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Bernanke Capitulates, Launches De Facto Nominal GDP Target

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The only way the unemployment rate can get back to 6.5% is to close the output gap, which remains extremely wide.

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Bernanke has put himself between a rock and a hard place. He can't come out and say that he wants to reach a nominal GDP number of 19.6 trillion by 2015, or worse, that he needs the growth rate to be 7.0% in order to close the output gap. The bond market would crash. But the market is not stupid. The longer he attempts to hold bond yields below the rate of inflation while at the same time trying to stimulate the inflation that erodes these same coupons, the more worthless they become and the more interest rate risk he generates. It seems at some point Bernanke will be facing a Pyrrhic victory. If he is successful eventually the curve will unwind and the bond market will crash.

At Wednesday's press conference that followed the FOMC decision, Chairman Bernanke was asked a good question by Market News International's Steve Beckner about the Fed's credibility in the context of using the world's reserve currency to monetize the US government deficit (emphasis mine).

Beckner:

With the federal government borrowing roughly one trillion dollars a year and now with the Fed on pace to buy roughly a trillion dollars a year in bonds, are you concerned about a public and possibly global perception that the Fed is accommodating not just growth but accommodating federal borrowing needs, and are you concerned about what this might do to the Fed's credibility and the credibility of US finances in general, and the credibility of the dollar as the world's leading currency?

Bernanke:

You know, we've been increasing our balance sheet now for some time, and we've been very clear that this is a temporary measure. It's a way to provide additional accommodation to an economy which needs support. We've been equally clear that we will normalize the balance sheet that will reduce the size of our holdings whether by letting them run off or by selling assets in the future. So this is, again, only a temporary step. It would be quite a different matter if we were buying these assets and holding them indefinitely. That would be a modernization. We're not doing that. We are very clear about our intentions. And I think up till now, it seems our credibility has been quite good. There is not any sign either of current inflation or of any -- there's no strong evidence that there are any increase in inflation expectations for that matter, looking at financial markets, looking at surveys, looking at economic forecasts and so on. So, this is one of the things that we have to look at. Remember, I talked earlier about the potential costs of a large balance sheet. We want to be sure that there's no misunderstanding, that there's no effect on inflation expectations from the size of our balance sheet. That's one of the things we have to look at, but as to this point, that there really is no evidence that the people are taking it that way.

Mr. Chairman, honestly, I think you are being a little disingenuous.

First, to say the Fed is not engaging in monetization because eventually the securities will run off or because there is no plan to hold them indefinitely is kind of a joke. We not only don't know how long they will hold them, but by my analysis, it is looking like this is going to be going on for a long time. Plus, not only are they printing money to finance the deficit, the Fed remits the coupon earned back to the Treasury. This means the Treasury can effectively borrow money from the Fed at no cost.

Second, to say that there is no evidence of inflation or inflation expectations in the markets is also a joke. The reason there is no actual inflation is because QE isn't working, and if you gauge the bond market's most inflation-sensitive metric for inflation expectations -- the yield curve -- it remains historically very steep. Despite the Fed's attempt to flatten the long end of the curve during Operation Twist, the 10-year/30-year spread is near the highs of its historical range above 100bps and in fact steepened further after the Fed's announcement last week.
No positions in stocks mentioned.
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