The Fed's Managed Deflation

by Michael Nystrom | March 19, 2008

Yesterday's 400+ point gain in the Dow Jones Industrial Average - the second such monstrosity in a week - was a spectacle to behold. Market pundits oohed and aaahed, mesmerized by the action and lauded the Federal Reserve's "decisive action" that "averted crisis" and "restored confidence" to the markets. And indeed, it worked! Confidence was restored! At least for yesterday.

Today is a new day, filled with fear and loathing. With the Dow closing down nearly 300 points, one cannot help but wonder: What happened to all of the excess confidence? Yesterday many market pundits said it "felt like" the bottom. I wonder how it "feels" today, after the Dow - for a second time in a week - has been unable to build on a 400+ point gain, to say nothing of merely holding it. But rather than rely on feelings, let's turn back to our trusty Dow range chart that we've been watching for the past several weeks the way we'd watch a baseball game - with one eye on the lazy action, waiting for something important to happen.



From the above, we can see clearly that in spite of all the fireworks, neither bulls nor bears have made any net progress over the past few weeks, and in fact things don't look bad at all. The Dow's nominal level has been whispering to the casual observer is that everything is fine. In spite of all the market turmoil of late, the Dow appears to have held its ground.

But all is not as it appears. Closer inspection reveals that things are not as they seem. This chart from the latest Elliott Wave Theorist (subscription required) shows that the Dow has been absolutely decimated when measured in real money - gold.

As the nominal Dow has meandered aimlessly, oil and gold, as well as agricultural commodities have soared to towering heights on inflation - the Fed's relentless printing of money. The mystery has been why inflation hasn't helped the Dow out as well? The answer is that it has! It has helped the Dow to tread water. On the back of soaring liquidity, inflation alone has allowed the Dow to maintain the 12,000 mark on a nominal basis, even as the underlying economy crumbles and the housing market deflates. Without that excess inflation, the nominal Dow would have crashed as well, as the above chart demonstrates.

But suddenly it appears that the Fed is concerned about inflation. From yesterday's statement:

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

While it isn't explicitly talking about doing anything, the Fed is telegraphing its concern about too much inflation. This is one of several clues that the Fed's next task will be to tackle the inflation problem. Another clue is that the Fed didn't lower rates the full 100 basis points that the market was expecting. Third, the Fed's myriad new "lending facilities" are addressed at liquidity, and are not inflationary, as this insightful piece shows. If the Fed were to start buying banks' subprime securities outright, that would be inflationary. The banks would have a reload of free money. But this way, the lending facilities are forcing banks to keep ownership of their rotten securities, and allowing them to write them down slowly over time. This is deflationary, but the Fed is attempting to create an orderly deflation.

Why deflate? There is simply too much debt in the system. I don't believe the Fed is stupid enough to believe that it can inflate forever. The dollar is at risk, and the dollar is the source of the Fed's and America's power. If we lose that, all is lost. The Fed's most important task must shift to saving the dollar by presiding over a managed deflation, economy be damned.

And lest you think that Wall Street banks will take their new found borrowings from the Fed's new lending facilities to go out and leverage up and party on like the old days, think again. The Fed has sent a loud and clear message with Sunday's ritual sacrifice of Bear Stearns.

That's right - ritual sacrifice. The Fed could have easily saved Bear if it had just given it access to borrow at the discount window. Investment banks have that access now, but poor Bear couldn't get the cash last week. Instead the Fed let JP Morgan eat Bear for dinner, in a shocking, brutal and bloody ceremony. The Fed even picked up the tab. Like all ritual sacrifices, the choice of the victim was random. It could have been any one of the banks on Wall Street. Confidence was crumbling across the board but it just happened to be that the bank run started at Bear Stearns. The purpose of the ceremony was to scare the crap out of all those watching. It was a display of Fed power both to the world and the rest of the banks on the street. To the world it was a statement that the Fed will protect the system. To the banks, it was a stark warning from the Godfather: "Forget moral hazard. If you f*ck up, you will be left with nothing. Do you understand me? Nothing!" Enough of the funny business that got Bear into trouble - everyone has to clean up their act, lest they too end up like the poor employees of Bear Stearns.

But this is highly deflationary. It means that banks, fearing for their very existence, have to cut back on all the crazy strategies of 100:1 leverage, exotic derivatives, etc. The Fed won't bail them out. But without all that funny leverage, how can markets keep going up? Answer: They can't, and I think today the market realized that. Across the board everything was down: Commodities crater as economic worries take hand

Oil futures lost 4.5% to end at $104.48 a barrel on the New York Mercantile Exchange, its biggest daily loss since 1991. Gold for April delivery, which hit a record high of $1,034 an ounce Monday, plunged $59, or 5.9%, to finish at $945.30 an ounce, its biggest one-day drop since June of 2006. Wheat futures lost 7.7% to trade at $10.74 a bushel.

But surprise, surprise, surprise. The dollar finally had a little rally. Obviously one day does not a trend make. However, if the Fed is serious about restraining inflation, it has a very tight rope to walk. In this super leveraged world, just a tap on the inflation brake could send markets spiraling into a deflationary collapse. The Fed has got a huge challenge on its hands, managing an orderly deflation.

Market watchers take note. If deflation is beginning to spread beyond the housing market, we should start to see it reflected in the Dow soon.