Category Archives: Federal Reserve

Why the Fed Is So Wound Up

There is endless talk about the Fed exiting from the QE-induced asset bubble on its balance sheet. We will show what the Fed can and cannot do to unwind its balance sheet. First some background data from its balance sheet in terms of assets and liabilities. The balance sheet is a wonderful tool for understanding what can happen, what can’t happen, and the corner the Fed has painted itself into.

The Fed’s Thinking and Policy Explained in Two Sentences

Our friend JR sent us this quote from the new Fed chairman Janet Yellen on Fed policy:

[You know, a lot of people say, this is just helping rich people. But it's not true.] Our policy is aimed at holding down long-term interest rates, which supports the recovery by encouraging spending. And part of it comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy.

We are struck with admiration – and we sincerely mean this. We had 18 1/2 years of Alan Greenspan and people are still trying to figure out what he said. Eight years of Ben Bernanke gave us a lot of academic theory applied in real-time to the economy without any understanding of the outcome. Then the new Fed chairman, in two sentences, explains in plain, clear English what the Fed has been doing all along. Let’s step through it.

One Bear at a Time

Fresh from finishing Summa: The Great Myth, we came across a Dec. 13 blog entry by Doug Noland, “The Prudent Bear”, titled Q3 2013 Flow of Funds. In reading his blog we came across a section that we reproduce below adding numbering in square brackets and emphasis. We then discuss the errors in his thinking.

Summa: The Great Myth

Listening to an interview of Richard Duncan by David McAlvany we were finally motivated to explore an issue that has nagged at us for quite a while. What disturbs us is that we find ourselves alone in disagreement with the prevalent ‘wisdom’ regarding the Fed’s quantitative easing (QE) policies and their effects on liquidity and markets. This essay will explore our position.

When the Bubbles Come Home to Roost

In arguing that it was impossible for China to “dump” their Treasuries (Who’s Dumping Treasuries?) we made these points:

  1. The total nominal value of their Treasury holdings (The table MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES) were – and remain – greater than the currency in circulation (Table 8 of the H.4.1 statistical release). In other words, there is not enough money to pay them for their Treasuries.
  2. The reason they hold Treasuries is that they held the equivalent amount of USDs that paid them nothing. Selling Treasuries simply gives them back the USDs they didn’t want.

Well it turns out that they now have a need for USDs so in June, the last month for which we have data, they sold some 20 billion of treasuries. We may now expect more sales because global liquidity issues – remember that the USD is the global reserve currency – are rising as foreign currencies are in chaos and many countries are experiencing runs on their pools of foreign reserves, read: Emerging market rout is too big for the Fed to ignore.

Flash Point: ****-For-Brains Bernanke

The place holder “****” may be filled in by you , dear reader, allowing you to accord Ben Bernanke the degree of respect that you think he deserves. Each “*” is the place holder for a string of characters from 0 to n where “n” is an arbitrary number. So some words that would fit these rules are: ‘mush’, ‘good’, ‘genius’, ‘outstanding’, ‘eh?’, and so on. The context for assessing respect may be based on the article in the Irish Times, Bernanke warns banks on excessive risk. In particular, this quote:

In a speech in Chicago, the US Federal Reserve chairman said he was watching for signs that banks were resorting to speculation [i.e. risk] because of low interest rates, highlighting the danger that easy monetary policy could inflate new bubbles in asset prices.

Bernanke, has done two things of note. He has driven interest rates to record lows, farther out the yield curve than any of his predecessors. In fact, real interest rates (adjusted for inflation) are negative for short term maturities and close to zero for longer term maturities. This has forced investors, whether they be banks, retail investors or institutions, to buy riskier assets and equities to try and create some positive return on their money.

The second thing that Bernanke has done is flood the market with liquidity, much more than the market could digest since most of it remains locked up in bank reserve accounts at the Fed. Some of this liquidity is undoubtedly driving the stock market to record highs, a fact confirmed by the market’s divergence from economic fundamentals.

In other words, Bernanke has destroyed savers and forced investors of all stripes to chase risk to try and get some return on their money. This guy has the unmitigated gall – we’ve not used this term before, but the alternative is a string of epithets – to create a situation and then blame the logical outcome on the very people whom he has forced his policies upon. Bernanke is blowing bubble after bubble – bonds, stocks – and he can’t even see it. This guy has “***”-for-brains.

Flash Point: Think! Please!

The $1 trillion dollar platinum coin (hereafter referred to as the 1T) has been burning up the media bandwidth of people who are either unable or unwilling to think deeper than their last tweet. Unfortunately, the 1T is a non-starter – or should be. We would love to see the government attempt it as it would be so entertaining. We confess we have ignored most of the discussion, but have caught a few points and comment herein.

Flash Point: Fed Math

Bloomberg has printed a summary of today’s FOMC meeting: Fed Expands Asset Buying, Links Rates to Joblessness, Prices. We will preempt the usual misinterpretations of a summary of the now and future position of the Fed’s balance sheet.

