Why Analysts are Scratching Their Heads Over QE 3

QE 3.  Open ended.  Fed has arrows in its quiver.  Buy mortgage securities and Treasuries until employment picks up.  Sounds like a plan!

When the Fed buys securities like mortgage securities and Treasuries, it takes its checkbook and creates money out of thin air.  When banks get the deposit, they can create money out of thin air by lending because of our fractional reserve  monetary system.  As it continues, the money supply increases by a multiple amount.

It's pretty clear that this should be the cure for what ails a very sick economy. Or maybe not.

This chart is the monetary base - currency + reserves- i.e. what is referred to as "high powered money." The monetary base is the raw material from which money is created.

 Uh... a lack of raw material does not seem to be the problem!

Maybe the banks are loaded with excess reserves, but interest rates are too high.  Yeah!  That's got to be it.  Let's look at the yield on the constant maturity 10-year U.S. Treasury note:

Hmm...the yield on the 10-year Treasury note started the century over 6% and now is below 2%!

Maybe the problem isn't rates.  Maybe the problem isn't a liquidity problem at all but, instead, is an on-going solvency problem.  Maybe banks have forgotten how to lend if they can't readily sell the loans to be securitized by Wall Street.

Maybe we have gone to the opposite extreme of moral hazard, where bank execs are overly cautious in their lending as they see that some high fliers (not Franklin Raines or James A. Johnson by the way, in case you're wondering) in the housing bubble actually had their lives ruined by greed.

One thing to be clear on is that the Fed, in our fiat money system, will never run out of arrows. Bernanke can literally walk down the street and write $50,000 checks to every homeowner if he wanted (I hope FOMC members aren't reading this; I'd hate to be the one to give them the idea).

Anyway, some analysts will continue to scratch their heads as they look at the charts and some will even wonder how the Fed (whomever is in charge at that point) will reverse Bernanke's actions.

Inflation Expectations Revisited

In this How To Calculate Expected Inflation post from April 2011, I described the process of finding the rate of inflation expected by investors.  At that time, the rate for the 10-year period examined was 2.65%.  This was based on a yield on the 10-year Treasury note of 3.52% and a rate on the 10-year TIP of  0.87%.

Well, yields have changed since then.  Today, going to Bloomberg, etc. as described in the previous post shows that the yield on the 10-year Treasury note is 1.83% and the yield on the 10-year TIP is -.74%. S ubtracting, gives us an inflation expectation of 2.57%.

I have to say that I am surprised that the expectation has dropped slightly, in light of the ongoing printing of money and monetizing the Debt; but I understand there are factors influencing inflation other than money and that a lot of what we have seen is a build-up of excess reserves which still, this late in the recovery, have yet to be lent. 

This inflation expectations number is important to follow because it impacts views on what the Fed can and cannot do, the budget, and yield premiums on longer-term fixed income instruments.

It is, however, in my view, a very narrow reflection of inflation.  In fact, I will go out on a limb and argue that most economists don't really understand inflation.  To many, inflation is measured by the cost of a basket of goods and services over a period of time.  Others take a somewhat broader view and take a measure based on GDP--called the GDP deflator--or focus on Bernanke's favorite--the PCE deflator--reported with Personal Income.

All of these measures, I believe, miss the totality of inflation.  To me, inflation has to itself be put in real terms - specifically into labor units.  If the average labor force participant has to work more hours today than a year ago for a basket of goods, then we have inflation.

Think about this in light of what was reported above from the perspective of the tidal wave of retiring baby boomers.  In April 2011, a retiree who put $1,000 worth of stored up labor (40 hours, say) into a 10-year U.S. Treasury note got to buy $35.20 worth of goods and services.  Today the same $1,000, i.e. 40 hours, based on the 1.83% yield on the Treasury note, can buy $18.30 worth of the basket!  He or she would have to give up approximately twice the number of stored-up labor hours to get the same goods and services!  This is an inflation that is missed and is part of what is killing the economy IMHO. In fact, from a retiree's perspective, looking at money market and CD rates, it borders on hyperinflation!

So, Helicopter Ben continues to write checks out of thin air and baby boomers continue to take on riskier and riskier assets and Helicopter Ben puffs up and proclaims that one mandate - stable inflation - is being met.  What he doesn't get is that when you control prices, i.e. the price of money via the fed funds rate you are going to get inflation in some form.  Right now, it is a form that beats up on retirees and those trying to save for retirement.

I believe his price control policies are wrong and, like 2001 and 2008, in the end we may end up once again walking around like zombies wondering why the economy isn't working -  muttering about bubbles.How to Calculate Expected Inflation

U.S. Central Planning Committee (aka FOMC) Meets Today

Source: audreymarie.edublogs.org

It is circus day in the financial markets.  It is Day 2 of a 2-day Federal Open Market Committee (FOMC) meeting.  The Committee will tell markets if it will do QE 3 and if it will extend low rates out to late 2015.  Bernanke has set it up so that financial markets see him and his committee as the chief price setter of  money in the economy.  This is what central planning committees do.  This is what the ex-Soviet Union did before its control policies imploded the economy.

