Dual Mandate Quagmire

(Excerpt from this week’s Stock World Weekly)
On Wednesday, February 16, the Federal Reserve Open Market Committee released the minutes of its most recent meeting. The transcript shows that the Federal Reserve is still unconcerned about inflation, in spite of significant evidence to the contrary. In fact, the Fed is so unconcerned about inflation that it needed to mention “inflation” 49 times in its report. The minutes also revealed that the Fed expects the jobless rate to remain “elevated” at the end of 2012, even though it claimed a rising real GDP might slowly reduce unemployment.

Considering the trillions of dollars the Federal Reserve spent continuing its quantitative easing program (the current round being “QE2”), its admission that the jobless rate will remain elevated for the next two years is sobering. The Fed has no means to fix the problem of joblessness, besides trying to stimulate the economy by flooding it with liquidity, or “printing money,” thereby devaluing the Dollar. Devaluing the Dollar is contrary to the Fed’s mandate for price stability. Printing money decreases the value of the Dollar, and makes saving Dollars less desirable. Instead, those Dollars chase assets such as commodities and stocks, driving up their prices. Moreover, quantitative easing has done little to boost employment.

Instead of creating jobs, Federal Reserve Chairman Ben Bernanke’s liquidity tsunami is triggering price inflation in necessities such as food and energy and, as Stock World Weekly has been reporting, fueling the stock market’s “Idiot-Maker Rally.” Whether the Fed calls rising commodity and energy prices “inflation” or not, higher prices are higher prices, and hurt lower income people the most.

“For more than 30 years, the Fed has been tasked with a so- called dual mandate, which outlines two important goals: keep prices stable and maximise U.S. employment… Some critics are sick and tired of the Fed prioritizing job creation at the risk of rising prices. They say the juggling act of promoting economic growth while staving off inflation has proven ineffective, and has led to a policy of too much cheap money with dangerous consequences for the economy.” (Republicans to Fed: Forget about jobs.)

The Fed’s strategy to devalue the Dollar has led to a “backlash among conservatives,” who wish to eliminate the Fed’s mandate to maximise employment. Theoretically, this would allow the Fed to stop pummelling the Dollar, while reining in the price inflation that is wreaking havoc on other countries.

With interest rates at effectively zero, the Fed has no plausible options for addressing unemployment in a stagnating economy. The net result is a situation in which the Fed is committed to continuing quantitative easing, at the expense of the Dollar and its mandate for insuring price stability. It has every motivation to diminish any news that indicates inflation is taking off. Acknowledging inflation would mean the Fed would have to put down its only remaining tool.

Commenting on the Fed’s minutes, Phil wrote, “It all comes back to inflation. The Fed simply doesn’t believe it exists or, if it does, believes it won’t last. It can’t really lose. The Fed can only be wrong this meeting and then do nothing and wait until next meeting and then ‘reevaluate.’ This is how hyperinflation happens, governments don’t want to deal with inflation. They wait and wait until it is so obvious and terrible that drastic action needs to be taken.” (FOMC minutes with Phil’s commentary are in the bonus section at the end of this newsletter.)

Last week, we became more bullish, considering the relentless move up in stocks: “Our market targets, breakout 2 levels, and major breakout levels are providing more bullish fuel to our market thesis.” We pointed out that the U.S. bond markets were reacting to inflationary concerns, resulting in Treasury- bond yields rising and bond prices falling. “With bond yields climbing, rising commodity prices, and rising food prices causing social and political instability, inflation cannot be ignored. It has become a key factor to keep in mind while considering investment and trade ideas.” We noted that the Baltic Dry Index had bottomed around February 4. This week, the Baltic Dry Index continued to rise, while Treasuries, and the Dollar, continued to decline.

We also mentioned several trade ideas such as a bullish call spread on Coke (KO) and our “Breakout defence Part Deux” portfolio. Our bullish positions continue to do well. Coke ended the week at $64.55, putting our bullish spread on KO into the black.

We remain concerned about the effect of QE2 on the value of the Dollar, but as Phil wrote on Saturday, “the Fed’s current permanent open market operations (POMO) schedule runs through May and we’ve gotten very clear indicators that The Bernank is in ‘Damn the torpedoes and full speed ahead” mode.'”

Click on Stock World Weekly for more.  Stock World Weekly archives here. 

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