mauldin on the us economy

  1. 470 Posts.
    Subject :
    The Doom and Gloom Fed - John Mauldin's Weekly E-Letter

    Date :
    Sat, 14 Dec 2002 00:08:03 -0600

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    Smoke in the Fed's Eye
    The Doom and Gloom Fed
    Making Predictions
    Where's the Deflation?
    Why Gold Is Going Up Even More
    Meet Me in Puerto Vallarta, and a Job Opportunity

    By John Mauldin

    Today we explore the very interesting differences between what the
    Fed told us about its last interest rate cut and what they actually
    said in the meeting. Then we look at my analysis of how Japan can
    have deflation when the money supply grows 21%, which will annoy the
    gold bugs among my readership. Then we look at why gold is really
    going up, and why it will continue to do so, which will make gold
    bugs happy. All that and more, as along the way we look at why it is
    so hard to predict anything with any sense of confidence.

    Smoke in The Fed's Eye

    I was reminded today of the great line by Paul McCulley of Pimco:
    "Philosopher kings, like Mr. Greenspan, know that some things are
    best left un-estimated, un-forecast, and un-said. Unless, of course,
    there is no choice, in which case euphemism, obfuscation and smoke-
    blowing should be the tools of first resort."

    We examine a case in point, where smoke is the tool of choice. The
    Federal Reserve Board meets 8 times a year. It is called the
    Federal Open Market Committee (FOMC). At the end of this meeting,
    they issue a brief statement, telling us what they will do about
    interest rates and giving us some hint as to their future policy. A
    little over a month later we get the minutes of the meeting where we
    can read what was generally discussed and said.

    After the end of the November 6 meeting, the Fed cut rates 50 basis
    points and then gave us the following re-assuring words:

    "In these circumstances, the Committee believes that today's
    additional monetary easing should prove helpful as the economy works
    its way through this current soft spot. With this action, the
    Committee believes that, against the background of its long-run
    goals of price stability and sustainable economic growth and of the
    information currently available, the risks are balanced with respect
    to the prospects for both goals in the foreseeable future."

    Three weeks ago, I reported a conversation with and speech by Wayne
    Angell, former Vice-chairman of the Fed. He basically said the Fed
    cut rates because of its concern about deflation and that the
    "neutral stance" (that is what is meant by "risks are balanced")
    they took in their public statement was because they did not want to
    spook the markets. The implication was that conditions were actually
    worse than the statement, and that the Fed would cut again and again
    if necessary.

    The Doom and Gloom Fed

    Yesterday, Art Caslin of CNBC fame wrote me a quick email and said,
    "John, look at the difference between the Fed statement of Nov. 6
    and the minutes they released today."

    I went to the Fed site, and the minutes, as Art suggested, did not
    read liked "risks are balanced." In fact, if I used the minutes as
    an e-letter, I would be called excessively bearish. Caslin made the
    following points today in his private morning market letter. I

    "The concern of the FOMC for the fragility of the economy jumps off
    page after page. (I encourage one and all to go to the Fed website
    and read the minutes in toto.)

    "And, as for the "soft patch", the minutes read more like they were
    worried about quicksand. We don't have room enough to reproduce all
    or substantially all the 12 page minutes. But here is a random
    sampling. Please take note of the verbs used.

    " '.....economic growth had slowed....consumer spending
    softened.....industrial production slipped....labor market
    conditions weakened further....number of jobs.....continued to
    fall....hours worked.....moved down....softness in the manufacturing
    sector was light of further weaker-than-expected
    incoming data.'"

    After the above assessment that the economic data is "weak", let me
    just present the following excerpted phrases for you to get even
    more of the general picture. This is important, as this is the
    reasoning that Fed governors are using to set the policy which will
    affect your investments. (I cut it down from 12 pages to one. You
    can read the full document at: )
    Emphasis is mine.