The Committee will also issue forecasts on the economy.  These forecasts are valuable in the same way you want to know the alcohol imbibed by the driver before you decide to get into a vehicle.  In terms of accuracy, the forecasts are of no value.  You can get better forecasts on where the economy is headed in any bar in Manhattan.  If you want to get a sense of their ineptness, check out their forecasts as the housing crisis unfolded.

In the afternoon, chief price setter Bernanke will play the role of professor and field soft ball questions from the financial press.  They'll ask whether the FOMC takes the developments in Europe into account.  They'll ask whether the FOMC is running out of arrows in its quiver and whether monetary policy can do anything further in light of the precarious fiscal policy position of the Federal government.

His responses will provide fodder to talking heads on CNBC and Bloomberg news as they parse each response.  Most pundits will say that QE3, if it occurs, won't have an impact.  They are talking about the economy.  They are talking about GDP and employment.  The impact is more subtle, and it has been ongoing.  It is pushing harder on retirees and others to take risks in the financial markets they don't understand.  It is creating underlying pressures as price controls always do for a spike in yields.  Along these lines, the financial press would do well to ask Bernanke to trace the likely consequences on investment markets, the housing market, and the Federal deficit if the yield on the 10-year Treasury spikes.

The bottom line is that all of this is pushing the U.S. towards a cliff other than the much bally-hooed "fiscal cliff."  It is like getting sucker-punched when looking the other way.  And when rates rise, Bernanke will follow his predecessor Greenspan, writing a memoir explaining why the debacle wasn't his fault.

The cure for all of this is simple.  Accept the lesson of history - price controls do not work.  Do what Volcker did to bring down the rate of inflation.  Get a good definition of money and have it grow in a range of say 2% to 4% and let the market determine interest rates, i.e. the price of money. 

Sandy Weill and Other Stuff

Yesterday Sandy Weill cleared his conscious and stunned the financial world by saying that he believes we should move back towards Glass-Steagall by separating commercial and investment banking.  This amounts to an admission that the banking supermarket he played a major role in creating was a huge mistake and that it created "too big to fail" behemoths that are harming the economy. Maria Bartiromo went apoplectic as she is wont to do, and politicians were trotted in front of the cameras to proclaim that it was a great idea worth considering.

Unsolicited advice to politicians:  keep your mouths shut.  Every time you open your mouths, you prove that you can't think for yourself.  You show that you are puppets spouting the party line, and you are pushing voters into the camp intending to vote across the board against incumbents.

Wouldn't it be something if Sandy Weill's McNamara moment will get Greenspan to admit that micro-manipulating the price of money via the federal funds rate was a mistake and caused the housing crisis leading to the Great Recession of 2008?  That would get me to go apoplectic.  Greenspan, in the '90s until the end of his tenure, and Bernanke today micro-manipulated this price.  Today it is at zero %, and markets are debating whether the Fed has any means at all to improve the economy.

What tends to be swept under the rug is that the Fed totally botched its mandate of ensuring a stable banking system, completely misunderstood the housing market debacle, and didn't understand the banking sector was in a solvency crisis rather than a liquidity crisis.  Other than that, they did a terrific job.  Banks loaded up on off-balance-sheet toxic debt as the FOMC focused on pontificating on their views of the likely course of the economy.

Speaking of forecasts - this from Ezra Klein in Why not Uncle Ben's Crazy Housing Sale?:

In January 2010, the Fed projected that the economy would grow 4.15% in so12.  By June 2011, it had revised that down to 3.5%.  By April 2012. it was down to 2.65 percent.  And in June, officials lowered expectations once again, saying they expect economic once again, saying they expect economic growth to be a mere 2.15% in 2012. Ouch.

Klein's article is worth reading because it illustrates so well how top analysts and observers fail to understand economic fundamentals.  Here is fundamental number 1, presented in the first week of Econ 101:  manipulating prices distorts resources.  This can be seen in the minimum wage market, rent control market, and even the Nixon price controls.  It is especially true for the price of money via the fed funds rate.

Lowering the fed funds rate to 1% in 2003 led to a moonshot in the housing market.  Resources gushed into housing.  People became mortgage bankers, real estate agents, carpenters, etc.  That's what prices do.  Then the Fed pushed fed funds above 5% - in effect, saying we didn't need all of the resources that had moved into real estate activities.  Think about this.  Today they wonder why it is so hard to get unemployment down.

As you read Klein's article and see that he supports buying mortgages and pushing down the rate on 30-year mortgages (again, affecting the price of money), you'll probably scratch your head.  This is exactly what got us into the present situation.

They say a definition of insanity is doing the same thing over and over and expecting a different result.

How about a different approach:  set a growth rate for M1 or M2 of 3%/year and let the market set interest rates, i.e., set the price of money.  Volcker did this, and it broke the back of spiraling inflationary expectations.

