attacked the lower classes and not stopped until it consumed the upper classes. This time looks no different.

Currencies everywhere were devaluing against tangible assets and necessities. Corn prices doubled between April 2006 and January 2008.  The principal cause was energy: ethanol, fertilizer, water, transportation. The best topsoil in North America had eroded from 18 to 10 inches over the past 50 years. The erosion would have been much greater without fertilizers.  More fertilizer, which might slow topsoil erosion, needed more energy. Potash Corporation from Canada expected the cost of producing potash fertilizer would rise by nearly 70% in 2007 due to increased demand for food and fuel. Cambridge Energy Research Associates estimated the worldwide cost to produce oil and natural gas (labor and equipment) had risen 53% since 2004. In some cases the rising costs had led producers to scrap exploration. Exxon estimated the cost of building a gas-to-liquids plant in Qatar at $3 billion in 2004. Estimates in 2007 were $18 billion. The joint project of Exxon and Qatar was dropped.

The United States has imported more than it has exported for decades. Central banks, such as China’s, collect dollars from its domestic exporters (from whom Americans had bought goods). The Chinese exporters are handed yuan in exchange for dollars by the central bank. This causes a rising supply of yuan in the local economy. Incomes rise. Necessities improved (more chicken and less rice was eaten) and the Chinese bought machines long considered part of the furniture to Westerners – air conditioners, refrigerators and televisions. China needed more energy.

These permutations of inflation, as they re-entered the United States, were understood by Harry Landis and non-college graduates, even if Fed staffers with their "expert judgment" could not comprehend the damage.

On November 7, 2007, Bernanke demonstrated that he had no understanding of inflation. In testimony, Congressman Ron Paul accused Bernanke of a loose money policy that was devaluing the dollar and causing consumer prices to rise. According to the Fed chairman, this was not the case: "If somebody has their wealth in dollars, and they’re going to buy consumer goods in dollars, for the typical American, then the deval-, the decline in the dollar, the only effect it has on their buying power is it makes foreign goods more expensive." This extraordinary demonstration of ineptitude was barely mentioned by the same group that thought the spelling of "potato" was of national importance.

On the same day, the Marxist president of Venezuela, Hugo Chavez, showed he understood economic claptrap better than the U.S. media, establishment economists, and the Wall Street publicists who regularly appear on Bubble TV. Chavez addressed an OPEC gathering: "Don’t you see how the dollar has been in free-fall without a parachute? The empire of the dollar has to end." The next day, the Archaeological Survey of India announced it would no longer accept dollars for admission to the Taj Mahal The dollar had fallen 12% against the rupee since the beginning of the year.

Oil moved above $90 a barrel in October 2007: the number of dollars needed to buy a barrel of oil had risen from around $40 to $95 since the beginning of 2005. Prices across the U.S. were rising, including – maybe most importantly – manufacturing costs. The Associated Press reported that over 3.2 million factory jobs had been lost in the U.S. since 2000, many of those jobs going to countries with cheaper costs. Wilbur Ross, long-time veteran in the buyout business, was interviewed by the Financial Times in April 2007. He noted the amount of debt used in private-equity acquisitions was at an all-time high, "a very dangerous phenomenon," with only a few making fortunes at the expense of many: "The danger isn’t so much inequality as that we’re gradually losing the middle class from the population [which is] one of the big contributors to social stability and the relative political stability of the country."

The commercial banks supplied much of the financing for buyouts. The Federal Reserve chairman could have slowed this to a crawl. The Fed has the authority to reduce reserve ratios of the banks. This was not discussed.

In March 2008, 91% of Americans polled were concerned about inflation.Commodity markets boomed. Rice prices passed their all-time high, which had been set in 1973. Costco and Sam’s Clubs in California rationed rice purchases.

On June 9, 2008, Chairman Bernanke stated "[t]he Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing from growth as well as inflation." Two weeks later, the

University of Michigan found consumers expected prices to rise 7.7% over the next year. Bernanke, before Congress on July 15, 2008, admitted "inflation expectations have moved higher." He reassured the politicians: "[L]onger-term inflation expectations remain reasonably well anchored."Given his July 2007, explanation of how the Federal Reserve thinks about inflation (see above), it is obvious he was talking through his hat. 

