Tag Archives: Fed

Reality Check – Five Mainstream Economists Sound a Warning

Here is Gary’s essay, Five Mainstream Economists Sound a Warning. For more by Gary, visit his website at http://www.garynorth.com/.

Gary reviews the situation of the US deficit:

  • the on-budget deficit: a mere $1.2 trillion a year.
  • the real federal deficit, which reflects the unfunded liabilities of the federal government, primarily in Social Security, Medicare, and Medicaid … has a present value of $222 trillion.
  • It cannot, except by one technique, namely, default.
  • The Fed now owns one in six dollars of the national debt
  • The five’s conclusion: The problems are close to being unmanageable now. If we stay on the current path, they will wind up being completely unmanageable, culminating in an unwelcome explosion and crisis.

Gary’s conclusion:

Nothing will change Congress. Nothing will change the executive. There will be no cutback in spending until the numbers force the Great Default. … Americans will not be ready. State and local governments will not be ready. … Will you be ready?

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: 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.

Flash Point: Welcome to Hotel California

Bernanke expressed confidence in his Jackson Hole speech,  Monetary Policy since the Onset of the Crisis, that the Fed can “exit smoothly” when it wants to:

The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.

In The Dilemma of the Impatient Trader, traders wishing to acquire or divest large positions quickly pay a premium for their impatience equal to the spread between average purchase and average sell prices minus the market bid/ask spread. Any exit strategy by the Fed must include the divestiture of their large securities position. This would begin if and when the economy were heating up and needled to be slowed. It might also become necessary if inflation takes off driving interest rates up. These would not necessarily be mutually exclusive scenarios.

From a balance sheet perspective, the cause of the exit is unimportant. What happens is the Fed sells securities to primary dealers (PDs) who pay for them from their excess reserves on deposit. These reserves were created by the Fed’s initial purchases of securities from the PDs. But the PDs are patient traders and the Fed is an impatient trader. The cost to the Fed, as its assets approach zero through sales, is the premium they paid on acquisition plus the premium they pay on sales. This means the PDs have a net balance left equal to this total premium. This is the money given to the PDs for their assistance in implementing Fed policy.

To balance assets and liabilities in true accounting fashion, the Fed’s capital position goes negative and the Fed becomes insolvent. Before this happens, however, by recent arrangement with the Treasury, the Treasury will backstop (bailout) the Fed.

The monetary base is considered the base of the money supply in the economy and is known as money with zero maturity. It is roughly the sum of the reserves on deposit with the Fed plus currency in circulation. Many have argues that if the excess reserves, currently standing at  about $1.5 trillion, enter the economy, large scale inflation will result. The caveat has been that the Fed could unwind its balance sheet. But as we have argued, it can’t entirely. The trading premium incurred will remain as a liability after assets are gone. It will also remain as part of the monetary base and the Fed cannot do anything remotely orthodox to fix this. The result: built in inflation.

So welcome to Hotel California where any central bank can check in but it can’t check out.

Update 20120917

It is always gratifying to get confirmation of our thinking from people much smarter and informed than we are. Today we got this eletter from Bob Eisenbeis, Chief Monetary Economist of Cumberland Advisors: We’ll Know It When We See It! These people understand the Fed, Fed operation and policies, and debt and bond markets as well as anyone and better than most. Bob wrote:

Certainly, the materials provided imply a long period of sustained asset acquisitions and a further substantial increase in the Fed’s balance sheet. This expansion will only exacerbate the Fed’s exit problem, and to the extent that it experiences capital losses on asset sales, those losses will accrue to the taxpayer through reduced remittances to the Treasury, and increase the deficit.

The “capital losses” are what we described as “premium paid” in The Dilemma of the Impatient Trader.

Flash Point: Where Does It End?

We had just finished our latest essay The Hole in Jackson Hole, when we got this article from Bloomberg: Fed Moves Toward Open-Ended Bond Purchases to Satisfy Bernanke. In our essay we presented our arguments that LSAPs (QE) have been ineffective in stimulating the economy. The Bloomberg article, however, suggests some new LSAP will be coming soon (something we agreed with as a result of our analysis of Bernanke’s speech).

