Bond Exit Fees?

There is some buzz being created on the idea, apparently floated by the Federal Reserve, of establishing fees to exit bond funds with the purpose being to essentially deflate a potential bond market bubble.

I just watched an incomprehensible presentation on this topic by Rick Santelli on CNBC.

Look, this is a sad state of affairs.  Stupid ideas are the end game of price controls.  In tightly controlling the short term interest rates, the most important price in the economy, the Federal Open Market Committee has created a situation with serious pressures.

Take the most recent embarrassing presentation by Ms. Yellen.  After setting definitive objectives in terms of 2% inflation and 6% unemployment, now the FOMC says it's "noise" when the objectives, so clearly communicated to the financial markets, are exceeded.  What happens if the inflation measure they follow, the PCE deflator, goes above 2%?  It can be considered noise and, actually, the FOMC follows many indicators to assess inflation and unemployment.  Huh?

Ms. Yellen informed us that policy changes would be clearly communicated to financial markets, even in between FOMC meeting, via speeches, etc.  Is there anybody today questioning that Wall Street is running the show?

If she took a truth serum, she would tell us the problem is that the FOMC is worried that all hell will break loose when rate increases start because the market knows interest rates tend to go up and down over a protracted period.  That is, the market will see the first increase as the beginning of a longer term trend of rising rates.

The hope out there is that, if the Committee obfuscates long enough, the economy will jump ahead and stocks continue up so that it offsets the downturn in bond prices.  Good luck.

Volcker stopped the interest rate control approach and set the growth rate of the money supply. Thereby, through considerable pain, he broke the back of a vicious ramping-up of double digit inflation.  Now, thanks to the Greenspan, Bernake, and now Yellen FOMCs that believe they can forecast the economy and control the price of money, we are again backed into a corner and hence considering a stupid idea.  Again, the most likely outcome is that mainstreet will take it on the chin, especially the gray tsunami of baby boomer retirees.

As you follow this, keep in mind the confidently proclaimed 2005/2006 predictions by Greenspan/Bernanke, et al., that real estate markets are local and weren't a macro concern.  Keep in mind that Greenspan, referred to as the "maestro" by many of his FOMC colleagues, recommended that more first-time home buyers should take advantage of adjustable rate mortgages.  We know how that worked out.

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.

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. 

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.

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.

Operation Twist

Bernanke

Just when we thought (and hoped) the Federal Reserve might have shot all its bullets (without hitting the target by the way), it turns out  there are plenty left.  The latest to garner attention, after Chairman Bernanke's mention in his much anticipated Jackson Hole speech, is "operation twist," an action last carried out in 1961 during the Kennedy administration.  It lowered longer term rates back then by .15% and raised shorter-term rates marginally.

Doesn't sound like much, but when employment is stalled at zero net job creation and GDP is anemically bouncing along at 1%, the Fed will try anything.

What is "Operation Twist"?

The Fed's usual modus operandi is to manipulate short-term interest rates by controlling the federal funds rate.  Federal funds are borrowed and lent by banks to meet their reserve requirements.  Banks can also buy or sell Treasury securities to meet reserve requirements, and so the Fed's manipulating of the fed funds rates affects other rates as well.

In fact, typically rates all along the maturity spectrum - the so-called yield curve are affected.


"Operation Twist" seeks to carry out this impact directly by changing the composition, instead of  the size, of the Fed's balance sheet.  The plan is to sell shorter maturity Treasury bills and buy longer-term Treasury notes.

The idea is that longer term yields will drop - specifically the rate on 30-year fixed rate mortgages.

Likely Impacts

Markets anticipate.  On Friday, the yield on the 10-year Treasury dropped to below 2% and the yield on the 2-year Treasury note rose 2 basis points.  Dealers and others want to position themselves ahead of the Fed's move.  This is similar to the carry trade that heats up when the Fed announces it will keep short-term rates low.

Secondly, the Fed will likely find itself loaded up with longer term securities at the lowest point in yields. When the inevitable rise comes, it will have on the books significant underwater positions.

