Category Archives: US Monetary Policy

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 (asset buying) 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.

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.

Flash Point: The Fed Prints

(hat tip Metanoodle)

From the latest FOMC statement:

FOMC Redline Sept

Key points and our interpretation:

  • The Fed will continue its zero interest rate policy (ZIRP) through mid-2015 at least.
  • The Fed will continue and extend “Operation Twist” to the end of the year. This recycles funds and creates no new money.
  • The Fed will buy $40 billion of MBSs per month with no set end. This would appear to require new money since no source of funding was announced.
  • Principal and interest from existing GSE debt and MBSs are currently reinvested. This practice will continue, recycling funds while creating no new money.
  • Total investment will be $85 billion a month so we expect the Fed’s balance sheet to increase by $40 billion per month of unsterilized financing. We will watch to see where the liability goes on its balance sheet.

Flash Point: Liquidity Traps; Lie Traps

In his Jackson Hole speech, (see our posts: The Hole in Jackson Hole, Flash Point: What We Missed the First Time Round), Bernanke reported on the two tools that the Fed has at its disposal and the various implementations and policies that they have used in this crisis. The first set of tools are designed to affect interest rates. The second set of tools are their communication programs used to affect market psychology. We will argue that the first set of tool have resulted in a liquidity trap. We will argue that the second set of tools have created a lie trap.

Flash Point: What We Missed the First Time Around

In The Hole in Jackson Hole we analyzed Bernanke’s Jackson Hole speech. We wish to revisit our key point #6 and this phrase of Bernake’s (marked as 3 parts):

[1] If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, [2] then econometric models can be used to estimate the effects of LSAPs on the economy. [3] Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy.

When we wrote the initial post, our attention had been arrested by the part of Bernanke’s speech marked [1]. That is, his assumption that in the current economic environment, Fed tools (stimulus) are operating as they have historically. As we noted:

 The fallacies in this assumption are the admission that with ZIRP, using tools they have no experience with, and failing to understand that this is a balance sheet as well as a business cycle recession means they have no historical referent to compare to! Their models cannot possibly work.

The implication of our assertion is that as per the part marked [2] above, Fed models cannot be used to estimate the effects of LSAPs on the economy.

What we missed was the importance of the part of his speech marked [3]. This part states that the Fed models show that LSAP programs have had a positive effect on the economy. This positive interpretation feeds back into the first part noted and is used to corroborate the validity of the Fed models (part [2]). In other words, there modes show that LSAPs have a positive effect and because they show a positive effect, the models are valid.

This circular reasoning is another argument for the fallaciousness of the Fed’s assumptions and their blindness to the ineffectiveness of their policies.

Flash Point: The Limits of QE3

The primary tool of the Fed for affecting the economy has been its ability to manipulate interest rates. Lowering them has traditional stimulated the economy promoting recovery. With the current recession, the Fed first lowered short-term rates to effectively zero. When that didn’t work, it tried Large Scale Asset Purchases (LSAP) or quantitative easing (QE). These programs effectively reduced longer term rates with each successive program working further out the yield curve to the 30-year bond. This has not worked. In the process, the term structure of the Fed’s Treasury portfolio has been altered dramatically as this video from Stone McCarthy shows:

Having lost all leverage at the front of the yield curve (short-term rates) it can only play at the back end, the longest-dated maturities. Moreover, we see that the Fed has very little left of shorter-term Treasuries to sell if it wishes to sterilize the purchase of longer-term Treasuries.

But more importantly, a study by UBS via Zero Hedge (The Scary Math Behind The Mechanics Of QE3, And Why Bernanke’s Hands May Be Tied) indicates the Fed doesn’t have much room there left to work.

the Fed owns all but $650 billion of 10-30 year nominal Treasuries.” Also as pointed out above, Twist 2, aka QE 3.5 is already absorbing all of the long end supply. And herein lies the rub. To quote UBS: “Taking out, say, $300 billion in long-end Treasuries almost certainly would put tremendous pressure on liquidity in that market….Ploughing ahead with a large, fixed size QE program could cause liquidity to tank.

This raises The Dilemma of the Impatient Trader. If it attempts an LSAP of long-dated Treasuries, it first of all may not find enough to create the stimulus effect it would like to, and second of all, would wildly distort markets with an unknown but likely disastrous effect.

UBS then goes on to explain why, if the Fed wanted to but mortgage-backed securities (MBS), it is limited to about $40 billion per month:

The alternative of tilting purchases toward MBS implies that the QE program would need to be quite protracted. Monthly supply of conventional 15yr, 30yr and 30yr GNMA has averaged about $85-90 billion over the past year and the Fed is already buying about $25 billion. The Fed might be able to buy another $40 billion without disrupting the market.

The result is that if the Fed wishes to implement a QE3, it has very real limits on the amount of securities it buys and the rate at which it buys them. And operating in markets where it is the largest player will mean the premium the Fed pays as an impatient trader may be huge.

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