Malpass Spot-On:

Today’s non-farm payroll data provide fodder for those believing U.S. recovery is on track.  I’ll stick with the view that a 10% unemployment rate after more than a year of extraordinary fiscal and monetary stimulus is indicative of deep underlying structural impairment.  Recent housing, household spending, mortgage delinquency, and state and local finances data all confirm our secular bearish prognosis.

I want to commend David Malpass for his spot-on op-ed piece in today’s Wall Street Journal, “Near-Zero Rates are Hurting the Economy.”
 
From the article:  “The Federal Reserve implemented an emergency monetary policy after the 2008 Lehman bankruptcy to salvage the world financial system. In his testimony yesterday… Ben Bernanke said, ‘We must be prepared to withdraw the extraordinary policy support in a smooth and timely way as markets and the economy recover.’  This leaves all-out emergency monetary stimulus in place, but with a different, much weaker justification. With the system stabilized, the Fed hopes that artificially low interest rates and its purchases of mortgage-backed securities will spur growth. Instead they are pushing dollars abroad and wasting precious growth capital in asset and commodity bubbles… more than a year after the heart of the panic, the Fed is still promising near-zero interest rates for an extended period and buying over $3 billion per day of expensive mortgage securities… Capital is being rationed not on price but on availability and connections. The government gets the most, foreigners second, Wall Street and big companies third, with not much left over. The irony of the zero-rate policy, coupled with Washington’s preference for a weak dollar, is a glut of American capital in Asia (as corporations and investors shun the weakening U.S. currency) and a shortage at home… Much of its current stimulus is being diverted to commodities and foreign economies—hence Asia’s complaint about bubbles… Wall Street will threaten a tantrum if the Fed even thinks about damping the air-raid sirens. The Street utterly loves the Fed’s largess…”

Mr. Malpass and others have recognized the dangerous flaws inherent in Federal Reserve doctrine.  It became the Greenspan Fed’s crisis management modus operandi to call upon Wall Street Credit creation and leveraging to lead systemic market liquidity and reflationary efforts.  For more than two decades, this proved history’s most powerful monetary mechanism.  Dominant “Monetary Processes” provided the key to “success.”   With the Fed guaranteed to slash rates and the GSEs guaranteed to buy and back hundreds of billions of mortgages at the first sign of trouble, the mortgage and mortgage-related securities arena attracted a massive and reinforcing influx of funds (what Mr. Malpass would refer to as “capital”). 

From my analytical framework, mortgage finance demonstrated a powerful “Inflationary Bias”.  Related forces inflated the GSEs, Wall Street firms, the hedge funds, home prices, household net worth, equity extraction, over-consumption, and malinvestment.  The inflationary bias inherent in U.S. mortgage securities (and related instruments) was instrumental to two decades of major U.S. structural transformation to a de-industrialized “services” economy.  Distortions in the pricing of mortgage finance fostered a massive misallocation of financial and real resources – both at home and abroad.  It also fueled a historic housing mania and attendant acute financial and economic fragility.

Mr. Malpass recognizes that the world has changed in fundamental ways.  Today, “capital” flows first and foremost to Asia and commodities rather than to job-creating U.S. businesses.  The more liquidity created here the more things inflate there.  In my nomenclature, predominant Inflationary Biases and related Monetary Processes have been radically altered.   Importantly, mania has given way to U.S. housing depression, while faith in sophisticated Wall Street Credit instruments has been shattered.  The dollar has been severely impaired.  There is no returning to previous cycle dynamics.   

The reliable old Monetary Process - where Federal Reserve and GSE reflationary measures would immediately stoke rapid (and self-reinforcing) mortgage Credit growth, housing inflation, inflating household net worth, equity extraction, spending and booming government receipts - is no longer operable.  Reflationary liquidity that for years gravitated predictably to our MBS and agency debt now prefers “undollar” asset classes, including emerging debt and equities, gold and metals, and commodities more generally. 

The Fed’s capacity for domestic monetary stimulus has been greatly diminished, with U.S. and global economic systems these days responding altogether differently to reflationary policymaking.  Yet the Bernanke Fed refuses to respond to the altered landscape.  Dangerously, the Fed adheres steadfastly to its old policy approach - only implementing it more radically.  Our central bank balloons its balance sheet with mortgage-backed securities, while pegging interest rates all the way down to zero.  Worse yet, the Fed has signaled that the markets can bank on near zero percent for a protracted period.  Global dynamics have changed, yet the Fed has locked itself into a precarious policy approach.  Dr. Bernanke testifies that U.S. asset prices don’t appear overvalued.  Meanwhile, price distortions and Bubble dynamics engulf the world.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.