The Weasel and the Fox

Suppose we sent the fox to investigate the weasel digging a hole under the fence to the chicken coop.  It's probably pretty clear to most people that the fox would be hard put to understand the problem and condemn the action.

Substitute the NY Fed (including former NY Fed president Geithner) for the fox, Barclays et al. for the weasel, and the Libor rate for the hen house, and you've got the gist of the Libor rate-fixing scandal and the failure of many to grasp the need to respond to the manipulation.

Here's the news:  the Federal Reserve manipulates the rate at which banks lend reserves in the U.S.  The target rate is determined by the Federal Open Market Committee, chaired by Bernanke, and detailed instructions are forwarded to the trading desk at the New York Fed. The New York Fed then buys and sells securities in the open market to manipulate the rate at the target level.  Push this rate to 1%, like they did in 2003, and you get a parabolic rise in house prices and all kinds of exotic mortgages offering low adjustable rate teaser rates, no doc loans, etc., coming out of the wood work.

The only difference here is that private banks have encroached on what central banks do on an ongoing basis.

This, of course, is likely to keep the Wall Street lawyer community pretty busy- as if they needed further work.  Hopefully it will also focus more attention on how central bank rate manipulation distorts resource allocation as well.

Bernanke starts his two-day Congressional testimony today.  Hopefully some senator will inquire as to when the Fed will start doing its job.

Bernanke Lectures

Interested in how central bankers think?  Here are the 4 lectures given by Federal Reserve Chairman Bernanke to GW students. Although they do take a bit of a time commitment, they are well worth watching IMHO.  The Chairman covers history, the crisis of 2008, the Fed's response, and the aftermath.

If you're like me, they don't provide a lot of confidence in the people flying the plane--if you get my drift.

Bernanke reminds me of a ghost buster who sees a ghost every time the bushes move.  He saw deflation in 2003 and, along with Greenspan, led the Federal Open Market Committee to push the fed funds rate to 1% in the face of a housing market that was already picking up. Why?  Because, as a student of the Great Depression, he arrived at the conclusion that the big mistake in the 1930s was the failure of the Fed to act aggressively in the face of an economic downturn.

He casually deals with criticisms of the Fed for lowering rates but cites weak data that 1% fed funds wasn't a serious cause of the housing bubble.  In this, he fails to mention evidence produced by John Taylor that suggested following the Taylor rule and keeping the rate at 3% and above would have dampened and possibly prevented the 2008 debacle.  The GW students, who on the whole asked some pretty good questions, failed to bring this up.

He also seems genuinely puzzled by the fact that the economy acted so differently to the housing bust compared to the 1987 stock market crash.  It is fact, supported by embarrassing quotes, that Fed officials, primarily Bernanke and Greenspan, were totally befuddled by the whole housing market downturn.  This extended to the Fed's confusing response of providing a liquidity response to what was (and still is!) a solvency problem.

Another puzzling piece to me is how Fed examiners didn't come up with a funny smell in doing their job of examining bank financials, because surely they came across their off-balance sheet holdings. Bernanke admits that the Fed was focused on controlling interest rates rather than ensuring a stable financial system (which is an important part of what Congress gave them a mandate to do!) during this period, but this simply isn't good enough IMHO.

In fairness, Bernanke, et al. deserve kudos for acting swiftly once they confronted the modern-day version of a panic when money market funds faced massive withdrawals.  I'm still not clear where they got the authority to guarantee everything they did, but they probably did prevent another Great Depression.

It is clear from watching the lectures that Bernanke is an excellent teacher.  I, for one, would like to see him go back to Princeton and resume his teaching career.



I'm sitting in the back of the plane until that happens--I hear that's the safest place.

What is the Treasury Yield Curve?

Yields have been pushed to historically low levels by the Federal Reserve, weak economic conditions, China pegging the Yuan, and a "flight-to-quality" as fears of Europe imploding increase.  One of the best ways to view this is with a graph of the Treasury yield curve:

Source: Barron's

The U.S. Treasury Yield Curve is a snapshot at a point in time of the yield-to-maturity of various maturity Treasury issues.  Issues that mature (i.e., pay back principal) in less than 1 year are called "bills," issues that mature between 1 year and 10 years are called "notes," and maturities out past 10 years are called "bonds."  Thus, the yield curve shows the yields on bills, notes, and bonds at a point in time.

As you can see in the graphic, the curve was upward sloping at each of the 3 dates shown.  Compared to a year ago and a month ago, Treasury yields were little changed for bills, (anchored by Federal Reserve policy) but fell sharply for notes and bonds.

Typically, an upward sloping yield curve presages an expanding economy because it is usually associated with an aggressive Fed policy.  Unfortunately, this hasn't been the case recently for the simple reason that, coming out of 2008, we didn't have so much a liquidity problem as a solvency problem.  Historically, liquidity problems have been solved by the Fed increasing the money supply and banks making loans with the resulting excess reserves.  Today, excess reserves are at record levels; but banks are still loaded with bad debts and are only cautiously beginning to lend.