    " analysis cited at this meeting suggested that the stimulus
    embodied in current legislation had diminished considerably since
    earlier in the year. ....Some members observed that further federal
    tax cuts, should they be enacted, would likely take effect too late
    to foster much added spending over the year ahead. At the state and
    local government levels, efforts to control very large deficits
    likely would lead to tax and spending legislation that would offset
    at least part of the remaining stimulus inherent in the federal
    budget....Members commented that little if any stimulus could be
    expected from the export sector of the economy in light of current
    and prospective shortfalls in the economic performance of important
    U.S. trading partners. Indeed, recent forecasts incorporated
    downward revisions to the growth of overall foreign economic
    activity." [This latter point will be taken up later- John]

    "....the prospect of some persisting slack in resource use over
    coming quarters pointed to further disinflation. In this regard,
    some members referred to the possibility, which they viewed as
    remote, of a period of deflation in the event of a strongly negative
    demand shock....the members were concerned that the generally
    disappointing data since the previous meeting, reinforcing the
    general thrust of the anecdotal evidence in recent months, pointed
    to a longer-lasting spell of sub-par economic performance than they
    had anticipated earlier..." [Translation: previous rate cuts did not
    work as they thought they would.]

    "...A further reason cited by some members for a sizable easing move
    related to their perceptions of a diminishing stimulus from earlier
    policy easing actions and indications that overall financial
    conditions, including bank lending terms, had become more
    restrictive this year even though the nominal federal funds rate
    target had not been changed since late 2001."

    "....The members agreed that monetary policy could do little to
    improve the performance of the economy in the near term, but some
    emphasized that a 50 basis point easing likely would feed through to
    some degree to market interest rates, with favorable implications
    for spending next year."

    "...The economy probably would continue to underperform in the
    period immediately ahead, but in the absence of unpredictable
    adverse shocks this sluggish performance was more likely to be
    balanced by subsequent economic strength in light of the policy
    action.....In the view of many members, retaining the assessment
    that the risks were tilted toward weakness would raise the odds of
    an overreaction in financial markets, which might well misread the
    Committee's decision as a sign that the members were more concerned
    about the potential for greater economic weakness than was in fact
    the case and that therefore the Committee currently saw a likely
    need for further easing later...."

    "....While the possible market response was not a primary factor
    determining the desirability of a policy action, the Committee
    needed to take it into account in gauging the potential effects of
    particular policy moves."

    Let me offer a translation. "The economic data is not encouraging.
    The economy is slowing down. There doesn't appear to be much
    inflation, there is still disinflation in the economy and there is
    some slight-small-not to be worried too much about- risk of
    deflation. As long as we do something about it now, it won't be a
    problem. We can't look to the rest of the world to help. Any tax cut
    Bush gets through Congress will be offset by local tax increases.

    The effects from our last cuts have stopped working. If we don't do
    something, the economy will still underperform. If we cut again, it
    won't do much good in the short-term, but after awhile it should
    have an effect upon the economy. Let's cut and hope it works. And
    for Pete's sake, let's don't tell the public our concerns today.
    Firm hand on the tiller and all that stuff is the order of the day.
    The public will read the minutes next month when no one will care
    about old news."

    These Fed minutes read pretty much as a description of the Muddle
    Through Economy. We are in for a period of slow growth in the next
    few months. Here is my continued prediction: Greenspan has not made
    his last cut. The "soft patch" we are in will prove frustratingly
    resistant to rate cuts, and there will be calls next spring for the
    Fed to once again "do something."

    Let's switch to another related story by Andrew Kashdan of Apogee
    Research. Kashdan cites a study by the Levy Institute. This study is
    another way of looking at the rationale behind my case for the
    Muddle Through Economy. Essentially, (if I understand this
    correctly, Andy) the Levy Institute suggests that one can model the
    economy as a balance sheet where the private, government and foreign
    sectors all have to "balance." The government surpluses allowed the
    private sector (corporate plus consumer) to "invest" more and save
    less in the 90's. Now the private sector is on track to get back to
    a more neutral stance (less investing by business and spending by
    consumers and more savings by both sectors).

