It's "Bubbles" to the Rescue!

In August 2010, Ben Bernanke gave a speech at the annual central bankers conference in Jackson Hole, Wyoming, in which he declared that inflation was too low, and that he intended to fix it. QE2 was born (2nd phase of quantitative easing). He didn't even begin the monetization of debt until November, but that didn't matter. It wasn't necessary, because the mere mention caused stock and commodity markets to surge higher just on the expectation that he would soon begin pumping money into the financial markets through what the Fed calls its "primary dealers" (google search term: "Fed primary dealers" and the link to the NY Fed's list of these institutions will be one of the first links). These "primary dealers" are essentially the too-big-to-fail banks. The list changes from time to time, but it essentially constitutes the 20 or so largest financial institutions in the US, Europe, and Japan.

Mr. Bernanke is convinced that if he just pumps up the stock market enough, he can jump start the U.S. economy. He ignores that this strategy has failed in Japan for 20 years, and that it hasn't done much but jump start the stock market, commodity prices, and inflation since he began QE1 in 2009. This is why John Hilsenrath's WSJ article last Friday was so significant. It was Bernanke message to Wall St that more welfare is on its way via another round of QE -- QE3 (or is it QEinfinity by now?).

Stocks are up another 100 points today, despite that Europe's plans for debt relief have fallen flat in the past week. So why should we care if stocks are higher? Doesn't that give everyone the appearance of prosperity?

Well, are you satisfied with an illusion of prosperity? Is it enough to perpetuate a mirage, rather than the "real deal"?

But there are also unintended consequences to this program of QE.

First, while it was originally intended to artificially suppress interest rates in order to make the cost of purchasing a home, running a business, and paying credit cards cheaper, by buying US government and Fannie/Freddie debt, it has consistently had the OPPOSITE effect on interest rates! Each time the Fed has initiated quantitative easing, interest rates have RISEN instead. Treasury interest rates have been higher the last three days, and are significantly higher since Oct 1st. The bond market has begun to sell off, as investors RUN -- not walk -- that inflation is being stoked by the Fed and they flee for higher-yielding investments.

Second, each round of QE has brought inflation with it also. Remember that Bernanke himself declared that inflation was too LOW mid-2010. In June 2010, a bushel of corn was $3.45. This morning, it was $6.60. It has been rising steadily since Oct 1st. But it's not just corn! Nearly every food and energy commodity has begun rising again in lockstep with Bernanke's announcement last Friday. Metal commodities too! Corn, soybeans, wheat, vegetable oils, milk, gasoline, crude oil, gold, silver, copper, lead, zinc, beef, pork, etc. have all turned higher in virtual lockstep with each other and Bernanke's announcement. This is why I use the nickname "Bubbles" with Mr. Bernanke. He is intentionally creating inflation despite that inflation is already substantially higher over the past two years!

As I read Mauldin's book, on page 21, he makes an interesting observation that escaped even me as a commodity trader:
"Prices for consumer goods went down, while commodity prices went up, sending false signals to central banks. The Fed mainly looks at core inflation, not headline. Consumer goods prices go into core inflation; commodity prices go into headline inflation. When they saw that core inflation was falling, they thought that monetary policy was not too hot, not too cold."

I knew about the difference between core and headline inflation, but hadn't connected the "stuff" versus "necessities" and the connection to commodity prices prior to reading that. Mauldin said it in few words that made that connection for me even more poignantly. Do you understand the significance of that? Consumer goods are peripheral products like iPads, furniture, etc. Material goods! Stuff! But commodities are necessities like food and energy. The Fed ignores the rising cost of food and energy that go into headline inflation -- necessities that we must ALL buy to survive, and only considers the cost of peripherals -- the "stuff" -- that we can all live without. It's worse than that, however, because even with headline inflation, in it calculations, the Fed assumes that if prices rise for one type of food, Americans will simply substitute a cheaper type of food. But doesn't that, by definition, ignore the true cost of inflation?

Now that the Fed has begun to reengage in creating more inflation, just as with QE1 and QE2, higher prices for necessities like food and energy are likely to begin to surge again. I've given several examples in the last paragraph, but here is a chart to illustrate too:

This is the daily chart for one of the primary commodity indexes. It had been falling from late summer into fall after the Fed slowed (but never halted)QE2 this past summer. Now, over the past few weeks, it has begun to rise again. Last week, aft Europe's debt relief plan collapsed, commodities began to dip again and were poised to continue to decline. However, on Friday, when Bubbles Bernanke announced a new round of QE, commodity prices reverse and begun to rise again. As you can see, the past two days (the last two green "candles") have shown this reversal and food and commodity prices are rising again.

Over the past year, manufacturers of food products have been squeezed as their profit margins have fallen. Their input costs -- these commodities -- have steadily risen, while they have tried to hold the line on the prices they charge to the grocery stores. Their input costs in many cases have risen 30%, 50%, even doubling in some cases, while they have only been able to push through modest price increases to US, their customers. In many cases, they reduced the size of the product packages instead of increasing the prices. To the Fed, the smaller package size doesn't count as inflation. Large manufacturers like Proctor and Gamble, because of their market dominance, have had more "pricing power" to impose higher prices. However, small and medium sized manufacturers are feeling even more of a squeeze because they don't have sufficient market size or dominance to absorb the higher costs, to buy in greater bulk, or to force higher prices upon their customers (the grocery stores and US, the consumer). These smaller businesses must eventually either raise prices and risk losing market share, or "eat it" and take a loss, thus risking insolvency, bankruptcy, and layoffs of employees that would only make the economy even worse.

I hope this helps to better understand why the Fed's actions on Friday are potentially so nefarious. They are determined to provide more "welfare for Wall St", while risking much higher food and energy prices for everyone else. But they are determined to do it anyway! Is it worth impoverishing everyday Americans in order to artificially pump up the stock market for Bernanke to create what he calls the "wealth effect". He obviously thinks so!