The Treasury Yield Curve is a useful tool for quickly grasping the movement in rates over time.  If you are interested in looking at historical yield curves, go to Living Yield Curve.  Here you'll find periods where the curve was inverted, i.e., the yield on shorter maturities exceeded the rate on longer maturities. These were times when the Fed was following a tight monetary policy and usually resulted in a slower economy.

The Grand Pooh Bah Price Fixing Committee

GRAND POOH BAH

Interest rates are among the most important prices in a credit economy.  Your monthly mortgage payment depends on the mortgage rate.  Your car payment depends on bank loans rates.  Longer-term rates are linked to short-term rates and short-term rates are set by The Grand Pooh Bah Price Fixing Committee, also known as the Federal Open Market Committee.

The Committee meets behind closed doors to set the price of money.  Some details on their deliberations are presented in the form of minutes on a delayed basis.  Yesterday the minutes of their most recent meeting was released, and markets took it on the chin.  Confusion reins.  In their ever-increasing arrogance, the Committee previously announced they would keep rates low to the end of 2014.  Now, with stronger economic data, dissension to that view is increasing.  Are they going to raise the price sooner?  Should we buy a house now or is it OK to hold off?  Is it safe for car dealers to hire sales staff or is the FOMC going to slam it with a 2x4?

One wag on CNBC pointed out that this Committee, that had boasted of transparency, has, in fact, created more uncertainty than ever.

Economics 101 teaches the folly of price fixing.  It emphasizes the distortions that occur over time because of price fixing.  The ex-Soviet Union learned the hard way.  The U.S. is following in its footsteps.

The Fed Transcripts - The Emperor Has No Clothes

"How could I have been so mistaken as to have trusted the experts?"- John F. Kennedy (after the Bay of Pigs fiasco)

More people today are learning what many have known for some time:  the Federal Reserve policymakers are a collection of arrogant clueless elitists.  If it weren't for the fact that their actions cause widespread misery, I would label them as a joke. The latest transcripts will be eye-opening for many.  After all, to the mainstream press, Federal Reserve Governors are viewed as rock stars. And Bernanke is lead singer.
 
Well, the 2006 transcripts have seen the light of day and they are, to put it mildly, embarrassing and highly revealing.  How will people keep from laughing when Congress next asks Bernanke for his view of the economy?  And what about Geithner?  Here's what he had to say before the housing debacle:

"We believe that, absent some large, negative shock to perceptions about employment and earned income, the effects of the expected cooling in housing prices are going to be modest,"

Our present Treasury Secretary obviously had no clue on the relationship between the financial markets and the mortgage market!  Recall that the Fed meets daily, with so-called primary dealers, to discuss markets and that the mandate of the Fed is to ensure a well functioning banking system.

Bernanke got a laugh when he responded,

"Anything to report on co-op prices in Manhattan?"

To keep the joke running, Geithner responded,

"If you see hiring at the New York Fed go up substantially in the market, that will be a good leading indicator of housing prices reverting somewhat," 

Yellen, president of the San Francisco Fed, chipped in on Greenspan handing the Chairmanship to Bernanke with,

"And if I might torture a simile, I would say, Mr. Chairman, that the situation you're handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot,"

The evidence is clear that the Fed had no clue how housing affected the economy, how Wall Street and the housing market were interconnected, and the appropriate policy to enact given the storm about to unfold.  This will be difficult for many to accept because, for many, it is hard to see that the emperor has no clothes.

But it goes beyond this and has more important implications.  The problem is that the Fed caused the crisis, and this is what the foxes inspecting the henhouse are missing in their rock star idolation.  The evidence clearly shows that, if the Fed had not lowered short-term interest rates to 1% in 2003, thereby throwing gasoline on the fire, the ensuing runup in housing prices and subsequent crash would have never occurred.  Forget rating agencies, the slime bags at Countrywide, Fannie Mae, and Freddie Mac, and even the government mandate to issue mortgages to the lower income sector.  They are all scapegoats.  Greed would never have had the chance to go hog wild if the Fed hadn't set the stage by pushing rates to historically unprecedented levels.

To fully grasp this, think about what would happen if the government set the price of gasoline at $1/gallon.  Clearly car dealers would go bonkers.  They would set financing terms at ridiculously low levels, offer car loans extended to 10 years, push gas guzzlers, etc.  The next thing we would see is that grid lock has worsened, pollution has worsened, accident rates have gone up ,etc.  Who would be the culprit here?

What should be done going forward? S hould we let the arrogant blind continue to steer the ship?  There is one more point that is worth making that bears crucially on how the Fed operates.  Almost from day 1 in an introductory economics course, students are taught that controlling prices distorts resources allocation.  Typically this is presented in terms of the minimum wage and rent control.  In both instances, there are well-documented impacts via unemployment and public housing that is boarded up and abandoned in the inner city.  Guess what?  The Fed controls the most important price in the economy by setting the federal funds rate.  This is the price of short-term money.  This determines the rate on adjustable rate mortgages.  This affects the rate on 30-year mortgages and other long term rates.  It even affects the price of goods in international markets via the impact on the value of the dollar.