Thirdly, this action, like much the Fed does, ramps up uncertainty.  What can I say to a client who asks if now is a good time to take a mortgage?  Very likely, by the Fed's manipulating longer term yields, 30-year mortgage yields could be lower in the near future.  Market observers believe the policy could be formally announced at the 9/21-22 Federal Open Market Committee meeting.  With the uncertainty, it is better to just sit on the sideline and wait.

Finally, this is another slap in the face to those who live off of fixed income.  The already anemic rates on such things as 3- and 5-year CDs will decline further.  But, hey, it's for the good of the bankers and we all have to sacrifice ( I'm getting ready for Obama's speech on Thursday!).


 

What is Stagflation?

Source: Time

Backstory:  Unemployment stubbornly high.  High percentage of unemployed chronically unemployed.  Official numbers underreport extent of unemployment.  Overall Consumer Price Index (CPI) reported at 0.5% - approximately 6% annual rate.

One of my favorite exercises with my macro econ students is to think about how many "inflation" words we can think of, to define them, and to give instances when they occurred.  There is inflation, deflation, disinflation, hyperinflation, and stagflation.  Stagflation is the one DIY investors are hearing more often today.

Stagflation doesn't often raise its ugly head - thankfully.  To understand stagflation, it is useful to understand that macro economic weakness is generally perceived as a problem in inadequate aggregate (total) demand.  In this view, the problem is corrected by increasing aggregate demand using standard monetary policies ( increase the amount of money in the economy, thereby lowering interest rates) or by fiscal policy (lowering taxes and increasing government spending).

There is a bit of a difficulty in this that we are currently facing.  If the Fed supplies excess reserves to the banking system, but the banks don't lend, then we are in a liquidity trap a la the U.S. in the 1930s and Japan in the 1990s.  The banks aren't lending because they need to recapitalize after their bad lending spree of recent years.  Businesses aren't borrowing because demand uncertainty is rising.

As an aside  I know some readers probably flinched at the mention of the typical fiscal and monetary policies because  they are the exact prescription for the mess the global economy finds itself in today. The problem is that, if you lower taxes and increase government spending to combat economic weakness, you commonsensically need to run surpluses, i.e. reverse the policies when the economy is strong.  This is what politicians do not have the stomach for and their economic advisors wimp out and "swallow the whistle," as we say when referees fail to call a blatant foul.

Anyways, with stagflation, the economy experiences weak aggregate demand and inflation pressures. The problem, then, is that the usual policies (which, in truth, are commonly viewed as the proverbial  free lunch) won't work.  Fiscal policy will only exacerbate inflation, and monetary policy that will lower inflation will ramp up unemployment.  This was the situation in the early 1980s.  Then Fed Chairman Volcker (we should have never let him resign!) cracked inflation expectations by letting short-term rates rise to 20%, and the unemployment rate skyrocketed.  In stark terms, stagflation causes the usual macro economic models to break down.  They fail to provide seemingly easy solutions.

After taking Volcker's medicine, the next 20 years produced exceptional economic growth and low inflation.  As a point of history, Volcker was almost tarred and feathered and run out of D.C. before his medicine took hold.

Since the 1980s, the U.S. economy as well as the global economy have become considerably wealthier; and it is probably true that the wealthier an economy becomes, or people for that matter, the more difficult it is to take corrective medicine when necessary.

Stay tuned.

Former Fed Officials Interviewed

I don't know about others, but when I see these types of interviews, I waffle between cringing and biting at the bit to ask a question. For example, when they say that QE2 was successful because it increased inflation, I want to follow up with the comment that unemployment is still above 9% and consumer confidence is plummeting! How can they say it worked? How can they be rationally talking about more of the same? Are they at all cognizant of the employment picture?
Then they go on and on about Fed forecasts and admit that they have been horrible. Their response "Wall Street forecasts have also been poor." So this is how we make policy? This is the basis of how they jerk around the price of money and create uncertainty in the business sector?
As you watch, ask yourself if they are aware of how bad the employment situation is. Over half of those out of work today have been unemployed for a long time. Furthermore, unemployment benefits are on the verge of being extended for a much longer time. And these former Fed officials talk as if we are in the economic environment of the 1980s.

Source: Wall Street Journal.