Subject : The Doom and Gloom Fed - John Mauldin's Weekly...

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
quote:

"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 widespread....in 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: http://www.federalreserve.gov/FOMC/ )
Emphasis is mine.

"....an 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
predictions.)

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
www.johnmauldin.com )

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
possible.

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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