To put this differently - the Fed snubs its nose at what is taught in introductory economics and, in its arrogance, believes it knows more than the marketplace on what these important prices should be.  The transcripts that have been released (and those that will be forth coming) are clear evidence the emperor has no clothes.

What should it do?  IMHO, the Fed would be better off controlling M1 (up 18% over the 12 months ended in December!) and letting the market determine the appropriate rate of interest, i.e. the price of money.  This, of course, is what former Fed Chairman Volcker did to defeat inflation and put the economy on a long-term growth path in the early 1980s.

Is This Another Great Depression?

John Maynard Keynes

The Dow is down 450 points, the S&P 500 is off 50 points, the 10-year Treasury note yield is close to 2%, and gold is up $31/oz.
 
As a long time observer of markets, I have studied and wondered about how it felt as the 1930s unfolded.  I 'm not claiming to be an expert on the Great Depression like our esteemed Federal Reserve Chairman, Ben Bernanke, but have read widely on the subject.

I find it ironic that Bernanke et al. find Federal Reserve policies  responsible for the duration as well as the magnitude of the 1930s economic downturn when, today, a well-supported argument is emerging pointing to the Greenspan/Bernanke Fed  playing a major role in today's debacle.  To wit:  look at today's inflation report and anemic employment number, both of which have been heavily affected by Fed policy.

It wasn't long ago that even the mention of the possibility of the U.S. entering a 1930s economic downturn was laughable.  The response was always a dimissive "we know too much today" in terms of economic policy to counter economic downturns.  Implication:  we are a lot smarter than they were in the 1930s!

The fact of the matter is that, at this point, just about everything, including the kitchen sink, has been thrown at the economy; and the response has been pitiful.

John Maynard Keynes, in the General Theory of Employment, Interest, and Money, famously painted the capital markets as a type of beauty pagent judging contest where the goal was to  guess which contestants others would think most attractive-thereby breaking down into an onion-peeling type situation.  Today all eyes are on governments.  What policies will they enact next?  What will be the outcome of the next press conference or Jackson Hole speech?  Investors are worrying about how other investors will react to government policies.  These events--in lieu of future earnings and other company and economic fundamentals.

Having said all this, I don't expect a serious double-dip type downturn and don't  believe a 1930s situation is unfolding.  Instead, I see this is as an opportunity with stocks offering exceptional dividend yields and growth prospects for those with a bit longer of an investment horizon.

Still, with politicians driving the bus, it is hard to hold onto confidence.  Be sure to keep your seat belt on!

Scratch Governor Perry - An Embarrassment

Campaign rhetoric can get ugly.  Everybody knows that, and the American public braces itself during campaign season--which, unfortunately, starts earlier each season.  Still, in the running for the ugly trophy, Governor Perry set the bar awfully high  let's hope nobody else gets near it during this campaign season) in remarks about Ben Bernanke, Chairman of  the Federal Reserve.

First he said they would treat Bernanke "...pretty ugly" down in Texas if he prints more money before the election.  Imagine your neighbor saying that to you for not cutting your grass say!  A rational response would be to try to get your neighbor locked up.  The only saving grace is the general public has no idea how monetary policy works and how the Fed prints money.  But still - a threat is a threat.

Secondly, he said it would be almost "treasonous."  What?  The definition of treason covers a gamut of actions, but in this context it has to be taken as political action betraying the country.  On the basis of this definition, they would have to bring in 75% or more of our legislators.  These are the folks who have spent, like drunken sailors, way more than they brought in during the periods when the economy was going gang busters.

I am certainly not a fan of Bernanke or Greenspan, his predecessor; but their actions didn't  put us in the precarious debt crisis we are in today.  Furthermore, it should be absolutely clear that the Chairman is doing everything he can possibly think of to get the country on the right track and put people to work.

I, and many others, believe he is taking the wrong measures; but they are not for the wrong reasons and, who knows, they may work.

Frankly, remarks like Governor Perry's remind me of pre-WWII Germany.  They have no place in America.  The American people should denounce Governor Perry - he is an embarrassment.

The Yin and Yang of Economics

According to Wikipedia, the Asian philosophy of Yin Yang describes how "seemingly contrary forces are interconnected and interdependent in the natural world, and how they give rise to each other in turn." Furthermore, "Many natural dualities—e.g. dark and light, female and male, low and high, cold and hot— are thought of as manifestations of yin and yang (respectively)."

Economics, with its concept of equilibrium, involves similar dualities. The fundamental principle of economics, for example,  is that buyers want low prices and sellers want high prices.  The result is that prices stay in check - unless, of course, you have a Federal Reserve bent on keeping prices low.  Then it will, over time, totally devalue the monetary unit - but that is another story.  It is important, in the context of Yin and Yang, in that it seems that by explicitly seeking stable prices the Federal Reserve, in fact, causes inflation over time. When your grandmother said that the dollar doesn't buy what it used to, it was her way of saying there has been significant inflation.

