Monday, November 8, 2010

Why I Do Not (Yet) Believe the FED on QEII

The hoopla over the FED's meeting is now thankfully over, and markets are in a tizzy over what its latest move means.  So far, it appears that they are enthusiastic about the FED's declared aim of trashing the currency by buying $600 billion worth of long term Treasury debt over the next several months and paying for it with freshly printed money.  The DOW had a 200 point day following the announcement, with similar stock rallies around the world.  Hooray for the FED!  The entire world showed just how thankful it was that the FED is willing to destroy America's currency with such carefree abandon.

Most of the finance community hangs on every word of these kinds of events and news stories, at least until the next one comes out at which point 'yesterday's news' is quickly forgotten.  This seems to be the working model of the 'up to the moment' media, for which the newness of news seems to be taken as the principle measure of its importance.  Hordes of reporters and analysts struggle to be the first to think of something clever to say about each little revelation, 'first' taking precedence over 'cleverest.'  Forget about 'depth.'

Kind of like a bunch of high school girls gossiping about one another, if you ask me.

I have learned not to pay too much attention to such announcements, especially the ones coming out of the FED, or to the talking heads trying to one-up eachothers' quips.  I have found that it's a bad idea, more likely to confuse than enlighten.  But before I get to that, let's go through the mental exercise of what this move hypothetically means. 

The main storyline coming out of the FED's announcement is that the FED is going to 'stimulate' the economy through QEII by driving down long term rates to encourage borrowing and investment.  Keynesians, naturally, think this is a splendid idea.  Some free-market types note that this will be at the expense of the integrity of the dollar, which will doubtless lose value as evidenced by rising food, gold, and energy prices, as well as a falling exchange rate.  We few Austrians will argue that these price increases clearly fall at the lower end of the production structure, just as Austrian theory predicts will happen near the end of the business cycle, with broader consumer prices sure to follow.  In addition, we note that interest rates are important economic indicators, and to suppress them is in effect to lie to the market.  Thus the activities spurred by the new lending will prove to be malinvestments in the long run, requiring yet another round of economic souring in the future to straighten out yet more of the same madness that landed us in this mess to begin with.

All true -- and it may just play out exactly as is said in this rather straightforward analysis.  In the longer term, that scenario is almost certainly correct.  But there's a fair span of time between now and then, and plenty of reason to believe that this is not exactly what the FED intends to do.  After almost a century of deception and monetary disaster, you'd think at least a few people would stop to ask a very simple question -- what if the FED is lying?  Or at least, was intent on doing just what it said, but failed to mention other activities whose purpose was to negate the price inflationary effects that would so obviously result from such a bald-faced debasement of the dollar?

People seem to understand that, despite every politician's protestation to the contrary, those who are elected to political office almost never actually do what they are supposed to --  uphold the Constitution and represent their voters.  Instead, they get to Washington, take the oath of office, and then break that oath and pursue their own interests.  And yet, for some reason, these same people seem to believe that the FED and its bureaucrats are impeccably honest, really do have everyone's best interest at heart, do what they say they are going to do, and actually manage the money supply the way they are 'supposed to.'

Perhaps an example is in order.

Let's play a game.  I'm going to provide you with economic data -- real data, mind you, from the recent economic past -- and let's see if you can guess what happened next.

Here is a graph of several prices -- gold, oil, the SNP 500, the CPI, and the target FEDFUNDS rate -- the price of an overnight loan within the banking system which is controlled by the FED  --

As you can see, commodity prices were rising, inflation was accelerating, and the stock market was stagnant.  What did the FED do?  It pushed the FED Funds Rate down practically to zero!  What do you think happened next?

Well, if one were to listen to today's analysis, one would've expected prices to shoot through the roof.  But the opposite happened --

The trick was that the FED got interest rates down without increasing the money supply.  Basically, it just let the crash happen, all the while announcing that it was 'lowering rates.'  Rates were actually lowering themselves.  It intervened to 'save the banks,' at least the ones it cares about, but as for the rest of us benign neglect seemed to be the order of the day.