    That means those economists looking for economic stimulus from
    consumers are going to be very disappointed, as that sector is
    running out of steam. To get the 3%-plus growth forecast by the
    Congressional Budget Office, this study suggest the government
    deficit would have to be almost 8% or around $800 billion, give or
    take a few hundred billion. "...this scenario implies an equal
    expansion in the current account deficit, making for "twin"
    deficits. And certainly, a current account deficit that amounts to
    8% of GDP is unsustainable."

    Kashdan then notes: "Under another scenario, if the private sector
    moves toward balance without such a large fiscal expansion, then GDP
    would grow only 1% per year between 2002 and 2006, with a
    substantial rise in unemployment to go with it. Finally, Levy's
    "dream scenario" entails an increase in net export demand to achieve
    growth without large government deficits. In other words, all
    sectors move towards balance. To arrive in Dreamland, the dollar has
    to depreciate by around 25% at the beginning of 2003, which would
    bring the current account to between 2% and 2.5% of GDP by 2006. The
    drawback is that even if the U.S. could pull it off, other economies
    would take a hit because the U.S. would no longer be importing so
    many goods."

    Making Predictions

    In a few weeks, I will write my annual predictions letter for 2003.
    The above scenarios illustrate the difficulty, if not the absurdity,
    of making any predictions. Nevertheless, I shall continue to make
    them, as I have done every year since 2000.

    (So far, I have been pretty much on target [read lucky] in my calls.
    We will see if I can continue to flip heads with this next year's

    Think for a moment. To get to the Levy Institute's dream scenario,
    we need outsize government deficits coupled with a seriously
    dropping dollar and increased exports. But the Fed just told us
    that relief from foreign buying is not likely. I absolutely believe
    we will see larger deficits, but nowhere the level Levy implies we
    will need for 3% plus growth. It is just not politically feasible,
    nor even desirable.

    The dollar is going to drop, but by 25% over the next few years?
    While anything is possible, with every country in the world involved
    in competitive currency devaluation against the dollar, that alley
    looks awful black.

    Let's go back to Levy's assessment: "...if the private sector moves
    toward balance without such a large fiscal expansion, then GDP would
    grow only 1% per year between 2002 and 2006, with a substantial rise
    in unemployment to go with it."

    In order to get back to a 90's type booming economy, every scenario
    I run involves some sort of action which just doesn't seem to be
    possible. If you push positively on this sector, you get a negative
    response from another sector. The stimulus that comes from tax cuts,
    rate cuts, deficits, Fed actions, etc. seems to serve to push things
    along but not to jump-start the economy. This is a prescription for
    the Muddle Through Economy: slow growth and sluggish employment.

    Where's the Deflation?

    Every week, I get letters from readers telling me that there is no
    deflation. Some suggest I should go back to Economics 101. They
    insist the money supply is growing and therefore, by definition, we
    have inflation. Well, as they say, not exactly.

    This insightful quote is from Gary North's Remnant Review: "Let's
    begin with a definition of deflation. There are two. There is
    monetary deflation. This is a reduction in the money supply.
    Problem: there is no agreement about what constitutes the money
    supply. Price deflation is a reduction in the official price level.
    Problem: there is no official price level. So, from the beginning,
    we are guessing. So are the economists. So are the statisticians who
    collect data in terms of the economists' theories." (I have been
    reading North for 20 years. I sometimes, even often, disagree, but I
    always read. He makes me think. For subscription information write
    [email protected] .)