The two-sided impact is always there but many times ignored or not realized.  An important example of the Yin Yang type of duality in economics involves interest rates.   It is common to laud the Federal Reserve (especially by the Chairman himself) for its policy of lowering interest rates to increase economic activity.  After all, lower interest rates make it easier for business and other economic entities to borrow and thereby increase economic activity.  But there is another effect of lowering interest rates.  It reduces income of people living on fixed income, (mostly retirees, who in fact have a high marginal propensity to consume) and, in fact, produces an incentive to take greater risk in the investment markets. Today, for example, retirees who can't live on the income produced by bank savings accounts or money market funds have put a greater percentage of assets in dividend paying stocks.

The macroeconomic impact of lowering income for investors who seek low risk investments should, it would seem, always be brought into the analysis but especially in demographic situations like the present-- where in the U.S. and other countries there is a significant aging of populations occurring.  To often it's not.  In the end, policy makers sit around after their actions have had their impact and try to figure why employment is stagnant.  Maybe a significant contributing factor is the loss of income from short-term rates being driven to zero.

Every economic policy has a positive and a negative impact.  Every policy has a Yin and Yang.  Both need to be understood, especially in relation to the environment in which they are undertaken.

Got a Question for Bernanke?

On Wednesday, Federal Reserve Chairman Bernanke testifies in front of the House Financial Services Committee. This testimony, which is mandated by law, is entitled "Monetary Policy and the State of the Economy."

If you have a question for the Chairman to be asked by a member of the Committee at the televised event, you can submit it by filling out the form: CLICK TO ENLARGE

Charlie Rose talks to Alan Greenspan

Charlie Rose:  Do you think any of the decisions you made as Chairman of the Federal Reserve contributed to the financial crisis?

Alan Greenspan:  The '08 crisis? The answer is no. And I wrote a long part of a paper for the Brookings Institution (on this).  If anybody wants to take the paper and tell me where I am wrong. I will listen.

Source: Bloomberg Businessweek, June 27 - July 3, 2011

This was the last question in the interview. It should have been the first. It could have been followed up with: "does controlling prices distort resource allocation?"  The answer is yes - this is Econ 101 week 1, typically demonstrated with an analysis of the minimum wage (causes unemployment among the unskilled) and rent control (see any major long-term rent controlled area in any major city to see the impact).

The follow-up question would be "is the fed funds rate a price?" The obvious answer that even a professional obfuscator on the order of Alan Greenspan couldn't get around is "yes; it is, in fact, the most important price in the economy."  The fed funds rate affects the price of short-term money across the spectrum and even the price of long-term money. That's one reason why it is a 3-ring circus day on CNBC whenever there is a meeting of the Federal Open Market Committee. Interest rates are the link between now and the future. As such, they directly affect the price of housing, automobiles, and even every day purchases in a credit economy.

What decision did Greenspan (and Bernanke) make that not only contributed, but in fact caused, the '08 crisis? They pushed the fed funds rate to 1% in 2003 at a time when the housing market as well as the automobile markets were strong and unemployment was at a level we would kill for today.  They saw deflation lurking in the bushes and around corners and in the shadows. The imaginary deflation they perceived led them to pour gasoline on a roaring fire that raged out of control.

The problem isn't just with this particular time frame, although it is vital to understand exactly what happened in '03 that led to '08. The problem is policy-making in general. Artificially controlling prices via policy actions, both fiscal and monetary, distorts resource allocation. By sharply lowering the price of short-term money, Greenspan and Bernanke pushed the labor force into becoming carpenters, construction laborers, mortgage bankers, and, yes, even securitizers of toxic debt. These are the real effects of artificially manipulating the price of money.  Today many of these workers are superfluous given the ensuing collapse, and Bernanke and Obama wring their hands and wonder why unemployment stays stubbornly high. They don't get that you can't turn a carpenter or construction worker into a health care professional all that easily. It's not just a matter of manipulating prices.

This whole idea of how policy has real effects is apparently beyond the understanding of Congress and many in the press, so maybe a straightforward analogy would be instructive. Imagine (if any members of Congress are reading this please inform them that this is merely a thought exercise and is in no way a proposal!) if we convened a committee of smart economists (hopefully not too much of an oxymoron) to set the price of gasoline on the basis of their macroeconomic forecast.  If they saw a weakening economy, they would set the price at $2 gallon or lower. This would get consumers to drive more, take vacations, provide greater spending power, etc.  Alternatively, if the economy is overheating, the price of gasoline can be raised.

Now imagine our committee of smart economists forecast an economy so weak that they push the price of gasoline down to $.50/ gallon.

This basically is what the Greenspan/Bernanke Fed did in '08 with the price of money. For gasoline, driving the price to $ .50/gal. would have all kinds of unintended consequences - from leading to used car dealers pushing lemons, to gridlock on major roads increasing, to pollution levels rising, etc.  In the end, the policy makers a la Greenspan/Bernanke would come up with all kinds of convoluted reasoning why driving the price of gasoline to below market levels didn't cause the observed effects.