Flash Point: The Fed is Dead!

We have written extensively on the Fed’s broken interest rate policies which along with propaganda (the use of  communications such as FOMC minutes and members’ speeches,  to influence investors and markets), are the main tools the Fed has to affect the economy. In short, lower interest rates encourage borrowing which stimulates the economy through added consumption (spending) and business investment. This traditional tool of using the Federal Funds Rate to control short term borrowing costs, broke in 2009 when effectively the zero rate lower bound was reached (ZIRP).

Unable to stimulate spending by this means, the Fed began a series of quantitative easing (QE) measures to bring down interest rates right across the yield curve to the 30-year long bond. The latest, dubbed QE3, was supposed to increase the downward pressure on long-term rates giving investors money to buy stocks, stimulating company investment.

In an article today titled QE Backfires as Dividend Quest Usurps Growth: Cutting Research, Bloomberg explains how this is not working as planned. Instead of increasing their debt load to invest in high-risk stocks with no return, investors are choosing to invest in the stocks of low-risk blue-chip stocks that pay a dividend and that by buying back their stock, raise the price giving investors a capital gain.

In driving real interest rates negative at the short end of the curve and well below 1-2% at the long end of the curve, the Fed has forced investors into equities to get some minimal positive return. It’s just that the investors didn’t quite go where the Fed wanted them to in terms of equities.

So QE has reached the end of its effectiveness leaving the Fed with what? The only question now is whether any further flatulent announcements and policy proposals are the product of a bad case of monetary overindulgent indigestion or the emissions of a rotting corpse. The Fed is not smart enough to realize that the problem is that of a debt cycle and not a business cycle. The consumer on the other hand, once again demonstrates wisdom as he manages his wealth.

Flash Point: You’ve got to ask yourself one question: “Do I feel wealthy?” Well do ya, punk?

In a recent Zero Hedge clip, our attention was caught by this part of a recent Bernanke interview (The Punchline In His Own Words: Bernanke Advocates Blowing Asset Bubbles As The Antidote To Depression):

There are a number of different channels — mortgage rates, I mentioned other interest rates, corporate bond rates, but also the prices of various assets, like, for example, the prices of homes. To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more — more disposed to spend. If house prices are rising, people may be more willing to buy homes because they think that they’ll, you know, make a better return on that purchase. So house prices is one vehicle.

 The part of this phrase we emphasized seems to be the basis for current Fed policy. It also contains a kernel of insight into why the Fed is so dangerous and why its policies no longer work.

Why do they want the consumer to spend? To stimulate the economy. The ‘economy’ is the great abstraction that the Fed thinks in terms of. But they have it all backwards! Their focus is on the ‘economy’ and what they can do to it to shape it into a form they want. The problem is that the economy is an emergent phenomenon, the result of the collective financial interactions of all the individuals, corporations and organizations that participate in it. And the Fed has little direct influence or control over these participants.

The great fear of central planners is that natural systems such as economies and markets, if left to themselves, will self-destruct or at least be subject to cyclical downturns that cause distress to some participants. A frequent argument for their interventions is the allegory of the “Tragedy of the Commons”. The fallacy in this thinking we discussed in Negative Feedback, the Tragedy of the Commons, and Complex Systems. Complex systems do not respond in the long run either well or predictably to centralized planning and control.

The Fed Is Wrong

If we were to use the analogy of the Tragedy of the Commons, the Fed would be the town council urging everyone to buy more cattle to pasture to raise the aggregate income of the community. The consumer would be the farmer who sees progressively less return for the cattle he is already grazing and tries to reduce his herd and his exposure to the debacle in progress.

Since the recession began, we have regularly heard authorities urging policies that would encourage consumer spending. We have concluded in Portrait of the American Consumer, that:

At a ratio of 120% debt/income, the consumer has little room and apparently little inclination to take on more debt. Moreover, with interest rates across the yield curve at historic lows and the fact that consumers are not taking advantage of this suggests that we are at a credit limit.

In Flash Point: How Is the American Consumer Doing?, we noted that:

total household credit market debt is decreasing but this as we see above is entirely due to the decline in mortgage debt. The upturn in non-mortgage debt is troubling. We do not see that the consumer will be in a position to raise GDP significantly any time soon.

We maintain the position that the consumer has reached his credit limit and knows it. This of course renders all Fed stimulus ineffective in the most important segment of the economy. The Fed’s last bullet, the psychological inducement to spend created by the “wealth effect” in the stock market, seems to be giving little traction to the economy at the cost of creating a stock market bubble that must end in at least a violent correction (crash). This is paper wealth and a serious attempt by market participants to crystallize the apparent wealth as real wealth will crash the market.

Addendum 20131024

A short history on Alan Greenspan and bubbles from Mike Shedlock: Clueless Magoo’s Crash Guarantee.

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