    The Bank of Japan is doing what it can to create inflation. The
    monetary base in Japan is up a stunning 21% vs. a year ago. This is
    on top of large growth from prior years. By the reasoning of my
    weekly critics, there is and should be inflation in Japan. But yet
    there is clearly deflation in Japan. One reason is the following:

    Today, Dennis Gartman tells us that "The Japan Daily Digest recently
    reported that in November in Japan the total of outstanding bank
    loans fell 4.7% year-on-year.... the 59th straight month of decline.
    As far as we know, this is unprecedented in any industrialized
    nation in modern times. For the "city banks," [large banks] their
    lending was down 7.4% y-o-y... and more astounding still is that
    this is the 75th straight monthly decline.

    "...According to The Japan Daily Digest (and this is a truly
    preposterous figure, but nonetheless it is true) "So little money is
    being lent that the banks now have almost as much money on deposit--
    Yen 476.4 trillion--as they do on loan." To put it metaphorically,
    the transmission is slipping, and the car cannot move forward." (The
    Gartman Letter, $2500 or so per year, [email protected] .
    Must reading for serious traders.)

    Looking at just one number or set of data and making predictions is
    often a fool's errand, if not a prescription for disaster. The
    complexities in the economic world are as great as those in the
    quantum world of physics. Physicists are hard at work on a Theory of
    Everything. They are trying to tie all the little disparities of
    physics into one neat package. I wish them luck.

    While any one economic theory can be useful at times, there is no
    Theory of Every Economic Thing. Nothing explains the macro and micro
    economic forces in toto. You can be Keynesian, Monetarist, Austrian
    or (my favorite) from the Economic School of Hard Knocks. There is
    always an asterisk by any prediction or explanation. In the long
    run, I favor von Mises and the Austrians, but you can go broke
    waiting for his long run to come about.

    There are just too many factors to take into consideration when
    making predictions. Each economic school emphasizes the importance
    of a different set of factors. That is why I like to drop back and
    try to get a bigger picture. It is also why I like to get a number
    of different viewpoints which lead me to the same conclusion. This
    is why I think we are in a secular bear market. There are half a
    dozen different factors which all point to the same conclusion, and
    none that I can find which argue against. (See my chapter on secular
    bear markets from my book-in-slow-progress, Absolute Returns, at )

    Deflation in the US (and Japan) is more than simply about money
    supply. It is about the velocity of money, bank loans, trade
    deficits, and a host of inputs. Even if it was simply about money
    supply, as North notes above, which money supply? If you use M1,
    then how do you figure the huge flows of US physical cash to foreign
    countries? If you use M2, then that figure grows when investors move
    from stocks to money markets.

    Deflation is a little bit like Judge Learned Hand's definition of
    pornography: I know it when I see it.

    The Fed has told us they know what deflation is, and they don't like
    it. They are not going to let "it" happen here. That is why I
    believe that over the long haul, we are likely to see a re-emergence
    of inflation. Paul McCulley of PIMCO goes so far as to say there is
    a regime change at the Fed. The new regime is now committed to
    openly reflating the economy. In his words, they know where the keys
    to the printing press are.

    Why Gold is Going Up Even More

    There may be more than meets the eye with the recent change of the
    Secretary of the Treasury. John Snow is an influential member of the
    Business Roundtable. They have openly advocated a weaker dollar.
    Former Secretary O'Neill more or less favored a strong dollar. While
    the major emphasis of Bush's appointment is to get someone who will
    argue for his tax cuts and other policies, a weaker dollar is also
    the prescription that the Fed (see Bernanke's speech) advocates as
    well. If the administration wanted a strong dollar, they could have
    found someone who believed as much who also would forcefully argue
    for tax cuts.

    My long standing view is that gold is a currency, nothing more or
    less, and thus floats in concert with whatever the relative value of
    any given currency is. Gold has dramatically risen in terms of yen
    as the yen has dropped 50% against the dollar. As the dollar begins
    to drop, we see gold rise. I became a gold bull early this year as I
    predicted the drop in the dollar against the euro. I suggested the
    dollar and the euro would be at parity at the end of 2002. We are
    now slightly past that point.