It is clear that Greenspan will never admit his role in the '08 crisis. This is understandable. Fed Chairman are not known for small egos. Still, it is critically important for Congress et al., if they are at all interested (and this is a legitimate question) in preventing the ongoing cycle of financial crises, to get a full understanding of the causes of '08.

For those interested in an econometric take on the period, an excellent book is

What is the Federal Funds Rate?

The federal funds rate is the rate banks pay each other for borrowing reserves. The Federal Reserve, the nation's central bank, requires banks to hold reserves against deposits. The Federal Reserve controls the federal funds rate. In effect, it is the price of money that they control.

Understanding the record in controlling this important price is key to understanding the housing crisis and the legacy of former Federal Reserve chairman Greenspan and the role of current chairman Bernanke.

Source: Baltimore Sun

As shown in the graph, the Federal Reserve lowered the rate to the unprecedented level of 1% in mid-2003 and kept it there for a year. Why? The party line was that the Fed was worried about economic weakness. This was after the dot-com meltdown in the stock market and the 9/11 attacks. Inflation had ratcheted down and  deflation was a worry. Looking over their shoulders, Fed governors saw Japan mired in a long-term economic slowdown because they didn't act aggressively  with macro economic policy.

But how weak was housing? The graph shows that single-family housing sales were on the upswing in 2003 as the Fed was aggressively cutting rates! Compare where housing sales were then to today, and think about the Fed and many others wondering why unemployment persists at such a high level.

Of course, all of this is history.  The Fed held the rate at 1% for a year starting in mid-2003 as the housing market went ever skyward!. Exotic mortgages were created. Mortgages were made with no down payment, no income requirements, and even the ability to have the principal increase over time as a payment option. Chairman Greenspan actually encouraged home buyers to use adjustable rate mortgages and take advantage of low teaser rates.

Gasoline was poured on a roaring fire. Bankers packaged and sliced and diced and manipulated ratings to push mortgage-backed structured product around the world. 

Then the Fed pulled the rug out from under the housing market. As shown in the first graph, they pushed the fed funds rate from 1% to above 5%. Again, the rest is history. Housing prices faltered, foreclosures rose, and the securities started to fall in price.

Today the federal funds rate is close to zero and has lost its capability to enable a pick-up in the economy. After all, it can't be pushed into negative territory.  Instead the Fed has come up with a new policy approach - "quantitative easing."  Quantitative easing is essentially an attempt to control the price of longer term money.

Part of the reason for the Chairman's recently instituted press conferences is to convince the American public he knows what he is doing.

Based on the record, I, for one, am not convinced.

Bond Vigilantes-Bernanke Thwarted?

Bernanke wants long term rates to drop. That is the purpose of the much bally-hooed Quantitative Easing II program. The program buys longer-term securities to the tune of $600 billion, pushes their prices higher and yields lower. The lower long-term yields feed into the already historically low mortgage yields, pushing them even lower still, thereby resuscitating the moribund housing market. At least that's 'da plan.

But--in a cloud of dust on the horizon--the infamous bond vigilantes are riding in. They've got a lot of rope and they've got ugliness in mind. They're selling bonds, driving prices down and yields higher.

Part of the problem can be traced back to early 1994, a watershed event in Fed policy. At that time, Greenspan undertook what had been the usual course of monetary policy - he surprised markets. Beforehand, investment bankers were coolly raking in billions with the so-called carry trade. This is simply borrowing at very low rates and lending at higher rates at longer maturities. As long as the Fed plays along, this is a low-risk strategy to keep Wall Street in $3,000 suits and block-long limos. But the Fed didn't play along. It surprised markets by raising rates. Havoc ensued, rates skyrocketed, and a lot of money was lost. Greenspan never liked upsetting investment bankers. Pulling the punch bowl at the party wasn't his style.

Since then, the Fed, at the Federal Open Market Committee meetings, and in public speeches, has played along. Today it carefully announces its intended policy. Before any actions are taken, it makes sure the investment banking world knows exactly what it will do.

The upshot of all of this is that prices react ahead of the action (would somebody please explain this to the Fed Chairman?). What would you do if you were in the market for a big screen TV and Best Buy told you they were raising prices 15% next month?

Today this creates a dilemma. The policy has been announced, rates dropped, and employment has been minimally affected. Now the policy is occurring, but the bond vigilantes are selling; and the outcome is the opposite from that intended. Interest rates are on the rise. It is indeed getting ugly.

QE2 for Dummies

There are a million things wrong in this video, but it is a big hit. The American public is going from total ignorance to being misinformed. The video makes one good point - it does seem that we are in an episode of the twilight zone. I am saying this as one who is totally against quantitative easing and one who believes the Fed has made serious errors.

I would like to make an unusual suggestion-why not require a course in economics in high school?

What Is Quantitative Easing?

Yesterday the Federal Reserve, accompanied by considerable hoopla, announced a $600 billion "quantitative easing" (QE)program. This is actually QEII. After QEI, the stock market moved higher; so understandably some are happy. The job market? Not so much.