My point is that it is easy to listen to the nice government men and get completely taken for a loop.  In general, people, whether assembly line workers or CEOs, politicians or central bankers, make decisions based on their own interests.  The FED is an organization composed mostly of bankers and some politicians tied to the banking community.  On top of that, only the largest, most powerful banks are the ones that own voting interests in the FED.  Smaller banks are not represented.  (Throws a whole new light on 'too big to fail,' doesn't it?) 

It shouldn't surprise anybody that the FED pursues policies that look out for the biggest banks, and not much of anybody else.  Those are the interests of the people making the decisions.  The FED is fine with 'economic growth' while it helps out the banks, but not so much once the later stages of the business cycle come around and price inflation and higher interest rates threaten the value of the banks' debt-based assets.

Now, let's look at the up to the minute data from today --

Here I have the same prices, plus the yield on 1-year and 20-year Treasury debt.  The short end of the curve is pretty much as low as it can go.  What happens when the 20-year gets pushed down?

Theoretically, 'all other things being equal' as they say, if the FED uses an increase in the monetary base to accomplish the suppression of rates, this should stoke price inflation, just as pushing down the FED Funds Rate 'should' have.  Since we are now late in the business cycle, new money will tend to bid up lower order capital goods, like commodities.  If enough inflation is used to push down unemployment, then it will rapidly produce consumer price inflation as well.  If slightly less, the CPI will increase more slowly.  So the prevailing analysis would seem to be more or less correct.

The question is -- are all other things really equal?  I suspect they are not.  The question one needs to ask with respect to the FED is 'What happens to the banks?'  Is it in their interest to pull the inflationary lever?

Will the FED actually increase the money supply? Or will we get rate suppression by other means?

In the long run, I suspect the issue will be forced by politics -- the deficit and unemployed voters.  The banks won't have much choice about it.  But in the meantime, inflation undermines dollar denominated assets -- exactly those assets the banks have spent the last twenty years accumulating and which hard-money people like me have been avoiding like the plague.  Gentle reader, do you really expect the banks to fall on their own swords by having the FED print up all that money, just like that, assuming that they still hold all that debt?

I don't, but on the other hand, we can't really know if the banks still have all that debt on their hands, either.  Maybe they've already pawned it off on others.  If we could see exactly what assets the big banks have on their balance sheets today compared to two years ago, we'd probably know where things were headed.  Or where the banks were directing things, rather.  But since we don't, we can only guess. 

My guess is that it's very difficult to unload trillions of dollars of long-term debt in the span of a couple of years, especially into this market, at anything like a price that would keep a bank solvent.  So, they probably still have a dangerously large fraction of their assets in long-term debt, too dangerous for substantial price inflation just yet.  The banks might like to 'stabilize the dollar' and essentially enslave the rest of the economy under the debt load.  But under present law, people can declare bankruptcy to escape repayment, which isn't exactly what the banks want.  They can't make it too difficult to repay, but they can't let the dollar go the dogs while they're holding dollar denominated assets, either. 

They need to preserve the dollar and to buy the time necessary to get rid of the trash on their balance sheets, before the eventual dollar slump that Washington is almost certain to demand.  A scenario that made it easier to unload long-term debt in the process wouldn't hurt, either.  Hmmmm....

Any ideas?

My guess is that the FED will attempt to buy this enormous load of Treasuries and create an artificial bull market in long term paper, while at the same time discouraging price inflation by limiting the flow of freshly printed money into markets.  Kind of like last time during QEI.  They basically want to print up money for use by the banks, but not for anybody else.  The first task is fairly easy to accomplish, and actually, so is the latter, at least temporarily. 

The FED can discourage new bank lending and therefore money supply growth by raising the rate it pays on reserves.  That is, assuming it even needs to, given the pathetic state of demand these days.  It can keep the monetary base from increasing much just by not buying any more mortgage debt. By simply collecting payments on the debt it already owns, the monetary base will shrink on its own.  If necessary, it can even sell some of these assets, assuming it doesn't have to sell too many.  After all, it will already be pushing down long term rates, boosting the dollar prices of its own assets.