    Given the Fed desire for a lower dollar, our trade deficits, a
    business desire for a lower dollar and now even a willingness at
    Treasury for the dollar to decline, it is likely the dollar will
    drop even more against the euro.

    Every time we have approached $320 gold in the past, there has been
    selling on the part of central banks which has knocked it back.
    Today it seems that those sell orders have been lifted. Are central
    banks now gold bugs? Hardly. But they are money managers, and are
    obligated to try and get the best returns for their reserves as

    My guess is they still think of gold as a barbarous relic. They
    still want to sell. But the signals from the Fed, the appointment of
    a man at Treasury who likely will let the dollar drift and the trade
    deficit all suggest to them they can get more for their gold if they
    sell later. They read the charts, and the charts say wait.

    The key for the price of gold, in my opinion, is the price of the
    euro in terms of dollars.

    In a preview of my 2003 forecast, I will give you my likely
    prediction on the euro today: I think the euro and dollar will
    approach the original levels of the euro when it was introduced -
    $1.17 or so. That is another 15-17% from here, and could easily take
    gold to $380.

    Ian McAvity, one of my favorite gold curmudgeons, and chartist par
    excellence, points out that we are now in a very important point in
    the technical charts of gold. If we move up over the current area,
    the next "resistance" is at the $380 level, which not coincidentally
    corresponds to a 15% or so drop in the dollar against the euro. (You
    can get McAvity's gold charts, plus his 24 page 2003 preview, for
    $49 with a four month subscription to his excellent technical
    letter. Email [email protected] for details.)

    I could launch into why the dollar dropping will be harder than it
    looks, why the Fed minutes confirm my opinion that we are in a
    Secular Bear Market and the recent rally is a bear trap, but it's
    time to go home, so I will quit here. I will save a few bullets for
    the 2003 preview. I can confidently predict, however, that sushi and
    sake are in my very near term future.

    Meet Me in Puerto Vallarta, and a Job Opportunity

    I am looking for an editor/writer/researcher/assistant/productivity
    enhancer. Writing and editing skills are important (witness the
    mistakes in this letter), as are intellectual abilities, but whoever
    I hire will be researching and doing a little bit of everything. I
    assume you will have solid technical computer and internet abilities
    and love to work long hours while you are underpaid (just like all
    my staff). This is not glamorous, but will be fun and should be
    interesting. You will need to work out of my office (Fort Worth) and
    therefore live in the Dallas/Fort Worth area. Send me your resume if
    you are interested.

    Next week is a lost cause for personal productivity. I have to go
    back to school in Dallas to study for yet another securities
    license. Two days of cramming on arcane details, one day of
    desperate study and then the test on Thursday. I will get to have
    dinner with David Tice and Marshall Auerbach of the Prudent Bear
    Fund on Monday, so there will be some fun as well. (Boy, have they
    been on a roll!)

    I am going to take a needed week off after Christmas and go to
    Puerto Vallarta, Mexico, with my wife. Besides the all important
    time with my wife (I have promised no business!), I will sit in the
    sun, read books, play golf and contemplate the future. I will then
    come home and write my annual predictions. Maybe a few margaritas
    and long talks with my wife will make the outlook more promising
    than merely Muddle Through. If you are in the area, and want to play
    some golf, I can get a day pass to meet you at the Marina Golf
    Course. Discussing the markets between shots is not a violation of
    the no business zone.

    I love this time of year. We will get all the kids back home for
    Christmas (all seven!), and my wife really knows how to decorate a
    home to make it feel special. I hope you are enjoying the time as
    well, and remember that there is no deflation in the value of time
    spent with family and friends. Even a central bank cannot destroy
    love. They do have limits.

    Your raw fish eating and hot sake drinking analyst,

    John Mauldin
    [email protected]

    Copyright 2002 John Mauldin. All Rights Reserved

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