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Fed Crossing the Line?

Interest-Rates / Central Banks Oct 05, 2010 - 12:40 PM GMT

By: Axel_Merk

Interest-Rates

William Poole writes: New York Federal Reserve Bank (Fed) president Bill Dudley’s speech Friday attracted much press attention, as it should have. His speech is correctly read, as in the press commentary, as providing a broad hint of more policy easing to come. During my tenure as president of the St. Louis Fed, I overlapped with Dudley, who, along with being president of the New York Fed, is Vice Chairman of the Federal Open Market Committee (FOMC). I know him to be a competent and cautious policymaker. It is hard for me to believe that he would not have cleared this speech with Chairman Bernanke before presenting.


During the Greenspan era, hints came from Greenspan himself, when he thought appropriate. Greenspan’s hints were less frequent than many remember; indeed, he was widely viewed as talking in riddles much of the time. Policy decisions were made primarily at FOMC meetings, or at least ratified and announced at those meetings. Greenspan, of course, dominated the process, but he always seemed to me to be careful to respect the role of other FOMC members. When I believed the policy course was a mistake, I dissented, as did some others. Although I worked hard to clarify my general policy stance in my speeches, I always tried not to take specific policy positions in advance of FOMC meetings. For one thing, why should I do so if the Committee were about to adjust the federal funds rate in the direction I thought appropriate? For another thing, would I not have misled the market, and damaged my own credibility, if the FOMC went the other direction?

If every FOMC member were to indicate his policy position in advance of each FOMC meeting, the result would be chaotic. It seems to me that Dudley has crossed this line. His logic is clear. Unemployment is too high and inflation too low. Moreover, “…the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. … We have tools that can provide additional stimulus at costs that do not appear to be prohibitive.” It is hard for me to imagine a stronger statement that Dudley will be arguing for the Fed to buy more assets—the policy discussed at some length earlier in his speech. “Unacceptable” is a pretty strong word.

Given this clear declaration, most likely with Chairman Bernanke’s blessing, what happens if Friday’s employment report is quite strong? One of the things I learned repeatedly is that data reports surprise. And sometimes the surprises are large. The bond market will take quite a hit if Friday brings a report of an increase of 200,000 in payroll employment and a decline of several tenths in the unemployment rate. But more than that. What is the hit to market understanding of Fed policy?

A buoyant employment report is not my forecast. I have no reason to depart from the market consensus of roughly no change in payroll employment and in the unemployment rate. However, surprises happen. What policymakers ought to do is to emphasize the conditionality of policy actions. I always argued that the FOMC would review all the information at hand at the time of the meeting and make the best judgment it could based on that information and the skilled staff analysis. That way, I left open the possibility that I would be dealing with a data surprise and I tried to convey to the market how I would react to it. Dudley does cover himself in his concluding remarks. “Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.” Unfortunately, he provides little guidance as to what might lead him to be more confident and this sentence does not undo the strong language earlier in the speech.

Here is another problem with an unconditional policy announcement, which is how I read Dudley’s speech. A strong employment report might well be explained by some anomaly in the data, and therefore not change the economic outlook. But it would seem very strange to the market if the FOMC pressed ahead on asset purchases shortly after a strong employment report. The November FOMC meeting occurs a few days before the October employment report, to be released November 5. Thus, the September employment report will be the most recent one available to the FOMC at its November meeting.

Finally, it is worth pointing out that Chairman Bernanke has misled the market before. In a speech in early December 2008, he indicated that the Fed might engage in large-scale purchases of long-term government bonds. Bond yields dropped sharply in response. When no such program was announced at the FOMC meeting later that month, yields rose and then rose further when no program was announced at the FOMC meeting in late January. Finally, at its March 2009 meeting the FOMC did announce and begin a program of buying Treasury bonds.

Bottom line: Bill Dudley seems to have provided clear policy guidance to the Treasury bond market, but traders should be wary.

P.S. I wrote the above commentary shortly after Dudley’s speech was reported and I had a chance to read the speech. Now, on Monday, I see that Fed staffers are getting into the act. According to press reports, Brian Sack, in a speech in California, reinforced Dudley’s message. In his speech, he made favorable comments about how expansion of the Fed’s Treasury’s portfolio could contribute to economic recovery.

Sack is not an obscure Fed staffer; he is the System Open Market Manager, which is one of the most important Fed staff positions. The Open Market Manager attends all FOMC meetings and makes a substantial presentation on the financial markets at the beginning of every meeting.

I know Brian a bit, and have very high regard for him as a professional economist and Fed staffer. However, is it wise for Fed staffers to join the policy debate fray a few days before an FOMC meeting? I do not think so. I realize that Sack’s speech includes the usual disclaimer that he is speaking for himself but the chorus of voices runs the risk of misleading the market. Sometimes silence is the clearest communication possible.

We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. The Merk Hard Currency Fund can be considered an international fixed income fund with a firm commitment to the short end of the yield curve. To learn more about the Funds, please visit www.merkfunds.com

By Axel Merk

Manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. Axel Merk wrote the book on Sustainable Wealth; order your copy today.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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