If things start to get hairy, it can ask Congress for the power to issue bonds of its own, which would allow it to pull money out of the markets at will.  I have no doubt that it would get such a power, as it would be for 'fighting inflation.'  Most other central banks already have that power, so it wouldn't be anything new, and the FED pretty much gets whatever power it wants and more from Congress anyway, present rancor notwithstanding.

This would not be much of a change of policy since pretty much all of this is what the FED is already doing.  It has already started buying long term Treasuries, and it has plenty of room in its balance sheet for at least $600 billion more given the rate at which its mortgage holdings seem to be disappearing.  It looks to me like it could easily accommodate this amount and more over the next eight months without much affecting the monetary base, if it so chose.

It looks like a win-win-win situation to me, at least to the parties that matter, which unfortunately don't include you or I.  The FED gets to do a debt switcheroo, relieving itself of sketchy mortgage debt and replacing it with 'quality' Treasuries.  Washington gets to retire upwards of half a trillion of its own debt into the FED's vaults (where it doesn't have to pay any interest!) plus it gets super low rates for long term financing of another giant chunk of debt, of an as yet indeterminate size.  And most importantly, the big banks get further support for their asset prices while they scramble to unload them, short term preservation of the dollar to protect them while they do, and long term escape from bankruptcy proceedings, a.k.a. the consequences of their own actions.  And the FDIC has less of a chance of having to pick up the pieces if any of them fail!  What more could you ask for?  The whole morass of pond scum gets to tell the public 'look, we're doing everything we can to support the economy,' all the while prolonging unemployment and absorbing the available capital to fix their own problems.  And setting the stage for another fantastic correction, further inflationary mayhem, and avoiding the consequences of any of this to their own balance sheets.


It would be very easy for me to sit and bray about how this move by the FED proves that I was right all along to be a stalwart inflationist, what I've been saying all this time is now taking place, the FED is starting to monetize the debt and is going to inflate us to oblivion.  I'd enjoy my few minutes of I-told-you-so, and the deflationists would say that debt levels were still falling and blah blah blah the FED can do what it wants, it can't make people borrow money.  We could all act like the airheads on TV news and shout at eachother until the next big announcement comes out, at which point everybody could start shouting again how this move proves such-and-such right or whatever, and forget about how the exact opposite or some other theory was proved right last week.

But I'm not going to do that.  My point here is that it's not as simple as listening to news reports.  The FED said in 2008 it was supporting markets.  It wasn't.  It said it would roll over the house payments it was collecting to purchase Treasury debt, again in support of markets.  It clearly isn't, because the monetary base isn't rising.  It now says that it is embarking on a 'new' round of asset purchases when it actually started doing so two months ago, as is clearly evident on its balance sheet, and these activities have been mitigated by other activities to keep the monetary base flat, contrary to what is implied by the whole 'quantitative easing' moniker.

The new program implies an inflationary bent, but who really knows?  Every announcement, while 'technically true,' has been a snowjob for other activities which are sometimes completely at odds with stated objectives.  I say, if you really want to know what's happening, pay attention to the numbers and ignore the talking heads.

I suspect the FED is blowing smoke.  It has kept the monetary base flat for a solid year.  It doesn't make sense to me to go critical mass just yet, while there's still a chance to use balance sheet monkeying to help the powers that be to stay that way.  I could be wrong, I have been before and on many occasions, but I'm still looking for another correction. 

You'll know I'm wrong if the monetary base starts climbing and the asset base starts balooning, which you can check here and here.  If the banks already have bunkered down their balance sheets for an inflationary blowoff, this may be the real thing and that is what will happen.  Conversely, if the monetary base is just sitting there and the FED's balance sheet merely changes composition, expect a correction.

And really good deals on gold and silver, too.

Keep an eye on those numbers.  I'll believe the FED is inflating when I actually see it.  And when I do, I'll be buying gold and silver like nobody's business. 

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