To understand QE, it is helpful to review normal Federal Reserve policy. Typically the Fed targets the federal funds rate. This is the rate at which banks lend each other reserves. Banks are required by the Fed to hold reserves versus deposits. The federal funds rate affects other short-term rates. Longer term rates are typically influenced by inflation expectations - not the Fed.

As it has turned out in the current business cycle, the targeting of the fed funds rate is no longer an option for improving the economy because the Fed has pushed it to practically zero, with zero results. In other words, the Fed lowered the rate to practically zero; and we still have unemployment close to 10% with the possibility of further job market deterioration.

QE is a different policy from targeting the fed funds rate. Instead of targeting a short-term interest rate, QE commits a certain amount of money to buy longer maturity bonds. It will impact longer term interest rates. Yesterday the Fed announced a $600 billion QE program.

Here's the thing to get: the Fed creates money out of thin air. Think about this - if you want to buy my house, you have to get the money from somewhere. You have to get it from your savings or borrow it from somewhere. Not so the Fed. It just writes a check. What backs the check? Nothing. It is what is called "fiat money" - money by declaration. Money is literally created out of thin air.

Yesterday I posted a video where people were interviewed asking if Obama was a Keynesian. The responses were pathetic. Some thought the question was about if he was from Kenya. Along the same lines, if you asked people if gold backs the nation's money supply, most would say yes. The American people have no idea how Federal Reserve policy works. This would require an understanding of our basic economic system - something our leaders in education haven't deemed important.

Anyways, when the Fed buys bonds, the check is deposited and, thereby, the amount of money in the economy is increased. Banks can lend the excess reserves created by this transaction, and the amount of money in the economy would go up even more. This is what the Fed is hoping for but hasn't occurred yet.

This process is called "monetizing the debt"." And there is a lot of debt out there. It is the equivalent of running the printing presses to print money.

Why is the Fed buying bonds? After all, they could put money into the economy by buying anything - used cars, for example. They are buying bonds because it is a way to control longer-term interest rates - like the rates on mortgages, for example. They've come to the end of the line on controlling short-term interest rates; now they are after longer-term rates. In other words, they are now controlling the price of short-term money and long-term money.

QE is just another step on Hayek's "Road to Serfdom".

The Wizard Behind the Curtain

Please help me. Does anyone know how long we're going to be in Oz? Is Jackson Hole Wyoming Oz? The Chairman says that the Fed maintaining its balance sheet by purchasing securities involves a lack of “very precise knowledge” of the impact of the buys and the possibility that increasing the Fed’s balance sheet further “could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time."

Here's just one little question that happened to pop into my mind-IF THE PUBLIC'S CONFIDENCE IN THE FED IS ALREADY ZERO, CAN IT DROP FURTHER?

A second possibility, according to Mr. Bernanke, would be to tell markets that the Fed will keep its fed funds target rate low for a “longer period than is currently priced in markets.” Does the Fed know the length of the period that is currently priced in? Do they think that pushing around fed funds futures is the way to go?

What are they smoking in Jackson Hole? Can it be any clearer that the Central Bank is clueless?

Bond holders today have no purchasing power because the Fed has driven short-term rates to zero. In some people's minds, this lack of purchasing power is a problem. In Bernanke's mind, the solution is to inflate the economy and thereby lessen the value of savings even more.

Isn't it time to send Chairman Bernanke back to academia and get some hard money advocates at the Fed? Somebody needs to stand up and proclaim that the printing presses are being shut down and the days of the Greenspan/Bernake Fed controlling the price of money are over.

Is There a Limb Getting Ready to Break?

The investment pros have been wrong along with most everyone else, except maybe for the small investor, in predicting a rise in interest rates. The yield on the 10 year Treasury note has fallen to a 16 month low. Amid the pros continual tsk tsking, the small investor has continued to pile into bond funds. Although this extreme drop in rates could very well be a bubble and come back to severely punish the small investor, it has been a very rewarding move up to this point.
In my experience, when these kinds of moves take place, there is the potential for a big accident. Simply, when the pros believe a move in prices is a sure thing (i.e. a drop in bond prices), they bet heavily on it. Unlike you and me (hopefully), they don't just put their money on i-- they borrow to the hilt and put it into the pot. For example, Paulson bet heavily on the housing bubble and won - from a no name hedge fund manager he vaulted to guru du jour. The rest of the banking system made leveraged bets on mortgage backed securities and insuring various instruments - and the American tax payer lost big time. Long-Term Capital Management bet heavily on mean reversion for global spreads and lost--the Fed had to be called in to engineer a bailout.

Very likely there is a trader somewhere - in a hedge fund or in a bank - who has made a heavy leveraged bet on rising rates and who is bathed in sweat night after night praying for rates to rise. The limb is bending mightily. To say the least, if it does occur, the timing couldn't be worse. The Fed is out of ammunition, basically proclaiming this past week that the printing presses are going to remain wide open.

Just some thoughts.