Oil peaked at $147 a barrel in July 2008. In August 2008, the chairman told the world’s leading economists in Jackson Hole, Wyoming that inflation should moderate later in the year due to "well-anchored inflationary expectations" and the "increased stability of the dollar." (The dollar had been rising for all of six weeks.) When had he discovered the dollar’s influence on inflation? The day before his Jackson Hole appearance, the U.S. Department of Agriculture projected 2008 food costs would be the highest in 20 years.

By the summer of 2008, the U.S. was submerging in the financial crisis, of which Chairman Bernanke has shown no more understanding than of inflation. Prices retreated but are rising again.

In August 2010, the U.N. Food and Agricultural Organization announced its (international) food index has risen 16% over the past year and is at the highest since 1990. Global meat prices are at a 30-year high. Lamb prices are at their highest since 1973. Wheat and corn prices are rising at their fastest pace since 1973, a year of severe price and social disruption. In April 1973, Time reported that "[p]rofessional thieves are increasingly hijacking meat trucks."  False rumors of a rice shortage led frantic Californians to drag 50-pound bags of rice from supermarkets to their cars.

Official U.S. government consumer price index (CPI) numbers have not been mentioned until now. They are important to investors since the monthly calculations, offered to the public as a single number by the media, are taken at face value by the learned financial scholars who are interviewed on TV. The calculations though are a negation of the truth.

It would have been difficult to find the CPI number that was announced when Bernanke was making his comments. The Bureau of Labor Statistics (BLS), which calculates the numbers, states on its website that the press releases (on its website archive) are not the same as the releases that were sent on the corresponding date (for instance, in June, 2006). The BLS has replaced the earlier numbers with newer, revised figures.

Since they have not yet been revised, we can compare a recent distortion between BLS numbers and a more candid approximation at reality. On August 13, 2010, the BLS announced the "index for all items less food and energy rose 0.1 percent in July" 2010. Dropping down the page, the agency claimed food prices fell -0.1% in July. J.P. Morgan analysts conduct supermarket surveys, comparing 33 current to past prices. They recently found that, in the Virginia area, food prices at Wal-Mart have risen 5.9% over the past year.

In July 2010, Chairman Bernanke appeared before the Congressional Committee on Banking, Housing and Urban Development. He stated: "Inflation has remained low. The price index for personal consumption expenditures appears to have risen at an annual rate of less than 1 percent in the first half of the year." He went on to make a statement that collected several hackneyed phrases of the sort that official bureaucrats use to disguise what they are thinking, assuming they do think: "At some point, however, the Committee will need to begin to remove monetary policy accommodation to prevent the build-up of inflationary pressures." He finished: "Near-term inflation now looks likely to be a little lower."

In July 2010, police in Homestead, Florida, "said thieves are striking at farms, stealing produce to sell on the black market." Three weeks later, in West Philadelphia, a four-year-old boy was "swallowed" by the sewer system after a manhole cover had been stolen. The Associated Press reported: "In 2008, the department began installing locks on some of the 76,000 manhole covers in the city but still officials are looking at options. ‘We’re also looking into alternative materials to where [sic] they won’t be attractive for the scrap yards’ ". (The four-year old lived.) In San Francisco, federal detention centers are "slowly filling up with a new type of criminal… a rising tide of copper thieves raiding abandoned government facilities for their heavy gauge electrical wire."

The Court’s Conclusion

To conclude: dismiss Bernanke and discussions about the Federal Reserve. Commodity prices are rising and time is better spent reading the Northern Miner and watching the Prairie Farm Report than Bubble TV. This is not a prediction that commodity prices can be extrapolated in a predictable upward path, but that investors will be able to make money by exploiting the vast ditch between the Federal Reserve’s false world and reality.

Frederick Sheehan writes a blog at www.aucontrarian.com

Frederick Sheehan

About 

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession. He is the co-author of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve. Mr. Sheehan was Director of Asset Allocation Services at John Hancock Financial Services in Boston. For more than a decade, Mr. Sheehan wrote the monthly "Market Outlook" and quarterly "Market Review" for clients. He is a frequent contributor to Marc Faber's "Gloom, Boom & Doom Report." He also has written articles for "Whiskey & Gunpowder" and the Prudent Bear website, among others. He currently serves as an advisor to an investment firm and a non-profit foundation. A Chartered Financial Analyst, Mr. Sheehan is a graduate of Columbia Business School.