LSAPs were introduced to manipulate interest rates because the traditional tool for doing this, the  Effective Federal Funds Rate (EFFR), became ineffective when it reached the zero lower bound. Since the EFFR was designed to manipulate short-term rates and these were effectively at zero, the Fed used LSAPs to affect longer dated maturities, eventually lowering rates across the entire yield curve to the 30-year bond. All have recently touched historic lows.

As we argued, there has been no observable effect of LSAPs on the employment situation. Bloomberg speculates that the Fed will soon introduce an LSAP policy that is open ended. Its goal will not be to acquire a certain class of assets in a specified quantity in a specified period of time as previous LSAPs have done, but to set an economic target for the program rather than an asset target. Jim Rickards suggested they would do this several months ago, targeting a certain level of GDP. Bloomberg suggests they may target a certain level of unemployment – say 7%.

In an economic environment where GDP and employment are in a cyclical downturn one might assume they will return to historic norms. If however, there are structural changes in the economy, this assumption is invalid. In our essay we showed a thirty year downtrend in GDP and employment growth. We argued that this is structural since it it spans four recessions or business cycles.

Bernanke’s bet is the recovery has a cyclical basis. We argue it has a structural basis*. If Bernanke is wrong and sets a policy objective for levels that are no longer relevant due to structural changes, then he will have created an open-ended ticket to money creation at the Fed bounded by a goal that is unattainable. But what is worse, he cannot realize that the failure of his policy is based on a fundamental misreading of the economy. Rather the danger is he will misread the situation as Paul Krugman has done and feel that the problem simply requires more money to be thrown at  it.

*Update: 20120914

We find today, Ambrose Evans-Pritchard arguing in The Telegraph in his essay Era of ‘jobs-targeting’ begins as Fed launches QE3, that the employment situation is due to a structural change. He quotes Bernanke’s concern as:

a grave concern, not only because of the enormous suffering and waste of human talent it entails, but also because high levels of unemployment will wreak structural damage on our economy that could last for many years

Then he quotes Minneapolis Fed chief Narayana Kocherlakota as saying that the lack of jobs skills imply less slack than assumed – known as an upward shift in the “Beveridge Curve”. The problem is “structural”.

In The Hole in Jackson Hole, Figure 4 shows that for the current ‘recovery’, the year-over-year change in GDP is at trend. This we interpret to mean the full recovery has happened and current employment numbers are the ‘new normal’. To support this notion, we note Ambrose’s statement America’s output is now well above its previous peak in late 2007, unlike Japan and most of Europe. If output has fully recovered, there is no room for any significant expansion in employment. Indeed, the larger levels of unemployed – the actual levels, not the official levels – will prove to be a drag on economic expansion as these people will require social service support while remaining unproductive.

The implication then for a QE program that targets a level of employment is that this level will be reached only when sufficient people drop out of the labour force to reduce the numbers and not by job creation. We have  a nagging feeling, not that QE will not be effective since we believe it won’t be, but that it will actually damage the economy at an accelerating rate. We’re thinking about it.

 

The Hole in Jackson Hole

Fed Chairman Ben S. Bernanke gave his annual address at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 31. We review the speech, Monetary Policy since the Onset of the Crisis, and suggest the Chairman has it wrong. As a consequence, the further policy intervention that he is signalling will likely not help the economy but will continue to distort markets making an inevitable market correction more severe. Call it building a Minsky moment.

The Dilemma of the Impatient Trader

In this essay, we want to argue a result of any market that individuals trade in. We recognize that such markets are dynamic or complex adaptive systems and as such we lack the tools to effectively determine quantitative results. We use a very simple case to derive our arguement from but we feel that contained within the simplicity is a kernel of truth. Our argument is that in any market, impatience costs money.

Midnight Musing: Can the US End Up Owning Itself?

We have been pondering the Fed’s control over interest rates, why it is possible and more importantly, what are the limits.

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